Bank of Tanzania WP No. 13, May 2018 Bank of Tanzania Working Paper Series Nguling’wa Balele Nicholaus Kessy Financial Sector Reforms and Zegezege Mpemba Innovations and their Frank Aminiel Implications on Monetary Policy George Sije Emmanuel Mung’ong’o Transmission in Tanzania WP No 13: May 2018 i Bank of Tanzania WP No. 13, May 2018 Bank of Tanzania WP No. 13, May 2018 Financial Sector Reforms and Innovations and their Implications on Monetary Policy Transmission in Tanzania Nguling’wa Balele, Nicholaus Kessy, Zegezege Mpemba, Frank Aminiel, George Sije, Emmanuel Mung’ong’o Bank of Tanzania e-ISSN 2546-1990 Bank of Tanzania WP No. 13, May 2018 Bank of Tanzania WP No. 13, May 2018 Disclaimer The views expressed in this paper are solely those of the author(s) and do not necessarily represent the opinion of the Bank of Tanzania. e-ISSN 2546-1990 i Bank of Tanzania WP No. 13, May 2018 Table of Contents Disclaimer .......................................................................................................................................... i Table of Contents ............................................................................................................................. ii Glossary of Terms ........................................................................................................................... iii Abstract ............................................................................................................................................ iv 1.0 Introduction ................................................................................................................................ 1 2.0 The Evolution of Reforms and Innovations in the Banking Sector ............................................ 2 3.0 Impact of Reforms and Innovations on the Banking Sector Development ................................ 5 3.1 Structural and Institutional Changes ..................................................................................... 5 3.2 Outcomes on Banking Sector Efficiency and Financial Products and Services ................. 12 4.0 Implications of the Banking Sector Developments on Monetary Policy Effectiveness ............ 27 4.1 Methodology ........................................................................................................................ 28 4.2 Empirical Results ................................................................................................................. 28 5.0 Conclusions and Policy Recommendations ............................................................................ 31 Reference ...................................................................................................................................... 34 Appendices .................................................................................................................................... 36 ii Bank of Tanzania WP No. 13, May 2018 Glossary of Terms ATM – Automated Teller Machine BFIA - Banking and Financial Institution Act BOT – Bank of Tanzania BRELA - Business Registration and Licensing Agency CBOs - Community Based Organizations CC – Currency in Circulation CMSE - Capital Markets and Securities Authority CPI - Consumer Price Index DFI - Development Finance Institution DFS - Digital Financial Services DIB - Deposit Insurance Board DSE - Dar es Salaam Stock Exchange EAC - East African Community EAMU - East African Monetary Unit EAPS - East African Payment System EFT - Electronic Fund Transfer FGFSR - First Generation Financial Sector Reforms FIU - Financial Intelligence Unit FSAP - Financial Sector Assessment Program FSP - Financial Sector Support Project GDP – Gross Domestic Product HMFF - Housing Micro Finance Fund HMFF - Housing Micro Finance Fund IBCM – Inter-bank Cash Market ICT – Information and Communication Technology IFC - International Finance Corporation IFEM - Inter Bank Foreign Exchange Market LART - Loan and Assets Realization Trust MFS - Mobile Financial Services MNOs - Mobile Network Operators MTM - Monetary Transmission Mechanism NEER - Nominal Effective Exchange Rate NPLs - Non-Performing Loans REPOs - Repurchase Agreements RM – Reserve money ROA – Return on Assets SACAs - Savings and Credit Associations SGFSR – Second Generation Financial Sector Reforms SIRESS - Integrated Regional Electronic Settlement System SMEs - Small and Medium Enterprises SSRA – Social Securities Regulatory Authority SVAR – Structural Vector Auto Regression TACH - Tanzania Automated Clearing House TCDC - Tanzania Cooperative Development Commission TIB - Tanzania Investment Bank TIRA – Tanzania Insurance Regulatory Authority TISS - Tanzania Interbank Settlement System TMRC - Tanzania Mortgage Refinance Company Limited URT – United Republic of Tanzania VECM - Vector Error Correction Model iii Bank of Tanzania WP No. 13, May 2018 Abstract Tanzania embarked on a series of financial reforms starting 1991 as an effort to promote the development of a market-based financial sector. The reforms were implemented in two major phases: The First Generation Financial Sector Reforms which started in 1991 targeting legal reforms to create competitive environment, modernization of the National Payment Systems, strengthening of BOT’s regulatory and supervisory capacity, restructuring and privatization of state owned banks and financial institutions. The Second Generation Financial Sector Reforms followed in 2003 aiming at strengthening the banking sector, developing financial markets, facilitating the provision of long term development finance, land reforms, creation of credit registry and strengthening of micro and rural finance. Using descriptive analysis and model-based approaches, this study assesses the impact of the reforms and innovations in the financial sector on the development of the banking sector in Tanzania and evaluates the implications of the banking sector development on the effectiveness of monetary policy. On the banking sector, the findings suggest that considerable achievements have been recorded, particularly in the structural change of the sector, as well as the quantity and quality of the financial services provided. Notably, the following achievements are worth mentioning: Firstly, increase in both the number of licensed banks and financial institutions and the expansion of bank branch network and market determined interest and exchange rates that respond to macroeconomic fundamentals. The number of banking institutions for example increased from 29 in 2000 to 59 in 2016 while the number of bank branches increased from 328 in 2007 to 810 in 2016. Secondly, modernization of payments, clearing and settlement systems have led to improvement in the revenue collection and government payments; reduction in risks associated with usage of high value cheques; reduction in operational costs; simplified reconciliation processes; efficiency in funds transfer; increased efficiency in cheque clearing from more than thirty days to T+1 clearing across the country; facilitation of direct deposit of salaries to beneficiaries’ accounts for government employees and settlement of other government’s recurrent low value payments. Thirdly, the transformation of Tanzania Investment Bank (TIB) and establishment of Tanzania Agricultural Development Bank (TADB), Tanzania Mortgage Refinance Company (TMRC) Limited and Housing Micro Finance Fund (HMFF) have led to increase in availability and access to long term financing for enterprises, infrastructure, and housing development. Fourthly, promotion of innovations for delivery of financial services using the digital financial services and agent banking has significantly increased access to financial services as evidenced by findings of Finscope Surveys. The Finscope survey of 2017 shows that 86% of Tanzanian adults iv Bank of Tanzania WP No. 13, May 2018 live within a 5km radius of financial access point. Further, the introduction of credit reference system and its accompanied regulations have improved credit risk management in the economy, thus assisting in lowering the cost of borrowing. Fifthly, financial depth and efficiency of the banking sector has improved overtime as indicated by both the indicators of financial depth (i.e. bank credit to private sector and deposits as a percentage of GDP) and by indicators of efficiency (i.e. interest rate spread, return on assets and access to finance). Credit to private sector went up from below 5% in 2000 to around 15% in 2016, interest rate spread decreased from above 10% in 2005 to around 6% in 2017, and return on assets increased slightly from below 1.5% to around 2.0% on average in 2016. Development of the banking sector is expected to provide a conducive environment important for enhancing effectiveness of the monetary policy. Although some studies provide evidence of the lending channel of monetary policy transmission in Tanzania, other studies point to a limited transmission of monetary policy through other channels such as the interest rate channel. An analysis on the interest channel using most current data and SVAR approach suggests a weak pass-through to inflation, partly pointing to remaining structural constraints in the financial sector. However, descriptive analysis suggests for some better monetary transmission outcomes going forward. This is evidenced by the declining trend of currency in circulation outside the banking system (CC/RM); increasing efficiency as reflected by declining interest rate spread and increasing return on assets; and increasing access to financial services