Why Do African Banks Lend so Little?

We put forward a plausible explanation of African financial under-development in the form of a bad credit market equilibrium. Utilis- ing an appropriately modified IO model of banking, we show that the root of the problem could be unchecked moral hazard (strategic loan defaults) or adverse selection (a lack of good projects). Applying a dynamic panel estimator to a large sample of African banks, we show that loan defaults are a major factor inhibiting bank lending when the quality of regulation is poor. We also find that once a threshold level of regulatory quality has been reached, improvements in the default rate or regulatory quality do not matter, providing support for our theoretical predictions.