I.0 ABSTRACT.................................................................................................................
                          RURAL FINANCIAL SUB-SECTOR


1.1   The 1999 vision st...

2.1     Although they are often under-emphasized in development programs, rural areas
        are im...
formal loans made to non-farm businesses in rural areas, various forms of
        informal finance in small towns and vill...
shrank substantially in size but continued to operate without much donor support.
        In only a few cases, Indonesia a...
central banks, subsidized loan guarantee schemes, and lending quotas have
       been elements of these efforts. Unfortuna...
were designed to provide an infusion of funds to ease credit constraints in the
        project area.

3.12    As a result...

4.1    The ADB funded or co-funded almost 2,400 projects between 1967 and 2000.
banks, other non-governmental organizations, and government parastatals. In
        some cases, funds from these loans wer...
evaluation studies found that the issues of outreach and sustainability seldom
       received attention.


5.1     The dismal performance of traditional agricultural credit programs, coupled with
3. View of users                  Beneficiaries: borrowers          Clients: borrowers and
Subsidized Credit and Poverty Alleviation

5.7    The attachment of subsidies to loans and attempts to direct these subsid...
5.11   One of the strongest reasons usually advanced by those in favor of maintaining
       subsidies is that subsidies r...
interests of dozens of lenders and thousands of borrowers whose actions take
       place beyond the control of credit pla...
by affected lenders. If, for example, the loan-size ceiling is binding and attempts
       to force lenders to make smalle...
5.26   These farmers are also rational in accepting subsidized loans directed at
       alternative crop production, there...
6.2    Comprehensive reform of rural financial markets in the extremely diverse regional
       member countries (RMCs) wo...
later develop the capacity to collect and manage voluntary deposits. Other
            organizations, such as postal savin...
not sustain their participation in microfinance programs if the quality of the
          financial products and services a...
banks often subsist on hefty subsidies, part of which they pass along to their
        clients in the form of low interest...
 Are there financial organizations operating badly in the rural area that might be
         crowding out more efficient f...
constraints. The Swazi Business Growth Trust of Swaziland (SBGT) was therefore established in 1992 as
a non-profit Swazi-d...
       the desired capitalization rate.

          Where inflation is expected to be important, the cost-of-funds element...
of these programs must be subsidized to start and persist. Third, no convincing
          evidence exists that these schem...
to receive funds will be shunned by depositors. Likewise, waiting in long queues
          to make small deposits or to wi...
The Postal Administration in Madagascar accepted deposits from 1918 to 1985; and it was then reformed
into the Savings Ban...
involve doing co-projects with other donors who are working on the supervision
        and regulation system.26

7.38    T...
opening rural offices where the primary objective is to mobilize deposits.
       Likewise, hefty legal reserve requiremen...
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
AfDB 2001 Rural Finance Strategy.doc
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AfDB 2001 Rural Finance Strategy.doc

  1. 1. I.0 ABSTRACT.....................................................................................................................2 2.0 INTRODUCTION...........................................................................................................3 Definition of Rural Finance...............................................................................................3 3.0 GENERAL EXPERIENCE WITH RURAL FINANCE ....................................................4 The African Experience....................................................................................................5 Explanations for the Poor Performance...........................................................................6 Recent Reforms...............................................................................................................7 4.0. ADB’s RURAL FINANCE ACTIVITIES.........................................................................8 Traditional Objectives and Evaluation..............................................................................9 Lessons Learned............................................................................................................10 5.0. SWITCH IN PARADIGMS...........................................................................................11 Comparison of The Old and New Paradigms in Rural Finance....................................11 Subsidized Credit and Poverty Alleviation.....................................................................13 Subsidized Credit and Production..................................................................................16 6.0. MARKETING NICHES................................................................................................17 Three Potential Niches...................................................................................................18 7.0. GUIDELINES FOR DESIGNING RURAL FINANCE PROJECTS..............................19 Necessary Preconditions...............................................................................................20 Crowding Out.................................................................................................................20 Sector Studies................................................................................................................21 Transaction Costs..........................................................................................................22 Interest Rate Policies.....................................................................................................23 Short-term Subsidies......................................................................................................24 Loan Guarantee Schemes.............................................................................................24 Deposit Mobilization.......................................................................................................25 Prudential Regulation.....................................................................................................27 Evaluation.......................................................................................................................29 Sustainability Measures.................................................................................................30 Outreach.........................................................................................................................34 Synopsis of Guidelines ..................................................................................................34 BIBLIOGRAPHY................................................................................................................36 APPENDICES....................................................................................................................42 Appendix Number 1: CREDIT-IMPACT STUDIES.......................................................42 Appendix Number 2: TRANSACTION COSTS..............................................................44 Appendix Number 3: MARKET RATES OF INTEREST...............................................48 Appendix Number 4: LOAN GUARANTEE PROGRAMS..............................................49 Appendix Number 5: THE SUBSIDY DEPENDENCY INDEX.......................................52 Appendix Number 6: SUGGESTED STEPS FOR IMPLEMENTING............................54 THE NEW PARADIGM...................................................................................................54 Appendix Number 7: SOURCES OF INFORMATION ON MICROFINANCE...............59 1
  2. 2. POLICY GUIDELINES FOR THE RURAL FINANCIAL SUB-SECTOR I.0 ABSTRACT 1.1 The 1999 vision statement of the African Development Bank (ADB) emphasized poverty reduction as its primary goal. Achieving this goal requires the bank to expand the scope of its development assistance in rural finance beyond the traditional agricultural lines of credit to employ a new paradigm in its rural finance programs: a paradigm that concentrates more directly on poverty alleviation. The new paradigm focuses more attention on building efficient, sustainable, and subsidy-independent financial infrastructure that provides deposit and lending services to people of modest means. Appropriate infrastructure might include rural branches of banks that mobilize deposits, reformed postal saving systems that handle deposits, savings and credit unions that both lend and mobilize funds, and non-governmental organizations that specialize in micro-lending. 1.2 In the past, the ADB lent large amounts of money through lines of credit and through credit components in rural development projects that were managed mostly by government-controlled agricultural development banks. The results of these efforts in: (a) boosting agricultural development, (b) reducing poverty, and (c) in building efficient financial infrastructure were rather disappointing. It is only in the late 1990s that the Bank begun to experiment with lending to non- traditional financial institutions that specialize in microfinance. Experience in other regions of the world suggests that microfinance can be done successfully using a new paradigm. 1.3 This paper provides general policy guidelines for designing microfinance projects and also identifies supplemental sources of information that might be useful in this process. The guidelines include, inter alia, the necessary preconditions in the project area for a successful take-off of a rural finance project, determining whether crowding out is a problem, and possibly conducting sub-sector studies to supply the requisite background information for project design. Some of the issues that must be considered in project design include reducing transaction costs, establishing proper interest rate policies, managing short-term subsidies, and avoiding loan guarantee schemes. Where deposit mobilization is a major part of the project, attractive deposit products must be designed and prudential regulation strengthened. The objectives of these new projects should be to build and strengthen financial infrastructure that can provide financial services on a sustainable basis to large numbers of poor people in rural areas. Carefully designed projects should clearly state these objectives and specify how the results will be measured. 2
