FACULTY
OF AGRICULTURAL
AND APPLIED
BIOLOGICAL SCIENCES
______________________________________
Academic year
1996 – 1997
LINKING
RURAL FORMAL AND INFORMAL FINANCE
Heleen KONING
Promoter: Prof. Dr. ir. P. VAN DAMME
Thesis submitted
in partial fulfillment of the requirements for the degree
SPECIALISATION
STUDY IN AGRICULTURAL DEVELOPMENT
INTRODUCTION
Financial
liberalisation and other reforms in
In
the vast majority of developing countries inflation is accelerating, which is
usually one of the results of a growing burden of foreign debt (Gonzalez-Vega,
1989). Foreign assistance can not last forever and many international lenders
are becoming unwilling to lend.
Furthermore, formal institutions fail to effectively mobilise domestic
resources, even though it is nowadays recognised that even the poorest are able
to save and do indeed save (Adera, 1995).
And lastly, the great majority of financial programmes in developing
countries have failed, or have suffered from great deficiencies and continue to
do so. Financial growth in these
countries has a prominent urban bias, which is clearly reflected by the
clustering of formal financial institutions in these areas (Gonzalez-Vega,
1989). Therefore, many authors express
their concern with the role of rural finance in developing countries.
In
short, developing countries are characterised by financial dualism. There is a co-existence of formal and
informal finance that appear to operate side by side. Formal finance is transplanted from abroad
and subjected to government regulation.
Hence, it becomes an institutional and organised system,
urban-orientated, catering for the financial needs of the monetised, modern
sector. On the other hand, the informal
system is in general unorganised and non-institutional and deals with the
traditional, rural, subsistence spheres of the economy. A substantial part of informal financial
arrangements root in the traditions and culture of local communities.
However,
no clear-cut line, that divides the formal and informal sector, exists. In fact, there are many indications of
substantial amounts of funds that flow between them in both directions. It enables formal finance to take advantage
of informal finance’s lower transaction costs and thereby reaches more small
and rural clients. Informal finance can
usually expand their activities if they have access to the stronger resource
base of formal finance and it can safely deposit informally mobilised resources
at these institutions (Germidis, 1990).
Financial
dualism has important policy implications.
According to Ghate (1990), the existence of a large informal sector has
implications for the efficacy of monetary and credit policies in achieving
stabilisation and liberalisation objectives.
Despite the fact that informal finance has a strong dynamism of its own,
the structure and functioning of the formal sector play a remarkable role in
determining the nature and extent of the informal sector. Policies can strengthen formal finance’s
competitive ability towards informal finance, stimulating the latter to improve
its terms; or otherwise promote linkages with all the benefits of such
(Germidis, 1990).
It
has increasingly been recognised that these links are valuable and should be
stimulated. Both sectors can benefit
from each other’s strengths if they are linked.
It could have a far-reaching impact on the mobilisation and allocation
of resources in developing countries (Adera, 1995).
The
present study investigates the possibility of linking formal and informal
finance, especially regarding rural areas.
It is divided into six chapters.
Chapter one highlights developmental views on and development
proceedings in rural financial markets (RFMs) of Third World countries since
after the Second World War up to the 1990s.
Chapter
two focuses on small farmers as a target group for informal finance. It reveals something about their living world
and constraints, especially regarding their relation to risk and finance. The saving potential of these people and
their demand for consumption credit are of special importance.
In
chapter three, the attention shifts to several decisive aspects that concern
RFMs and their efficiency. Here,
information asymmetry, fungibility, transaction costs regarding rural areas,
and fragmentation and dualism need to be accentuated. We try to find an answer to the question what
a successful RFM look like.
In
the fourth chapter formal finance is discussed, with special attention for the
two major formal financial institutions found in developing countries:
development banks and commercial banks.
Their major shortcomings as well as the strengths of formal finance are
summarised.
Informal
finance is the topic of chapter five.
Several informal arrangements are presented, whereafter the general
strengths, but also the limitations of informal finance are listed. The second part of this chapter deals with
semi-formal financial institutions.
Co-operatives and NGOs receive a closer look.
Chapter
six contains the main emphasises of this study.
Is formal and informal finance complementary or competitive? Different suggestions, experiences and
strategies, which are associated with a linked system, are discussed. They are sorted under themes like:
strengthening existing linkages; tying loans with deposits; using groups to
provide financial services; using informal as well as semi-formal financial
institutions as intermediaries; and loan guarantees. The chapter ends with several considerations
regarding the different parties involved in such an approach.
CHAPTER 1 HISTORICAL REVIEW
1.1 After the Second World War Until the 1960s
Immediately
after the Second World War, the ability of people in least developed countries
(LDCs) to accumulate savings was considered to be extremely limited. Especially small farmers and rural people in
general were seen as subjected to a lack of employment opportunities and unable
to generate surpluses to locate to market-orientated investments and other
productive activities. In short, they
were generally seen as too poor to engage in meaningful production, and any
form of capital accumulation seemed to be out of their reach (Coetzee, 1992).
However,
western history proved that investment is a major prerequisite for growth, and
investment requires capital availability.
Thus, large-scale transfer of capital to developing countries seemed to
be the only solution that could be used by international development aid. These
took the form of grants, which were targeted to large-scale industry, and
import of agricultural technologies and infrastructure that seemed to be the
most urgent or promising investments. Both capital and technologies mainly came
from the industrialised countries. Small
farm and complementary off-farm activities were rarely promoted or supported. It was expected that small farmers would see
medium- and large-scale modern agricultural enterprises as an example and that
they would then adopt the new techniques they use (Schmidt & Kropp,
1987).
The
essence of this policy was that its benefits would reach the whole population
through the so-called “trickle down” effect (Schmidt & Zeitinger,
1995). During the 1950 and 1960s,
development economics were also strongly influenced by Lewis’ two sector model,
first published in 1954. In this model
the subsistence sector (mainly agriculture) is seen as an ”unlimited” source of
labour for the 'capitalist' enterprises.
Moreover, during the same period Clark (1940) and Kuznets (1966)
formulated their view on the declining role of agriculture in economies over
time with development (Staatz & Eicher, 1990).
In
the 1960s, financial markets in general were essentially seen as tools to tap
funds for government use by bureaucrats, or to use to direct credit to a few
selected sectors. Industry was
considered as the sector with the highest priority (Coetzee, 1992). Loans with low interest rates and long
maturities (i.e. periods due for repayment) granted by developed to recipient
countries were supposed to create incentives for both public-and private-sector
entities to initiate investments (Schmidt & Zeitinger, 1995).
1.2 The End of the 1960s and the 1970s
By
the end of the 1960s, it was clearly realised that the hoped-for process of
industrialisation and the subsequent “trickle down” effect had failed. Instead, industrialisation even aggravated
the existing social and economic inequalities and led to widespread poverty,
rather than socially balanced growth (Staatz & Eicher, 1990). In fact, it became clear that
industrialisation policies of many countries had in effect been used to finance
urban development. Urban areas were
favoured through government policies directed to economic development, which
were usually very short-sighted. They
included the setting of price ceilings for food products below free market
prices and overvaluation of national currency, which favour (industrial)
imports and hinder (agricultural) exports of primary products. There was also the installation of marketing
boards and similar compulsory government-steered schemes for export crops by
which the gains from exports were mainly channelled to governments, rather than
the producers. On top of it all, these
economies were soon paralysed by inflation (Schmidt & Kropp, 1987).
These
policies and processes had numerous negative side-effects. For example, there was a great migration from
rural to urban areas (Schmidt & Kropp, 1987). The income gap between rich and poor was
frequently seen to widen (Staatz & Eicher, 1990). At the same time financial institutions that
had been created to channel external funds to target groups, e.g. small
farmers, regularly collapsed under the weight of their accumulated loan losses
(Schmidt & Zeitinger, 1995) (for more details, see Appendix III).
A
lot of theories and arguments were developed to try to explain what precisely
went wrong. The notion of “trickle down” was a major point of critique. At the beginning of the 1970s, the
expectation that the principle of “trickle down” will occur was, so to speak,
officially abandoned. It became apparent
that if agriculture were to play a more important role in development
programmes, policy makers would need a more detailed understanding of rural
economies than that of the simple two-sector models of the 1950s and early
1960s. The late 1960s and early 1970s were
thus characterised by an expansion of research on micro-level phenomenon. Through this, the complexity of many
To
mitigate the effect of urban migration, a re-channelling of capital into rural
areas occurred (Schmidt & Kropp, 1987).
Development policies were now directly geared to poverty alleviation and
“the poor” became a target group as direct recipients of the necessary support,
int. al. as loans on favourable
terms. Socially committed institutions,
e.g. NGOs (non-governmental organisations) which were close to low-income
target groups, became the alternative for existing commercial and development
banks, which mainly focussed on loans for large enterprises. Still, these new institutions were seen as
distributors of credit, but nobody seemed to be concerned with the capability
of these institutions to survive. The
criterion used to determine their success was rather their ability to reach
target groups among poor populations and to involve them in credit programmes
(Schmidt & Zeitinger, 1995).
It
was also during this period that women’s access to credit drew remarkable
attention. Development agencies started
to focus on demonstrating the legitimacy of women’s economic activities and of
microenterprise as a productive area (Women’s World Bank, 1994).
Still,
a central policy theme remained up to this stage: the notion that a massive
infusion of external capital was needed to overcome
·
farmers are too poor to save
and thus investment is out of their reach;
·
cheap and subsidised credit
is the only key to innovation and development in agriculture;
·
informal lenders are
exploitative, while formal financial services do not exist or else their credit
provision is insufficient;
·
thus, rural regions have an
acute capital shortage;
·
the presence of a credit
supply will stimulate overall demand for products and services and induce
investment. State intervention is the
appropriate means to do this.
Agricultural
loans granted in these times - be it for large enterprises, or be it for small
subsistence enterprises - were only to be used for productive purposes in the
strict sense of agricultural production stimulation. Representatives of those who granted these
loans supervised if loans were appropriate used. It often went hand in hand with
agro-technical assistance, the provision of other inputs like fertiliser and
seed, as well as marketing assistance.
National governments and foreign donors defined detailed specifications
on the characteristics that the target group should have, regardless of their
creditworthiness. They also specified
the conditions for extending credit.
There was, however, little concern about important financial market
factors, e.g. transaction costs and the risk incurred by financial
intermediaries. In addition, they
defined the productive inputs that could be financed, regardless of their
actual availability and efficiency in the local setting. These loans were targeted at whole
agricultural sectors or areas, e.g. as programmes for a specific crop. In most cases, a routine credit appraisal of
clients was not part of the packet.
Thus, financial institutions were limited to the granting of credit,
exclusively for agricultural activities.
There was no question about the provision of comprehensive banking
services in response to potential clients’ demand. Also, other rural businesses that did not
form part of the target group were often excluded from financial assistance
(Schmidt & Kropp, 1987).
The outcome of these development strategies, also called the
traditional approach, was disappointing.
Total agricultural output increased only marginally and in some cases
the income of rural poor even decreased.
Many agricultural development banks became technical insolvent or
otherwise dependent on a continuous flow of assistance money from their
governments and/or foreign donors (Schmidt & Kropp, 1987).
To summarise, this uni-directional stream of investments failed, or at
least, proved not to be the right approach to enhance development. The greatest
misunderstanding was rooted in the idea that intervention and huge subsidies in
financial markets could overcome restrictive regulations in agricultural
product markets. Broadly spoken,
planners’ perception of the actual situation was based on false assumptions
regarding the economic conditions in rural,
1.3 The 1980s
During
the 1980s, many economists realised that, in their quest for a better
micro-level understanding of the rural economy, sight had been lost on how
agriculture relates to the broader macro-economic context. A renewed concern about how agriculture
contributes to overall economic growth flared up. A swing from micro-economics to macro-economics
occurred. There was increased emphasis
on markets, institutions and sustainability.
Macroeconomic adjustment and Structural Adjustment Programmes (SAPs),
became famous concepts. The focus
shifted to economic growth, policy reform and market liberalisation (Staatz
& Eicher, 1990).
Many
governments initiated major restructuring and reforms of their financial
systems as part of SAPs (Aryeetey et al.,
1997). These programmes and policies
were essentially intended to improve the development incentive structure, trade
regime, allocation of resources, and efficiency in the use of resources to
stimulate growth. It emphasised the need
to adopt financial liberalisation measures, and to enhance regulatory and
supervisory functions to ensure prudence of financial institutions (Bagachwa,
1995). Financial liberalisation measures
included the removal of restrictions on interest rates, the elimination of
credit ceilings, opening up the banking system to more competition (Aryeetey et al., 1994), while decentralisation by
existing credit institutions was propagandised (Spio, 1994).
As
a result, several development-oriented financial institutions, which had an
unsatisfactory performance, were closed.
This created a vacuum in which NGOs established themselves as financial
intermediaries with considerable funding from major development agencies. At the end of the 1980s, it was clear that
these organisations started to play an important role in development finance
(Schmidt & Zeitinger, 1995).
According
to Aryeetey et al. (1997), financial
reform through SAPs had limited developmental effects. The limitation to liberalisation policies has
been insufficient to stimulate a strong response in terms of wider access to,
and use of financial services, and failed to enhance savings' mobilisation, financial
intermediation, and increased investment by the private sector. Financial fragmentation, which impedes
efficient resource mobilisation and financial intermediation, showed limited
improvement.
Boehmer
(1995) also reports that while financial liberalisation measures positively
affected incentives to lend, other measures taken to stabilise the economy and
strengthen the banking system had a short-run negative impact on credit
availability to small enterprises. Tight monetary policies resulted in higher
interest rates on government paper than on loans to long-standing commercial
clients, leading in turn to non-competitive higher rates to new, smaller
borrowers. Efforts to improve portfolio performance led banks to centralise
decision-making and maintain their insistence on rigid collateral requirements,
a stumbling block for many small entrepreneurs (Aryeetey et al., 1994).
At
the same time, most microenterprise development practitioners realised from
experience that the poor, especially women, do indeed save and often repay
their loans on schedule. Nevertheless,
most traditional development banks were not interested to provide financial
services to these groups. The lack of interest of most banks in developing
smaller enterprises as clients, particularly in the face of high yields available
to banks, shows that liberalisation of financial policies by itself is not
sufficient to improve access of small firms to formal finance (Aryeetey et al., 1994). The need of a greater
incorporation of institutional and cultural variables into analyses of the
development process was also realised (Staatz & Eicher, 1990).
1.4 The 1990s
According
to Staatz & Eicher (1990)’s “Lessons and Insights for the 1990s”, the
success of macro-economic and agricultural policies depends, among others, on a
political environment conducive to mobilise the energy and capability of the majority
of rural people. They stress that one of
the clearest lessons of the past four decades is that agricultural and rural
development requires strong local institutions and well-trained
individuals.
Despite of all the SAPs, that have been initiated in LDCs, there is
still room for substantial improvement in macroeconomic policies in developing
countries. However, improving
macroeconomic policies is only part of the larger development effort of
building institutions, creating infrastructure, and putting in place the social
policies needed for broad-based growth and poverty alleviation (FAO, 1994).
The
new approach concentrates on deposits, the viability of financial institutions
and the sustainability of rural financial markets. It is believed that this approach is more
balanced and that it acknowledges the existence of informal financial markets
(Coetzee, 1995).
A
closer look to current policies of leading financial development organisations
(ABOS, 1995; Bilance, 1995; and NOVIB, 1995) confirms these findings. Building permanent financial institutions,
and not temporary micro-lending projects, is a central point of departure. The new emphasises has spawned a debate on
the definitions of subsidy, self-sufficiency, financial viability and financial
sustainability.
The
viability of financial institutions and their services are closely related to
the extent to which they respond to clients’ needs and the efficiency of their
operations (Women’s World Bank, 1994).
Coetzee (1995) also points out that successful credit delivery and
satisfying repayment rates depend on several sound financial principles such as
understanding the needs of clients, increasing efficiency by cutting administration
costs and to adapt the structure of services to local circumstances.
Nevertheless,
credit has been over-emphasised in the past.
It must be seen as a developmental strategy, which has its limits. If credit is excessively stressed, all
practices and operational procedures tend to be designed to promote the
interest of the borrower, while the interest of the lender and of the
institution are being neglected. Savings
mobilisation has to play a central role in financial institution development
(Spio, 1994).
Nowadays,
the role of financial subsidies is rather seen as an element to get programmes
started, or to improve the structure of existing programmes, rather than to
provide cheap loans to individuals (Women’s World Bank, 1994).
Aryeetey
et al. (1997) report that, unlike the
1980s, the 1990s have been marked by increased support for the informal finance
sector, because their operations perform remarkably well, despite many attempts
in the last few decades to replace it by formal financial services. Many informal financial institutions possess
several of the recent desired characteristics such as sustainability, high
repayment performance, high savings mobilisation, substantial outreach to lower
income segments of the population, etc. (Aryeetey et al., 1997). However,
according to Aryeetey et al. (1997),
reforms so far have not provided incentives for formal institutions to link
more closely with informal/semi-formal agents.
In fact, although the negative consequences of the traditional approach are
clearly evident, it is still followed to a large extent in many countries
(Schmidt & Kropp, 1987).
CHAPTER 2 SERVING THE SMALL-SCALE FARMER
2.1 Introduction
There is a general
understanding that rural areas suffer most from poverty (see Appendix VII.1 and
VII.3). A highly unequal income
distribution, a most undeveloped infrastructure (both social and economic), and
low human development indices accompany this opinion. Only 30 % of
Farmers
all over the world dealing with costs, returns and risks, can be considered as
calculating economic agents. Small
farmers, however, are often described as poor people that operate on
smallholdings. However, just like all other farmers, are entrepreneurs in their
own small domain in which they subtly adapt to economic conditions. Yet, many experts fail to recognise how
rational and efficient they really are (Schultz, 1990), basically because of a
lack of proper data.
Measuring
rural parameters, for example, household incomes, often creates problems. Rural
income is seldom recorded and usually fluctuates from month to month. Rural households usually have multiple income
sources. Apart from diverse farm
activities, they might also earn income through other, non-farm activities
(Koch & Soetjipto, 1993). Temu &
Hill (1994) found during a survey in
Small
farmers are usually illiterate and tradition-bound. These families usually deal with costly
traditional functions, such as funerals, marriages and other religious
ceremonies (Hartman, 1985). From their
context, they are efficient and rational in relation to their environment. This is part of the factor-quality hypothesis where rural stagnation is ascribed to
low-quality production factors (Thomas & Tyobeka, 1995).
Available
resources and the tradition-bound objectives of the farm enterprise prevent the
small farmer from reallocating production factors to improve his current
output. Schultz (1990) argues that the
solution lies in investing in human capital (training) and in improving the
farmers' access to agricultural inputs and technology.
2.2 The Small-farmer and Risk
The
institutional-uncertainty hypothesis,
as defined by Thomas & Tyobeka (1995),
adds another few elements to this analysis by stating that central to
farmers' decisions to try new (more risky) practices are their expectations
concerning the economic environment.
Institutional uncertainty appears in questions and apprehensions like:
will production services be of satisfactory quality and delivered in time? To what extent will I control the functioning
of the delivery system? How will my
farming be affected if changes take place in the political and policy
environment? How much influence will I have
over them? Thus, institutional
uncertainty leads to a climate in which otherwise motivated farmers are not
eager to invest in and/or adopt more productive practices, because of
uncertainty of possible gains (Thomas & Tyobeka, 1995).
In
reaction to this uncertainty, farmers tend to narrow their practices and
investment options to those that have proven to withstand bad
circumstances. By doing this, they try
to minimise the cost of failure (Thomas & Tyobeka, 1995). Therefore, households will take-up low-risk
activities, even if they imply lower returns (Dercon, 1996). Profit maximisation becomes a higher-order
goal, which is only achievable, once lower-order goals have been obtained. In short, the aim is to select safe-enough
outcomes. Subsistence and security are
first priorities (Thomas & Tyobeka, 1995).
.
One
has to keep in mind that the agriculture business in LDC deal with a
considerable variety and extent of risks.
Not only are the natural and weather-related risks usually remarkable
high, but there is often also an underdeveloped infrastructure, such as a lack
of transportation or electricity, which increases risks for rural borrowers
(Schmidt & Kropp, 1987).
Risks
of borrowers are in fact also risks of their lenders. Usually, financial institutions “defend”
themselves against the investment risks of their borrowers through applying the
banking’s “normal” forms of credit securities, e.g. in the form of
collateral. However, rural borrowers
seldom possess such forms of security (Schmidt & Kropp, 1987).
According
to Dercon (1996), the strategies that rural households use to offset adverse
effects of income shortfalls can be divided into two types: (a) risk-management
strategies, and (b) risk-coping strategies.
Risk-management
strategies aim to reduce income risk.
Farmers will thus alter their farming system techniques, e.g. by
building ridges and furrows for water conservation, in order to reduce
production risks. Otherwise, households
diversify their income sources (although not all income diversification
measures are practised together to reduce risk) and skew risk distribution by
concentrating on low-risk income sources.
The effectiveness of such a strategy is related to the covariance
between the different income sources.
For example, if a household diversify its total income between livestock
and crop production activities, total income is still very vulnerable to
drought, although less vulnerable to livestock diseases. If selling of handcrafts is also a source of
income, this household will still have some income in the case of a severe
drought. Risk-management strategies
cannot be viewed independently from the strategies to cope with risks.
Risk-coping
strategies aim to cushion the effects of income risk on consumption, temporary
through savings and across households through mutual support networks as a
risk-sharing mechanism. The way in which
households respond to income risks, depends on the options available to
smoothen their consumption. In semi-arid
It
is clear that it is wealthier households that end up with higher average
returns, which makes further accumulation possible. Thus, risk affects rural growth and increases
rural inequality via a ‘poverty trap’ in which the poorest get caught. Campaigns to promote the cultivation of e.g.
drought-resistant crops in a certain area will on themselves fail to cut
through this trap. There will be a
higher supply on the local market, which will lower the returns to the farmer
and therefore will actually encourage the development of new poverty
traps! An alternative, among others,
could be the creation and promotion of appropriate liquid assets for the poorer
households by encouraging savings in good years which result in relative high
returns and could be easily turned into money (liquidated) (Dercon, 1996). Otherwise, the availability of credit
possibilities may help to overcome this problem (Heidhues, 1992). Such mechanisms may both supply a safety net
for bad years and, in the case of savings, enhance unfolding of a higher asset
base for poorer households (Dercon, 1996).
Hartman
(1985) argues that farmers also avoid taking risks for fear of experiencing
adverse community opinion in case of failure.
It has discouraged many farmers from investing in innovative production
techniques.
2.3 The Small-Farmer and Finance
Farmers
differ in their ability to perceive, interpret and take appropriate action in
response to new information and situations.
Nevertheless, they all represent the essential human resource of
entrepreneurship. Agriculture is in
general a highly decentralised sector of economy (Schultz, 1990).
Allocative
ability is daily display by numerous men and women on small-scale production
units. The importance of the allocation
role and insight of farmers and farm women should not be underestimated. Thus, their economic opportunities matter,
they are no less concerned about improving their lot and that of their children
than rich people are (Schultz, 1990).
According
to Dercon (1996) there are three perspectives that justify the promotion of
sustainable financial services’ systems for poor people.
a) Financial
service development - People that are excluded from formal financial
services due to gender, ethnic identity, low incomes, remoteness or poor
infrastructure often have promising potential as markets for institutions that
can thus reduce the costs and risks of serving them.
b)
c) Poverty
reduction - The poor can smoothen their consumption over periods of
cyclical and unforeseen crises if they have access to stable, monatised savings
facilities, thus enhancing their economic security. Dercon (1996) argues that if economic
security is reached to some extent, access to credit will help them to overcome
their poverty through production improvement of their enterprises, or through
the creation of new income sources.
However,
it is often found that small farmers and other low-income households in LDCs
are reluctant to use formal financial services.
Boehmer (1995) finds that the most prominent factors contributing to the
low level of financial intermediation are:
·
low confidence in the formal
financial system;
·
macroeconomic instability;
and
·
lack of competition among
financial institutions.
For
formal institutional institutions to be accepted by the rural population – as
with all clients -, they must provide services that are appropriate to the
needs of potential borrowers, easily accessible and inexpensive (Schmidt &
Kropp, 1987).
2.3.1 The Small-Farmer and Credit
2.3.1.1 Credit Demand
Credit
demand from small farmers can be divided into three categories: (1) production
credit; (2) consumption credit; and (3) insurance.
2.3.1.1.1. Production Credit
Granting
production credit is based on the believe that productive investments will
enhance the production capacity of the borrower. The typical business and investment loan does
not serve the adjustment of income flows to planned expenditure, but rather the
creation of additional income. It is
believed that increased income will generate the ability to create (1) the
basis for servicing loans plus interest; and (2) additional profit, which will
raise the borrowers’ living standard (Schmidt & Kropp, 1987). Productive investment is indeed the
precondition for sustained credit (Abugre, 1994). This point of view has been the centre theme
of the majority of financial market development literature and research.
Heidhues
(1992) states that the three dominant development objectives are (1) promoting
economic growth; (2) improving distribution; and (3) strengthening
institutions. Yet, when measured by
these three objectives, this approach has failed in many countries. Agricultural production did not expand as
much as was hoped for and credits were not repaid. In addition, not all farmers or potential
clients were reached and institutions providing such credit became increasingly
weak. Some even collapsed under the
burden of credit defaults. It seems as
if there is an inverse relation between (i) the failure of production credit
and the faltering of formal rural finance, and (ii) the income level of a
country. The explanation lies in the
fact that the poorer countries are not able to subsidise loss-making financial
institutions for any extended period.
It
was, therefore, also found that formal rural banks failed, particular in the
poorest of Sub-Saharan countries. It
might also indicate that rural populations have a significant demand for a
wider range of services, namely consumption credit and insurance, especially in
poor countries. By ignoring these
demands and only focusing on production credit, however, financial institutions
will fail to build a broader-based clientele in rural areas (Heidhues,
1992).
2.3.1.1.2. Consumption Credit
The productivity of a household economy does not solely depend on
conventional production inputs and income-generating activities. Skills, education and the nutritional status
of the family labour force also play a crucial role (Zeller et al., 1994). A farm household is a complex interlinked
system of production and household activities characterised by common use of
labour, land and capital (Heidhues, 1992).
There
is no strict division between consumption (in the household) and investment (in
the enterprise) applications in rural households. Consumption activities are usually
inseparably linked with the production sphere and vice versa, and can thus
hardly be measured separately. Labour is
their most important production factor after land. Therefore, expenditures for
food, health and education are all needed to maintain production. The question
therefore is to know whether the maintenance of labour potential and health is
a form of consumption or whether it should be considered as a long-term
investment in human capital (Schmidt & Kropp, 1987)? Another example: if a farmer borrows what is
necessary to make up for a temporary shortfall in food availability, an animal
will be saved which would otherwise have been slaughtered. Such an animal is then still available to
produce young, milk, blood, etc. and to provide plough power, etc., which all
are of economic value. This further relates
to the insurance mechanism (Abugre, 1994).
Furthermore, social activities may serve to build a mutual support
system (Heidhues, 1992).
Thus,
consumption credit is an important component of rural households' financial
needs. Schmidt & Kropp (1987)
describe consumption loans as loans that permit consumption to be realised before
income is actually earned and, like saving, are also a means of adjusting
income flows to planned expenditure.
Rural
financial markets' roles in consumption stabilisation can be divided into two
possible strategies: (1) the savings/dissavings process; and (2) consumption
credit. Both are connected. For instance, households, which are subjected
to food shortfalls, can choose from various strategies to deal with this problem. In a case of temporary food insecurity, i.e.
a short-term shortfall of food availability and thus consumption below the
needed level, households may diversify their income sources, sell assets or ask
for support by others. However, they may
also knock on the door of informal or formal financial markets. The closer a household is, even in a “normal
situation”, to inadequate food consumption level, the greater the need for
access to any of the food securing strategies.
Thus, the more income diversification, asset sale and interhousehold support
strategies become limited, the more important will access to financial markets
be (Heidhues, 1992).
In
many cases, transitory food insecurity occurs frequently, which weaken income
and productive basis development more and more.
At the end, these households are faced with a chronic food shortage. Such a chronic food security problem can be
prevented by a timely access to credit and savings markets (Heidhues,
1992). Therefore, credit use for
consumption plays a more important role in poorer households than in more
affluent household (Zeller et al.,
1994).
|
An investigation was done in Table
2.1. Use of credit in The |
|||||
|
|
Income
groups |
||||
|
Loan Use (%) |
Total |
Lowest |
Low |
High |
Highest |
|
Agricultural
inputs |
46.0 |
37.0 |
47.0 |
52.0 |
46.0 |
|
Food |
7.0 |
10.0 |
12.0 |
7.0 |
4.0 |
|
Other
items (clothes, etc.) |
12.0 |
23.0 |
9.0 |
5.0 |
14.0 |
|
Cash |
35.0 |
30.0 |
32.0 |
37.0 |
37.0 |
According
to Heidhues (1992), the interlinked phenomena in rural households have been
well covered in research and documents on farming systems, and literature and
development projects take this increasingly into account in their
approach.
This
can not be said for rural financial market literature and even less for the
project approaches in these areas. The
concept of “agricultural credit” project still dominates over “rural financial
market” development. If financial
services do not provide for all needs of their rural clients, financial market
development will be impeded. Ignoring
these facts will lead to approaches and programmes that bypass important needs
of the rural population, especially in stress situations. The end result will be an alienation from
financial programmes of a big part of the rural clientele, particularly women
and poor (Heidhues, 1992).
Abugre
(1994) argues that in the case of consumption credit, amounts granted must be
small on average. Consumption credit
usually does not result in immediate income improvement, and can, therefore,
easily turn into a debt burden. By
granting them with the minimum of procedures, they can be inexpensive. Community and informal groups can be used to
manage the system, thus, bureaucratic structures are unnecessary. Social norms and peer pressure within these
groups will ensure repayment. It can
even be blended with the family savings, augmenting it in the process.
(A
simple household model explaining the demand for consumption credit is
presented in Appendix II.)
|
Temu & Hill (1994) did a survey in Table
2.2 Financial constraints experienced
by coffee farmers in |
||||||
|
Farmer Income Group |
Number enquired |
Children's education |
Health |
Building |
Food |
Agric. Inputs |
|
1990 |
||||||
|
Low |
71 |
26(36.6%) |
27(38.0%) |
5(7.0%) |
8(11.3%) |
5(7.1%) |
|
Medium |
14 |
5(35.8%) |
7(50.0%) |
- |
1(7.1%) |
1(7.1%) |
|
High |
3 |
2(66.7%) |
- |
1(33.3%) |
- |
- |
|
Total |
88 |
33(37.5%) |
34(38.6%) |
6(6.8%) |
9(10.3%) |
6(6.8%) |
|
1991 |
||||||
|
Low |
64 |
24(37.5%) |
6(9.4%) |
11(17.2%) |
17(26.6%) |
6(9.4%) |
|
Medium |
15 |
5(33.3%) |
4(26.7%) |
3(20.0%) |
2(13.3%) |
1(6.7%) |
|
High |
2 |
1(50.0%) |
- |
- |
- |
1(50.0%) |
|
Total |
81 |
30(37.0%) |
10(12.3%) |
14(17.3%) |
19(23.5%) |
8(9.9%) |
2.3.1.1.3. Insurance
Production
and consumption credit has as immediate goal to influence income or consumption
directly in a particular period.
Insurance, on the other hand, aims to increase the range of options a
household has at its disposal to cope with periods of income or consumption
stress (Heidhues, 1992). It enables
households to make intertemporal adjustments of disposable income, by improving
their ability to adjust their consumption and investment options between
periods of income and food access and shortage (Zeller et al., 1994). In other
words, insurance wants to improve a household's ability to cope with potential
risk situations (Heidhues, 1992).
Besides
the fact that the sources of risk in rural households are manifold, their
timing, intensity and income impact are difficult to anticipate. Many rural households have seldom access to
insurance schemes. Even against common
hazards, insurance is scarce (Baker & Bhargava, 1983). Formal insurance markets and social security
systems are often non-existent or, at least, non-accessible for the poor
(Zeller et al., 1994). In fact, formal forms of insurance are merely
one element of the financial security system.
The financial security system in rural areas are most often dominated by
traditional self-insurance (Temu & Hill, 1994).
There
is a range of informal strategies that are used.
Some
people believe in building insurance networks of social relationships, by
establishing an image as reliable and creditworthy in the village, the family,
with the neighbours or with local money-lenders and other potential credit
providers (Schmidt & Kropp, 1987).
Others diversify their production structure, cropping pattern and income
source, by off-farm activities. Still,
these self-insurance mechanisms may not be enough, especially in situations of
extended or co-variate risk, i.e. where the whole community is simultaneously
affected by an emergency, e.g. climatic catastrophe, or unexpected price shocks
(Heidhues, 1992; Zeller et al., 1994).
Self-insurance
strategies of poorer households tend to have negative side effects. Their low-risk resistance makes them cling to
production practices and crop diversification patterns that they known
well. Thus, the adoption of new
technologies is hampered and economies of specialisation and technology
transfer are thereby foregone (Zeller et
al., 1994).
However,
populations with a lack of access to appropriate formal finance and insurance
schemes will turn to indigenous informal savings and credit arrangements,
despite of all their shortfalls (Heidhues, 1992).
The
mere access to credit, not actually borrowing, can serve as an important
insurance substitute. Potential access
to borrowing will enable a household to transfer a part of its risk to the
financial market (Heidhues, 1992). It
gives them a feeling of consolation by knowing that there is a way out if
things go wrong. Therefore they might be
more willing to take riskier steps than without this insurance. Abugre (1994) also argues that credit
availability to the poor in flexible forms may be the most secure insurance
against emergencies.
