Africa’s banking sector has been growing strongly as new lending models, rising incomes and improved technology help to widen access to finance. Now, risk management systems need to be put in place to deal with the changing threats brought on by financial deepening.

In the 1980s, Africa’s banking sector was dominated by state-owned banks and hamstrung by restrictive regulations, such as interest rate ceilings and credit quotas. Today, financial liberalisation, regulatory reform and globalisation have freed up the sector, helped along by the continent’s robust growth.

The depth and coverage of financial systems – as measured by the ratios of broad money and private sector credit to GDP – have been increasing, albeit from a low base. One study by Oxford University found that the median African country has made marked improvements over the last decade across financial indicators including loan to GDP and deposits-to-GDP ratios. Mobile money has helped, with more than 80 percent of Kenyans making use of such services, while the likes of Kenya’s Equity Bank have shown that inclusive banking models can be commercially sustainable and profitable.

Across Africa, sectors once viewed as too risky are enjoying a rebrand. Mohit Arora, head of agriculture lending at Standard Bank, last year told This is Africa that his bank was bullish on farming, a sector often viewed as too risky for bank lending, especially at the smallholder level.

But with all this growth comes risk, spanning credit threats – such as defaulting loans; operational risk, which covers inadequate or failed internal processes, people or systems; and external shocks. As credit is extended to more people, risks of default can increase, especially once it reaches individuals or enterprises at the lowest incomes where financial literacy may be lower and vulnerability to shocks higher. Examples of operational risk could include fraud, poor governance, contagion effects of crises elsewhere, and crime.

Nigeria, for example, was affected more by the global financial crisis than other African economies, while South Africa is grappling with a deteriorating credit environment and sluggish growth. Banks, governments and regulators now have to find ways to manage all of these emerging threats.

“It is not an exaggeration to say that the only way African banks can grow in a sustainable way is by implementing good corporate governance and risk management procedures and systems,” says Saadia Khairi, vice president of risk management at the International Finance Corporation. The Washington-based lender has been growing its engagement with the African continent markedly, through its ability to mobilise funds and offer loans, equity and guarantees. Ith $5 billion of investment last fiscal year in Africa came as part of a 40-fold increase over the last decade, while the institution’s risk management programme has conducted 129 workshops across 41 countries worldwide. Ms Khairi believes the institution is well placed to support banks and regulators on the African continent.

“Many banks on the continent are unable to properly measure credit, market and operational risks,” says Ms Khairi. “These banks have been building more complex balance sheets with greater assets and liabilities risks. They are entering new markets and sectors, such as infrastructure, agribusiness, retail, housing, and microfinance. They are offering new lending products and instruments and also dealing with technology changes that are affecting all aspects of the financial system. There are data risks and  there is mobile and internet banking. At the same time, banks are operating more and more in a world of greater connectivity with the rest of the global economy. So rapid growth does not necessarily mean sustainable growth, and this is where risk management is  crucial”.

Preparation is everything

Africa has suffered comparatively few banking crises to date – in part due to its insulation from the global financial system. Low credit leverage in most economies, adequate liquidity, mostly little reliance on external funding, and little exposure to toxic financial assets all helped the continent come through the 2008 financial crisis.

Some pockets of fragility continue to exist, though, often relating to political crisis and governance deficiencies. Moreover, Africa’s integration into global financial flows is deepening, meaning future external crises could have a bigger impact that then the 2008 crises.

Financial institutions want to upgrade their risk management capability beyond basic credit processes, and to develop an integrated framework. “African banks are realising that they must invest more in risk management. Governments too are strengthening regulatory frameworks and improving their investment climates to support sustainable growth,” says Ms Khairi.

But are they keeping pace? While many banks have made material progress and formed independent risk management functions, non-performing loans have been on the rise in numerous countries. Back in 2011, the Central Bank of Kenya reported that 95 percent of the country’s banks had formed independent risk management functions to deal with the growing challenges of growth. But last year’s data from the country’s central bank showed that non-performing loans increased 34.4 percent over the year, and the ratio of gross non-performing loans to gross loans rose from 4.5 percent to 5.3 percent.