  3. 3. 2.0 INTRODUCTION 2.1 Although they are often under-emphasized in development programs, rural areas are important in most developing countries because they produce basic necessities such as food and fiber and provide markets for goods produced in urban centers. From a social perspective the rural areas are even more important because of the large number of poor people who eke out livelihoods there. 1 In the past, credit programs were mostly aimed at boosting agricultural production and investments. Recently, development practitioners have increasingly refocused finance programs on reducing poverty. 2.2 The 1999 Vision Statement of the African Development Bank called for the bank to make similar changes by concentrating on poverty alleviation. In the section on agriculture and rural development it states that: “…the Bank would facilitate rural financial intermediation by supporting bottom-up, demand driven, micro and rural finance schemes aimed at assisting the poor and vulnerable groups of society” (p. 10). Past ADB practices in agricultural credit are largely inconsistent with this new objective because relatively little of the lines of credit funded by ADB has reached the poor. The Bank, therefore, must make major adjustments in the way it designs and evaluates rural finance projects to accomplish this new objective. These adjustments ought to be consistent with the new dominant development model that relies mostly on market forces to guide development, instead of central planning and directed credit. Making these adjustments will necessitate a fundamental switch in the basic paradigm used to design rural finance projects. 2.3 This paper is a follow up to two other ADB policy publications [see African Development Bank, “Agriculture and Rural Development Sector Bank Group Policy (2000)”: and African Development Bank, “Bank Group Financial Sector Policy (2001)]”. It also takes account of the preliminary findings of the ongoing study on Development Finance Institutions (DFIs). It provides guidelines on ways to develop microfinance programs to more directly address poverty in rural areas, a problem highlighted in the Agricultural and Rural Development Policy paper. It also augments and supplements the discussion of microfinance introduced in the more general Financial Sector paper. This paper provides guidelines on how to expand and improve the sub-sector of the financial system that operates in rural areas, in ways that will more directly benefit poor people -- through microfinance programs in the rural areas. Definition of Rural Finance 2.4 Rural finance is a relatively new term used to describe the portion of the financial system that supplies financial services and financial products outside urban areas. It includes traditional agricultural credit to small holder farmers, formal and semi- 1 About half of the 600 million people who live south of the Sahara are embraced by poverty and the bulk of the poorest-of-the poor live in rural areas. 3
  4. 4. formal loans made to non-farm businesses in rural areas, various forms of informal finance in small towns and villages, and formal deposit-taking from rural clients.2 The use of the term “rural finance” results from an evolution in development thinking. Previous concerns with producing more food through agricultural credit programs have evolved to broader concerns about lessening poverty, boosting employment, treating women more fairly, and using financial markets more effectively to support development. 3.0 GENERAL EXPERIENCE WITH RURAL FINANCE 3.1 Rural financial intermediation is problematic everywhere. The small size of the typical transaction, both loans and deposits, the dispersion of potential clients, the risks associated with farming, and the lack of bankable land documents result in rural finance being both costly and risky; it is the most difficult activity that financial markets undertake. It is not surprising, therefore, that most governments and many donors gave ample attention to expanding agricultural credit for several decades after World War II. In numerous countries, Mexico and the Philippines, for example, large increases in the volume of directed credit -- often provided through government-owned banks -- were the main instruments used to promote agricultural development during the 1960s and 1970s. 3.2 Donors supported these efforts with hundreds of agricultural credit projects. Starting in the 1970s, however, these activities were seen to produce increasingly unsatisfactory results. The effects of credit projects on agricultural production were ambiguous; loan recovery problems were chronic; the purchasing power of many agricultural credit portfolios were eroded by inflation; poor people received few of the subsidies associated with these programs; and many of the development banks administering these efforts collapsed. 3 These disappointing results caused donors such as the World Bank, the U.S. Agency for International Development, and the Inter-American Development Bank to reduce sharply in the 1980s their agricultural credit efforts and to refocus attention on helping poor people in new ways that were more consistent with a new paradigm on rural finance (see Section V). 3.3 During the 1980s and 1990s a number of specialized agricultural development banks were liquidated or merged with other banks. Some development banks 2 The term formal finance here refers to the portion of the financial system that is supervised by a central monetary authority. Semi-formal finance is provided by organizations that are officially recognized or permitted to offer financial services, but which are not systematically supervised by a central monetary authority. This includes financial activities in co-operatives, loans made by non-governmental organizations, and licensed pawnbrokers. Informal finance includes all other forms of finance that occur without official supervision or permission: e.g., moneylenders, self-help financial groups, and merchant and dealer lending. 3 The first comprehensive evaluation of these efforts was done by the U.S. Agency for International Development in 1972-73 in its Spring Review of Small Farmer Credit Programs (Donald). This was followed by a Colloquium on Rural Finance in Low-Income Countries held in Washington, D.C. in 1981. The World Bank and the Agency for International Development sponsored the Colloquium where the results of directed credit programs were criticized (Adams, Graham, and Von Pischke). Later, both the World Bank and the Inter-American Development Bank issued policy papers on finance that led both banks to abandon gradually most directed credit efforts. 4
  5. 5. shrank substantially in size but continued to operate without much donor support. In only a few cases, Indonesia and Malaysia being prime examples, were agricultural development banks successfully reformed along lines that were consistent with a new paradigm. Increasingly, donors shifted away from agricultural credit and supported the microlending provided mainly by non- governmental agencies (NGOs). At the same time, the World Bank and the International Monetary Fund helped to provide more hospitable environments for all finance projects through structural adjustment programs. The African Experience 3.4 Agricultural credit efforts in Africa have been even more problematic than similar activities elsewhere. This is a conundrum. On the one hand, informal finance in Africa provides sustained and subsidy-free financial services -- both loans and deposits -- to large numbers of rural people. Research suggests, for example, that self-help financial groups manage large amounts of money in countries as diverse as Cameroon, Ethiopia, Ghana, and South Africa. In some countries, including Egypt, Gambia, and Nigeria, informal money-keepers keep substantial amounts of cash for rural people. In most countries, merchants, dealers, and traders extend large amounts of informal loans to facilitate purchase or sale of products and inputs (Meyer and others). 3.5 Most central markets in Africa have dense networks of informal financial arrangements and many villages have one or more self-help financial groups (see Bouman; Lukhele; Seibel and Marx; Shrieder and Cuevas; Shipton). In West Africa (Ghana, Ivory Coast, and Nigeria, at least) susu or tontine collectors mobilize surprising amounts of money informally from poor people (Steel and Aryeetey). In some countries, including Algeria, Ghana, Lesotho, and Somalia, substantial inflows of remittances to rural households dwarf donor and government efforts in rural finance. These informal systems would not be persistent if most Africans did not fulfill their informal financial obligations and derive substantial benefits from these arrangements. 3.6 The experience with formal rural finance, on the other hand, has been much less satisfactory. Millions of borrowers across the continent have failed to repay their loans from development banks and from co-operatives. Most countries in Africa have also endured episodic institutional fads: co-operative credit organizations sponsored by the British, credit unions promoted by North Americans, rural private banks and supervised credit programs promoted by the Americans, specialized agricultural development banks supported by the World Bank and the French, and more recently, a variety of non-governmental organizations that specialize in microlending, especially for women.4 3.7 In many countries, governments or donors have also attempted to force commercial banks to lend more to agriculture. Concessionary rediscount lines in 4 Institutional transplants in some Asian countries have been more successful. The Japanese transferred their co-operative agricultural credit/deposit model successfully to both Korea and to Taiwan. Some of the rural financial institutions started by the Dutch in Indonesia flourished and grew into efficient forms of rural finance. 5
  6. 6. central banks, subsidized loan guarantee schemes, and lending quotas have been elements of these efforts. Unfortunately, no aggregate figures exist on the number of these efforts or their costs. Over the period 1967 to 1987, the World Bank alone financed 167 projects in Africa with major agricultural credit or rural credit components. The total value of these credit efforts was US$390 million. 5 If it were possible to aggregate other government- or donor-sponsored agricultural credit programs, the total likely would be many multiples of the World Bank’s commitments. 3.8 With few exceptions, the results of these programs have been disappointing. Some of them may have had positive, short-run effects on agricultural production and investment, but most of these effects were transitory. At the start of the second millennium, few countries in Africa had a healthy agricultural sector, and even fewer countries had durable and efficient rural financial infrastructure. Probably more rural Africans had dependable access to formal finance several decades earlier than in the year 2000. Many postal savings systems, government-owned development banks, credit co-operatives, and credit unions that once provided financial services in rural areas either have disappeared altogether, have little outreach, are heavily subsidy dependent, or are moribund. Aside from the African Development Bank, other major donors have terminated or substantially reduced lines of credit through agricultural development banks to promote agricultural development in Africa. Explanations for the Poor Performance 3.9 Various explanations exist for the disappointing performance in Africa. In some cases natural disasters such as floods or droughts undermined for a time the performance of rural finance in Africa. However, man-made disasters in the form of wars, bad governance, hostile macroeconomic environments, damaging financial policies, and poorly designed projects are more general explanations for these unfavorable results. 3.10 Rural financial markets can only expand and thrive where law and order exists, where inflation does not discourage savings and continually erode the real value of financial assets, where economic policies result in attractive investment opportunities in rural areas, and where financial markets are not heavily repressed by government controls. Repressive instruments include interest rate ceilings, excessive legal reserve requirements, large numbers of directed credit programs, loan guarantee schemes, defective bank regulation and supervision, and limits on bank branching. 3.11 The designers of donor and government-funded credit programs also contributed to the poor performance of rural credit projects. Most of these efforts, for example, were based on the assumption that credit shortages were a major constraint on agricultural production and investment. Based on this assumption, donors and governments strove to augment the supply of agricultural loans through lines of credit in government-owned development banks. Projects usually 5 A survey done in 1987 of these projects suggested that few of them would have been classified as success stories (Thillairajah). 6