2.3.2 The Small Farmer and Savings
(Appendix
II gives a broad discussion on savings mobilisation.)
Contrary
to the believe that rural people have no margin to save, it is widely
documented that they do indeed save (Adams & Canavesi, 1989; Adams &
Graham, 1980; Coetzee, 1992; Mauri, 1983; Miracle, 1980; Schmidt & Kropp,
1987; Spio, 1994; Von Pischke, 1983).
In
fact, they have to save! Liquid reserves
are necessary to meet emergencies, which frequently occur in subsistence
farming. The agricultural production
cycle requires accumulation of surplus to rely on during non-productive
periods. Thus, these people are forced
to abstain from immediate consumption of their produce because there is an
absolute need for savings, at least on a temporary basis (Mrak, 1989).
Rural
savings occur through formal or informal intermediaries, or otherwise through
hoarding (Mrak, 1989).
Adams
& Canavesi (1989) state that the primary motivation for most people who
want to participate in a financial system is to save, and not to borrow. This is in sharp contrast to the basic
assumption behind many governmental and donor sponsored financial projects that
stare blindly at credit provision.
According to Adams & Vogel (1990), the volume of funds that can be obtained
through effective saving mobilisation and loan recovery programmes, is
potentially far greater than most estimated amounts of subsidised loans and
grants available from governments and donors.
There is enough evidence that substantial amounts of savings can be
mobilised in the rural areas of LDCs (Adera, 1995; Miracle et al., 1980; Von Pischke, 1996).
|
After years of only supporting subsidised
credit programs, the government of |
Any
effort to mobilise savings should begin by emphasising incentives for voluntary
savings. The client must see the deposit
facility as a valuable service and not as an imposition or a mere tool to
increase the effective cost of credit.
Forced savings will lead to aversion at the clients’ level and let him
loose interest in his accounts. To
prevent this, high quality banking services should be provided to depositors
(Spio, 1994).
The
core factor in a voluntary savings mobilisation programme is to create
attractiveness through a reward paid on savings along with the convenience,
liquidity and security of savings (Yaron, 1994). Therefore, savings financial institutions
should adapt appropriate financial technology which includes attractive rates
of interest as well as conveniently located banking facilities and offices, so
that farmers have quick access to them.
It is also recommended to link saving deposits with other services, both
financial and non-financial, e.g. credit with purchase of surplus farmers'
produce. Services should be based on a
sufficiently low cost basis (Mrak, 1989).
Furthermore,
according to Dercon (1996), savings, i.e. the amount of liquid assets that are
available as a buffer, affect the amount of risk a household is willing to
take. Improved savings mobilisation may
support other development activities in the sense that farmers are less
hesitant to try unknown innovations, which they would normally perceive as
risky.
2.3.2.1 National Accounts and Forms of Saving
According
to Mauri (1983), the contribution of subsistence economy to the GNP is very
often underestimated. Moreover, the
savings threshold (i.e. the minimum income above which savings can occur) is
much lower in Third World than in First World countries and also lower in rural
than in urban areas. Especially in rural
areas of LDCs, a substantial part of the household's disposable income is kept
aside from consumption.
Nevertheless,
Mrak (1989) points out that savings potential in rural areas is
underestimated. There is a discrepancy
between real household’s saving and savings accounted for in the country’s
national accounts, especially regarding rural areas. Reasons to explain this could be divided into
two broad categories:
1.
non-monetary (i.e. physical
goods) forms, where savings occur in a non-mobilised way through non-monetised
investments, including livestock, jewellery, precious metals, construction
materials, etc. Agricultural products
surpluses are kept as a safety precaution for a possible bad crop the following
year. Traditionally, cattle have been an
important non-monetary form of peasants’ savings in many African cultures. It can be referred to as "the classic
symbol of the African's social standing" (Temu & Hill, 1994). Cattle are often used as a measure of
value. In fact, in cases where there
exists a high inflation rate and little market integration there is little or
no incentive to keep assets is the form of money. Boehmer (1995) argues that, conservatively
estimated, if 16 percent of existing non-financial savings in
2.
a considerable part of
monetary savings stays out of reach of formal financial institutions (Mrak,
1989). In cases where the economy is
already partly monetised and where cash crops have replaced subsistence crops
to a certain extent, surplus money emerges.
This does not imply that savings’ mobilisation will occur, since money
itself can also be hoarded (Mauri, 1983).
For example, in
The
extent of hoarding, no matter in what way, is an indication of the gap that
exists between what is productively invested and what could be invested without
substantially changing consumption patterns (Mauri, 1983). In general, savings in rural
Traditional
forms of savings are subjected to a range of risks, which include theft, pest
and disease in case of livestock and crops, etc. If money is hoarded, it is subjected to the
loss of purchasing power due to inflation.
Saving in the form of jewellery is often done simply to convert personal
savings in a form that is not readily accessible by other household members,
relatives and friends (Zeller et al.,
1994).
2.3.2.2 The Small Farmer and Saving Institutions
Theoretically,
it can be argued that setting up financial outlets or banking facilities in
rural areas will enable savings to be properly invested, rather than that they
would remain idle and sterile. It is
supposed to even stimulate farmers to save more. However, such institutions, e.g. commercial
banks, are not eager to attract small savings accounts, because they are
troublesome and costly to handle (Mauri, 1983).
Nevertheless,
Coetzee (1992) finds that where formal institutions are available, rural people
use them intensively to keep their savings and that they are willing to pay
these institutions to do so. It has been
illustrated by the popularity of postal savings and some commercial banks as
deposit taking institutions. It is only
in areas where there is a risk of high inflation that people tend to save in
the form of physical assets, like jewellery, livestock and implements.
Personal
savings formed in urban areas can not be expected to flow to the farming sector
due to the more attractive opportunities offered in other economical sectors,
e.g. industrial investments. Local
agricultural investments must mainly rely on what is saved by rural households
themselves (Mauri, 1983). Yet, if
financial institutions succeed in mobilising funds from farmers, they often
cause savings to flow from rural to urban areas instead of being ploughed back
in rural areas (Coetzee, 1988; Mauri, 1983).
A good example of rural deposits channelled towards the public sector is
postal savings. Postbanks only offer
saving services, thus no credit options exists.
Rural people are encouraged to use these institutions, because
transaction costs are relative low to other formal financial institutions and
these banks are prepared to handle small amounts. A wide network of branches exists, which
means that rural people do not have to travel long distances (Coetzee,
1988). Mrak (1989) refers to a similar
case: the savings bank in
Due
to the limited availability of convenient formal financial institutions, many
rural communities depend on informal financial arrangements to meet their high
demands for financial services.
Regarding savings, examples are self-help groups like ROSCAs and ASCRAs,
and informal mobile bankers like susu
collectors in
CHAPTER 3 RURAL FINANCIAL MARKETS
3.1 Introduction
Financial
markets can be described as a range of institutions that specialise in
accepting saving deposits and granting credit and finance (Schmidt & Kropp,
1987). Rural financial markets (RFMs)
consist of relationships based on transactions between sellers and buyers of
financial assets in a rural economy.
These transactions include lending, borrowing and the transfer of
ownership of financial assets (Von Pischke et
al., 1983). Some also offer
insurance services (Zeller et al.,
1994).
Savings
reduce disposable income and consumption in the current period, but increase it
for future periods. Borrowing, on the
other end, increases current disposable income at the expense of available
income in future periods. It enables
investment into human and physical capital that may improve future income and
consumption, or avoid shortfalls in current consumption (Zeller et al., 1994).
As
for all financial markets, the ultimate function of RFMs is to increase the
financial resources available to the economy and to enable a more efficient use
of resources. This indicates that
financial markets facilitate financial intermediation and management in order
to stimulate and accelerate the process of economic growth (Coetzee, 1992).
Besides
formal institutions, RFMs also involve informal-sector intermediaries as well
as private borrowing and lending that do not include intermediaries. RFMs are an alternative for rural people to
hold their liquidity reserves in savings trusts rather than hoarding. Otherwise, unused credit potential is offered
as means of synchronising their expenditures and receipts over time (Lee,
1983).
Thus,
RFMs are supposed to fulfil several important functions. They include:
(a)
income generation/increase
through production/investment credit (Heidhues, 1992). As a result, it can improve income
distribution, by making purchasing power available to those with few resources
of their own. With this they can take
advantage of productive opportunities that otherwise would have been forgone
(Gonzalez-Vega, 1989);
(b)
income and consumption
stabilisation through savings/dissavings and consumption credit (Heidhues,
1992);
(c)
overall financial stability
is also enhanced through greater market integration and opportunities for risk
management (Gonzalez-Vega, 1989). The
demand for income security/insurance is fulfilled through providing potential
access to financial resources (Heidhues, 1992);
(d)
increasing the productivity
of available resources, which means that the efficiency of resource allocation
is enhanced (Gonzalez-Vega, 1989);
(e)
increasing the flow of
savings and investments, thus contributing to faster economic growth
(Gonzalez-Vega, 1989).
3.2 Important Elements in Finance
3.2.1 Intermediation
The
conventional explanation of the idea of financial intermediary is usually in
the sense of the activities of formal financial institutions that
simultaneously mobilise resources from a certain part of the population
(savers) and transform it to fulfil the need of others (borrowers)
(Christensen, 1993). In other words,
financial intermediaries are third parties that activate the transfer of
resources from less productive uses to activities where it can be more
profitably employed (Gonzalez-Vega, 1989).
This is a critical process in order to assure efficient use of financial
resources (Christensen, 1993).
It
is important to keep in mind that financial intermediaries are active in
imperfect markets. The greatest
constraints imposed on them by these circumstances are a lack of information,
imperfect competition, factor immobility and significant externalities. Furthermore, different intermediation
institutions have different strengths and shortcomings. Some are very awkward if it comes to small
deposits and loans, others are not capable to handle the risks of financial
intermediation in rural areas, while some have weaknesses as specialised
lenders (Von Pischke et al., 1983).
The
rural population is heterogeneous, mostly with seasonal expenditures and
incomes and submitted to technological change and high risks. This suggests a strong demand for effective
financial intermediation in these areas and that even the poorest will
participate in effective credit and savings mobilisation programmes. This demand is reflected in the fact that
households normally hold only relative small amounts in liquid financial
savings and possess relative large amounts of goods. To worsen this idea, these real goods are
subjected to storing costs, spoilage and theft and are usually unproductive and
not suitable to be mobilised to support loans (Dercon, 1996).
To
overcome the many hindrances that hamper the access of large potentially
productive segments of the developing world’s population to formal financial
institutions, more conventional financial intermediation is needed. More attention should be given to the
building of confidence, knowledge, information and skills among these groups.
This implies that the financial institutions should change their operational
procedures and skill mix in order to expand their outreach. This process of developing new markets among
the working poor is referred to as social
intermediation. It must change the
idea of a beneficiary to that of a client that get involved in a contract
with reciprocal obligations. The level,
nature and time horizon of the investment required for social intermediation
depends on the barriers that a certain group has to deal with. It also varies according to the level of
responsibility in financial intermediation that is required (or willing to be
acquire) by the client group (Dercon, 1996).
Financial
intermediaries need to generate sufficient surplus to be self-sustaining. This may be hampered by governments and
foreign assistance changing their priorities from time to time which causes
shifts that have a profound effect on institutions supplying rural loans and
other financial services (Von Pischke et
al., 1983).
Government
policies have a great effect on the performance of financial
intermediaries. Intermediaries come with
new techniques or services to bypass regulations that adversely effect their
costs and revenues. These arrangements
often tend to be anti-developmental because they increase the social costs of
the intermediation process (Von Pischke et
al., 1983).
It
is found that most informal lenders provide valuable intermediation services
that formal intermediaries fail to provide effectively. Therefore, these informal activities will
expand with the growth of economic activity in rural areas, rather than - as often
expected - disappear. However, if the
development process is prolonged and sustained, structural changes may happen
that make formal intermediation more attractive and accessible for rural
habitants and thereby reduce the share of informal finance (Von Pischke et al., 1983) (see chapter 6 for a more
in depth discussion about Informal Finance).
3.2.2 Fungibility
The
Concise Oxford Dictionary (1990) defines fungible as being “something that can
serve for, or be replaced by, something else answering to the same
definition”. In other words, fungibility
can be explained in the sense of the interchangeability
of things that are the same or uniform (Adams & Vogel, 1990). For example, each kilogram of grain of a
specified type and grade is for all practical purposes identical to any other
kilogram of grain of the same type and the same grade. Likewise, one unit of a country's currency is
identical to every other unit of this currency, and therefore, finance is fungible.
One unit of money, be it owned or borrowed, is just like any other unit of
money. Fungibility underlies the
usefulness of money in the sense that a lack of fungibility creates the
inconvenience of barters (Von Pischke, 1996).
Any
household can make three choices as a result of a loan (Adams & Vogel,
1990):
(a)
it can increase its
expenditure on agricultural production by using all of the borrowed money to
buy agricultural inputs. Thus, its own
money plus borrowed money is used to buy agricultural inputs;
(b)
the borrowed money alone may
be applied to buy agricultural inputs.
Its own money is then used for household consumption;
(c)
all the available money can
be diverted to consumption.
Loans
give borrowers greater liquidity, increasing their overall purchasing
power. This might allow the household to
buy some costly consumption items that it was unable to buy without the loan
(Adams & Vogel, 1990).
For
all practical means, all sources of funds contribute to all uses of it. Thus, money acquired from loans, sale of
livestock and assets, savings, etc. can be used to buy loan-financed goods,
home improvements, clothes, land acquisition, etc. (Von Pischke, 1996). It makes it difficult to identify what
exactly is financed by a loan. The
problem worsens when large numbers of borrowers, who are geographically
dispersed, are involved (Adams & Vogel, 1990). This is the bottomline of fungibility and the
difference of finance with other inputs, tools and machinery of which the uses
are restricted to specific purposes. For
example, tractors can only provide motive power (Von Pischke, 1996).
According
to Von Pischke (1991), small rural borrowers in developing countries, where
economic conditions are improving and markets are reasonable competitive, tend
to multiply their sources of income.
Their agricultural incomes are erratic due to natural factors that have
a negative impact on yields or production, and relatively low due to market
conditions. Government policies may also
have an adverse effect on farmer's income (Adams & Vogel, 1990).
In
their role as resource allocators rural people have a great incentive to
diversify their income, which include their loans. It is furthered by low and uncertain returns,
which is often the case. To grant loans
in kind is not a solution, because borrowers can usually sell these inputs in
secondary markets. This cash is then of
course available to buy other goods or services (Adams & Vogel, 1990). According to Aryeetey et al. (1997), even if the diversity of funds is effectively
controlled, the recipients of the funds frequently represent only a small
portion of the farming population and thus the distortion in resource
allocation is not significantly modified.
Fungibility
diffuses the impact of finance (Von Pischke, 1996) and it is hard to
control. It is virtually impossible for
policy makers to allocate loans effectively in accord with a credit allocation
plan, together with the fungibility factor and the numerous borrowers and
lenders that participate in decentralised rural financial markets. This is especially true where loans are
targeted to specific activities (Adams & Vogel, 1990).
The
allocation of money by the farmer is not necessarily aligned with the
intentions of the planner who decided on a credit scheme. For example, cheap
loans may be programmed for a crop like maize to compensate for low maize
prices. Policy makers will then tend to
convince financial intermediaries to extend loans for this purpose. But low maize prices will cause the expected
returns from investment also to be low.
Thus, borrowers will rather divert additional liquidity to activities
where he/she will receive higher returns (Adams & Vogel, 1990). The essence of this is that the argument that
subsidised credit should compensate farmers for other policies that penalise
agriculture is often not valid, because the subsidy does not alter the
profitability of agricultural activities that are adversely affected. It also implies that additional loan funds
may generate only a partial or even no increase in investment (Yaron, 1992). This is one of the most important factors
that distinguish credit from other inputs.
Credit or money is not just another input!
The
fungibility of money poses a serious problem for the evaluation of credit
programmes (Coetzee, 1992). In this
respect,
Diversion
refers to the use of a loan for a means not authorised by the loan
contract. It is not only a symptom of
programmes that lack proper supervision or management information systems, it
happens even in well-administered programmes.
In addition, the close supervision of numerous rural clients is an
expensive process. And last, but not least,
most of the relevant countries suffer under inflation, which erodes the purchasing
power of their citizens. Thus, even if
the nominal amounts of loans and farmer expenditures expanded in the right
direction, the real value of it may remain constant or even decline, due to
inflation (Von Pischke & Adams, 1983).
Von Pischke (1996) also states that the future is unknown and the fact
that credit has a time dimension makes the counterfactual or 'what if?'
situation speculative and hypothetical.
|
From 1960 to 1978 a total amount of $95
million was granted to the government of a Latin American country from a
foreign aid agency for agricultural credit projects. After implementation, a positive evaluation
report was submitted on the project.
Loan officers and borrowers indicated that project objectives related
to type of borrower, enterprise, inputs, and loan term structure were largely
met. Still, small farmers complained
about a shortage of agricultural credit.
Another evaluation was done, but with other criteria for success. Imports, the government budget, and overall
financial market performance were examined.
Over the period that the project was implemented, the proportion of
government funds allocated to agriculture was more or less equal to the
loan. There was no additional funding
from the government. At the same time,
other sectors received increased budget allocations (in real terms) from the
government, e.g. defence, non-agricultural development and general
expenses. No wonder the second
evaluation revealed that the volume and loan term structure of agricultural
loans stayed the same or even decreased.
This clearly demonstrates the concept of diversion of funds and
fungibility at government level (Coetzee, 1992). |
According
to Abugre (1994), on the level of the rural farmer, quality of life indicators
may be more appropriate to explain and overcome fungibility complications of
credit than purely economic measures.
To
conclude, fungibility implies that the use of finance does not directly
correspond with the purpose for which it is obtained. This emphasises the importance of confidence
and trust in financial relationships. It
can even be said that the confidence in the borrower is just as important as
the confidence in the project or loan purpose (Coetzee, 1992).
3.2.3 Information and Risk
A
loan transaction is much more complicated than transactions in, for instance,
product markets. In the latter case the
task and objective is simple: sell the good and the transaction is terminated
upon receipt of payment. There is no
concern about who the client is or what happens to the commodity after the
transaction. As long as the seller gets
his/her money, everything is all right (Llanto, 1990).
In
the case of a loan transaction, the lender requires a great deal of
information. Well-run financial
institutions are well informed about their clients, their clients' activities,
and the markets in which their clients operate (Von Pischke, 1996). In other words, personal characteristics of
the borrower, the loan purpose, the creditworthiness of the borrower and his
strategic behaviour.
In
short, loan allocation has all to do with risk and risk management. Von Pischke (1994) states that information is
the most crucial ingredient in risk management.
Relevant, valid and timely information is needed in order to understand
the operations of an enterprise. The
greater the amount of such data about the loan applicant and the markets in
which he operates, the more refined the rational credit or investment decision
will be.
Finance
is always a risky business. Financial
markets trade cash in the present time for promises of returns in the
future. The chance that the promise
realises relates for a significant part to creditworthiness. To conquer this
uncertainty, confidence is needed. Yet,
confidence is nothing else than an emotion, an impression or a state of mind,
with the concomitant subjectivity. To be
rooted in a firm foundation, it has to be backed up by often complex and
profound analyses, which brings us back to the extreme importance of
information (Von Pischke, 1994).
Moreover,
it is not always easy to establish creditworthiness. A lender has to estimate the probability of
lack or failure of repayment, which gives rise to a lot of questions. This information is accumulated through
experience and a continued relationship with a particular client. Once a good reputation has been established,
the client protects it, because it is a valuable, though intangible asset. This asset becomes more valuable if the
financial programme is not a transitory project, but a permanent institution
(Gonzalez-Vega, 1989).
This
means that, in general, all banks spend a lot of time investigating the
viability and creditworthiness of new or less known projects and
borrowers. They are concerned about what
the borrower will do with the loan, how it will be used, if he will be able to
stick to the terms and conditions of the contract, if he will be able to pay
back, etc. (Llanto, 1990). Another
question is to know whether the profit on the investment will be high enough to
repay the loan with interest and what the chances of failure in the project are
(Rajasekhar, 1996).
At
a reasonable cost, the lender is unable to distinguish between a potentially
good and bad borrower. 'Reasonable
costs’ imply costs that are still acceptable for the bank and the clients to
make the transaction worthwhile. This
principle is called adverse selection
(Aryeetey et al., 1997).
Borrowers,
on the other hand, have far more information on their intended action and
creditworthiness than the lender. They
know their own intentions better than, for instance, the bank. They are also aware of their own
industriousness and moral standards and have “inside information” about their
own projects. Furthermore, borrowers can
derive potentially great benefits from understating personal and project's
weaknesses and exaggerating positive qualities.
Thus, they can not be expected to fully surrender all relevant personal
and project information (Llanto, 1990).
This leads to a situation called asymmetric
information (Coetzee, 1992). Still,
the borrower may face a risk that the expected increase in income from an
investment project for repayment may or may not materialise.
It
can thus be said that the lenders' risk has two elements; one relates to the
same risk that the borrower has and the other is the borrowers' commitment to
pay: even if he is able to repay, he may not actually repay. In other words, it might be a situation of
wilful default. The perception of both
lender and borrower of the risk of their ventures, or in other words, their
expectations to the outcome of a credit transaction, depends on whatever
information and data are available to each one of them and their interpretation
of them. It is thus very subjective
(Rajasekhar, 1996).
The
acceptance or rejection of a loan application depends on the amount and quality
of the information about the borrower and his/her project. The chance that borrowers might disguise
their true worth and character are counteracted by the lenders' preference to
those with proven credit track record and acceptable collaterals, apart from
the profitability and bankability of a project.
Therefore, the lender becomes also concerned about variables such as
collateral, borrower's equity, cash flow, consumption patterns, other debts and
other personal characteristics of the borrower.
Because of this, most lenders are forced to install elaborate screening
systems for granting credit and even more for rural credit, in order to
identify good borrowers, viable projects and sure income and profits (Llanto,
1990).
Asymmetric
information is a serious problem in rural financial markets. It causes a complex credit market structure
and an institutional bias against small, rural borrowers that are both
formidable and severe. Loan contracting
becomes even a bigger problem to borrowers who can not send the appropriate
signals or indicators of bankability, which is most often the case in rural
areas in developing countries.
Furthermore, the production and transfer of information is costly and
make banks even more reluctant to lend (Llanto, 1990).
The
economic agents of rural credit markets are very heterogeneous. Their characteristics, attributes and
personal circumstances may not be quite acceptable to banks. Regarding the rural economic agents, the bank
and its operations may be totally strange to them. Thus, the information gap exists from both
sides (Llanto, 1990).
In
the end, asymmetric information hampers the borrowers' access to financial
resources and the bank looses the chance to mobilise and invest the rural
financial surplus. Llanto (1990)
illustrates the denial to financial resources through figure 3.1.
Cell
(d) represents the situation where a serious information gap exists between the
two transactors, which leads to little or no contracting. On the other side, the two contractors may
have 'perfect' or at least satisfactory information about each other and the
project that is to be funded. In this
case the loan is contracted, as shown by cell (a). When the information structure for banks and
rural borrowers is inefficient or imperfect, partial contracting results as
shown in cell (b) and (c). This may
include credit-rationing (Llanto, 1990).
|
Bank |
Information Efficiency |
|
Rural
Borrower |
|
|
|
|
|
Information
Efficiency |
|
|
|
|
|
Perfect |
Imperfect |
|
|
|
Perfect |
(a)
Loan is contracted |
(b)
Partial loan contracting |
|
|
|
Imperfect |
(c)
Partial loan contracting |
(d)
Little or no contracting |
Figure 3.1
Transaction matrix in credit markets (Llanto, 1990)
Von
Pischke (1996) also mentions that this situation of limited information may
prevent outsiders (formal lenders) to penetrate the credit markets in villages
he surveyed. Furthermore, imperfect
information can result in the persistent fragmentation of financial markets
(Aryeetey et al., 1997).
Another
remarkable problem that results from asymmetric information is moral hazard. It can be defined as the actions of economic
agents where they maximise their own utility to the detriment of others. In a system of joint liability, such as in
cohesive group situation, an individual member reaps all the benefits of his
action, but the group bears the negative consequences (Coetzee, 1992). It is a significant problem at group lending
schemes (Huppi & Feder, 1990) (see also section 6.4.3).
3.2.4 Transaction Costs
Financial
services are not cheap. Transaction
costs have a central role in explaining trends and difficulties in
finance. In financial markets, these
costs arise from the contracts between actors, or otherwise the costs of
establishing and maintaining financial relationships (Von Pischke, 1996). It
represents all the resources and sacrifices needed to transfer one monetary
unit of currency from a saver to a borrower, and recover that unit after a
certain period of time and therefor create friction in financial markets (
The
amount of transaction costs and the way in which they are shared tell a great
deal about how RFMs perform (Adams & Vogel, 1990). According to Gonzalez-Vega (1993), the
measurement of transaction costs is an important component of evaluating the
effectiveness and efficiency of RFMs.
Mainstream
economists until after the Second World War basically neglected all transaction
costs. In the 1960s, it was realised
that market failures had transaction cost origins. Economists, both from the neo-classical school and the new institutional school started
to highlight this phenomenon, but not without disagreement. The neo-classical school mainly sees
transaction costs within the context of a market failure, while the new
institutional economists sees it as an integral part of the market (Coetzee,
1992). During the 1980s, the measuring
of transaction costs resulted in different explanations of their magnitude and
variations. Still, there was a firm agreement
on the fact that transaction costs have major consequences for resource allocation
(Gonzalez-Vega, 1993).
Transaction
costs are specific to each transaction.
They include information gathering, security arrangements to protect
cash, documents and other data, recording systems for transaction processing,
and decision-making. Transaction costs
determine which products are generated in financial markets, as well as who
provides these products and who makes use of them (Von Pischke, 1996). They play an important role in limiting the
services that financial institutions are willing to provide in rural areas, to
poor people, and to new clients (Coetzee, 1995). That is why innovations that reduce
transaction costs widen access to financial services (Von Pischke, 1996). Coetzee (1992) also states that the higher
the transaction costs, the lower the volume of transactions in a specific
market. If the transaction costs is
extremely high, exchange can not take place and therefore it can be said that
the market does not exist.
Transaction
costs have a fixed-cost character, which implies that smaller financial
transactions are more expensive when compared to larger transactions. Therefore, a reduction in interest rates will
have a greater effect on bigger loans and deposits, because transaction costs
stay the same (Zeller et al., 1994). Transaction costs are not related to the
account balance or the transaction amount (Von Pischke, 1996). Different studies indicate that in the case
of small borrowers, borrowers’ transaction costs are more important than
interest rates. This is in contrast with
large borrowers, who are very sensitive to interest rates, because interest
make up a large part of their total borrowing costs. For them, transaction costs are small
compared to the amount deposited or borrowed, and thus often negligible (Adams
& Graham, 1980). Therefore,
borrowers and depositors of small amounts are often treated with a sense of
inferiority (
The
key to understand intermediation and the structure of markets lies in
transaction costs. The lack of
information and uncertainty as well as the enforcement of contracts
(Gonzalez-Vega, 1993) stands high on the list of elements contributing to
transaction costs. Transaction cost
would have been needless and measurement and enforcement unnecessary, if
information were perfect and costless.
Yet, information is imperfect and costly, although in varying degrees
(Coetzee, 1992).
Transaction
costs are most often too high in relation to the expected return from a loan to
obtain the ideal quality and quantity of information. Thus, incomplete and restricted contracts
arise. Furthermore, the uncertainty
about the future is great, the number and nature of eventualities to be
considered are very large. Therefore, it
is impossible to cover the cost of anticipating them all, or to write a
contract, which specifies desired actions in case that one of these
eventualities becomes reality. This is
especially true when transactions are infrequent and small. Therefore, participators of financial
agreements have to settle for second best contracts. Uncertainty and incomplete contracts lead to
the situation where economic agents do not bear the full consequences or do not
enjoy the full benefits of their actions (Coetzee, 1992).
Transaction
costs include non-financial costs. All participants
in the market, including depositors, borrowers and financial intermediaries,
are tied to non-financial costs. The
level and distribution of these costs amongst participants in a market are
influenced by changes in technology and consumer preferences, enforceability of
contracts as well as the internal efficiencies of financial institutions
(Coetzee, 1992).
Sustaining
and expanding financial services depend for a great part on decreasing
transaction costs, both for the institutions and their clients (
3.2.4.1 Clients' Transaction Costs
The
main transaction costs for savers and loan applicants at the formal market are
to gain access to them by establishing financial relationships (
Savers
are concerned about the net return on deposits, after transaction costs are
subtracted from interests earned (Gonzalez-Vega, 1993). They must win confidence in the institutions
and be assured that their deposits will be accepted. They desire to be treated respectfully. When an account is opened, a photograph or
document of their identity and residential address is most often required by
formal institutions. In many countries,
these identity documents may be costly and/or difficult to obtain (Von Pischke,
1996).
Rural
areas and less prosperous urban areas are often characterised by a lack of
modern financial institutions or inconvenient office hours. Aspirant depositors have to spend time and/or
money, walking, cycling or riding to get to bank offices. Moreover, these trips have their own
challenges, including temptations to spend, security worries, long queues at
public transport halts and stations as well as in banking offices (Von Pischke,
1996). Other costs include bribes, legal
and title fees, paperwork expenses, etc. (Adams & Graham, 1980). All these costs often force low-income
depositors to accumulate wealth in other forms, such as domestic animals
(Gonzalez-Vega, 1989).
What
matters for borrowers is the total cost of funds, including interest and
transaction costs. This is the case for
both production and investment decisions (Gonzalez-Vega, 1993).
Aspirant
borrowers have to obtain information about the available sources for funds, the
terms and additional conditions attached to them. Credit relations also require documentation
and possibly an existing deposit account relationship. In addition, loan applications are subjected
to processing delays. Here, the time and
money consumed by transport, queuing and all other effort, is also part of the
deal (Von Pischke, 1996). Clients may be
forced to visit the bank many times, in order to negotiate, obtain, and repay
the loan (Adams & Vogel, 1990). Time
spent in these activities has an opportunity cost. It means lost opportunities to generate
income or enjoy leisure. Moreover, there
are the risks of lawsuits and losses of collateral, if repayment fails
(Gonzalez-Vega, 1989). This results in a
suppression of the attractiveness of borrowing and impedes the value estimation
of it (Von Pischke, 1996).
Transaction costs of borrowing and depositing
was measured in several countries, including the |
3.2.4.2 Intermediaries' Transaction Costs
The
intermediary 's aim is to cover the costs of both fund mobilisation and risks
of lending, and to make a profit (Gonzalez-Vega, 1989). The costs for the lender include costs of
collecting information about potential borrowers, the expenses of mobilising
funds to lend to borrowers, and the costs of extending, maintaining and
collecting loans (Adams & Vogel, 1990).
Thus, the transaction costs of lending are the costs of administrating
credit and the cost of default risk (Aryeetey et al., 1997).
Non-financial
costs incurred by financial intermediaries may be grouped as costs to (1)
mobilise deposits; and (2) costs incurred in the process of lending. Costs to mobilise deposits can include all
costs like labour, capital and materials used anywhere in the process of
handling deposits. On the other hand,
lending costs are those associated with loan processing, disbursement,
monitoring, recovery, obtaining information on potential clients and assessing
validity of collateral offered. In
addition, the element of default, or the risk of granting a loan to the wrong
borrower, also increases the aforesaid cost elements. It is difficult to estimate the danger or
potential of default, especially at a first contact between an intermediary and
a client. Hence, intermediaries follow
diverse and usually undisclosed procedures in accounting for it. This contributes to estimation problems of
transaction costs of financial intermediaries (Coetzee, 1992).
Von
Pischke (1996) refers to areas where people are not considered as creditworthy
as the "financial frontier".
Transaction costs of formal financial institutions increase as they
approach this frontier. Depositors keep
smaller and smaller savings, while transactions also seem to become small. Turnovers in accounts tend to be high in
relation to average balances held. Other
transactions such as money transfer or other fee-based services are also
restricted. Furthermore, these
depositors prefer to use cash instead of checks or money orders for
transactions. This means that the
intermediary has to keep relatively large amounts of non-interest-earning cash
available.
Borrowers
at the frontier are often spread over wide geographical areas. This hampers the ability of lenders to trace
and contact them (Christensen, 1993). In
addition, these clients tend to be quite heterogeneous (Gonzalez-Vega,
1993). Thus, this complicates and increases
the costs to obtain and verify information from these applicants. Borrowers may be unaccustomed to making
timely payments. They often lack
collateral or credible guarantees.
Dealings with illiterate clients or those who do not speak the business
language of the country or of the loan department staff consume more time. Incomes of borrowers tend to be unsteady and
loans tend to be small, while the sources of repayment are not always very
clear. Hence, financial transactions
have a fixed-cost character (Von Pischke, 1996).
Rajasekhar
(1996) points out three specific problems:
(a)
screening problem - borrowers differ
in their likelihood to default. It is
costly to determine the extent of that risk for each borrower;
(b)
incentives problem - it is costly to
ensure that borrowers take those actions that make repayment most likely;
(c) enforcement
problem - it is difficult to compel repayment.
