This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The World Bank does not guarantee the accuracy of the data included in this work. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The material in this publication is copyrighted.
Public Disclosure Authorized
FINANCIAL SECTOR ASSESSMENT PROGRAM Public Disclosure Authorized SUDAN
TECHNICAL NOTES MAY 2005
Public Disclosure Authorized
Public Disclosure Authorized
INTERNATIONAL MONETARY FUND THE WORLD BANK MONETARY AND FINANCIAL SYSTEMS DEPARTMENT FINANCIAL SECTOR VICE PRESIDENCY AFRICA REGION VICE PRESIDENCY
Contents
Glossary ...... 4
I. Prudential Regulation and Supervision ...... 6
II. Stress Testing ...... 10 A. Introduction ...... 10 B. Identification of Risk Factors ...... 11 C. Stress Test Scenarios and Results ...... 14 D. Future Capital Needs ...... 20 E. Conclusions ...... 24
III. Efficiency of Sudanese Banks ...... 26 A. Introduction ...... 26 B. Estimation of Efficiency ...... 26 C. Estimation Results ...... 27 D. Effects of Bank Characteristics on Efficiency ...... 30 E. Profitability Versus Efficiency ...... 31
IV. The Insurance Sector in Sudan ...... 34 A. Market Development...... 34 B. The Regulatory Framework ...... 40
.V Assessment of the Sudanese Payments System ...... 46 A. Introduction ...... 46 B. Information and Methodology Used for Assessment ...... 46 C. Institutional and Market Structure—Overview ...... 46 D. Payment Systems Infrastructure...... 47 E. Reforms Under Way ...... 52 F. Recommended Actions ...... 57
VI. Legal Framework ...... 64 A. Introduction ...... 64 B. Financial Sector Legislation ...... 65 C. Commercial Law Framework...... 68 D. Corporate Governance ...... 69 E. Accounting and Auditing ...... 70 F. Company Registration ...... 70 G. Bankruptcy and Creditor Rights ...... 71 H. The Court System...... 72 I. The Peace Accord ...... 74 J. Recommendations ...... 75
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Tables 1. Financial Soundness Indicators for the Banking Sector, 1999–2003 ...... 15 2. Stress Test Scenarios...... 17 3. Growth Stress Test Scenarios ...... 23 4. Sensitivity of Relative Efficiency Ranking ...... 29 5. Regression Results ...... 31 6. Indicators of Bank Efficiency and Profitability ...... 32 7. Comparison of Insurance Markets in Africa ...... 34 8. Insurance Sector Growth...... 35 9. Market Shares of the Largest Insurance Companies, 2003 ...... 36 10. Insurance Company Investments ...... 40 11. Premium Income and Claims ...... 40 12. Detailed Assessment of Observance of CPSS Core Principles for SIPS and ...... 54
Figure 1. Distribution of Efficiency in the Benchmark Case ...... 28
Box 1. Sharia-Compliant Insurance ...... 38
Appendices I. Stochastic Production Frontier Approach: An Example ...... 33 II. IAIS Principles ...... 43 III. Statistical Information on the Payment System ...... 61 IV. Extract from the Comprehensive Peace Agreement ...... 76 V. Issues in the Introduction of a Dual Banking System ...... 78
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GLOSSARY
Acronyms
AAOIFI Accounting and Auditing Organization for Islamic Institutions AML/CFT Anti-Money Laundering/Combating the Financing of Terrorism BOS Bank Of Sudan CAR Capital Adequacy Ratio CDD Customer Due Diligence CPA Comprehensive Peace Agreement DIF Deposit Insurance Fund FATF Financial Action Task Force FIU Financial Intelligence Unit FSAP Financial Sector Assessment Program FSSA Financial Sector Stability Assessment GIC Government Investment Certificate GMC Government Musharaka Certificate ISA Insurance Supervisory Authority KSE Khartoum Stock Exchange MFE Ministry of Finance and National Economy MFI Micro-Finance Institution MLCA Money Laundering (Combating) Act NPL Non-Performing Loans/Investments NPO Non-Profit Organization ROA Return On Assets ROE Return On Equity ROSC Report on Observance of Standards and Codes RTGS Real Time Gross Settlement System SD Sudanese dinar SME Small and Medium-sized Enterprises STR Suspicion Transaction Report TPL Third Party Liability
Islamic Financial Terms
Al-Wadiah Safekeeping arrangement of funds with no interest payment Government Investment Securities based on securitized leasing and project financing Certificate (GIC) Government Musharaka Securities based on units in a mutual fund of publicly-owned Certificate (GMC) companies Ijara Leasing contract Istisna’a Financing of work in progress, whereby financer receives goods when manufactured Mudaraba Instrument, in which one party contributes capital, the other labor/expertise
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Murabaha Instrument, in which financer purchases good with agreement on resale at a price based on initial cost plus a mark-up Musharaka Instrument, in which parties contribute equity and share profits and losses Riba Interest Salam Instrument, in which buyer pays price before receiving goods Takaful Islamic insurance; operates similar to a mutual benefit company
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1 I. PRUDENTIAL REGULATION AND SUPERVISION
Introduction
1. The banking sector is the backbone of the Sudan’s financial system and will continue to play an important role as financial intermediary and primary source of financing for the domestic economy. As of December 31, 2003, there were 26 commercial and specialized banking institutions in Sudan which comprised 23 domestic banks and 3 foreign banks. The operations of these banks are based on Islamic principles.2
General assessment
2. The banking system in Sudan is regulated and supervised by the Bank of Sudan (BOS) as provided under section 6 (c) of the Bank of Sudan Law 2002 which states that one of the objectives of BOS is to “regulate, control and supervise banking activity and act to develop and enhance the effectiveness of banking activity, so as to achieve balanced economic and social development.” Prudential regulation and supervisory by the BOS have improved significantly in recent years. The BOS has made progress toward enhancing banking supervision system and has achieved a degree of compliance with the Basel Core Principles. Much effort has also been made to restructure the banking sector that includes plans to merge the banking institutions. Compliance is enforced through appropriate off-site supervisory activities and regular on-site inspections. Supervision and regulations have been adapted to incorporate Islamic principles but the needed modifications have not been severe. However, the BOS should continually ensure that prudent banking practices are followed and never compromised.
3. The law governing Sudan banking sector is generally adequate. As the sole authority responsible for the Sudan banking system, the BOS has exclusive powers to license, supervise and inspect all institutions. The BOS’s broad powers and discretion include issuing of prudential regulation and addressing compliance with laws and regulations. The Banking Supervision Department is the department responsible for the issuance of prudential regulations as well as off-site monitoring, while the Banking Inspection Department is responsible for conducting regular inspections on banking institution. The BOS staff is protected from being sued for performing their duties as long as they follow the BOS’s procedures.
4. Starting in 2000, the BOS has increased the minimum absolute capital requirement in stages to the equivalent of US$12 million with the aim of encouraging consolidation and the realization of economies of scale. To meet this requirement, capital has been injected into four state-owned banks. The capital of private and mixed public/private banks has been
1 Prepared by Mohamed Khairudin Abd Aziz (Bank Negara Malaysia). 2 Additional information on the structure of the financial system is contained in the FSAP Aide-Mémoire and the Financial Sector Stability Assessment.
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increased through a combination of retained earnings, asset re-evaluations and realization, and rights issues (the latter being more frequent in the case of banks with foreign participation). Two banks have been merged to reach the minimum paid up capital requirement. The BOS intends to announce a further increase in minimum capital to the equivalent of US$25 million by December 2005.3
5. The BOS requires banks to comply with the 8 percent risk-weighted capital adequacy requirement. While most of the banking institutions have complied with the requirement, the 8 percent minimum risk-weighted capital adequacy requirement however, may not be adequate given the inherent vulnerabilities of a developing economy dependent on the production of primary commodities. The BOS’ plan to increase the minimum capital adequacy ratio a 12 percent —which would be in line with levels in other countries of the region—is therefore appropriate. From a prudential perspective, this may be more important than the announced process of increasing the required absolute minimum capital.
6. The definition of regulatory capital allows banks to include relatively illiquid fixed assets. This reduces the effectiveness of capital as a buffer against shocks, and adds uncertainty to the valuation of capital, especially given the recent rapid upward revisions in real estate prices. Therefore, the BOS may need to consider limiting the inclusion of fixed assets in regulatory capital. Introducing such limitation could be partially offset by a reduction in the minimum capital requirement.
7. The BOS sets criteria for establishment of a new bank. Evaluation on proposal to set- up a new bank is made among others, by reviewing ownership structure, assessing the operating plan, and evaluating proposed directors and management. For prudential purposes, a large shareholder is defined as one holding at least 7 percent of shares. This cut-off point seems somewhat high and should be reconsidered; a shareholder with 5 percent of shares could have a strong influence if other shares are widely held.
8. Banks are required to obtain approval from BOS when providing financing to directors and shareholders of the bank. It is recommended that financing to directors and shareholders’ related companies should also be subject to BOS approval. While the banking law contains restrictions on lending to individual director and shareholder of the bank, there is a need to introduce a restriction on aggregate financing of such connected parties. Currently, only financing to members of the bank’s board of directors is subjected to the limit which at anytime should not exceed the total of the whole capital and the bank’s reserves or 10 percent of the financing portfolio whichever is greater. It is recommended that financing exposures to directors or large shareholders should be aggregated with that to their related companies and be subject to a limit set by the BOS.
9. Corporate governance is one of the areas that needs improvement. To improve corporate governance and enhance board effectiveness, the BOS should consider expanding
3 All new banks are required to have a paid-up capital equivalent to US$25 million.
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the number of qualified non-shareholders to sit on the board of banking institutions as independent directors. In addition, BOS should consider discontinuing its practice of appointing BOS staff to sit on bank boards. This is to avoid actual or apparent conflicts of interest. Moreover, the appointed senior government officials may not be able to devote sufficient attention to their duties as board members.
10. Classification of non-performing loans and required provisioning rates for NPLs are differentiated between murabaha financing and non-murabaha financing.4 Murabaha financing is considered non-performing if the installment is one month overdue; non- murabaha financing is considered nonperforming if three months overdue.5 Details of the classification of financing and provisioning rates are as illustrated in the following table:
Classification Murabaha Financing Non-murabaha Financing Provisioning Rate
Ordinary No overdue installment No overdue installment 2 percent
Substandard Installment overdue from 1 Installment overdue from 20 percent to 3 months 3 to 6 months
Doubtful Installment overdue from 3 Installments overdue 50 percent to 6 months from 6 to 12 months
Bad Installment overdue for Installment overdue for 100 percent more than 6 months more than 12 months
11. While not obviously inappropriate, the BOS should gather the necessary data to study default rates and estimate expected loss in case of default under different circumstances. On this basis, the provisioning rates may need to be revised. In addition, the BOS may also need to review its asset valuation methods regarding fluctuations in the prices of underlying contracted commodities that expose banks to risk.
12. Regular and formal contacts between the BOS and management of banks have been part of the BOS’s coordinated on- and off-site supervisory activities. As part of the BOS’s efforts to strengthen its supervision function, a meeting with the board of directors and senior management of banks is held on a monthly basis. The performance of banks and policy direction will be communicated to the banks at the meeting.
13. While consolidated supervision has yet to be developed in the BOS, on-site inspections are conducted to ensure that banking institutions are sound and that the banks comply with rules and regulations issued by BOS. The Banking Inspection Department has
4 The Aide-Mémoire and the Financial Sector Stability Assessment contain explanations of these terms in Islamic finance. 5 Required provisioning is also adjusted depending on the availability of collateral.
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adopted the CAMEL (Capital adequacy, Asset quality, Management competence, Earnings potential, and Liquidity position) framework in assessing the overall performance of the bank. Under this framework, each component is assessed based on quantitative and qualitative factors. A rating ranging from 1 to 5 is assigned to each component (1-strong, 2- satisfactory, 3-fair, 4-marginal and 5-unsatisfactory). Each institution is then assigned a composite rating (1 to 5) after taking into consideration the rating of each component. In performing its function, BOS has the legal right of full access to all bank records and information. BOS also can request information as and when it needed, apart from regular reports that banks have to submit to BOS.
14. There is a need to strengthen supervisory capacity that includes providing adequate resources to perform on-site inspections and upgrade the technical skills of inspectors. The scarcity of inspectors in the Banking Inspection Department has resulted in the inability of the department to perform inspections on all banking institutions. As of November 30, 2004, the department had only conducted inspections on 13 banks (out of 26). The IT inspection was not conducted due to the unavailability of IT inspectors to perform this kind of inspection. This problem was further compounded by the BOS’s practice of transferring staff (after about five years in the department) to other departments, which to a certain extent has affected the effectiveness of on-site supervision.
15. There is also an urgent need to improve coordination between on-site and off-site supervision, and between supervision and the rest of the BOS, for example on data management, reporting to BOS senior management, and the analysis of cross-section variations and time trends.
16. The Sudan banking law provides the BOS with a wide range of corrective measures to ensure the safety and soundness of banking institutions. Such measures include, depending on circumstances: imposition of a directive, removal of the director and senior management, cancellation of the license, and liquidation of the bank. Penalties are also provided in the regulation to deal with infringement of legislation and regulation.
17. Cross-border cooperation is an area that needs to be enhanced. BOS should develop cooperation with the home country supervisory authorities; moreover with foreign entry becomes more pervasive. The existing law does not provide BOS with the express power to share confidential information with the home country supervisory authorities, which is needed for effective cooperation. Nevertheless, local branches of foreign banks are still subject to the same prudential, inspection and reporting requirement as domestic banks.
Conclusion
18. While prudential regulations and supervisory skills by the BOS have improved over the years, there are areas of concern that need the central bank’s attention to further strengthen the banking system. For example, corporate governance should be enhanced in the banking system. Regulations on financing to connected parties should be tightened. The capital adequacy ratio should be reviewed. The supervisory capacity should be strengthened.
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The coordination among the BOS departments should be improved. Finally, cross-border cooperation should be enhanced. This becomes more important with the following events that will take place—that is, a proposed bank merger, the introduction of a conventional banking system in the South, and the entry of additional foreign banks into Sudan.
6 II. STRESS TESTING
A. Introduction
19. The Sudanese financial sector is small relative to GDP, but is rapidly growing. Deposits in the banking sector currently represent a little over 10 percent of GDP, and credit to the private sector has been rapidly expanding, driven by a strong economy. At present, the banking system is small enough that a crisis would not have much immediate impact on the overall economy. However in this environment there are still two reasons to be concerned about the stability of the nascent banking sector.
20. First, as the banking sector grows it will eventually become systemically important. In the past three years alone, broad money and total net domestic credit to the economy have both more than doubled. If Sudan’s political and security problems can be resolved, there is the potential for an even more rapid growth of credit. It is likely that in the near future Sudan’s banking sector will become systemically important, so that a financial crisis could possibly have a severe impact on the economy.
21. Second, if Sudan is to move forward, it will need a well-developed financial sector. The deepening of the financial sector will depend on the gradual establishment of confidence in financial institutions, a slow process that can take time and can be significantly delayed by events that reveal weaknesses. While a crisis today might not have a strong immediate impact in terms of GDP, it could have a tremendous cost over time by delaying for an indeterminate period the development of the supporting financial structure without which the present fast pace of growth cannot be sustained.
22. To assist in the authorities’ preparations to avert or to manage potential strains, the staff conducted stress tests. These tests examined the effects of a set of quantified financial and macroeconomic shocks that were identified and agreed on with the authorities as having a reasonable chance of occurring. To some extent these shocks were calibrated to test the limits of the system. The analysis focused on calculations of banks’ soundness indicators— particularly capital adequacy ratios—after the hypothetical shocks occurred. A second analysis looked at the possible effects on banks’ soundness indicators of a continuation of the recent rapid expansion of the banking system and other structural changes, and assesses the extent to which banks will have to adapt to keep up with changing circumstances.
6 Contributor: Joseph Crowley.
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23. The analysis was hampered by data limitations. Data even for main aggregates such as loans, deposits, or bank profits were provided only with a delay of months, left out some banks (not always the same set), including some large banks, and were sometimes difficult to reconcile with each other or with published data. Moreover, there are questions about the measurement of capital. The results of this analysis should therefore be considered as indicative only. The Bank of Sudan (BOS), the central bank, recognizes the need for improving their data management capacity and is interested in taking urgent steps to address the problem, including taking advantage of technical assistance.
B. Identification of Risk Factors
24. After reviewing country documents on Sudan, drawing on the experience of past FSAP teams, and holding discussions with the Sudanese authorities and members of the Sudanese private sector, the mission considered several sources of potential stress to the Sudanese economy. Five short-term risk factors were considered.7 Actual events that affect the banking sector would possibly result in a combination of these stress factors occurring. Analyses of future capital needs and the implications of rapid growth of the banking sector were also undertaken and are discussed in a subsequent section. The five risk factors considered were:
Risk factor 1: nonperforming loans (NPLs)
25. The mission found widespread agreement that the greatest risk to the banking system at present would be from an increase in NPLs. Several factors in the Sudanese economy make the system particularly vulnerable to such a rise: (a) financial investments by banks have grown rapidly in recent years, buoyed by a strong economy; the quality of these investments is uncertain as many of them have not had time to become nonperforming even if they are fundamentally unsound; (b) many investments have been growing over time, so it is possible that new financing could have been used to repay old financing; (c) weak accounting practices, questions about the effectiveness of management, and limitations on the effectiveness of banking supervision add to the uncertainty about investment quality; (d) the Sudanese economy is in a precarious position; it is poorly diversified—dependent on a small number of primary commodities, including petroleum, which currently enjoys record price levels that may not be sustained; and (e) political uncertainty could have an economic impact.
26. The ratio of NPLs has declined rapidly, but this has occurred at a time of dramatic expansion of bank financing of the private sector (a threefold increase between end-2000 and end 2003). The absolute quantity of NPLs actually increased during this period. The Sudanese authorities note, however, that the threshold for identifying a loan as nonperforming is unusually strict (one month of delinquency versus an international norm of
7 Over the medium term, an additional risk factor is that banks may become capital constrained if they do not achieve high enough profitability (see below).
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three months) and therefore they argue that there are unlikely to be large quantities of loans that have already gone bad but have not yet been classified as nonperforming.
27. NPLs could also increase throughout the economy as a result of an economic shock. An economic shock could be limited to certain sectors. Financing of the agricultural sector, for example, could be affected by inclement weather, or financing of the construction sector could become defective if the economic boom leads to overdevelopment. As the economy becomes more open, certain sectors could also fall victim to foreign competition. Alternatively, NPLs could increase in the absence of a shock, simply because the strong economy and the rapid growth of financing result in careless investment evaluation.
28. Regardless of the behavior of NPLs, banks could suffer a regulatory shock if provisioning requirements are increased. Higher provisions would immediately have a direct negative effect on banks’ capital (though there would be a compensating decrease in non- provisioned losses in the future). At end-2003 barely one-third of NPLs in Sudan were provisioned for, so this risk is significant.
Risk factor 2: exchange rate risk
29. Sudan’s exchange rate regime is classified as a managed float, but the exchange rate remained remarkably stable at around SD270 to the dollar for an extended period before recently appreciating to SD250 to the dollar. Furthermore, levels of external reserves are returning to normal levels and are expected to increase further. In this environment, many financial institutions have become complacent about the volatility of the exchange rate and have not devoted significant resources to hedging their positions.