  7. 7. were designed to provide an infusion of funds to ease credit constraints in the project area. 3.12 As a result, project outreach was often limited. In some cases this involved repeated injections of funds without increasing the overall capacity of rural financial markets to sustain financial services. Benefiting from hindsight, the project designers might have asked more fundamental questions like Why do rural financial markets lack the capacity or incentive to provide loans that donor employees think are required for development? And, how can one design a project that will enhance the sustained performance of providers of rural financial services so that periodic insertions of outside funds are unnecessary? 3.13 Several other features of donor-sponsored credit programs negatively affected the performance of these markets. In some cases, donors and governments applied concessionary terms to agricultural loans. This made it impossible for lenders to cover their costs and risks of lending, thereby, de-capitalizing lenders and condemning them to subsidy dependency. Furthermore, in many cases, the rates of interest allowed on agricultural loans were less than rates of inflation, thus assuring that the purchasing power of the lender’s portfolio would further diminish over time. Tolerance of massive loan defaults further shrunk the funds that lenders had to re-lend. In most cases the infusion of funds at concessionary prices also discouraged the financial system from mobilizing deposits, because it was cheaper for lenders to process inexpensive donor and government funds for agricultural lending than it was to mobilize small voluntary deposits in rural areas. 3.14 Large numbers of targeted credit programs sponsored by donors and governments also increased the costs of participating lenders. Each of these lines of credit typically had idiosyncratic lending and reporting requirements. In most cases the types of information collected to satisfy the accounting necessities of the funds provider were of little use to managers of the financial institution. The information required by the providers of targeted credit funds warped management information systems. In doing so, it crowded out more useful management information such as timely loan recovery data and information on operating costs. Recent Reforms 3.15 With assistance from the World Bank, the International Monetary Fund and the Bank, a number of countries in Africa implemented important macroeconomic and financial market reforms during the 1990s that provided a more positive environment for rural finance projects. Macroeconomic reforms include lessening distortions in foreign exchange markets, reductions in subsidies and price controls, and privatization of major industries. In the financial sector, some of the useful reforms included liberalization and rationalization of interest rate policies, bank restructuring and privatization, and bank liquidation.6 6 See African Development Report 1997 for further discussion of these economic reforms. The reforms that were specifically aimed at financial sectors are described in ADB, “Bank Group Financial Reforms.” 7
  8. 8. 4.0. ADB’s RURAL FINANCE ACTIVITIES 4.1 The ADB funded or co-funded almost 2,400 projects between 1967 and 2000. Cumulatively, slightly less than one-fifth of the total funds disbursed by the bank have been for agricultural purposes. In the late 1990s, agricultural projects made up over one-quarter of the value of the active portfolio of ADB, indicating that agricultural projects increased in importance over time. As much as one-third of the total value of these agricultural projects was comprised of funds for rural credit. Most of these projects can be assigned to one of three groups: 4.2 First, the bulk of the money lent by the bank for agricultural credit purposes involved loans made through traditional agricultural development banks. Examples of these projects can be found in Algeria, Egypt, Ghana, Morocco, and Tunisia. In most cases these loans were made to provide foreign exchange for imports and also to augment the supply of local funds available for agricultural credit programs. (See box No. 1.) Box Number 1, Line-of-Credit Loans in Tunisia. In 1985 the ADB extended a loan of UA 18 million to the National Agricultural Bank of Tunisia. The foreign exchange involved was used to finance imports required in agricultural sub-projects financed by the agricultural bank. This loan was totally disbursed by 1991 and a second line of credit for UA 50 million was extend to the agricultural bank by ADB that began to disburse several years later. The objective of the second loan was to strengthen the operations of the agricultural bank and to expand its volume of lending. 4.3 Second, a substantial amount of money was also channeled through agricultural credit components that were included as part of more comprehensive development projects. These components were designed to foster the adoption of new technology, stimulate targeted farm enterprises, or facilitate a targeted investment. Credit-component projects have a long history in the bank, and many of the Bank's agricultural projects have included line items for credit augmentation. Use of these components is an admission that the existing rural financial system is unable to provide sufficient loans to support the activities stressed in the project. (See box No. 2). Box Number 2, An ADB project that includes a credit component: The Cashew Project in Ghana. Ghana requested an ADB loan of nearly UA 10 million in 2000 to promote cashew production. More than 40 percent of this loan was earmarked for a lending scheme to promote cashews. The Agricultural Development Bank of Ghana administered the credit component. Both individual and group loans were allowed under the project. 4.4 Third, in 1991 ADB began to experiment with microlending. Some of these involved loans to non-traditional lenders in rural areas: credit unions, village 8
  9. 9. banks, other non-governmental organizations, and government parastatals. In some cases, funds from these loans were channeled to the ultimate lender through a second tier institution (see box Number 3). By 2000 ADB had programs in 21 countries with microfinance components, some of which were formed through the leadership of AMINA, a small unit in the Bank devoted to promoting micro-finance7. A number of these programs were co-financed with the World Bank and involved modest credit components for microlending, especially for women. The total value of these micro-credit components in late 2000 was about US$150 million, perhaps something less than half going into rural or peri-urban areas. Box Number 3, An ADB project that works through non-traditional rural lenders: Irrigation Project in Zambia. During the construction of the Kariba dam in the 1950s a number of families were displaced and relocated in 60 settlements elsewhere in the Southern Providence of Zambia. An ADB loan for about UA 5.3 million was proposed in 2000 to build small-scale irrigation schemes and to establish five new village banks in these settlements. About 15 percent of the funds for the project were to be set aside to establish a credit fund. These loan funds were to be channeled through a commercial bank, to a selected micro-financial intermediary, and then to new village banks affiliated with existing or newly formed cooperatives. Farmers received group loans with five members in each group. The village banks were to be capitalized by withholding 15 percent of the value of each loan, which then became share capital owned by the borrowers. Village banks were designed to accept voluntary deposits. Traditional Objectives and Evaluation 4.5 Most of the Bank's projects with agricultural credit features had the objective of promoting project activities such as selected crops or farm enterprises, new technologies, or rural investments. Serious evaluations of these credit projects require measuring the impact of credit use on the activities selected as goals for the project. Credit-impact studies, however, are expensive to do and are laced with methodological difficulties.8 4.6 These studies involve collecting substantial amounts of primary information from borrowers who participated in the program (see Appendix Number 1). As a result, it is not surprising that few of the evaluations of ADB-funded agricultural credit projects include empirical information about credit impact. During project implementation, a lot of weight is put on disbursement of loan funds and compliance with the Bank's accounting and reporting requirements. Consequently, 7 AMINA stands for ADB’s Micro-Finance Initiative for Africa 8 A comprehensive World Bank evaluation of its agricultural credit activities illustrates these problems (World Bank, 1993). 9
  10. 10. evaluation studies found that the issues of outreach and sustainability seldom received attention. Lessons Learned 4.7 The primary lessons that can be gleaned from the Bank's experience in rural finance include the following:  Hostile macroeconomic and macro-finance environments had powerful negative impacts on rural finance projects. Nonetheless, recent reforms provide more hospitable environments for new approaches in rural finance;  Until recently, few of the Bank's projects were directed at expanding and enhancing rural financial infrastructure that primarily served poor people in rural areas. Few of these new projects have been carefully evaluated.  As a result, the bank must mostly look elsewhere for best practices and success stories in microfinance. Fortunately, the microlending industry has ample experience in many countries that can provide useful guidelines for ADB. There are many publications available on best practices, useful guidelines, and examples of success and failure. Although ADB is a late entrant to this field, it can benefit greatly from the experience of others.  The ADB has done very little lending to promote deposit mobilization. Although an increasingly dense network of organizations in the microlending industry exists worldwide, little experimentation in the mobilization of deposits in rural areas has been done. As a result, few experts and even fewer publications on this topic exist. A small number of successful programs in Asia and a handful of interesting pilot projects in Latin America, nonetheless, provide useful guidelines for deposit mobilization efforts.  Questions as to whether past ADB agricultural credit efforts were successful in boosting agricultural growth are moot. Instead, the critical focus for the Bank now is how to reduce poverty more directly, and in that context, how to employ rural financial markets more effectively in these efforts.9  Aside from a few recent projects, most of the Bank’s efforts in rural finance have paid only modest attention to creating additional financial infrastructure in rural areas or been successful in enhancing the performance of existing infrastructure.10 Adjustments in Bank practices to implement the New Vision and the application of a new rural finance paradigm will require more attention to building efficient financial infrastructure that is capable of providing sustainable rural finance services to poor people. 9 If done well, some of the improved practices introduced through successful microfinance projects may spill over into improving traditional credit practices. 10 Exceptions are new microfinance projects in some countries, such as Cape Verde, Senegal, and Malawi. 10