In
addition, in the case of donor-driven credit, the cost of engineering a
community (clients) to fit into a need which has been externally identified,
could be very high.
|
The programmes of ACORD, a NGO active in,
among others, |
In
conjunction with what has been said earlier, the main indicator of a country's
financial progress is a reduction in the level and dispersion of the
transaction costs incurred by all. The
latter include actual and potential participants, as well as borrowers and
lenders (Gonzalez-Vega, 1993). Research
has indicated that the costs of financial intermediation are not shared by
borrowers and lenders in fixed proportions.
For example, intermediaries may find it their interest to absorb some of
the transaction costs normally incurred by clients, for clients they prefer
above others. At the same time, an
intermediary may force non-preferred clients to incur transaction costs
normally absorbed by the intermediary, as a way to discourage them from making
use of his services (Adams & Vogel, 1990).
3.2.5 Interest Rates
The
Concise Oxford Dictionary (1990) defines financial interest as “money paid for the use of money lent, or for not
requiring the repayment of a debt”. The
market rate of interest is that rate which cover the costs of funds,
administrative costs, risks and an adequate profit margin (Seibel, 1994).
Many
previous strategies used to promote rural finance blindly stared at interest
rates as the only, or at least, most important factor that influences choice of
intermediary. Appendix III gives some
insight on the role that interest rates played in financial development in the
previous decades.
If
financial institutions are forced to lend at undifferentiated commercial rates,
subsidised interest rates for certain clients are demanded, with the same
consequences as any type of subsidised credit (Seibel, 1994).
Interest
rates above the inflation rate alone are not enough to ensure healthy financial
markets. Appropriate interest rates should
go hand in hand with policy and financial markets reforms in order to create a
favourable economic environment that enhances sustainability (Spio, 1994). Financial institutions must also be
stimulated to rely on their own resource base.
This is hindered by inappropriate loan guarantees and liquidity
provision (Seibel, 1994).
|
Zeller et al. (1994)
interviewed rural households in The Gambia.
This revealed that the problem is access to credit, rather than the
level of interest rates charged.
Autonomously regulated village-based banks which charge relative high
interest rates in relation to, e.g. NGO subsidised credit, confirmed it. Rural Gambians were willing to pay these
interest rates for timely loans. In
fact, the members of the village banks decided annual rates of up to 60
percent on loans and 40 percent on deposits. |
Likewise,
Aryeetey et al. (1997) found in
several Sub-Saharan African countries that interest rates charged in segments
of both the formal and the informal financial sector have little influence on
each other, implying that it does not play a highly decisive role in choice of
intermediary.
Nevertheless,
interest rates are critical in determining the performance of financial
markets. Favourable interest rates are
necessary as an incentive for rural households to save in a financial form in
order to strengthen the resource base of the national economy and to improve
financial institutions’ viability (Coetzee, 1992).
3.2.6 Loan Repayment
Repayment
default rates are measured in various ways, for example the collection ratio
for an accounting period, the percentage of the portfolio in arrears at a given
time, the proportion of borrowers who repay, and the repayment index. If defaults are seen as loans overdue for
repayment, it is difficult to determine how many of these loans will ultimately
be recovered. It has been found that the
longer the arrears, the greater the likelihood that the loan will not be repaid
(Von Stockhausen, 1983).
High
default rates are especially related to subsidised credit programmes (see
Appendix III). Farmers in developing
countries show a higher tendency to withhold repayment if there are no
emotional tie between the farmer and the intermediary or if local savings do
not contribute to the portfolio of the intermediaries (Coetzee, 1992).
Table
3.1 Estimated Percentage Loan Delinquency Rates in Developing Countries (Coetzee, 1992)
|
|
|
|
|
50 |
|
|
55 |
|
|
33 |
|
|
80 |
|
|
50 |
|
|
|
|
|
76 |
|
|
15 |
|
|
24 |
|
|
41 |
|
|
|
|
|
68 |
|
Al Salvador |
81 |
Traditionally,
borrowers who failed to repay were divided into two categories: they were seen
as either unable or unwilling to repay.
Recently, there has developed a trend of not making a distinction or
division. There is rather an increased
awareness of the importance of incentives for both lenders and borrowers in
determining loan delinquency. At the basis
of this recent view stand the costs and the benefits to a borrower of repaying
or not repaying a loan. A borrower may
choose to repay because of the probability of receiving a larger loan in the
future, on which a positive rate of return can be expected. Against this must be weighed the explicit
financial charges on the possible new loan, which include transaction costs
involved in repaying the current loan and then negotiating and receiving the
new one, as well as the timeliness of the new loan (Adams & Vogel,
1990).
If
the borrower chooses not to repay a current loan, two main outcomes are
possible. One is that the lender may do
nothing, although future loans from this lender will most probably be
denied. Otherwise, the lender may take
strong action so that the borrower may, for instance, lose collateral pledge
for loans, in addition to denial of future loans from this and/or other
lenders. The probability of obtaining a
new and larger loan in the future on a timely basis seem to be a very important
determinant of loan repayment (Adams & Vogel, 1990).
Delinquency
in timely repayment is a sign that borrowers are not concerned about the
survival of an institution or its future.
They will grasp loans while funds are available, especially in the case
of cheap loans, but will not bet on the institution's survival. Default weakens the institution and thereby,
confirms the borrower's pessimistic presentiment. As a result, a vicious circle arises wherein
banks get trapped. On the other hand, if
loans are paid in time, it can be regarded as a signal that clients value the
relationship with the intermediary. The
expectation of a reliable and continued access to valuable financial services
is the most powerful incentive for the repayment of loans (Gonzalez-Vega,
1989).
Koch
& Soetjipto (1993) found that the loan period is negative correlated with
the collection rate: the longer the loan period, the lower the collection
rates.
|
In |
3.2.6.1 Collateral
The Concise Oxford Dictionary (1990) defines collateral as “security
pledge as guarantee for repayment of a loan”.
According to
Collateral
can also be defined as a physical asset which satisfies the following three
conditions:
(a)
appropriability, which
refers to the ease of liquidating the collateral by the lender in case of
default;
(b)
absence of
collateral-specific risks, which implies that the collateral’s subjection to,
e.g. theft, fire, disease, inflation, political risks etc. must be minimised;
(c)
accrual of the returns to
the borrower during the loan period, which refers to the direct economic
returns earned from the use of the asset, or the indirect economic returns
earned from the investments made with loans obtained using the asset as
collateral (
However, collaterals in financial markets are generally discussed in
the context of formal financial markets in developed countries. Collateral, as defined above, is rarely used
in less-developed economies where informal finance dominates rural financial
markets (Esguerra & Meyer, 1989).
Small
farmers do often not possess the required assets to use as collateral. In many countries, both developed and
developing, land is an important physical collaterals (Zeller, 1994). Due to traditional land tenure systems, e.g.
communal systems, many small farmers are not able to acquire credit through
these means. They have to rely on other
assets such as livestock, jewellery, labour, etc. to secure their loans. It implies that there is a positive relation
between a farmer’s wealth and his/her access to credit. This situation maintains equity problems.
|
Surveys done in two villages of |
Some
credit programmes in the past did not require any collateral at all. The general experience was that the rate of
recovery was initially good but later declined.
This outcome is ascribed to less discrimination in the selection of
borrowers, to less supervision of lent funds, or to more political interference
and corruption as the credit programme progresses (Von Stockhausen, 1983).
However,
there are also non-tradable assets of which the value is increasingly
recognised, that help to enforce contracts.
They are referred to as collateral substitutes. They include, among others, reputation,
access to future loans, third party guarantees, and fear of social ostracism.
Collateral substitutes are usually based on “inside knowledge” that informal
lenders presume to have about their clients.
They often form the basis of informal financial arrangements (see
chapter 6). These assets are generally
of more value for the borrower than the lender and they will not cover the
lender’s loan loss in the case of default.
Nevertheless, they can be very effective to reduce moral hazard (
The
appropriate collateral substitute in a transaction depends on the specific
circumstances. The use of specific
collateral substitutes can be traced to the behaviour of lenders and borrowers
in other factor and product markets. So
those borrowers are screened according to the type of collateral substitute
that they can offer and that lenders desire.
It leads to specialisation in terms of borrowers groups (Esguerra &
Meyer, 1989).
Ghate
(1990) also points to collateral substitutes as an effective mechanism to
enforce repayment, for example interlinking credit with marketing, employment or
leasing transactions.
In
practice, the kind of collateral/collateral substitute used, depends on the
particular production, social, legal, economic and political environment of a
country and are subjected to evolution over time (
3.2.7 Segmentation, Fragmentation and Dualism
Aryeetey
et al. (1997) define segmentation as the existence of
multiple financial markets without cross-linkages, where distinct institutions
serve clients with different characteristics and needs. According to Von Pischke (1996), segmentation
is not necessarily undesirable per se. It may even lead to improved efficiency
through specialisation for different market niches. Hence, the main point is the extent to which
these several segments are integrated.
Prices and terms of similar transactions are often comparable, which
reflects a competition effect.
Specialisation also implies that differentiated risk and cost
characteristics yield comparable risk-adjusted returns across segments. The result is a financial system that is
successful in its task, i.e. the mobilisation of resources and intermediation
(Aryeetey et al., 1997).
Fragmentation
indicates a lack of interaction within and between segments, i.e. a lack of
integration. It is often used in the
sense of a situation where detrimental effects of weak linkages among segments
outweigh benefits of specialisation. It
is characterised by wide differences in prices for the same product, high
interest rates, insignificant flows of funds between segments, differences in
risk-adjusted returns and limited access by clients to financial instruments
and institutions (Aryeetey et al.,
1997).
Where
extreme fragmentation exists between formal and informal sectors it is referred
to as dualism. Thus, there is an inherent dualism of
economic and social structures. The
modern and traditional financial sectors can be regarded as more or less
discrete financial enclaves, even though their degree of formality could be
expressed as a continuum (see 6.2). This
situation reflects an underlying production structure and distribution of
wealth of an economy (Ghate, 1990).
Theoretically, the formal sector would be associated with an
urban-orientated, institutionalised, organised system that is modern and
monetised, while the informal sector would cater for the traditional, rural,
non-monetised parts of the economy. Yet,
in reality, the division is not so clear.
There is sometimes a substantial flow of funds between the two sectors
in both directions (Germidis, 1990).
However,
the formal and informal sectors face a great difference in their relative
prices and flows between them are limited.
In countries where the development process was less successful,
financial dualism seemed to have deepened over time and the two sectors often formed
almost discrete financial enclaves (Aryeetey et al., 1997).
Accurate
categorisation of supply and demand for financial services between the formal
and informal sectors is difficult. The
nature of the institutions and individuals involved in these financial
transactions are diverse. There is also
diversity among public attitudes to different services. Thus, there are different demand and supply
structures for each sector and these ensure continued segmentation of the
market. Hence, it has implications on
the relationships between them (Aryeetey, 1992b).
Fragmentation
and dualism limit the efficiency of financial markets. This lack of
substitutability between segments paralyses intermediation between savers and
investors, in allocating financial resources, and in transforming and
distributing risks and maturities.
Potential household savings go untapped and profitable investments can
not be financed. In such situations
integrative mechanisms are needed to improve the efficiency of the financial
system (Aryeetey et al., 1997).
A
well-functioning system, on the contrary, is thoroughly integrated. Formal and informal financial institutions
are specialised for their respective market niches. The integration lies in a flow of funds
between them, as well as some degree of substitutability among
institutions. Substitutability results
from overlapping clientele of separate institutions. These clients can choose freely among
institutions (Aryeetey et al., 1997).
There
exist several hypotheses to explain fragmentation and dualism. The financial
repression hypothesis asserts that restrictive financial policies shift the
allocation of investible funds from the market to the government, through
indiscriminate control of financial prices.
It includes administered exchange rates, credit allocation, interest
rate ceilings, etc. This results in
parallel markets in order to accommodate those crowded out by government
intervention (Aryeetey et al.,
1997). In other words, the informal
sector exists in response to the deficiencies and inefficiencies of the formal
sector (Germidis, 1990).
Coetzee
(1992) also mentions that fragmentation results from the absence of a legal
framework that can enforce the enactment of contracts. Artificial fragmentation results from
government actions, which aim to address perceived market failures through
policy instruments. Often the wrong
instrument is chosen and additional distortions arise, adding to the already
high transaction costs that exist in a specific market.
The
imperfect information hypothesis
blames inherent information problems as the source of segmentation and
fragmentation. It points at insufficient
flow of funds or overlap in clientele among segments to equalise risk-adjusted
returns. It also relates to the great
variation in financial technologies that lenders use in RFMs to screen
borrowers and to enforce loan repayment.
These problems may not simply be overcome by liberalisation (Meyer &
Nagarajan, 1991). The high cost of
obtaining information on, and transacting business with small clients persists
for formal institutions. It suggests
that market failures result from adverse selection and moral hazard. Weak legal systems, underdeveloped marketing
support infrastructure and expatriate roots of banking in
Germidis
(1990) points out another argument: there is an existing, intrinsic dualism of
economy and social structures in LDCs.
It results from the fact that the rural population is attached to its
traditional values and customs.
Therefore, financial dualism is just one aspect of the overall
structural dualism of the economy.
According
to Coetzee (1992), the extent of fragmentation depends on the magnitude of
actual and potential transaction costs.
Transaction costs are described as a consequence of poor infrastructure
and communication services, especially in remote areas. Thus, this brings us back to the information
problem.
However,
the fact is that financial dualism limits economic growth through an adverse
effect on accumulation and distribution processes in LDCs. It results in sector and regional disparities
in terms of mobilisation and allocation of funds. The development of each of the two economic
sectors depends for a great extent on the accessibility of their credit sources
and therefore a difference in their growth rate emerges. The formal financial sector seldom caters for
small and poor clients. These clients
have to choose between higher-cost informal financial services and no financial
services at all (Germidis, 1990).
Dualism
undermines the implementation of a consistent economic, monetary, and financial
policy. Informal sector escapes taxation
and its activities do not appear in the national accounts. Due to this absence of aggregate economic
indicators, it is it difficult for public authorities to determine the source
of money supply and monetary targets and therefore, to define objectives. It is also impeded by the capital flight that
takes place through informal channels.
Regulation, e.g. through interest rates, is difficult if there is a
significant amount of liquidity outside the formal banking system (Germidis,
1990).
3.3 Conclusion
What could be regarded as a successful rural financial
institution? Although there are
differences in opinion about how a successful rural financial institution could
be defined, most core elements correspond.
The two main elements are (a) self-sustainability, and (b) substantial
outreach.
(a)
Self-sustainability
This
implies an institution’s independence from subsidies from outside, e.g. from
governments or donors (Yaron, 1994) in its aim to be a permanent, rather than a
temporally institution. Furthermore, a
borrower also expects a financial institution to be reliable in order to build
a long-term financial relationship (Gonzalez-Vega, 1989). It is important that a borrower has 100 %
trust in the integrity of his/her financial intermediary (Thillairajah, 1992).
In
order to achieve this, rural financial institutions should at least:
·
avoid loan subsidies,
targeting and concessionary discount lines (Thillairajah, 1992). These
strategies usually imply that RFMs are asked to do tasks beyond their inherent
abilities (
·
have positive interest rates
(Thillairajah, 1992). This is essential
to cover financial costs. High enough
deposit interest rates are required to ensure voluntary savings (Yaron, 1994). Hence, it is necessary to continue to expand
(
·
mobilise deposits (Thillairajah,
1992). Apart from the fact that
voluntary savings are necessary to finance the loan portfolio, it offers
potential borrowers a systematic way of establishing their creditworthiness. Lenders are hereby provided with expensive
information that is useful in screening potential borrowers and impose more
discipline on lending. In order to
assure financial viability, successful RFMs have to provide deposit services to
a much larger number of depositors than borrowers (Adams, 1992);
·
achieve a high rate of loan
collection (Yaron, 1994);
·
reduce transaction costs for
both intermediary and client (Adams, 1992; Thillairajah, 1992). Ensure favourable lending rates through
efficient procedures for assessing investment plans, screening borrowers,
processing loans, collecting repayments, as well as mobilising and servicing
savings (Yaron, 1994). Thus, financial
institutions should develop appropriate technologies to carry out these
procedures (Gonzalez-Vega, 1993).
(a) Substantial outreach
It includes the
following points:
·
focus on usually excluded clients. Services should be accessible to all rural
clients, including low-income clients, women or any other clients lacking
access to financial institutions (Debar & Van Lint, 1995; Gonzalez-Vega,
1993);
·
client-appropriate lending. It refers to quick, simple and convenient
access to small loans, often on short-term, as well as the use of collateral
substitutes (Debar & Van Lint, 1995).
Financial services should fit the needs of these clients (Debar &
Van Lint, 1995; Gonzalez-Vega, 1993);
·
saving services.
The ideal would be if financial services facilitate small deposits,
convenient collection, safety, and ready access to funds (Debar & Van Lint,
1995; Spio, 1994);
·
growth of outreach.
It reflects strong client response to services offered and competence in
service delivery management (Adams, 1992; Debar & Van Lint, 1995).
CHAPTER 4 FORMAL FINANCE
4.1 Introduction
Both
formal and informal financial institutions provide financial services, or
rather supply financial “products”, in rural financial markets. The distinction between formal and informal
is usually made according to whether the institution is subjected to government
registration, regulations and control as well as to the control of the central
bank. Formal status is usually a
precondition for direct government promotion.
To be classified as “formal” usually determines whether or not the
institution has access to development funds as well as other forms of support from
their own country and from those provided by foreign donors (Schmidt &
Kropp, 1987).
Formal
financial institutions (FFIs) are structures transferred from abroad which
seldom take into account the preferences and needs of the average saver in
LDCs. Despite of a wide-spread emergence
of formal financial institutions all over these countries, it is clear that
their track record is a sorrow one (Miracle et
al., 1980). The distribution of bank
branches is mainly concentrated in urban areas (Germidis, 1990). They are unsuccessful in tapping the savings
potential from rural areas, while the default in loan repayment is almost
uncountable. In fact, the arrears'
ratios in the formal sector are alarming and the droughts of the 1980s and the
first half of the 1990s increased the problem.
In addition, formal institutions fail to sufficiently reach the rural
poor, which really need such services (Miracle et al., 1980).
Despite
of the implementation of reform measures, the deposit base of banks is volatile
and no significant change has yet been observed in their liability
structure. Few innovation instruments
and products have been developed, and bank loan portfolios have experienced no
significant change. Banks continue to
concentrate lending on their traditional clientele: large, established customers. In spite of liberalisation and the attempt to
introduce greater financial competition, formal financial agents fail to
significantly increase their accessibility to a large part of the population
(Aryeetey et al., 1997).
4.2 Formal Institutions
In
most developing countries, the central bank and commercial banks dominate the
formal credit market. Supply is mostly
limited to short-term resources due to a lack of an effective capital market,
although there are indications that this is slowly changing to longer
terms. Foreign investors and donors
mainly supply long-term resources and, therefore, these resources are scarce
(De Jong & Kleiterp, 1991).
According
to Germidis (1990) and Meyer & Nagarajan (1991), the formal financial
sector consists of three levels. The
central bank and other regulatory and prudential institutions represent the
first level. The second level is
represented by an abundance of banking and non-banking financial
intermediaries. It includes commercial
banks, development banks, postal saving networks, saving banks, insurance
companies, building societies, etc.
Commercial and development banks are usually the most prominent. These institutions are directly involved in
providing borrowers and savers with financial services (Meyer & Nagarajan,
1991).
The
third level refers to capital markets.
In developing countries they are represented by a multiplex of
institutions including the relative atrophy of financial, bond, or stock
markets in
Banks
are western institutions that were transplanted to developing countries. Therefore, they usually provide purely
financial services. Formal sector
bankers, being in white-collar employment, tend to be unfamiliar with the
problems and constraints faced by many of their rural clients. Many rural people feel uncomfortable in banks
and with the banking personnel of the formal sector (Miracle et al., 1980).
4.2.1 Central Bank
The
central bank and other regulatory and prudential institutions determine the
"rules of the game" for most formal institutions. These regulations have consequences for the
formal and semi-formal financial institutions.
As a rule, it tends to play an interventionist role in local financial
activities of developing countries (Germidis, 1990; Meyer & Nagarajan,
1991).
According
to Adera (1995), central banks' development and promotional role in
4.2.2 Banking and Non-Banking Financial Intermediaries
It is often found that banks are required to follow administrative
procedures set by the government. In
this situation they seldom learn from each other or from their own experience,
leave alone from local or informal financial institutions. Loans are uniformly allocated according to
defined production goals. Administration
delays have no impact on lending decisions.
Loan collection tends to be passive with no social controls at all. Active savings collection is usually badly
neglected. Moreover, loan sizes,
maturities and grace periods are not individually determined. Quarterly or seasonal instalments are often
used, instead of accommodating individual repayment capacities deriving from
other income sources. Penalties are not
always enforced, which lessens incentives for repayment (Seibel, 1994).
As
a result of liberalisation, many banking systems are being strengthened in
various ways, for example by improved supervision. However, they have so far tended to focus on their
best clients to improve portfolio performance, rather than reach out to new,
smaller clients (Aryeetey et al.,
1997).
4.2.2.1 Commercial Banks
According
to Schmidt & Kropp (1987), large commercial banks, as found in western
countries, have been regarded as capable to function in a dynamic and efficient
way. The structure of these institutions
is mostly transferred from abroad to developing countries with little thought
for the needs and preferences of the average local saver and borrower (Adera,
1995). They are the most dominant formal
financial institutions in LDCs (Aryeetey et
al., 1997) and are normally found in urban areas. Thus, their efforts to improve the range and
quality of rural financial services are usually not very successful. They have no interest in lending to small
farmers because the risk of default and transaction costs are high, and an
acceptable collateral can rarely be provided (FAO, 1994).
It
is doubtful if commercial banks possess the necessary know-how to fulfil the
task of financing innovative investments, which are needed to stimulate
development, and the follow-up services in these areas. Managers of commercial banks are seldomly
trained to cope with agricultural problems.
The problem is aggravated by the rotation of managers, whereby relations
with the community can not be established.
These relationships, however, are essential for managers to acquire the
knowledge necessary to efficiently screen and administer agricultural loans
(Hartman, 1985). It is also doubtful
that they consider innovative financing in rural areas as an important element
of their business strategy (Schmidt & Kropp, 1987).
Their
activities in rural areas are mostly limited to financing commercial farming
and co-operatives with government guarantees (Hartman, 1985). When they do provide other rural financial
services, they primarily accept savings deposits in these areas, which are then
mostly transferred to urban areas (Mauri, 1983). These deposits, however, are seldom used to
provide loans in rural areas. In fact,
credit is seldom extended within rural areas, and especially not to target
groups in the poorer rural population (Schmidt & Kropp, 1987).
In
Few
African governments have deliberately directed the lending pattern of
commercial banks to stimulate development-oriented investment, e.g. industrial
activities. Moreover, there is a latent
demand for credit by small borrowers, which remains unsatisfied, while the
banking sector accumulates excess liquidity.
This further lessens the support from productive investment. This situation can give rise to a “low
lending trap”, whereby efficient resource allocation is hampered and the
emergence of entrepreneurship is impeded.
Many commercial banks are often unable to deliver credit without elaborate
paperwork and complicated collateral requirements. This factor alone is enough to steer many
potential clients away from the formal sector.
In addition, in some countries there is a distrust in government and
associated institutions, because of a fear of interference, control, taxation
or outright confiscation (Adera, 1995).
Schmidt
& Kropp (1987) argue that the prevailing regulation of interest rates and
prices of commercial banks in most countries is one of these institutions’
major constraints with regard to the provision of credit in rural areas. It precludes the profitability of loans (see
Appendix III.1 Subsidised Finance). The
relatively few commercial banks that do have rural credit programmes usually
consider and execute them as welfare projects and public relations activities
that are not expected to cover their costs.
4.2.2.2 Development Banks
These
banks were created to fill a gap in the institution system where other banks
were lacking (Schmidt & Kropp, 1987).
Development banks were initiated, on the initiative of national
authorities, to fulfil the lacking demand for long term credit (Lambrechts
& Debar, 1995). They are often found
in the form of specialised agricultural banks dealing with individual farmers
(Argyle, 1983), although Adera (1995) points out that in practice many turn out
to cater mainly for the manufacturing and mining industry. Most of them are government or
para-governmental banks, specialised in the credit business and partially or
wholly financed by foreign donors, the national government and/or the central
bank. The acceptance of savings deposits
or savings mobilisations is usually not within the scope of these institutions
(Schmidt & Kropp, 1987). These
institutions have in practice become mere retailers of foreign loans and
government funds, although many were empowered to mobilise resources when they
were established. Their high operating
costs and slow loan recovery cycle erode their capital base for onward lending
to a diverse set of customers (Adera, 1995).
According
to Lambrechts & Debar (1995), there are several factors that made
development banks fail. They are accused
of high operating costs, inadequate consecution of credit dossiers, strong
political influence, incompetence to cover their own banking costs, and credit
conditions that are too strict.
For
the past few years, development banks have been reoriented to broaden their
field of intervention by supplying credit to small and medium-sized enterprises
as well (Schmidt & Kropp, 1987). Yet,
successes in this field were rather exceptions, whereas small-scale enterprises
and small farmer have not yet tasted much of the potential benefits (Adera,
1995).
In
general, development banks failed in their newly orientated role. They did not reach the targeted groups of
small-scale enterprises to a sufficient extent and/or they did not prove
themselves to be stable and efficient institutions. This may be due to the fact that their
business policy was, and still is, more orientated towards implementing
government policies than serving the needs of clients (Schmidt & Kropp,
1987).
4.3 General Shortcomings of Formal Financial Institutions
According to Von Pischke et al. (1983), it is the performance of government lending
institutions, i.e. formal institutions, rather than that of borrowers that need
most improvement. From the forgoing
discussions it is clear that there are numerous reasons to explain the
disappointing performance of formal rural financial institutions in rural
areas. They can be summarised by means
of a few broad categories.
4.3.1 Formal Financial Services do not Reach Rural Clients
FFIs are mainly urban-orientated, while state- or donor-sponsored
credit programmes often reach only a minority, often the wrong minority, of the
rural population, i.e. the wealthy and influential farmers (Yaron, 1994). As a rule, higher income farmers interact
more with formal institutions as sources of inputs and market outlets for their
produce, than farmers from lower income groups (Germidis, 1990).
FFIs
tend to prefer to deal with large amounts of both savings and loans, due to the
high transaction costs incurred through documentation, legal fees, loan
appraisal, etc. Hereby, the majority of
potential rural clients in LDCs are excluded (Germidis, 1990).
Zeller et al. (1994) also
found that in The Gambia, the level of household income has a significant
effect on whether an individual received formal credit or not. The
Moreover,
the formal financial system often does not have the capacity to serve small
borrowers. Many rural areas lack access
to formal financial services, despite all extensions done by the formal
financial sector the last few decades (Aryeetey, 1994). Cuevas (1989) points at poor conditions of
communication, rural infrastructure and transportation. Macroeconomic conditions and financial
regulations often hinder these institutions to directly provide financial
services in rural areas.
FFIs
have a triple bias regarding the mobilisation and allocation of resources. There is a preference for:
(a)
the public sector over the
private sector;
(b)
large-scale enterprises and
upper-income households over small-scale enterprises and lower income
households;
(c)
for non-agricultural
(construction, manufacturing, commerce, industry) over agricultural loans
(Germidis, 1990).
According
to
4.3.2 FFIs Fail to Provide the Financial Product that Rural Clients are Looking for
Lower
income groups avoid FFIs because of these institutions' rigid, bureaucratic
procedures with loan disbursement and deposit-taking. Long travelling distances, various
processings, slow disbursements and cumbersome paperwork are too much for many
potential rural clients. A significant
part of them are often illiterate (Germidis, 1990). All these procedures lead to high transaction
costs and long waiting periods to receive loans (Yaron, 1994). Nagarajan et
al. (1994) also stress that the inability of many FFIs to provide credit on
the point of time when borrowers need it, as well as elaborate paperwork which is
needed to carry transactions through, steer many potential clients away from
FFIs. Rural communities place a higher
premium on convenience, accessibility and trust than on nominal interest rates
(Aryeetey, 1994).
Many
rural borrowers can not meet the collateral requirements demanded by FFIs
(Germidis, 1990). Credit controls may
prevent the formal sector from making loans for a variety of purposes,
including consumption loans, so that the borrower has no alternative than to
make use of informal financial opportunities (Ghate, 1990).
4.3.3 High Transaction Costs
Formal finance most often implies a lot of paperwork, delays, and fees,
while bribes are not excluded (Lee, 1983).
It subjected to a variety of regulations relating to capital, which my
include reserve and liquidity requirements, ceilings on lending and deposit
interest rates, mandatory credit targets and audit and reporting
requirements. This, together with
internal bureaucratic procedures, raise transaction costs in the formal sector
to levels usually well above the informal sector (Ghate, 1990) (see Appendix V
for an illustration on the difference in costs incurred by the formal and the
informal sectors).
4.3.4 Neglecting Savings Mobilisation
Adams & Vogel (1990) refer to saving mobilisation as the forgotten
half of rural finance. Many FFIs have
thus ended up as mere disbursement windows, rather than balanced, full-service
financial institutions (Yaron, 1994). Despite the fact that there is a very promising
potential of savings mobilisation in rural areas (Miracle et al., 1980), transaction costs in relation to deposit amounts of
rural savers are very high. FFIs tend to
devote most of their energy to credit allocation for highly productive
investments, to create money as quick and cheap as possible. They neglect, however, the mobilisation of
household savings (Germidis, 1990).
Low, often negative, interest rates seem to be the major reason for low
saving mobilisation rates (Adams & Vogel, 1990; Lee 1983; Yaron 1994). Depositors are forced to make use of less
productive savings alternatives while funds are limited to relative few,
usually wealthier borrowers (Lee, 1983).
4.3.5 Internal Structure
FFIs
find it important to exert control over the use of funds. They want to ensure that loans are used for
productive and, preferably, long-term investment projects. It implies that they exclude a lot of
would-be clients for whom consumption credit may sometimes be a requisite
before productive investments can follow (Germidis, 1990). Lee (1983) argues that FFIs are too rigid,
for instance, through inflexible minimum transaction requirements.
Nevertheless,
formal channels for legal contract enforcement are inadequate in many
LDCs. The absence of proper
administrative machinery has also been a reason for high loan delinquency, e.g.
in
Despite
reforms many FFIs in LDCs have not yet developed the capacity for risk
management. In fact, they still operate
in an extremely constrained environment, with underdeveloped market-supporting
infrastructure and poor information base.
They have become too hesitant regarding risk in their asset management
(Aryeetey et al., 1997).
Furthermore,
according to Temu & Hill (1994), rural people are reluctant to accept
formal finance, because of their adherence to traditional practices that have
served their saving and borrowing needs for a long time.
4.4 Superiority of the Formal Financial Sector
Despite all the failures of formal finance in developing countries, it
has several important characteristics which make it indispensable as financial
intermediary. Several major points
contribute to its superiority.
·
Formal financial services
operate on a global scale. They have
formed networks that tie them together nationally and internationally. Hence, they can exchange money from one currency
to another (Argyle, 1983). Modern
telecommunication enables them to move money in larger sums and over greater
distances at short notice (Guate, 1990; Von Pischke, 1996). Therefore, there is interaction within the
formal sector (Aryeetey et al.,
1997).
·
FFIs are protected by
legislation, controlled by a central bank that guards against breaches of
monetary policy and supported by the state and the national and international
banking community. Therefore FFIs could
be steered by policies in the direction deemed appropriate, although
side-effects are difficult to predict (Von Pischke, 1996).
·
Banks are able to lend large
amounts of capital over long periods of time (Von Pischke, 1996). This is possible because they have a greater
reliance on the pooling of deposits and maturity transformations. Therefore, they enjoy greater economies of
scale and of scope. It implies that FFIs
are better suited to the large- and medium-scale needs of clients (Ghate,
1990).
·
Banks are able to provide a
range of services, e.g. they can receive farmers deposits and provide credit on
a variety of terms (Argyle, 1983), although their specialisation often leaves
much to be desired (Ghate, 1990).
In
short, formal financial institutions have the potential to provide dynamic and
efficient financial services, as has been proved in
CHAPTER 5 INFORMAL AND SEMI-FORMAL FINANCE
5.1 Informal Finance
No
standard definition exists for informal finance (Meyer & Nagarajan,
1991). According to Von Pischke (1996),
informal finance can be described as borrowing among individuals and firms that
are not registered with the government as financial intermediaries and are not
subject to government supervision.
However, there are countries that have usury and other laws that take
informal financial arrangements into account (Meyer & Nagarajan,
1991). Larson et al. (1994) describe informal financial transactions as the
creation of financial asset and liability contracts without the intermediation
of FFIs, e.g. commercial banks, development banks, etc., whereby these
contracts escape the control and review of monetary authorities, i.e. central
bank.
Informal
finance is extremely diverse (
It
is mostly conducted within broader relationships, ranging from kinship,
friendship, customary social bonds, etc.
These financial transactions are embedded in multifaceted relationships
that implicitly tie other activities to saving and lending (
The
informal sector plays an indispensable role in rural economies of LDCs
(Shanmugam, 1989), because it is the only source of financial services for the
poor, the landless, and those living in isolated regions (Meyer &
Nagarajan, 1991).
