Finance for All?: Policies and Pitfalls in Expanding Access

FINANCE FOR ALL?

A World Bank Policy Research Report

FINANCE FOR ALL?

POLICIES AND PITFALLS IN EXPANDING ACCESS

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ISBN: 978-0-8213-7291-3

eISBN: 978-0-8213-7292-0

DOI: 10.1596/978-0-8213-7291-3

Cover photo: Comstock.

Cover design: Critical Stages.

Library of Congress Cataloging-in-Publication Data

Demirgüç-Kunt, Aslı, 1961–

Finance for all?: policies and pitfalls in expanding access / [by Aslı Demirgüç-Kunt, Thorsten Beck, and Patrick Honohan].

p. cm.

Includes bibliographical references and index.

ISBN 978-0-8213-7291-3 -- ISBN 978-0-8213-7292-0 (electronic)

1. Financial services industry--Developing countries. 2. Banks and banking--Developing countries.

I. Beck, Thorsten. II. Honohan, Patrick. III. World Bank. IV. Title.

HG195.D46 2007

332.109172’4--dc22

2007033387

Contents

Foreword

Access to financial services varies sharply around the World. In many developing countries, less than half the population has an account with a financial institution, and in most of Africa less than one in five households do. Recent development theory sees the lack of access to finance as a critical mechanism for generating persistent income inequality, as well as slower growth. Without inclusive financial systems, poor individuals and small enterprises need to rely on their own limited savings and earnings to invest in their education, become entrepreneurs, or take advantage of promising growth opportunities. Financial sector policies that encourage competition, provide the right incentives to individuals, and help overcome access barriers are thus central not only to stability but also to growth, poverty reduction, and more equitable distribution of resources and capacities.

The World Bank Group has long recognized that well-functioning financial systems are essential for economic development. The work of its financial sector has, over the years, emphasized the importance of financial stability and efficiency. Promoting broader access to financial services, however, has received much less attention despite the emphasis it has received in theory. The access dimension of financial development has often been overlooked, mostly because of serious data gaps in this area. Empirical evidence that links access to financial services to development outcomes has been quite limited, providing at best tentative guidance for public policy initiatives. The increasing emphasis by policy circles in recent years on building more inclusive financial systems thus highlights the need for better data and analysis.

Measuring access to finance, its determinants, and its impact has been the focus of a major research effort at the Bank in recent years. This research has included case-study analyses of specific policies and interventions, as well as systematic analyses of extensive cross-country and micro data sets. Finance for All? presents first efforts at developing indicators illustrating that financial access is quite limited around the world and identifies barriers that may be preventing small firms and poor households from using financial services. Based on this research, the report derives principles for effective government policy on broadening access.

The report’s conclusions confirm some traditional views and challenge others. For example, recent research provides additional evidence to support the widely-held belief that financial development promotes growth and illustrates the role of access in this process. Improved access to finance creates an environment conducive to new firm entry, innovation, and growth. However, research also shows that small firms benefit the most from financial development and greater access—both in terms of entry and seeing their growth constraints relaxed. Hence, inclusive financial systems also have consequences for the composition and competition in the enterprise sector.

The evidence also suggests that besides the direct benefits of access to financial services, small firms and poor households can also benefit indirectly from the effects of financial development. For example, the poor may benefit from having jobs and higher wages, as better developed financial systems improve overall efficiency and promote growth and employment. Similarly, small firms may see their business opportunities expand with financial development, even if the financial sector still mostly serves the large firms. Hence, pro-poor financial sector policy requires a broader focus of attention than access for the poor: improving access by the excluded nonpoor micro and small entrepreneurs can have a strongly favorable indirect effect on the poor.

Expanding access to financial services remains an important policy challenge in many countries, with much for governments to do. However, not all government action is equally effective, and some policies can be counterproductive. Policy makers need to have realistic goals. For instance, while access to formal payment and savings services can approach universality as economies develop, not everyone will or should qualify for credit. There are instances where national welfare has been reduced by overly relaxed credit policies.

Government policies in the financial sector should focus on reforming institutions, developing infrastructures to take advantage of technological advances, encouraging competition, and providing the right incentives through prudential regulations. The report discusses experience and evidence of different government interventions—such as those through taxes, subsidies, and direct ownership of institutions—illustrating how they sometimes tend to be politicized, poorly structured, and beneficial mainly those who do not need the subsidy. In the absence of thorough economic evaluations of most schemes, their net effect in cost-benefit terms also remains unclear.