  11. 11. 5.0. SWITCH IN PARADIGMS 5.1 The dismal performance of traditional agricultural credit programs, coupled with the increasing reliance on market forces to guide development and heightened concerns about poverty, have caused most major donors to sharply decrease their commitments to targeted credit in all sectors, but especially in agriculture. This has been accompanied by a major switch in the dominant paradigm used to formulate rural finance programs. Under the old paradigm, subsidized and targeted agricultural credit was often an important part of attempts to promote agricultural growth. Under the new rural finance paradigm, more emphasis is placed on strengthening rural financial infrastructure and improving its performance, especially regarding those services used by poor people. 5.2 As is explained in more detail below, one of the most important lessons learned from directed credit efforts is that due to the excess demand for agricultural credit engendered by heavy subsidies, poor people are able to capture few of the subsidies associated with these loans. Experience has also shown that new technology and product and input prices are far more important than the price or availability of credit in influencing production and investment decisions.11 Furthermore, there is ample empirical evidence to show that credit targeting and credit subsidies reduce the ability of financial systems to assist with the efficient allocation of resources. Comparison of The Old and New Paradigms in Rural Finance 5.3 Differences in nine features distinguish the old and new paradigms in rural finance.12 As can be noted in Table 1, these features include problem definition, the role assigned to financial markets, and how users of financial services are viewed. They also include the involvement of financial systems in administering taxes and subsidies, the primary sources of funds used in the system, the nature of associated information systems, views about sustainability and outreach, and how activities are evaluated. Table 1: Primary features of the old and new paradigms Features Directed Credit Financial Market Paradigm Paradigm 1. Problem definition Overcoming market Lowering transaction imperfections costs 2. Role of financial -help the poor Intermediate efficiently markets -stimulate production 11 During the 1970s several countries such as Brazil, Indonesia, the Philippines, and Sri Lanka sharply increased the availability of formal agricultural credit. Subsequently, inflation, financial market reforms, and changes in development policies resulted in sharp declines in the total real value of formal agricultural credit in these countries – as much as halving earlier volumes of formal agricultural credit. Despite these sharp reductions in credit supplies, the rates of agricultural growth over the same periods show few or only minor fundamental changes in historical patterns of growth. 12 See Vogel and Adams, 1997b for further discussion of the two paradigms. 11
  12. 12. 3. View of users Beneficiaries: borrowers Clients: borrowers and depositors 4. Subsidies and taxes Lots of both Few of either -subsidy dependent -subsidy independent 5. Sources of funds Vertical: governments Horizontal: primarily and donors voluntary deposits 6. Associated Dense, fragmented and Less dense and mainly information systems vertical – were targets horizontal – management met? information 7. Sustainability Largely ignored Major concern 8. Outreach Mostly ignored Primary concern 9. Evaluations Credit impact on Performance of financial beneficiaries – mainly institutions – mostly primary data secondary information 5.4 The directed credit paradigm focuses on overcoming imperfections in financial markets and assigns a robust role to these markets in addressing numerous social and economic problems.13 Borrowers under this old paradigm are often referred to as beneficiaries who receive loans that are subsidized either through concessionary interest rates or through loan defaults. Because of these subsidies a substantial portion of the funds involved in directed lending is provided by a governments and donors. These programs, in turn, typically require lenders to develop dense information systems that demonstrate compliance with loan targeting provisions as well as collect information on the impact of loan use among borrowers. Typically, under the old paradigm, little concern is given to the sustainability or long-term outreach of the credit program. 5.5 The new financial market paradigm, in contrast, assigns a limited role to financial markets. That role is assisting in the efficient allocation of resources through mobilizing deposits from surplus clients and then lending the surplus funds to clients with economic opportunities but with too few resources to capitalize on these opportunities. The new paradigm stresses the importance of lowering transaction costs in these markets and regards depositors and borrowers as valued clients. Under the new paradigm, financial markets avoid taxing or subsidizing market participants. 5.6 Because of the emphasis on deposit mobilization under this paradigm, deposits eventually provide most funds for lending. Since financial institutions are not involved in targeted lending their information systems are less dense than are those managing directed debt. Instead of evaluating performance by trying to measure loan impact among borrowers’ activities, the new paradigm concentrates on measuring the performance of financial institutions using secondary data such as lender profits, loan recovery performance, outreach, and subsidy-dependency. Because of the emphasis on developing strong and efficient financial markets, sustainability of lending and deposit mobilization efforts is a major concern. 13 Initially, market imperfections were vaguely defined by citing the high interest rates charged on informal loans and the inability of poor people to access formal loans. Later, economists, particularly Joseph Stiglitz, supplied a more rigorous definition of imperfections. 12
  13. 13. Subsidized Credit and Poverty Alleviation 5.7 The attachment of subsidies to loans and attempts to direct these subsidized loans to groups or activities selected by policy makers is the feature that most clearly distinguishes the old and new paradigms. The structures of financial systems involved in directed lending are also distinctive. Typically, government- owned institutions are in the midst of credit-directing efforts and several techniques are used to channel funds into directed lending. Most commonly, the central bank offers rediscount lines that permit financial institutions to access government or donor funds at below-market rates for targeted purposes. Another technique is to require financial institutions to lend a certain amount for targeted purposes, or to deposit funds at concessionary rates in other institutions that are able to comply with loan-target quotas. In practice, most of the countries heavily involved in directed lending use both techniques. 5.8 Forms of loan subsidies: Three types of subsidy may be associated with loans: an interest rate subsidy that might be captured by either the lender or borrower, a default subsidy that is captured by the borrower, and implicit subsidies embedded in loan guarantee programs that are usually captured by lenders. Interest rate subsidies occur when borrowers are charged interest rates that are below market rates for similar loan contracts with the rate of subsidy being the difference between the two rates. This may involve lenders receiving concessionary funding from governments or donors, or final borrowers receiving loans that carry concessionaL terms. A default subsidy occurs when borrowers fail to repay all or part of their loans with the amount of the subsidy being the loan principal and interest due but not recovered by the lender. 5.9 The magnitude of the interest rate subsidy increases when nominal interest rate policies are sticky and inflation increases. Likewise, the magnitude of the default subsidy usually increases when: (a) loans are made quickly; (b) loans are allocated on the basis of need and not effective demand; (c) the macroeconomic environment deteriorates; and (d) when loans are made by organizations that lack experience in creditworthy lending. Typically, loan guarantee programs that support directed credit are subsidized by governments or donors, and this subsidy most often is captured by lenders who shift part of their loan recovery risk to the guarantee program. 5.10 Someone ultimately pays for all subsidies. As a result, credit subsidies entail implicit taxes. These taxes might be paid by foreign citizens who provide donor funds to finance credit subsidies; by domestic citizens who pay taxes that are used to fund credit subsidies; or by all holders of financial assets -- particularly depositors -- whose real values of financial assets erode with the onslaught of inflation. The overall social benefits of subsidized credit programs are partly determined by who receives the subsidies and partly by who pays the associated tax. If, for example, relatively well-to-do borrowers captured most of the credit subsidy, while most of the associated taxes are paid by poorer depositors or by poorer taxpayers, one might conclude the program yielded negative social benefits. 13
  14. 14. 5.11 One of the strongest reasons usually advanced by those in favor of maintaining subsidies is that subsidies represent the most direct way to assure an equitable redistribution of income. They argue that small holder farmers pay high producer taxes on the export crops they grow, and so the subsidies are meant to compensate them for those heavy producer taxes. Another strong argument advanced by proponents of farmer subsidies is that even the Western and advanced countries spend billions of dollars to subsidize agricultural production and protect the interests of their farmers, so what is wrong with developing countries follow suit? 5.12 The case for/against subsidies: This policy guideline is not against the provision of farmer subsidies aimed at supporting African agriculture. Rather, what it is against is the type and mode of administering subsidies that never reach their intended beneficiaries. When agricultural credit is priced below market-clearing levels, the excess demand created engenders a rationing credit delivery system that only tends to promote rent-seeking behavior and corruption among government officials with the end result that the bulk of the funds get siphoned to those with political clout. 5.13 The net effect is three-fold. First, the rationing system only adds to the already high transaction costs of administering small amounts of credit to a large number of scattered small holder farmers and rural operators. Second, as long as rent- seeking behavior is used to justify subsidized credit, an infinite supply of funds will be required to meet the “over-blown” demand for credit, throwing into question the long term financial sustainability of the credit scheme. Third, channeling huge amounts of cheap subsidized credit through the formal financial system introduces distortions that can have adverse effects on the overall financial system. 5.14 This paper, therefore, advocates that rural finance programs should be designed and administered in such a way that credit subsidies do not lead to distortions in the overall financial system, and also that the subsidies are financial sustainable over the long term. In practice, this implies that the use of credit subsidies should be limited, clearly budgeted, time-bound, and linked solely to start-up activities and training programs of indigenous credit and savings societies. 5.15 Why cheap credit did not reduce poverty: A subsidized credit program is only effective in treating poverty if poor people capture most of the associated subsidy. Two elements determine the distribution of credit subsidies: the access to subsidized credit and the magnitude of the subsidy attached to the loan. Only those who receive subsidized loans, for example, benefit from the loan subsidy, with the magnitude of the subsidy captured by those with credit access determined by a subsidy formula. 5.16 Who receives subsidized loans? At first blush, this appears to be a superficial question since many subsidized credit programs are directed at pre-selected target groups such as poor people, women, micro-entrepreneurs, or operators of small farms. Research on microfinance, however, shows that the differences between what the designers of directed credit programs intended and what later actually happened may differ substantially because of the microeconomic 14
