By: Udaibir Das
This article originally appeared in the OMFIF on October 8, 2024.
From risk management to catalysts for growth
Following the Asian and 2008 financial crises, financial stability became the bedrock on which modern market-based financial systems were designed to withstand shocks. This shaped how central banks globally managed systemic risks, with many, especially in advanced economies like the Bank of England and Sveriges Riksbank, beginning to publish financial stability reports. As a policy instrument, the FSR reflected a system’s robustness in managing systemic risks and the needed reforms.
Fast-forward to today: 70 central banks across all income levels release reports primarily detailing macroeconomic conditions, systemic risk threats, stress test results and adherence to international standards.
However, adopting an FSR suited for developed financial systems does not cut it for low-income developing countries where the context could not be more different. These countries, with small and shallow financial markets and highly adverse macroeconomic and balance-of-payment conditions are particularly vulnerable to disruptions and drying up of financing, magnifying endogenous structural weaknesses. Reliance on market mechanisms and private sector agents to adjust to such disruptions or respond to a country’s development financing needs is a tall order.
The state of financial systems and their riskiness vastly differs along income lines (Figure 1). Some countries have elevated risk of government debt and banking crises, and most of the countries with a high sovereign-bank nexus – a phenomenon prevalent across all LIDCs – tend to be less ready to manage financial stress and make timely policy interventions.
Figure 1. Readiness and risk
Financial sector risk outlook in the next 12 months by income group (% of countries in sample)
Source: World Bank, Finance and Prosperity Report 2024
Note: Panel A: Assessment of domestic financial sector risks over the next 12 months as identified by World Bank regional staff. The sample includes 50 EMDEs. See the report’s Appendix B for specific countries.
The case for rethinking financial stability
The Covid-19 pandemic and the ensuing crises – rising debt, climate change and developmental failures – have pushed LIDC financial systems to their limits. Over 50 conflicts worldwide, many in Africa, have further weakened financial systems by eroding public confidence, disrupting financial flows, diverting money into nonformal channels and uses, and exacerbating fiscal distress.
OMFIF’s 2023 Absa Africa Financial Markets Index offers a detailed assessment of the financial market vulnerabilities highlighted in the FSRs. It underscores significant disparities in financial market development across the continent. In 2023, South Africa and Mauritius led the index in market transparency, liquidity and regulatory frameworks, with scores exceeding 70. These countries benefit from well-developed financial systems that attract foreign investment. However, countries like Ghana, Nigeria and Kenya lag, struggling with limited capital market depth and weak regulatory environments.
Global economic disruptions, including supply chain shocks and exchange rate volatility, have compounded these local vulnerabilities. These pressures prevent LIDC financial systems from facilitating much-needed investment growth and development financing.
Areas for improvement
Unfortunately, as a policy instrument, many African FSRs mirror templates used in advanced economies, focusing on traditional risks – liquidity, credit and market risks – without addressing the role of finance in long-term growth. These LIDCs require a tailored approach towards financial stability policies, aligned with their local market realities and capacity, which goes beyond systemic risk and prudential management to include fostering long-term and sustainable economic growth. Several key areas are underrepresented in African FSRs, limiting their effectiveness to evaluate the tradeoffs between finance for development and finance as a vehicle for wealth management, unhealthy arbitrage and speculative investment.
For LIDCs, FSRs must sharply and analytically reflect local economic realities and the critical role of finance in growth and development. Recent African FSRs highlight risks such as inflation, fiscal dominance and sovereign debt challenges. But they are unable to offer a clear narrative on how the traditional measures of financial soundness and financial stability are impacting development and growth.
Three actions could help address this shortcoming and provide a more country-specific framework for monitoring the role finance is playing in a country’s development.
First, to improve the effectiveness of FSRs, the financial stability construct should be broadened beyond managing risks to include facilitating investment in development infrastructure that supports economic growth and climate resilience. This reorientation would transform FSRs into strategic instruments that guide policy towards ensuring that financial intermediation and risk-taking foster broad-based societal benefits, rather than exacerbating existing income disparities. By expanding their scope, FSRs could play a crucial role in aligning financial stability with sustainable development goals, particularly in emerging and low-income economies.
Second, African FSRs must prioritise financial inclusion. Large segments of the population in LIDCs remain disconnected from formal financial systems, exacerbating economic fragility. Without access to credit, savings and other financial services, marginalised groups – such as microenterprises and rural communities – are excluded, weakening the broader economy. Expanding financial access would not only bolster economic resilience but also cultivate a more robust middle class, which in turn enhances financial stability. To better demonstrate this impact, FSRs should move beyond descriptive statistics on financial inclusion and incorporate impact indicators that capture the transformative role of finance in these communities.
Third, partnerships and collaboration are critical for building financial resilience. While African economies are deeply interconnected, their financial systems remain fragmented. Most FSRs narrowly focus on domestic risks, often overlooking the potential of regional or continental arrangements – including data sharing, statistics and digitalisation – to enhance the role of finance in driving growth. Incorporating regional risk assessments in African FSRs could not only help manage external shocks but also enable coordinated cross-border responses, boosting investor confidence and attracting long-term investments to the region.
As Jay Shambaugh, undersecretary for international affairs at the US Treasury, noted earlier this year, addressing the challenges of debt and development is a ‘generational challenge’ requiring decisive local and global action.
LIDCs can navigate their need for financing by strengthening the FSR as a policy instrument. The next generation of African FSRs should evolve from narrow systemic and prudential risk management tools into strategic financial policy instruments that prioritise sustainable, long-term economic progress. More robust, realistic and forward-looking FSRs will provide a blueprint for navigating Africa’s complexities, meeting its financing needs, reassuring investors and financiers and ensuring a prosperous future for its economies.
Udaibir Das is a Visiting Professor at the National Council of Applied Economic Research, a Senior Non-Resident Adviser at the Bank of England, a Senior Adviser of the International Forum for Sovereign Wealth Funds, and a Distinguished Fellow at the Observer Research Foundation America.