30. The limited data that were available on foreign currency positions suggested that most banks do not have large net open positions, but that a few banks (some large) had large long positions, that in some cases exceeded their stock of investment financing. Banks that do not bear a direct exchange rate risk can nevertheless be indirectly exposed through enterprises receiving financing, particularly if there are enterprises which must repay loans in foreign currency but do not have matching revenue in foreign currency. Exchange rate risk scenarios would therefore have a direct component and an indirect component through NPLs.
Risk factor 3: rate of return risk
31. The Sudanese financial system is run entirely according to Islamic principles, which forbid the charging of interest. Therefore, there is no explicit interest rate in Sudan. Nevertheless, all investments have a rate of return. In principle, investment account holders share the risks that their bank takes with their money, and the rate of return to account holders is theoretically closely related to the rate of return the bank earns on the investments made with those funds, but in practice this is true only to some extent. In many cases in Sudan, a rate of return is explicitly included in contracts, including but not limited to sight deposits, which pay an explicit return of zero. This practice is much more prevalent with deposit contracts than with lending contracts. In the case of investment accounts that earn a variable rate of return, they are very unlikely ever to lose their principal, and even the rate of
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return will probably not be fully adjusted to reflect economic realities, particularly adverse ones, since banks feel pressure to realize a rate of return close to what was expected at the time the investment was made.8
32. Thus many deposits in Sudan have a rate of return that is fixed or does not fully reflect economic shocks. The same cannot be said of the investments that banks make. An economic downturn would possibly reduce bank investment incomes without reducing their investment expenses. And to the extent that there could also be some lack of responsiveness in the rate of return on banks’ investments any benefit to the bank is likely to be lost to a corresponding increase in NPLs.
33. Rate of return shock scenarios would ideally include a full breakdown of deposits by type, though no such data were available. Even if a complete breakdown were available, assumptions would need to be made about the capacity of banks to require different types of depositors to accept losses related to their investments. In the history of Sudanese banking, no depositor has ever received less than 100 percent of his original investment. It is difficult to say whether an unprecedented crisis in the banking system could result in an exception to this pattern.
Foreign competition
34. The BOS anticipates an increase in the number of foreign banks operating in Sudan. It is this increase that is the motivation behind the bank restructuring program, which aims to consolidate the local banking sector into a small number of large banks. Competition is likely to increase the rate-of-return risk by squeezing spreads in the banking sector. The proliferation of conventional banks in the south could also provide a new source of competition.
35. More efficient foreign banks might offer sight deposit accounts without associated fees and might even pay returns on these accounts. Depositors with high-fee, non-interest bearing sight deposit accounts in local banks could switch those accounts to foreign banks, depriving local banks of a vital source of profit.
Risk factor 4: deposit volatility
36. A loss of confidence in the banking system could result in deposit flight. To the extent that capital controls are not airtight deposits could leave the country, resulting in a significant liquidity drain. This could force the government to provide liquidity to banks (to maintain their viability) and to absorb it elsewhere (to head off inflationary pressures), including through a corresponding primary surplus adjustment.
8 Banks are permitted to make use of special reserves to smooth returns on investment accounts.
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37. Furthermore, if a large share of the reduction in deposits were sight deposits, the profitability of banks would suffer, since these deposits earn fee income but pay no return. Investment accounts, which earn returns, often have penalties associated with early withdrawal, and would therefore be less likely to be withdrawn than sight deposits.
38. To the extent that capital controls are effective, deposits could be converted into cash, which would entail the same risk, though to a lesser degree. Even if there is no system-wide capital flight, news of weaknesses in certain banks could cause deposits to move from those banks to stronger ones, jeopardizing the weak banks.
Risk factor 5: capital valuation risk
39. Investments of banks must be backed by physical assets under Islamic law. Since the valuation of these assets can change, bank capital is always subject to being reduced by a capital revaluation. This can occur in the absence of any real shock, but it would be more likely to occur in an economic slowdown, when other factors are likely to have a negative impact on capital adequacy, such as an increase in NPLs.
C. Stress Test Scenarios and Results
Initial condition of the banking system and effects of full provisioning
40. At end 2003, the reported capitalization of the Sudanese banking system suggested that the system was generally sound (Table 1). The reported ratio for the banking sector as a whole was about 20 percent, and for the majority of publicly owned banks it was 17 percent. Three banks with 9 percent of the assets of the banking system (two of which were majority publicly owned with 7 percent of the assets of the banking system) did not meet the required 8 percent capital adequacy ratio (CAR) quantity and one majority publicly owned bank with nearly 4 percent of the assets of the banking system was insolvent (i.e., had negative net worth).9
9 It is often difficult to establish definitively the solvency of a bank. Experience in many countries suggest that with low but non-negative measured solvency are very vulnerable. Therefore, the stress tests report also the numbers of banks whose CAR fall below 8 percent and 4 percent.
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Table 1. Financial Soundness Indicators for the Banking Sector, 1999–2003 (in percent, unless otherwise indicated; end of period)
1999 2000 2001 2002 2003 Capital Adequacy Regulatory capital to risk-weighted assets 33.2 13.9 19.3 13.0 20.1 Regulatory Tier I capital to risk-weighted assets ...... Capital (net worth) to assets 65.1 21.3 19.3 16.8 35.0 Free capital to assets 1/ ...... 1.1
Asset composition and quality Loans to nongovernment to total assets 10.7 15.7 21.6 26.7 30.8 Gross NPLs to gross loans ...... 13.4 NPLs net of provisions to gross loans ...... 10.5 NPLs net of provisions to capital ...... 29.8 Loan provisions to NPLs ...... 21.2 Foreign currency loans to total loans 2/ ...... 16.0 27.9 Deposits and investment accounts to total assets 44.0 55.9 71.1 55.1 54.8 Foreign currency deposits to total deposits 42.2 37.3 37.2 46.2 42.4 Off-balance sheet commitments to assets ...... 19.8 17.4 48.7
Earnings and Profitability ROA (before tax) ...... 0.5 1.1 1.5 ROA (after tax) ...... 0.1 0.7 0.9 ROE (before tax) ...... 6.7 13.6 11.2 ROE (after tax) ...... 4.3 8.8 7.3
Liquidity BOS deposits to total assets ...... 13.5 11.4 12.7 Required reserves to total assets 0.7 7.3 9.1 6.1 5.6 Required reserves to total reserves 29.7 70.7 77.8 46.7 48.4 Cash in vault to total assets ...... 2.3 Liquid assets to total assets 11.6 16.7 14.1 11.8 12.4 Liquid assets to total short-term liabilities 68.1 70.2 53.1 46.7 47.8 Customer deposits to total (non-interbank) loans 195.5 188.9 197.8 152.4 145.2
Sources: Bank of Sudan, and staff estimates
1/ Free capital equals regulatory capital minus fixed assets. 2/ Does not include specialized banks.
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41. Several caveats should apply to the reported capitalization levels, however. First, limited data management capacity raises uncertainties about the actual levels of capitalization. Because these uncertainties include limited checking of data submitted by banks, they are likely to be biased toward overstatement of the CARs. Second, most banks do not fully comply with their provisioning requirements. Adjusting capital levels to take account of incomplete provisioning reduces the overall CAR by nearly 4 percentage points, causes two additional (small) banks to drop below the required 8 percent capital adequacy, and renders two additional banks insolvent (Table 2). Third, bank capital includes fixed capital, a practice that does not conform to international standards and that the BOS intends to review.10
42. Data on fixed capital were available only late in the mission and their reliability could not be checked, so it was not possible to do a thorough test of the impact of a change in classification. However, a preliminary estimate suggested that full provisioning combined with adjusting for fixed assets in CAR calculations causes the overall CAR to drop below 3 percent with nearly half of the assets of the banking system to be in insolvent banks.
43. Making an adjustment for fixed capital would result in a further significant deterioration: based on preliminary estimates, deducting all fixed assets would reduce the average capital adequacy ratio to 2.6 percent, 14 banks with three quarters of the assets of the banking system would fall below 8 percent capital adequacy, and 8 banks with nearly half of the assets of the banking system would have a negative capital adequacy ratio.
Stress testing results
44. One large majority publicly owned bank with over a fifth of the assets of the banking system dominates the results in this section. This bank meets the required 8 percent CAR even when it is required to fully provision. It has some vulnerabilities, however, and therefore results indicating what proportion of the assets of the banking system are in undercapitalized banks or insolvent banks after a shock are heavily influenced by the results of this bank. Notably, this bank becomes insolvent if its capital is adjusted according to the preliminary data on fixed assets that the mission was provided with.
45. Mainly—though not exclusively—because of this one large bank, the majority- public-sector-owned banks were found to be on average significantly more vulnerable than other banks. They have lower initial levels of capitalization and are at greater risk of being undercapitalized or insolvent in response to a shock.
10 Banks have held fixed assets as a hedge against inflation, which practice helped them survive past episodes of high inflation.
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Table 2. Stress Test Scenarios (data as of December 2003)
Number of banks Percent of assets CAR 1/ CAR CAR CAR CAR < 8% < 0% < 8% < 0% Actual situation at end-2003 All banks 20.4 3 1 9.2 3.8 Majority public 17.0 2 1 7.4 3.8
Full provisioning All banks 16.6 5 3 14.9 10.8 Majority public 13.4 2 2 7.4 7.4
Full provisioning and adjust for fixed capital All banks 2.6 14 8 77.1 46.8 Majority public -1.1 5 3 43.8 29.0
15 Percent of all loans deteriorate by 1 loan provisioning category 2/ All banks 17.9 5 1 33.1 3.8 Majority public 13.7 3 1 29.0 3.8
15 Percent of all loans deteriorate by 2 loan provisioning categories All banks 14.4 7 2 37.8 25.3 Majority public 9.0 3 2 29.0 25.3
30 Percent of all loans to the agricultural sector deteriorate by 1 loan provisioning category All banks 19.6 3 1 9.2 3.8 Majority public 15.8 2 1 7.4 3.8
30 Percent of all loans to the agricultural sector deteriorate by 2 loan provisioning categories All banks 18.6 3 2 9.2 7.4 Majority public 14.3 2 2 7.4 7.4
Capital revaluation results in a 20 percent loss All banks 16.3 5 1 12.4 3.8 Majority public 13.6 2 1 7.4 3.8
10 percent appreciation of the exchange rate 3/ All banks 17.5 4 2 32.0 5.6 Majority public 14.8 3 1 29.9 3.8
Source: BOS, and staff estimates.
1/ Ratio of capital to risk-weighted assets, in percent. 2/ 15 percent of all performing loans move to the 20 percent provisioning category, 15 percent of all loans already in the 20 percent category move to the 50 percent category, and 15 percent of all loans in the 50 percent category move to the 100 percent category. 3/ Estimated using net open foreign exchange positions from November 30, 2004.
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46. Nonperforming loan tests: The Sudanese banking system was found to be moderately vulnerable to increases in NPLs. The threat is greater from the possibility that a moderate quantity of loans could eventually be completely written off than from the possibility that a large quantity of loans could require moderate levels of provisioning.
47. Several tests were performed to measure this vulnerability, including ones that examined different rates of deterioration of loans. Since breakdowns of loan data into three of the five loan classification categories were available stress tests could examine the effects of a certain percentage of loans deteriorating by one or more categories of nonperformance.
48. For example, one test examined what would be the effect of 15 percent of all performing loans moving into the first category of nonperformance, 15 percent of all loans already in the first category moving into the second category, and 15 percent of all loans in the second category moving into the third (total loss) category. The results of this test were comparable to those of requiring full provisioning. The overall CAR fell only to 18 percent and only two additional banks would fall below the required 8 percent CAR, though because one of these banks is large one third of the assets of the banking system would be in undercapitalized banks.
49. The banking system was fairly resilient to even a large quantity of loans deteriorating by one category. In the event that 30 percent of all loans deteriorate by one category, the overall CAR falls to 15 percent; nearly 40 percent of the assets of the banking system are in undercapitalized banks; and no additional banks become insolvent. Even in the extreme scenario where 100 percent of all loans deteriorate by one category, the overall CAR remains positive at nearly 4 percent; 60 percent of the assets of the banking system remain in solvent banks; and nearly 40 percent of the assets of the banking system remain in banks that meet the required 8 percent CAR.
50. Under scenarios where loans deteriorate by two categories, however, there are more significant consequences. If 15 percent of all loans deteriorate by two categories there is a significant drop in the overall CAR to 14 percent, and because a large bank becomes insolvent, one-quarter of the assets of the banking system remain in banks that are insolvent. If 30 percent of all loans deteriorate by two categories, the overall CAR decreases to 8 percent; nearly half of all assets continue in undercapitalized banks; and 30 percent of assets are in insolvent banks. A 51 percent shift of all loans by one category represents the breaking point where the system becomes insolvent on average.
51. Sectoral tests indicated that the banking system is not particularly vulnerable to a deterioration in one sector of the economy. The mission focused on the agriculture sector because it is particularly volatile and loan data were available. A 30 percent deterioration in all agricultural loans reduced the overall CAR of the banking system by less than 1 percent and did not cause any banks to become insolvent or undercapitalized. Even if 100 percent of all agricultural loans deteriorate by one category, the overall CAR falls only to 18 percent, but some specialized banks would be in difficulties. Many banks are reluctant to make loans to the agricultural sector because of the risks involved, so agricultural loans are concentrated
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in a small number of banks and this particular test may not be as revealing as the subsequent one on dollar loans.
52. Dollar loans would be vulnerable to a deterioration in the exchange rate since some borrowers who owe dollars earn revenues mostly or entirely in local currency, however, because banks generally have long net open positions in dollars they would benefit from the devaluation. A deterioration of 30 percent of all dollar-denominated loans by one performance category as a result of a 10 percent depreciation would result in an increase in the average CAR to 22 percent and the assets of the banking system are in banks that do not meet the minimum 8.0 percent CAR would increase slightly to 9.7 percent as one private bank falls below the required 8 percent ratio while the foreign bank that was initially below it comes into compliance. A worse deterioration of two performance categories maintains the overall CAR at 22 percent, and one additional private bank becomes insolvent or undercapitalized, and even In the extreme case where 100 percent of dollar-denominated loans deteriorate by two categories, the overall CAR falls only to 13 percent; three-quarters of the assets of the banking system remain in solvent banks; and over 60 percent of the assets of the banking system remain in banks that are fully capitalized.
53. Exchange rate risk: There appears to be limited risk at present from movements in the exchange rate. Because of banks’ long position in dollars they are somewhat exposed to an appreciation of the currency. A 10 percent increase in the currency means that the overall CAR will fall to 18 percent; a third of the assets of the banking system are in banks that are undercapitalized banks, and 6 percent of the assets are in insolvent banks. Under an extreme case of a 30 percent appreciation, the overall CAR falls to 12 percent; nearly half of the assets of the system remain in undercapitalized banks; and a third of the assets of the system continue in insolvent banks. Such a scenario would be problematic, but is unlikely to unfold since the authorities would likely take steps to resist an appreciation before banks suffered serious consequences.11
54. Rate of return risk: In 2003, five banks with 9 percent of the assets of the banking system earned negative profits.12 Two types of test were performed on rate of return shocks. First, a decline in average rates of return was considered. For simplicity and to accommodate data limitations, all rates of return were assumed to decline by an equal proportion. For example, in one test the fixed proportion was 25 percent, meaning that an 8 percent rate fell to 6 percent, a 12 percent rate fell to 9 percent, a 20 percent rate fell to 15 percent, and so on. Under this scenario, eight banks with 20 percent of system assets make negative profits.
11 End-November 2004 data for net open foreign exchange positions were used instead of end- 2003 data, which were not available. All other data in these tests were from end-2003. An exchange rate of SD250 to the U.S. dollar was used to convert the net open foreign exchange positions into Sudanese dinars. 12 It is also notable that 19 banks with 60 percent of the assets of the banking system earned less than a 13.7 percent return on equity, which is the average return on investment deposits. Thus, the majority of bank shareholders could improve their return if they sold their shares and deposited the proceeds with their competitors. This suggests that there are nonfinancial benefits to owning a bank, which should be investigated and understood.
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Under a more drastic scenario where all rates of return were reduced by half, 14 banks with nearly half of system assets would make negative profits.
55. The second test looks at a decline in the fee income on which banks rely heavily. A 25 percent decrease in fee income causes 9 banks with 23 percent of system assets to make negative profits. A 50 percent decline in fee income causes 15 banks with 71 percent of system assets to make negative profits.
56. Deposit volatility: Tests of vulnerability to deposit volatility are discussed in the next section on future capital needs.
57. Capital valuation risk: Capital revaluation is not a significant risk in itself, but if it precedes other shocks it could have a more serious impact. These tests were straightforward. If capital revaluation results in a 20 percent loss of all capital the overall CAR falls by 20 percent to 16 percent and two additional banks fall below the required minimum CAR so that 12 percent of the assets of the banking system are in undercapitalized banks. Capital revaluation can result in the loss of over 60 percent of all capital before half of system assets are in undercapitalized banks.
D. Future Capital Needs
58. Perhaps the greatest potential risks to the Sudanese banking system, and especially incumbent institutions, were found to be related to the outlook for the expansion of the banking sector. Between end-2000 and end-2003, net domestic credit in the Sudanese economy approximately tripled, and deposits of the banking system increased by about two and a half times between end-2000 and end-January 2004. The likelihood that this growth will continue (or even accelerate in the context of improved domestic security and international relationships) presents opportunities, but also risks. As bank balance sheets and especially financing of the non-government sector grow, the banks will need more capital, which they can obtain by retaining earnings or by attracting new capital. Both approaches require that banks earn a sufficient return on capital, or else growth will eventually be hindered by lack of capital. Hence, adequate profitability is required at a time when banks will be exposed to increasing international competition. Capital injections or limits on growth (such as prohibiting undercapitalized banks from accepting new deposits) are likely to be needed under all but the best of circumstances.
59. The composition of the growth of the banking system will be crucially important since banks offer a variety of services, some of which are more profitable than others. Zero- return checking accounts that generate fees are particularly profitable for banks, which would like to expand this business. However, longer-term investment accounts are needed if banks are to provide longer-term project financing while maintaining a reasonable degree of matching of asset and liability maturities. Over the past several years there has not been a clear trend in demand deposit accounts as a share of total accounts. Data that were provided to the mission indicated surprisingly erratic behavior of this ratio. However the trend is likely
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to shift toward accounts that earn a return when foreign competition increases in the context of the bank restructuring program.
60. The composition of assets does not have as much impact, but enterprise financing appears to have been historically been more profitable than other types of investments that banks make, so strong growth in such financing—which has occurred during the past several years and could accelerate in the near future—would be to banks’ advantage. However, such financing receives a 100 percent risk weighting, and therefore growth in financing requires additional capital. The behavior of rates of return on financing will also have an impact.
61. Assumptions: Assets are broken down into “lending to the economy” and “other assets.” Liabilities are broken down into “Demand plus savings deposits,” “time deposits,” and “other liabilities.” Profits are equal to income minus expenses and then taxes are subtracted from any profit using the individual 2003 tax rate for each bank. Income includes “investment income,” “fees,” and “other income”; expenses include “investors’ return” on time deposits, “provisioning,” “personnel costs,” and “other expenses.” The following assumptions were made:
“Demand plus savings deposits” earn a rate of return of zero.
“Investment income” grows at the same rate as the volume of “lending to the economy.”
“Fees” grow at the same rate as the volume of “demand plus savings deposits.”
