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February 23, 2019

Wider reforms in finances are a necessity

As the debate on whether or not to adopt interest rate ceiling gains momentum, perhaps it is time to also evaluate whether it will increase effectiveness of the key functions of the banking system in a growing economy. A well functioning financial system needs to perform a few key functions effectively to support the growth of a nation at the desired rate.

One, it needs to optimise the allocation of scarce funds to the most worthy projects. These projects could be defined as critical to the achievement of economic goals in Vision 2030, for instance an annual growth rate of 10 per cent in GDP. As a developing country with high youth unemployment, allocating resources to sectors with high employment potential such as manufacturing and agricultural value-addition is critical. A CBK report in March shows credit allocation to manufacturing and agriculture is 13 per cent and 4.4 per cent respectively. Personal and household on the other hand account for the highest credit allocation at 26.6 per cent followed by trade at 21.6 per cent.

Secondly, it needs to allow savers, borrowers and investors to maximise their return for a given level of risk. The CBK report for 2015 shows the return on equity at 24.3 per cent for the banking sector, which is well above any other industry. Lending rates have remained high, at an average of 17.79 per cent as at end March, while the average deposit rate was 7.17 per cent, showing a total spread of 10.62 per cent, which is significantly above the average of lower and middle income countries of eight per cent. This could imply that the risk for investors is over-rated, with the resulting higher return compared to savers and borrowers.

Thirdly, an effective financial system allows risks to be diversified across a wide pool of families and businesses. The disparity between the formal and informal sector is reflected in the lending rates offered to the two sectors, with the informal sector at a disadvantaged position of high borrowing rates and low savings rates. Credit spreads for the informal sector are well above 15 per cent compared with the 10.62 per cent for the banking sector as a whole.

Finally, it facilitates the transformation of short-term assets into funds that can support longer-term projects. Investments in infrastructure such as roads, railway, housing ports and energy requires long-term funding which is consistent with the long-term nature of the projects. More emphasis may need to shift to capital markets as an alternative source of credit with a wider participation of insurance and the pensions industry.

Creating an effective financial system may therefore require more than fixing interest rates. It will require a wider reform of the financial system including the capital markets, insurance and pensions industry.

Karen Kandie is a financial and risk consultant with First Trident Capital

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