The
extent to which the informal financial sector's activities are entrenched in
the general operation of the economy, its linkages to other sectors, as well as
the strengths of various aspects of its operations, vary across countries. In some countries informal savings
mobilisation flourishes, while in other countries informal financial activities
are limited to credit activities (Aryeetey, 1992a). According to Christensen (1993), the informal
financial sector increases in importance in proportion to the level of
underdevelopment.
|
In |
It
is extremely expensive to conduct surveys that investigate the relative
importance of informal finance to the entire economy. This is because of heterogeneity, small
transactions, legality questions, and dispersion of informal finance. Therefore, if figures are
given, they are usually based on rough estimations. Nevertheless, there are enough indications that
informal finance plays a very significant role in developing countries (
Informal
financial operations depend on the traditions and values of the societies in
which they operate. Therefore, these
financial markets vary between different people and regions and with different
customary values and attitudes to finance (Ibe, 1990). Characteristics intrinsic to the
household/non-corporate sector have an important bearing upon the way financial
systems function in the economy, explaining both the relative size and vivacity
of the informal financial sector (Aryeetey et
al., 1997).
Rural
households are increasingly shifting away from the traditional non-monetary
forms of savings, e.g. livestock, stocks of agricultural products, household
assets and other valuable property, toward monetary forms of savings. More liquid forms are necessary to finance
children's school fees and to buy other commodities, or to expand investments. Nowadays, money is also used to cover
irregular expenses such as funerals and weddings (Bagachwa, 1995).
Seasonality
is an important determinant of IFI economic activities in these areas. Money revolves around the harvest
season. As can be expected, lending
activities flourish when harvests have been poor, while repayments are highest
immediately after good harvests. The
informal sector thus operates largely part-time (Bagachwa, 1995).
The
large majority of informal finance consists of transactions that are not
provided by formal agricultural credit programmes such as deposits, small loans
and short-term loans (
5.1.1 Types of Informal Finance
There
is a multiplicity of informal financial arrangements. Some of them are centuries old, and most of
them are constantly evolving, following the changes in society and economy
(Adams, 1989b; Miracle, 1980).
Credit
markets in LDCs are a matching system where different borrowers are sorted
across different lenders according to the lender's ability to screen its
borrowers and enforce contracts.
Informal financial units serve distinct niches, which mean that each
segment of the informal financial sector designs its loans to satisfy the needs
of a specific group. Informal finance is
able to tailor financial contracts to satisfy the dimension, requirements and
tastes of the individual lender (Aryeetey, 1994). An important principle behind this is that
informal financial units have been developed in response to the demand of distinct
clientele (Aryeetey et al., 1997).
Three
basic types of informal financial operators can generally be distinguished:
groups of individuals organised mutually (associations); individual
moneylenders; and partnership firms (Germidis, 1990).
The
following gives a broad outline of the categorisation of informal finance as
found in LDCs. It is impossible to
provide a clearly demarcated classification system, because this sector is
extremely heterogene. Each and every
informal financial system is a dynamic system, shaped by its own unique
socio-economic environment to something that best fits the service provider and
the client in their environment.
5.1.1.1 Self-Help Groups
Bouman
(1995) and Llanto (1990) defined self-help groups (SHGs) as voluntary
associations of people at grassroots level that are formed in order to cope
with the difficulties of conducting economic and business activities in the
rural economy. These groups are usually
autonomous, self-sufficient, self-regulated and self-controlled (Bouman, 1994).
The
members are held together by the common objective of overcoming problems (both
economic and non-economic) that affect the well-being of group members (Bouman,
1995). In general, groups are usually
formed on the base of the same interest.
This fosters the building-up of mutual trust and enhances group
homogeneity. Homogeneity is an important
pre-condition for dealing with complicated financial matters. People in a group usually have common bonds,
e.g. they are living in the same area, have the same profession, the same
religion, or they are from the same ethnic group. They expect that members in the group will
help them to achieve their individual goals (Koch & Soetjipto, 1993). Zeller et
al. (1994) also point out that access of poorer households to informal
financial services in group-based schemes is usually positive correlated to the
degree of social cohesion and democratic participation of members within the
group.
|
A survey was conducted in ·
the major bond is the same
living area (85 %); ·
nearly half of the groups
(43 %) have common social activities (e.g. family planning and family
welfare-related activities); ·
another half (42 %) have
the economic activities or the same profession; ·
and for 30 % religion is
the common bond (Koch & Soetjipto, 1993).
|
Groups
are continuously evolving, adapting to changing conditions. The most important
factor that influenced the spread and development of SHGs is the growth of the
commercial and monetary economy (Bouman, 1995).
Self-help
groups appear in many forms. The core
element is that they are organised, owned, operated and controlled by the
members themselves. Member meetings may
be conducted on a regular or irregular base (Koch & Soetjipto, 1993). These groups often operate as
"clubs" with their own "rules of the game" to ensure that
members stick to their contracts (Llanto, 1990). They are especially important in
In
sub-Saharan countries a variety of examples of indigenous groups exists that
provide mutual help at village level.
They are called nnoboa and susu in
|
It has been
postulated that kafos were formed
in the early sixteenth century in areas currently called The Gambia when the
majority of the tribes now found there migrated from |
A
group leader may be appointed. Sometimes
commissioned agents manage the group (
Bouman
(1995) summarises the functions of SHGs in three main points: (1) security or
insurance; (2) economic; and (3) socialising.
These functions are fulfilled by serving several purposes, for example:
·
to pool labour, goods or
cash for purposes of social security by creating insurance mechanisms against
loss of income or harvest, accident, illness or death. At another level the pool could be used for
community development projects to improve public facilities like churches,
temples, mosques, roads, bridges, schools, dispensaries, etc. (Bouman,
1995). According to Miracle et al. (1980), pooled funds may be used
to make bulk purchases or exercise monopoly power, while
|
Ibe (1990) reports that many of the village societies found in |
·
some groups have several
functions; they may combine religious, recreational, occupational and other
functions. In addition to their primary
objectives (singing, dancing, praying, exchange of intelligence and craftsmanship)
they often have financial activities as secondary functions (Bouman, 1995).
|
As a result of growth in organisation funds in several village
societies in In The Gambia, indigenous informal groups are usually also
multifunctional, endogenous and most often homogenous in terms of members'
age, ethnicity, gender and occupation, but they vary in membership sizes
(Nagarajan et al., 1994). |
There
are also traditional groups, sometimes referred to as tontines, which mainly serve as financial institutions, with saving
and lending as their primary objective. They are adapted to the informal sector
where incomes are uncertain and where there is considerable social pressure on
those with visible liquidities (Balkenhol
& Gueye, 1994).
If
the group’s fund has a more or less permanent character, it is referred to as
an Accumulating Saving and Credit Association (ASCRA). If the case of a fund with a rotating
character, it is called a Rotating Savings and Credit Association (ROSCA). In essence, these groups are building
reciprocal credit possibilities through their deposits (Bouman, 1995). Savings and loan associations can offer members
several other economical benefits, for example exchange of economic
information, organising beneficial joint action or assistance and helpful
guidance from others in managerial aspects of their business such as farming
(Miracle et al., 1980).
Tontines
in
5.1.1.1.1 Accumulating Saving and Credit Associations (ASCRAs)
Many
ASCRAs resemble banks of the formal sector.
Members deposit savings at regular or irregular intervals with a
treasurer who holds it for safe keeping and returns it after a period that the
participators have decided upon (Bouman, 1995).
There are usually several hundred members involved (Bouman, 1994), it
can even involve a whole community (Balkenhol & Gueye, 1994).
Mostly
the treasurer lends the pooled money to other members and sometimes to
non-members as well (Bouman, 1995). The
loan decision is made by a board or subjected to the consent of members. Collateral is often required. Records are kept and loan administration
tends to be extensive (Bouman, 1994).
Non-members
that borrow from an ASCRA are usually charged interest. In some cases borrowing members also have to
pay interest, but normally less than non-members (Bouman, 1995). Bouman (1994) reports that high interest
rates to borrowers are not uncommon. It
may be as high as 10 to 15 per cent a month, which makes the fund accumulate
very fast. This increases the
opportunity for borrowing as well as the value of member’s savings. Interests earned are ultimately distributed
among members. Sometimes the aggregate
savings, or a part of it, may be used to finance a project that will benefit
the entire group, e.g. building a dam, a school, etc. (Bouman, 1995).
5.1.1.1.2 Rotating Savings and Credit Associations (ROSCAs)
ROSCAs
are the most famous type of SHGs. It is
a universal practice that is centuries old.
The Kye in
It
can broadly be defined as people that, by agreement, form an association to
pool fixed contributions to a pot at fixed intervals. The pot is then given, in
whole or in part, to each contributor in turn (Adams & Canavesi, 1989;
Bouman, 1995). The amount to be
contributed, or the size of the contribution, by each individual is usually
decided on consensus. There are
significant variations in contribution sizes among different associations
(Aryeetey, 1992a). The contributions to
the pool may be in money, labour or goods.
The agreement and the association end when each member has had his turn
from the pot (Bouman, 1995). Typically,
membership varies between six to fifty individuals and therefore ROSCAs are
remarkably smaller than ASCRAs (Adams & Canavesi, 1989; Bouman, 1994). Normally, members are allowed to make
multiple payments to the pool. In this
context a member collect from the pool as many times as he/she contributes to
it. It allows the better-off members to
boost the size of the fund and also improves their own access to lump-sums
(Aryeetey, 1992a).
The
decision as to who will receive the pot may be determined by bidding
(Shanmugam, 1989), drawing lots (Adams & Canavesi, 1989), age, social
standing, need (Miracle et al.,
1980), etc.
Hence,
when the cycle terminates, the process may start again. The group may decide to increase or decrease
their periodical deposits, the number of members, or the frequency of meeting. Usually, the order in which the members get
the collective deposit changes with each cycle (Miracle et al., 1980).
The
type of resources that are pooled, the rules that the members agree to abide
to, in fact the whole nature of a specific ROSCA, depend on the needs of
members and the ingenuity of the organiser.
It is also related to changes in circumstances (Bouman, 1995; Miracle,
1980).
One
of the biggest advantages of ROSCAs is that all the members, except one, can
acquire the amount of the pot sooner than if they would have had if they saved
on their own (Adams & Canavesi, 1989).
In other words, unless a sort of interest is charged, all members of the
group, except one, are able to borrow from the rest of the group at a zero rate
of interest. If there is any inflation,
the real interest will be negative. The
last person to receive the pooled fund gets what he would have had if he had
saved the required deposit each period on his own (Miracle et al., 1980).
Another
advantage is that savings are not left idle, as they would be if kept, for
instance, under the mattress, but are automatically lent to other members of
the group (Miracle et al.,
1980). Therefore, savings are secured
against theft, natural hazards like fire, illness (livestock) or pests like
rodents and termites (crops) (Shanmugam, 1989).
Moreover, administration costs are kept low by the fact that no costs
are incurred for safekeeping of money (Aryeetey, 1992a).
Traditionally,
ROSCAs had, and still have, several functions: insurance, socialisation and
economic support. Insurance has been the
basis of many ROSCAs. Increased
monetarisation and commercialisation since the 1960s, shifted the emphasis to
the economic function (Bouman, 1995).
Adams & Canavesi (1989) also state that ROSCAs may evolve over time
as economic objectives strengthen against social functions. However, many ROSCAs still play an important
social role as well. Shanmugam (1989)
reports that in
The
rate of default in ROSCAs is relative low in comparison to other credit schemes
(Aryeetey, 1992a). This is because the
selection of members by the organiser or other members is usually based on
personal knowledge and therefore, possible defaulters are eliminated
(Shanmugam, 1989). Miracle et al. (1980) also explain the low rate
of default in terms of institutional safeguard and community pressure. Moreover, a defaulter would hardly be
accepted again in another financial transaction with that specific
community. Default on payment is a
stigma (Shanmugam, 1989).
However,
Aryeetey (1992a) reports that growing economic difficulties have put several of
these associations under strain. The
cases of default are increasing. This
may be attributed to low income, e.g. poor sales and the rising costs of
living.
According
to Balkenhol & Gueye (1994), a hybrid of ROSCAs and ASCRAs also
exists. In this scheme members leave 5
to 10 % of the distributed sum with the manager to build up a separate common
fund facility. However, the latter is
not used for on-lending purposes, but rather to finance social investments or
part of it, like festivities.
5.1.1.2 Individual Moneylending
Germidis
(1990) divides individual moneylending in (1) non-commercial arrangements that
include friends, neighbours, and relatives; and (2) commercial
arrangements. The credit activities of
the latter could be (i) money-based;
(ii) land-based; or (iii) commodity-based.
5.1.1.2.1 Friends, Neighbours and Relatives
Loans
from relatives and friends are the most common form of informal finance. Many of these loans involve no interest or
collateral and many have open-ended repayment arrangements. An important feature often found in these
arrangements is the expectation that the borrower is willing to provide a loan
to the lender sometime in future. If
access to other forms of finance is weak, this reciprocity may be an important
way of risk management. Therefore, these
people put high priority on establishing and strengthening interpersonal ties
(Adams, 1989b; Temu & Hill, 1994).
A
disadvantage of such interpersonal transactions is that pooled savings are not
always channelled to superior investments.
This phenomenon can be described as a vehicle of, so- called,
dis-intermediation, because it impedes efficient mobilisation and allocation of
savings. It may even stimulate the
fragmentation of financial markets (Temu & Hill, 1994).
5.1.1.2.2 Moneylender
The
moneylender is a typical example of a money-based commercial arrangement
(Germidis, 1990). Of all informal
financial arrangements, moneylenders most probably receive most publicity. They are remarkable sources of loans
especially in
Moneylenders
may engaged in this activity full-time or part-time. Full-time moneylenders may be registered as
such. Part-time moneylenders
occasionally use surpluses from their other business activities, such as
trading, to lend for short term, mostly at very high interest rates. In both cases, moneylenders usually use their
own savings to grant loans, rather than intermediating third-party savers and
borrowers (Aryeetey & Steel, 1996).
Hartman
(1985) describes moneylenders as flexible and available, with knowledge of the
borrowers' home and economic-commercial environment. They usually have daily contact with their
clients, which leads to comprehensive information about them. Clients often have long-standing credit
relationships with "their" moneylender (Schrader, 1992).
The
greatest point of critic is that they often charge extraordinary high interest
rates (Adams, 1989b; Cuevas, 1989; Hartman, 1985). It is usually ascribed to a case of monopoly
profit (Schrader, 1992), which results in a wide range of nick names e.g.
loan-shark, exploiter, usurer, etc. (
|
In |
Furthermore,
moneylenders are an open source of credit to the general public and the
borrower does not have to satisfy any distinct conditions, for example,
membership of a group. Several borrowers
may prefer to use a moneylender, because they can be almost certain that their
loan request, regarding amount, time of disbursement and repayment period, will
be met. Other moneylender-clients are
those that were precluded from other informal financial associations or were
refused formal credit. Therefore, it can
be expected that many clients of moneylenders are highest-risk borrowers
(Aryeetey, 1994).
5.1.1.2.3 Mobile Informal Bankers
Mobile
bankers are another example of money-based commercial arrangements (Germidis,
1990). This system is found in countries
like
Mobile
bankers are usually active at market places.
Individual savings collectors collect an agreed amount from each client
every day and at the end of the month return an amount equal to the sum of the
deposits minus a certain part (usually one-thirtieth, or one day's deposit),
which is the banker's fee (Aryeetey, 1992a; Aryeetey & Steel, 1996). The fact that collectors live and work in the
same place as their clients, seem to be sufficient to provide a sense of
security for those who entrust there savings to them (Aryeetey, 1992a). In
Mobile
banking usually has an impersonal nature between participators. Many clients prefer it this way. Therefor, it seems if mobile banking has
largely replaced collegial, organised and managed rotating credit associations. It frees participants of the interpersonal
tensions that often seem to build up in rotating credit associations (Aryeetey
& Steel, 1996). Mobile bankers offer
considerable convenience, for example, for a trader who must tend a stall in a
market place during hours when formal banks operate (Miracle et al., 1980). In this way the transaction costs of clients
are greatly reduced (Von Pischke, 1996).
In
Over
90 % of the loan applications that savings collectors receive come from clients
that also save with these collectors (Aryeetey et al., 1997). Access to
loans proofed to be another major reason to use these informal collectors
(Aryeetey, 1992a).
Miracle
et al. (1980) did investigations in
5.1.1.2.4 Savings and Loan Companies
Since
1985, new forms of susu collectors
emerged in
The
prospect of credit motivated a substantial number of people to put their
savings in these institutions (Aryeetey & Steel, 1996). Guaranteed credit disbursement depends on
these companies' ability to mobilise new savings at any time. Some SLCs fail to do so and, therefore,
suffer from liquidity problems. Hence,
the difficulty of these companies to return deposits to savers resulted in
discontented clients (Aryeetey, 1992a).
Aryeetey & Steel (1996) also report problems at the level of
mismanagement of collected funds, excessive lending as well as a lack of
adequate screening and monitoring in this system.
5.1.1.2.5 Loan Brokers
Loan
brokers facilitate contacts among people that have money to lend and borrowers
by trading inside information about potential clients. In contrast to most informal loans, these
loans are usually larger and provided on longer terms. Interest rates charged are usually high (
These borrowers usually have no access to
other lenders, e.g. formal lenders. The
service that the broker provides to the lender, is the provision of information
regarding the potential borrower. The
loan broker is paid by the borrower for his effort to find a lender that is
willing to engage in a transaction (Coetzee, 1992).
5.1.1.2.6 Money Guards
Money
guards are responsible persons who are willing to safeguard cash for
individuals. In essence, they offer a
secure place to deposit funds. Most
often these savings do not generate any interest, although it is sometimes
found that guards give depositors token favours or gifts. Usually no restrictions are placed on the
utilisation of the deposited funds by money guards. The amount of money deposited by each
depositor is normally small. In some
cases, depositors feel guards are doing them a favour by holding their money (
5.1.1.2.7 “Non-Financial” Financiers
The
"middlemen" that operate between rural producers and for the greater
part, urban consumers, often offer credit possibilities to producers. These types of financiers include, among
others, input suppliers, merchants, traders, millers and processors of
agricultural commodities (Aryeetey, 1994).
Their financial arrangements are normally commodity-based and therefore,
such loans link credit transactions with output sales or purchase of inputs
(Germidis, 1990). They will typically
offer either supplier’s credit or an advance payment from a “middleman” against
future purchases. Middlemen do not ask
for collateral but instead they enter into agreements with farmers, for
example, to purchase all their farm produce over an agreed period. However, these arrangements generate product
prices that are invariably lower than market prices (Aryeetey, 1994).
This
system can comprise an important source of credit for rural borrowers. They
have a comparative advantage over financial institutions in lending to farmers
because of stronger informational links that exist due to other business
activities and relations with their rural clients. Due to this additional involvement, lenders
can effectively enforce repayment and incur lower transaction costs and risk
(Esguerra, 1987).
5.1.1.2.8 Landlords
Landlords
are the most common lenders in land-based commercial arrangements. They are especially found in
According
to
In
5.1.1.3 Partnership Firms
Examples
of partnership firms are pawnbrokers, indigenous bankers and also a range of
companies, including finance, investment, leasing, and hire-purchase
companies. Although many of these
institutions do have a corporate structure with legal regulations on their
activities, they are exempted, at least to a certain extent, from central bank
controls and therefore included in the informal sector.
5.1.1.3.1 Pawnbrokers
Pawning
is one of the oldest forms of lending.
Pawnshops typically make small loans for short periods of time and
require borrowers to exchange physical collateral for loans. Unlike most informal financial arrangements,
pawnbrokers usually have no information about their clients (
The
size of the loan is based on the value of the collateral that the client
offers. It tends to be less than the
value of the article presented for collateral.
After loan repayment, the client receives the collateral back. If he/she fails to repay the loan by due
date, the pawnshop owner has the right to sell the collateral to redeem the
loan (Coetzee, 1992).
There
are great variations between countries in the extent to which pawnshops are
regulated. In some countries, pawnshops
are even regarded as formal financial institutions (Ghate, 1990).
In
5.1.2 Advantages and Disadvantages of the Informal Financial Sector
As
already mentioned, the informal financial sector is of a very heterogeneous
nature and shaped by the circumstances of the specific area. Therefore, one should be very careful with
generalisations (Aryeetey, 1992a). Yet,
there are several aspects that are common in most informal financial activities,
while certain principles are found in several distinctive informal financial
arrangements. It will become clear from
the following discussions.
5.1.2.1 Advantages of Informal Finance
5.1.2.1.1 Information
Informal
lenders have inside information of their clients which enables them to sort
doubtful borrowers and exert peer pressure to compel compliance to the loan
contract (Llanto, 1990). Information on
the creditworthiness of potential borrowers can be easily obtained with minimal
costs in comparison with FFIs. Lenders
usually live and work in the circumscribed area of their financial operations,
which makes effective follow-up of outstanding loans possible (Germidis, 1990). Therefore, moral hazard and adverse selection
problems, which results from asymmetric information, are not as prominent in
informal as in formal financial arrangements (Meyer & Nagarajan,
1991). The importance and advantages of
these informational links is well documented (Esguerra, 1987; Germidis, 1990;
Meyer & Nagarajan, 1991). It is most
probably the biggest strength of informal finance.
|
A survey done on
informal finance in |
Information
is the core element of the application “screening” process. Aryeetey (1994) states that screening is the
most important component of the lending process for the informal sector. In the case where groups are formed on basis
of financial objectives “screening” of members are not based on whether they
can pay back, but if they are committed to the group's goals. Therefore, in the community or group-based
arrangements, standard screening practises arise from group observations of the
habits of individuals and group obligations towards applicants. Aryeetey (1994) concludes that they do not
screen loans, but membership, which totally depends on whether the person can
be trusted to meet the obligations to the group routinely. It is an effective disciplinary measure that
the group exercises in the case of trouble.
A major criterion is the individual's character and how reliable he or
she is. Loan application usually occurs verbally.
This
stands in sharp contrast with banks which are normally only interested to know
about the existence and extent of indebtedness.
Their standard screening practice is usually to visit the place where
the project is to be conducted, before granting credit (Aryeetey, 1994).
Therefore,
informal sources of credit in rural areas often demand no collateral. Usually the main guarantee for repayment is
an oral promise by the borrower.
Security on loans is contingent upon the borrower's past savings and
credit record and on social pressure to abide certain rules of behaviour
(Germidis, 1990).
5.1.2.1.2 Personal Ties and Social Pressure
Financial
transactions imply trust as measure of the level of confidence that lenders
have in the borrowers ability and willingness to repay in the future. Trust-building in informal finance appears to
revolve around personal relationships.
Personal considerations seem to be a cardinal loan criterion. Hence, proximity of friends and family
reduces information and monitoring costs, kinship ties exert social pressure to
repay and a well-established tradition of mutual help is considered as a social
obligation (Bagachwa, 1995). Bonds of
mutual trust are usually build to assure future access to loans through
reciprocity (
The
group often satisfies more needs than just the financial needs of the
individual member. The social and other
aspects as motives for groups’ existence have already been emphasised
earlier. Hence, each member is normally
subjected to peer sanction and even eviction from the group (Bagachwa,
1995). Termination of membership on
account of a wilful breach of contract is thus besides being financially, also
a socially costly, experience to defaulter (Llanto, 1990). Therefore, most loans among relatives and
friends do not require guarantees and collaterals. Members also stick to their loan contracts in
fear of being refused future loans in case of default (Bagachwa, 1995).
5.1.2.1.3 Accessibility
Banks
and other FFIs are normally found exclusively in urban areas, with few
exceptions, while the majority of populations in developing countries lives in
rural areas. Access to informal finance
is relatively easy for all sorts of clients in comparison to the formal
sector. It is due to, among others,
IFIs' flexibility of operations to meet specific needs, clear and easy
understandable rules and regulations, use of collateral substitutes, and rapid
processing of requests and delivery of credit.
Loans can usually be obtained on short notice. Hence, IFIs are willing to handle small
amounts in both savings and loans (Bagachwa, 1995; Germidis, 1990).
Meyer &
Nagarajan (1991) also comment on the accessibility of IFIs, which are used by
the rich and the poor, but it is often the only source for the poor while it is
an alternative source for the rich.
5.1.2.1.4 Flexibility and Adaptability
IFIs
can adjust to the specific needs of the transactors. Informal loans are usually more ideal for
rural borrowers concerning timing and use, in comparison to formal loans
(Esguerra, 1987). Moreover, IFIs are
extremely responsive to their clients' economic and social requirements and
characterised by local adaptability (Bagachwa, 1995). Clients of formal intermediaries must
normally subject themselves to the premises of the intermediary at times that
may not be convenient to clients (
Informal
finance is usually open to new innovations and proposals from creative
members. These innovations may increase
the efficiency of the specific system and make it even more tailor-made for its
members. Innovations in formal financial
markets are often warped by regulations (Adams & Canavesi, 1989).
As
already mentioned, different IFIs serve distinct niches of the informal
financial market (Aryeetey, 1994).
Hence, a client's choice of what IFI to use also depends on
circumstances. Changes in the structures
and functioning of IFIs usually reflect changes in the financial requirements
of the members that, again, are a response to changes in the national
economy.
|
|
5.1.2.1.5 Transaction Costs
Transaction
costs are cut by informal finance in several ways:
·
low overhead costs, because
normally no facilities are being built or rented and no or low salary fees have
to be paid;
·
low loan processing costs,
because of personal contact and collective experience creditworthiness of
members can readily be assessed.
Activities are usually done with the minimal of paperwork;
·
low loan recovering costs,
due to better knowledge about prospective borrowers and due to community and
kinship pressure that can be exerted once a loan is in arrears (Bagachwa,
1995).
Thus,
transaction costs are cut for a great part due to a minimal of formal
procedures and close proximity. Interest
rates are often more flexible in informal finance and therefore financial
contracts can adjust more easily to differences in costs and risks (Meyer &
Nagarajan, 1991).
According
to
Table
5.1. Average values for variables in
transaction costs of formal and informal sources of finance in
Variable |
Formal |
Informal |
|
Distance to source (km) |
40 |
34 |
|
Number of visits to obtain a loan |
6.4 |
3.1 |
|
Application time (days) |
60 |
8 |
|
Form of pay-out |
|
|
|
Cash (%) |
19 |
95 |
|
Kind (%) |
81 |
5 |
|
Interest rate (% per annum) |
12 |
16 |
|
Deposit requested (%) |
36 |
11 |
|
Size of loan (US$) |
433.8 |
99.1 |
|
Aryeetey et al. (1997) did a study of both informal and formal financial
markets in |
5.1.2.1.6 Collateral Substitutes
Informal
financial arrangements use non-conventional guarantees. Less emphasis fall on material guarantees,
which are usually used by commercial banks.
Procedures of informal finance are mostly characterised by a high level
of social control (Debar & Van Lint, 1995).
Informal
financial arrangements effectively use collateral substitutes. It might involve:
·
a tied contract where a
borrower is compelled to sell his products to the trader lender at a price
determined by the latter (Llanto, 1990; Zeller, 1994);
·
impledge of cultivation
rights to the lender for a specified period of time (Llanto, 1990);
·
more favourable terms like
lower interest rates and longer maturities
for tested borrowers (Llanto, 1990);
·
loss of future access to
credit (Zeller, 1994);
·
repayment of principle and
interest in kind (Llanto, 1990);
·
terms and conditions suited
to the specific geographic location and the borrowers individual
characteristics (Llanto, 1990; Meyer & Nagarajan, 1991).
According
to Zeller (1994), the efficient use of collateral substitutes depends on the
lender’s ability to obtain creditworthiness information about the borrower at
low cost, which is the case for informal lenders.
5.1.2.1.7 Loan Use
Informal lenders normally do not specify loan use. Thus, the borrower is free to use the loan
fund for whatever provides him higher returns or greater utility, e.g. to
overcome periodic consumption shortage (Aryeetey, 1994; Bagachwa, 1995; Esguerra,
1987). Furthermore, it lessens
transaction cost (less paperwork to justify the loan) (Esguerra, 1987) and
monitoring costs (Aryeetey, 1994).
5.1.2.1.8 Loan Repayment
Not
all informal loan contracts specify when the loan is to be fully repaid. Many of these contracts are orally made,
while some are incomplete or open-ended.
There is often an implicit understanding, especially with loans between
relatives and friends, that the borrower will pay back when he/she is able to
do so. In other cases, an implicit
understanding exists that the loan period is fluid and subjected to
renegotiations under changing conditions (
Aside
from loans among family and friends, most informal financial contracts include
specifications about the form and what point of time loan repayments is to be
made. Loan specifications refer to
whether loans are being disbursed in cash or in kind, and if repayment has to
be done through money, products or services.
A silencer on the advantageousness of informal loan repayment is that in
some societies debt obligations are inheritable, which means that if a father
dies, his unpaid dept is passed on to his children (Adams, 1994).
Notwithstanding
this, loan repayment rates are much higher at informal than at formal credit in
LDCs (Llanto, 1990). This is due to
factors explained above, e.g. peer pressure, better information that helps to
overcome moral hazard and adverse selection, flexibility regarding loan terms,
etc.
|
Aryeetey et al. (1997) conducted a survey in |
Adams
& Vogel (1990) point out that borrowers’ motivation to repay loans is
strongly influenced by a belief in the timely availability of subsequent
funds. Moreover, it is often found in
informal finance that loan repayment is the key to new loans. This is a strong incentive to repay. In other words, loan repayment guarantees
financial access and security in the future to a significant extent (Debar
& Van Lint, 1995).
***
Together,
all these factors give the informal lender the edge over banks. This results in a myriad of contracts between
informal financial agents and rural clients, which are designed and adopted to
the idiosyncrasies of the locality and the characteristics of the clients. It is doubtful whether formal institutions,
like state-owned banks, can as efficiently produce the same valuable, inside
information that informal lenders posses and whether they can, at the same
time, keep transaction costs low enough to give them a competitive alternative
(Llanto, 1990).
5.1.2.2 Disadvantages of Informal Finance
5.1.2.2.1 Segmentation, Fragmentation and Dualism
(See also section
4.4.6)
Formal
and informal sectors face great difference in their relative prices and are
characterised by barriers against flow between them, therefore it leads to
dualism in the financial economy of the country (Ghate, 1990). Coetzee (1992) also reports that fragmented
markets and lack of integration of financial markets in most LDCs have not been
positively influenced by informal activities.
Moreover, interactions within the informal sector are seldom observed
because of the strict nature of its operations (Aryeetey et al., 1997). The principal limitation of informal agents is that
they tend to operate on only one side of the market or within a circumscribed
group. Savings collectors' funds come
entirely from their clients, while moneylenders use their own funds and do not
borrow to increase their loanable funds, even though many of them are
creditworthy. ROSCA members have access
only to the group’s savings.
Intermediation in terms of savings mobilisation and transmitting them to
borrowers in other groups is limited.
The isolated, personalised nature of informal finance can provide
substantial monopoly power, especially if the legal framework restricts
moneylending. It results in great
differences in interest rates across different segments of the financial sector (Aryeetey et al., 1997).
Gonzalez-Vega
(personal notification, 1997*)
argues that informal financial transactions are mostly competitive only among
agents who are in close “proximity”, i.e. in small market segments. Outside the local boundaries, these financial
services are prohibitively expensive, especially due to high information costs
to screen and monitor borrowers.
Informal finance is seldom seen among agents who are far away from each
other. Thus, informal financial
arrangements have difficulties to operate over long distances (Cuevas, 1989)
and therefore activities take place in small geographic areas with limited
links between these areas (Coetzee, 1992).
Llanto
(1990) also states that informal finance is usually very group and location
specific. Although this is an advantage
in the sense that it is shaped by the demands and social structure of the local
people, it makes successful schemes hard to transfer to other communities. Even within a country there are differences
between ethnic groups, which make a financial system that is successful for one
group, often unsuitable without adaptation for another group (Zeller et al., 1994).
Fragmentation
among informal financial units result in significant variation in transaction
costs between them. However, there is no
indication that these come primarily from different screening, monitoring and
contract enforcement practices. Differences
in transaction costs rather originate from the type of “infrastructure” used by the units. It varies particularly by personnel costs and
extent of record keeping and stationary use (Aryeetey, 1994).
Competition
among informal lenders in the same informal financial segments is limited
between those who have access to the same “screening technology”. For example, a lender that is not involved in
trading, can not offer tied output as a suitable collateral substitute to
potential borrowers (Esguerra & Meyer, 1989).
According
to Miracle et al. (1980), savings and
loans groups are reluctant to make loans to individuals not known to at least
part of the group. Specialisation, which
results from the high information efficiency in IFIs, may provide efficient
services, but also limits access to new clients (Meyer & Nagarajan, 1991). Likewise, Esguerra & Meyer (1989)
conclude from a survey done in the
Balkenhol
& Gueye (1994) doubt if tontines
can and/or want to grow, due to the required mutual acquaintance
criterion. The closed character that
many tontines have stems from the
fact that members do not wish their families and friends to know that they have
come into the possession of a cycle.
This has been labelled the “illiquidity preference”. Hence, it is argued that with increasing
numbers of members the risk of not being able to benefit from one’s turn,
increases.
The
heterogeneity and flexibility of informal financial arrangements make it
difficult to quantitatively model informal finance. There are a wide variety of informal
financial institutional forms, moreover, within any one type, a variety of
financial contracts between savers and borrowers exists. It is difficult to determine trends, e.g.
growth and decline, of informal finance.
Therefore, standard policy making is a very complicated matter (Meyer
& Nagarajan, 1991).
5.1.2.2.2 Exploitation
Exorbitant
interest rates are not unknown in informal finance. In fact, critics usually refer to it as the
major justification to condemn the informal financial sector. Cases where lenders charge 10 percent per
cent per day on loans are then used as examples. Horror stories are often cited and
generalised about moneylenders or merchants who extend loans to persons whom
they expect will be unable to repay.
Other examples are landlords who tie their tenants to land through dept
at the company store or merchants who link loans to repayment in kind through
products that are grossly underpriced (Adams, 1989b).