“Other income” grows at the same rate as the volume of “other assets.”
“Investors’ return” on “time deposits” grows at the same rate as the volume of “time deposits.”
“Provisioning” grows at the same rate as the volume of “lending to the economy.”
“Personnel costs” grow at the same rate as the volume of “demand plus savings deposits,” but are not allowed to decrease. (Note, however, that this is a conservative assumption since personnel costs have decreased in recent years.)
“Other expenses” grow at the same rate as the volume of total deposits.
Risk-weighted assets were assumed to grow by 85 percent of the increase in “lending to the economy” plus 20 percent of the increase in “other assets.”
62. Tests: A three-year horizon was considered, and it was generally observed that trends became more pronounced in the third year, suggesting that they would continue to accelerate if left unaddressed (Table 3). There are favorable scenarios and unfavorable scenarios. Favorable scenarios are ones that have relatively high rates of growth of “demand plus savings deposits.” Higher growth rates of “credit to the economy” are also helpful, though
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not nearly as significant. Under the most favorable scenarios, conditions for Sudanese banks improve somewhat. Under the most unfavorable scenarios, all capital is eliminated, profits become negative, and significant corrective actions would need to be taken within the next couple of years or even the next several months.
63. Favorable scenarios: If “demand plus savings deposits” and “credit to the economy” both grow by 30 percent, while investment deposits grow by only 15 percent and “other liabilities” grow by 20 percent per year, the share of “demand plus savings deposits” in total deposits grows from about two-thirds to about three-quarters and credit to the economy expands in line with recent years. After three years, there is a slight increase in the capital adequacy ratio and a doubling of the return on assets (from [0.8] to [1.6]), leaving most banks well-capitalized and with a source of income to strengthen their capital stocks, though two additional small banks become insolvent.
64. Even under this favorable scenario, however, the banking system is vulnerable to a decline in rates of return. If rates of return decline uniformly by a quarter (as discussed above), the overall CAR falls to 13 percent after three years and the return on assets halves instead of doubling. If rates of return decline uniformly by half, the overall CAR falls to 5 percent after three years, profits become negative, two-thirds of system assets are in undercapitalized banks, and a quarter of system assets remain in insolvent banks.
65. Unfavorable scenarios: Minor adjustments to rates of growth turn favorable scenarios into unfavorable or even crisis scenarios. If “demand plus savings deposits” and “credit to the economy” both grow by 20 percent instead of 30 percent, while investment deposits grow by 50 percent and “other liabilities” grow by 20 percent, there is a decline in the share of demand and savings deposits to about half and a somewhat more moderate expansion of credit to the economy. However, the outcome is drastically different than in the previous scenario. After three years the average capital adequacy ratio falls to 5 percent, average profits become strongly negative, 13 banks with 60 percent of all assets would be undercapitalized, and eight banks with over 40 percent of assets would be insolvent.
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Table 3. Sudan: Growth Stress Test Scenarios (data as of December 2003)
Number of banks Percent of assets CAR 1/ Return on CAR CAR CAR CAR assets < 8% < 0% < 8% < 0% Actual situation at end-2003
All banks 20.4 0.8 3 1 9.2 3.8 Majority public 17.0 0.8 2 1 7.4 3.8 Scenario 1--Favorable growth rates: Situation after 3 years All banks 20.9 1.6 4 3 10.7 7.4 Majority public 16.8 1.7 2 1 6.7 3.5 Scenario 2--Unfavorable growth rates: Situation after 3 years All banks 5.1 -2.7 13 8 60.5 41.1 Majority public 0.3 -3.1 4 4 34.6 34.6
Scenario 3--Liquidity crisis Situation after 3 years All banks 14.7 -1.9 9 4 33.4 16.2 Majority public 12.7 -1.3 3 2 15.9 11.2
Scenario 4--Unfavorable growth rates and all rates of return and fees decrease by 1/4 Situation after 3 years All banks 0.4 -3.2 15 12 74.1 58.5 Majority public -3.0 -3.5 5 4 44.1 34.8 Growth rates of balance sheet components Favorable growth rates Credit to the economy 30.0 Deposits 25.0 Demand and savings deposits 30.0 Investment accounts 15.4 Other liabilities 20.0 Unfavorable growth rates Credit to the economy 20.0 Deposits 30.0 Demand and savings deposits 20.0 Investment accounts 49.3 Other liabilities 20.0 Liquidity crisis Credit to the economy 0.0 Deposits -17.0 Demand and savings deposits -25.0 Investment accounts -1.6 Other liabilities 10.0 Other assumptions: Investment income grows at the same rate as credit to the economy. Fees and other income grow at the same rate as demand plus savings deposits. Returns paid by banks to investors grow at the same rate as investment deposits. Provisioning grows at the same rate as credit to the economy. Personnel and other costs grow at the same rate as total deposits.
Source: BOS, and staff estimates. 1/ Ratio of capital to risk-weighted assets, in percent.
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66. In this unfavorable scenario a concurrent decline in rates of return would result in a need to take action to avoid a crisis. If there is also a decline in rates of return by a quarter, and there is no intervention, all capital of the banking system is wiped out after three years, profits become strongly negative, and 60 percent of system assets are in insolvent banks.
67. Even growth scenario: Even growth of all types of banking business would be a relatively favorable scenario (in the absence of a decline in rates of return). After three years of uniform 30 percent growth, the overall CAR ratio would decline only to 17 percent, and return on assets (ROA) would remain at 0.8 percent. However, if there is a decline in rates of return of a quarter, after three years the overall CAR ratio would drop to 10 percent and profits would become negative.
68. Liquidity crisis: If there is a loss of confidence in the banking system or the economy in general there could be a sudden loss of deposits from the banking system, and capital controls may or may not be adequate to keep funds from leaving the country. Yet, the banking system is not especially vulnerable to such a liquidity crisis. In the envisioned scenario—an extreme case where demand and savings deposits contract by a quarter each year for three years, credit to the economy ceases, and banks respond with a combination of selling assets and recourse to borrowing—the average capital adequacy ratio falls only to about 15 percent, though profits become negative; eight banks with a third of banking system assets would be undercapitalized, and four banks with a sixth of all assets would be insolvent. And even this decline is heavily dependent upon the assumption that personnel costs would not decline in spite of the decrease in the volume of deposits and associated transactions. Bank assets are highly liquid, so liquidity would not appear to be a serious concern.
69. These scenarios focused on the significance of the composition of growth of the financial sector. The indication above that rapid credit growth also has risks related to credit quality should be reiterated. Such risks are not as easily quantifiable because the timing of the emergence of NPLs resulting from over-aggressive lending is uncertain and would depend on overall growth and the general state of the economy. But a rapid expansion of the banking sector would call for more cautious policies regarding bank capitalization.
E. Conclusions
70. This analysis is based on capital adequacy figures that may be overly generous, yet under plausible scenarios, this large stock of capital can become largely or completely exhausted, and adjustments for full provisioning and subtraction of fixed assets could potentially erase a large share of the capital stock before these scenarios even unfold. The developing environment of high growth and increasing competition will require banks to become more efficient, as the most significant threats to stability impact banks through their profitability. In a well-developed competitive financial system, banks will not be able to rely on large stocks of unremunerated fee-generating deposits, but will have to actively seek out productive investments and other competitive advantages.
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71. Some caveats to the warnings should be offered. The unfavorable scenarios are unlikely to unfold as indicated in the stress tests because the BOS and commercial banks would take actions in response to the adverse developments. In particular, banks could respond to an unfavorable composition of growth rates by refusing to take investment deposits or lowering the returns that are offered. Much of the capital needs of the expanding banking sector and the demand for remunerative deposits could be satisfied by new foreign banks, and this is to a large extent envisioned in the bank reform program now underway. An expanded foreign presence in the Sudanese banking system may offer a desirable increase in diversity. However, it would be unfortunate if domestic banks were unable to compete and thrive alongside their foreign counterparts. While a foreign bank presence in Sudan may have benefits, complete domination of the banking sector by foreign banks may be harmful.
72. To address the immediate risks from NPLs, exchange rate movements, and capital revaluation, the BOS should strengthen the supervision of banks. Capital adequacy, provisioning, and net open position requirements should be carefully monitored and enforced.
73. To prepare for the expected expansion of the banking sector, bank owners should be alerted to the possibility that significant capital injections may be required and warned of the impending risks and the need to improve efficiency. Early warning systems—including improved data and information collection and internal communication at the BOS—should be implemented as soon as possible,13 and emergency and lender-of-last-resort policies should be clearly defined in advance of any crisis. The bank restructuring program will provide an excellent opportunity to address bank efficiency, and the large minimum stocks of capital will provide banks with a cushion to enable them to adapt to the envisioned foreign competition. Foreign competition has been associated with improved efficiency and lower spreads in banking systems in other countries, and foreign bank entry should be welcomed as a means to invigorate the Sudanese banking system, make it more resilient, and enable it to more reliably accommodate the increase in economic growth that is anticipated over the coming years.
74. The mission presented only one multiple-shock scenario for the static stress tests (NPLs and exchange rate), however such multiple-shock scenarios are common. An increase in nonperforming loans is likely to be associated with (if not caused by) a depreciation, a change in rates of return, or a decline in capital valuation. To assess multiple scenarios the decline in the average level of capitalization can be determined by adding the declines from separate scenarios. However it should be noted that the number of banks that are insolvent or undercapitalized will not necessarily increase in a linear fashion.
13 This will require a strengthening of data management capacity of the BOS, as envisioned.
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14 III. EFFICIENCY OF SUDANESE BANKS
A. Introduction
75. This note estimates the efficiency of the Sudanese banking system, particularly the distribution of efficiency across banks, and explores what could explain the cross-bank divergence in efficiency. It also examines how the efficiency of Sudanese banks has been related to their profitability over the recent years.
76. From the analyses, we found that Sudanese banks differ considerably in their efficiency, measured by total factor productivity (TFP). In addition, cross-bank differences in TFP seemed to be closely associated with those in wage per employee and investment rate spreads. We also found that, over the past three years, the Sudanese banks’ profitability has risen without substantial increases in their efficiency.
77. The empirical results are interpreted as tentative rather than conclusive, given the serious limitations in both coverage and quality of the available data. The number of observations is small, and some variables (notably fixed capital) may be measured imprecisely.15
B. Estimation of Efficiency
Methodology and data
78. To estimate the TFP of Sudanese banks, we use a standard Cobb-Douglas production functions. Assume that the production technology of each bank is represented by:
β α (1) yi = Ai li ki , where yi is output, Ai is total factor productivity, li is labor, ki is capital, β is the labor income share, and α is the capital income share of the i-th bank, respectively.16 Then a bank’s total
yi factor productivity, which represents its efficiency, is: Ai . lkii
79. To estimate TFP at the individual bank level, we use financial statement data of 21 Sudanese banks for the period 2001-2003, provided by the Banking Supervision Department of the BOS. The data do not provide information that exactly matches the concept of output 17 and physical capital. As a proxy for output of individual bank, we use yi, the sum of profits,
14 Contributor: Se-Jik Kim 15 There is a large academic literature on measuring bank efficiency and productivity, where various techniques are employed. One controversial issue is the measurement of bank inputs and outputs. 16 Use of a more flexible functional form is precluded by the limited number of observations in the sample. 17 The definition of bank inputs and outputs is the subject of some controversy in the literature on the estimation of bank productivity and efficiency. The definitions used here were largely dictated by the limited availability of data.
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labor costs and capital costs, which approximates “value-added,” a standard concept of output in economics. To measure total capital costs, we use fixed assets multiplied by a unit cost of capital. For physical capital, ki, fixed assets is used as a proxy. Regarding labor input of each firm, li, the number of employees is used.
80. The financial statement data on Sudanese banks does not provide information on the capital and labor income share parameters, and the unit cost of capital. For the parameters for which information is not readily available, we make some reasonable assumptions, which serve as a benchmark.18 Then we carry out the estimation of TFP on the benchmark case, and check the sensitivity of the results to alternative assumptions on the parameters to reassure that the benchmark assumption is not critical to deriving the results.
81. For any given set of parameters, total factor productivity of each bank can be calculated using the above equation for TFP and the annual data for yi, li, and ki, for each of the three years, 2001, 2001, and 2003. To reduce potential measurement errors generated by year-specific idiosyncratic shocks, we use a three-year-average productivity for each bank, 1 2003 that is, At Ai,s , where Ai s represents the TFP of the i-th bank in year s. The three- 3 s2001 year average productivity (Ai) may represent the underlying long-run productivity of each bank as long as there is strong persistence in productivity of each individual bank over time. We also use annual TFPs (Ai, s) to examine changes in efficiency over the past three years.
82. We can then derive a distribution of estimated TFP across banks. The bank (or a group of the banks) with the highest TFP can be considered to have reached the “best practice” or efficiency frontier. A bank’s distance from the best technology (in terms of estimated TFP) can be interpreted as representing the degree of its inefficiency.
C. Estimation Results
Benchmark case
83. As a benchmark case, we assume that the sum of capital and labor income shares is one (as in the standard Cobb-Douglas case), and that the capital income share of any bank is 0.7, with the labor income share being 0.3 (α = 0.7 and β = 0.3). The assumption might capture the fact that the marginal product of capital tends to be higher than that of labor in developing countries. We also assume that the unit cost of capital is 10 percent, which is close to the average of the effective investment (lending) rate and deposit rate of the banking system in 2003.
84. In the benchmark case, the TFP calculation shows that there is a large dispersion in productivity across 21 Sudanese banks. By ranking the banks according to their estimated TFPs, the distribution of Ai can be derived. The estimated productivity distribution across the
18 An alternative approach based on the estimation of a production frontier was also tried; results are reported in the appendix.
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banks shows wide diversion (Figure 1). The average productivity is 1.9, and the standard deviation is 2.3.
85. We may consider that the average TFP of the five most efficient banks could form a feasible efficiency frontier that other banks could reach. Then the TFP of other banks compared to the efficient frontier can be interpreted as representing the degree of their inefficiency. The estimated TFP of the five most efficient banks, which constitute 13.4 percent of total assets of the banking sector, surpasses by more than 20 times that of the five least efficient banks, which hold 12.4 percent of total assets.19 This suggests the existence of many inefficient banks.
Figure 1. Distribution of Efficiency in the Benchmark Case
Frequency
10
9
8
7
6
5
4
3
2
1
0 1 2 3 4 5 6 7 8 9 -2 -1.5 -1 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 10 10.5 More -8.63476E-14 TFP
Sensitivity analysis
86. Alternative assumptions on the key parameters can be made to examine the extent to which the choice of the parameters affects the results obtained in the benchmark case (including the relative ranking of TFPs across banks).
19The relative asset shares of the second most efficient group of banks (ranking between 6 and 10) and the second least efficient group (ranking between 11 and 16) are 46.4 percent and 23.6 percent, respectively.
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87. The sensitivity analysis suggests that the main results are robust against alternative assumptions on income share parameters. Table 1 shows that the relative efficiency rankings among the banks remain very stable even when we assume that α = 0.5, β = 0.5, or that α = 0.3, β = 0.7. Despite the different assumptions on capital income share parameters, the ranks of the five most efficient banks, and those of the five least efficient banks do not change. The estimated TFP of the five most efficient banks amounts to about sixteen times and twelve times that of the five least efficient banks in the case of α = 0.5 and α = 0.7, respectively.
88. The results are also insensitive to the assumptions on the unit cost of capital. The last column of Table 1 illustrates the relative efficiency rankings in the case where the unit cost of capital is assumed to be 5 percent, close to the effective deposit rate of the banking sector (instead of 10 percent in the benchmark case). A comparison between the first and the fourth column suggests that the relative rakings in efficiency is little affected by the assumption of lower cost of capital except a minor change in ranking between Banks 11, 12 and 13. In this case, the ratio of TFP of the five most efficient banks to that of the least five efficient is even larger than that of the benchmark case.
Table 4. Sensitivity of Relative Efficiency Ranking
α = 0.7 α = 0.5 α = 0.3 α = 0.7 β = 0.3 β = 0.5 β = 0.7 β = 0.3 r = 0.10 r = 0.10 r = 0.10 r = 0.05 Bank 1 Bank 1 Bank 1 Bank 1 Bank 2 Bank 2 Bank 2 Bank 2 Bank 3 Bank 3 Bank 3 Bank 3 Bank 4 Bank 4 Bank 4 Bank 4 Bank 5 Bank 5 Bank 5 Bank 5 Bank 6 Bank 6 Bank 9 Bank 6 Bank 7 Bank 9 Bank 15 Bank 7 Bank 8 Bank 8 Bank 6 Bank 8 Bank 9 Bank 7 Bank 8 Bank 9 Bank 10 Bank 15 Bank 11 Bank 10 Bank 11 Bank 11 Bank 14 Bank 12 Bank 12 Bank 14 Bank 7 Bank 13 Bank 13 Bank 10 Bank 16 Bank 11 Bank 14 Bank 12 Bank 10 Bank 14 Bank 15 Bank 13 Bank 12 Bank 15 Bank 16 Bank 16 Bank 13 Bank 16 Bank 17 Bank 17 Bank 17 Bank 18 Bank 18 Bank 18 Bank 18 Bank 17 Bank 19 Bank 19 Bank 19 Bank 19 Bank 20 Bank 20 Bank 20 Bank 20 Bank 21 Bank 21 Bank 21 Bank 21
Source: BOS, and staff estimates.
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89. Thus, the main result of this note—that Sudanese banks differ considerably in their efficiency—is robust with respect to changes in key parameters and proxies. The high efficiency of banks following international best practices might suggest that there is considerable scope for efficiency gains for less efficient banks. Note that the extent of cross- bank difference in efficiency is crucial to determining the benefit of banking sector reform. The greater the productivity difference across banks, the larger the benefit of banking sector restructuring.
D. Effects of Bank Characteristics on Efficiency
90. This section explores what could potentially explain wide cross-bank divergences in efficiency. To this end, we run regressions of the TFP calculated in the benchmark case on various variables that might characterize banks.
91. Regressions of the three-year average TFPs on three-year averages of explanatory variables generate the results reported in the first three columns of Table 2. The explanatory variables we consider include total assets (as a proxy for the size of a bank); wage per employee (as a proxy for the quality of workers); investment rate spreads (as a proxy for the bank’s ability to effectively manage financial resources); the ratio of time deposits to total deposits, the equity-liabilities ratio, and the ratio of fee income to total assets (as an indicator of business strategy).
92. From the regression analysis, we find that banks with higher wages per employee tend to have higher total factor productivity. The coefficient is positive and statistically significant in all of the regressions. Provided that higher quality workers get paid more, the result would suggest that the improvement in the quality of workers is critical to raising efficiency. Furthermore, a bank that cuts its labor costs without due consideration on maintaining the quality of its employees might undermine its efficiency (although the reduction might raise its profitability over the short term). It should be noted, however, that the correlation between the two variables does not necessarily imply that higher wages per employee cause higher TFP; the correlation is also consistent with a contrasting hypothesis of efficiency wage, whereby higher wages induce higher workers’ efforts.
93. In addition, the investment rate spread, calculated as the effective investment rate (total income from credits/total credits) subtracted by the effective deposit rate (total expenses paid to deposit holders/total deposits), appears strongly associated with TFP. The coefficient tends to remain positive and significant as long as the number of explanatory variables is limited. Again, the correlation between TFP and investment rate spread does not imply a causal relationship between the two variables.
