As world financial markets edge slowly into recovery, North African banks are also looking to the economic upturn and the prospect of new growth in business. Many are starting out from a much stronger position than counterparts across the Mediterranean in Europe.

Banking reform is a major issue for the region, although the challenges vary from country to country

Focused on local demand and funded mainly from domestic deposits, they were spared the traumas of the global liquidity squeeze and the worldwide collapse of confidence in speculative investment products.

The crisis which had a severe impact on Gulf economies such as Dubai and Kuwait was barely felt in North Africa.

High reserve funds in Algeria and Libya

The weakening of oil prices ate into Algeria’s and Libya’s export earnings, but both countries already had substantial funds in reserve, so the softening of hydrocarbon revenues had limited impact on the internal economy.

Tunisia and Morocco, more reliant on tourism and the flow of remittance payments from Europe, along with revenues from export sales to the EU, did feel the cool breath of the recession. But the impact on their domestic financial markets was also limited. Their banks, having already acted to curb bad loans, were well positioned to cope with any limited side effects on domestic credit risk.

To this end, banks across North Africa have been operating in a comfortable and well-cushioned context. For national governments, reform of the sector has been a long-term strategic question rather than a response to the crisis.

Banking reform has long been a major issue for the region, although the challenges vary from country to country. In broad terms, the priority for Morocco and Tunisia has been to strengthen the core financial and risk position of their sectors that operate on Western-style commercial lines. This began years ago, long before the global crash.

 “The biggest challenge was to improve asset quality,” says Mohamed Damak, senior banking analyst for the Middle East at Standard & Poors. “The majority of the banking systems in North Africa, particularly in Tunisia and Morocco, were initially used by the authorities as a means of building up the local economy and financing those sectors that were judged to be strategic at that time. Coupled with risk management standards and practices that were below international standards, this created a structural weakness in the quality of the assets held by banks operating in this environment.”

The reform effort has been under way since 2003, notably in Morocco – with a consolidation of the banking system – and also in Tunisia, where the process of cleaning up the banking system is still underway. These changes were also accompanied by an improvement in risk management techniques and a business focus on less risky areas of activity, such as loans to individuals and mortgages.

By contrast, the questions facing Algeria and Libya have been more fundamental: how to move from a banking system shaped strongly by state socialist economics to one that is more competitive and service-oriented, particularly in providing credit for the private sector and smaller businesses whose growth is vital to create the jobs their fast-growing populations need.

Industry observers generally rate Morocco as the reform leader, and when the crisis hit global markets its banks had little exposure to toxic assets. In particular, it was able to weather the storm well as only 2.4 per cent of loans in its financial system are denominated in foreign currency, according to the Washington-headquartered International Monetary Fund (IMF).

Credit growth has been rapid in recent years, averaging 23 per cent a year during 2006-08, until last year, when it almost halved to 12 per cent amid a more cautious approach to both borrowing and lending.

Loan books in North Africa

Although the banks have been lending more, the authorities in Morocco have insisted that they improve the quality of the assets on their books. As a result, while total loan books have grown, the combined nominal value of non-performing loans (NPLs) has not risen significantly.

NPLs accounted for about 19 per cent of all loans in 2004, but only 10.9 per cent in 2006, and by June last year just 5.5 per cent. Meanwhile, the average level of provisioning against them has risen from an already high 71.6 per cent in 2006 to some 77.6 per cent in mid-2009. Many NPLs have been, first, fully provisioned, and then written off; some problem loans have been restructured.

Tunisia has emulated the example set by Morocco, cracking down on bad loans and gradually strengthening the risk position of its banks. NPLs accounted for almost a quarter of all loans back in 2004, but by 2008 this had fallen to 15 per cent. Moreover, Tunisian banks have a strong deposit base. They do not need to resort to international financing and thus survived the global liquidity crunch unscathed.

“The reforms are continuing,” says Damak. “Their second phase, once the balance-sheet clean up is completed, is implementation of Basel II [banking regulations]. This has already happened in Morocco and is now underway in Tunisia…The regulation of banks in these countries remains fairly restrictive. For example, this prevented the banks from taking on exposure to structured investments. Supervision in Morocco and Tunisia meets what is necessary; the central banks are well informed about the risks that lie within their banking systems.”