  15. 15. interests of dozens of lenders and thousands of borrowers whose actions take place beyond the control of credit planners. 5.17 Loan access is determined by actions of both lenders and borrowers. Attaching a subsidy to loans complicates analysis of these actions. As already argued, when the subsidy component is relatively large, it may convert borrowers into rent seekers who primarily wish to capture the subsidy rather than to apply borrowed resources in a profitable economic activity. If the subsidy component is large enough, the demand for subsidized loans may become essentially infinite, thereby forcing lenders to ration loans through non-interest rate mechanisms. This might include lenders imposing additional loan transaction costs on non-preferred clients to discourage them from asking for credit, and loan officers’ participating in rent seeking by soliciting bribes. 5.18 Lending small amounts to new clients, especially those in rural areas, is naturally costly and risky for lenders. Credit subsidies make this type of lending even less attractive for lenders. The net result of this is likely to be lenders favoring previous clients over new clients, and lenders preferring large loans over small loans, thereby further shrinking poor peoples' access to formal loans. 5.19 The subsidy formula: In most subsidized credit programs, the interest rate subsidy and the default subsidy are always proportional to the size of the loan. If the interest rate subsidy, for example, is equal to 10 percent of the value of the loan, a borrower of $100 receives an interest subsidy equal to 1/10th the size of the interest subsidy received by someone who receives a loan 10 times as large (or $1,000). Likewise, a borrower who fails to repay a loan of $100 receives a default subsidy that is only 1/10th the size of the default subsidy captured by someone who fails to repay a loan of $1,000. 5.20 This leads to the following general conclusion that:  those who are unable to access subsidized loans receive no loan subsidy;  those who obtain small, subsidized loans receive small subsidies; and  those with access to large loans receive large subsidies. Since loan access and wealth are highly correlated everywhere, subsidies attached to loans are inevitably distributed regressively. In the end, those borrowers who are more well off and politically powerful capture a larger proportion of the total subsidy than do those who are less well off and who have a weak political voice. If a uniform formula regarding interest rates and loan recovery enforcement is applied to all borrowers, subsidies attached to loans exacerbate, rather than ameliorate, income- and wealth-distribution problems. 5.21 To overcome this proportionality problem, policy makers may attempt to adjust the subsidy formula in favor of the poor. This might include loan size ceilings on subsidized loans, application of differential interest rates on loans, or application of differential loan recovery standards depending on loan size. All three of these policy options have important implication for the microeconomic decisions made 15
  16. 16. by affected lenders. If, for example, the loan-size ceiling is binding and attempts to force lenders to make smaller loans than they would otherwise voluntarily choose to make, lenders may meet the letter of the law by making multiple loans that fit under the ceiling to single individuals or families that are normally favored by the lender. The lender thereby evades the spirit of the law and avoids making additional small loans to new clients. 5.22 Preferential interest rates and preferential loan recovery standards on loans to poor people provide perverse incentives for lenders. In large part, formal lenders avoid making small loans to new clients because the costs of doing so often exceed expected revenues. Forcing lenders to charge even lower interest rates on these loans and asking them to tolerate higher rates of default on these types of loans than they would otherwise, makes lending to poor people even less attractive. Lenders may feel compelled for public relations purposes to do token poverty lending under these preferential subsidy formulas, but they will do so with little enthusiasm or outreach. In the end, the ultimate objective of reaching large numbers of the poor is defeated, with the subsidized funds going to politically powerful interest groups with clout in the society. 5.23 The proportionality feature of loan subsidies and the perverse incentives provided to lenders by preferential subsidy formulas have caused some students of microfinance to conclude that subsidized loans are uniquely unsuitable for treating poverty. Because subsidized credit is associated with even lower interest rates on deposits, and since many of the potential users of deposit services are poor people, cheap credit may have a triple negative effect on the poor. First, the poor are unable to capture a significant portion of the credit subsidy. Second, because of cheap credit policies they have no access to attractive deposit services, and, third, in the long run, the processing of subsidizing loans is likely to weaken or even destroy the very financial infrastructure that might otherwise provide financial services to poor people. Subsidized Credit and Production 5.24 Subsidized credit was used under the old paradigm as a tool to boost production, investment, and/or technological change. Economic logic shows, however, that the relationship between the price of a loan and the incentives to produce, to invest, or to use new technology is ambiguous, especially in rural and microlending. The prices and yields of the goods that borrowers produce have far more powerful impact on producers’ decisions than do loan subsidies. 5.25 A simple example may help clarify this important point. In several countries in Latin America, farmers with small units find it highly profitable to grow coca plants whose leaves are used in the production of cocaine. These farmers live in remote areas where the yields and prices of other crops they might raise are relatively low and unstable. From an economic point of view, these farmers maximize their profits by specializing in coca production; the income derived thereby is far higher than from any other alternative. 16
  17. 17. 5.26 These farmers are also rational in accepting subsidized loans directed at alternative crop production, thereby capturing the credit subsidy. They continue their rationality by only growing a token amount of the alternative crop and diverting most of the borrowed liquidity into additional consumption, or into the planting of more coca. The availability of the borrowed funds and the interest rate attached to the loan does not alter the relative profitability (or desirability) of the economic choices faced by the borrowers – coca production is always their best choice. 5.27 The second-best argument: Attempts to compensate farmers through subsidized credit is similarly ineffective. A government, for example, may have price controls or exchange rate regimes that depress the price farmers receive for their cocoa. As a supposed second-best solution, the government may attempt to compensate farmers for some of the losses in income they suffer because of the low prices by dispensing subsidized credit. 5.28 There are two primary problems with this. First, it is impossible to fairly match the amount of “taxes” imposed on the cocoa growers by the price distortion with the amount of the credit subsidies. All cocoa growers pay the price-distortion tax in proportion to the amount of cocoa they sell at the depressed prices. Only those who can access the subsidized credit, however, receive a compensating subsidy. Since credit subsidies, as suggested earlier, tend to shrink the access of non- preferred borrowers to cheap credit, a few large borrowers are likely to capture the bulk of the so-called compensating credit subsidies, thereby violating the fairness principle of the second best: all producers pay the tax, but only a few are compensated through subsidies. 5.29 Production is the second problem with using cheap credit to compensate for low cocoa prices. As mentioned earlier, receiving a subsidized loan does not affect the relative attractiveness of the economic choices that are faced by the borrower. If farmers view additional cocoa production as not worth doing, the availability of cheap credit will not alter that perception. They may take the loan with concessionary terms to capture the associated subsidy, but they have no economic reason to direct these borrowed resources into an activity they perceive will yield low returns. Credit subsidies may attract borrowers but will have little effect on their decisions to produce, invest, or use new technology. 5.30 The fungibility of money allows borrowers to direct the additional liquidity provided by loans to activities that offer the highest expected marginal returns, regardless of whether these activities are the objective of the subsidized loan. If the targeted activities are perceived as high return activities by borrowers, credit subsidies or loan targeting is unnecessary. 6.0. MARKETING NICHES 6.1 Realizing the goal of poverty alleviation and employing the new paradigm would require major changes in the Bank addresses rural finance. It also forces the Bank to identify niches in rural financial markets that are within its capabilities. 17