Although
these situations are not always the rule, or simply cited out of context, they
are possible. Yet, it becomes evident
when the lender exercises a large measure of monopoly power (
These indictments ignore the endless number of informal loans made and
repaid, some of which required only modest lending costs and often even no
collateral. In fact, a large number of
borrowers who pay high interest rates on loans have the incentive to do so, due
to investment possibilities that offer higher rates of return. Inflation is also often ignored (
Ibe
(1990) argues that whenever communities are able and willing to form voluntary
self-help organisations, the reliance of individuals on professional
moneylenders will be low. This competitive
situation makes it difficult for moneylenders to charge exorbitant rates on
their loans.
However,
unjustifiable exploitation does occur.
Pledging of collaterals that are worth several times the loan is a good
example. It may happen that the borrower
loses use rights of the collateral pledge through pawning. Examples are borrowing at some pawnshops in
Even
in indigenous systems there is evidence of exploitation. Bouman (1994) refers to the Ogbo system, a hybrid between ROSCA and
ASCRA with a long history (unfortunately the author does not say how long),
where too much power is placed in the hands of a few headmen, thus abusing
their privileges.
1. What are the risk involved in lending and what
are the lender's opportunity costs?
2. Are most informal lenders in a monopoly
position in order to charge exorbitant profits?
3. Are credit transactions linked with marketing
and production to enhance exploitation by lenders?
5.1.2.2.3 Small Amounts on Short Term
In informal finance it are rather small amounts that change hands,
whether we are talking about saving or borrowing (Coetzee, 1992). It does not function well with large amounts
of funds (Cuevas, 1989). According to
Christensen (1993), informal finance is superior to formal finance regarding
transaction costs only when transactions are kept to a small scale. Therefore, informal finance is seldom suited
to provide in the medium and long-term credit needs of their clients (Aryeetey,
1992a; Cuevas, 1989). De Jong &
Kleiterp (1991) confirm that long-term credit in the informal sector hardly
exists. It limits the economic
development dimension of this sector to a great extent. It implies that the added value of a loan is
generally limited.
Currently, poorer rural households usually have a high demand for
liquidity, especially before a sowing period or a harvest, or to cover running
costs. There is a demand for short- term
credit that has direct positive effects on income. This contributes to the popularity of
informal finance. However, Aryeetey et al. (1997) point out that many
informal financial agents are unable to satisfy demand for loans by clients
they considered creditworthy. Moreover,
as an enterprise develops through changes in products and forms of production
and as there is an increase in market orientation, an increase in demand for
long-term loans can be expected. Thus,
as the level of development rises there will be an increase in the demand for
more fixed capital in order to invest in, e.g. more sophisticated machinery. Informal finance might then not be able to
meet the populations’ financial needs (Schmidt & Kropp, 1987).
5.1.2.2.4 Co-Variant Situations
Informal
security social networks at grassroot level are seriously weakened in the case
of price shocks, as well as in times of natural catastrophes, e.g.
droughts. The effectiveness of these
community networks is diminished by co-variate risk factors. It is aggravated by the coincidence of
seasonal credit needs for food and agricultural inputs at the beginning of the
rainy season (Zeller et al., 1994).
Coetzee
(1992) also points out that informal finance is often incapable to handle
co-variant risk situations. The total demand for financial support in such a
period can not be satisfied from local mobilised resources.
***
Thus,
informal finance is not adequate to reallocate purchasing power throughout a
country’s national economy, which makes it difficult to increase the
productivity of available resources.
Moreover, informal finance’s negative consequences are hard to control
and it does not meet the existing financial demand. Hence, in order to stimulate economic growth,
formal finance is needed.
5.2 Semi-Formal Finance
Semi-informal
finance is usually not subjected to governmental registration or supervision,
although rules of functioning may be laid down by law (Germidis, 1990). It falls outside the purview of the formal
banking authorities (Coetzee, 1992).
However, they are not a spontaneously result of local and/or traditional
structures. They rather have a
"foreign" origin. Still, they
are mostly in the form of self-help groups and are often owned by their
members.
Key
entities in semi-formal finance are (1) co-operatives and credit unions, and
(2) Non governmental organisations.
5.2.1 Co-operatives Institutions and Credit Unions
Co-operatives
and credit unions can be treated together because of similarities in their
operational goals, and lending and savings characteristics. Whereas co-operative movements deal mainly
with agricultural and rural schemes, credit unions tend to be more urban
orientated (Aryeetey, 1992a). According
to Aryeetey et al. (1997), rural
co-operatives are more informal in their operations when compared to credit
unions. This study concentrates on rural
finance, therefore more attention will be given to co-operatives.
The
Concise Oxford Dictionary (1990) defines co-operative as “a farm, a shop, or
other business, or society owning such a business, owned and run jointly by its
members, with profits shared among them.”
From
a wide spectrum of co-operative financial institutions, there are two basic
forms:
(a)
multi-purpose co-operatives
whose main activities lie in the areas of product procurement and marketing,
but which have a loan and/or savings component; and
(b)
rural savings and loan
associations which provide their members with rudimentary financial services
(Schmidt & Kropp, 1987).
Schmidt
& Kropp (1987) state that at least one principle is common to all
co-operatives: members are both clients and owners and they are normally
organised along a grass-root democracy philosophy.
In
the last few decades co-operatives have been an important source of farm
credit, especially for small farmers.
Many governments have relied heavily on co-operatives to reach small
farmers (Argyle, 1983).
Not
all co-operative financial institutions conform to the ideal (Schmidt &
Kropp, 1987). Co-operatives were often
intended to spearhead a process of rural transformation. Yet, success stories are not so abundant as
was hoped for. In fact, there was an
abundance of unsatisfactory results in comparison with the postulated outcome
(Adera, 1995). Many co-operatives in
However,
government intervention may be the most important problem. Co-operatives often become the enforcement
channels of government policies, which seriously damage their stability,
efficiency and the autonomy of these institutions (Schmidt & Kropp, 1987). They are often linked to the national
agricultural development bank or the central bank (Argyle, 1983). Failure has been a common denominator under
military, civilian, capitalist and socialist governments (Adera, 1995). This is especially true where co-operatives
are established as a cloak for government intervention regarding taxation of
agricultural products, or if these institutions were used to enforce production
increase (Schmidt & Kropp, 1987).
Many
co-operatives tend to reinforce existing dualistic local structures or even
aggravate class division rather than act as vehicles of equitable change
(Adera, 1995).
5.2.2 Non-Governmental Organisations (NGOs)
Semi-formal
operations often have a high involvement of non-government organisations (NGOs)
(Coetzee, 1992). In contrast with most
FFIs, NGOs are interested in, and therefore, developed the ability to reach and
serve the poor and the rural sector (Nwanna, 1994). Schmidt & Zeitinger (1995) also describe
NGOs in general as “motivated” and “dynamic”.
They work under most difficult circumstances, where governments and
other institutional donors fail to reach people in need due to a lack of
capacity (Abugre, 1994). That is why, at
the end of the 1980s, an enthusiastic believe in the potential of NGOs and
their role in development flared up.
There
is a great diversity in the number, growth rate, and activities of NGOs among
LDCs. Besides financial activities they
also provide a range of other services including disaster relief and
rehabilitation assistance, as well as other developmental programmes in connection
with communication, construction, water, education, health, non-food relief,
women's activities, etc. (Larson et al.,
1994). In fact, generally spoken, NGOs’
policy has undergone a major shift in emphasises during the past two
decades. Initially their policies were
mainly welfare and relief orientated, but nowadays their policies seem to
centre more around income generation (Bouman & Hospes, 1994).
In
almost every LDC, financial services are provided by some active NGOs. Besides financing income-generating
activities, most of them are primarily involved in providing short-term,
seasonal credit to farmers and microenterprises. A large number of NGOs, however, do not have
enough financial resources to meet the needs of their target groups. NGOs tend to be small and poorly funded,
often depending on assistance from abroad.
With a few exceptions, most of their activities are limited to resource
allocation (Nwanna, 1994). There are
rarely NGOs found that can survive without heavy subsidies and grants from
donors (Bouman & Hospes, 1994).
CHAPTER 6 LINKING FORMAL AND INFORMAL FINANCE
6.1 Introduction
According to Abugre (1994), donor agencies must avoid to introduce new
financial systems hurriedly. Setting up
new organisations is a money- and time-consuming process, while experience
proofs that the chances of success are rather few. Using and strengthening existing structures
might be more feasible (De Jong & Kleiterp, 1991). In several cases, existing informal systems
are more appropriate, more adaptable and provide more insurance in comparison
with any new or formal system, especially in crisis and turbulent situations
(Jones, 1994).
Flexibility
and adaptability is required from financial services and their arrangements in
situations of change. This is especially
true, because change is a discontinuous and turbulent phenomenon. In such circumstances it would be unwise to
interfere with informal financial systems that are adapted to the specific
local conditions (Abugre, 1994).
Indigenous finance has its own sophisticated culture. It can not easily be diminished or replaced
by formal financial institutions or authorities (Jones, 1994). However, informal finance alone is
insufficient to meet all financial demands, leave alone to make a country
international financially competitive. A
country can only develop to its highest financial potential through formal
finance.
Leaving
both formal and informal finance for what they are, will not help to overcome
the duality of national economies (Abugre, 1994). Dualism and fragmentation inhibit development
due to the fact that potential household savings go untapped and profitable
investments cannot be financed (Aryeetey et
al., 1997). The only solution to
overcome financial dualism is through integration and interlinkage between the
formal and informal financial sectors.
Germidis (1990) defines integration
as "transforming the formal sector and substituting it for the informal
sector” and interlinkage as
"preserving and using to advantage those characteristics of the informal
sector which constitute its strength".
These two processes are sequential: linkage in the short term will bring
integration in the long term. In other
words, until the formal sector can cover the country's financial needs on its
own, the informal sector could be used to do part of the job and, for example,
“retail” formal credit to its clients.
Informal
finance has a great influence in resource allocation of rural households and
micro-enterprises, but many of them are unable to meet the financial needs of
their clients. The resources available
to the informal sector are too limited, especially on the long term. In addition, access to formal financial
institutions remains considerably limited, which means that a substantial number
of loan requests by rural households and small businesses remain unmet (Nwanna,
1994).
However,
the formal sector in LDC, just like the informal sector, is often also
constrained by a lack of long term resources.
LDCs are mainly dependent on foreign aid to fill this gap. Therefore, foreign aid has to be linked with
informal finance as well (De Jong & Kleiterp, 1991).
6.2 Competition or Complementation
Many
financial strategies of the past (see Appendix III) aimed to displace the
informal financial sector. There is
little evidence that this has succeeded.
The formal financial sector showed significant growth in LDCs, but the
extent of gain that they brought to national incomes is disappointing. Where formal finance is constrained, informal
finance will usually find ways around these constraints (McLeod, 1994). Gonzalez-Vega (1997, personal notification*)
believes that informal finance will never disappear although its role may
become less important as formal finance develops more. However, formal finance needs informal
finance in order to grow. Therefore,
informal finance must get its rightful place in a national economy.
Despite
of the clear dualism that exists between formal and informal financial sectors
in developing countries, they do not function independently from one
another. An expansion of the formal
sector often results in a corresponding expansion in the informal sector. Likewise, a contraction of the formal sector
often leads to a contraction of the informal financial sector (Adera,
1995).
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Some IFFs have strong links
to formal finance, while others operate completely outside the formal system.
Therefore, two motivations can be differentiated for the existence of informal
finance: (1) informal finance as an autonomous system; and (2) informal finance
exists as a reaction to the formal financial sector (Coetzee, 1992; Meyer &
Nagarajan, 1991). How significant
linkages between formal and informal finance are for the development of the
entire financial sector of the economy depends for a great part on whether the
relationship between the two sectors is mainly complementary or competitive
(Ghate, 1990).
The
formal and informal financial sectors can be seen as a continuum of sub-markets
arranged in declining order of degree of requirements met by the formal
sector. Each sub-market consists of a
complex of inter-related variables, which include borrowing purpose, loan size,
loan duration, the borrowers’ income and asset position, etc. Figure 6.1 represents this model.
The
left end consists of sub-markets whose needs are entirely met by the formal
sector. The segment to the right is
totally catered to by the informal sector.
The reasons why certain financial clients belong to a particular
sub-market are discussed in chapter 4 and 5.
In between the formal and informal ends is a range of sub-markets where
the demand for financial services is fulfilled by both the formal and the
informal sectors (Ghate, 1990).
In
their respective areas (A and B in figure 6.1), the two financial sectors have
comparative advantages, and they are therefore complementary. For example, a certain borrower may not be
able to satisfy the requisites of the formal sector, such as a required
collateral. He therefore turns to the
informal sector. Here, he can acquire
the loan on the basis of first hand information, or collateral substitutes,
such as the inter-linkage of credit with marketing, employment or leasing
transactions. On the other hand, the
formal sector may not offer the financial product that the borrower is looking
for, e.g. consumption loans (Ghate, 1990).
Coetzee (1992) gives the example where FFIs do not serve remote areas,
and therefore, the informal financial services that are provided there are
complementary to the formal sector.
Formal
sector Both
sectors Informal
sector
A = Sub-market catered to
entirely by formal sector, e.g. long term loans for fixed
investments in large industry.
B = Sub-market catered to entirely
by informal sector, e.g. small short-term loans to
poor borrowers with no
collateral.
C =
Sub-market catered to by both formal and informal sector, e.g. crop loans or
working
capital for small enterprises
Figure 6.1 Sub-markets, arranged in declining order
of financial needs provided by the formal financial sector (Ghate, 1990)
A
lack of competition has unfavourable implications. Borrowers can not freely negotiate on the
formal and informal credit markets for the best terms and conditions. This hinders them to improve their welfare
(Chipeta & Mkandawire, 1992b).
In
the middle segment, complementary relationships between the two sectors are
also found. In other words, growth in demand in one sector is not at the
expense of the other (Aryeetey, 1992b).
In this situation, they usually both grow together in absolute sizes. For example, some sub-markets turn to the
formal sector for their long-term financial needs, i.e. fixed investments,
while working capital is borrowed from the informal sector. Thus, as the supply of formal credit
increases for one purpose, fixed investment, the demand for informal credit
increases for the complementary purpose, i.e. working capital (Ghate,
1990).
Aryeetey
(1992b) gives another example of a possible complementary relationship,
although it is seldom the case in reality.
If growth in investment possibilities, which usually relies on formal
credit, increases, and if this additional capacity can only be met by informal
credit, the application of the two types of credit may be regarded as
complementary. Thus, the informal sector
plays a role as provider of residual finance.
The net impact that the two sectors will have on the national economy
will depend on the volume of residual financing done by the informal sector in
relation to total financing requirements.
Residual finance can be seen as additional finance available to
investors in excess of what is offered by the formal sector. Therefore, increased demand for informal
credit is the result of a growing use of formal credit, due to a growing
economy.
Nevertheless,
formal and informal finance may also compete with one another. These financial demands occupy the middle
segment, C, in figure 6.1. In such a
case the availability and terms on which financial services of the two types
are available will determine the choice of sectoral source. If there is improvement in one sector, one
could expect clients to switch from the other source to this one. Thus, the quantity of credit in a particular
informal sub-market is the difference between the total demand for loans of
that type, and that part of total demand supplied by the formal sector. As formal loans of this type become more
easily available on more favourable terms than those in the informal market,
formal loans will displace informal loans (Ghate, 1990). Likewise, financial sector repression, as was
the case in
However,
this model is too simple to illustrate the real situation. Other factors are usually related to informal
finance, such as social ties. Thus,
informal finance offers another product than formal finance does. Therefore, clients of informal finance may be
willing to pay a higher price for a financial aspect, e.g. a loan of a certain
amount, in the informal sector than at FFIs.
This reflects additional satisfaction that clients receive from informal
arrangements (
McLeod
(1994) argues that formal finance should complement informal finance, except if
it is better able to compete. As an economy
evolves, individual incomes rise and medium and large-scale business activities
begin to proliferate. Therefore, a
demand for all sorts of financial services appears, which creates opportunities
for establishing specialised FFI.
Nevertheless, pre-existing demands for low-income households and
small-scale businesses remain. New FFI
might still not be able to serve this demand better than existing informal
arrangements. Banks should simply be
doing that what they are good at doing.
Aryeetey (1992a) confirms that the informal sector could play an
effective complementary role to services offered by established FFIs and new
innovative credit schemes.
Thus,
integration can only be achieved if various segments are linked in such a way
that they complement each other on those aspects where they have comparative
advantage, while having access to the resource base of the entire financial
market as a result of functional linkages.
If various segments fail to complement each other in the delivery of
financial services, unrelated niches develop, which implies that large sections
of the real economy are left with inadequate financial services. Such considerable gaps in financial services
are detrimental for overall financial sector development (Aryeetey et al., 1997).
6.3 Justifications to Enhance Linkages
6.3.1 Advantages for Formal Finance
The
number of rural borrowers can easily overwhelm formal finance, e.g. banks. Many of them are small farmers applying for
relative small loans without collateral and subjected to the risky nature of
agriculture. It results in transaction
costs beyond price for the formal intermediary.
A major part to these costs results from asymmetric information (Llanto,
1990).
Informal
financial agents and self-help groups possess a lot of valuable information and
create precious avenues to bank credit and services (Llanto, 1990; Zeller et al., 1994). The specificity of information and IFIs’
particular rules of exchange that assure contractual behaviour within the group
are the informal sector's greatest asset.
They can internalise the costs of acquiring and generating information
and use this information to tap bank resources (Llanto, 1990). Zeller et
al. (1994) report that the problem of information asymmetry, which leads to
adverse selection and moral hazard, could be addressed by a
linking-approach. Indigenous, social
cohesive village groups that traditionally perform coinsurance functions to
their members, may be employed as a screening device for causes of defaults.
Thus, if informal groups are linked with FFIs, two costs of the latter are
shifted to the borrowers: (1) borrower screening costs, and (2) monitoring
costs thus reducing transaction costs and repayment problems (Nagarajan et al., 1994).
Interlinking
financial market implies, therefore, that the formal sector can build on mutual
trust developed over time and the operation of effective sanctions against
deviant behaviour (Llanto, 1990).
FFIs
tend to neglect rural savings, mainly due to the high transaction costs that
result from numerous small amounts. In
contrast, several IFIs are recognised by an effective savings mobilisation
performance. Setting a link between
these formal and informal financial institutions may imply that many deposits
that would otherwise have remained outside the banking system, could end up
with FFIs. This additional savings
mobilisation could be done through a relative inexpensive way in comparison of
the costs FFIs would have incurred to mobilise these savings on their own
(Aryeetey et al., 1997).
6.3.2 Advantages for Informal Finance
Rural
people are reluctant to accept formal finance, because of their adherence to
traditional practices, which have served their saving and borrowing needs for a
long time (Temu & Hill, 1994). Linking
formal and informal finance might be the answer in that these people enjoy the
benefits of formal finance in their own familiar environment.
A
linkage system brings valuable information about the bank, the services it
offers, the bank's own "rules of the game" and much more about
banking technology to people at grassroot levels (Llanto, 1990).
Informal
social security networks at grassroot level are seriously weakened in the case
of price shocks, as well as in times of natural catastrophes, e.g. droughts and
floods. The effectiveness of these
community networks is limited by co-variate risk factors. It is further aggravated by the coincidence
of seasonal credit needs for inputs at the beginning of the planting season
(Zeller et al., 1994). These problems could be overcome if the IFIs
have access to the stronger financial base of the formal sector.
Moreover,
the financial base of informal financial activity could be broadened to a
larger membership than could be handled by ROSCAs or money keepers, if more
formal financial institutions like co-operatives and credit unions could build
on the existing informal system (Spio, 1994).
6.3.3 In General
The
options available for the promotion of new foreign concepts to the rural poor
have been limited in the sense that rural habitants have grown sceptical of
government credit institutions and promotion offers, e.g. cheap inputs. On the other hand, they still expect to
receive new subsidies, which is incompatible with the long-term sustainability
objective (Schmidt & Kropp, 1987).
According
to Nwanna (1994), increased IFI access to formal financial market credit may
lower the costs of funds to both parties and may reduce interest rates charges
on their loans. Thus, the cost of
lending/borrowing will be lowered for both the lender and the ultimate
borrower. It may result in economies of
scale, as well as greater competition in the delivery of services to rural
clients, and therefore lead to deepening of the financial system.
The major reason
to link formal and informal finance is to enhance the integration between rural
and urban financial systems (Zeller et
al., 1994). Spio
(1994) argues that linking formal and informal financial markets may trigger a
potential advantageous snowball effect.
A broader base will at the same time enhance the integration of
currently fragmented markets. Financial
intermediation will be allowed to spread across larger geographic areas and
thereby link the financial part of villages and involve more savers and
borrowers. Such an expanded geographic
area would provide a large source for savings mobilisation. It implies that a much larger fund pool is
created from which loans can be granted.
This, in turn, allows farmers to increase their dept capacity and to
make larger investments that might yield higher returns (Arteetey et al., 1997). Thus, financial intermediation and allocation
of financial resources will be much more efficient, and, thereby, enhance rural
development (Spio, 1994).
According to Aryeetey et al. (1997), the effects of interest rate liberalisation in the
formal sector greatly depend on the linkages between the formal and informal
sector. Liberalisation can result in a
substantial and abrupt shift of funds toward the formal sector, attracting
funds away from the informal market. If
there are no effective linkages, access of small micro-enterprises, small
holders and the poor to credit will be reduced and thereby detrimentally affect
their future income stream.
6.4 Options and Strategies
The
following section must not be seen as a menu from which one suggestion can be
chosen in order to make a formal-informal link.
It is rather a rough sorting of experiences, case studies, principles,
and other suggestions that can be useful when one wants to establish a
link. Therefore, some sub-sections may
overlap.
6.4.1 Strengthening Existing Linkage
Many
informal saving groups deposit their funds in banks, while a lot of informal
credit originates in the formal sector (Adera, 1995).
According
to Nwanna (1994), collaboration and relationships between formal and informal
financial markets are mostly limited and weak.
Direct linkages that presently exist are mainly limited to group lending
schemes and credit co-operatives.
However, according to Germidis (1990), there is a substantial number of
existing linkages, but they are not documented and formal financial institutes
are not aware of them. For example,
funds of mutual savings and loan associations may be deposited in accounts with
a formal financial intermediary. On the
other side, private individuals with access to formal funds may use their
position to lend informally.
Interlinkage is made easier by the fact that financial flows already
occur between the informal and formal financial sectors.
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A survey done by Aryeetey et
al. (1997) on finance in several Sub-Saharan African countries (Ghana,
Malawi, Nigeria and Tanzania) revealed that all types of informal deposit
mobilisers, except ROSCAs, operated accounts with the banking system in order
to ensure safety of mobilised funds. Aryeetey & Steel (1996) interviewed 151
savings collectors (susu) in Banks mostly use these informal mobilised savings to enhance
lending operations mainly to urban borrowers (Aryeetey, 1994). The hybrid of the ROSCA and the ASCRA type, found in |
There
is a need to strengthen and broaden these relationships. To accomplish it, participants from both
sides of the financial markets must get involved and associated with the
activities of the financial market on the other side. This will require adopting techniques of the
other that are appropriate and beneficial.
Informal financial institutions must be encouraged to deposit surplus
funds at the formal financial sector and increase their own resources for
onlending by borrowing from the formal sector (Nwanna, 1994). Banks must avoid skewed lending patterns to
the advantage of urban areas (Aryeetey, 1994).
Germidis (1990) also argues that existing linkages should be consolidated
and systematised.
Existing
links where informal financial units serve as conduits for formal credit are
rarely found, even though informal lenders may benefit from it by lower
transaction costs. Mostly, when informal
lenders borrow from banks, they can do so mainly because banks do not know that
the loan purpose is on-lending. Lenders
seldom reveal such information to bank officials and many are not known to
their bankers as informal lenders. It is
ascribed to the way that informal finance organises itself. Many lenders (moneylenders, traders, estate
owners, etc.) operate their lending operations together with other
businesses. Profits are often switched
between the two, depending on the relative capitalisation needs. For example, a farmer-lender will only seek
formal sector credit if it is no longer possible to switch farm incomes into
lending and vice versa. Others require such credit only when they
need to expand beyond the size made possible by their deposits (Aryeetey et al., 1997).
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6.4.2 Mimicry Option
Several
functions and mechanisms of informal finance could be adopted by formal
intermediaries (Zeller et al.,
1994). A competitive environment can be
promoted by allowing formal institutions to match the terms obtainable in the
informal market (Esguerra, 1987). This
strategy is applied by many semi-formal institutions.
Credit
retailing schemes tend to be more successful if they adopt informal practices
such as:
·
financial operations in the
close vicinity of clients;
·
operation with small amounts
of credit or savings per transaction;
·
the use of character-based assessment and pragmatic
concepts of collateral;
·
the use of extremely simple
documents;
·
the application of
simplified repayment terms; and
·
extremely rapid and
decentralised approvals (Aryeetey,1992a).
However,
the use of denial of access to future loans is a more powerful sanction against
loan default in informal than in formal arrangements (McLeod ,1994).
According
to Temu & Hill (1994), "inter-personal reciprocity" and
"trust through first-hand knowledge of customers" are probably the
most difficult elements to emulate.
Although FFIs can never be a match for the level of closeness available
in interpersonal relationships, farmers need to have a sense of ownership of
the financial institution they use. They
should appreciate the institution's dual functions: deposit taking and credit
granting, which is the essence of “reciprocity”. Farmers should have confidence that the value
of their money will be protected against bankruptcy or inflation, which
reflects “trust”.
Some
FFI find daily collection a very effective way to provide their services to
those clients that are accustomed to informal finance. For example, the 'Pygmy Deposit' scheme of
the Syndicate bank in
6.4.3 Groups
Credit
could be extended to a group of persons instead of each individual
separately. The group members themselves
decide on the allocation of the group’s loan amount among the members (Adams
& Vogel, 1990; Ladman & Afcha, 1990).
It is believed that group members have better information about their
fellow group member’s creditworthiness and efforts than bank agents do. The form of sanctions taken to penalise
defaulting groups varies greatly in practice.
A mechanism often used is the threat to loose future access to formal
credit (Zeller, 1994).
Within
groups, leaders play an important role.
They carry the responsibility to act on the group’s behalf. Therefore, they play a very decisive role in
the success of such a scheme (Ladman & Afcha, 1990).
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Grameen Bank's group lending scheme in |
Small,
active deposits and loan services can incur unmanageably high transaction costs
(A.I.D., 1991). Transaction costs are
now allocated to the group. Moreover,
the bulk of responsibility of promoting the programme, selection of client
members, group formation, and repayment goes to the client (Women’s World Bank,
1994). It is most significant for FFIs’
lenders who are not responsible for the formation of the group, e.g. when
existing informal groups are used. Group
loans save the lender transaction costs and the lender has only to concentrate
on the group, rather than on each member individually (Huppi & Feder, 1990;
Ladman & Afcha, 1990). The group benefits
from the fact that they do not all have to travel to bank branches, except for
one, most probably the leader (Huppi & Feder, 1990). Moreover, the cost per farmer for delivering
of technical assistance is reduced, because it can be provided to groups,
rather than on an individual basis.
Therefore, more farmers can benefit from financial and technical support
(Ladman & Afcha, 1990). Thus, group
participants get improved access to credit above individuals. Group finance produces economies of scale. Groups can usually obtain better borrowing
terms through improved bargaining (Huppi & Feder, 1990).
Groups
are formed on the basis of a common bond, social or economic. Each group has some level of group
homogeneity through interpersonal ties, which result in joint liability. The latter acts as a substitution of physical
for social collateral and can contribute to increased participation of the poor
in credit markets (Zeller, 1994).
Farmers with mutual social and economic ties who form groups can provide
lenders with valuable information about group members. It lessens the lender’s transaction costs for
the greatest part. Personal ties give
group members also the option of applying sanctions to enforce repayment (Huppi
& Feder, 1990), because future access to individual credit usually depends
on the repayment of all group members (Yaron, 1994). Homogeneity and joint liability are of
particular importance in order to assure peer pressure (Ladman & Afcha,
1990) and to reduce moral hazard. It
determines if the social cost of individual default exceeds its private cost
(Huppi & Feder, 1990).
However,
individual members have little incentive to repay if the majority of the group
members fail to repay (Huppi & Feder, 1990). It is difficult to create appropriate groups to provide financial services. The level of homogeneity depends on emotional
bonds, which could not be enforced.
Strong emotional bonds usually take time to develop (Ladman & Afcha,
1990).
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In |
Group
size is negatively related to the advantages of informational or kinship ties
(Huppi & Feder, 1990). Unlimited
expansion of a group is not recommended.
If groups get too big it leads to congestion problems and friction
(Llanto, 1990). Meyer & Nagarajan
(1991) also report that group dynamics may create problems when informal
finance is used as a conduit for funds.
6.4.4 Tying Loans and Deposits
This
strategy implies that individuals can increase their access to credit by
proving themselves through deposit performance. Previous savings serve as a proof
for creditability as well as partial collateral, which could be blocked on the
lender's account until the loan is repaid (Germidis, 1990). Thus, bonds of mutual trust are usually build
to assure future access to loans through reciprocity. Sometimes participants are allowed to
gradually enhance their creditworthiness, initially through savings, then
through borrowing and repaying small loans and ultimately by gaining access to
relative large loans (
The
high collection rate of ROSCAs can be contributed to the fact that debtors are
at the same time creditors. Experience
proofed that effective savings mobilisation is highly dependent on savers being
offered loans. Without this inducement,
many potential depositors would probably invest in more secure savings, such as
jewellery, property, canned food and so forth (De Jong & Kleiterp, 1991).
Lambrechts
& Debar (1995) also recommend that savings in foregoing of investments have
to be encouraged. This principle is
important considering the fact that financial projects have to become
self-relying and sustainable. A good
example is the Grameen Bank in
6.4.5 Incorporating Traditional Informal Financial Institutions
The significance of informal financial activities in many LDCs is clear
through the extent by which it services the credit needs of small businesses,
the poor and the rural sector. They have
an overall prominence in rural areas, and a great influence in resource
allocation of rural households and microenterprises. Therefore, policy makers have to consider
using at least some of them as financial intermediaries. IFIs could play a significant role in both
savings and credit intermediation between donor agencies, governments, formal
financial institutions, and rural households (Nwanna, 1994).
Aryeetey
(1992a) calls this kind of financial strategies "Innovative
Credit-Retailing Schemes". It
intends to improve access to financial services, especially for the poor, and
to help members to accumulate savings.
It mostly originates form the believe that through the provision of
capital the poor can generate self-employment and that it can, thereby, assist
them to break out of their poverty.
Thus, it is believed that it will bring an uplift in their living
conditions.
Women’s
World Bank (1994) argues that channelling funds through existing savings clubs
and self-help groups is a key way to reach the poor, especially women. This strategy is an effective means for
micro-lenders to increase their geographical reach and number of clients, and
enables them to be more physical decentralised.
Well-organised
IFIs could at least help FFIs to screen, monitor and enforce financial
contracts (Aryeetey et al.,
1997). Otherwise, FFIs could use
approved informal operators as local representatives or “financial retailers”
by providing them with access to credit so that they could lend it onwards to
their clients or members. Hereby FFIs
benefit from IFIs' low transaction costs and closer contact with the target
groups. IFIs are required to open
accounts with FFIs, as part of the loan or on-lending arrangement and interlinking
process (Germidis, 1990). In addition,
some IFIs may serve as deposit-taking institutions or operate deposit
facilities independently or in collaboration with FFIs. It could be formalised through legal
authorisation (Nwanna, 1994).
Apart
from Innovative Credit-Retailing Schemes’ economic function, it has also social
goals. It stimulates communities to
develop managerial and organisational skills in the mobilisation of local
resources. These factors are essential
in order to assure financial sustainability (Aryeetey, 1992a).
It
is important that the traditional mode of operation of IFIs, and the factors or
structures that account for their popularity and acceptance by the rural
population, are kept intact. Outside interference, e.g. from the government or
development organisations, must therefore be minimal (Nwanna, 1994).
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The project “Linking Banks and Self-Help
Groups in The decisions on interest rates are taken by
consensus by group members. The margin
is usually used to strengthen the ability of the group to meet its members'
needs. It will either increase the
loanable funds of the group, or a part of it will be distributed among the
members, depending on the group's internal regulation (Koch & Soetjipto,
1993). |
In
the long-term, as the system deepens and the economy becomes more developed and
rural inhabitants more enlightened, one will expect the formal sector to take
over and to play a bigger role in rural finance. Otherwise, some IFIs, which act as financial
intermediaries with deposit-taking authority in the linked-system may grow and
graduate to formal institutions. This is
what happened in
If
collectors, or savings organisations, are backed by an overdraft facility, they
can expand lending activities to more clients.
FFIs could be ideal to fulfil this need.
In the case of savings collectors, who make advances and loans from their
own resources, the overdraft will only be needed to cover the end-of-month gap,
when collectors have to repay all their depositors. Such a linkage could be made more feasible by
the presence of an association that can act as an intermediary and provide
collateral to the bank. Such a body may
as well ease technical assistance to informal financiers, e.g. training in the
techniques of financial intermediation to its members (Aryeetey & Steel,
1996).
However,
clients attracted primarily by access to credit may be riskier borrowers than
existing clients whose primarily motive is saving. Furthermore, new clients are associated with
high information costs. This risk can be
manage by requiring a period of saving, e.g. six months, before a client can
receive credit. Yet, it has to be
supplemented with careful selection and daily monitoring. Through such a system, the individual credit
ceilings can be established in proportion to the client's daily average bank
balance. Success will depend on the
ability to judge the creditworthiness of its members and prevent them from
taking excessive risks. The initial
design of guidelines of such a system must therefore be conservative, but
fair. It can gradually be eased if
experience proofs such steps as appropriate (Aryeetey & Steel, 1996).