94. Finally, other bank characteristics such as total assets, the ratio of time deposits to total deposits, equity-liabilities ratio and fee income-asset ratio appear not to be closely associated with TFP. Their coefficients are consistently insignificant in various regressions or their significance substantially varies across regressions.
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95. We also ran regressions using annual data instead of three-year averages (the last two columns of Table 2). In this case, we control bank fixed effects by grouping the banks into high TFP, middle TFP, and low TFP banks, or, as an alternative, foreign, state-owned and other domestic banks (based on BOS classification). The results in this case are similar to those in the above case of using three-year averages: the coefficients for wage per employee and the interest rate spread are positive and significant. Furthermore, we find that dummies for high TFP banks and foreign banks are positive and significant. But the dummy for state- owned banks is not significant, suggesting that there is no significant difference in efficiency between state-owned and other domestic banks after controlling for other factors.
Table 5. Regression Results
(1) (2) (3) (4) (5) constant -2.1 -1.3 -2.3 -1.5 -1.1 (-2.0) (-0.9) (-1.0) (-1.9) (-2.0) wage per employee 2.1 1.9 2.0 1.3 1.1 (4.0) (3.1) (3.0) (4.5) (5.3) total assets -0.000003 -0.000006 -0.000008 -0.000005 -0.000002 (-0.2) (-0.4) (-0.5) (-0.7) (-0.3) investment rate spreads 7.7 8.2 8.1 5.4 3.8 (2.3) (2.4) (2.3) (3.1) (3.2) time deposits/ total deposits 3.1 -3.1 -2.4 -1.8 -0.6 (-2.5) (-1.5) (-1.0) (-1.6) (-0.7) equity/liabilities -1.9 -1.3 -0.3 -0.8 (-0.9) (-0.5) (-0.5) (-1.5) fee income/total assets 16.6 12.0 12.7 (0.5) (1.0) (1.6) dummy for high TFP group 1.7 ... (3.0) dummy for middle TFP group 0.0 ... (0.0) dummy for foreign banks 4.8 (8.9) dummy for state-owned banks 0.3 (0.7) Adjusted R2 0.55 0.54 0.52 0.62 0.81
Source: BOS, and staff estimates. Figures in parentheses are t-values.
E. Profitability Versus Efficiency
96. This section explores how changes in bank efficiency have been related to developments in bank profitability. Table 3 summarizes the developments in profitability and efficiency of the banking sector over the past three years.
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97. The profitability of the banking system, measured by return on assets (ROA), has trended upward over the past three years. In 2003, the before-tax return on assets amounted to 1.6 percent, a significant improvement from 0.5 percent in 2001.
98. The rise in profitability (by 1.1 percentage points) reflects rises in net interest revenues and above all large reductions in labor costs. Sudanese banks have raised net interest revenues as a share of total assets by 0.6 percentage point. More important, they have cut their personnel expenses from 4.4 percent of total assets in 2001 to 2.5 percent in 2003 (by 1.9 percentage points). This cut in wage expenses may reflect bank efforts to contain the increases in both the number of employees (including even a substantial downsizing in 2002) and wage rates.
99. Meanwhile, the average TFPs of the banks calculated for each year declined in 2003. So the substantial improvement in profitability has not been accompanied by persistent increases in efficiency. This suggests that recent growth in profitability is largely attributable to improved trading conditions and might mask potential weaknesses in bank efficiency. The decoupling of movements in profitability and efficiency may partly be explained by reductions in wage per employee. Given that wage per employee is closely correlated with efficiency in the Sudanese banking sector, the decline in wage per worker to SD 1.38 million in 2002 might have induced the decline in TFP. Meanwhile, declines in wage expenses as a fraction of total assets may have induced increased in return on assets. This suggests that restraints on wage increase might help improve profitability but undermine efficiency.
Table 6. Indicators of Bank Efficiency and Profitability
2001 2002 2003 (Percent of total assets) Return (before tax) 0.5 1.1 1.5 Net interest revenues 2.5 2.4 3.1 Fee income 4.0 3.5 3.6 Wage expenses 4.4 3.1 2.5 Other operating costs 2.0 1.6 1.9 Other net revenue 0.4 -0.1 -0.8 (In millions of Sudanese dinar) Wage per employee 1.43 1.57 1.38 (In thousands of persons) Number of employees 12.6 11.4 13.3 Average TFP 1.93 1.99 1.75
Source: BOS Banking Supervision Department, and staff estimates
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Stochastic Production Frontier Approach: An Example
100. In this appendix, an alternative approach to estimate total factor productivity is presented, namely, the stochastic frontier approach based on a logarithmic expression of the Cobb-Douglas production function:
(2) ln yi = ln Ai + β ln li + α ln ki.
101. Using data from individual bank financial statements, the labor and capital income share parameters (which are assumed to be common to all the banks) can be estimated, as well as each bank’s individual TFP.
102. An advantage of this approach is that labor and capital income share parameters can be estimated (rather than assumed as in the deterministic used above). However, this method has the shortcoming that data on the banks that suffered negative TFPs must be excluded , because variables are in logarithmic form,. Hence, the regression equations cannot capture information on an important group of banks, that is, the least efficient banks with negative TFPs. Because the banks that had experienced negative value-added in at least one year are excluded, the number of banks in the sample is reduced from 21 to 18.
103. If we use the three-year average TFP, the number of observations in the sample falls to only 18. To mitigate small sample problems, we may use annual TFPs of each bank for 2001, 2002 and 2003, rather than the three year averages, which raises the number of observations up to 54. To limit potential bank-fixed effects in the panel data, we use dummy variables based on the grouping of the banks into high, medium, and low TFP banks.
104. The result from a regression with group-of-bank fixed effect is as follows:
(3) ln yi,t = 1.4 + 0.23 ln li,t + 0.57 ln ki,t + 1.0 DH + 0.1 DM (3.4) (2.0) (5.4) (5.6) (0.8)
Adjusted R2 = 0.81, Observation = 54, where DH represent a dummy variable that takes 1 for high TFP banks, DM is a dummy variable for middle TFP banks, and the figures in the parentheses are the t-values of the estimated coefficients. Based on the regression, we can calculate log Ai,t (and hence Ai,t ) for each bank for each of the three years. Then we derive TFP of each bank by taking the three year average of the calculated annual TFPs.
105. We find that Sudanese banks differ considerably in their TFPs even when we adopt a stochastic frontier approach. The most efficient bank in this case (which is the most efficient in the benchmark case), has a three-year average TFP 10 times that of the least efficient among those with positive TFP. Note that the results obtained under this approach should be also cautiously interpreted, given limitations on the availability and quality of data.
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IV. THE INSURANCE SECTOR IN SUDAN20
A. Market Development
Size and growth
106. The insurance sector in Sudan is still small. With total premium income of SD 23.6 billion (US$89 million) in 2003, the overall ratio of premiums to GDP (the penetration ratio) was about 0.5 percent. Factors contributing to this low level include the low per capita income and lack of a middle class, past economic and political instability, lack of a general understanding and awareness among the public of cultural issues, limited investment opportunities for insurance companies, weaknesses in the legal and regulatory framework for the sector, and weaknesses in supporting infrastructure, such as accountancy practices and the availability of actuarial expertise. The penetration ratio is low relative to many other countries in Africa (Table 4), although not much below that seen in some countries with higher per-capital income.
Table 7. Comparison of Insurance Markets in Africa (in 2003)
Premium Volume Insurance Penetration (in US$ millions) (Premiums as a percent of GDP) Morocco 1,288 2.8 Egypt 566 0.7 Zimbabwe 482 4.2 Tunisia 456 1.8 Nigeria 422 0.8 Kenya 411 3.0 Algeria 399 0.6 Mauritius 241 4.6 Sudan 89 0.5
Source: Swiss Reinsurance Company, and staff estimates.
107. Nonetheless, the insurance sector is growing rapidly (Table 5). Over the last four years, non-life insurance premiums have been growing faster than life premiums, perhaps because the life business is only just now being established.
20 Contributor: Serap Oguz Gonulal.
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Table 8. Insurance Sector Growth
Premium Income 1/ Growth (In SD millions) (percent) 1999 2003 Life (takaful) 1,763 2,485 41 Non-life 7,644 20,689 171
Sources: Sudanese authorities; and staff estimates. 1/ Excludes re-insurance.
Structure
108. No new firms have entered the market since 1990, and two insurance companies have had their licenses withdrawn in recent years. At end-2003, 14 insurance companies and one reinsurance company were licensed and operating. There are three composite companies, including the largest, Sheikan, and 11 non-life companies.
109. The state is heavily involved in the insurance and reinsurance sector. The largest company, Sheikan Insurance and Reinsurance Co. Ltd., is fully state-owned. Established in 1991 to serve as the government’s insurance agent, it is now the only company allowed to provide the government with insurance (the government currently accounts for some 40 percent of insurance market premiums). Some of the government business is spread around the market by way of coinsurance and reinsurance, but the restriction strengthens the control of the government over the sector. One consequence of giving a government-owned business a monopoly on government business is that the government is indirectly exposed to all insured risks, although it benefits from Sheikan’s expertise in such areas as loss adjustment and the management of reserves; in addition, the government can receive dividends from Sheikan.
110. Sheikan dominates the market (Table 6). It received the majority of the sector’s gross premium income in 2004, and is almost the sole supplier of life insurance, with 95 percent of gross premium income in 2003.21 It has a special social mandate to provide service to lower income groups, and in some ways acts to promote the sector as a whole rather than maximizing its short-term advantage (e.g., by ceding co-insurance to smaller companies and providing training).
21 The term “takaful” is often used in Sudan to refer to life insurance in particular, although the term can be used to denote Islamic insurance more generally.
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Table 9. Market Shares of the Largest Insurance Companies, 2003
Insurance Company Total Direct Premiums Market Share (in SD millions) (percent) Sheikan Ins & Re. 11,221 55 Islamic Insurance Co. 1,661 8 The United Ins. Co 1,374 7 Wataina Ins. 1,261 6 Sudanese Ins & Re. 874 4 Five largest companies 16,391 80 Total insurance market 20,689 100
Sources: Sudanese authorities; and staff estimates.
111. Other insurance companies are mainly owned by commercial enterprises and by individuals, and five insurance companies are partially owned by banks. A number of small insurers are little more than captive companies dealing mainly, although not exclusively, with their own shareholders; this structure allows the policy-holding shareholders to obtain a sizeable share of any profits made. The Sharia (Islamic law) requires that profits generally be distributed to policyholders (see below).
112. Foreign involvement in the insurance sector is minimal. No major international groups have shareholdings or formal links with Sudanese companies. However, several companies have links with companies in various Middle Eastern countries, particularly Saudi Arabia.
113. Insurers attract business on a direct basis as well as via agency networks. The main distribution channel for personal business is each company’s branch network. Sheikan has the largest distribution network, with 22 branches throughout the Sudan.
114. A large number of principal agents operate, at three levels: principal agents, branch agents, and producers. Principal agents have the highest levels of authority and are often permitted to issue policies. All agents must be registered and licensed. In 2003, there were 777 agents, accounting for 80 percent of the market. Bank assurance is practiced widely in Sudan. Virtually all Sudanese banks have agency relationships with insurers, and distribution of insurance products via banks accounts for a significant volume of overall market premium. At present there are no locally licensed insurance brokers operating in Sudan.
Business lines
115. Besides government business, the main products offered by insurance companies are coverage for motor, worker compensation, and property risks. Insurance companies have been innovative in introducing new products in recent years in such areas as health, crop agriculture, and life products.
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Motor insurance
116. Motor (or auto) insurance is the major line of business for insurance companies (as is the case in many developing markets). Motor third party liability insurance is compulsory both with respect to property damage and bodily injury. The level of compliance is difficult to ascertain.
117. A mandatory tariff applies to third party motor rates. The setting of the rates is coordinated by the Association of Sudanese Insurance and Reinsurance Companies and approved by the Insurance Supervisory Agency (ISA), the regulatory agency (see below). However, there is no claims database on the frequency and severity of claims to help insurers and supervisors appropriately to price various products, including compulsory motor insurance. On occasion, the industry has obtained large increases in rates. There is no guarantee fund to compensate victims of accidents caused by uninsured vehicles or by drivers.
Agriculture insurance
118. The authorities are considering the establishment of a National Fund for Alleviating the Impact of Agricultural Hazards and for Agricultural Insurance Support that could contribute to the further development of agricultural insurance. Given the importance of agriculture to the Sudanese economy and the fiscal burden from the current provision of agricultural subsidies offered by the government in response to insurable events, there would seem to be broad scope for development of new products. 22 The government could choose to replace various subsidies for the sector with an Agriculture Insurance Scheme built on a new policy framework. In the process, part of the risk currently borne by the government could be transferred to private insurance companies as a percent of the premium, and/or by providing that partion of the reinsurance cost that exceeds the allowed limits. The advantage of such a policy is that it helps develop the insurance sector while allowing the government to budget more accurately its support to the agriculture sector. A cost benefit benefit analysis of could be undertaken as part of provided technical assistance.
119. Limited crop insurance was recently introduced by Sheikan, and is currently only available for irrigated cotton.23 Risks covered include pests, for example the boll weevil, but excludes rats, locusts and birds. Cotton diseases are covered, as are weather conditions
22 In 1999, agriculture (mostly subsistence agriculture) accounted for about 43 percent of GDP and 80 percent of employment. About 17 percent of the 80 million hectares of arable land is currently under cultivation, and livestock—consisting of cattle, sheep, goats and camels—is estimated at about 100 million head. Agricultural products such as cotton and live animals are major export earners. However from 2001, the ISA has been compiling separate statistics for livestock insurance, according to which livestock insurance premiums amounted to just SD 245 million, or 1 percent of total gross premiums at end-2003. 23 In 1995, Sheikan assigned a British consultancy to prepare a detailed feasibility study of the project, and the consultancy proposed a Gezira pilot project for cotton and sorghum, given their importance as export and staple crops respectively. The plan was delayed until 2001 when the reinsurance company was invited to update the feasibility study and prepare a work plan for a pilot project in cotton, which is now covered by Sheikan.
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(excessive rainfall or heat). The scheme involves close monitoring of farmers involved and the provision of technical advice, and is operated in cooperation with the Agricultural Bank. Initial indications are that the scheme is successful—false claims have decreased and productivity has increased—but government subsidies are still required. Because of high costs and the need to accumulate technical knowledge, livestock and crop insurance are generally beyond the capacity of the smaller insurance firms.
Life insurance
120. Life insurance accounted for just over 10 percent of premium income in 2003. The life or takaful contract market is particularly carefully monitored and supervised by the Sharia Supervisory Boards because compliance with Sharia is more complex for life products (Box 1). Nonetheless, companies are investigating how to develop a wider range of Sharia- compliant life products, including annuity-type products.
Box 1. Sharia-Compliant Insurance
The insurance sector, like the remainder of the Sudanese economy, is governed by a legal framework that mandates that all activities be compliant with Islamic law (Sharia). This requirement imposes some special conditions on insurance and particularly on non-term life insurance, where longer-term contracts with a savings element are involved. The main relevant considerations are the prohibitions on gambling and on the conduct of financial transactions unconnected with underlying “real” activity.
Sharia requires insurance to be a “donation contract,” whereby policyholders donate the premiums to a common pool of resources, and payouts are considered a form of charity. Since policyholders are donors, no gambling is deemed to have occurred. Any surplus may be set aside as reserves or distributed to policyholders in proportion to the contributions paid. Owing to the charitable, voluntary nature of the business, company profits on underwriting and policyholders’ receipt of payouts are tax free, whereas profits on investment income are taxable.
Insurers must maintain separate accounts for each policyholder to track all contributions. Administrative charges and costs of claims are allocated in proportion to contributions. Any surplus (after making provisions for pay-outs, operating costs, depreciation, bad debts and establishment of reserves) is allocated to policyholders in proportion to contributions paid, or set aside as reserves and investments on behalf of the policyholders. Shareholders—as opposed to policyholders—may not profit from the insurance business, for example, by receiving dividends, but may receive a fee for management services. In addition, it has been argued that shareholders can share in profits on the invested reserves, as distinct from the underwriting business itself. Investments must be in Sharia-compliant instruments. A Sharia supervisory board must be appointed by every insurance company to ensure compliance with Islamic law. This Sharia board has wide powers to vet business activities and conduct inspections.
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Reinsurance
121. There is only one local licensed reinsurance company in Sudan, the National Reinsurance Company (National Re.), which was established in 1974. The government owns 52 percent of National Re., with the remaining shares held largely by institutional investors including banks and insurance companies. National Re. benefits from a compulsory reinsurance treaty of 50 percent of all locally insured business, including life (takaful), and facultative insurance (placed through treaty programs).24 This arrangement means that half of all insured risk covered by one insurer will be passed on to another insurer (National Re. in this case) in return for a premium.
122. Insurers have to place 10 percent and 5 percent of their international treaty business through PTA-ZEP Re. and Africa Re. respectively in addition to the 50 percent of their treaty business that must go through National Re.25 However, this requirement is not always observed. Support is also available from a number of international reinsurers and reinsurance brokers. External reinsurance companies used are in the main Arig Re., Arab Union Re., Best Re. (Tunisia), Egyptian Re., and Munich Re., which, at least in the past, was the lead insurer on many engineering and Contractors/Construction All Risk treaties. Generali, once very important in the local market, is no longer renewing its treaties. The main writer of domestic market reinsurance is Sheikan.
Performance
123. At end-2003, most reserves were invested in bank deposits (Table 7). This tendency, in part, reflects regulatory requirements, but is also the product of a lack of alternative investment vehicles and the short-term nature of most underwriting business.
24 Facultative reinsurance is an optional, case-by-case method used when the insurance company receives an application for insurance that exceeds its retention limit. The insurance company is under no obligation to cede insurance, and the reinsurance company is under no obligation to accept the insurance. 25 The commitment to PTA-ZEP Re. reflects Sudan’s membership in the Common Market for Eastern and Southern Africa. The commitment to AFR Re. reflects Sudan’s membership in the African Union.
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Table 10. Insurance Company Investments (2003)
Type of Investment (In SD thousands) (Percent of total) Deposits 5,489,711 71.0 Shares 958,355 12.4 Government certificates 660,772 8.5 Land and real estate 578,857 7.5 Loans 5,674 0.1 Other Investment 36,158 0.5 Total 7,729,527 100.0
Sources: Sudanese authorities; and staff estimates.
124. In Sudan, lack of competition, significant levels of reinsurance, and unpaid and non- requested claims by policyholders have resulted in low claims ratios (Tables 8). Hence, companies can make adequate profits on underwriting provided that they contain operating costs.
Table 11. Premium Income and Claims
Net premium Income Net Claims Net Loss Ratio Year (In SD millions) (In SD millions) (percent) 1999 4,231 2,053 48.5 2000 6,238 3,289 52.7 2001 8,127 4,687 57.6 2002 9,926 5,095 51.3 2003 13,075 6,431 49.1
Sources: Sudanese authorities; and staff estimates.
B. The Regulatory Framework
125. The authorities have been making efforts to upgrade the legal, regulatory, and supervisory framework governing the insurance sector. However, they are aware that more needs to be done if the sector is to develop on a sound basis. At present, few of the International Association of Insurance Supervisors (IAIS) Principles would be observed; for information, a summary of the IAIS Principles is included as an appendix.