  18. 18. 6.2 Comprehensive reform of rural financial markets in the extremely diverse regional member countries (RMCs) would require a lot more resources than the Bank has or is likely to have in the future. The Bank must, therefore, carefully select a small number of marketing niches for its rural finance programs that are consistent with its resource outlay and with the new paradigm on rural finance. Selecting these niches should also take into consideration what other donors are doing in Africa. 6.3 One way of identifying marketing niches for the Bank’s poverty alleviation efforts is to study the informal financial products and services that are popular among poor people. Informal finance involves small transactions, procedures that impose few transaction cost on clients, large numbers of people who save through money- keepers or in self-help financial groups, flexible loan procedures, and short-term loans. As a starting point, therefore, the Bank’s micro-finance efforts must be designed to provide financial products and services that at least partially compete with informal finance. In some cases this will involve forming new organizations that specialize in microlending. In other cases it may include strengthening and expanding existing organizations that do microfinance. It will also require creative work in reforming or building new financial infrastructure that can effectively mobilize rural deposits. More deposit mobilization, in turn, requires enhanced prudential regulation and supervision of deposit takers. Box Number 4, Self-help Financial Groups in Cameroon Self-help financial groups are widespread and important in Cameroon. It has been estimated that nearly 80 percent of the adults in the country participate in these groups and that they manage about half of the total financial savings nationwide. An historical case study of one of these groups suggested that some of these organizations may persist over long periods of time and may grow increasingly complex as they evolve. These groups may manage multiple funds that rotate the distribution of funds among members. Groups may also develop parallel, non-rotating funds that assemble money from group members that is used for emergencies, or used as a loan fund. These groups may perform social as well as economic functions. In some cases, members of the group may also meet periodically to share business information. Source: Tonkou and Adams Three Potential Niches 6.4 The niches that the Bank might fill to help poor people through rural financial markets are the following: • First, the Bank might support the establishment and growth of specialized microlending organizations that operate mainly in rural or peri-urban areas. These organizations should not be viewed as charities but rather as ways to provide sustained financial services to people of modest means; • Second, the Bank could also support the reform and establishment of financial organizations that efficiently mobilize voluntary deposits in rural areas. Some organizations might be NGOs that start out specializing in microlending, but 18
  19. 19. later develop the capacity to collect and manage voluntary deposits. Other organizations, such as postal savings systems and credit unions and banks, might be involved in projects primarily aimed at encouraging them to expand savings opportunities for rural people; or • Third, the Bank could reinforce the capability of central monetary authorities to regulate and provide prudential supervision to those organizations that are involved in mobilizing rural deposits. This may require regulatory innovations where postal savings systems, credit unions, and other NGOs are doing deposit mobilization. 7.0. GUIDELINES FOR DESIGNING RURAL FINANCE PROJECTS 7.1 The huge diversity among member countries makes it virtually impossible to provide detailed uniform guidelines – recipes -- that can be routinely applied to all of the Bank's rural microfinance projects. Moreover, microfinance is a new industry where best practices are still evolving. As a result, project designers must tailor each project to fit local conditions and read recent literature14 on micro- finance to keep abreast with new guidelines. ADB micro-finance project designers should refer to recent publications that describe in detail how to formulate microfinance projects, how to design financial products, how to establish management information systems, how to set up accounting systems, and how to measure performance.15 7.2 Some general issues, however, must be dealt with in the design of every project. These issues range from assuring that the economic environment will reinforce a project, to designing appropriate evaluation criteria. Understanding why some practices must be avoided and outlining new practices that should not be overlooked are a major part of these guidelines. 7.3 Three general problems, namely: transaction costs, risks, and quality of services, must be kept in mind when developing any microfinance project for rural areas. The transaction costs that are typically imposed on financial market participants and the associated risks of lending and making deposits are the primary explanations for the scarcity of formal and semi-formal finance in rural areas. Every micro-finance project must reduce these costs and risks if it is to have a high probability of success. Neither lender nor borrower will eagerly participate in a microfinance program if the transaction costs of doing so are onerous. Moreover, lenders must be confident that they will recover most of their loans, and depositors must feel that their deposits are safe.16 Equally important, clients will 14 See Appendix 7 for contact information about new publications on micro-finance. 15 At the time this paper was written, the state-of-the-art in this regard was the Microfinance Handbook complied by Joanna Ledgewood. The Microbanking Bulletin published by CALMEADOW is also another excellent source of information on microfinance. Periodic publications issued by the Consultative Group to Assist the Poorest (CGAP) are other useful sources of new information about microfinance. 16 The risks of microlending are exacerbated by the paucity of bankable collateral among poor people, an important point discussed by de Soto. 19
  20. 20. not sustain their participation in microfinance programs if the quality of the financial products and services are unsatisfactory. Necessary Preconditions 7.4 In substantial part, the success or failure of microfinance projects depends on the environment in which they operate; hostile environments can damage even the most carefully designed project.17 Conducive environments include law and order, price stability, laws that allow flexible interest rate policies, and the absence of competing lenders that are poorly managed; loan repayment discipline is more difficult to cultivate among borrowers who have been conditioned to expect that loans need not be repaid. 7.5 Deposit mobilization and successful lending are also more difficult in areas that lack attractive investment opportunities. This may be because of natural causes such as persistent drought or government policies. Distorted exchange rates and other trade policies, for example, often effectively tax the agricultural sector and thereby diminish both rural incomes and rates of return on rural investments. Price controls on food commodities have the same effect. Where these types of price distortions are severe, it is probably best to look elsewhere for project possibilities. 7.6 In some African countries, such as Ghana, Egypt, and Lesotho, remittances flowing into rural areas are substantial. Where these remittances occur, there may be more opportunities for deposit mobilization than where these flows are absent. 7.7 The success of a microfinance project may also depend on the presence of other social infrastructure. Dependable electricity, a good and functional telephone network into the rural areas, roads, and court systems all contribute to lessening the costs and risks inherent in microfinance. It is also cheaper to make small loans and mobilize small deposits in areas where populations are relatively dense and where levels of education are relatively high. These factors help explain why microfinance programs have been concentrated in urban centers. Crowding Out 7.8 A form of Gresham’s Law operates in rural finance. The Law states that bad money replaces good money; people attempt to pass on to others units of money they distrust or dislike and hold types of money they think are more desirable. In rural finance, a variant of Gresham’s Law operates when inefficient finance replaces or crowds out efficient finance. 7.9 Crowding out occurs when a lender provides subsidized financial services that undermine or eliminate competition. Examples of this are the activities of highly subsidized traditional agricultural development banks in many countries. These 17 See Lockwood, Chapter 1 for an expanded discussion of these issues. 20
  21. 21. banks often subsist on hefty subsidies, part of which they pass along to their clients in the form of low interest rates on loans and in the guise of loan defaults. 18 Non-subsidized lenders find it difficult to operate in such environments for two reasons. First, they cannot compete with the subsidized interest rates offered by development banks, and second, they typically encounter difficulties with loan repayment in the same areas where many borrowers from development banks seem to avoid repayment and get away with it. 7.10 Similar crowding out occurs when one or several NGOs provide subsidized loans in rural areas and thereby unfairly compete with other lenders who operate without subsidies. Crowding out also diminishes the amount of informal finance in rural areas. 7.11 Where crowding out is severe, it will be difficult for the ADB to develop microfinance projects that will have high probabilities of success. In these cases the lender(s) that is (are) causing the crowding out must either be liquidated or substantially reformed to eliminate and/or minimize unfair competition. Experience in several Latin American countries (in Peru and Bolivia, for example) suggests that the financial vacuum created by liquidating Agricultural Development Banks is gradually filled with time. Some of the filling is done by an expansion of informal finance and some is done by formation of new financial institutions. Still more filling is done by an expansion of existing financial institutions into rural areas. Sector Studies 7.12 Ideally, project design should be preceded by a study of the financial sector.19 The study should clarify the extent to which there is a market for the proposed project and also conduct a diagnosis to explain why more formal and semi-formal finance does not penetrate the rural area, thereby laying the groundwork for an ADB project that will overcome these problems. The study should include an overall assessment of the economic environment for microfinance in rural areas and an analysis of the laws and regulations that might impede the expansion of formal or semi-formal finance into the countryside. It should also document the status of formal and semi-formal finance in rural areas, along with any major in- flows of remittances. The status of usury laws, the coverage of prudential regulation and supervision, and requirements of licenses or permission to lend or to mobilize deposits should also be covered by the study. 7.13 In some cases it may also be useful to provide histories of any postal savings or credit union activities in the country, along with an inventory of non-governmental organizations that provides financial services in rural areas. Likewise, an inventory and assessment of NGOs that provide financial services largely in urban areas might identify organizations that are using interesting innovations or which have potential to expand into rural areas. The study might also answer questions such as the following: 18 Bank employees also often capture some of the subsidies in the form of bribes or redundant employment. 19 Two examples of useful financial sector studies in Africa are World Bank, 1995 (Nigeria) and Fitchett (Ghana). 21
