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Audrey Nguema Bekale

Imhotep Paul Alagidede

Jones Odei-Mensah

May 10th, 2023

Does the growing use of derivatives in Africa create systemic risk?

2 comments | 17 shares

Estimated reading time: 5 minutes

Audrey Nguema Bekale

Imhotep Paul Alagidede

Jones Odei-Mensah

May 10th, 2023

Does the growing use of derivatives in Africa create systemic risk?

2 comments | 17 shares

Estimated reading time: 5 minutes

Africa’s derivatives markets are growing. Derivatives can bring salutary effects to a market but can also make them more vulnerable to external shocks. Audrey Nguema Bekale, Imhotep Paul Alagidede and Jones Odei-Mensah quantify systemic risk for 40 listed derivatives user-banks from 11 countries and depict the systemic risk status for the African banking sector. Their work underlines pathways to ease the risk of a banking crisis in similar transitional economies.


 

The use of derivatives was identified as a major factor of risk that caused the last global financial crisis in 2007/08 (Zhou, 2021). Since the crisis, there have been concerns that future systemic crises may originate even in remote developing markets (Foggitt, Heymans, Van Vuuren & Pretorius, 2017; Catalán & Demekas, 2015). For most of the past decade, the lessons arising from the financial shocks and the ripple effects of producing suboptimal growth have not been properly imbibed. More so, mainstream analysis has failed to touch on the link between derivatives and the preponderance of system risk in Africa’s emerging financial markets.

We focus on how the use of derivatives links to systemic risk formation in Africa’s banking ecosystem, adding to the topical debate about its financial stability in the face of financialisation.

Simply put, “systemic risk,” a phenomenon that affects all countries, entails “… the risk of a crisis in the financial sector and its spillover to the broad economy” (p. 6), and a “disruption to the provision of financial service caused by impairments in all or parts of the financial system” that create economic tumults (p. 3).

Derivatives markets, in turn, are known as the ultimate endowment of financial systems. They are mainly found in advanced financial ecosystems, which thrive primarily on derivatives’ proven risk management function and innate financial innovations. Derivatives entail a very complex category of financial instruments.

Africa’s derivatives markets are growing. North African exchange-based derivatives operations are reportedly flourishing. In Sub-Saharan Africa (SSA), South Africa’s Johannesburg Stock Exchange (JSE) has a long-standing formal derivatives operation (since 1987). The number of options and futures trading on JSE has increased from close to 15 million in 2005 to 264,6 million in 2018 (Keffala, 2015; World Federation of Exchanges, 2019).

SSA’s second exchange-traded market in derivatives was launched in 2019 by the Nairobi Securities Exchange. Additionally, Nigerian Exchange Limited (NGX) has operated a similar formalised market since 2021 and plans to spread its coverage to the West-African region (Nairobi Securities Exchange, 2022; Reuters, 2019; Steves, 2021).  Other initiatives are likely to follow.

By adopting derivatives, African economies are expected to advance their financial liberalisation and globalisation in their financial practices (financialisation). As financial markets gain more influence, they can help enhance financial and economic stability while fostering bank lending towards the business sector. Conversely, financialisation can engender systemic threats, causing disruptions in financial intermediation (Akinsola & Odhiambo, 2017; Keffala, 2017; 2015; Catalán & Demekas, 2015).

Derivatives have been touted as the instruments that reinforce the interdependence of market participants in the Global Financial Sector (Titova, Penikas & Gomayun, 2020). Using derivatives can weaken the financial sector, creating financial illiquidity linked to external liquidity shocks and contagion and transmission of such shocks between banks (Louhichi, Saghi, Srour & Viviani, 2022; Zhou, 2021).

Despite a nascent financial history, Africa has suffered its fair share of banking and systemic distress. As the continent strives for market-based financial ecosystems, significant energy ought to be focussed on creating robust markets and instruments that overcome the weaknesses of existing ones. Our work offers an original depiction of the systemic risk status for the African banking sector and underlines pathways to ease the risk of a banking crisis in similar transitional economies.

We quantify systemic risk for 40 listed derivatives user-banks from 11 countries between 2011–2017. We employ the systemic risk index (SRI) (Kleinow & Nell, 2015), as it combines the popular contagion and sensitivity dimensions of Conditional Value at Risk (CoVaR) and Marginal Expected Shortfall (MES). We also examine the impact of derivatives use on systemic risk using a seemingly unrelated regression (SUR) analysis, and a generalised method of moments (GMM) model as a robustness check. The systemic risk development dynamics is then captured by modelling the SRI as dependent variable in relation to several independent variables involving bank-specific characteristics such as derivatives use (Derivatives), and aspects of the macroeconomic landscape.

Beforehand, we underlined the unfolding instability in the way African banks engage with derivatives use. We established that using derivatives yields mixed effects on banking (Efficiency) development (Nguema Bekale, Alagidede & Mensah, 2022) and increases idiosyncratic bank risk-taking, which possibly masks risk on a systemic scale (Nguema Bekale, Alagidede & Mensah, 2023).