Legal framework
126. The insurance sector is governed by the Insurance Supervision Act, 2001, which replaced the Insurance Supervision Act, 1992. The current act may be amended in the near
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future. There is no separate Insurance Contracts Law to regulate legal relations among insured parties, policyholders and insurance companies. The Road Traffic Act, no.5 of 1962, which includes the requirement to obtain third-party liability insurance, was amended in 1993 to take Sharia into account.
127. The present legislative framework is weak in several ways. It does not include important internationally-accepted principles; it lacks regulations concerning implementation; and, in general, does not give sufficient powers to the supervisory authority to fully discharge its responsibilities. However, the Insurance Supervisory Agency (ISA) is authorized to conduct checks and inspections whenever it deems necessary.
128. Investment, capital, solvency and liability determination rules are not clearly set forth in the law, and this should be addressed in the new legislation currently under preparation. Technical provisions should ensure that the companies are in a position at all times (or at least in the vast majority of circumstances) to meet their commitments toward the insured.
The Insurance Supervisory Agency
129. The ISA, located in the Ministry of Finance and National Economy (MFE), is the regulatory and supervisory agency responsible for supervision of the insurance sector and licensing insurance companies. It approves policy conditions and premium schedules, monitors insurers’ compliance with the law, and ensures that companies comply with minimum capital and solvency requirements.
130. The ISA was established by government decree on June 12, 1991.26 The director of the ISA is chosen by the Board and approved by the Minister of Finance and National Economy. The Director should be well experienced in non-life insurance matters. The director is supported by two deputies, who monitor takaful and non-life insurance sector. There is also a part-time legal adviser employed, in addition to a mathematician.
131. There are four main departments in the ISA: licensing, financial, technical, and research. ISA has a staff of 44, of which 20 are professional staff and the rest administrative. There is substantial scope for strengthening the supervisory and institutional capacity of the ISA.
132. For financial supervision—including capital resources (solvency), the formation of technical provisions, and the existence and composition of assets (investments) necessary to meet the insured liabilities—the ISA relies on its desk analysis of financial information submitted by companies, and limited on-site supervision. Such off-site surveillance is insufficient and may fail to obtain critical information, including quarterly reports, annual reports, balance sheets, financial profit and loss accounts, or periodic statements of their technical reserves and solvency margins.
26 It was previously called the Insurance Supervision and Control Public Cooperation (ISC).
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Regulation
133. The minimum capital requirement for insurance companies of SD 300 million (about US$1.2 million), which, however, is not achieved by all companies. The ISA requires a 30 percent solvency margin for both life and non-life business. Companies are required to present to the ISA a certificate of solvency, an action plan to move into compliance, or acceptance of the plan suggested by the ISA. The ISA also requires a minimum level of legal reserves that can be easily liquidated (in the form of short-term bank deposits or easily- liquidated government bonds).
134. Companies are required to establish unearned premium reserves, outstanding reserves, and “incurred but not reported” reserves, though the insurance law does not specify exactly how these should be calculated. Companies have little experience of claims reserving, and it is not clear how reserves are calculated in practice. It seems likely that many companies have neither the expertise nor the will to capitalize these liabilities in their outstanding reserves. Sudan also suffers from inadequate technical provisions resulting from the lack of historical data for calculation and weak actuarial system. There are no specific regulations with respect to insurance company risk retention levels. The ISA has in theory introduced a requirement that companies restrict their involvement in motor accounts to 60 percent of the gross premium, but it is unclear whether all companies are compliant.
135. Insurance companies may reinsure without additional capital. There are no special criteria for the licensing of reinsurance companies. Any insurance company has the right to perform reinsurance operations on the basis of the licenses held. According to present insurance legislation in Sudan, reinsurance should only be ceded abroad after it has been offered to, and declined by the local market.
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IAIS Principles
Organization of insurance regulations and supervision (IAIS Principle 1) a) Regulatory Authority - The new IAIS Methodology approved in October, 2003, has significantly expanded the Core Principles dealing with the structure and operations of insurance supervisors. b) Supervisory Authority - As a rule, insurance supervision is carried out by a special institution. The insurance supervisory authority should be independent of political influences and the supervised insurance companies. Supervisors should have legally defined objectives, tasks, rights, and protections. Personally, supervisors should be professionally independent and impartial, and they should have wide knowledge and experience. c) Financing - In the majority of countries, the regulatory and supervisory body is financed by the insurance industry. d) Workforce -The number of persons employed in insurance supervision depends on the size of the country and the number of insurance companies operating there.
Licensing (IAIS Principle 2). Companies wishing to underwrite insurance in the domestic insurance market should be licensed. If a company fails to comply with conditions imposed with the license, then it is appropriate to cancel the license before the company issues any more policies. The law should at least set out the minimum requirements for licensing and the procedure for application.
Minimum licensing requirements:
Legal Form—should be either a joint stock company or mutual company. Business Plan—must include at least pro forma financial statements and a capital plan and projected solvency margins. Managerial Requirements—must include fitness and propriety requirements of company officers. Shareholder Information—must include mention of the reputation of strategic shareholders. Financial Requirements—must include adequate capital and all other significant financial information.
Changes in Control (IAIS Principle 3). The law should set up some rules to review changes in the control of companies that are licensed in the jurisdiction. The insurance supervisor should establish clear requirements to be met when a change in control is envisaged. These may be similar to the requirements for granting a license.
Corporate Governance (IAIS Principle 4). It is desirable that standards be established in the jurisdiction to deal with corporate governance. Preferably, the insurance supervisor should
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have responsibility for setting the requirements for corporate governance. The present law does not deal effectively with expectations in respect of corporate governance.
Assets (IAIS Principle 6). Standards should be established with respect to the assets of companies licensed to operate in the jurisdiction. Where insurance supervisors have the authority to establish the standards, these should apply at least to an amount of assets equal to the total of the technical provisions. Maximum exposure rules for assets covering technical provisions include the following:
no more than 10 percent of gross technical provisions can be in one property investment (including a number of pieces of land or buildings close enough to each other to be considered as one investment); no more than 5 percent of gross technical provisions can be, in aggregate, in the securities of, or as loans to, any one firm, company, or undertaking. This can be raised to 10 percent for public sector issuers, provided total exposure to such entities does not exceed 40 percent of technical provisions; no more than 5 percent of gross technical provisions can be in unsecured loans; no more than 3 percent of gross technical provisions should be in cash in hand; and no more than 10 percent of gross technical provisions can be in shares and debt securities which are not dealt in on a regulated market.
Liabilities (IAIS Principle 7). The law should establish standards with respect to the liabilities of companies licensed to operate in the country. Liability requirements should only be established after exhaustive consultation with the actuarial profession and industry practitioners.
Capital Adequacy and Solvency (IAIS Principle 8). The requirements regarding the capital to be maintained by companies, which are licensed or seek a license in the jurisdiction, should be clearly defined, and should address the minimum levels of capital or the levels of deposits that should be maintained. Capital adequacy requirements should reflect the size, complexity, and business risks of the company in the jurisdiction.
Solvency Margin (IAIS Principle 9). Solvency requirements should take account of current developments in international criteria. The solvency margin sets out the amount of capital funds an insurer must have at its disposal during current operations. The present European Union (EU) requirement is for a capital base of the same amount as either the premium index or the loss/claim index, whichever is higher, defined as follows:
Premium Index: 0.18 or 0.16 x (gross premiums) x (retention rate) Loss or Claims Index: 0.26 or 0.23 x (gross claims) x (retention rate) Retention rate: Net claims/gross claims (but no less than 0.5)
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Reinsurance (IAIS Principle 10). Insurance companies use reinsurance as a means of risk containment. The supervisor must be able to review reinsurance. Reinsurance policy should be subject to supervision
Market conduct (IAIS Principle 11). Supervisors should ensure that insurers and intermediaries exercise the necessary knowledge, skills and integrity in dealings with their customers. The Law should include significant scope for the supervision of intermediaries. Intermediary supervision is becoming a fundamental issue in insurance markets, and is the main concern of the EU and IAIS. The law should address the requirement that the Regulatory and Supervisory Body should have legal powers to publish guidance on pure premiums, to facilitate data sharing by insurers and to specify general prudential requirements in setting premiums.
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V. ASSESSMENT OF THE SUDANESE PAYMENTS SYSTEM27
A. Introduction
136. This assessment reviews the payment clearing and settlement procedures in Sudan. It follows the Financial Sector Assessment Program (FSAP) for Sudan, conducted jointly by the IMF and the World Bank.
137. The Commercial Banks Technology Directorate (ComBTD) as well as the Central Banking Technology Directorate (CenBTD) within the Banking Technology Department (BTD) in the Bank of Sudan (BOS) were very generous in making themselves available for discussions, in addition to their coordination with other departments and parties outside the BOS.
B. Information and Methodology Used for Assessment
138. Information was obtained during two missions in October and December 2004 by carrying out extensive discussions with the BTD, the “Khartoum Branch” of the BOS (operating the local Check Clearing House—CCH—for checks in local currency), the Foreign Relations Department of the BOS (operating the CCH for checks denominated in foreign currency), the Research and Statistics Departments of the BOS, a selection of commercial banks, the Sudanese Financial Services Company (SFSC), the Electronic Banking Services Company (EBS), and the Khartoum Stock Exchange (KSE).
139. While the BOS staff made an effort to provide information, the lack of certain statistical and other information made it difficult to assess some details of the payment systems. Access to regulations and laws governing the payment systems was very limited. The response to the questionnaire was brief, and no self-assessment was provided. Hence, the assessment could often only examine the practice as presented by the BOS staff.
140. This note does not contain a full, detailed assessment of the payment system following the Committee on Payment and Settlement Systems (CPSS) Core Principles for Systemically Important Payment Systems and Central Bank Responsibilities in applying the Core Principles (CPs). Rather, it uses the CPSS as a framework to describe and analyze the strengths and weaknesses of the current system, and to identify measures that could make the system more secure and efficient. The CPSS tabular format (Table 1) is used to present the analysis.
C. Institutional and Market Structure—Overview
141. There are 26 commercial banks with 547 branches covering all districts of Sudan (Dec. 2003). The relative size of the Sudanese financial sector is small: assets of banks
27 Contributors: Bassam Farmawi (Central Bank of Jordan) and Jens Clausen.
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constituted only 17.1 percent of GDP at end-December 2003—low compared to levels observed in other countries.28 The financial sector in Sudan is almost entirely composed of banks; assets of other financial institutions (mainly insurance companies and exchange bureaus) constitute less than 1 percent of GDP. The outstanding stock of domestic government certificates (known as GMCs and GICs) is equivalent to about 2.5 percent of GDP. The SFSC supports the market for government certificates. There is a small but active stock exchange, the KSE, where mainly equity and government securities are traded.
142. The payment system is dominated by the use of cash; currency outside banks constituted 32.7 percent of M2 (currency in circulation plus deposit liabilities of the banking system) in December 2003. Checks come in the second place; in the fourth quarter of 2003, about 11,000 checks per day were processed at the Khartoum CCH. Although there is an upward trend in the use of checks in terms of value and volume (see Figure A1), each Sudanese individual issues on average about 0.125 checks per year. The total value of checks cleared in 2003 relative to nominal GDP equaled 16.25 percent.29 The average value for an individual check in 2003Q4 was SD 256,000, equivalent to about US$1,000. The use of electronic credit transfers is rarely observed (except within a single bank); and statistics for the volume and value of credit transfers were not available. Hence, the check clearing system operated by the BOS is the only formal, systemically important payment system (SIPS).
143. The BOS has overall responsibility for the payment system. Within the BOS, the BTD takes the lead on the development of the system; while the ComBTD within the BTD is responsible for connecting the BOS with the commercial banks, the CenBTD within the BTD is responsible for implementing an electronic system to connect the 11 branches of the BOS with its head office. The CCHs are operated by local branches, and the Foreign Relations Department handles foreign currency-denominated payments.
144. The BOS Law and the Banking Law provide the BOS with broad powers and responsibilities over the payment system. Implementing regulations reportedly exist, but they are not readily available. Legislation in such areas as electronic transactions is in preparation.
D. Payment Systems Infrastructure
Check clearing
145. The domestic currency check clearing system operates through CCHs at each of the BOS’s eleven branches. Every bank operating in a particular region has an account at the local BOS branch in order to participate in the local CCH and for cash-in-vault handling. Under the current system, these accounts are not automatically consolidated. A general
28 In contrast, banking sector assets in Egypt constitute 125 percent of GDP, in Jordan 220 percent, and in the Islamic Republic of Iran 55 percent. 29 Source: BOS 2003 annual report and Central Bank of Jordan 2003 annual report. The corresponding figure for Jordan is 202.23 percent for the same year.
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annual membership fee of SD 100,000 (approximately US$400) is to be paid for joining a CCH.
146. The Khartoum branch of the BOS is by far the most important center to clear and settle credit transfers. The incoming average daily number of checks processed at the Khartoum CCH was about 11,000 in the last quarter of 2003 (the latest confirmed number available), for an average total value of SD 2,825 million, or about 70 percent of the check transactions in the whole country. After netting, the Khartoum branch processes per day about 250 transactions between participants. It hosts about 540 accounts (in local currency), which belong to three categories of customers (banks: 27; ministries, government entities, and state-owned institutions: 513); all commercial banks are members of the Khartoum Branch CCH. Five divisions execute the paper-based credit transfers on the local so-called ORACLE software applications.
147. The clearing sessions in Khartoum start at 9.00 a.m. and normally end at 11.00 a.m. The closure time is not fixed; the session normally continues until the processing of the incoming checks is completed. The clearing cycle allows three business days to ensure clearance during the full cycle, including the possibility of the return of a check. Checks drawn on banks located outside the Khartoum area take between two to three weeks to be cleared and settled because of the time to transport the check.
148. Clearing is processed manually and checks are physically exchanged at the CCH. Once checks are sorted by payee and payer bank, the net payments are calculated. A “double user entry method” is followed to check for the accuracy of entered data, but there is no system to allow verification of transactions by the management of the respective division in the CCH. When there are no complications, the net payments are then effected through BOS transfers. However, finality of payment is not observed, because as any transaction could be reversed upon instructions from the originally transferring party.
149. Operating hours at the BOS are from 8.30 a.m. to 2.30 p.m. The transfers have to be received between 9.00 a.m. and 12.30 p.m. All received transfer orders are normally processed the same day. In exceptional cases, transfers could be postponed to the next business day. Any transfer received later will be treated individually depending on the overall circumstances such as the importance and value of the transfer and depending on whether the application is still running.
150. In principle, sufficient funds in the commercial banks’ accounts at the BOS are necessary before any credit transfer is processed. It is not clear whether the software application itself would permit overdrawing of accounts or whether the user has to check for sufficiency of funds before any transfer is entered into the system.
151. An automatic overnight overdraft is provided in the BOS Khartoum branch for those members who experience a shortage of liquidity as a result of the clearing session in the
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CCH, to cover their positions and to ensure settlement of the net result.30 Thus, the BOS bears the credit risk if the commercial banks fail to settle. Penalty fees exist (in tranches) on the overdrawn account if the balances are not restored within the closure of the next business day. If the overdrawn balance is not restored within three days, the member is suspended from the CCH.31 The incident will also be reported to the inspection department of the BOS by its representative in the CCH. The bank in need of liquidity can then transfer the needed amount from its branches’ balances outside the Khartoum area (balances of commercial banks at other BOS branches are not accounted for by the BOS Khartoum branch). Besides this possibility, the bank would usually turn to the BOS by selling foreign exchange or government securities. Approaching the interbank money market or using the capital market operation is rarely considered by banks as a source for liquidity, in part, reportedly, because banks fear revealing a liquidity shortfall to their competitors. There are no failure-to-settle procedures in place, that is,. the system is not “capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation” (Core Principle V).
152. The BOS’s Foreign Relations Department operates a separate CCH for checks in foreign currency (U.S. dollars, euros, and Saudi Arabian riyals). Almost the same regulations apply for both the local currency CCH and the foreign currency CCH.
153. At the moment, banking operations between the BOS and the commercial banks are mostly paper-based. At the end of each business day, the BOS produces hard copies of statements of accounts and credit/debit notifications to be delivered physically to the commercial banks.32 The only operations between the BOS and commercial banks conducted electronically are found in the trading room in the Foreign Relations Department of the BOS, which receives electronic messages through the Society for Worldwide Interbank Financial Telecommunications (SWIFT) from some commercial banks.
154. The check clearing system is thus relatively slow, and gives rise to significant risks. It also raises the costs of intermediation, mainly because banks have to keep large excess reserves in each of their many accounts with BOS branches (Table A2): banks lack the information and means to manage their liquidity, and therefore need a large stock of liquidity as a buffer. As a result, they have less incentive to mobilize savings or need to obtain a higher return on investments.
30 In 2005 the BOS is expected to tighten conditions on the provision of central bank liquidity and raise the associated charges. 31 It was difficult to establish how frequently this penalty has been applied. However, one incident related to the NIMA bank in 1999, a bank that was liquidated later. Another incident occurred when a major bank experienced a suspension in 2001. 32 The BOS is able to use the “Data Cloud” or the SWIFT network (see below) to relay instructions and/or information to commercial banks.
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Electronic payments and communications
155. All 26 banks, except Habib Bank, are connected to the electronic SWIFT messaging system. The EBS manages the gateway by installing the SWIFT alliance software at their premises and providing workstations at commercial banks premises.33 Banks benefit from this electronic means to connect to the whole banking community and to their cross-border correspondents. The EBS provides an on-site primary server and, concerning business continuity, a hot off-site back-up server. It has been reported that the average daily outgoing and incoming messages are between 1,000 and 1,500. These are divided into 80 percent for payments and 20 percent for trade finance and money market operations. Due to the U.S. embargo, the EBS could not work as a service provider connected directly to SWIFT network. The EBS solved this situation by connecting through another country. Special attention should be paid to the utilization of this network because it provides the basis for inter-bank communication. The SWIFT messaging system is used by most of the countries operating modern Real Time Gross Settlement (RTGS) systems.
156. The physical infrastructure for conducting electronic inter-bank and inter-branch operations has been recently installed in the form of a fiber-optic frame relay, called “Data Cloud”. There are round 300 access points, inside and outside Khartoum. So far, they are only used by commercial banks to conduct inter-branch operations in the form of transferring balances from branches to its head office and vice versa. The BOS uses the network, which connects 8 of its 11 branches, at the moment only to communicate with them via email, but not for daily banking operations. So far, the BOS does not utilize the network to electronically communicate with the commercial banks.
Government certificates
157. The SFSC is the primary dealer for selling government securities (GMCs, GICs). This company was established in 1998 and is owned by the BOS (99 percent) and the MFE (1 percent). Its customers are commercial banks, financial institutions and funds, corporations, and the broad public (individuals) who participate in the primary offerings of GMCs and GICs and in the secondary market. In the primary market, the clearing and settlement of the cash-leg is usually done as follows: cash payments by individuals as well as checks and credit transfers are directed to the account of the SFSC at the BOS. The delivery of securities, the securities-leg, is conducted in a registered form in the SFSC registry within one month from the date of issuance. This period is used by the SFSC to ensure that the respective amount has been received in its account. This procedure could be considered as a credit risk management technique: if a buyer does not fulfill its financial obligations partially or totally, then the unpaid securities are usually sold to the BOS and the buyer is allotted with the portion he has paid for. The SFSC estimates that between 4,000 and 5,000 new records
33 The “Electronic Banking Services Company (EBS)” was founded in 2000 to outsource and to delegate the objective of modernizing the banking infrastructure. The BOS holds 49 percent of its capital, Sudatel (a government owned telecommunications company) 30 percent, and the largest 21 banks hold equally 21 percent.
