Convergence of banking sector regulations and its impact on Bank performances and Growth: the case for Algeria, Egypt, Morocco, and Tunisia

International standards and norms on banking regulations have, once again, leaped to the forefront of the policy discussion in developed nations due to the recent crisis in the world’s financial markets. This discussion is far from new, nor does it apply exclusively to the world’s most advanced economies. A sound and well-enforced regulatory regime can help developing nations to channel financial resources more efficiently into investments. For open economies, it can also act as a buffer, an important stability factor in today’s shaky market situation.Against this backdrop, this study examines the impact of banking sector regulations on bank efficiency and economic growth in four Southern Mediterranean countries (referred to collectively as ?South-MED?) ? Algeria, Egypt, Morocco and Tunisia ? while exploring the level of convergence of regulatory practices and efficiency to EU Mediterranean1 standards.In particular, the study first compares the banking sector and its regulations in Algeria, Egypt, Morocco and Tunisia, to international standards using measures on the adequacy of regulatory and supervisory practices. Second, banking efficiency and the level of convergence to best practices are examined using Data Envelopment Analysis (DEA) and complemented by Meta Frontier Analysis and the beta-convergence and sigma-convergence methodologies. Third, the impact of the regulatory environment on the efficiency of banks is investigated using the developed measures of regulatory and supervisory practices. In addition to the regulatory details, the performance analysis also considers the legal and institutional characteristics of the South-MED countries. Fourth, the study explores how compliance with these standards and norms may influence the growth potential of each country.Chapter 1 provides a descriptive analysis of the banking sectors of the South-MED countries covered in the study. Chapter 2 then develops measures of regulatory adequacy in a number of areas and provides comparisons with the EU-MED. Chapter 3 summarises the analysis of efficiency and convergence between the South-MED and EU-MED. Chapter 4 analyses empirically the determinants of the efficiency scores, paying special attention to the regulatory adequacy measures developed. Chapter 5 provides a similar analysis for economic growth. The final chapter concludes and puts forth the main policy recommendations.Chapter 1: Overview of the national banking sectors in North AfricaThis chapter provides a descriptive analysis of the financial systems of the four South- MED countries. The role of the public sector and the changing regulatory and legal framework are assessed qualitatively to highlight the main shortcomings of the banking system. Apart from legal sources and international assessments, the discussion relies on quantitative measures of the banking sector in each country, ranging from structure of banking, details on aggregate balance sheets and indicators of financial soundness.The foregoing analysis reveals several common features of the banking sectors of the Southern Mediterranean countries. In recent years, the authorities of the four surveyed countries have engaged in a variety of reforms to modernise their banking systems. These include restructuring and privatisation of public banks, implementation of prudential regulation and risk management frameworks and enhancing supervisory responsibilities.Morocco and Egypt have improved the availability and sharing of credit information. These reforms have led to a persistent growth of credit to the private sector.The analysis shows that one potential explanation of financial under-development is the heavy presence of the state, either directly in the form of publicly-owned banks or indirectly in the form of public debt in banks’ portfolios. For the latest years for which data are available (2008-09), the market shares of public banks range from a low of one-quarter of total banking assets in Morocco and Tunisia to highs of 67% over 90% Egypt and Algeria, respectively. These ownership structures and the underlying conditions, such as the high returns that government debt earns in Egypt, are likely to crowd out the credit to private enterprises. Indeed, public debt and loans, including loans to public enterprises, account for nearly one-third of the total balance sheets of the Algerian and Egyptian banks, surpassing the share of private credit.Aside from crowding out private credit and constraining financial development, the state’s dominant role in the banking sector appears to have a serious negative impact on credit quality. Indeed, the ratios of non-performing loans to gross loans for the Southern Mediterranean countries are among the highest globally. Owing to the relatively limited role of the state, Morocco is once again an exception, with the lowest NPL ratios among the four countries. Moreover, the four countries have implemented policies to improve the quality of loans, including privatisation improvements in credit information systems, loan repurchase programmes and other plans to clean balance sheets.The persistence of the non-performing assets and underdeveloped financial systems remain leads to questions on the adequacy of the recent regulatory reforms in the banking sector in the four countries covered in this study. As noted above, the prevalence of the publicly-owned banks may be at the root of the problem. However, shortcomings in various legal, regulatory and supervisory frameworks may also matter.Chapter 2: Convergence of banking sectors regulationsThe previous chapter has shown that all the four countries have faced substantial reforms in their financial sectors in recent years. In this chapter, a number of indices are developed in order to assess and track the evolution of the adequacy of banking regulations using publicly available and comparable surveys on banking regulations for a large sample of countries since the early 2000s. To allow comparability across the Mediterranean, the section develops the measures for a total of 11 