Banks and other financial intermediaries can perform an important developmental function, especially in Africa, where alternative sources of finance are limited or nonexistent. By providing firms with essential finance, they help them to take advantage of productive investment opportunities which may not otherwise materialize. By screening loan applicants, they can help to address adverse selection in the credit market and channel funds toward productive uses. By monitoring borrowers, they can contain moral hazard behavior, for example, excessively risky investment activity that could undermine a borrower's ability to repay a loan. Through long-term bank-borrower relationships, well-established banks can address both adverse selection and moral hazard. This not only helps banks to remain solvent but also ensures that bank finance is channeled toward productive and sound investments.
There is a large body of empirical evidence which suggests that the development of banking systems goes hand in hand with economic development (see, e.g., Levine 2004). Although the evidence on causality is mixed (see, e.g., Demetriades and Hussein 1996), there is broad consensus that well-functioning banking systems promote economic growth (Demetriades and Andrianova 2005). It is, therefore, a puzzle that so many countries remain financially underdeveloped. This is particularly true of Sub-Saharan Africa, which remains one of the most financially under-developed regions in the world. A recent study by the World Bank has shown that African banking systems lack depth compared to other regions in the world, but are also excessively liquid (Honohan and Beck 2007). According to the World Bank, banks themselves complain that there is a lack of creditworthy borrowers, while at the same time households and firms find finance to be a major constraint. The evidence presented by the World Bank also suggests that the least developed banking systems are also the most liquid, suggesting that excess liquidity is a common feature of financial under-development.
This article aims to shed light on these features of financial under-development in Africa, utilizing a panel data set comprising the banks operating in the West African Economic and Monetary Union (UEMOA) during 2000-2005. The UEMOA provides a uniform financial system across eight countries; the structure of this system has changed little in the last 15 years. Therefore, we can be sure that the variations in bank behavior we observe within the UEMOA are not because of variations in the nature of public financial institutions which the banks face. This makes feasible the identification of the institutional sources of the variations in bank behavior, which are not correlated with variations in the quality of public financial institutions.
Our data set includes balance sheet information on each bank in the UEMOA, including bank characteristics such as age and ownership type, profitability, and the number of urban and rural branches. We also utilize country-level data on loan defaults, which provides information on the average quality of borrowers; we use this as a proxy for the severity of information problems faced by banks in the credit market. We combine this information with macroeconomic data including institutional quality indices constructed by the World Bank. Our data set enables us to examine the extent to which informational and institutional factors, and interactions between different factors, can explain a bank's loans to assets ratio, which is an inverse measure of bank liquidity. Our data set is also used to examine the microeconomic and macroeconomic determinants of the total volume of assets of an individual bank, which is a good micro-level indicator of overall banking sector development.
Our results suggest that to a large extent financial under development, including excess liquidity and low banking sector development, can be attributed to severe informational problems. …