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In |
Moreover,
serious default rates can easily develop if collectors become too aggressive
about lending to new clients. It emphasises the need to install credit
ceilings. Depositors may suffer if
collectors are unable to meet their liabilities at the end of the month, due to
liquidity problems. A collector who
fails to pay will most probably immediate loose his depositor, because these
depositors usually have no more than a month's savings at stake (Aryeetey &
Steel, 1996).
|
GASCCS update the credit ceilings of its
members by adjusting it to their daily average bank balance. They can thereby warn those members who may
overextend lending. In some instances,
GASCCS helps collectors who have already lend beyond their ability. In such situations, GASCCS provides
emergency loans at a higher rate to enable these collectors to stay in
business, on the condition that they reduce lending (Aryeetey & Steel,
1996). |
Banks
can also be encouraged to offer informal deposit mobilisers, e.g. susu collectors, preferential interest
rates, which are higher than the rates of return on their other deposit or
investment opportunities. Banks thereby
encourage an institutional link between them and the informal sector. Thus, informal agents are given incentive to
use formal facilities and it would also confer recognition of their role in
savings mobilisation. Moreover, where
transactions at specific bank branches take unacceptable long, “special” clerks
or tellers could be assigned to frequent depositors, in order to reduce the
length of time they spend at bank counters (Aryeetey et al., 1997).
6.4.6 Formalising Informal Financial Institutions
Several
investigators propose to bring effective informal finance under the monitory
influence of regulatory agencies. A
well-known examples are registered moneylenders (Aryeetey & Steel, 1996)
and the Grameen Bank, which after several years of operating as programme
linked to existing banks (Meyer & Nagarajan, 1991).
Meyer
& Nagarajan (1991) propose that successful financial orientated NGOs and PVOs
(Private Voluntary Organisations) that serve marginal groups must eventually
evolve into formal financial institutions.
Ibe
(1990) did a survey on the informal finance in
6.4.7 Incorporating Semi-Formal Financial Institutions and Other Non-Financial Entities
One
of the greatest problems in the provision of credit to small households and
businesses is the high dossier and collection costs. These costs of small amounts are seldomly
worth the return on the transaction for both banker and client. The problem could be overcome by engaging
non-financial organisations such as NGOs, churches, co-operatives, and other
entities (traders, input suppliers, millers, processors of agricultural
produce, etc.) who are in close contact with these clients. These organisations or entities take the responsibility
of the administrative side of credit dossiers, which includes the initiation
and follow-up of these financial projects.
They have a comparative advantage in the sense that they are already
active in the area or sector where financial target clients are present
(Lambrechts & Debar, 1995). Aryeetey
et al. (1997) also stress that the
semi-formal agent could bridge the information gap between the formal and the
informal sectors. These organisations
may significantly aid the process of financial market integration.
Many semi-formal organisations are already active in the provision of
financial services to the poor and other retarded communities in several
ways. Most of them try to find a golden
midway between formal and informal financial procedures (Aryeetey, 1992a). However, they are often faced
with higher costs when they deal directly with small clients than when they
channel operations through informal operators (Aryeetey et al., 1997).
6.4.7.1 Co-operatives
Co-operatives
provide an alternative form of financial intermediation to small-scale savers
and borrowers that are based on the concept of self-help through mutual
solidarity. They are often seen as the
main avenues for linking informal and formal financial sectors, because they
provide financial facilities to small-scale farmers and because of their close
resemblance to the informal sector through mechanisms of mutual
solidarity. They can establish linkages
in several ways; from a simple assistance function, e.g. rediscounting facilities
with the central bank, to national centralisation of funds collected locally
(Germidis, 1990).
Aryeetey
et al. (1997) argue that in countries
where co-operatives are relatively well-developed, they could be the ideal
institutions to link the formal and informal financial sectors.
The
basis of their potential can be summarised in five points (Schmidt & Kropp,
1987).
(a)
They are easily accessible
to the target groups, due to their design and functions.
(b)
Their purpose is to give
support to all their members, thus it can be expected that they will correctly
identify and satisfy the needs of specific target groups.
(c)
Its self-help character can
supplement a discriminatory or incomplete financial system, especially when
interest rates are controlled by the government and set at a level below
presumed market rates. Such conditions
imply that borrowers will benefit at the expense of lenders and/or savers. In a co-operative, these gains will at least
be retained within the group.
(d)
Due to social relations, co-operatives
usually know members well who apply for credit.
Social control and pressure can enhance repayment of loans.
(e)
Within such a co-operative
group there is a combination of loans, savings and the provision of
inputs. This results in a reduction of costs
and risks of extended credit. Such a
comprehensive provision of services strengthens the economic position of the
borrower, and simultaneously reinforces incentives for repayment through
his/her dependency on the service of the co-operative.
Some
co-operative associations originate from indigenous co-operative behaviour,
which encompasses the mobilisation of labour, capital, land, food and other
resources. Chiryelano, chiperegani,
and chilimba in
Chipeta
& Mkandawire (1992a) report that the popularity of CSAs in
According
to Aryeetey (1992a), co-operatives have been less dominant in the mobilisation
of savings and the allocation of credit in areas where informal financial
institutions are abundant.
Many
co-operatives tend to reinforce existing dualistic local structures or even
aggravate class division rather than acting as vehicles of equitable change
(Adera, 1995). Cases where co-operative
credit union movements led to the concentration of loans in the hands of a few
beneficiaries are numerous. These beneficiaries
usually tend to be in the upper stratum of the regional society (Adera,
1995). Hartman (1985) also reports that
most co-operatives in
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Wa, Hamile and Jirapa Credit Unions are
situated in the northwest of |
Co-operatives
often become dependent on aid agencies or government money due to the paucity
of local financial savings. This
facilitates and promotes political interference. In the case of such a subsidy, the members'
own capital is not at stake. This
precludes the sense of joint ownership that could serve as a driving force
behind loan repayments. For example, in
However,
more successful stories of co-operatives have also been reported. Mrak (1989) points at
6.4.7.2 Non-Governmental Organisations
Historically,
many NGOs with credit programmes in the developing countries had a welfare
orientation with heavy external subsidies.
However, a growing number of NGOs are attempting to operate on a
commercial and financially sustainable basis, often using informal techniques
such as group-based lending. They might increasingly play a role in financial
intermediation for lower-income households and microenterprises (Aryeetey et al., 1997).
NGOs
could play a critical and important role in linking the two major financial
sectors. Most simply they could assist
FFI in screening potential clients and help clients to prepare their loan
application forms (Aryeetey et al.,
1997).
To
encourage target group members to save, NGOs could develop some form of saving
facility or arrangement in their procedures.
For example, members or beneficiaries may be required to open a savings
account with them as a prerequisite to receive assistance on other functions,
e.g. agriculture. Beside the advantages
of such arrangements to rural savers, it would enhance the viability and
self-sustainability of the particular NGO.
Hence, these additional resources will enhance NGOs’ independence. They could be used for on-lending purposes,
investments, or it could be deposited at a FFI.
Another option is that NGOs may require members to open a savings
account with FFIs as a prerequisite to be served by the NGO (Nwanna, 1994);
If
the objective is to strengthen IFIs in order to formalise them on the long run,
NGOs can act as confidence brokers in communities. They can be active in organisational
development, training, communication strengthening, and infrastructure and
institution building (Nwanna, 1994);
NGOs
can promote and organise self-help groups, e.g. around specific production
activities, joint farming groups, or pure savings and credit groups. These groups can then be used by banks to
channel funds to individuals, and thereby link the flexibility and
responsiveness of the informal credit system with the funding base and
administrative ability of formal credit institutions. Thus, NGOs can assist these groups so that
they can do the assessment of credit needs, appraisal, disbursal, supervision,
and collection of funds themselves. This
is the strategy that NABARD (National Bank for Agriculture and Rural
Development) uses in
In
crisis-threatening situations the provision of financial services could at best
be part of a strategy to strengthen local control of resources and consolidate
cohesion. If communities are recovering
from a crisis, they will basically require rehabilitation of services,
infrastructure and a supportive and flexible environment (Abugre, 1994).
ACORD
(Agency for Co-operation in Research and Development), a consortium of European
and Canadian NGOs active in 14 African countries, gives priority to local
institution building. It has a leverage
in promoting locally controlled sustainability programmes, by providing a
conductive environment for the promotion of reciprocal systems, including informal
finance. Thus, NGOs, especially those
who are well established and active for at least a few years, can help to
create the right environment to activate local people to participate in their
own development. NGOs can provide
targeted support and help these groups to become stronger, or to make a
transformation, if desired. For example,
to change rotating savings and credit systems into non-rotating systems. However, inappropriate meddling can be very
destructive (Abugre, 1994).
Not
all authors are very enthusiastic about the role of NGOs in providing financial
services. Schmidt & Zeitinger (1995)
did an investigation on credit-granting NGOs and found that all too many NGOs,
which had taken up lending activities, experienced serious problems. At the end of the 1980s, donor agencies did not
look further than the fact that NGOs are capable of reaching the poor, the
major point on which development banks failed.
There was little concern about whether they were also capable of doing
more than simply distributing funds entrusted to them by external entities,
e.g. their self-sustainability.
Therefore, many NGOs still battle to recover funds they disbursed as
loans and can not survive without continuous subsidisation from donors. Many of them defend their aim from a
social-welfare standpoint. They feel
that it is the duty of national governments or the international donor
community to compensate them for their work.
Recipients are seen as too poor to be expected to pay for services
provided to them. This is why many NGOs
did not make cost-coverage one of their goals.
Nevertheless, most of them proved to be good providers of socially
orientated financial services, particularly because their work is voluntary and
not for profit. Larson et al. (1994) report the same problem in
The
standpoint of De Jong & Kleiterp (1991), on what they call “integrated”
NGOs, corresponds strongly with the latter description. Several NGOs, who aim at
consciousness-raising and organisation of target groups, have their own credit
programmes. However, it seems if many of
them suffer from a lack of administration, which results in a lack of financial
settlement in transactions. They often
run on high costs, despite of the fact that a lot of work are done by
volunteers. Hence, they also suffer from
a low level of professionalism and management experience. Due to low collection efficiency and poor
assessment of risks, the number of arrears is high. In the long run, these credit projects hardly
take root and often fail.
Some
credit-granting NGOs make use of the, so called, “minimalist approach”. They use cost-covering interest rates,
justifying it as the only way to ensure access for rural clients to permanent
credit supply. One of their major
objectives is to keep costs as low as possible.
After an investigation done on seven of this kind of NGOs in
However,
Schmidt & Zeitinger (1995) admit that their investigation dealt only with
the year 1991, a year in which many of the NGOs were expanding rapidly, and
therefore costs can be expected to be higher than during periods of average
growth. At that time no other similar
investigations have been carried out on other financial organisations who focus
on small entrepreneurs and low-income households as target groups, and which
grant loans of matching size.
Another
recent type of NGO is associated with the private sector. They base their operations on the Grameen
Bank model by making use of joint-liability in small homogenous groups. Their programme is accompanied by intensive
training, which they provide to participants.
Judging on the number of participants and collection rates, success
stories are more abundant with this kind of outreach activities (De Jong &
Kleiterp, 1991).
|
Kenya Rural
Enterprise Program (K-REP) can be regarded as a successful intermediary NGO,
which, through its Chikola scheme,
lends directly to Chikola organisations
or existing indigenous rotating saving and credit groups (Women’s World Bank,
1994) (for a more comprehensive description, see Appendix IV). Since 1989, FWWB (Friends of Women’s World Banking) lends to
member NGOs in |
Nwanna
(1994) argues that despite many failures in the past, NGOs can be very useful
as agents to reach and service the poor because they are interested in the
rural sector, and many have successful methods, and the ability, to reach them.
6.4.7.3 Non-financial Agents
As
mentioned earlier, input suppliers, merchants, traders, millers and processors
of agricultural commodities are often important sources of credit for the
poor. Through their better information
links with these people than FFIs, they can be ideal to channel formal credit
to these borrowers (Esguerra, 1987).
|
A successful scheme is found in the |
If
non-financial agents, e.g. traders, are used to reach certain target groups
with financial services, the financial institution, e.g. the bank or donor, has
to be responsible for the training of these agents and their personal to carry
out their new tasks. To assure that
loans are only passed on to creditworthy borrowers, the non-financial entity
usually has to set a guarantee to cover (or partially cover) defaults. For example, an amount agreed upon could be
deposited at the FFI by the trader, which he receives back if there is no
default. The trader receives also
payment for his intermediary service, e.g. from a donor, the FFI, or the
government (Lambrechts & Debar, 1995).
6.4.8 Guarantees
Guarantees
are a form of collateral substitute and thus a mechanism to conquer the problem
of insufficient collateral. It offsets
all, or a part, of default risk and thereby helps lenders to overcome their
unwillingness to lend to clients that are regarded as more risky (Llanto,
1990). Guarantees can be very beneficial in making credit available to target
groups in the short term, while it can improve the effectiveness of banking
systems in the middle term. It can help
to enhance the capital flow between FFIs and target groups (Von Stockhausen,
1983). However, the success of a
guarantee programme greatly depends on the circumstances in which it is used
(Allahar & Brown, 1995).
Collective
guarantees are a popular means to promote loan provision to informal groups
with joint liability. A lot of variations
on this theme exist. First, the group
may, or may not, have liability for loans received. If they do, any payments to compensate
default would be made entirely, or at least partially, by the group. If they do not, it implies that the group is
not liable for the obligations of other members that fail to repay their
loans. The latter system presupposes
strong cohesive social ties among the individual group members whereby social
actions can be used by the group to punish members that default. In this case another party, a guarantor
organisation, covers default risk (Von Stockhausen, 1983).
In
the case of a guarantor organisation, there are also several
possibilities. Usually, it implies a
third party in the loan transaction.
Otherwise, the lender might offer guarantee services, or the group might
accumulate a fund to cover non-repayments.
Moreover, the guarantor organisation usually charges for the
service. If this fee is passed on to the
borrower group, group members might put an initial amount into a guarantee fund
before they receive any loan funds (Mody & Patro, 1996). In several cases the government, a donor, or
the guarantor organisation itself, subsides it to support the purpose of the
fund (Von Stockhausen, 1983).
Collective
guarantees can provide two types of security.
First, institutional lender-borrower security reduces risk of both
borrower and lender. For example,
government price and purchase guarantees, life insurance policies for
borrowers, and crop and livestock insurance. The intention is to increase credit
availability and the likelihood that borrowers will use it, since some of their
risk is now covered. Secondly,
institutional lender security mainly reduces lenders’ risk in order to convince
them to extend their lending operations.
Most types of credit guarantee fall into this category (Von Stockhausen,
1983).
Allahar
& Brown (1995) argue that a loan guarantee makes only sense when the
financial institution that has to extend its credit services, possesses sufficient
liquid funds, but is reluctant to grant loans to the target group. Guarantees will not be very helpful to
convince lenders to provide credit to costly or risky target groups if the
financial system is short of funds.
Suppose
that a competitive market prevails and that the target group already receives
some credit. During periods of high
liquidity, it can be expected that lenders will expand this group of borrowers,
although they might increase interest rates to cover the higher risk and
administration costs that are involved.
It implies that the guarantee would merely serve to encourage lenders to
insure only their borderline cases.
Thus, it results in adverse selection.
On the contrary, if there is a shortage of liquid funds, it might be
expected that borderline cases would be reduced in favour of lower-risk clients
who do not need the support of guarantees (Allahar & Brown, 1995).
Guarantees with the purpose to expand the number of borrowers, often
result in higher lending costs for all borrowers. Adams (1997, personal notification*)
is concerned about the fairness of charging all borrower-members in the group
more for their loans to cover loan recovery risks that result from a few new
borrowers.
Some
considerations can be pointed out regarding the implementation of loan
guarantees.
·
The guarantor must possess
credibility. Hereby the guarantor
attains the confidence of lenders.
Credibility could be achieved through (i) explicit and clear procedures
regarding coverage and claims; (ii) prompt payments on claims; and therefore
(iii) implement an agency that has direct control on payment funds, rather than
the Central Bank or an other central state department/agency (Allahar &
Brown, 1995).
·
Even the best run loan
guarantee schemes increase the transaction costs, especially if third parties
are involved (Adams, 1997, personal notification*). It might be argued that a guarantee reduces
risks, and therefore interest rates charged to ultimate borrowers should be
lower than without the guarantee. However,
Allahar & Brown (1995) stress that lenders must have the freedom to charge
interest rates regarded as suitable for each loan, in order to cover their
transaction costs.
·
All parties of the agreement
must have a reasonable exposure to risk.
This is to avoid massive defaults and extensive claims (Allahar &
Brown, 1995; Lambrechts & Debar, 1995).
Once a guarantee is provided, lenders often have little incentive to
monitor the performance of the group. Therefore it is recommendable to employ
partial guarantees whereby the guarantee covers only part of the
transaction. Through this risk-sharing
strategy, the lender has incentive to monitor borrowers’ activities (Mody &
Patro, 1996). Thus, an appropriate loan
guarantee helps to complete collateral requirements, rather than to substitute
it. A common feature in bad credit
guarantee systems is the provision of 100 per cent guarantees (Allahar &
Brown, 1995).
·
Assessing the strengths and
weaknesses of participating lenders deserves adequate attention, especially
regarding informal or semi-formal lenders, and the credit technology and
criteria that they use. For example,
some credit-providing NGOs might have a welfare approach towards lending and
therefore they are not rigid enough to enforce loan repayment. This was the experience of
·
The guarantee should be
accompanied by a set of other developmental services that improve the
borrowers’ ability to repay. It refers
to training, information, and technical assistance (Allahar & Brown,
1995). Von Stockhausen (1983) also
stresses that guarantee programmes should be supplemented with the promotion of
savings mobilisation in order to create sustainability.
·
Entities that provide guarantees,
e.g. governments, formal banks, and donors, must give sufficient attention to
the accounting and administration side of guarantees. This specially relates to the fact that
contingent liabilities do not demand immediate payment. Payments resulting from default can have
severe budgetary consequences if they are not adequately accounted for (Mody
& Patro, 1996).
·
A close working relationship
between lender and guarantor could be very advantageous. Liability towards one
another is strengthened and better understanding of the other party’s behaviour
is created. It provides opportunities to
exchange ideas, information and experiences (Allahar & Brown, 1995). Nevertheless, all agreements between
guarantor and lenders must be treated in a professional way in the form of
contracts (Lambrechts & Debar, 1995).
6.5 Thoughts on Achieving Effective Linkages
Reducing
financial dualism in LDCs assumes a multidimensional character. The government in collaboration with private
agents should develop a dynamic programme that implies a far-reaching
modification of economic and social behaviour patterns. In general, such a programme should be based
on the adaptation of appropriate structures and procedures. All decisions and activities must be rooted
in the specific features of each country (Germidis, 1990).
Development
models may not be directly copied from one country to another. It is totally wrong to assume that a policy,
which has been successful in one country, will necessarily produce the same
effects in another country at another point of time. However, exchanging views and experiences can
be very useful in the search for the appropriate set of policies that should be
implemented in a specific country (Germidis, 1990). Abugre (1994) also warns that the replication
of successful models and programmes, developed under different environments,
e.g. the Grameen Bank model, into untested ground, will require great caution
and testing. Social values play a very
important and decisive role (Yaron, 1994).
Moreover, the potential of financial integration is much stronger in
some countries than in others (Aryeetey et
al., 1997).
Likewise,
a linked relationship formed between a formal institution and, e.g. a self-help
group, is usually very specific and only applicable to that particular
group. It implies that every self-help
group has to design its own link with, e.g. the bank. Such a process may be long, expensive and
bothersome for the entire community of self-help groups to develop (Llanto,
1990).
According
to De Jong & Kleiterp (1991), there is an instinctive distrust between the
formal and informal sector. It becomes
apparent through several prejudices and misunderstandings that stand in the way
of further initiatives. The most
appropriate means to change this situation is dialogue.
Policies,
regardless if they come from government, FFIs, or donors, should deal with
problems facing informal lenders. It
especially relates to transaction costs, implying that poor infrastructure and
the absence of market information should be addressed. For example, telecommunications and cheap,
accessible forms of electricity should be supported. Problems facing small borrowers should
receive adequate attention (Bagachwa, 1995).
A
financial intermediary, e.g. a NGO, should separate the administration of
financial and non-financial services in order to measure financial progress
precisely. This is necessary to
determine progress in the level of financial self-sustainability (Pederson
& Kiiru, 1996).
An
effective link implies that certain principles have to be strictly maintained,
otherwise the innovation might loose its force of impact. For example, Koch & Soetjipto (1993)
report that the principle of saving as prerequisite for a loan is sometimes
distorted. In
6.5.1 The Role of the Government
The
number of LDC governments that has already formulated an explicit policy to
reduce financial dualism is limited.
Attitudes range from near indifference to awareness of the problem, up
to an active effort for financial innovation and financial deepening (Germidis,
1990).
One
of the greatest priorities that a government should have regarding the
financial system is to create and maintain a stable macro-economic environment
(Aryeetey, 1997; Debar & Van Lint, 1995).
Peace, stability and confidence influence the types, sizes and use of
informal and parallel financial markets (Larson et al., 1994).
It
is important to encourage development of insurance and social security
structures in LDCs, e.g. pension schemes.
The co-ordination of such a task lies primarily in the hands of the
government. If the savings and credit
functions of the informal sector are eventually institutionalised, alternative
options must be open to ensure that its social function continue to be
fulfilled. Therefore, a social security
system or insurance sector has to be developed.
Such institutions do exist in several LDCs, but they tend to be
inefficient. It is believed that the key
to success lies in the adoption of a more decentralised structure, with a large
degree of independence granted to local bodies.
Furthermore, methods used must be based on those traditionally used by
the specific community (Germidis, 1990).
Due
to the complementation between the formal and informal sectors, the
government’s monetary policy would not only affect the formal sector of the
economy, but would have a far-reaching impact on the informal sector too. Therefore, if monetary policy restrict the
credit availability in the formal sector, supply of credit in the informal
sector often drops as well. For example,
a restrictive credit policy in the formal sector can result in a excess demand
for funds, which spill over to the informal sector, and thereby costs of funds
in the informal sector increase also (Aryeetey, 1997; Germidis, 1990).
Interest
rate policy should contribute to positive real interest rates. The gap between borrowing and lending
interest rates should also be reduced.
It must go hand in hand with deflationary measures to protect savings
against monetary depreciation (Germidis, 1990).
Debar & Van Lint (1995) emphasise the need that governments have to
control inflation in order to stimulate a satisfying functioning of financial
institutions. The value of funds can
hardly be guaranteed if the level of inflation is high and/or fluctuating. Exchange rates should be placed in a golden
midway between fixed rates and liberalised capital movements (Germidis,
1990).
In
general, national policies have to enhance public confidence in the financial
system. This implies that they should
include relative stable prices of funds, because high levels of inflation often
result in negative real interest rates on deposits. Another important measure to raise confidence
is to include deposit insurance (Gonzalez-Vega, 1989).
As
financial programmes in developing countries grow, governments should play an
appropriate regulatory role. For example, they should protect savers, while
guarantees regarding the credit policy of banks have to be subjected to government
regulation in order to assure that banks have enough of their own capital, and
that their credit portfolio is adequately diversified. However, it must be avoided that commercial
banks excessively influence or dominate the setting and implementation of these
regulation policies. In the past,
governments tended to focus mainly on the modern formal financial sector. Sufficient attention should be given to
smaller and informal financial sectors as well.
Donors could play an important advisory role to prevent that government
policy would favour the modern financial system (Debar & Van Lint,
1995). Given the uneasiness with which
formal institutions view informal financial operators, it is important that the
government clearly states its support for the informal sector (Boehmer et al., 1994).
Regulation
and supervision of informal financial institutions could be made the
responsibility of a body that understands the procedures of informal finance
and its operational goals, rather than solely by representatives from the
government and the central bank. For
instance, semi-autonomous regulatory agencies outside the banking system could
be established, which are directed by representatives of each type of
informal/semi-informal institution as well as from the government and the
central bank (Aryeetey et al., 1997).
Lack
of funds is not always the constraining factor in RFMs. Many individuals and groups have insufficient
skills to manage funds and ensure repayments.
In these cases, the state could play an active role by allocating
resources for upgrading the creditworthiness of individuals and informal
self-help groups through extension and training on finance, project
identification, project management and other relevant aspects (Llanto, 1990).
Many
governmental departments and agencies are in direct contact with indigenous
organisations at grassroot level.
Through these close contacts government representatives obtain valuable
information about the strengths and the weaknesses of a lot of these organisations. Thus, it is possible that formal financial
institutions can get a good idea of the bankability of specific groups and its
members from governmental departments and agencies. A system of accreditation can be developed by
the government where specific groups are conferred some "status"
which will interest formal institutions.
Hereby information of a public character is created of which the
consumers are the formal financial sector and the producer is the state
(Llanto, 1990).
Perfect
information does not exist. Rural loans
always bear a risk element to some extent, even in informal arrangements. Governments can enter in risk-sharing schemes
and cover the major part of default risk.
These guarantees can at the same time substitute collaterals, often
required by banks (Llanto, 1990).
However,
success with a linking scheme will depend on the extent to which there is
limited interference by the government with the IFI’s traditional mode of
operation. In other words, government
intervention should not harm factors or structures that account for the
popularity and acceptance of an informal arrangement within the rural
population (Nwanna, 1994).
|
In 1986, the
Philippine government decided to scrap the major agricultural credit schemes
and pool the loanable funds into the CALF (Comprehensive Agricultural Loan
Fund). CALF was used to guarantee
rural-based loans. Due to problems of
moral hazard and wrong incentives on the part of banks, it does not provide
full guarantee cover. Risks are
shared, but the government carries the major part, i.e. 85 percent. After payment of a
premium, any farmer that receives a bank loan can get a guarantee cover from
the CALF. The premium is the bank's 15
percent share part of default risk. At
the end of June 1989, the total amount of loans covered was equivalent to
12.7 million Typhoons, drought
and pest infestation seemed to be the main causes for repayment default. This guarantee
scheme encourages the banks to lend to small farmers who turned out to be
good clients (Llanto, 1990). |
6.5.2 The Role of Formal Financial Institutions
The
structure of FFIs is transplanted from outside, i.e. western countries, and
therefore it does not relate to local indigenous institutions, which are born
out of the culture and traditional values of local people. Formal institutions need to be adapted to the
local culture or context, in order to be accepted and respected by people which
they have to serve (Dia, 1996).
FFIs
should avoid over-specialisation and rather aim to be multipurpose financial
institutions. It is important that
savings and credit functions should be integrated. As a result different banks would have a more
or less common range of activities and thereby enhance inter-institutional
competition (Germidis, 1990). Esguerra
(1987) argues that it is desirable to have a variety of mechanisms for credit
delivery to the rural sector.
Under
a "link-up" concept, a tie-up or institutional link is developed
either through the initiative of the informal group, or through the formal
institution, e.g. bank. Such a link is
much more than a passive and one-sided deposit-taking relationship of the
bank. Instead, it is an active and
symbiotic economic and financial interaction between two parties. A wide range of contracting possibilities is
available through the link (Llanto, 1990).
FFI should see IFIs as partners,
and not as beneficiaries.
Banks
could reach out to informal financial operators and institutions by widening
their policies and by making special arrangements for specific informal
practices. For example, Aryeetey et al., (1997) suggest that susu collectors in
As
in the case with the role of the government, FFIs and other key entities must
avoid to interfere with the traditional functions of informal structures. It usually happens unintentionally, and as a
side-effect of well-meant innovations.
Programme designers must keep a holistic insight in the local
situation. According to Nagarajan et al. (1994), the net effect of FFI’s
interference as financial intermediaries in traditional structures is related
to two factors: (1) the primary reasons for the existence of the traditional
structure, and (2) the substitutability of functions provided by the
traditional structure and FFIs.
|
Recently, some
international NGOs started to offer financial services in The Gambia, due to
the inefficiency of local formal banks.
Their policy is to channel outside loanable funds through the existing
kafos structure, the indigenous
informal groups providing mutual help.
This shifts two types of costs from the intermediaries to the
borrowers: (1) borrower screening costs; and (2) monitoring costs. By doing this, the NGOs hoped to reduce
their transaction costs and repayment problems. However, the traditional kafos provide multiple services,
including insurance, financial intermediation, labour exchange and social
services. This is in contrast with the
NGOs that offer only a single service.
The result was that the presence of the NGOs that used the kafos as channels of their loanable
funds only lead to a shift in the relative importance within and across the
functions performed by the traditional
kafos. The provision of financial
services may partly shift from the traditional kafos to NGOs, but the traditional kafos remain active to fulfil other village needs and
demands. However, the activities of
the NGOs deteriorated the traditional insurance mechanism of the kafos, which is indispensable for the
marginal members. This was due to a
reorientation of the traditional functions of the kafos. The coexistence of
both NGOs and kafos could lead to
an institutional dualism in a single village.
The NGOs prove to be incomplete substitutes for the traditional
structure. They do not provide the
multiple services demanded by villagers (Nagarajan et al., 1994). |
6.5.3 The Role of the Informal Financial Sector
In
the first place, the informal sector should overcome their mistrust of formal
financial institutions. Informal
operators should be encouraged to seek contacts with formal institutions (Boehmer,
1995).
According
to Germidis (1990), the challenge is to organise
the informal sector through closer linkages with the formal sector operators in
providing better and increased financial services to the community by the
availability of additional funds and guidance.
It is important that the characteristics of the informal sector that
constitute its strength are preserved: flexibility, rapidity, transparency of
procedures, personal relationships, low transaction costs. It is a fine line to tread. Therefore, local participation is extremely
important in the design, implementation and evaluation of financial projects
and programmes. Local people know best
what the reasons are for the popularity of their informal financial
arrangements.
Nevertheless,
informal institutions, need to adapt to the changing outside world and
challenges (Dia, 1996). Intermediaries
of the informal sector must be convinced to participate in training programmes,
and to make use of specialised supportive services that provide information on
the supply of production factors or marketing techniques. It will allow them to manage the collection
and allocation of deposits more efficiently.
Existing informal groups, without financial activities, can be convinced
to facilitate savings and credit activities, if they are seen as capable of
handling it. Otherwise, appropriate
training can be provided through the government or other aid organisations
(Llanto, 1990).
Aryeetey
et al. (1997) suggest that informal
financial operators form associations, which play a self-regulatory role by
accrediting their members. Borrowers and
lenders, as well as FFIs can then be encouraged to deal with accredited
agents. Such a body may be better
equipped in its regulatory function than the central bank. These associations can also enhance
interlinkage by developing relationships with banks and non-financial
intermediaries.
6.5.4 Role of Foreign Aid
The task of financial
developmental organisations and donors in the North is more than just providing
financial capital (see Appendix III).
The danger of excess credit provision has already been emphasised. The new
intervention mechanism is based on the idea of strengthening existing financial
systems in the South. Thus, donors
should play a more indirect role in improving financial access for retarded
rural populations in relation with their role during the last few decades
(Lambrechts & Debar, 1995).
Massive
infusion of external funds into the informal financial sector may undermine the
basic foundation of its success.
Potential benefits of informal financial intermediaries as conduits of
donor funds should be thoroughly gauged against the possible damage that
linkages can entail to the roots of IFIs (Cuevas, 1989).
|
Credit unions in
many Latin American countries were first organised to operate with their own
savings in the 1950s and 1960s. In
these times many were healthy, self-sustaining institutions. However, in the 1970s, many began to lend
borrowed funds. This changed their
operations from being saver-dominated to being borrower-dominated. Savings mobilisation was ignored, interest
rates were not properly adjusted for costs and inflation, and loan recovery
declined. There is not yet any clear
understanding about the appropriate incentive structure to use to prevent
external funds from harming these groups (Meyer & Nagarajan, 1991). |
Abugre
(1994) argues that it is better not to provide credit at all, than to provide
excessive credit. Subsidies could rather
support institution-building, e.g. by financial infrastructure development at
grassroot or village level, which is necessary in most LDCs. However, sponsors must not expect that these
investments will pay off immediately (Seibel, 1994).
Short-
and medium-term subsidies are most often necessary to make credit more
accessible to the poor, small farmers and other micro-enterprises. The benefits of these subsidies should reach
the right sectors, i.e. retarded groups, while it may not disturb the market in
such a way that the negative effects are greater than the positive
effects. For example, subsidised credit
programmes in the past had a negative effect on production efficiency and most
loans ended in the hands of large farmers (De Jong & Kleiterp, 1991).
Organisations in the North can assist in
strengthening and widening existing financial institutions’ foundations, e.g.
through supporting technical, organisational and other developmental
aspects. Their aim should be to develop
competition in financial markets and to strive for healthy credit
administration under honest market conditions.
Interventions should shift the balance of power towards those demanding
financial services. They can have a
correcting function, and see that government regulation do not favour the
modern financial sector (De Jong & Kleiterp, 1991; Lambrechts & Debar,
1995). Donors can encourage savings
mobilisation and management, and support the creation of a macro environment
that stimulates informal finance to flourish (Abugre, 1994).
Due to the uncertain prospects in most LDCs,
savings tend to be of short duration.
Therefore, resources for short-term credit could most probably be found
locally. If foreign agencies decide that
it is suitable to provide financial capital, it might be appropriate to focus
on long-term credit (De Jong & Kleiterp, 1991).
