The African Credit Trap

We put forward a plausible explanation of African financial underdevelopment in the form of a bad credit market equilibrium. Utilising an appropriately modified IO model of banking, we show that the root of the problem could be unchecked moral hazard (strategic loan defaults) or adverse selection (a lack of good projects). We provide empirical evidence from a large panel of African banks which suggests that loan defaults are a major factor inhibiting bank lending when the quality of regulation is poor. We also find that once a threshold level of regulatory quality has been reached, improvements in the default rate or regulatory quality do not matter, providing support for our theoretical predictions.PublishedAllen, F., I. Otchere, and L. W. Senbetm (2010): “African Financial Systems: a Review,” SSRN working paper id 1569613. Andrianova, S., P. Demetriades, and A. Shortland (2008): “Government Ownership of Banks, Institutions and Financial Development,” Journal of Development Economics, 85, 218–52. Arellano, M., and S. Bond (1991): “Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations,” Review of Economic Studies, 58, 277–97. Blundell, R., and S. Bond (1998): “Initial Conditions and Moment Restrictions in Dynamic Panel-Data Models,” Journal of Econometrics, 87, 115–43. Demetriades, P., and S. Law (2006): “Finance, Institutions and Economic Development,” International Journal of Finance and Economics, 11, 245–60. Easterly, W., and R. Levine (1997): “Africa’s Growth Tragedy: Policies and Ethnic Divisions,” The Quarterly Journal of Economics, 112(4), 1203–50. Freixas, X., and J. Rochet (1997): Microeconomics of Banking. MIT Press, Cambridge, Mass. Gries, T., M. Kraft, and D. Meierrieks (2009): “Linkages Between Financial Deepening, Trade Openness and Economic Development: Causality Evidence from Sub-Saharan Africa,” World Development, 37(2), 1849–60. Honohan, P., and T. Beck (2007): Making Finance Work for Africa. The World Bank, Washington, DC. Kaufmann, D., A. Kraay, and M. Mastruzzi (2009): “Governance Matters VIII: Aggregate and Individual Governance Indicators 1996-2008,” The World Bank, Policy Research Working Paper 4978. Milgrom, P. (1987): “Adverse Selection Without Hidden Information,” University of California, Berkeley, Working Paper 8742. Rioja, F., and N. Valev (2004): “Does One Size Fit all?: A Re-examination of the Finance and Growth Relationship,” Journal of Development Economics, 74, 429–47. Salop, S. (1979): “Monopolistic Competition with Outside Goods,” Bell Journal of Economics, 10(1), 141–56. Windmeijer, F. (2005): “A Finite Sample Correction for the Variance of Linear Efficient Two-Step GMM Estimators,” Journal of Econometrics, 126(1), 25–51