Mediterranean countries, including five South MED countries (Algeria, Egypt, Israel, Morocco and Tunisia); and six EU-MED countries (Cyprus, Spain, Greece, Italy, Malta and Portugal).The aim of this chapter is to develop quantitative measures of regulatory development that could serve as an indicator in the empirical exercises that follow. Seven distinct regulatory areas are identified for assessing different dimensions of regulatory adequacy. These cover definition of banking, licensing requirements, capital requirements, independence and power of supervisor, presence of safety nets, disclosure and availability of credit information using distinct data sources. Although these provide a broad view of the extent of regulation, several potential areas (i.e. payment and settlement systems, credit guarantee schemes, financial inclusion, etc.) have been excluded due to the unavailability of comparable information sources for the sampled countries.This chapter reviewed the quality and the level of convergence of the regulatory and supervisory structures of the South-MED and EU-MED. The assessment included seven dimensions, including scope of banking, entry obstacles, the stringency of capital requirements, the power and independence of the supervisory authority, incentives provided by the deposit insurance scheme, private monitoring and creditors’ rights and access to information.Despite some improvements, key weaknesses remain in deposit insurance, entry obstacles and credit information. Moreover, some recent issues recent disparities have also become apparent, especially in the stringency of capital requirements, potential for political interference and private monitoring.The deposit insurance index has failed to improve since neither the Egyptian nor Tunisian authorities have put in place an explicit insurance scheme. As discussed previously, implicit schemes may enhance risk-taking through a blanket government guarantee for the leading institutions. Moreover, even in Algeria and Morocco, no effort has been made to align the banks’ incentives by implementing risk-based premiums or co-insurance schemes, which would help internalise some of the costs to the deposit guarantee schemes due to excessive risk-taking.The South-MED countries have implemented a number of reforms to improve the availability and use of credit information by financial institutions. Egypt and, more recently, Morocco have established private credit bureaus in 2006 and 2009, respectively. Nevertheless, the South-North gap has not been narrowed. Algeria and Tunisia continue to rely only on public registries, restrict the borrowers’ right to inspect their credit histories, fail to collect and distribute detailed data, including from non-bank sources, such as retail stores or utility companies. Although the literature provides little guidance, private credit bureaus have an improved access to new technologies and know-how to ensure that information-sharing mechanisms work effectively. The countries in the region should continue to monitor developments and spearhead innovative systems to use the stock of information and infrastructure already set-up by the public systems.Another major issue, the presence of entry obstacles, continues to be a key weakness of the regulatory structures of the region. Although the licensing requirements exhibit similarities on both sides of the Mediterranean, other indicators point at substantial barriers to entry.Government ownership, which is widespread in the region, gives undue advantages to incumbent banks and restricts entry incentives. In Morocco, the government-owned banks represent a declining proportion of total bank activities; in Algeria, Egypt and (to some extent) in Tunisia, the government-ownership persists. Although government ownership may have some beneficial side benefits, the authorities have to ensure that such roles are well-defined and should not be an obstacle to the development of the financial system. The rates of foreign denials are also very high, further supporting the idea of substantial entry barriers and competitive advantages enjoyed by domestic incumbent banks.In addition to these three key weaknesses, the 2007 survey points at three new concerns.The stringencies of capital requirements, which were in line with the EU standards in 2003, have deteriorated according to the latest BRSS survey. There are some exceptions, like Algeria and, to a lesser extent, Tunisia. However, in Egypt and Morocco, the capital requirements and accounting standards have become more flexible and less risk-sensitive. Poor accounting practices have also contributed to an increasing disparity in private monitoring indices.Lastly, political interference has become a significant possibility, potentially undermining supervisory authority and reinforcing the governments’ direct control ? an additional concern on the competitiveness and efficiency of the banking sector. As the eruption of public discontent in Tunisia and Egypt in early 2011 clearly attests, the region’s governments have attempted to maintain (perhaps for far too long) a tight grip on their countries’ political and economic systems. It is exactly such forms of interference that may conflict with the objectives of the financial and competition authorities.Chapter 3: Analysis of efficiency and convergence This part of the study attempts to shed light on these issues by examining the effect of financial reform on the efficiency of the banking sector in 11 countries in the Mediterranean region: Cyprus (CY), Algeria (DZ), Egypt (EG), Spain (ES), Greece (GR), Israel (IL), Italy (IT), Malta (MT), Morocco (MA), Portugal (PT) and Tunisia (TN) over the period 1995-2008. The second part of the analysis aims to contribute to the current debate on fostering integration in the Mediterranean region. Following Casu & Girardone (2010), we use the concepts of ?-convergence and ?