Different financial challenges for North African countries

For Libya, the challenges have been different. After many years of relatively isolated operation as an oil-funded socialist economy, the country is now opening up, seeking to develop a more diverse and entrepreneurial society. An economy that is more commercial requires a banking sector managed so it can cope with the risks thrown up by the more market-oriented business environment that is slowly developing.

Its banks are well-capitalised and profitable – partly thanks to interest income on funds they have placed with the central bank – but the bad loans issue clearly had to be faced.

Back in 2005, some 33 per cent of the loans on bank balance sheets were categorised as non-performing. So the Tripoli authorities set up an asset management scheme to deal with portfolios of bad loans. They also increased capital requirements and encouraged experienced foreign banks to buy into Libyan institutions. These reforms made considerable progress and, by the end of 2008, the average capital adequacy ratio of local banks stood at 16 per cent, while NPLs as a proportion of the total loan book had sunk to 20 per cent.

Meanwhile, the IMF has provided technical help with improvements to bank supervision, such as the training of regulatory staff, the reinforcement of licensing procedures and the calculation of prudential ratios.

One issue that has posed particular challenges is the role of specialised credit institutions (SCIs) in Libya’s distinctive economic structure. Set up in the 1970s and 1980s as development finance outfits, their initial role was to provide subsidised credit to fund housing, small business and agriculture. But after the turn of the century, these specialist lenders rapidly expanded their activities. Their share of lending rose from 13 per cent in 2001 to almost 40 per cent in 2008, whereas in the other three Maghreb states, institutions of this type account for only 1-5 per cent of credit.

Libya’s SCIs have crowded the commercial banks out of the lending market, winning business through highly subsidised interest rates and a relaxed attitude to risk.

The level of lending to the Libyan private sector is just a fraction of that in Morocco and Tunisia, at just 7 per cent of gross domestic product (GDP). But as the economy modernises and becomes more market-oriented, this will need to change if a strong business sector is to develop. Commercial banks, with their more prudent standards and ties to experienced foreign counterparts, are better placed than SCIs to meet this future growth.

As a first step, the IMF has pressed Libya to toughen the regulation of the specialist institutions. If this process runs in parallel with the growth of conventional banks, the latter should gradually be able to expand the provision of credit to meet private sector business needs.

Algeria’s banking sector was ahead of Libya’s in advancing down the path of structural change, with a strong presence by selected foreign institutions by the middle of the last decade. But it also suffered a painful spike in bad loans, which climbed from just 3 per cent of total loans in 2005 to some 22 per cent in 2007, before slipping back to 18 per cent the following year.

 Furthermore, Algerian banks have been sluggish in extending credit to the private sector economy, partly because credit risks are high. Banks have accumulated a large base of deposits, but they are sitting on much of this money, rather than recycling it out to business customers.

The government has tried to tackle the problem. It has strengthened the banks through higher capital requirements and government purchase from banks of old NPLs owed by state companies. It has also offered incentives for mortgages and other loans to small and medium enterprises.

Senior officials insist they are aware of the need for financial sector reform. But there are still obstacles in the way of change. Algeria’s wariness of foreign investment could stand in the way of any new tie-ups between local and the foreign banks that might be able to provide new technology and specialist expertise.

Balancing economic reform in North Africa

For Algeria and Libya, the dilemma is how to balance reform and inject new vigour and credit flows into the business economy, with a reinforcement of banking risk controls and techniques.

In Tunisia and Morocco, the challenge is more classic: the need for care as economic activity picks up, with a particular eye on the risks in sectors of major exposure such as real estate.

“In Morocco the overhaul was accelerated, to some degree, by a rapid growth in total lending and the clean-up is now finished,” says Damak. “But there is a danger that the good progress will be reversed in the real estate sector – which could have serious consequences. In Tunisia, the clean up continues, with a well-managed growth in the overall volume of credit.”

“We expect things to get better over the next 12-24 months in Tunisia and Morocco, provided that economic recovery continues as expected,” he adds.