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FUNCTIONS OF FINANCE

The financial system is a key component of the institutional infrastructure that is required

for the efficient operation of all markets. The most important contribution of the financial system is its ability to induce a larger size and foster a greater degree of integration of the markets for provision of goods and services, factors of production, and other assets. This expansion of markets is a precondition for powerful processes of division of labor and specialization, greater competition, the use of modern technologies, and the exploitation of economies of scale and of economies of scope. As already noted by Adam Smith, these are the processes that increase the productivity of available resources and lead to economic growth. With economic growth there are multiplier effects that spill off to Financial Development and Poverty Reduction.

The expansion and integration of markets is achieved through the provision of monetization services and the efficient management of the payments system, the development of services of intermediation between surplus and deficit economics agents, and the establishment of opportunities for the accumulation of stores of value, the management of liquidity, and the transformation, sharing, pooling, and diversification of risk (Long). Particularly important are the services of financial intermediation, which transfer purchasing power from agents with resources in excess of those needed to take advantage of their own (internal) opportunities (surplus agents, such as savers), to those with better opportunities but not enough resources of their own (deficit agents, such as investors). This is critical for financial inclusiveness. By making this division of labor between savers and investors possible, financial intermediaries channel resources from producers, activities, and regions with a limited growth potential to those where a more rapid expansion of output is possible.

Since there always are more economic agents who claim that they have superior uses for

resources than there is purchasing power available, financial markets must contribute to the selection of the best possible uses of resources. These markets can also offer monitoring services, ensuring that funds are profitably used, as promised, and they can contribute to the enforcement of contracts, making sure that those who have borrowed repay the loans (Stiglitz). This is where regulators such as central banks come into play. After all, finance is about promises to pay in the future that are expected to be fulfilled. If this is not handled properly the consequences are disastrous, like the current economic crisis that has its roots in poor regulation of the financial sector. The conditions of such repayment influence, in turn, who bears what risks.

We cannot sufficiently emphasize the extent to which the efficient provision of financial services is extremely critical for the operation of the economy at large. Because financial markets essentially influence the allocation of resources, Stiglitz has compared them to the “brain” of the entire economic system, the central locus of decision making: if they fail. . .the performance of the entire economic system may be impaired. Why this is the case is a complex question, but if it is indeed so, there is clearly a major social interest at stake here. Most governments have recognized this and many have gone to extremes in order to prevent a collapse of their financial systems. Frequently, however, while recognizing but (mis)understanding their powers, governments have intervened in financial markets, in the pursuit of a varied range of worthy nonfinancial objectives, but with negative consequences. We need to think through as regulators therefore to mitigate this competing needs of positive and negative consequences when coming up with financial inclusion vision.

5.0  FINANCE AND POVERTY: LESSONS FROM THE PAST

A good number of the initiatives to directly assist the poor with financial services (may)

fall under this category of unsuccessful interventions. In considering such interventions,

moreover, a key question to address is their potential cost in terms of the reduced efficiency of the financial system at large. This is a cost that it might be worth enduring, if the expected benefits were sufficiently large. Unfortunately, this is typically not the case, given the very nature of financial markets.

According to Gonzalez-Vega this is one of the most important lessons learned from earlier attempts to use formal financial markets to ostensibly promote particular activities, to compensate producers for other repressive policies, to free them from the grip of moneylenders, or to redistribute income towards the poor (Gonzalez-Vega 1993). The subsidized interest rates and administrative loan allocations through targeted credit programs, used for these purposes, did not displace informal sources of financial services and hardly promoted anything. They only redistributed income, but in reverse, from poor to rich (Gonzalez-Vega 1984). So, despite the best of intentions, they frequently turned out to be harmful for the particular segments of the population (marginal clientele) they had been set out to help. As a country, therefore we need a concise visionary action to avoid redistribution of income from the poor to the rich. This is common where commercial lenders with the high pegged interest rates are targeting the poor exploitatively.

These outcomes are well known and have been extensively documented for dozens of

countries (Adams et al.). Too much effort was spent in small farmer credit programs, for

example, to obtain meager results. The primary objective of increasing the farmers’ access to formal credit was poorly met and a reduction in the cost of borrowing was achieved only for a few larger borrowers in most poor countries. Despite artificially low interest rates, formal credit did not become cheap for small rural producers and most credit portfolios became concentrated in a few hands. Even in stagnant economies, nevertheless, finance plays a role in consumption smoothing. This role is frequently performed well by informal financial arrangements (Udry).