-convergence and employ a dynamic panel data analysis to assess the speed at which financial markets are integrating.Our results indicate an improvement in bank efficiency across the region, particularly in the latter part of the sample period. The overall mean efficiency in the region is increasing, driven by technological improvements by the best practice banks. Spanish banks dominate the region both in terms of overall efficiency and of meta-technology ratios. Nonetheless, during the sample period, the average meta-technology ratio for the region is also increasing, thus indicating an ability of banks in all countries to appropriate the best available technology.These results are supported by the estimation of beta-convergence and sigma-convergence. The beta coefficient is always negative and statistically significant, thus indicating that convergence in efficiency scores has occurred across countries in the MED-11 area. Furthermore, results for the sigma-convergence suggest an increase in the speed of convergence as the sigma coefficient is always negative and statistically significant. This indicates that, whereas the technological gap is still wide, it is narrowing at a faster speed.Chapter 4: Impacts of bank regulations on efficiencyThis chapter focuses on a very specific question: Are the banks in the Mediterranean more cost efficient in countries with sounder regulatory and supervisory conditions? The results echo the recent findings in the literature. Certain regulatory aspects, such as disclosure requirements, credit information availability and entry obstacles, are highly important. The presence of an explicit deposit insurance scheme also improves efficiency, drawing attention to the importance of enhancing confidence for depositors. Other findings are less clear and require further investigation. For example, although restrictions on activities lower efficiency, it is possible that they could lead to increased risks.The results of this chapter clearly show that the banks in countries with a sound regulatory structure are significantly more efficient. In particular, the presence of deposit insurance schemes, disclosure standards that facilitate private monitoring and the availability of and access to credit information all enhance the cost efficiencies of banks. The stringency of capital requirements also has a positive impact on bank efficiency, albeit to a less extent. In turn, according to our findings, there is a case for allowing banks to engage in a wider scope of activities and dismantling entry obstacles. Supervisory independence seems to have no impact on cost efficiency, most likely due to the offsetting impact of increased risks arising from concentrated political power.In short, our results support mainly the third pillar of Basel II with weaker support for the capital requirements. The rapid deployment of private credit bureaus, possibly modelled after the regional best-practice as evidenced by Morocco’s brand new system, is also important in enhancing efficiency. However, none of these factors should be treated in a vacuum.Institutional quality, measured here by an aggregation of a number of political and governance related factors, is a substantially important factor. Lastly, macroeconomic stability is also an important contributor to the efficiencies of banks.It should be highlighted that the results of this chapter have assessed the importance of regulatory and supervisory practices for achieving bank efficiency. Other issues should also be considered for making a broad assessment of the suitability and adequacy of certain rules and standards. For example, while certain regulatory conditions may improve banks’ cost efficiencies, they may undermine profits (e.g. systemic stability).Chapter 5: Impacts of bank regulations on growthT his chapter turns to a broader investigation of the economic benefits of regulatory and supervisory practices. The main question is whether banking regulations and practices have an impact on growth. Several channels through which the relationship may operate are considered, including the impact of regulations on cost efficiency, issuance of credit to the private sector and capital market activity. The empirical analysis also controls for the presence of other intermediate channels that are not accounted for.According to our specifications, financial regulations have a relatively limited direct impact on growth. Among the seven regulatory areas considered throughout the paper, only government ownership?a proxy for entry obstacles and market conditions?appears to have a consistent and significant negative impact on growth. Moreover, there is limited evidence that financial development leads to economic development. Although efficiency and stock market turnover appear to increase income per capita growth, private credit appears to have little (and possibly negative) impact.These results show that regulatory factors operate mostly through the financial variables.Based on the results reviewed in this section, the regulatory factors considered in the paper have at best an indirect impact on growth, working their way through financial development.Moreover, lack of corruption has a clear impact on growth, which underlines its importance as a precondition for growth.Several technical shortcomings have to be noted at this stage. First, due to the small sample size considered in the study, panel estimations were not feasible. Second, the similarities between the countries considered might have generated sampling biases, which imply that the results have to be interpreted with care and should be adequately re-assessed before applying to other regions. Third, the similarities between countries also make the task of finding strong indicators more difficult as the cross-country variation is relatively limited. This is indeed one of the main causes for the apparent weaknesses of the instruments for the share of private credit in GDP. Lastly, the regulatory variables are assumed to remain fixed over long periods; although this assumption is unlikely to lead to substantial biases, it creates another source of homogeneity.ConclusionsThis study sheds light on the changing regulatory environments of four south Mediterranean countries: Algeria, Egypt, Morocco and Tunisia. Over the past two decades, all four countries have engaged in financial sector reforms, with varying degrees of depth, engagement and success. Morocco has achieved the most advanced