Although one should be careful with the
formulation of intervention programmes, programmes with an experimenting
character should not be avoided.
Nevertheless, professionalism is always required (Lambrechts &
Debar, 1995). Donors and other
interventionists must be prepared to take risks (Debar & Van Lint, 1995).
Donors should adopt a pragmatic and
commercial approach to support financial projects and programmes. Financial discipline, the prospect of
achieving long-term continuity, viable institutions, and self-sufficiency of
beneficiaries should be core elements right through the implementation of any
financial programme, no matter whether donors are driven by economic
development principles, social motivations, or a mix of both. Long-term dependence should be avoided by all
means. Donors should state it clearly to
beneficiaries that subsidies and other assistance are on a temporary base (De
Jong & Kleiterp, 1991).
Donors should strive at flexible
funding. The intention is to support a developing financial
system. The specific situation has to
determine if subsidies are necessary, and if so, the size and the duration of
it (Debar & Van Lint, 1995). It relates
to a more commercial approach that donors should take in identifying and
funding initiatives. Programmes that put
high priority on “full-cost pricing” in order to assure viability should be
supported without losing eyesight on reaching the critical mass of clients (De
Jong & Kleiterp, 1991).
It is recommended to separate operating
support cost and funding of loan capital from each other and tie each to its
own performance indicators. A realistic
time-frame, based on experience of similar programmes and filled in by
realistic targets, should be established between donor and recipient. Indicators and level of funding, or otherwise
the discontinuation of it, should be based on audited annual statements. Moreover, if a five-year or more commitment
is made, donors can enhance institutional stability by subjecting recipients to
certain performance standards (De Jong & Kleiterp, 1991).
Foreign aid has the choice to invest in a
wide range of financial programmes for the poor. Different donors and development
organisations must avoid competing with each other. There has to be consultation between them in
order to assure they co-operate (Debar & Van Lint, 1995). If there is a commitment to learn from
experiences, dissemination of “lessons learned” between different donors,
development agencies and governments could be of high value (De Jong &
Kleiterp, 1991).
Appendix V gives some information on the
background, objectives, and views of a few European donors. Alterfin, a
CONCLUSIONS
Developing
countries are marked by an apparent dualistic financial structure due to a
co-existence of formal and informal financial services. Dualism implies that there is a skewed
balance in the accumulation and distribution process of resources, which hinder
economic growth. It hinders the
implementation of consistent economic, monetary, and financial policy.
Formal
finance institutions are foreign concepts, transferred from abroad. They prefer to deal with the public sector,
large-scale enterprises and upper-income households. Financial transactions in rural areas imply a
high number of small amounts, which formal institutions avoid because of the
fixed cost character of finance. IFIs
usually channel savings to urban investments.
Infrastructure is most often under-developed and bank branches limited
in rural areas. Weather and other
environmental circumstances in most LDCs place small farmers in a high-risk
category. FFIs find it important to
exert control over the use of loans they have granted so that it is used
productively, preferably, in long-term investment projects.
On
the other hand, rural habitants find formal financial institutions
inconvenient. Far travel distances, long
queues, cumbersome procedures, long waiting periods before loans are granted,
rigid collateral requirements, a lack of consumption credit and several other
factors steer many away from banks.
Informal
finance is a heterogeneous myriad of financial arrangements of which many root
in the culture and traditions of local communities. It is shaped by demand, and local and
macro-economic circumstances. Informal
finance implies more than just satisfying current financial needs. It often relates to factors such as
“reciprocity” and “togetherness” resulting from personal ties. The problem of information asymmetry is
significantly reduced, because informal financial operators and their clients
know each other personally. Thus,
screening of clients is simple, and adverse selection and moral hazard are less
prominent in these transactions. Due to
personal ties, social pressure could be used as collateral substitute. Informal finance is more accessible through
reasons like simple rules and regulations, quick request processing and it is
near at hand. It is flexible regarding
repayment period and loan use, and it makes use of collateral substitutes such
as loss of future access to credit in case of repayment failure. Due to these factors and low overhead costs,
informal finance’s transaction costs are low for both client and supplier.
Thus,
it seems unlikely that formal finance could replace informal finance. However, there is a high level of
segmentation within the informal financial sector with limited fund flow
between segments. It is often hard for
outsiders to be accepted in these arrangements.
Informal finance is not subjected to formal regulation and legislation,
which make exploitation hard to control.
Demand for large, long-term financial transactions can seldom be met,
while it is also seldom capable to handle co-variant risk situations. It makes informal finance unsuitable to lead
financial development.
Formal
finance must engage the total rural population in their activities due to two
main reasons: (a) there is a high demand for financial services in rural areas,
which will increase as development improves; and (b) there is a latent savings
potential.
Capacities
such as global telecommunication networks, unconstrained handling of large
amounts, appropriate regulation, control and legislation, and combining
multiple services “under one roof”, make formal institutions indispensable in
the development process.
Linking
formal and informal financial services might imply that both parties benefit
from each other’s comparative advantages.
However, any linkage system should be foregone by a thorough
investigation regarding the prevailing relationship between the two
parties. Competition indicates that the
formal sector could reach more clients if it improves its terms. Complementation suggests potential for a beneficial
link. Moreover, if a link is considered,
all factors that contribute to the success of the informal party should be
assessed in order to assure that they are not harmed by the consequences of the
link.
Several
options, strategies, experiences and suggestions for a linked system have been
discussed in the previous chapter. As a
start, countries could strengthen existing linkages. The “mimicry” option, group lending, and
tying deposits and loans have already proven successful in many cases. Formalising informal institutions should
usually be carried out over an extended period of time. Incorporating traditional informal
institutions to intermediate formal funds should be considered with great
caution, so that it not harm socially fine-balanced structures, but should not
be excluded. Semi-formal institutions
have great potential in a linked-system, because they already try to find a
golden midway between formal and informal financial services. In the case of loan guarantees, consideration
should be given to long-term sustainability, while 100 % guarantees should be
avoided. In general, local participation
is indispensable when a system is designed.
Successful
systems may not be copied from one place to another without adapting them to
local conditions. Policies should be
more directed to the alleviation of constraints that face informal
lenders. Especially governments should
keep in mind that their policies do not only affect the formal sector of the
economy, but also have a far-reaching impact on the informal sector. Real interest rates should be positive. Stability and peace are other important
points on the government’s agenda.
Formal
financial institutions should see informal financial institutions as partners, and not as beneficiaries. Informal institutions
must be adaptable and open to learn new practices. Foreign aid must avoid extending excessive
credit and rather focus on local institution strengthening e.g. by
supporting technical, organisational and other developmental aspects. Developing agencies must learn from each
other. They must not be scared to
experiment, but should stay professional at all times.
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APPENDIXES
Appendix I. Standard Household Model for Consumption Credit
Zeller
et al. (1994) explain the demand for
consumption credit on the basis of a standard household model. In this model, the utility from consumption
and leisure is maximised over two periods:
Max U = U(C1, C2, L1, L2) [1],
where U = Utility;
C
= Consumption;
and
L = Leisure.
The
household is considered to act as a single decision maker, its utility function
is twice-continuously differentiable, increasing and absolute concave in its
arguments. The issue of time preference
and interest rates as well as the possibility of disinvestment of assets to
smoothen consumption is not taken into account.
Utility U can be separated over distinctive periods:
Max
U = U1(C1,
L1) + U2(C2,
L2) [2].
The
households face a time constraint in each period i shown by,
Ti
= Wi + Li [3],
where Ti = total time available in period I;
Wi = the sum of time devoted
to self-employment in home and farm production and to wage employment in the
labour market;
and
Li = leisure time.
Income
is generated through on-farm activities and through wage employment. If a perfect labour market exists, the
household will, in theory, allocate its labour in a way that equates marginal
returns of self-employment and opportunity costs of leisure to the wage
rate. Income Y in period i can thus be
expressed as a function of wage rate 1 and total work time W: Yi = Yi(Wi, Ii).
The
household deals with a budget constraint B in each period, but can smoothen
total household income between period 1 and 2 in the amount of D by either (1)
borrowing (D>0) in the first period and paying this loan back in the second
period, or (2) by saving (D<0) in the first period and consuming in the
second period. Thus:
B1
= Y1(W1,
I1) + D [4],
B2
= Y2(W2,
I2) - D [5].
Assume
that the household has access to a non-binding credit access and that they are
submitted to non-stochastic, but different periodic incomes due to fluctuations
in wage rates. This means that the
optimal borrowing or saving in period 1 is:
D
= (Y2 - Y1)
/ 2 [6].
With
a fluctuating income and perfect access to financial markets, the household can
smoothen its consumption by adjusting disposable income through credit. In short, this simple model illustrates the
potential of credit access to improve the surviving strategies of households
through optimal consumption allocation over time. It reflects the economic demand for
consumption smoothing by financial services.
Households are prepared to pay a certain price for it. In fact, “consumption” loans, such as for
education, health and even food, are highly productive, because they preserve
and enhance labour productivity (Zeller et
al., 1994).
Appendix II.
Savings
1. Introduction
Savings
mobilisation is often referred to as the forgotten half of rural finance. The role of financial intermediaries is not
only to lend, but also to provide deposit facilities for savers (Adams &
Vogel, 1990).
The
simplest definition of saving can be stated as the reserving of a person’s
income or wealth for future consumption (Lee, 1983). This ‘reserving’ implies a protection of
funds against several other appeals including demands of other family members,
as well as their own extravagance and immediate consumption (Coetzee, 1992).
2. Reasons to Mobilise Voluntary Rural Savings
Numerous
reasons that justify and promote savings mobilisation are found in literature. Those that are most important can be briefly
summarised in a few points.
·
Savings encourage the
economic wealth of a country. Adequate
levels of savings guarantee sufficient financing for capital accumulation as
well as avoiding an excess of investment over savings. The latter may create inflationary pressures
or cause disequilibria in the balance of payments. In developing countries, where extensive
capital market imperfections and liquidity constraints on firms and households
are abundant, increasing private savings may be essential to enhance investment
(Schmidt-Hebbel et al., 1996).
·
It improves overall
performance and viability of financial institutions in the long term (Coetzee,
1992; Spio, 1994) and they are strengthened in their role in development (
|
In the 1960s, a
network of rural co-operatives were brought about in |
Repayment
performance may be better on loans made by funds mobilised through savings for
several reasons. This includes the fact
that borrowers are more likely to repay in time and that lenders take more responsibility
for loans, especially if resources are tapped from people in their community
rather that from a distant international donor or governmental agency. In these circumstances lenders also tend to
take greater responsibility for loan recovery.
In addition, financial institutions are able to develop loan programmes
that conform to their own lending standards and are more in touch with the
needs of local farmers and communities, because credit is not rationed (Adams
& Vogel, 1990).
·
Savings improve resource
allocation. Effective deposit
mobilisation by financial institutions prevent that resources are allocated to
low-return investments, on the condition that real interest rates are positive
(Adams & Vogel, 1990). According to
A.D.I. (1991), RFMs feel more responsible for lending funds that have been
withdrawn from local deposits, rather than from some far off donor. It motivates them more to improve their
efficiency and therefore they allocate mobilised funds more wisely. Excessive household consumption is
discouraged (
·
Savings mobilisation
enhances the relationship between intermediaries and clients (
·
Savings promote a more
equitable income distribution. Projects
based on low-interest lending tend to bias distribution away from the rural
poor. Improved savings opportunities,
however, can help the poor by giving them access to financial assets with
higher returns than those received from tangible savings. An important function of financial
intermediaries is to pool funds, in other words, to bring small amounts
together so that loans for relatively large projects, involving economies of
scale, can be made. Thus, financial intermediaries
should serve more savers than borrowers.
Appropriate savings programmes can thus contribute to social
cohesiveness (Spio, 1994). Von Pischke
(1996) and Yaron (1994) also argue that because deposit-taking serves more
people than credit services, the possibility to reach more people at the
so-called financial frontier, with less effort, is increased. On the average, depositors will have lower
incomes than borrowers. That is why
policies that focus on improving services for savers are a better way to help
the rural poor than those that conform to cheap credit (Spio, 1994).
Neglecting
savings mobilisation leads to a subjection to the feast-and-famine cycle of
governments and donor funding. If
savings mobilisation is effectively done, there will be an increase in the
capital pool available to farmers and these financial institutions will have a
continual flow of funds available for lending.
Savings mobilisation is thus a practical alternative for foreign
funding. When cheap funds are available,
e.g. through government loans, central bank rediscounts and loans from
international donors, financial institutions are likely to have little interest
in savings mobilisation or loan recovery (Adams & Vogel, 1990). Subsidies discourage banks from mobilising
their own resource base (Seibel, 1994).
A.I.D. (1991) argues that when RFMs are dependent on savings
mobilisation for survival and cannot rely on donors to bail them out when
lending funds are depleted, they are compelled to increase their profitability. This means that adopting more sound banking
practices, that reduce operating costs, will improve creditworthiness decisions
and intensify loan recovery efforts.
According
to Yaron (1994), the financial ratio of the value of a rural financial institution’s
savings to its loan portfolio, and changes in this ratio over time, indicates
how successful the institution has been in replacing concessional funds from
the government or international donors by savings.
3. A Warning
In
spite of all advantages of savings mobilisation, Von Pischke (1996) warns that
this strategy may not be an appropriate immediate or general objective of
development projects or of development assistance agencies. It should not be seen as a service that can
easily be added to credit projects or as a natural possibility for specialised
lenders. He points out that the
performance of credit projects and financial institutions in developing
countries that offer savings possibilities should take a moment of
reconsideration and first ruminate on a few questions like: can they
effectively intervene in financial markets and can they design financial
instruments that are sustainable? Does
their incompetence to perform satisfactory in these respects indicate deeper
problems that would lead to costly miscalculations and skewed oversights in
savings mobilisation? Can those that
fail to succeed in lending be expected to perform well as deposit-takers?
Von
Pischke (1996) refers especially to problems of bad bookkeeping, fraud and poor
lending decisions leading to the malfunction of the institution offering
deposit services. The harm done by
incompetent deposit takers can be large and politically troublesome with fatal
consequences. To overcome many of these
type of problems, institutions tend to use deposit insurance by
governments. Yet, it has been seen that
government insurance may even enhance failure.
|
In the |
Even
if deposit-taking is done by private, domestic institutions without
governmental insurance, an assumption or expectation usually prevails that the
government will give a helping hand to overcome losses of deposit funds. Therefore, it can be argued that whether or
not deposit insurance exists, in many countries a unit of money mobilised in a
savings account could someday result in a charge to the government
account. As an end result the taxpayer
shall have to pay at least some part of this unit of money. This will be the outcome if deposit-takers
make misjudgements in granting loans that cause losses that outrun their
capital.
Von
Pischke (1996) concludes that in the light of recent experience with failed
deposit-takers the quality of lending and capital need to be high in order to
meet risks of intermediation. Otherwise,
institutional sustainability will be hampered.
Deposit-taking is more than a remedy for lenders with a battling
performance. Deposit-taking services can
not simply be added, institutions should start by upgrading their lending
operations as well. Capital should be
sufficient to safeguard the interest of depositors, before deposit-taking
services are offered. Von Pischke (1996)
stresses that international standards of capital adequacy, e.g. capital equal
to 8 percent of risk-adjusting assets, do not prove save play at the financial
frontier or in other financial circumstances that are generally tough. High-risk loan portfolios require a larger
capital base than low risk ones. He
recommends that separate risk evaluations should be made, as well as separate
determinations of capital adequacy standards, for each financial institution at
the financial frontier.
Appendix III. Strategies to Promote Rural Finance
1. Introduction
Intervention mechanisms traditionally used in the
past by financial development organisations in the North are based on the idea
of market failure. Therefore, several
instruments were used to overcome market imperfections. Development organisations were convinced that
they have to intervene directly into the credit policy of banks in the South in
order to improve credit access to small farmers and enterprises (Lambrechts
& Debar, 1995). However, it is now
clear that these practices did not lead to improvement
in the financial system in LDCs.
2. Subsidised Finance
Cheap
credit refers to interest rates being subsidised to a lower level than the
market rate, i.e. those charged to business or households in the more
developed, formal financial markets.
These rates are usually lower than the rate of inflation and therefore
negative real interest rates are charged to farmers. Most of the time, interest rates are too low
for lenders to cover loan transaction costs (Coetzee, 1992).
Cheap
credit programmes started in times of colonial governments. The target beneficiaries in these days were
large-scale farmers that were producing for the market of the mother
country. Credit was strictly allocated
for the production of commercial produce on large scale (Coetzee, 1992). In the newly independent countries more
attention went to retarded, poor small farmers.
The hope was that they would also gain from new modernisation
innovations, e.g. the Green Revolution (Bouman & Hospes, 1994).
Later
on, it became clear that the benefits of the Green Revolution did not reach the
small farmer, thus there was hardly evidence of improvement in their living
conditions. Therefore, politicians,
planners and donors agreed that they should be helped and the most obvious way
seemed to be to provide capital in the form of cheap loans. Since the informal financial sector was
regarded as inferior (Bouman & Hospes, 1994) and “exploitive” (Coetzee,
1995), it became the task of formal financial institutions. Hundreds of billions of dollars were poured
in countless projects, as low-priced small farmer credit became the major tool
of rural development (Bouman & Hospes, 1994).
The
justification for cheap credit was mainly based on two assumptions: farmers
need cheap loans to induce them to produce, and rural habitants are too poor to
save (Coetzee, 1995). The hope was that
cheap funds would motivate farmers to overcome their unwillingness to adopt new
technologies and investments, thereby stimulating them to participate in
developing programmes (Coetzee, 1992).
The
cheap credit policy soon largely dominated the financial sector in developing
countries, and therefore had a shaping influence on the financial
reconstruction process. To channel soft
loans, numerous formal financial institutions were established, while
regulations and policies regarding financial intermediation, manipulations by
financial authorities, and the domination of research, political and scholar
debate all centred around cheap credit (Bouman & Hospes, 1994).
This
strategy ignored the opportunity costs of funds, the exchange rate risks of
foreign borrowed money and last, but not least, the costs of loans to small
farmers. In well-functioning financial
markets interest rates would reflect the risk involved in a certain
investment. Subsidising interest rates
ignore this and send out wrong signals to farmers (Coetzee, 1992).
One
of the biggest problems of these programmes were transaction costs, which were
greatly underestimated. High overhead
costs and low loan recovery were no exception to the rule (Spio, 1994). Institutions could only survive with
continued capital injections from governments and donors (Coetzee, 1995). In this respect, repayment rates as low as 2
% have been found (Coetzee, 1992).
These
credit programmes were usually viewed as part of a package. Measures used to determine success were the
number of loans made, inputs purchased with loans, output increase through
borrowing, and changes in income or employment among borrowers. Thus, these
measures concentrated on borrowers (Coetzee, 1995).
One
of the basic missing elements typical of policies of this scope is that it has
no savings component (Coetzee, 1992).
Subsidisation of interest rates by most African governments is a policy
that has reduced incentives to save in the formal sector. Intermediaries were forced to pay low rates
on deposits, usually negative in real terms (Miracle et al., 1980). It resulted
in credit dependency, rather than self-reliance through self-financing (Seibel,
1994). Moreover, subsidies make credit a
bargain that attracts mainly those who are political and economical
powerful. As a result this formal credit
ends up with those who are already well-off relative to the average economic
well-being of the population (Miracle et
al., 1980).
|
In the period of 1970 to 1980, formal loans targeted to small
farmers in |
In
most developing countries, subsidised credit is one of the main reasons why the
banking system developed unevenly across regions and wealth groups (Rajasekhar,
1996). Moreover, these policies lead to
a less equitable income distribution.
The size of the interest rate subsidy is positively correlated with the
amount of the loan, therefore larger borrowers receive larger subsidies and
vice versa (Adams & Vogel, 1990).
Due to artificially low interest rates, intermediaries battle to cover
their transaction costs and thus they rather focus on larger loans. Furthermore, better-off farmers are also more
preferred clients in the sense that they usually possess the required
collaterals or have an existing banking dossier that can be used to proof their
bankability. It leads to the neglecting
of small farmers and tenants (Seibel, 1994).
Coetzee
(1992) argues that there are a lot of factors that may constrain farmers that
are not surmounted by cheap credit, e.g. inappropriate infrastructure, lack of
marketing structures, lack of access to inputs, lack of extension, low farm
gate prices, etc. In fact, one of the
greatest arguments to justify cheap credit is called the “second best”
argument. It refers to the recognition that the rural sector is penalised in
many ways by government policies. For example: pricing policies that favour the
consumer, taxes on farm inputs, taxing agricultural produce by fees to finance
control entities, e.g. marketing boards and agricultural organisations (from
whom only selected farmers benefit), over-evaluated exchange rates, and
under-investment in rural infrastructure and services. Cheap credit is therefore used as a tool to
compensate for adverse production and equity effects of several policies (Adams
& Vogel, 1990; Coetzee, 1992). Thus,
some of the intended beneficiaries, the poor rural farmers, were doubly injured
by these policies: (a) they did not receive cheap loans because it went to the
better-off farmers, and (b) they were taxed with low farm gate prices.
This
also implies that raising interest rates above the inflation rate is only part
of the solution to financial problems, because it is only one of the many
determinants of savings and credit behaviour (Bouman & Hospes, 1994). Therefore, favourable interest rates alone
will not produce sustainable results.
They have to be supported by fundamental policy and financial market
reforms. Policy reform is necessary to create
a favourable economic environment in which inflation can be controlled,
investment opportunities improved, especially in rural areas, and to end
political intrusion into financial systems that damage the accountability of
banks and their borrowers (Spio, 1994).
3. Targeting
Targeted
financial services can be described as services that are channelled to a
specific group, often poor farmers. The
specific financial service may vary, e.g. it might be cheap loans, but it might
also be to force banks to extend their services to rural areas. Hence, because targeting is a planned
activity, it usually implies that periodic reports on the extent to which
programme objectives are met, have to be provided (A.D.I., 1991). Many subsidised loans were directed to
priority borrowers and crop-related activities.
It implies that agricultural production, rather than rural development,
was the objective (Seibel, 1994).
There are broadly five categories of
techniques used to target loans. These
include (1) loan portfolio requirements, (2) rediscount facilities, (3) crop or
loan insurance, (4) quotas for commercial banks, and (5) nationalisation of
banks. According to Spio (1994), these
instruments do not generate good loans.
They tend to weaken controlled lenders because the approach does not
address the problem that makes lenders reluctant to advance the financial
frontier voluntarily. They are usually
designed without reference to the cost of their implementation.
3.1 Loan Portfolio Requirements
Governments also try to influence lender
behaviour by setting floors or ceilings on certain types of lending and by
placing limitations on loan size, e.g. for the farming business (Adams &
Vogel, 1990).
According
to FAO (1994), some of these attempts were strongly resisted by commercial
banks and generally unsuccessful. It is
not difficult for a lender to evade the intent of a portfolio restriction and
still conform to the restrictions. A
lender can, for example, redefine the purpose of a loan - a loan for purchasing
a truck becomes an agricultural transportation loan. Likewise, a lender can make multiple
medium-sized loans to one borrower and by this evade the loan-size ceiling
(Adams & Vogel, 1990).
Spio
(1994) also points out that credit ceilings reduce efficiency in two ways. First, all banks are limited the same way,
including those that have been more efficient than others in lending and those
that have dynamic entrepreneurs as their clients. Second, credit ceilings seriously erode
competition for deposits. Banks loose
incentives to attract deposits and to provide good services to existing
depositors.
Moreover,
according to Aryeetey et al. (1997),
imposed ceilings undermine the risk-return configuration of bank lending. Negative side effects, such as rent seeking,
corruption and leakages, are no exception to the rule.
3.2 Rediscount Facilities
Rediscount facilities can be seen as windows
at the central bank allowing final lenders to discount target loans with the
central bank and receive funds at concessionary interest rates. Final lenders are allowed an attractive
spread between the concessionary rate pay to the central bank and the rate
charged to final borrowers in the hope that this will induce them to stress
target loans (Adams & Vogel, 1990).
Besides the central bank, national
development banks may also make funds available to commercial and development
banks on an interest margin and maturities that are suitable for financing
small-scale enterprises(De Jong & Kleiterp, 1991).
However, most commercial banks are not
suitable for lending to small enterprises, in fact, few of them are really
interested in doing so. Most of these
loans ended up in the hands of larger scale and urban small-scale enterprises due
to the fact that short-term loans can be used more than once in a roll-over
system. Results of this scheme have thus
been disappointing (De Jong & Kleiterp, 1991).
There are two main shortcomings. In the first place, it induces intermediaries
to neglect private deposits, because the concessionary interest rates on
rediscount lines are usually lower than the rates intermediaries would
otherwise pay to mobilise voluntary private savings. It implies that fewer funds for agricultural
lending will be available in the long run.
In the second place, lenders can exercise fungibility, whereby loan
decisions are not much influenced by concessionary discount facilities. For example, if a low ceiling is imposed on
the price of a certain crop, final lenders may be hesitant to expand lending
for it, because farm returns on this crop can be expected to be low. Lenders will rather transfer their regular
clients who satisfy the target criteria to the rediscount line and thereby
expand the volume of funds available for non-target lending (Adams & Vogel,
1990).
3.3 Loan and Crop Guarantees
These schemes have been set up to overcome
the problem of lack of securities (De Jong & Kleiterp, 1991). This strategy may also imply an insurance to
lessen lenders' risks from loan default.
In order to assure that formal lenders extend more
loans to a target group, financiers may agree to pay lenders a certain
percentage of the loan in the case of default.
For example, a governmental agency promises to reimburse a certain percentage of
loan defaults. These loans are usually
targeted to a certain crop, and reimbursement occurs after crop damage has been
verified. Thus, the main objective is to
induce lenders to extend more loans to a target group by transferring part of
the loan recovery risk to other agencies
(Adams & Vogel, 1990).
There
are several problems with loan guarantees programmes:
·
they are expensive. Large subsidies are necessary to cover
defaults. The guarantor is usually also responsible for the administration
costs (Adams & Vogel, 1990);
·
crop damages affect numerous
producers at the same time; therefore a large staff is required to make timely
assessments of crop damage (Adams & Vogel, 1990);
·
guarantees discourage banks
to collect loans in arrears, which enhance loan defaults (Seibel, 1994).
Experience
reveals that it is difficult to set up a credit guarantee fund that can
function independently in the long run (De Jong & Kleiterp, 1991).
3.4 Quotas for Commercial Banks
Some LDC
governments oblige commercial banks to invest a certain percentage of their
portfolio in a specific sector, e.g. small-scale enterprises. In some cases it resulted in an increase in
the number of small loans, but simultaneously decreased the supply of credit to
other more profitable sectors (De Jong & Kleiterp, 1991). For example, commercial banks in
Likewise, in some LDCs commercial banks are
forced to open a certain number of rural branches before they can receive
permission to open additional urban branches (which are more profitable). As a result, many banks often build token
branches in rural areas that offer only a limited range of services and that are
open for only a few hours per week. In
Such a system can only be effective if there
is adequate supervision. Hence, it is
doubtful if pressure is the right way to bring about relationships that are
based on mutual trust (De Jong & Kleiterp, 1991).
3.5 Bank Nationalisation
Several LDCs have nationalised some or all of
their commercial banks. They include Mexico, India, Costa Rica, Sudan, Pakistan, and
Bangladesh. This may happen when a
colony becomes independent or otherwise to promote greater governmental control
over financial intermediaries. In certain cases, nationalised banks have been
very successful in increasing the number of bank branches, but it is uncertain
if they are more effective than other financial intermediaries in increasing
the financial opportunities for the rural poor and farmers. These opportunities include financial
services available for the poor, the provision of attractive deposit services,
an increase in the amounts of medium- and long-term loans for farmers, a
lowering in the transaction costs associated with financial intermediaries and
the creation of rural financial institutions that are self-sustaining and
innovative (Adams & Vogel, 1990).
***
It is thus clear that the results of many of
these policies has been to orient the financial intermediaries away from
mobilising private savings in rural areas and toward obtaining loanable funds
from donors and governments (Adams & Vogel, 1990).
The
effect of targeted loans is often a
sharp increase in the lender's cost. In
Moreover,
governments or donor agencies usually require intermediaries to adopt new
procedures when loans are targeted, which implies that training and other
adaptations are necessary (A.D.I., 1991).
Extensive loan targeting reduces the operating efficiency of financial
markets and causes an increase in the amount of friction. There exists a danger that the new procedures
will not, or only partially, be integrated in the existing scheme and thus
decrease their effectiveness.
According
to Seibel (1994), the low repayment rate of subsidised credit and targeted
credit can be explained by several reasons:
·
farmers tend to consider
such loans as free presents attained through government patronage and they are
not seriously committed to repay;
·
farmers tend to use these
funds for other purposes and find themselves unable to repay;
·
funds may be invested into
activities that are productive but not profitable due to certain policies, such
as price controls;
·
financial institutions are
forced to accept non-banking criteria in credit decisions and thereby allocate
wrong loan sizes at the wrong time to the wrong borrowers for the wrong
purposes. This results in high default
rates.
Moreover,
donors often come from developed countries.
Prosecution of individual farmers is impractical. Hence, the fact that the borrowers do not
know the lenders at all, as well as the notion that none of their local savings
are involved in the lender’s portfolio lessens the farmers’ feeling of
responsibility towards the funds (Coetzee, 1992).
4. Rationed Credit
Subsidised
credit results in a wide discrepancy between supply and demand for credit,
while the price for it, i.e. interest rate, is far from equilibrium. Therefore, credit rationing is one of the
principle strategies in credit allocation (Seibel, 1994).
Rationed
credit hampers the ability of financial institutions to reject poor credit
risks, and to resist political pressures that enter into loan allocation under
these circumstances due to excess demand (Spio, 1994). It implies that wrong recipients obtain the
wrong quantities of credit for the wrong objectives. In such a situation, government officials and
experts substitute their own rationality and decision for those of farmers and
of the market. Hereby farmers are forced
into diversion of funds, which lead to distorted factor allocation (Seibel,
1994).
To
simply adjust low interest rates to market rates after cheap credit programmes
is not enough to restore financial markets.
Bank’s demand for liquidity credit is not satisfied by simple raising
interest rates to market level.
Therefore, even when subsidies have been stopped, donors and governments
frequently continue to supply liquidity.
This still discourages banks to mobilise their own resource base. It is seldom found that the negative
consequences of subsidised credit have been alleviated (Seibel, 1994).
Appendix IV. Kenya Enterprise
1. Introduction
The Kenya Rural Enterprise Programme (K-REP) is
an intermediary NGO, which was established in 1984. Its aim is to promote growth and generate
employment in the micro-enterprise sector and, therefore, they lend to clients
who are limited in their access to credit from commercial banks and other
formal financial institutions.
Currently, K-REP offers credit directly through group lending and
indirectly through other NGOs. Its
operations are currently concentrated in
In
1989, the Juhudi Scheme was initiated.
Hereby, individual loans are provided using a modification of the
Grameen Bank Model. K-REP facilitates
the formation of five-member groups called watanos. Up to six watanos
confederate into a kiwa, which is
registered by the Ministry of Culture and Social Services as a self-help
group.
In
1991, the Chikola Scheme was initiated.
It provides credit to individual entrepreneurs through existing
ROSCAs. In this case, K-REP provides a
single loan to an established group, which usually have an average membership
of 20 persons. The groups are
responsible for retailing loans to their individual members.
After
a Juhudi group has been in existence for some time, it may seek approval to transform
into a Chikola group. Nevertheless,
K-REP maintains a wholesale credit facility for selected NGOs. They on-lend credit to their clients on the
basis of the Juhudi methodology. K-REP
has also combined the Juhudi and Chikola schemes at the area field office
levels and separated the administration of sustainable (micro-enterprise
lending) and non-financial services.
Clients
are required to save a minimum of 10 % of the loan, before they become eligible
to borrow. This has helped to raise the
volume of savings deposits as the number of borrowers and loan volume increase.
2. Financial Performance
Table
IV.1 summarises the results of the K-REP Programme from 1991 to 1995.
The
number of active savers grew most rapidly over the period 1993-1994 when the
Chikola Credit Scheme was expanded.
K-REP
has depended on donor funding for on-lending and institutional support. During
the 1991-1995 period, K-REP received a total of Ksh 352 million in grants from
the World Bank, UNDP, ODA, USAID, the European Union, Ford Foundation and CIDA
jointly. Total assets increased from Ksh 66 million to Ksh 377 million.
The
increase in lending as a proportion of total assets reflects greater direct
lending to members of the Chikola Scheme. Growth in volume of outstanding
direct loans can be explained by several factors, including more branch
offices, greater efficiency in credit delivery and additional staff trained in
group-lending methods.
Table IV.1. Results of K-REP
Programme from 1991 to 1995 (Pederson & Kiiru, 1996)
|
|
1991 |
1993 |
1995 |
|
Direct individual borrowers |
1377 |
|
15,014 |
|
Member savings |
Ksh 2.4 million |
|
Ksh 55.3 million |
|
Number of active savers |
2,337 |
5,429 |
15,014 |
|
Lending as proportion of total assets |
0.5 |
|
0.67 |
|
Outstanding direct loans |
Ksh 32.5 million |
|
Ksh 294 million |
|
Arrears and defaults: |
|||
|
Juhudi |
|
Ksh 4.4 million |
Ksh 23.6 million |
|
Chikola |
|
Not available |
Not available |
|
Repayment rates |
|||
|
Juhudi |
96 – 99 % |
97 % |
|
|
Chikola |
99 % |
|
90 % |
|
Coverage of expenses through income (grants excl.) |
59 % |
88 % |
98 % |
Note:
The value of the Kenyan shilling to the US dollar varied considerably over the
years referred to in this section. An
indicative figure of Ksh 50 to 1
Arrears
and defaults on loans have generally been maintained at a low level until
recently. During 1994 and 1995, the repayment rate for Chikola loans fell
significantly, primarily due to problems at one branch. Nevertheless, it is believed that revenues
generated through lending and investing activities are beginning to approach
levels that could eventually make K-REP self-sustainable.