  22. 22.  Are there financial organizations operating badly in the rural area that might be crowding out more efficient forms of finance?  Could their activities adversely affect an ADB program? 7.14 The study should also collect information about common forms of informal finance in rural areas. This information can be useful in two ways for designers of ADB projects. It can show the extent of the competition that a project might face and also identify the types of microfinance that are most popular in the countryside.20 7.15 Finally, the study should conclude with recommendations that are useful in designing ADB projects and in selecting financial organization participants. 21 Will it be necessary to create new institutions to implement an ADB project? Are there existing institutions that might be reformed or assisted that could carry out ADB sponsored programs? What are the policy or legal changes that will be necessary to enhance the chances of success in an ADB project? Transaction Costs 7.16 Micro-finance is often costly for both clients and intermediaries. Limiting or reducing these costs must be a primary concern for those who design and manage microfinance projects. Lenders will not make small loans if their loan transaction costs are excessive. Likewise, individuals will not seek loans if they are forced to navigate numerous administrative hurdles that impose hefty transaction costs on them. Deposits involve the same problem, so savers will not travel long distances or suffer administrative hassles to make small deposits, and intermediaries will avoid taking modest deposits if the costs of managing these accounts are substantial (see Appendix Number 2). 7.17 Project designers may address transaction costs in two ways. The first is through supporting the establishment of management information systems that allow the participating intermediary to process small loans or manage small deposits efficiently. The second way is to be judicious in setting up project-reporting requirements. Requiring the participating agency to collect and report data that is not useful in managing an efficient financial intermediary only elevates transaction costs. For example, information about the purported uses of loans is generally of little use to managers. Instead, project designers should require reports that document the progress made toward achieving sustainability, subsidy independence, and outreach goals. Box Number 5, Use of Smart Cards in Swaziland Even though the banking industry in Swaziland is fairly well developed, the commercial banks generally show little interest in the small businesses and the poorer segments of the market because of the usual 20 See Ledgerwood, Chapters 3 and 5 for further discussion of the design of microlending products and services. 21 See Ledgerwood, Chapter 4 for additional discussion of the problems of selecting participating institutions. 22
  23. 23. constraints. The Swazi Business Growth Trust of Swaziland (SBGT) was therefore established in 1992 as a non-profit Swazi-directed NGO to facilitate the development and growth of Swazi small business. The Trust introduced a SmartCard to minimize the transaction costs associated with extending and recovering loans. The SBGT supplied participating commercial banks with the equipment that facilitated the use of the SmartCard at participating banks, which allowed SBGT clients to draw funds and make loan repayments and/or deposits. A SmartCard transaction takes only a fraction of both the time and cost of a regular teller transaction; and helps both outreach (in terms of the numbers reached) and easy access by clients to funds and loan repayments. Source: Abstracted from Fitchett. 7.18 Managers of participating agencies should also be encouraged to make their financial services and products more attractive by reducing the transaction costs their procedures impose on clients. Many clients involved in small financial transactions are more concerned about these costs than they are about the interest paid on loans or received on deposits. Simplifying paperwork, opening branches near clients, and requiring fewer visits to negotiate loans are some of the ways of reducing these costs. Interest Rate Policies 7.19 The interest rates paid on deposits and those charged on loans are vital elements in microfinance programs. The former rate must be high enough to compete with other sources of deposit services. The interest rates charged on loans must be sufficient to eventually cover the costs and risks of making microloans. Temporary subsidies may be used to bridge the initial gap between the costs of providing small loans and what borrowers are charged. Plans should be made to close this gap though scale economies and other efficiencies so that the interest payments on loans cover the full costs and risks of making microloans in the foreseeable future. 7.20 Two general criteria should be used in setting interest rate policies for microlending programs. First, interest rates should not be used to subsidize borrowers. Second, interest charges should be enough to allow the lender to become subsidy independent, to protect the real value of its loan portfolio, and to become sustainable when the organization reaches a projected scale of operations. 7.21 No single market rate of interest can be used in microlending programs (see Appendix Number 3). Instead, project designers and managers must calculate unique rates for each program. Four major elements should be included in these calculations, namely:  projected administrative expenses,  projected loan losses,  the cost of funds, and 23
  24. 24.  the desired capitalization rate. Where inflation is expected to be important, the cost-of-funds element must be adjusted upward to protect the purchasing power of the lender’s loan portfolio. (For a practical guide on how to calculate these interest rates see CGAP Occasional Paper No. 1, 1996.) 7.22 If a project involves an institution that is new, has a small volume of lending, or which is expected to expand its scale of operations substantially with project assistance, interest rates likely will not cover all costs for several years. A subsidy for the organization may be justified until the lender achieves its projected scale of operations.22 That scale and the estimated time needed to achieve this goal should be part of the project design. Project reports should include indicators that measure the progress being made by the lender to become subsidy free. Short-term Subsidies 7.23 It may be necessary for project designers to include some short-term subsidies to support institutional development or expansion. The institution handling the project, for example, may need new offices or branches in rural areas to achieve outreach. Most participating institutions will also require investments in data processing equipment and training. Some of these investments might initially be subsidized through a carefully designed grants program (for example, see Westley and Branch, pp. 115-128). 7.24 The guiding principle of the grants program should be to reward performance. This might include allocating grants when management plans are complete, when loan recovery targets have been met, or when deposit mobilization goals have been achieved. The expectations of the managers of the program should be that subsidies will end in a relatively short period and that the institution must plan for subsidy independence. Loan Guarantee Schemes 7.25 As mentioned earlier, microlending is constrained by the costs of making small loans as well as by the associated risks. Small loans often involve substantial risks because borrowers do not have bankable collateral and because the borrowers are not well known by the lender (information asymmetry problem). Subsidized loan guarantee schemes have been used widely to address these problems. Typically, these schemes involve the lender transferring all or part of the loan recovery risk to a third party who manages the loan guarantee program. The primary objective of these schemes is to induce lenders to make more loans to a target group than they would otherwise. 7.26 These guarantee programs have four major problems. First, they increase transaction costs by introducing a third party into the lending process. Second, all 22 CGAP estimates that most economies of scale in microlending are achieved with 5,000 to 10,000 clients. 24
  25. 25. of these programs must be subsidized to start and persist. Third, no convincing evidence exists that these schemes result in much additional lending for targeted purposes (see Appendix Number 4). Fourth, the availability of the loan guarantee scheme may lessen the incentive that lenders have to pursue loan defaulters aggressively. Until more conclusive evidence is available on the costs and benefits of these programs, it is probably best for ADB to avoid putting resources into these schemes. Deposit Mobilization 7.27 Deposit mobilization is important for three reasons. First, and foremost, under normal circumstances, a much larger number of poor people will avail themselves of deposit services than will use loans. Second, as mentioned earlier, a financial system must mobilize deposits if it is to assist in reallocating resources more efficiently. Third, deposit mobilization can force more discipline on financial intermediaries than occurs in organizations that largely depend on funding by donors or governments. Organizations that perform poorly generally experience more difficulty attracting deposits than do those that perform well. Also, depositors can discipline financial institutions by withdrawing funds from deposit takers that perform poorly, thereby depriving the organization of funds. Box Number 6, Deposit mobilization in Peru Economic turmoil and hyperinflation in Peru during the late 1980s and early 1990s severely stressed all banks in the country and made it difficult for them to mobilize deposits. Major economic and financial market reforms during the 1990s, however, gradually provided a more hospitable environment for deposit mobilization. During the later part of the 1990s several of the 13 Municipal Banks (Cajas Municipales de Ahorro y Credito) in Peru were highly successful in mobilizing small deposits. One of these banks, in Arequipa, was outstanding in these efforts. It was formed in 1985 and initially relied mostly on outside funding for money to lend. The bank experimented with various ways to attract more deposits, including doing lotteries that were tied to deposit accounts. Later, the bank placed more emphasis on providing attractive interest rates on deposits, making it easier for depositors to withdraw funds, and offering insurance that was tied to the deposit account. This included life insurance, burial insurance, and modest health insurance. These attractive deposit accounts allowed the bank to more than double its number of deposit clients between 1996 and 1999. This resulted in the real value of deposits in the bank going up by about 150 percent in just three years and allowed the bank to reduce sharply its reliance on outside funds and to increase lending substantially. Source: Swisscontract 7.28 Any deposit mobilization project that the Bank sponsors should emphasize several basic principles.23 Most savers are concerned primarily about the security and liquidity of their deposits. They are also concerned about the transaction costs involved in making deposits and in withdrawing funds. A postal savings system, for example, that forces savers to wait several weeks after request for withdrawal 23 See Ledgerwood, Chapter 6 for further discussion of the design of microdeposit products. 25