Table 1. Systemic risk prevalence of African banks

Source: Authors’ construct based on risk measurements executed in Stata and R. Notes: Standard deviations are denoted as “SD”. The indices entail marginal measures of risk and may alternatively be expressed as percentages. 

The industry’s contribution to systemic risk (SRC) is moderate, ranging between 48.78% to 67.95%, steadily decreasing throughout the sample period and suggesting that the banks become less contagious or less influential. Furthermore, the systemic risk sensitivity (SRS) index indicates that banks across individual countries are insensitive to externalities stemming from the broader market and remain remarkably isolated from the system’s distress.

The aggregate systemic risk index (SRI) measuring the banks’ systemic risk prevalence is significantly below the 50 per cent mark throughout the years, reflecting a fundamentally diluted and depleting systemic risk formation process. Systemic risk is thus low, unstable, deteriorating, and scattered among the countries over time, translating Africa’s low sectorial concentration and possibly high foreign presence in the banking sector.

Derivatives use and systemic risk formation

In both the seemingly unrelated regression (SUR) analysis and generalised method of moments (GMM) model (see regression results in Table 2 below), most indicators, even conventional defining risk factors, are insignificant/irrelevant vis-à-vis systemic risk development. The evidence underscores Africa’s lack of derivatives origination capacity, where financial proceedings unconventionally fail to achieve a tangible impact on broader scales.

The bank’s efficiency component is also insignificant, negating the impact of systemic moral hazard problems. Considering our previous conclusion that derivatives use fosters moral hazards at micro-levels (Nguema Bekale et al., 2023), we confirm that threats from Africa’s financial industry, or at least its subcomponents, remain confined within the sector.

Increasing bank liquidity (Liquidity) and credit risk (CreditRisk) present slightly negative implications towards systemic risk development, though. The odd conflict materialising between credit risk and systemic risk build-ups underlines the alarming defect of wrong-way risks.

The impact of banking diversification on stability depends on the diversifying activities of the institutions. Mainly, the variable measuring income diversity (MID) is positively correlated with systemic risk development. Together, the reported insignificance of the measures for asset diversity (MAD) and the controversially behaved MID prove that the current shift towards fee-generating and non-interest banking practices fuels systemic risk formation, most likely stemming from businesses’ lines outside the desired market-based intermediation.

Africa’s changing macroeconomic conditions are included, reflected by the national levels of real GDP growth (∆RGDP) and stock exchange capitalisation (MarketCapitalisation). The related evidence demonstrated the accepted listlessness of Africa’s financial system and markets. Africa’s financial practices remain decoupled from the evolution of globalised financial markets and systemic risk formation. Yet, the inherent fragilities of its financial system remain favourable to the occurrence of internal banking crises.

Not all levels of systemic risk are harmful. The operation of a healthy banking system must at least detectably generate risks that spread to other industries. Unfortunately, this is not the case in Africa.

In a nutshell, we expose the unconventional systemic risk development in Africa resulting from its lack of banking diversification, insignificant market-based activities, and the listlessness of the broad financial system, and confirm a previous report that threats from Africa’s financial sector, or at least its subcomponents, remain confined within the industry (Nguema Bekale et al. 2023).

Generally, the unusual risk development in Africa’s banking environment is typical to underdeveloped financial ecosystems where the pricing of financial assets tends to follow randomised, overvalued or undervalued processes.

Given lagging financial activities and the absence of dynamic derivatives dealings, African markets most certainly remain non-compliant with the rational market paradigm and suffer from serious informational issues. As a result, the continental capital markets fail to incorporate vital information into the prices of financial products swiftly.

More than ever, regulatory and policy attention must focus on driving a collective structural shift towards market-based financial ecosystems and a meaningful expansion of banking practices.

Table 2. Regression results for the determinants of systemic risk

Source: Authors’ construct using sureg and ivregress in Stata. Notes: P-values are provided in the parentheses below the coefficient estimates. *, ** and ***, respectively, imply significance at 10%, 5% and 1% levels. “cons” represent the model’s constant.

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About the author

Audrey Nguema Bekale

Audrey Nguema Bekale is a finance expert and holds a PhD from the Graduate School of Business Administration of the University of the Witwatersrand, Johannesburg. His research focuses on Africa’s economic transformation through harnessing derivatives markets, and the potential role of capital markets.

Imhotep Paul Alagidede

Imhotep Paul Alagidede is a professor of finance at the Graduate School of Business Administration of the University of the Witwatersrand, Johannesburg, a metaeconomist at the Nile Valley Multiversity, Bono East Region, Ghana, and professor of finance at the Simon Diedong Dombo University of Business and Integrated Development Studies, Ghana.

Jones Odei-Mensah

Jones Odei-Mensah is an associate professor of economics at the Graduate School of Business Administration of the University of the Witwatersrand, Johannesburg. He is the director of training at AREF Consult and the editor-in-chief of the African Review of Economics and Finance Journal.

Posted In: Economics and Finance

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