3. Innovations and Lessons Learned
The
K-REP methodology benefits client groups in several ways. Clients expand their
businesses and employ more people. Clients are also introduced to the banking
system and their productive activity is integrated into the formal financial
system. Further, K-REP involves clients in making major decisions, such as loan
approvals, and in improving the schemes.
K-REP
increasingly takes the approach to charge interest rates sufficient to cover
operating and financial costs. It has
begun to transform its financial services into a bank that will provide access
to deposit funds available in the areas it serves. Grants and subsidised loans
may be justified to start and strengthen operations, but the idea is to
decrease dependence on them over time.
In
response to the declining repayment rates that showed up in a few cases,
management has sought to give more direction to the formation and
administration of groups.
The
Chikola Scheme offered the advantage of tapping into existing groups of
entrepreneurs with existing businesses, who needed additional access to
credit. Since those groups and their
businesses already existed, K-REP could minimise the transaction costs of
delivering credit, side-step the problems and costs of forming cohesive groups
and increase outreach through group-based lending.
Nevertheless,
in 1995 some Chikola groups’ repayment rates declined unacceptably, due to not
exhibiting the required solidarity.
Therefore, now they are given a longer gestation period and need to pass
the same tests of cohesiveness applied to the Juhudi groups. The credit officer
evaluates the cohesiveness and stability of the group prior to extending credit
and may extend loans on a different sequence, with faster or slower
disbursement, in accordance with the spesific group’s characteristics.
Moreover,
in order to properly address the default issue, the underlying causes of
non-repayment have been studied by K-REP management. Subsidised interest rates and credit
programmes associated with other social welfare services were pointed out as
inappropriate institutional practices. Additionally, delegating credit
assessment to the groups yields poor results since group members are not objective
regarding their colleagues. Bad screening of potential borrowers by the credit
officer and bad appraisal of the investment also increased the default rate.
The use of group member savings as collateral may enhance default in the sense
that borrowers do not like to forfeit their savings on account of their
peers. Theft, destruction of business
assets, mismatch between loan size and expected income flow, diversion of loan
purpose, and fraud and death or sickness, are other factors that contributed to
the unsatisfying default rate.
Through
client interaction and internal research and evaluation, K-REP has pursued
innovations to provide greater access and outreach, lower intermediation costs
and better prospects of sustainability.
It is believed that client input is necessary to assess performance and
to formulate institutional policy. Some
of the more promising innovations that K-REP has adopted, such as more flexible
loan size and increased group meeting frequency, surfaced initially through
interactions with some borrowers.
K-REP
has also implemented a monitoring system that identifies appropriate operating
and financial performance indicators.
The resulting information is fed back into operations.
There
is a general consensus among clients, especially the smaller businesses, that
credit from K-REP has resulted in improved incomes, increased output and growth
in their businesses. However, the estimated number of micro-enterprises in
Appendix V. Mean Loan Administration Costs
Table V.1. FFIs’ mean loan
administration cost during 1992,
|
|
Type of |
|||
|
SSEs |
LSEs |
SSA |
Others |
|
|
Commercial Bank |
1.2 |
0.3 |
4.7 |
2.5 |
|
0.9 |
0.2 |
2.9 |
0.4 |
|
|
3.0 |
- |
2.8 |
1.3 |
|
|
1.7 |
0.3 |
3.4 |
1.4 |
|
LSE
= Large scale enterprise
SSA
= Small scale agriculture
Table V.2 IFIs’ mean loan
administration cost during 1992,
|
Region |
Moneylender |
Susu Collector |
SLC |
Credit Union |
||||
|
|
Urban |
Rural |
Urban |
Rural |
Urban |
Rural |
Urban |
Rural |
|
|
1.8 |
2.7 |
0.9 |
0.6 |
0.3 |
0.3 |
2.6 |
4.4 |
|
|
0.6 |
0.6 |
- |
- |
0.2 |
0.2 |
0.4 |
0.1 |
|
|
3.2 |
2.7 |
0.6 |
0.6 |
1.0 |
0.6 |
1.9 |
0.6 |
|
|
1.7 |
2.6 |
- |
- |
0.1 |
0.1 |
2.5 |
3.0 |
Appendix VI. Donor Organisations
1. ALTERFIN
Alterfin
is a Belgian organisation, created in 1991, in the form of a co-operative
partnership. It consists of two banks
(HBK Savings Bank and Triodos Bank) and nine NGOs that are active in
development assistance. The
organisations are Boliviacentrum Antwerpen, Coopido, FADO, FOS, NCOS, Oxfam
There
are two main reasons for the origin of Alterfin:
(a)
several financial projects in the south have a
great demand for support. Yet, they are
uncomfortable with northern grants and gifts, because these projects have an
inherent rendability and can, therefore, bear the cost of financing themselves;
(b)
a lack of mechanism exists in the south to
stimulate local capital mobilisation.
In
its information pamphlet Alterfin describe their goal as follows:
“Alterfin’s
purpose is to contribute to the expansion of a durable financial network in the
South, a network which is accessible by socially and economically
underprivileged groups. Alterfin aims to
achieve its purpose by offering financial instruments and technical guidance in
a creative way.”
At
this stage they are active in seven
1.1 In the South
Alterfin’s
activities include provision of credit, guarantees or temporary share
participation, as well as provision and/or mobilising of technical
support. It is done through a local and
target-group oriented financial network in the South. Their aim is to involve those that are
excluded, or not reached, by formal finance for different reasons.
Assistance
is channelled through existing credit schemes and initiatives in LDCs that
originated out of development projects, or other professional movements, e.g.
farmers associations. These financial
schemes are most often not part of the national regulation of the specific
country. The role of Alterfin is that of
an additional financier and advisor.
Thus, Alterfin neither aims to make use of local traditional financial
structures as such (i.e. cultural habits of a tribe), nor does it grant credit
directly to the client e.g. small farmer, but it rather tries to make
accessible semi-formal institutions available for those previous excluded from
financial services. Yet, bigger
co-operatives may receive investments directly from Alterfin. The probability that traditional structures
may underlay these semi-formal structures is not excluded. Thus, Alterfin lends capital to intermediary
organisations, which divide it in the form of loans among ultimate users. In
Groups
that have partnerships, or are involved, with one of the NGOs of the Alterfin
co-operative, receive priority when Alterfin allocate assistance. Alterfin works through a local representative
who knows the local situation. Due to
its insufficient knowledge of the local circumstances, Alterfin itself has no
contact with the ultimate beneficiaries of the credit and other services
supported by it.
Alterfin
predicts a snowball effect as other groups see the benefits that participating
organisations receive, and therefore these groups may also be anxious to get
involved. On the other hand, many
beneficiaries, e.g. small farmers, may not be aware of the role that Alterfin
plays, although it is not the intention to keep its role secret.
An
applying organisation has to propose a dossier on which they are evaluated
before a partnership with Alterfin is contracted. This dossier describes, among others, the
intended credit use, financial indicators of their credit portfolio, the way in
which credit is going to be granted to ultimate users, risk management,
etc. If the application is successful,
Alterfin demands a six-monthly report of the partner’s activities and
results. Thus, Alterfin itself does no
loan supervision at the level of ultimate users.
The
end goal is that these institutions become independent within a certain period
of time. Alterfin’s argument is that in
order to achieve such independence, initial capital, input and
institutionalisation is necessary to get them off the ground. Thus, there has to be a satisfactory amount
of local capital, or mobilisation potential.
A
credit committee in
To
ease the judgement process, the following list of criteria for development
initiatives is set:
1.
it must benefit socially and
economically marginalised persons and groups;
2.
it must exhibit a definite
financial and economic sustainability;
3.
the initiative must have the
potential to become independent of Alterfin support within a planned period;
4.
it must use, as far as
possible, local available human and natural resources in order to minimise
ecological strain and dependency;
5.
it has to be
gender-conscious in order to assure that benefits and tasks associated with the
initiative are fairly divided between male and female participators.
In
some cases, Alterfin indirectly interact with local formal banks. For example, in
At
this stage primarily credits are granted, rather than emphasising savings
mobilisation.
1.2 In the North
Alterfin
wants to increase the awareness of people and institutions about the role that
money can play to develop a society that is more environment- and
culture-friendly. That is why investors
or potential investors are asked to consider the ethical aspect of their
investments and not in the first instance the profitability or returns of such
an investment.
Funds
are channelled through the North-South Savings Products of the Triodos
Bank. Triodos Bank makes a credit line
available to Alterfin, which it uses to finance its activities in the
South. This credit line is guaranteed by
Alterfin’s registered capital. To
realise this, Alterfin makes an appeal to individuals, NGOs, banks and other
organisations to invest in Alterfin’s shares, and also involve them in its
policy making.
Alterfin
offers three financial products to potential financial supporters:
(a)
shares in the co-operation;
(b)
savings in co-operation with
the two banks involved; people are
encouraged to save in a so called
North-South account at these banks, the account being opened by Alterfin. Alterfin receives a commission on the amount
collected in this account and this money is used to grant credit to Alterfin;
(c)
obligation loans to
Alterfin, with a running time of seven years, at an annual interest rate of
3.75 %.
1.3 Transaction Costs
The
client in the south has to pay for the dossier costs or otherwise a membership
fee is required. These costs are
calculated apart from the interest rate charged. Alterfin believes that accessibility,
flexibility and creativeness are more important for clients than cost of
lending.
The
transaction costs and the costs of every dossier for Alterfin’s account are
mainly met by the co-operative of NGOs.
1.4 Repayment
The
kind of collateral that is required by the ultimate credit user is locally
determined. In some cases, peer pressure
and joint responsibility are exerted among members through the solidarity
group-method. The success rate of this
implementation varies from situation to situation. It is difficult to prescribe fixed rules for
these kinds of methods, therefore creativeness is important. Sometimes collaterals, such as radios and
bicycles are required, while in other cases credit depends on a satisfactory
savings or repayment record. The latter
simultaneously creates healthy financial habits.
Alterfin
usually prescribes the repayment period.
It varies between one to five years The expected repayment frequency is
two times a year in order to reduce transaction and administration costs. In some cases, Alterfin grants credit for
shorter periods, but these loans are usually the beginning of longer financing
projects.
1.5 Credit Use
Alterfin
does not prescribe specific uses for funds from credit grants. However, local institutions must become
self-sufficient in a certain period of time.
The purposes for which credit will be used are left to the discretion of
the local representatives. Thus, if the
local representative regards it necessary to provide consumption credit and if
this does not obstruct the representative’s independence, Alterfin has no
objection.
1.6 Hindrances
Alterfin
prefers to see hindrances or difficulties as challenges. The biggest challenge seems to be the
acquisition of sufficient capital to lend to the South. Alterfin started with BEF18-19 million, at
this stage they possess ca. BEF 30 million and are heading for BEF 50 million,
while BEF100 million is seen as optimal.
The
second challenge is to find guarantees for financing activities carried out by
Alterfin. This is not an easy task,
neither locally in the South, nor in
REFERENCE
Information
is based on a personal interview with dr. Couderé, director of Alterfin,
***
2. BILANCE
Since
the beginning of the 1960s, several developmental bodies stemmed from Christian
missionaries. Two Dutch, Catholic examples
are Vastenaktie and Cebemo. Since the
1960s, it was Vastenaktie’s aim to support small projects in the South or to
focus on other specific issues, which were food for thought during fasting
periods. Cebemo’s objective was to
properly channel the increasing demand for programme funds in the South and the
layout of government money. At the
beginning of 1995, these two organisations merged into one organisation, today
known as Bilance. Together with HIVOS,
ICCO and NOVIB, Bilance is one of The Netherlands’ major development
organisations. Hence, they are also part
of CIDSE (Coopération Internationale pour
le Développement et la Solidarité), a Catholic umbrella organisation, which
also includes similar organisations from the
2.1 Bilance’s Policy
Bilance proclaims that it puts the initiative of local people in
developing countries central. It
emphasises the development of skills and self-confidence of the beneficiaries
that are needed to actively participate in local management. They want to stimulate people to improve not
only their own living conditions, but also those of other people with more or
less the same conditions.
To support the initiatives of poor groups alone is not sufficient. The factors that cause these groups to be
socially, politically and economically excluded from privileges, should be
removed. Therefore, Bilance puts high
priority on stability, upliftment of women where necessary, and fair
redistribution of land. A core priority
is that beneficiaries should become self-sufficient in the long run. Interventions are seen as temporarily, but
durable. The idea is that beneficial
effects remain the same when Bilance withdraws after a certain period. Therefore, viability of projects plays a
central role.
2.2 In the North
Bilance finds it important that people in the North get involved in the
welfare of those in the South. Therefore
they promote their vision in schools and church communities and actively
participate in national and international political debates. Through public campaigns, approximately 13
million Dutch guilders (6.84 million
2.3 Organisational Structure
A central body, which delegates core activities to four main head
departments, manages Bilance. The head
departments are
New project proposals are judged on the basis of their policies, aim
and effectiveness. The local situation,
where the planned activities are to be conducted, is thoroughly analysed. It is for this complex task that local
expertise (see later) plays an important role.
Each project that receives support from Bilance has to report back on
its progress and financial situation on a twelve-monthly basis.
In order to fulfil its aims, Bilance co-operates with other
developmental organisations. In the
light of financial development it forms part of the MFP (Co-Financing
Programme), an internationally acknowledged entity. MFP consists out of HIVOS (Humanitarian
Institute for Development Co-operation), NOVIB (Organisation for International
Development Co-operation of The Netherlands), ICCO (Inter-Church Organisation
for Development Co-operation, and Bilance.
2.4 In the South
Bilance puts high priority on using local advice institutions that have
proven to possess a high level of local expertise. These institutions give their advice on
project proposals and assist in financial planning, management, monitoring,
evaluation and other special expertise.
In this way, local initiatives could be connected with programmes, and
local knowledge is optimally used.
Bilance does not have projects or field offices of its own. It rather supports initiatives and
organisations of the people in the South, since these are rooted in the local
society.
Hence, Bilance believes that beneficiaries should be actively involved
when projects are carried out. It is
important that local people themselves provide labour, materials and
money. The intention is to enhance the
self-sustainability of projects.
Regarding the provision of financial services, Bilance does not see the
formation of savings and credit groups as a goal, but rather as an option to
reach its higher order objectives. A
closer look at the projects of Bilance, as published in its 1995 Continental
Reports, reveals that Bilance does not specifically aim to make use of local
traditional financial structures, neither does it explicitly avoid them. However, they are active in the promotion,
formation and/or strengthening of co-operatives and other rural organisations
and groups to promote financial services and access to the poor. Moreover, they also support several NGOs who
assist low-income communities to improve their financial organisation. For example, in
REFERENCES
Vastenaktie/Cebemo Jaarverslag, 1995. Stichting Samenwerking
Vastenaktie/Cebemo,
Oestgeest, The Netherlands, 189 pp.
Vastenaktie/Cebemo Asia, 1995. Stichting Samenwerking Vastenaktie/Cebemo,
Oestgeest, The Netherlands, 71 pp.
Samenwerking Vastenaktie/Cebemo, 1995. Opbouw door mensen zelf. Deel 1: Beleid, praktijk en resultaten, Oestgeest, The
Netherlands, 24 pp.
Nieuwe wegen.
An
notion of HIVOS, ICCO, NOVIB, and VASTENAKTIE/CEBEMO, 7 pp.
***
3. ECUMENICAL DEVELOPMENT CO-OPERATIVE SOCIETY (EDCS)
EDCS is a Dutch association, established in 1975, under the influence
of the World Council of Churches. It
possesses corporate status according to the laws of the kingdom of the
The original aim was to create an ecumenical international
organisation, which provides loans, guarantees and equity capital in developing
countries. Therefore EDCS offers an
alternative investment opportunity to capital-rich churches in the North that
want to support development in the South.
They are offered shares by EDCS in order to become members. In fact, the society is owned by its members
throughout the world. They include
churches, sub-divisions of churches, councils of churches, church-related organisations,
project members, and support organisations.
Differently stated, EDCS refinances itself entirely through equity
capital from those who subscribe to the promotion of development as a
liberating process aimed at economic growth, social justice, people’s
participation, self-reliance and respect for creation.
According to EDCS’s 1995 Annual Report, there are 14 Regional Offices
throughout the South. The organisation is steered by 16 board members, most of
whom come from
EDCS strives to provide an alternative to gifts and subsidies. Support is given to generate the
understanding for borrowers’ and creditors’ mutual obligations. Therefore, available capital should be used
to generate a yield, and not merely be consumed.
The business concept can be described as risk financing combined with
business development in the initial stages of a project. Thereafter the project has to become
self-reliable on its own strengths to become a strong business that finances
itself. Through the duration of each
project there is continuous control and monitoring of progress, as well as
provision of training and advisory support.
The fact that EDCS refers to the Grameen Bank in
3.1 Objectives
EDCS summarises its objectives as follows:
·
to support poor people in their efforts for
self-reliance;
·
to be an investment vehicle for churches and others
who want to provide that support;
·
to be a viable business model for a more just
economic order;
·
to be of assistance to people world-wide in learning
to practice stewardship, and accept co-responsibility towards the world
entrusted to us all;
·
to communicate widely inside and outside churches,
the EDCS experience that an economic approach rooted in the liberating force of
the gospel leads to sustainable communities.
3.2 Project Criteria
The basic criteria can be summarised in the
following points:
·
projects must support poor
people who live in unfavourable conditions;
·
the proceeds of each project
must reach a broad base of beneficiaries and not contribute to the benefit of a
few organisations or investors;
·
projects should contribute
to large-scale social and economic progress regarding local participators. Ecological impact plays an important role;
·
preference is given to a
co-operative structure, because it allows the intended beneficiaries to
directly participate in the business and management of the project. Priority also goes to projects where women
are the direct beneficiaries or where there is high female involvement
regarding decision-making, organisation, implementation and evaluation;
·
the business has to be able
to survive financially and the availability of competent management and technical
know-how should be ensured in order that it can become self-supporting within a
reasonable period of time. Thus, EDCS’s
involvement has to become unnecessary;
·
there has to be a need for
foreign investment which can be provided within terms that can secure the
necessary government approvals and that are beneficial to the project.
3.3 In the North
A
Board of Directors manages EDCS. They
have formulated a set of Standard Operating Procedures (SOP), which serves as
general guidelines for the Board’s and company’s work. The SOP can be changed by the Board through a
majority decision and are not regulated by laws or bylaws. The Board has also adopted a set of House
Rules for the company’s work.
In
order to enter EDCS, members must have at least one share. EDCS has an unlimited number of shares. The shares have a par value of either NLG 500
or US$ 250.
At
the start in 1977, the share capital was only NLG 2,928,000. The total share capital in 1995 was NLG
146,000,000.
Furthermore,
EDCS’s American subsidiary, EDC-USA, has issued a number of bond series in the
At
their Annual General Meeting, 1995, it was decided to intensify co-operation
with other development agencies with more or less the same objectives as EDCS
in order to increase lendable funds.
Project
participators in the south often possess sufficient knowledge about production,
however, they often lack marketing and sales competence. Therefore, EDCS attempts to establish sale
channels in industrialised countries, known as Alternative Trade Organisations
(ATOs).
3.4 Challenges
Although
there has been a continuous growth in its share capital since EDCS originated,
the demand for project funding has grown more rapidly. Thus lendable funds can not cover
demand. Therefore, EDCS has to
increasingly prioritise and at the same time give more attention to the
monitoring of the existing project funding portfolio. Intensified co-operation with other financial
development organisations is one measure taken to improve this situation.
3.5 In the South
Beneficiaries
in the south may receive their loans directly from EDCS, or otherwise EDCS
makes use of financial intermediaries, e.g. co-operative banks, co-operative
lending institutions, etc. There has
been a substantial increase in lending to financial intermediaries for some
years now. According to EDCS, it is
advantageous in the sense that it gives the opportunity to provide loans in
smaller amounts and thus reach borrowers who are at the lower levels of
development. Also, these institutions
are established in the environment in which they operate and strive to
contribute to the development of local societal structure. Hence, many of them have an organisation that
provides technical assistance, training and other services, as well as
evaluations and monitoring of projects.
Through financial intermediaries, EDCS can reach projects that fit well
into the objectives and have the potential to develop, despite the fact that
they are too small to receive financing directly from EDCS. Furthermore, international loans, no matter
how large they are, require a great amount of work in order to meet the legal
requirements and tax and currency regulations.
It implies that only larger direct loans can cover their own costs for
this handling.
EDCS
finds the use of group solidarity as a collateral substitute an effective
instrument to reach the poor with financial services. In fact, most financial intermediaries
supported by EDCS have shown a recovery rate of more than 95 %.
However,
EDCS is also aware of the disadvantages that result from using financial
intermediaries. Many of them have a
narrow business orientation, with short-term loans for trade or as operating
capital. Therefore, these institutions
are not established in all areas.
Borrowers’ cost for loans is usually higher than they would have been
for a loan received directly from EDCS.
Nevertheless,
in EDCS’s Newsletter 7(2) (1996) its regional manager for French-speaking
3.6 EDCS Case Study
In 1994, EDCS invested in the Davao Co-operative Bank (DCB) of Tagum in
the
Members
grouped themselves in clusters of around five members after they had attended
compulsory group trainings for seven days.
Their activities are small daily savings (US$ 0.03), weekly meetings,
availing loans and weekly loan repayment.
The average size of loans received per member is US$ 172, while average
savings are US$ 19. Calculated earnings
on an average loan of US$ 172, through self-employment, are around US$ 845 a
year. The repayment rate at the end of
1995 was 95 %.
REFERENCES
EDCS,
Annual Report, 1995. P.C. Hooftlaan 3,
3818 HG
EDCS Nieuwsbrief.
(1996). Mariam Dao: “Afrika mag
niet meer falen”. 7(2), 6-7.
JAGERSTAHL, L., LOMBACH, J & BACKMAN, M. (1994).
EDCS Report, June. 26 pp.
Appendix VII
African Development Indicators
1.
Poverty (The
World Bank, 1996)
2. Urbanisation (The
World Bank, 1996)
3. Percentage of Population Below
Absolute Poverty, 1992* (The
World Bank, 1996)
INTRODUCTION........................................................................................................................ 1
CHAPTER 1 HISTORICAL REVIEW....................................................................................... 3
1.1 After the Second World War Until the 1960s............................................................................................................... 3
1.2 The End of the 1960s and the 1970s............................................................................................................................... 3
1.3 The 1980s............................................................................................................................................................................ 6
1.4 The 1990s............................................................................................................................................................................ 7
CHAPTER 2 SERVING THE SMALL-SCALE FARMER......................................................... 9
2.1 Introduction....................................................................................................................................................................... 9
2.2 The Small-farmer and Risk................................................................................................................................................ 9
2.3 The Small-Farmer and Finance...................................................................................................................................... 10
2.3.1 The Small-Farmer and Credit.................................................................................................................................. 10
2.3.1.1 Credit Demand.................................................................................................................................................. 10
2.3.1.1.1. Production Credit................................................................................................................................. 10
2.3.1.1.2. Consumption Credit............................................................................................................................. 10
2.3.1.1.3. Insurance................................................................................................................................................ 10
2.3.2 The Small Farmer and Savings............................................................................................................................... 10
2.3.2.1 National Accounts and Forms of Saving..................................................................................................... 10
2.3.2.2 The Small Farmer and Saving Institutions.................................................................................................... 10
CHAPTER 3 RURAL FINANCIAL MARKETS...................................................................... 10
3.1 Introduction..................................................................................................................................................................... 10
3.2 Important Elements in Finance...................................................................................................................................... 10
3.2.1 Intermediation.......................................................................................................................................................... 10
3.2.2 Fungibility................................................................................................................................................................. 10
3.2.3 Information and Risk............................................................................................................................................... 10
3.2.4 Transaction Costs................................................................................................................................................... 10
3.2.4.1 Clients' Transaction Costs.............................................................................................................................. 10
3.2.4.2 Intermediaries' Transaction Costs................................................................................................................. 10
3.2.5 Interest Rates........................................................................................................................................................... 10
3.2.6 Loan Repayment...................................................................................................................................................... 10
3.2.6.1 Collateral............................................................................................................................................................ 10
3.2.7 Segmentation, Fragmentation and Dualism......................................................................................................... 10
3.3 Conclusion....................................................................................................................................................................... 10
What could be regarded as a successful rural financial
institution? Although there are
differences in opinion about how a successful rural financial institution could
be defined, most core elements correspond.
The two main elements are (a) self-sustainability, and (b) substantial
outreach......................................................................................................................................................... 10
CHAPTER 4 FORMAL FINANCE.......................................................................................... 10
4.1 Introduction..................................................................................................................................................................... 10
4.2 Formal Institutions.......................................................................................................................................................... 10
4.2.1 Central Bank............................................................................................................................................................. 10
4.2.2 Banking and Non-Banking Financial Intermediaries.......................................................................................... 10
4.2.2.1 Commercial Banks............................................................................................................................................ 10
4.2.2.2 Development Banks......................................................................................................................................... 10
4.3 General Shortcomings of Formal Financial
Institutions............................................................................................ 10
4.3.1 Formal Financial Services do not Reach Rural
Clients....................................................................................... 10
4.3.2 FFIs Fail to Provide the Financial Product that
Rural Clients are Looking for............................................... 10
4.3.3 High Transaction Costs.......................................................................................................................................... 10
4.3.4 Neglecting Savings Mobilisation.......................................................................................................................... 10
4.3.5 Internal Structure..................................................................................................................................................... 10
4.4 Superiority of the Formal Financial Sector.................................................................................................................. 10
CHAPTER 5 INFORMAL AND SEMI-FORMAL FINANCE................................................ 10
5.1 Informal Finance.............................................................................................................................................................. 10
5.1.1 Types of Informal Finance..................................................................................................................................... 10
5.1.1.1 Self-help Groups............................................................................................................................................... 10
5.1.1.1.1 Accumulating Saving and Credit Associations (ASCRAs)............................................................ 10
5.1.1.1.2 Rotating Savings and Credit Associations (ROSCAs)................................................................... 10
5.1.1.2 Individual Moneylending............................................................................................................................... 10
5.1.1.2.1 Friends, Neighbours and Relatives.................................................................................................... 10
5.1.1.2.2 Moneylender........................................................................................................................................... 10
5.1.1.2.3 Mobile Informal Bankers...................................................................................................................... 10
5.1.1.2.4 Savings and Loan Companies............................................................................................................. 10
5.1.1.2.5 Loan Brokers.......................................................................................................................................... 10
5.1.1.2.6 Money Guards........................................................................................................................................ 10
5.1.1.2.7 “Non-Financial” Financiers............................................................................................................... 10
5.1.1.2.8 Landlords................................................................................................................................................ 10
5.1.1.3 Partnership Firms.............................................................................................................................................. 10
5.1.1.3.1 Pawnbrokers........................................................................................................................................... 10
5.1.2 Advantages and Disadvantages of the Informal
Financial Sector.................................................................. 10
5.1.2.1 Advantages of Informal Finance................................................................................................................... 10
5.1.2.1.1 Information.............................................................................................................................................. 10
5.1.2.1.2 Personal Ties and Social Pressure..................................................................................................... 10
5.1.2.1.3 Accessibility............................................................................................................................................ 10
5.1.2.1.4 Flexibility and Adaptability................................................................................................................ 10
5.1.2.1.5 Transaction costs................................................................................................................................... 10
Variable................................................................................................................................................................................... 10
Formal...................................................................................................................................................................................... 10
Informal................................................................................................................................................................................... 10
5.1.2.1.6 Collateral Substitutes........................................................................................................................... 10
5.1.2.1.7 Loan use................................................................................................................................................... 10
5.1.2.1.8 Loan Repayment..................................................................................................................................... 10
5.1.2.2 Disadvantages of Informal Finance............................................................................................................... 10
5.1.2.2.1 Segmentation,
Fragmentation and Dualism..................................................................................... 10
5.1.2.2.2
Exploitation............................................................................................................................................ 10
5.1.2.2.3 Small Amounts on Short Term............................................................................................................. 10
5.1.2.2.4 Co-variant situations............................................................................................................................ 10
5.2 Semi-formal Finance........................................................................................................................................................ 10
5.2.1 Co-operatives Institutions and Credit Unions.................................................................................................... 10
5.2.2 Non-Governmental Organisations (NGOs).......................................................................................................... 10
CHAPTER 6 LINKING FORMAL AND INFORMAL FINANCE......................................... 10
6.1 Introduction..................................................................................................................................................................... 10
6.2 Competition or Complementation................................................................................................................................. 10
6.3 Justifications to Enhance Linkages.............................................................................................................................. 10
6.3.1 Advantages for Formal Finance............................................................................................................................ 10
6.3.2 Advantages for Informal Finance......................................................................................................................... 10
6.3.3 In General.................................................................................................................................................................. 10
6.4 Options and Strategies................................................................................................................................................... 10
6.4.1 Strengthening Existing Linkage............................................................................................................................. 10
6.4.2 Mimicry Option........................................................................................................................................................ 10
6.4.3 Groups....................................................................................................................................................................... 10
6.4.4 Tying Loans and Deposits..................................................................................................................................... 10
6.4.5 Incorporating Traditional Informal Financial
Institutions................................................................................. 10
6.4.6 Formalising Informal Financial Institutions......................................................................................................... 10
6.4.7 Incorporating Semi-Formal Financial Institutions
and Other Non-Financial Entities................................... 10
6.4.7.1 Co-operatives.................................................................................................................................................... 10
6.4.7.2 Non-Governmental Organisations................................................................................................................. 10
6.4.7.3 Non-financial Agents...................................................................................................................................... 10
6.4.8 Guarantees................................................................................................................................................................ 10
6.5 Thoughts on Achieving Effective Linkages............................................................................................................... 10
6.5.1 The Role of the Government.................................................................................................................................. 10
6.5.2 The Role of Formal Financial Institutions............................................................................................................ 10
6.5.3 The Role of the Informal Financial Sector............................................................................................................ 10
6.5.4 Role of Foreign Aid................................................................................................................................................. 10
REFERENCES........................................................................................................................... 10
APPENDIXES............................................................................................................................ 10
Appendix I.
Standard Household Model for Consumption Credit............................................................................... 10
Appendix II.
Savings........................................................................................................................................................... 10
1. Introduction................................................................................................................................................................... 10
2. Reasons to Mobilise Voluntary Rural Savings........................................................................................................ 10
3. A Warning..................................................................................................................................................................... 10
Appendix III.
Strategies to Promote Rural Finance......................................................................................................... 10
1. Introduction................................................................................................................................................................... 10
2. Subsidised Finance...................................................................................................................................................... 10
3. Targeting........................................................................................................................................................................ 10
3.1 Loan Portfolio Requirements................................................................................................................................ 10
3.2 Rediscount facilities............................................................................................................................................... 10
3.3 Loan and crop guarantees.................................................................................................................................... 10
3.4 Quotas for Commercial Banks.............................................................................................................................. 10
3.5 Bank Nationalisation.............................................................................................................................................. 10
4. Rationed Credit............................................................................................................................................................. 10
Appendix IV.
Kenya Rural Enterprise Model................................................................................................................... 10
1. Introduction................................................................................................................................................................... 10
2. Financial Performance.................................................................................................................................................. 10
3. Innovations and Lessons Learned............................................................................................................................ 10
Appendix V.
Mean Loan Administration Costs.............................................................................................................. 10
Bank Type.............................................................................................................................................................................. 10
Development bank............................................................................................................................................................ 10
Unit Rural Bank................................................................................................................................................................. 10
Overall................................................................................................................................................................................ 10
SSE = Small scale enterprise............................................................................................................................................ 10
SLC = Saving and loan company................................................................................................................................... 10
Appendix VI. Donor Organisations................................................................................................................................... 10
1. ALTERFIN..................................................................................................................................................................... 10
1.1 In the South....................................................................................................................................................... 10
1.2 In the North....................................................................................................................................................... 10
1.3 Transaction Costs............................................................................................................................................ 10
1.4 Repayment......................................................................................................................................................... 10
1.5 Credit Use.......................................................................................................................................................... 10
1.6 Hindrances........................................................................................................................................................ 10
REFERENCE...................................................................................................................................................................... 10
2. BILANCE....................................................................................................................................................................... 10
2.1 Bilance’s Policy............................................................................................................................................... 10
2.2 In the North....................................................................................................................................................... 10
2.3 Organisational Structure............................................................................................................................... 10
2.4 In the South....................................................................................................................................................... 10
3. ECUMENICAL DEVELOPMENT CO-OPERATIVE SOCIETY (EDCS)................................................................ 10
3.1 Objectives.......................................................................................................................................................... 10
3.2 Project Criteria................................................................................................................................................ 10
3.3 In the North....................................................................................................................................................... 10
3.4 Challenges........................................................................................................................................................ 10
3.5 In the South....................................................................................................................................................... 10
3.6 EDCS Case Study............................................................................................................................................. 10
Appendix VII.......................................................................................................................................................................... 10
African Development Indicators (The World Bank, 1996)............................................................................................. 10
1. Poverty.......................................................................................................................................................................... 10
2. Urbanisation.................................................................................................................................................................. 10
3. Percentage of Population Below Absolute Poverty................................................................................................ 10