financial system as compared to the three others, eliminating interest rate subsidies and controls; reinforcing the responsibilities and roles of the supervisor; improving the risk-management practices along with the state-of-the-art; successfully implementing of a deposit insurance scheme; and introducing a credit information system that may well serve as a best-practice for other developing financial systems.The other South-MED countries examined in this study have been less successful in implementing key reforms. The banks in all of the three countries have relatively poor asset qualities, as evidenced by high rates of non-performing loans (NPLs). The policies put in place to respond to low asset quality have either led to limited improvement, a decline of credit availability or both. The privatisation efforts have been only partly successful and at times have not led to any change in the market conditions and financial development. In Algeria, the publicly-owned banks continue to dominate the banking sector, accounting for over 90% of total assets. In Egypt, although privatisation efforts have been partly successful, public loans and debt represent a substantial proportion of the portfolios of banks, which hampers financial development and growth opportunities. In Tunisia, a majority of the top three banks remain owned by the state.The comparisons among the EU-MED countries reveal particular shortcomings. Despite some recent improvements, entry obstacles continue to be widespread in all of the South-MED countries, arising from high rates of denied foreign applications and closely linked with a dominant state ownership. Capital requirements are less stringent in the Southern Mediterranean under examination, increasingly so due to the disparities in the risk-sensitivity of the minimum capital requirements. The existing deposit insurance schemes in place, i.e. those in Algeria and Morocco, provide adverse incentives and may increase moral hazard risks. In Egypt and Tunisia, the implicit government guarantees may also aggravate the moral hazard problem. Although private monitoring and disclosure requirements appear in line with the EUMED standards, accounting practices are increasingly poor in the South-MED. Lastly, despite recent improvements, especially in Morocco and Egypt, credit information availability is relatively low within the region.Turning to the cost efficiency analysis, results indicate an overall improvement in efficiency levels for the EU-MED and South-MED in the later stages of the analysis, from 2005 onwards (with the exception of Egypt). For the South-MED, this improvement is particularly remarkable for Moroccan and Algerian banks, but for different reasons. The overall mean efficiency in the region is improving, once more driven by improvements in the best practice.EU-MED banks, in particular the Spanish banks, dominate the region, with average efficiency scores of 80.4% against the region’s average of 63.5%. Spanish banks also exhibit the highest meta-technology ratios and the ratios increase over time. This indicates that Spanish banks consistently improved their performance, and their banking technology became best practice.Nonetheless, during this period of analysis, the average meta-technology ratio is increasing, which indicates an ability of banks in all countries to appropriate the best available technology.These results are supported by the estimation of beta-convergence. The beta coefficient is always negative and statistically significant, thus indicating that convergence in efficiency scores has occurred across countries in the MED-11 area. Furthermore, results for the ?-convergence suggest an increase in the speed of convergence as the ? coefficient is always negative and statistically significant. This indicates that, whereas the technological gap is still wide, the gap is narrowing at a faster speed.When examining the impact of the regulatory and supervisory practices on cost efficiency of banks, the results clearly show that a sound regulatory structure is a forceful contributor to an efficient system. The case of Morocco is revealing in this respect. In particular, deposit insurance schemes, adequate disclosure requirements and credit information availability seem to improve the efficiencies of banks. A broader definition of the banking market by imposing fewer scope restrictions and removing entry obstacles also improves efficiency, albeit less significantly so than the previous factors. The rapid deployment of private credit bureaus, possibly modelled after the regional best-practice as evidenced by Morocco’s brand new system, is also important in enhancing efficiency.Lastly, the pro-growth impact of regulatory adequacy appears to operate mainly though its impact on financial development. The study shows that government ownership in banking is detrimental to growth, even outside the scope of financial development and other financerelated variables. Moreover, more restrictive disclosure and capital requirements as well as less limited scope restrictions have pro-growth impacts by enhancing financial development.It is important to note that the regulatory practices and adequacy factors should not be treated in a vacuum. Institutional quality, measured in the study by a variety of political and governance-related factors, is a substantially important factor in all of the regressions. The control of corruption and the presence of democratic institutions are also important factors, which need to be considered alongside the regulatory conditions.To sum up, the study highlights some of the key shortcomings of the banking regulations of the South-MED countries. It appears that some of the newer standards, such as the Basel II capital requirements, have been conceived with developed nations in mind and may not be appropriate, due to a variety of deficiencies in information-sharing and institutional and disclosure mechanisms. A key aim of the upcoming reforms should be to look for ways to reduce the role of government in the banking sector while ensuring that the regulatory framework and the relevant institutional development adequately respond to the market imperfections.