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are created whenever a new issue is undertaken because the certificates are issued in small denominations (SD 50,000 for GMCs and SD 10,000 for GICs).
158. The SFSC manages an electronic registration system. The back-up server is fed updated data on a daily basis. It is worth pointing out that the back-up server is located in the same room as the regular server. Original documentation in hard copy and electronic copy are kept in a fireproof safe in the same building. The physical proximity of these systems reduces their value in ensuring operational continuity. Furthermore, the various lags and other aspects of the system create operational risk. In the secondary market, the government securities are traded at the Khartoum Stock Exchange (KSE). While over-the-counter trading between commercial banks is forbidden, the BOS can trade over-the-counter with commercial banks.
Stock exchange transactions
159. Government securities and shareholding equities are traded on the KSE, which was established in 1992 by an Act of the National Assembly. In 2003, the daily average value of trading reached SD 100 millions for 39.9 million shares in 13 contracts. There are 16 brokerage firms and 47 listed companies. Stock market turnover (number of shares traded relative to outstanding stock) increased in 2003 by 26.2 percent compared to the previous year, and the traded value amounted to SD 24.4 billion, or slightly over ½ percent of GDP.
160. Trading hours are between 10.00 a.m. to 11.00 a.m. from Saturday through Wednesday. The trading hall manager has the discretionary authority to lengthen the trading session by up to about 10 minutes. In case he does so, he has to justify his action in written form. Small investors can pay in cash (banknotes) to the broker, who will then settle by check. Until about 1.00 p.m., checks are exchanged manually on a gross bilateral basis between members. That means that a check is exchanged for every deal. Cash-settlement will take at least three working days because the checks have to be cleared in the CCH.34 Therefore, brokers are exposed to credit risk until checks are settled. This credit risk is managed by the KSE by allowing the general manager to suspend the broker who provided a check with insufficient funds from trading sessions (also a report to the KSE’s board is issued). The paying broker still has to settle his outstanding obligations. No Delivery-versus- Payment (DvP) arrangements are available for normal transactions. Members, who have accounts at the BOS where they can deposit these checks on the same day of trading, can make express settlement for checks. The BOS will then settle the check by debiting the drawer’s account and crediting the beneficiary’s account directly.
161. Extraordinarily high value transactions can be treated separately by the KSE by arranging for the issuance of the certificate of ownership on the same day of the contract, and settlement of the cash-leg. The system does not allow credit transfers between brokers unless
34 The practice whereby brokers settle their obligations by exchanging checks on the basis of individual contracts increases the importance of the outcome of the CCH.
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both brokers agree on arrangements where a proof from the transferring and beneficiary’s bank can be presented.
162. No central registry for equities and government securities exists. The registry for equity shareholders is located at the headquarters of the issuing companies, while the SFSC keeps the electronic registry for government securities. The registry for equity is in registered form where a certificate is actually issued, but kept on the company’s premises or in a bearer form where the certificate is physically handed over to the owner. A potential seller has to prove ownership; in the case of the bearer form, he/she has to hand over the ownership certificates, in the registered form the broker will ask for a proof from the issuing company. Upon completion of a trade, a copy of the contract should be sent to the company to change the title to the new owner. The KSE receives the new certificates and distributes them to the respective broker where they are handed over to the respective investor. If within six days from the date of trading the new certificates are not received, the broker should report the incident to the KSE in order to follow up with the issuing company. The same procedure is followed with the SFSC regarding government certificates.
Exchange bureaus
163. Exchange bureaus conduct cross-border transfers as one of their main activities. Regulations are issued by the BOS to govern their activities.35 A customer can deliver cash to a money exchanger outside Sudan in any currency and ask that the same value of money will be delivered to him personally or to someone else in Khartoum in any currency.36 37 This implies a credit risk carried by the customer versus the creditworthiness and credibility of the money exchanger. Although the regulations issued by the BOS state that foreign exchange bureaus must keep a certain amount as “insurance” in the form of collateral with the BOS (5 percent of the paid capital for companies established in Sudan), it is not clear that this collateral can cover any risk carried by the customers. Moreover, this risk could potentially have systemic implications. There may also be some informal remittance systems in operation, although reportedly banks and exchange bureaus compete effectively with informal systems. It proved not to be possible to estimate the size of the formal or the informal section of this market since no data was available
E. Reforms Under Way
164. Modernizing the payment systems is high on the agenda of the BOS. There have already been significant efforts to install the necessary infrastructure, mainly by installing electronic communications networks. The BOS is leading a complex project to modernize most areas of the payment system, including its local applications. The department in the BOS responsible for establishing the future payment system is the BTD.
35 See the Detailed Assessment of Compliance with the AML/CFT Recommendations on the extent to which regulations address AML/CFT issues. 36 Banks conduct similar business. 37 Effectively, the bureaus facilitate informal remittance services.
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165. The commercial banks have recently introduced other payment methods with the cooperation of the EBS, but so far with limited success. Seven banks have issued 514 prepaid cards (Shamekh) for use at 130 points of sale in the Khartoum area (see Tables A3 and A4). There is a limit of SD 3 million (US$12,000) that can be transferred onto the card. Besides targeting private customers, the prepaid cards are intended for government officials. There are problems with new regulations and laws dealing with this kind of electronic payment. Legislation is in preparation, but has not been passed yet. One basic goal of these prepaid cards is to get customers acquainted with “plastic money.” There is only a volume-based fee for merchants. From anecdotal evidence it, could be established that some merchants, despite the existing reading machines for the prepaid cards, prefer cash payments. There is no credit risk because of the nature of the prepaid cards. Nevertheless, operational risk might exist while processing the transactions.
166. In addition, five ATM machines have been installed, which only allow for local and regional use. Most of these ATMs are located at the head offices of the issuing commercial banks. A wide area network can be used to install ATM machines in other places, especially in commercial centers. Most projects employing electronic means of payment are financially supported by the BOS to create an incentive for commercial banks to adopt new technologies. Reasons for not relying more on electronic payment tools could be the limited resources of the banking sector, limited awareness, and limited demand from the side of customers.
167. Credit cards are not available at the moment. Banks do not issue credit cards and commercial centers do not accept credit cards issued from foreign countries (except Diner’s Club). If the U.S. embargo is lifted, the authorities plan to apply for licenses and to install an authorization center.
168. There are three projects under way in the ComBTD:
the “Electronic Check Clearing Project” started in August 2004. Its objective is to connect 150 branches in the Khartoum area to clear and settle checks in T+0 via an image-based system (and at a later stage connect branches outside Khartoum). It is supposed to be launched in the second or third quarter of 2006;
the “National Switch Project (ATM)” started in September 2004. Its main objective is to install ATMs (for cash withdrawals and later for balance inquiries and transfers) and to connect various banks’ ATM applications so that each participating bank can service the customers of other banks as well as its own. The “National Switch” is also necessary to connect commercial banks electronically with the BOS. It is supposed to go life in 2005Q2. A contract with the company “S2M” from Morocco has been signed. At the moment, the BOS finances this project, the pricing is unclear; and
the “Electronic Fund Transfers (EFT)”/“Online Settlements of Payments (RTGS)” project constitutes a future undertaking, which has not started yet. Its objective will
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be to transmit, process, and settle interbank payments on a real-time gross settlement basis. It is planned to start the implementation at the beginning of 2006.
169. The CenBTD has two on-going projects:
the “core banking” project’s objective is to allow the BOS to manage its basic banking activities and operations through real-time processing of financial and accounting transactions and also to centralize customer accounts at the head office (a contract with the company “SYSTEMACCESS” from Singapore has been signed). It is planned to go live at the end of 2005; and
for the “banking returns” project, which is to help the BOS monitor and supervise the banking sector’s performance, a contract has not yet been signed.
Table 12. Detailed Assessment of Observance of CPSS Core Principles for SIPS and Central Bank Responsibilities in Applying the CPs
CP I - The system should have a well-founded legal basis under all relevant jurisdictions. The BOS Law and the Banking Law give the BOS responsibility and discretionary powers for payment system oversight. Description BOS staff were unable to provide the FSAP team with other laws and regulations that might be considered a basis for a sound legal framework for a payment system. Laws governing, for example, final settlement, netting, contracts, electronic payments and insolvency are necessary to provide a well-founded legal basis for the payment system. These laws and regulations must define rights and responsibilities of relevant parties, including the system operator. Rights and obligations need to be established, especially for Comments operations related to risk management. However, in practice the BOS proved to run, unchallenged, a manual system, assumingly based on “instructions” issued by the BOS to the banks. During the mission’s visit, the BOS staff was unable to provide such documents either in English or in Arabic. CP II - The system’s rules and procedures should enable participants to have a clear understanding of the system’s impact on each of the financial risks they incur through participation in it. Description Financial risk management is implicitly addressed by the BOS in practice. There is no clear understanding on the participants’ side for the systemic effect of liquidity and credit risk. This could be a result of the BOS practice to provide a “safety net” for banks when they are in need of liquidity. No rules or regulations clearly define the rights and obligations of all the parties involved. Comments The BOS should consider revising and/or drafting a new governance and regulatory structure to operate and manage the whole system on the basis of comprehensive and sound rules and procedures. Participants, the system operator, and other involved parties should clearly understand the financial risks inherent in the system and where they are assumed. The rules and procedures of the system will determine who has to bear the risks. These rules should clearly define the rights and obligations of all the parties involved and all such parties should be provided with up-to-date explanatory material. In particular, the relationship between the system’s rules and the other components of the legal environment should be clearly understood and explained. In addition, key rules relating to financial risks should be publicly disclosed. Training might be a good source for proper awareness.
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CP III - The system should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain those risks. Description Credit and liquidity risks are not well recognized at the BOS (as the operator of a manual payment system). Paper-based transfer orders are easily queued and reordered depending on the availability of funds. The subsidiary system (CCH) in Khartoum is not supported by any financial risk management procedures. The BOS carries the credit risk by providing free of charge overnight liquidity to the member with an insufficient balance to meet its net debit position. Comments Redesigning the procedures for the existing manual system or designing the future electronic (RTGS) system should take into consideration the effective management of financial risks. An efficient information system through real time monitoring will be a good basis for credit and credit risk management. Gridlock resolution, a pool of collateral securities, and a loss-sharing agreement should be taken into consideration. CP IV - The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day. Description BOS staff stated that any payment could be unwound if “convincing” justification is provided from the concerned ordering party (orders are processed on gross basis). Therefore, payments are not irrevocable and not final. Comments The design for a future modern electronic system should ensure the promptness of final settlement on the day of value which entails the following: (i) clarity in the system rules and procedures that a payment accepted by the system for settlement cannot be removed from the settlement process; (ii) a clearly defined and legally effective moment of final settlement; (iii) assurance that the interval between the system’s acceptance of a payment and the payment’s final settlement at least never lasts overnight and preferably is much shorter; and (iv) assurance that operating hours and the settlement processes are strictly enforced. CP V - A system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation. Description Multilateral netting is done only in the CCHs. There is no significant delay between the acceptance of payments for settlement and the final settlement of the payment. A pre-net settlement file is submitted to the local BOS general ledger for settlement right after the conclusion of the check clearing session. Comments Uncollateralized, free-of-charge liquidity is automatically provided by the BOS if one or more of the CCH members do not have the ability to cover their short net position. Therefore, the BOS is exposed to credit risk. Liquidity risk can be managed normally by other solutions to support the system, such as committed credit lines, a pool of collateral deposits or securities. Alternatively, the promotion of a credit transfer system design (an RTGS system) would give a better chance to control credit and liquidity risk and avoid complications associated with multilateral netting systems. CP VI – Assets used for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk and little or no liquidity risk. Description Settlement is done using member banks’ accounts across the BOS books in Sudanese dinars. This applies for the manual exchange of credit transfers. In addition to Sudanese dinars, a separate CCH is operated by the BOS in foreign currencies including U.S. dollars, Saudi Arabian riyals and euros. Comments The BOS applies the same rules for both CCHs. Liquidity and credit risk are valued in the same manner. The foreign currencies are ultimately claims on other central banks. The credit worthiness of the issuers of those settlement assets is not questionable. However, for international transactions in foreign currency, which are settled with the
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correspondent network, there is a settlement bank risk. Also, transferability into other assets could be a valid question considering the current political situation of Sudan. CP VII – The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion of daily processing. Description The central system at the BOS is still paper-based and manually operated. A security policy and service level agreement between operator and members does not exist. Comments Issues in this context should be taken into account in the design of the intended “On-Line Settlements” system. The design of the procedures should cover security and operational reliability from end-to-end, or from the end user at the input level to the final settlement of the money transfer. Well-trained staff is a must for successful implementation at member and operator level. Sound technical design for hardware, software, and network including back-up sites cannot be avoided to ensure business security and continuity. CP VIII – The system should provide a means of making payments, which is practical for its users and efficient for the economy. Description It is clear that the current paper-based system is inefficient and slow. Comments Using the local applications at the BOS is a good start, but it does not mean that the system is efficient. Payment order creation, submission, processing with all the risk management procedures included, should be reviewed. The system does not necessarily have to be sophisticated and costly to be considered efficient. Using electronic infrastructure which is already at hand, combined with a sound design of business rules, can create a practical and efficient system. Efforts should be directed to replace cash payments with less costly alternatives. This does not mean the promotion of the use of checks. CP IX – The system should have objective and publicly disclosed criteria for participation, which permit fair and open access. Description Under the current manual system, access is permitted for all banks and financial institutions. Comments Criteria should be in place for the future implementation of the intended “On Line settlement” system. Concern should be given for the system’s safety. CP X – The system’s governance arrangements should be effective, accountable and transparent. Description Governance of the BOS in general is effected through several means (see main report). Regulations on the operation of the payment system and its governance are not readily available. Comments Preparations for the future payment system should take into account the core principles. Central Bank Responsibilities in applying the CPSIPS
Responsibility A – The central bank should define clearly its payment system objectives and should disclose publicly its role and major policies with respect to systemically important payment systems. Description The BOS plays a leading role through the Commercial Banks Technology Directorate (CBTD). Nevertheless, the objectives, the role of the BOS and major policies are not clearly defined or disclosed. Projects within the framework are not prioritized. The business model is not clearly understood by the banking community. There is a relatively low public awareness. Comments CBTD and EBS are supposed to lead the payment system modernization project in Sudan. Market needs should be defined more clearly. Market conditions should be taken into account. The introduction of the prepaid cards (“Shamekh” ) has not prove to be a successful project. To identify the market needs is an essential element to ensure the proper acceptance by the community. A very limited number of prepaid cards issued and a low volume of transactions covering very limited value of transfers compared to the reasonable number of POS points (as a start) can be regarded as evidence.
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Responsibility B – The central bank should ensure that the systems it operates comply with the core principles. Description The BOS operates the paper-based credit payment system and the CCH. Comments Legislative framework and details of the projects currently under way should be revised to ensure compliance with the CPs. Responsibility C – The central bank should oversee observance with the core principles by systems it does not operate and it should have the ability to carry out this oversight. Description The network for prepaid cards is operated by the Electronic Banks Services (while the EBS is 49 percent owned by the BOS). Comments Legislative framework and details of the underway projects should ensure compliance with the CPs. Responsibility D – The central bank, in promoting payment system safety and efficiency through the core principles, should cooperate with other central banks and with any other relevant domestic or foreign authorities. Description The BOS cooperates with the SFSC, the EBS and the KSE in designing and implementing the payment system’s interaction with the securities settlement system. Comments Activities of payment system oversight, supervision of financial institutions and the surveillance of financial markets can be carried out within the central bank or within separate authorities. The flow of funds between components of the system imply a systemic risk. For Sudan, disruption in one sub-system (including future projects such as ECCH and ATM switch) may cause disruption in others.
F. Recommended Actions
170. Feasible enhancements to the payment system could yield a significant improvement to the soundness and efficiency of the financial system. Some possible measures could include the following:
To start with, highest priority should be given to the development of a strategic plan on how to modernize the payment system. This plan should help make the government, banking industry, and the public aware of the need for development; create the institutional framework for development, cooperation, and oversight (see next bullet point); and link ongoing with future initiatives.
To help refine the BTD’s modernization projects, a “Payments Council” could be established, including top-level officials from the BOS as well as management representatives from commercial banks, to decide on the strategic and broad policy framework. A “Technical Committee,” in which the EBS, commercial banks, and other financial institutions are represented, should be established, which should have the authority to decide on the technical details of the payment system issues at the nationwide level, given the approval of the Payments Council. More generally, greater effort is required to regulate securities markets, and coordinate regulation and supervision across financial markets (see elsewhere in the FSAP documents).
More trained staff should be allocated to Working Groups to help design the business model and its implementation. Legal issues should not be ignored within a specialized team. The building of a common database, which collects statistics relevant to the
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payment system, should become a priority. The centralized data would ensure an analytic framework for reaching decisions in this area.
The BOS should be more transparent in the regulatory form of all segments of the payment systems. The BOS should ensure that the current and future payment systems have a well-founded legal framework and governance basis (including an electronic transactions law) and clearly defined procedures for the management of financial risks. The same rules should apply to, and be known by all participants in the system. Special attention should be given to issues related to finality and irrevocability of payments.
The electronic worldwide used messaging system, SWIFT, should be utilized more extensively. All Sudanese commercial banks except one are SWIFT members and the infrastructure to use it is in place, but the system does not seem to be utilized for daily transactions (except a few transactions between some commercial banks and the Foreign Relations Department at the BOS). One of the reasons for this could be the lack of training at the users’ level, concerning the technical side as well as the language side (English is predominantly used in employing the SWIFT system). The BOS may direct banks to use SWIFT because of its low cost, safety, efficiency, and high standards. In addition, it will enable the Sudanese banking community to interact more strongly with the international community.
The existing CCH should improve its measures that ensure business continuity. It is recommended to establish a hot back-up server at the Khartoum branch. The existing CCHs in other regions could serve as remote back-up sites for each other. To avoid incorrect data entries and to ensure an efficient procedure, software should allow the verification of transactions by the management of the respective division before being sent to the accounting system. In this case, there would be sufficient oversight, but no need for a secondary user entry, unlike in the current “double user entry” method.
It is not normal for a central bank to provide liquidity in a failure-to-settle incident within a netting system.38 In this case, an arrangement among the netting system members should be established to protect against liquidity and credit risk. This arrangement should comply with CP V and ensure the timely settlement of the netting result. The BOS provides an (automatic) overnight draft in case of a short member. The penalty in the form of a suspension of commercial banks from the CCH is problematic and may add additional complications. Instead, collateralized credit lines based on government securities may be provided. A pool consisting of cash or securities could form the collateral behind a “loss-sharing agreement”, which is a typical solution for a failure-to-settle incident.
38 See BIS (Bank for International Settlement) publication “Core Principles for Systemically Important Payment Systems,” Section 7.5.5, Jan. 2001, “Central banks do not normally provide specific committed facilities in this context although they could be a potential source of support.”
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The balances of commercial banks at BOS branches may add extra liquidity to the useable funds to settle the net result of the CCH. Therefore, those balances should be consolidated in the BOS books for operational purposes. Such consolidation will require the availability of a robust network (the existing “Data Cloud” system seems usable) and appropriate application software. Furthermore, a modernized system should provide banks with better access to information, in particular information on balances with the BOS at the end of the day and even during the day; in some systems, each bank has access to real-time information on payment order queues affecting its position.