More importantly, these government-sponsored credit programs distracted attention from technological innovation, infrastructure development, and human capital formation, which directly increase the productivity of resources. Finance, instead, can only contribute to this goal indirectly, by making it possible for some to take advantage of the opportunities created by those other growth-inducing processes. In the absence of such opportunities, however, there is only a limited role for finance to play.

There is an increasing body of evidence confirming that economic growth and reductions

in poverty go hand in hand. Clearly, a substantial improvement in living standards requires economic growth (Biggs et al.). Further, securing full participation of the poor in such process is a long-term effort and it involves improving their employability, expanding the educational opportunities for their children, improving the performance of labor markets, creating a hospitable environment for their productive activities and much more. An efficient provision of the financial services that they demand is part (but only a part) of all of this process.

So, to the question “Can financial services be used to assist the poor in improving their

lot?” the answer is “only when finance is allowed to do what finance is supposed to do.”

That is, only when:

(a)       finance allows a transfer of purchasing power from uses with low to uses with high marginal rates of return;

(b)       finance contributes to more efficient inter-temporal decisions about saving, the

accumulation of assets, and investment;

(c)       finance makes possible a less costly management of liquidity and accumulation of stores of value; and

(d)       finance offers better ways to deal with the risks implicit in economic activities.

Otherwise, financial interventions (such as the early subsidized and targeted credit

programs) are a weak instrument to achieve different, non-financial objectives and frequently lead to unexpectedly negative outcomes (Gonzalez-Vega, 1994). This section can be summarized with the proposition that many ingredients are needed for the poor to come out of poverty and that credit is only one of them. Credit is an important ingredient, but it is not even the most important one. Financial services play the key role of facilitating the work of growth-promoting forces, but only when the opportunities exist. In this case the poor also need saving facilities as it is one of the most important ways of storing their value. Therefore poor countries should encourage deposit taking MFIs for this objective to be fully met.

6.0  LESSONS LEARNED ABOUT LOANS AND DEPOSITS

As alluded to above, a second important lesson learned from accumulated experience is that, among financial services, credit is not the only one that is important for the poor. In particular, deposit facilities provide valuable services for liquidity management and for the accumulation of stores of value by poor firm-households. Researchers are always surprised by the intensity of the demand for deposit facilities in the rural areas of very poor countries (Gonzalez-Vega et al.). According Robinson, to satisfaction of this demand has been a distinctive feature of programs that have been successful in delivering financial services to the poor (Robinson). An outstanding example is the unit desa program of the Bank Rakyat Indonesia, with over 12,000,000 small depositors for only over 2,000,000 small borrowers (Patten and Rosengard). Thus, while not all producers demand loans and, among those in need the majority needs saving facilities. Among others, we need to emphasize the importance of payments services, particularly for remittances and other money transfers In this regard financial inclusion will be approached in a holistic manner. We fully agree that a payments service is another important service for the poor. Therefore payment system should collaborate well with saving and provision of credit for the full attainment of financial inclusion.

Empirical evidence clearly demonstrates that the poor do not demand credit all of the time, most (if not all) economic agents demand deposit and other facilities for liquidity management and reserve accumulation, all of the time.

A third lesson from direct experience is that the demand for credit is not just a demand for loanable funds. Finance is intimately linked to inter-temporal decisions, and in this sense it plays a critical role not only in savings and investment processes but also in dealing with the lack of synchronization between income generating (production) and spending activities (consumption and input use decisions), as well. Finance is also closely associated with risk management. It facilitates the accumulation of reserves for precautionary reasons (to be able to survive emergencies) and for speculative purposes (to be able to take advantage of unexpected future opportunities). For this, being creditworthy is critical. Being creditworthy is equivalent to possessing a credit reserve: poor people do not necessarily want a loan now; they want the opportunity to get one, if and when they need it (Baker). They want this potential access to a loan to be reliable, to result in a timely and flexible disbursement of funds, to be always there. According to research finding, because the informal sources of credit do offer these opportunities, poor people are reluctant to substitute formal sources of funds, no matter how subsidized, for the flexible and reliable informal financial arrangements that have served them well over the years.

Thus, what matters is not just access to loanable funds (credit) but the development of an

established credit relationship. This, in turn, implies a sense of permanency of the financial institution. A fourth lesson learned, in this connection, is that a financial intermediary cannot be restricted to credit provision alone but to institutional framework support.