  26. 26. to receive funds will be shunned by depositors. Likewise, waiting in long queues to make small deposits or to withdraw small amounts discourages depositors. 7.29 Micro-savers are more sensitive to quality of service than they are to returns on deposits. Nonetheless, they will not deposit significant amounts if the returns are negative in real terms. The rates of interest paid on deposits must be higher than the expected rate of inflation. 7.30 Providing attractive deposit services is not easy. Accepting deposits increases the workload in financial institutions. Typically, there are a larger number of transactions associated with deposit accounts than there are with loan accounts. Combined with the substantial increase in number of deposit clients, this adds to the data processing problems in deposit takers. Deposits must be posted quickly and clients must be able to make immediate withdrawals from most of their deposit accounts. These two requirements force the intermediary to have cash on hand, which, in turn, leads to security problems. 7.31 Deposits also increase other problems for managers. Typically, there are seasonal ebbs and flows in rural deposits that force managers of intermediaries to deal with transferring excess liquidity in some periods and drawing on outside liquidity in other periods. Matching term structures between loans and deposits is a further problem faced by these managers. 7.32 Three general approaches might be used to mobilize deposits. The first is to focus on reforming or expanding financial organizations that are already licensed to accept deposits. This might include encouraging banks to open new branches in rural areas or reforming postal savings systems. The second approach is to add deposit taking in organizations that have experience in making rural loans. The third approach is to promote new organizations that have the capability of doing both lending and deposit taking, such as credit unions (see Westley and Branch; de Stemper). 7.33 In some cases, banks are discouraged or prohibited from opening rural branches by regulation or by hefty legal reserve requirements. These constraints might be addressed through an ADB project. In other cases, reforming banks that have substantial numbers of rural branches may be another way of boosting deposit mobilization in rural areas.24 7.34 A number of countries in Africa have postal savings systems that once provided useful deposit services in rural areas. An advantage of these systems is that they have post offices and a mail delivery system that allows deposits to be mobilized at little additional cost. Their main disadvantage has been the inability to provide depositors with the liquidity they often desire. Perhaps helping to reform some of these systems to make them more attractive sources of deposit services is an area the Bank could look into. (See Box 7.) Box Number 7, Savings Bank of Madagascar (SBM) 24 The reform of the Units portion of the Bank Bakyat Indonesia is an example of this approach. 26
  27. 27. The Postal Administration in Madagascar accepted deposits from 1918 to 1985; and it was then reformed into the Savings Bank of Madagascar (Caisse d’epargne Madagascar) in 1985 with 46 postal offices. Financial supervision was by the Ministry of Finance, while the Ministry of Post and Telecommunication exercised technical supervision. By June 1996, SBM was operating out of 174 windows located in both cities and small towns. SBM provides its clients with savings services only, and based on the time of deposits, interest is paid on these savings (accrued interest is calculated annually on the account balance for each depositor). The bank focuses on poor clients, and its savings balance per client in1996 averaged US$32, representing about 28 percent of GDP per capita. By June 1996, the total number of clients was more than 370 thousand, of which almost half were women. Source: Abstracted from Fitchett. 7.35 As discussed in the next section on prudential regulation, promotion of deposit taking in non-traditional financial institutions is problematic. In most countries, only institutions that are licensed to do so can legally accept deposits. Helping non- traditional institutions to become licensed may require waiting until they are creditworthy themselves, and this is usually a long-term goal. Nonetheless, where feasible, the Bank could help regulatory agencies establish procedures for institutions to qualify for deposit-taking licenses and also assist them to become creditworthy.25 7.36 The credit union model offers a third approach. Some countries in Africa once had credit unions or credit co-operatives that had a significant presence in rural areas. At least in Kenya, floundering credit co-operatives have been successfully reformed (Westley and Branch, pp. 129-134). The growth of healthy credit unions recently in Benin and Togo is also an indication that credit unions have promise in Africa (de Stemper; Tounessi). These small co-operatives have several advantages in deposit taking. Members contribute most of the initial share capital and this lessens concerns about prudential regulation and supervision. Members are also expected to monitor the operations of the co-operative to assure that their share capital and voluntary deposits are managed prudently. The Bank could, therefore, consider promoting the reform and development of credit unions in rural areas. Prudential Regulation 7.37 In most cases, allowing financial institutions to mobilize deposits when these organizations are not prudentially regulated and supervised is an unwise policy. It is one thing to dispense loans with some altruistic motives, but it is quite a different thing to allow an organization to solicit poor peoples’ savings and then tolerate careless management of these funds. Any Bank-assisted rural finance project that includes deposit mobilization, therefore, should assess the capability of the regulatory system and, if necessary, strengthen its capacity. This may 25 Regulatory agencies in Bolivia and Peru, with assistance from the Inter-American Development Bank, have developed new regulations that allow qualified non-traditional institutions to qualify more easily as deposit takers. 27
  28. 28. involve doing co-projects with other donors who are working on the supervision and regulation system.26 7.38 The regulatory problem might be divided into two segments (CGAP, 2000). The first segment involves a central monetary authority granting permission for an organization to accept deposits. The second segment involves prudentially regulating and supervising the organization after it begins to mobilize deposits from the public. 7.39 In most countries, there are minimum thresholds that financial organizations must meet before they are licensed to accept public deposits. This includes minimum capital requirements, maintaining elaborate loan files, and being subject to independent external audits. Typically, only banks and other relatively large financial institutions can meet these requirements. In some countries authorities are allowing a few non-traditional financial institutions to mobilize deposits after they have been licensed as banks or after they meet requirements specially tailored for microfinance institutions. Understandably, banks and bank regulators are seldom eager to adjust requirements downward for licenses to mobilize deposits. Banks resist encouraging competition, and overworked regulators are not eager to add to their workload. 7.40 There are two primary justifications for prudential regulation and supervision, namely, first, to protect depositors, and second, to defend the overall financial system. In large measure, finance operates on trust. If any significant bank fails, it can threaten the survival of the entire banking and financial system. Bank regulators, as a result, must concentrate their attention on the largest elements of the financial market. In most low-income countries, bank regulators who are fully occupied in dealing with stressed banks have little capacity or desire to regulate small organizations that might mobilize deposits in rural areas. 7.41 The capacity to regulate is not the only limitation. In many countries the existing regulatory system is tailored to deal with banks and is not well suited to supervising organizations that are on the fringe of the formal financial system (Von Pischke). Procedures used to regulate banks are often too costly and cumbersome to extend to non-traditional deposit mobilizers. Innovations may be needed to extend some measure of regulation to cover non-traditional deposit takers. These might include giving an organization permission to accept deposits from the public but also requiring a large amount of transparency in the operation of the organizations in the form of understandable statements on interest payments, regularly published audited financial statements, and published information about insider borrowing. Another option is to license an organization to accept payments for redeposit in a financial institution that is prudentially regulated (see CGAP, 2000). 7.42 In some countries it may be possible to use an ADB project to encourage those elements of the financial system that are already prudentially regulated to expand into rural areas. Branching regulations, for example, may discourage banks from 26 It is difficult to enhance the capacity of agencies that do prudential regulation and supervision because trained people often find more attractive employment elsewhere, including in banks that are being reformed by the regulatory agency. 28
  29. 29. opening rural offices where the primary objective is to mobilize deposits. Likewise, hefty legal reserve requirements may discourage banks from seeking new depositors in rural areas. Similar attention might be given to reforming or strengthening postal savings systems or credit unions in rural areas. 7.43 Finally, in remote areas where it is impractical to extend prudential regulation, it may be necessary for regulators to ignore non-traditional organizations that accept deposits. Although risky, depositors may prefer to hold their savings in these types of organizations compared to other alternatives available to them. Evaluation 7.44 Rural finance projects established under the new paradigm require justifications and evaluations that are quite different from projects designed under directed credit programs. Directed credit projects were justified by what they did to borrowers. Accordingly, evaluations of these projects focused on measuring what borrowers did after receiving loans. 7.45 Under the new paradigm, the attention shifts from what borrowers are doing with their loans to how well the financial intermediaries, that provide financial products and services to people of modest means, are performing. The underlying rationale is that as long as the rural financial intermediaries are operating efficiently, there is a greater likelihood that the rural financial services they provide can be sustained over the long term. 7.46 In the old paradigm, there was a pre-occupation (too much emphasis) with access to cheap credit to the relative neglect of the sustainability of the services provided through the agricultural development banks. Thus, massive amounts of money were channeled through these banks for on-lending to the poor at fairly low interest rates, without addressing the question of how long such cheap credits could be sustained. The shift in focus is, therefore, necessary to ensure a “sustainable access”, of the rural dwellers, to credit and other financial services. Proponents of the new paradigm also argue that borrowers indirectly indicate the usefulness of improved financial services by repaying their loans, requesting for new loans, and by augmenting their deposit savings. 7.47 Two major advantages of the new type of evaluations are obvious. First, information used in the new evaluations is the exact information that has to be collected by any well-managed financial institution as a normal part of their business.27 Thus, the new evaluation method, unlike the old method, does not impose additional costs on the financial intermediaries. In short, the type of secondary information gathered is much less costly for evaluators to assemble than the primary data needed to evaluate borrower activities. The second advantage is that encouraging the participating organization to provide this type of information reinforces good management practices. As was mentioned earlier, under the directed credit paradigm, lenders were required to collect information 27 See Ledgerwood, Chapter 8 for guidelines on how to establish proper financial statements for microfinance projects. 29