Instead of putting too much effort into the modernization of the debit system, namely checks, resources should be allocated to modernize the credit transfer system. Reasons for that are the overall weak use of checks in Sudan and the systemic risk inherent in netting systems (like the multilateral net check clearing), in addition to the legal, administrative, and operational risks and complications associated with this process. It is questionable whether Sudan needs a technically advanced complicated electronic clearing system based on imaging, considering the low value and volume of checks exchanged in Sudan, and considering that many of the advanced financial systems still depend on an “Automated CCH” and on the use of electronic “Truncation.” It is advisable to give priority to a core RTGS payment system along with the electronic retail payment tools, such as debit cards, credit cards, prepaid cards, and internet banking, which normally replace the use of checks.39
The BOS has decided to finance the projects under way. A cost recovery plan should be detailed. A membership fee, an annual fee, and a transaction fee can be considered as the basis for the pricing policy to recover the capital and running costs. Initial financing by the BOS will create an incentive for introducing and adopting new technology. Simple cost effective solutions are needed more than unnecessarily complicated ones.
A high commission to oversee the securities market is needed to play a connecting role between the trading and settlement procedures. Brokers exchange checks at the end of each trading date. However, the rules for a settlement value date are not clear for the final investor. Change of title is allowed within six working days. Synchronization for the settlement date for both legs is needed. A late change of title is a hindrance for investors who want to sell securities bought on the same day or shortly thereafter, because the certificate of ownership should be presented together with the selling order and payment. The existence of a central depository for securities would ensure that standardized procedures are followed and enhance investor confidence.
39 See the BIS publication “Core Principles for Systemically Important Payment Systems,” Section 9.1.22, January 2001.
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Greater security could easily be achieved by storing the SFSC backup data outside the SFSC building, for example, at the BOS. The observed operational risk could be reduced if more efficient procedures are followed to ensure timely registration on the day of issuance and settlement.
To increase efficiency in settlement at the KSE, net bilateral positions could be calculated, which will reduce the number of checks exchanged after each session. The most efficient way to settle is by sending the net settlement file electronically to an on-line, Real-Time Gross Settlement (RTGS) System, taking into consideration compliance with CP V.
A central registry for securities (concerning stocks and Government securities) should be established as it would simplify matters and minimize financial and operational risks. T+0 settlement and DvP arrangements should be part of any preferred solution.
Concerning the North-South Peace agreement, the integration of the south in the ongoing and future payment system projects would prevent unnecessary additional investment spending and ensure the inevitable, free movement of capital.
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STATISTICAL INFORMATION ON THE PAYMENT SYSTEM
Table A1. Settlement Media Used by Nonbanks (SD billion)
(end-December) (October) 2000 2001 2002 2003 2004 Currency outside banks 142.1 153.8 193.6 240.2 276.2 Narrow money supply M1 234.6 271.4 352.3 458.5 542.4 Broad money aggregate M2 346.7 432.2 563.7 734.1 909.7
Source: The BOS – Research and Statistics Department.
Table A2. Settlement Media Used by Credit/Deposit-taking Institutions (SD billion)
(end-December) (October) 2000 2001 2002 2003 2004 Required reserves at the central bank: In domestic currency 15.4 16.3 23.4 28.4 37.2 In foreign currency 9.7 10.2 11.6 13.8 18.0 Excess reserves at the central bank In domestic currency 18.0 16.8 12.9 23.2 32.8 In foreign currency 3.7 5.0 6.0 8.2 9.8 Institutions’ borrowing from the central bank 17.1 18.8 5.7 17.3 18.2 Transferable deposits at other institutions 0.0 0.0 0.0 0.0 0.0
Source: The BOS – Research and Statistics Department.
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Table A3. Prepaid Card (Shamekh) (2004)
Bank Name Issuing Issued Cards Number of Branches POS Units Saudi Sudanese Bank 8 145 39 Islamic Cooperative Development Bank 8 113 53 Animal Resources Bank 3 133 14 Farmers’ Commercial Bank 4 70 9 Al Baraka Bank 4 10 10 Omdurman National Bank 1 126 5 Workers’ National Bank 1 18 ... SUM 29 514 130
Source: Electronic Banking Services Company (EBS) Note: “...” means that no data is available.
Table A4. Shamekh Transactions
Month 2003 2004 No. of Trans. Value No. of Trans. Value (in Sudanese (In Sudanese dinars) dinars) January ...... 79 293,410 February ...... 80 291,624 March 133 411,924 77 290,068 April 159 1,010,083 87 346,003 May 251 1,133,180 80 468,319 June 247 1,251,339 108 485,374 July 191 2,702,785 89 320,569 August 152 2,114,622 57 249,923 September 122 574,110 62 206,301 October 156 916,068 60 270,551 November 123 1,174,356 50 233,233 December 110 456,158 ......
Source: Electronic Banking Services Company (EBS) Note: “...” means that no data is available.
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Table A5. Cash Dispensers (ATMs) (2004)
Bank Name Issuing Issued No. of Average No. of Branches Cards ATMs Withdrawals per Month Omdurman Nat. Bank 1 340 1 700 Islamic Coop. Dev. Bank 2 65 2 100 Byblos Bank 1 ... 2 30 Total 5 405 5 830 Source: Electronic Banking Services Company (EBS) Note: “...” means no information is available
Figure A1. Value and Volume of Checks
Use of Checks - Quarterly Average Volume (right scale) and Quarterly Average Value (left scale)
210,000 800,000
190,000 700,000
170,000 600,000
150,000 500,000
130,000 400,000
110,000 300,000
90,000 200,000
quarterly average volume (no. of average checks) quarterly quarterly average value in millions in of value SDD average quarterly
70,000 quarterly average value 100,000 quarterly average volume 490,932 50,000 0
2000Q1 2000Q2 2000Q3 2000Q4 2001Q1 2001Q2 2001Q3 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4
Source: BOS.
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VI. LEGAL FRAMEWORK
A. Introduction
171. Among the key components of a country’s financial sector are the laws, regulations and other legal instruments on which the sector is based, the institutions by which such laws are implemented and the manner in which the laws are enforced. In most parts of the world the laws are generally satisfactory–the main problems lie with their implementation and enforcement. Sudan has weaknesses in both areas. The country has a plethora of laws and regulations on its statute books, but most are outdated and the country has not been able to keep up with the many developments that have taken place over the last two decades particularly in relation to the legislation governing the business environment.
172. The Sudanese legal system is based on a combination of English common law and Islamic law. Before, and for a period after independence in 1956, the country’s legal system was entirely based on U.K. law. Following the imposition of military rule in 1971, efforts were made to convert this system into one based on Islamic principles. This was not successful and in 1974, the conversion approach was abandoned. In 1983, President Nimeiry attempted once again to introduce Islam as the basis of the country’s legal system. This was primarily achieved by the enactment in 1984 of the Civil Transactions Act. This law incorporated a very wide range of provisions dealing with agency, sale of goods, companies, land and torts, and was intended to constitute the civil law of the country. It drew upon civil law concepts from the Egyptian, Jordanian and French legal systems and is similar to comparable laws adopted in other parts of the Arab world. The Civil Transactions Act was supplemented by the Sources of Judgments Act of 1984 which required the judges to interpret laws in accordance with Sharia principles. At that time, a number of laws that were based on U.K. practices and principles were repealed, although not the Companies Act of 1925 or the Bankruptcy Act of 1929.
173. The current situation is that in some areas the common law prevails while in other respects the courts are bound to apply Sharia law. The situation is further complicated by the fact that some of the country’s judges are trained only in Sharia principles and have no familiarity with common law concepts. Similarly, some of the older judges continue to adhere to the common law when deciding cases. The result is a degree of confusion and a lack of predictability within the legal system which is unsatisfactory. Confidence in the legal system is not high and its complexity represents a hindrance to its implementation and, more generally to economic development. The uncertainty surrounding the country’s legal regime is likely to be compounded having regard to the changes that will soon need to be made to implement the recently signed Comprehensive Peace Agreement between the North and the South. A large number of laws will need to be substantially revised and updated to accommodate the values and traditions of the South and to bring the country’s overall legal system into line with international best practices.
174. The focus of this chapter is on four key elements of the legal regime governing the financial sector in Sudan. The chapter begins with a brief review and assessment of the core
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financial sector legislation. The commercial framework including corporate governance, company registration, and accounting are then reviewed. The third section deals with issues of insolvency, creditor rights, and the taking and enforcing of security. The fourth section offers a brief assessment of the judicial system as it impacts on the operation of the financial sector. Finally, the chapter incorporates a brief discussion of the implications of the Comprehensive Peace Agreement on the financial sector and some of the legal issues that will need to be addressed in order to implement the new Agreement. The chapter concludes with a series of recommendations for specific reform. It should be noted that the legislative underpinnings of other sectors including securities, insurance and pensions, and anti-money laundering/combating the financing of terrorism are dealt with comprehensively in other sections of this report.
B. Financial Sector Legislation
175. The key laws underpinning the financial sector in Sudan comprise:
(a) The Bank of Sudan Act, 2002 (BOS Act); and (b) The Law on the Regulation of Banking Activity, 2003 (Banking Act).
Other key laws that impact on the financial sector include:
(c) The Money Laundering (Combating) Act, 2003; (d) The Property Mortgaged to Banks (Sale) Act, 1990 as amended in 2003; and (e) The Code of Administrative and Financial Penalties for Banking Violations, 1992.
The BOS Act
176. The BOS Act is well drafted and relatively modern in its scope and content. It provides that the BOS should be an independent legal entity governed by a Board of Directors comprised of 9 individuals including the Governor, the First Deputy Governor, a representative of the Ministry of Finance, the Chairman of the Sharia High Supervisory Board and 5 qualified individuals appointed by the President in consultation with the Minister of Finance. The Governor is appointed for a term of five years and may be reappointed. He may not be dismissed except for prescribed causes. The independent members are appointed for three-year terms which are renewable and again may not be removed except as prescribed by law.
177. The objectives of the BOS are to implement the following:
(a) Issue, regulate, monitor, and supervise currency of various types; (b) Issue and manage monetary and financing policies in consultation with the Minister of Finance, so as to achieve the national objectives of the national economy;
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(c) Regulate, control and supervise banking activity and act to develop and enhance the effectiveness of banking activity so as to achieve balanced economic and social development; (d) Act to achieve economic stability and the stability of the Sudanese dinar exchange rate; (e) Serve as the government’s bank and its advisor and agent regarding monetary and financial affairs; and (f) Adhere to Islamic Sharia law provisions in the performance of its duties, achievements of its objectives, discharge of its authorities and supervision of the banking system.
178. The Governor and the Board have wide powers to achieve the objectives of the BOS. The Governor may require banks to obtain BOS approval for financing requests that exceed certain prescribed amounts, may establish a ceiling on the investment financing by banks and a ceiling on the total value of investment financing. The Governor also has wide powers to request the banks to provide information. The BOS serves as the Government’s bank and it is empowered to make temporary financing available within customarily prescribed limits. BOS supervisors have very broad powers although no specific protection is available against prosecution. The mission was advised that immunity from suit is contained in the Penal Code.
179. Anecdotal evidence suggests that the BOS exercises a high degree of influence and control over all banking sector activities. There are no obvious deficiencies in the BOS Act and no current proposals to amend the law except such as will be necessary to accommodate the need to introduce conventional banking in the southern part of the country. The BOS Act is substantially in line with international best practices for central banking legislation.
The Banking Act
180. The Banking Act is also well drafted and relatively modern. It provides for the granting and revoking of licenses of banks. Ministerial approval is required in the case of the licensing of a foreign bank although that is rather academic as to date no such bank has sought approval to establish a presence in Sudan. The BOS is responsible for supervising and controlling all banks and financial institutions and any other person that engages in all or other banking activities. The Act provides for the normal provisions regarding capital, reserve provisions, ratios, retention of liquid assets and broad restrictions on financing. Fitness and propriety criteria are adequately addressed as are the related lending provisions although these do not appear to apply to family members. A restriction on the aggregate financing of connected parties should also be introduced. The Banking Act would also benefit from a strengthening of the provisions dealing with coordination between on-site and off-site supervision and between the supervision staff and other parts of the BOS. Banks are required to comply with relatively modern accounting and audit requirements.
181. The BOS has broad powers to inspect banks, to approve the appointment of senior managerial staff, to remove such staff in appropriate cases and to supervise all aspects of
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banking operations. In appropriate cases, the BOS may, in consultation with the Minister of Finance, cancel a bank license and/or submit a request to a court to approve the liquidation of a bank. While the BOS has broad operational independence, the requirement to consult with the Minister of Finance and the power of the Sharia High Supervisory Board to intervene in certain circumstances, in theory if not in practice, limits this independence. The provisions governing the merger and liquidation of banks are contained in the Companies Act of 1925. The BOS must be appointed liquidator in any proceeding to liquidate a bank and has the power to attach the assets of that bank and to require the management of a bank to refund assets improperly disposed of. The BOS also has wide powers to impose penalties. These are also governed by the Code of Administrative and Financial Penalties for Banking Violations of 1992.
182. There are currently two banks in liquidation, in both cases as a result of BOS intervention. In one case, the general manager and his deputy were suspended and ultimately replaced. The BOS’s decision on this matter was unsuccessfully appealed in the court, which ruled that the BOS’ actions were consistent with its powers and responsibilities under relevant laws. There are a small number of cases outstanding against the BOS brought by foreign parties relating to the repayment of certain deposits that were confiscated 10 to 15 years ago. Liability in each of these cases is admitted, but the government does not have the resources at the moment to repay damages. The BOS is in the process of trying to settle these cases.
183. The Banking Act creates the Sharia High Supervisory Board, giving it the primary function of overseeing the implementation and application of Sharia laws and principles by the BOS and by the banking sector. The Sharia Board comprises experts in Sharia law, economics, and banking. It meets weekly and issues fatwas (formal Islamic legal opinions), in addition to advising on standardizing the principles and provisions of Islamic law underpinning banking and financial activity. It also monitors the BOS policies and performance, as well as the activity of banks and financial institutions to ensure compliance with the provisions and values of Sharia. All commercial banks are required to create a Sharia Supervisory Board. Appeals from such Boards are heard by the BOS High Supervisory Board. Fatwas issued by the Sharia Board in any dispute concerning banking activity are binding on the BOS and on banks and other financial institutions unless they are appealed to the judiciary. So far, there has not been any such appeal.
184. Islamic financial institutions are characterized by two features: a) A prohibition against the payment and receipt of a fixed or predetermined rate of interest. Islamic transactions consist of profit and loss sharing (PLS) arrangements. Where the rate of return on financial assets held in financial institutions is not known and not fixed prior to the undertaking of the transaction, the actual rate of return can be determined only ex post on the basis of actual profits accrued from real sector activities that are made possible through the productive use of financial assets.
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b) A requirement to operate through Islamic modes of financing which affects both the asset and liability side of bank balance sheets. These modes can be divided into two groups: those that are based on the PLS principle and those which are not. PLS-based lending principles include Mudaraba (trustee financed), Musharaka (equity participation), and direct investment. The main non PLS financing modes include Bai-Salam (purchase with deferred delivery), Ijara (leasing and leased purchase) and Murabaha (mark up).
185. The BOS has issued regulations relating to Mudaraba, Musharaka, and Bai-Salam modes of financing and these are strictly regulated. Mudaraba is a profit partnership between investors and workers and is executed between holders of investment accounts and the bank. It entails dividing profits according to the agreement and provides that the investor will assume the loss. Mudaraba is generally considered the main pillar of the Islamic banking operations. In the case of Mudaraba, i Short- and long-term Mudaraba liabilities are measured according to their nominal value when they are entered into. If the bank realizes that the cost of the asset that is available for sale may not be recouped, the asset must be accounted for according to the cash value that is expected to be realized. The BOS may from time-to-time stipulate to banks and nonbanking entities the rate and division of profits relating to various transactions and modes, the percentage of a partner in a Mudaraba transaction and any other provision that serves the public interest in this regard.
186. The Sharia Board is also empowered to “purge the charters, bylaws, guide books and activity of the BOS, the banks and financial institutions of usurious transactions and the visible and invisible force of such transactions and anything conducive to the unlawful spending of the people’s funds on that which is worthless.” In practice this means that non- Sharia compliant contracts, etc. are judged to be void; no compensation is payable because the transaciton is treated as if it never existed. The Sharia Board has wide powers to examine and express an opinion on issues presented to it, undertake research, resolve Islamic law disputes, summon employees and request documents. However, it may not examine matters before the judiciary or in which a competent court has issued a judgment.
187. The Banking Act is relatively modern and given the context and the level of sophistication of banking activity in Sudan is appropriate for the current state of the country’s banking sector development. Amendments to the Act will be required to give effect to the provisions of the Power Sharing Agreement and these are in the process of being prepared.
C. Commercial Law Framework
188. Sudan’s commercial law is primarily governed by the Companies Act of 1925. Although this law has served the commercial community reasonably well many of its provisions are archaic, outdated and in need of reform. The Act provides the standard framework for the incorporation and internal management of companies but basic corporate governance concepts are almost entirely missing from the law, the liquidation provisions are outdated and there is no reference to mergers or restructuring. Moreover, the Act is
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increasingly perceived by legal practitioners to be a major obstacle to economic development and foreign investment, as it does not cater for modern contractual structures.
189. The authorities have long recognized these deficiencies. Initial efforts to review and update the Companies Act were made in 1982 but these did not proceed. One cause of delay was conflicts among partial reason for the delay in the reform process has been a series of disputes involving Islamic scholars on the perceived conflict between some aspects of traditional company law and the principles of Sharia. More recently, a Commission has prepared a new draft of the Act which is currently being considered by the authorities. There is doubt among some Islamic scholars as to the legality of an entity which purports to have perpetual succession. There are also reservations over the use of preference shares, and there is a particular concern with the concept of limited liability. Widespread abuses have occurred with promoters forming companies with limited liability, securing bank finance and then seeking to liquidate the companies and avoid the obligation to repay. The authorities are under pressure to abolish the concept of limited liability.
190. While the mission was not given the opportunity to review the current draft of the Companies Bill, it is understood that it is more in the nature of a piece-meal amendment than a substantial re-write of the law. A new law is needed to reflect current international best practices in relation to director’s duties, shareholder rights, audits and auditor responsibilities, and other standard corporate governance safeguards. The liquidation provisions should be separated from the Act and enshrined in a new and updated insolvency law. The provisions that deal with company objects, capital, accounts and types and attributes of shares also need updating. The review process should involve wide stakeholder participation and be followed up with an extensive education and training program. Any such revision will also need to be harmonized with the commercial sector legislation that currently exists in the South of Sudan.
D. Corporate Governance
191. Robust corporate governance in legal entities is an essential underpinning of risk management. The corporate governance provisions applicable to Sudanese banks and financial institutions are generally satisfactory but their implementation needs to be improved as indicated in the section on Prudential Supervision in these Technical Notes. The appointment of senior bank management officials is subject to confirmation by the BOS and managers are subject to specific responsibilities and obligations under the Banking Act. Commercial banking activity is also subject to strict audit controls in accordance with procedures laid down by the BOS that conform with international auditing standards.