7.0  INSTITUTIONAL VIABILITY AND THE POOR

With every program we have learned that the most severe deficiency of the earlier

interventions to provide financial services to the poor was the lack of institutional viability of the organizations that were created for that purpose. For instance, why does viability matter so much? The concern with viability springs first from a clear recognition of the scarcity of resources. If resources are limited, without self-sufficient financial institutions there is little hope for reaching the numbers of poor firm-households that are potential borrowers and depositors. The amounts required are beyond the ability and willingness of governments and donors to provide them (Otero and Rhyne). We therefore, as poor nations need to guard against weak prospective financial services in the system to compliment government and donors’ efforts.

The alternative to viable organizations are expensive, unviable quasi-fiscal programs that reach only a selected few beneficiaries. Thus, viability matters the most from this equity perspective: to be able to reach more than just a privileged few. Moreover, if the objective were just a one-time (transitory) injection of funds, then lump-sum transfers are always a more efficient way of accomplishing this. If, on the other hand, sustainability is important, then the viability of the financial organization matters.

Further, in addition to being fiscally feasible, the most important contribution of a concern with institutional viability is that it elicits appropriate incentives among all the participants in financial transactions. Thus, for example, while poor loan recovery rapidly destroys viability, an image of viability improves repayment discipline. A reputation as a good borrower in an established intermediary-client relationship is a more valuable intangible asset if the financial institution is expected to be permanent rather than transitory.

When this intangible asset is sufficiently valuable, it elicits punctual repayment. When the organization’s survival is questioned, on the other hand, default follows in stampede, and institutional breakdown becomes a self-fulfilling prophecy. Viability matters when repayment matters. Therefore, there is strong need to ensure that borrowers have a good credit culture. This is where a strong credit reference service is imperatively needed to enhance good credit culture.

In this way, a concern with viability makes it possible to identify one way how interest

rates and default rates are linked. Too low interest rates that cause intermediary losses are

perceived by borrowers as signals of lack of permanency and thus delinquency follows..

Moreover, in the same way that very high interest rates may induce adverse selection (Stiglitz and Weiss), too low rates tend to attract rent seekers who eventually default (Gonzalez-Vega 1993). Thus, both too high and too low interest rates may reduce expected intermediary profits through higher expected default rates. There is need to strike a balance, to make sure that real interest rates strike a balance

As another example, the targeting of loan uses, irrelevant because of the fungibility of

funds (Von Pischke and Adams), basically increases both lender and borrower transaction costs and reduces the quality of the services supplied by the intermediary and thus lowers the value of the intermediary-client relationship.

In summary, targeting hurts viability in several ways. It reduces the scope for portfolio diversification in already highly specialized lenders. It limits the lender’s degrees of freedom in screening loan applicants, and it reduces incentives for vigorous loan collection, shifting accountability for default from the lender to the donor that conditions the availability of funds to their use for specific targets (Aguilera-Alfred and Gonzalez-Vega). Findings reveal that compliance with the targeting becomes imperatively difficult, for a long time many donors ignored this potential impact of targeting on delinquency, but they were very surprised when rampant default destroyed the institutions that had been (ab)used to easily channel donor funds.

Deposit mobilization, on the other hand, is not an easy task. It requires an appropriate organizational design, liability management techniques, and prudential supervision to protect depositors. You therefore require a strong and resilient regulator.

Finally, deposit mobilization is also intimately linked to the importance of institutional

viability. Deposits provide information to the lender about the potential borrowers, create a basis of mutual trust, and facilitate the accumulation of a down payment that can serve as a deductible in any future loan contract. Deposits contribute, therefore, to the solution of difficult information problems frequently encountered in financial markets. Moreover, healthy deposit mobilization creates an image of institutional viability that promotes repayment. Thus, while donor-funded loans may not be repaid, those funded with the neighbor’s deposits are (Aguilera-Alfred andGonzalez-Vega).

Most importantly, depositors create institutional independence from the whims of donors

and politicians; they shield the financial organization from political intrusion (Poyo, Gonzalez-Vega and Aguilera-Alfred). In general, deposit mobilization contributes to sustainability and to an organizational environment (corporate culture) where permanency becomes an important (compatible) incentive to attract and retain competent managers and induce the agency’s staff to behave in ways compatible with the viability of organization. For them, the value of their relationship with the organization increases when deposits are an important source of funds. This encourages correct decisions and effort (Chaves 1993).

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