Banks are again stepping up their efforts. In March 2014, Bank of Africa became the latest institution in Kenya to strengthen its remit, deploying new technologies to help mitigate losses stemming from defaulted loans, allowing it to have a better oversight of customer activities and improving credit application turnaround times. But clearly, more attention is needed by institutions across the board.

Regulators and industry associations are key participants. The continent’s two biggest economies can provide some leadership. South Africa has shown a strong track record in risk management, establishing the South African Banking Risk Information Centre (SABRIC) in 2002 as a wholly owned subsidiary of the Banking Association of South Africa. The initiative is funded by industry, including ABSA, First National Bank, Nedbank and Standard Bank.

More drastically, Nigeria’s banking system has undergone far-reaching changes which other countries could aspire to, especially when trying to deal with malpractice and fraud. Over the 1990s, the Nigerian situation was dire. There was a rapid rise in non-performing credit portfolios, as well as of predatory debtors who would abandon debt obligations in one bank and take out new debts in another. Poor communication between banks meant some of them extended facilities to customers who had significant and un-serviced debts elsewhere. Major regulatory overhauls gave birth to a credit risk management system in which the Nigerian central bank could obtain relevant credit data from all banks, requiring banks to update such data on a monthly basis with penalties for non-compliance.

The country has still proven more vulnerable to contagion effects, though, such as with the flight of foreign portfolio capital after the 2008 financial crisis, which caused the collapse of  a stock market bubble fueled in part by margin lending by banks to equity investors. But here again, the response of the regulator was swift and effective, with the Central Bank of  Nigeria eventually taking control of 10 banks which accounted for one third of banking system assets, and which had suffered large losses on their loan  portfolios. The economy did not come out unscathed but the action was widely viewed as having been effective.

Now, with the early departure of the central bank governor Lamido Sanusi after he blew the whistle on missing oil revenues, there are fears his reform effort could stall or backslide. Yet his legacy, and the example set by his reform effort – and that of Charles Soludo before him – provides something to aspire to.

But systemic institutional changes are no use if banks do not have the right skill sets in place to act on risk management, so human resource development is also crucial. The increasing numbers of highly skilled African diaspora returning from overseas banking posts to work in the domestic financial sector is a welcome trend. Moreover, more young people are enrolling for finance and business degrees on the continent, increasing the skills base further. Add to this a growing effort on the part of some governments to improve financial literacy among the broader population. Arunma Oteh, who heads the Nigerian Securities and Exchange Commission, has been working with the Nollywood industry to create film projects to increase people’s understanding of financial issues.

Holistic understanding

African banking will change a great deal more in the years to come. Most banking systems are still small in both absolute and relative size, characterised by low loan-to-deposit ratios and therefore large shares of  assets held in the form of government securities and liquid assets. Lending is predominantly short-term, with about 60 percent of loans having a maturity of less than one year. Financial institutions are on their guard as all of these fundamentals start to shift, country by country, bringing new problems.

The big regional banks face a testing transition. Togo-based Ecobank has the broadest footprint in the region, with a presence in 33 countries. South African and Nigerian groups have also expanded aggressively, including Standard Bank and United Bank for Africa. Collectively, with the Bank of  Africa group, which operates in 11 sub-Saharan African countries, these four are managing more than 30 percent of  deposits in 13 countries in the region. Analysts have noted important supervisory weaknesses in the areas of consolidated banking supervision and of coordination between home and host supervisors, making this a key area to watch.

Ultimately, each country and sector has its own unique risk profile and generalisations are perilous. Even regional lenders have to ensure they understand the details of each of their local markets. Data-related crime, for instance, may be a far larger risk in better developed economies.

The most robust approaches to risk management will be holistic ones, claims Ms Khairi. “We have learned that we must focus on all aspects of sound risk management including corporate governance, credit risk, non-performing loan management, market risk, liquidity risk, operational risk, asset liability management, and capital adequacy. A lesson from the 2008 global financial crisis is that all these risk areas are interconnected, and one type of risk can often transform into another.”

This article is published ahead of an event collaboration between This is Africa and the International Finance Corporation. The African Risk Management Banking Forum will be held on 19th-20th March in Cape Town, South Africa. This article was written solely by This is Africa and does not represent the views of the IFC.