192. Outside of the banking sector, however, awareness of the importance of corporate governance is extremely limited and a great deal of education and training will be required to bring the Sudanese practice into line with international best practices. While the basic rights of shareholders and functions of company directors are understood, there is no concept of shareholder protection or minority rights and accounting and auditing standards are not well
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understood or applied. Most corporate entities are small and privately owned so corporate governance is perceived as having limited relevance or application.
E. Accounting and Auditing
193. Corporate accounting in Sudan is governed by the Accounting and Financial Procedures Act, 1977. This Act provides for accounting procedures and standards to be followed in the preparation of accounts, their review and certification by external auditors and for disclosure of information. In addition, since 1988 all Sudanese banks are required to apply the Islamic accounting standards prescribed by the Accounting and Auditing Organization for Islamic Institutions (AAOIFI). Section 5 of the Banking Act imposes obligations on banks to prepare balance sheets and related provisions. Banks produce three general types of financial statements. The first relates to financial statements prepared for internal purposes, the second are those prepared for the BOS and the third are those that are used for public disclosure purposes. The AAOIFI standards are broadly consistent with international accounting standards although, of course, appropriate modifications are required in view of the prohibition on interest. Financial disclosure standards for banks are sound and auditing standards and practices are prescribed under regulations issued by the BOS.
194. Sudan enacted the Society of Accountants Act in 1988 to create an independent profession for accountants. The mission was informed that shortly thereafter the authorities expressed reservations about the existence of an independent accounting profession and steps have recently been taken to bring auditors under government control To this end, the Law on Organization of Accounting Act was passed as a provisional decree in 2003 and purports to repeal the 1988 law. It appears to provide that the accounting profession will be operated somewhat akin to a government department with the members of the management council being appointed by government. The constitutionality of this law is presently under review.
F. Company Registration
195. The registration requirements are contained in the Companies Act. As at the end of November, 2004, over 23,600 companies were registered of which the vast majority were private. In addition, there were 5,334 branches of foreign companies. The registry has a staff of approximately 150 people operating out of seven branches in Sudan. Anecdotal evidence suggests that company registration is relatively straight-forward and efficient. Companies can typically be formed within three days once approval of the proposed name has been obtained. Where foreign companies are registered, delays can occur while security concerns are addressed. The Act imposes the normal registration requirements for proposed companies and the level of compliance with registration obligations appears to be reasonably good. The registry is in the process of being computerized. It is open to the public and filing and inspection fees are modest. Where enforcement becomes necessary, action is taken through the Commercial Court and this process seems to operate efficiently. Problem areas relate to the need for additional training and improved infrastructure. The system also suffers from a
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wide spread practice of individuals forming companies, borrowing funds then liquidating the companies and disappearing without repaying their loans.
G. Bankruptcy and Creditor Rights
196. The bankruptcy of individuals is governed by the Bankruptcy Act of 1929. Bankruptcy has a certain social stigma in Sudan and bankruptcy proceedings are relatively uncommon. However, there recently have been some bankruptcy cases against high-profile individuals and these have apparently had a very salutary effect on the repayment of debts by these individuals in their desire to avoid the shame attached to being a bankrupt.
197. Insolvency of corporate entities including arrangements and voluntary and court- ordered winding up actions are governed by the Companies Act. Liquidation proceedings have been rather more common than bankruptcy. The procedures are well defined in the law but are rather outdated. Anecdotal evidence suggests that the liquidation process is well understood by the judges and the parties involved and works satisfactorily albeit slowly. There is no provision for workouts, mergers or restructurings and, again, in many technical respects, the legal framework needs to be updated to accord with modern insolvency law and practice. While insolvency reform is not an immediate priority, it should form part of an overall strategy to modernize the business environment legislation.
198. Problems in enforcing the repayment of outstanding bank credit led the government to enact the Property Mortgaged to Banks (Sale) Act in 1990. This Act was subsequently amended and substantially revised in 2002. It provides that a bank creditor may enforce the repayment of debt without recourse to a court of law. The Act provides for a relatively simple process whereby a creditor gives notice of the debt and, in the event it is not repaid, can proceed immediately to the sale of the collateral, usually real estate, by means of a public auction. The Act also applies to the recovery of pledged movable property and contains provision for the resolution of any disputes that may arise in the course of these proceedings. In the event that the debtor disputes the claim then the matter will be dealt with through the courts. It appears, however, that this is a seldom occurrence. Usually, the debtor comes to an accommodation with the creditor by persuading a third party to take over the debt. Anecdotal evidence suggests that this law has been effective. A key element of the bank collateral regime is the practice of requiring the debtor to sign individual checks to secure the repayment obligation. In the event that these checks are presented and there are inadequate funds to support the check, a criminal offence is deemed to occur and the debtor can be imprisoned until such time as the debt is repaid. Again, anecdotal evidence suggests that the threat of prison has a salutary effect on the repayment of bank debt.
199. Bank credit is almost always secured in Sudan, with the level of collateral cover typically one and a half times the value of the loan. Land is the primary form of collateral. Creditors can rely on a range of fixed assets to secure loan transactions but, surprisingly, there is no concept of a pledge over movable property such as vehicles, consumer items, and equipment. Experience in other countries suggests that access to finance for such types of property is an important factor in facilitating small- and medium-sized enterprises (SME)
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development. It is recommended that a study be commissioned to explore options for introducing a register and regime for movable property.40 Evaluation of assets is carried out by the creditor and the lending formalities are relatively straightforward provided the transactions fall within one of the approved forms of Islamic financing.
200. The land registration system is also well established and regarded as efficient and reliable. The registration requirements are set forth in the Land Settlement and Registration Act of 1925. All urban land is registered and freely transferable on the basis of 99-year leases. Conveyances are typically registered in a matter of days and cases of mistake, fraud or misfiling are rare. Registration is not compulsory and as filing fees are relatively high (2.5 percent of the value of the property if registered within six months), it is not uncommon for parties to fail to register transfers of land. This practice undermines the integrity of the system and exposes the parties to considerable risks. It is recommended that registration of all land transfers be made compulsory.
201. The Land Registry is part of the Judiciary and the Registrar General has the status of a high court judge. The registry is open to the public in the sense of being open to parties who have a specific interest in accessing the register and is in the process of being computerized. The system is based on U.K. legislation. Auctions for the sale of land appear to operate smoothly although are not very common. Banks are permitted to purchase at auction but are required to dispose of the properties as soon thereafter as possible. The main problem with the auction procedure is that it is often difficult to find a buyer. There is a certain social reluctance to acquire the assets of a defaulting debtor.
H. The Court System
202. In most parts of the world, the court system represents a weak link in the contract enforcement process. The courts are frequently described as slow and expensive and the judges viewed as incompetent and, at times, corrupt. . The Sudanese court system certainly has its weaknesses but in the context of the financial sector these criticisms have relatively little application. Because of the Property Mortgaged to Banks (Sale) Act, banks have relatively little need to rely on the courts to recover debt. Where transactions are disputed as being in conflict with the principles of Sharia, the High Sharia Board of the BOS resolves such issues. There has never been a case of an appeal from the High Sharia Board to a court of law. The courts are involved in liquidation proceedings but no particular criticism was voiced of their performance in this area.
203. The judicial structure consists of a Supreme Court made up of approximately 100 judges operating in panels of three judges. They have the power to co-opt experts as needed, and the experts are regarded as well qualified. At the Court of Appeal, there are approximately 158 judges. The next level is the Public Courts of which there are some 190.
40 This could be extended, for example, to secured interest in nontangible assets such as accounts receivable and intellectual property.
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These are courts of general jurisdiction. At the District Court level, there are about 400 judges, and in the towns the rural courts are presided over by local lay people, often tribal chiefs who are familiar with customary law. There are approximately 1100 courts in this category with some 900 lay citizens serving as judges. Members of the town or rural courts are selected from citizens of good standing such as tribal chiefs and community leaders. These courts deal exclusively with customary law and are conciliatory in nature.
204. The Judiciary also includes a Constitutional Court which has authority to adjudicate on constitutional issues, the bill of rights and disputes between states. In addition, the court has jurisdiction over any issue, civil or criminal, which involves the violation of a right, and therefore the court has begun to assume major powers and is increasingly perceived as a court of more general jurisdiction. This is a major problem as the Supreme Court has no jurisdiction to consider appeals from the Constitutional Court. It seems to be the view of the members of the Constitutional Court that they have jurisdiction to hear almost any case since all cases can be formulated in such a way as to appear to involve a violation of a right.
205. A new Commercial Court was established in January 2002 by a Decree of the Chief Justice pursuant to the Judiciary Law of 1986. Its formal title is the Khartoum Commercial and Intellectual Property Court. The court deals with all commercial cases and the judges appear to be well trained and well regarded. They have their own special jurisdiction and all five judges have been serving since the commencement of the court’s operations. There is a commercial division within the Court of Appeal and within the Supreme Court. Anecdotal evidence suggests that the Commercial Court is well regarded and cases are disposed of reasonably efficiently. The court keeps good statistics and is about to issue its first published series of judgments. All judges use computer facilities, and the court is making an effort to become a paperless court. There is no evidence of corruption or political interference in the operation of this court.
206. The Judiciary is essentially run by the Chief Justice and his three deputies. All 26 states within Sudan have their own separate judicial organ. The Supreme Council of the Judiciary is responsible for planning, promotion, appointments, discipline and general supervision and inspection responsibilities. The court budget is not significant and under funding of the judiciary is an ongoing problem.
207. Anecdotal evidence suggests that Sudanese judges are respected, perceived as independent, and relatively free from political influence and corruption, although some recent appointments were seen as overtly partisan. Judges are well paid by Sudanese standards and receive generous allowances. Competition for positions on the judiciary is keen. Infrastructure facilities are not good and computerization is only just being introduced. There is an urgent need to strengthen the IT capacity of the courts, together with improved transport, library and research facilities and training. Case management procedures are at a very basic level and delays in the hearing and processing of cases are becoming significant.
208. Judges are not necessarily trained in both English common law principles and principles of the Sharia law. Their different training backgrounds lead occasionally to
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inconsistent judgments on similar issues. There is also a perception that standards within the judiciary have fallen in recent years. Following the introduction of Islamic law in 1983, many of the country’s leading lawyers and judges left to take up judicial positions in other parts of the Middle East. Some training programs have been held but there is a need to develop a much more comprehensive and systematic training program for the judges.
209. Some judges speak English and are well informed about common law principles but others do not speak English. Judges used to be qualified by the National University of Law but now there are some 15 institutes which provide training for potential judges. The quality of instruction is said to vary considerably and most of the institutes have a purely Islamic focus.
210. Arbitration is becoming increasingly common. The arbitration provisions are contained in the Code of Civil Procedure but a draft Law on Arbitration is currently under consideration. Efforts are also being made to establish a Center for Arbitration independent of the government structure and to join the New York, Paris and Cairo Conventions.41
I. The Peace Accord
211. On December 31, 2004, representatives of the parties involved signed a Comprehensive Peace Agreement. This Agreement has broad implications for all aspects of Sudan’s political, legal, economic, social and cultural life. Article 14 of this Agreement, which is attached as an Appendix to this chapter, provides for the monetary policy, banking, currency and borrowing regimes that will apply under the new united political framework. The major implications for the financial sector are as follows:
Introduction of a dual financial system involving Islamic institutions in the North and conventional institutions in the South, Amendments to the BOS management structure and the creation of a major branch of the BOS in the South, The maintenance of a unified monetary policy, The issue of a new currency, The maintenance of a free flow of goods, services, capital and labor across regions, and An even distribution of net oil revenues between the Governments of the North and the South.
These terms will apply for at least six and a half years.
41 The New York convention is the Convention for the Recognition and Enforcement of Foreign Arbitration Awards (1958). The Paris convention is the Convention for the Protection of Industrial Property (1883). The Cairo convention (1997) addresses the Greater Arab Free Trade Area (inaugurated in 2001).
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212. The provisions outlined in Appendix I are statements of general intent. Much detailed negotiation will be required to resolve the many issues that will need to be addressed in order to give effect to the dual financial system. Appendix II provides a breakdown of some of the more important financial sector issues that are likely to arise. It should be noted that the South also has a central bank law and a banking law drafted with the help of foreign consultants. Draft legislation dealing with companies and other essential elements of a normal business environment are also currently under consideration by the authorities in the South. These will need to be harmonized with their Northern counterparts.
J. Recommendations
213. The immediate task confronting the BOS is to begin the process of introducing a dual system of banking. This will involve significant amendments to the BOS Act and to the Banking Act. The wider objective for the country is to review the entire legal system with a view to determining which laws, regulations and institutions will need to be amended to give effect to the Comprehensive Peace Agreement. This will necessarily be a long and detailed process. In the meantime, progress can and should be made in terms of modernizing the existing legal framework to improve efficiency in the financial sector. Specific areas of reform include the following:
Updating the Companies Act of 1925, Amending the Banking Act to include restrictions on aggregate financing to connected parties, including family members in the definition of connected parties, and strengthening the coordination between on-site and off-site supervisory staff and between such staff and other parts of the BOS, Introducing a new Law on Insolvency, Requiring the registration of all transfers of interests in land, Commissioning a study to review the merits of introducing a regime for movable property, Initiating a training program for the members of the judiciary with a particular focus on modern banking and corporate sector issues.
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EXTRACT FROM THE COMPREHENSIVE PEACE AGREEMENT
14.0. MONETARY POLICY, BANKING, CURRENCY AND BORROWING
A. MONETARY POLICY, BANKING AND CURRENCY
14.1. The Parties agree, consistent with the Machakos Protocol of 20th July 2002, to have a dual banking system in Sudan during the Interim Period. An Islamic banking system shall operate in Northern Sudan and conventional banking system shall operate in Southern Sudan.
14.2. The Parties agree that conventional banking facilities are urgently needed in Southern Sudan. The Parties therefore shall agree to establish, during the Pre-Interim period, the Bank of Southern Sudan (BOSS) as a branch of the Bank of Sudan (BOS) consistent with paragraph 14.1 above.
14.3. The Parties agree to restructure, during the Pre-Interim Period, the BOS so as to reflect the duality of the banking system in Sudan. The BOS shall therefore use and develop two sets of banking instruments, one Islamic and the other Conventional, to regulate and supervise the implementation of a single monetary policy through: (i) an Islamic financing window in Northern Sudan under a deputy governor of BOS using Islamic financing instruments to implement the national monetary policy in Northern Sudan; (ii) the Bank of Southern Sudan (BOSS), headed by a deputy governor of BOS, to manage the conventional window using conventional financing instruments in implementing the same national monetary policy in Southern Sudan.
14.4. The BOS shall be responsible for the conduct of monetary policy. All banking instructions shall be subject to the rules and regulations set by the BOS.
14.5. The primary responsibility and mandate of the BOS shall be ensuring price stability, maintaining stable exchange rate, sound banking system and issuance of currency. The monetary policy shall be carried out accordingly relying primarily on market- based instruments instead of administrative allocation of credit.
14.6. The BOS shall be fully independent in its pursuit of monetary policy.
14.7. The Governor of the BOS and his/her two deputies shall be appointed by the Presidency. The Governor of the BOS shall appoint in consultation with his/her two deputies other senior officers within the Central Bank.
14.8. The Parties agree to establish, during the Pre-Interim Period, an independent Board of Directors (BOD). Decisions of BOD on matters that may affect adversely the interest of either Party to this Agreement shall be by consensus. The BOD shall be responsible to the Presidency on the accountability of the BOS and shall consist of nine (9) members as follows:
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a) Governor of the BOS (Chairperson) and his/her two deputies and; b) Six highly qualified Sudanese to be appointed by the Presidency taking into account the agreed formula in the Power Sharing Protocol for the institutions of the National Government.
14.9. The BOS shall adopt a program to issue a new currency as soon as is practical during the Interim Period. The design of the new currency shall reflect the cultural diversity of Sudan. Until a new currency has been issued with the approval of the Parties on the recommendations of the BOS, the circulating currencies in Southern Sudan shall be recognized.
14.10. The BOS shall be responsible for chartering and supervising financial institutions in Southern Sudan.
14.11. All financial institutions shall be subject to internationally recognized regulatory and prudential standards for Islamic and conventional finance, as set by the BOS.
14.12. All financial institutions shall be bound to implement monetary policies set by the BOS.
B. BORROWING
14.13. The Government of Southern Sudan and the states/regions may borrow money based on their respective credit worthiness. Neither the National Government nor the BOS shall be required or expected to guarantee borrowing by sub-national governments.
14.14. The GOSS and all sub-national governments shall report financial and fiscal data to the relevant National Government bodies for statistical purposes.
14.15. The Government of Southern Sudan and the states/regions may borrow money from foreign sources based on their respective credit worthiness.
14.16. Foreign borrowing by all sub-national government shall be done in a manner that does not undermine national macroeconomic policies and shall be consistent with the objective of maintaining external financial viability. All sub-national governments’ foreign borrowing transactions shall conform to the BOS specifications.
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ISSUES IN THE INTRODUCTION OF A DUAL BANKING SYSTEM
1) Currency exchange a) Production and distribution of new currency b) Treasury/vault arrangements c) Conditions for conversion d) Conditions under which the BOS or banks will buy foreign banknotes. Note that, unless conversion at a market exchange rate is offered, an arbitrage opportunity will be created e) Conditions under which the BOS or banks will exchange old Sudanese pound banknotes
2) Legal a) Legislation i) Laws amended not to stipulate that all financial institutions be Sharia-compliant ii) Laws (including BOS Law) permit transactions between Islamic and non-Islamic financial institutions b) Court system i) Mechanism to resolve dispute between financial institutions and nonfinancial agents across regions ii) Mechanisms to resolve disputes among financial institutions across regions, possibly through a BOS arbitrage service or contracting in other jurisdictions iii) Enforcement of contracts across regions
3) BOS organization a) Supervisory Board and Executive Board reorganized i) to include regional representation ii) possibly to include cross-regional economic interests b) Internal organization allows i) devolved elements. An important branch is to be established in the south and possibly other regions ii) coordination mechanisms iii) effective data management, including exchange of information and analysis c) Accountability mechanisms d) Responsibility for BOS capitalization, and allocation of dividends/seigniorage e) Human and physical capacity building, especially in new branches f) Development and implementation of technical assistance program
4) Monetary policy a) Determination of common policy b) Nominal anchor with monetary instability c) Exchange rate regime and exchange arrangements. Rules and implementation d) Management of international reserves e) Analysis of regional and sectoral economic developments f) Devolved implementation
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g) Monetary instruments i) Standing facilities ii) Open market operations iii) Reserve requirements h) BOS and government support for credit programs for such sectors as agriculture
5) Regulation and supervision a) Effects of free movement of goods, capital and people b) Adapting current regulations while ensuring a level playing field c) Off-site supervision responsibilities d) On-site supervision responsibilities e) Reporting, analysis and information aggregation across regions and between on-site and off-site supervision, especially for financial groups f) Licensing criteria and decision making g) Scope for banks to operate different “windows” h) Tax treatment i) Accounting rules and their implementation
6) Government finances (see also under BOS) a) BOS role as government agent b) Government accounts and transaction services for central and regional governments c) BOS role in issuing and registering securities d) Access to certificates market e) Financing of regional governments from BOS and commercial banks
7) Non-bank financial institutions. Similar to banking issues a) Insurance b) Stock exchange c) Other
8) Payments system a) Role of BOS branches b) Developing system in the south
9) Corporate sector a) Corporate accounting b) Corporate accountability, disclosure c) Credit register d) Property register