Despite best efforts, it seems likely that provision of some financial services to the very poor may require subsidies. Generally speaking, the use of subsidies in microcredit can dull the incentive for innovative new technologies in expanding access, with counterproductive long-term repercussions for the poor. Besides, evidence suggests that for poor households credit is not the only—or in many cases, the principal—financial service they need. For example, in order to participate in the modern market economy even the poor need—but often cannot access—reliable, inexpensive, and suitable savings and payments products. Subsidies may sometimes be better spent on establishing savings and payment products appropriate to the poor.

This report reviews and synthesizes a large body of research, and provides the basis for sound policy advice in the area of financial access. We hope that it will contribute to the policy debate on how to achieve financial inclusion. While much work has been done, much more remains to be learned. The findings in this report also underline the importance of investing in data collection: continued work on measuring and evaluating the impact of access requires detailed micro data both at the household and enterprise level.

The World Bank Group is committed to continuing work in the area of building inclusive financial systems, helping member countries design financial system policies that are firmly based on empirical evidence.

François Bourguignon

Senior Vice President and Chief Economist

World Bank

Michael Klein

Vice President, Financial and

Private Sector Development, World Bank

Chief Economist, IFC

The Report Team

This policy research report was written by Asli Demirgüç-Kunt, Thorsten Beck (both with the Development Research Group), and Patrick Honohan (Development Research Group and Trinity College Dublin), under the general supervision of L. Alan Winters (Development Research Group). It draws heavily on the results of the on-going research program in the Finance and Private Sector Team of the Development Research Group at the World Bank. Original research as background for this report includes work by the authors and by Meghana Ayyagari (George Washington University), Robert Cull, Xavier Gine, Leora Klapper, Luc Laeven (now at the IMF), Ross Levine (Brown University), Inessa Love, Vojislav Maksimovic (University of Maryland), Maria Soledad Martinez Peria, David McKenzie, Sergio Schmukler, Colin Xu, and Bilal Zia.

The peer reviewers for the report were Franklin Allen (Wharton School), Stijn Claessens (IMF), Augusto de la Torre, Michael Fuchs, Richard Rosenberg (CGAP), and Guillermo Perry. The authors also benefited from conversations with and comments from Finance and Private Sector Board members, members of the UN Advisors Group for Building Inclusive Financial Systems, participants of the 2007 IMF-World Bank Dutch Constituency meeting in Moldova, and the 2007 WBER-DECRG conference on Access to Finance in Washington, DC. While the analysis in this report needs to satisfy scientific standards and hence is mainly based on academic research, the study has also benefited from extensive discussions with policy makers and advisers in the course of operational support for World Bank diagnostic and policy development work in the financial sector.

The authors are also grateful to Priya Basu, Gerard Caprio (Williams College), Shawn Cole (Harvard Business School), Gerrardo Corrochano, Carlos Cuevas, Uri Dadush, Enrica Detragiache (IMF), Quy-Toan Do, Samir El Daher, Aurora Ferrari, Francisco Ferreira, Inderbir Dhingra, Matthew Gamser, Alan Gelb, Michael Goldberg, Arvind Gupta, Santiago Herrera, Alain Ize, Eduardo Levy-Yeyati, Omer Karasapan, Shigeo Katsu, Aart Kraay, Anjali Kumar, Rodney Lester, Latifah Osman Merican, Pradeep Mitra, Ashish Narain, Tatiana Nenova, David Porteous, Roberto Rocha, Luis Serven, Patrick Stuart, and Willem van Eeghen for comments.

The authors would like to acknowledge the editorial assistance of Mark Feige. Edward Al-Hussainy and Subika Farazi provided excellent research assistance and Agnes Yaptenco superb administrative support. Polly Means contributed to cover design and graphics. Report design, production, and dissemination were coordinated by the World Bank Publications team. We are grateful to Stephen McGroarty and Santiago Pombo Bejarano in the Office of the Publisher, and to Arvind Gupta, Merrell Tuck-Primdahl, and Kavita Watsa for assistance in dissemination.

Financial support from the Knowledge for Change Program is gratefully acknowledged.

The findings, interpretations, and conclusions of this policy research report are those of the authors and do not necessarily reflect the views of the World Bank, its executive directors, or the countries they represent.

Abbreviations

Overview and Summary

Introduction

Finance is an essential part of the development process—

FINANCIAL MARKETS AND INSTITUTIONS EXIST TO MITIGATE THE effects of information asymmetries and transaction costs that prevent the direct pooling and investment of society’s savings. Financial institutions help mobilize savings and provide payments services that facilitate the exchange of goods and services. In addition, they produce and process information about investors and investment projects to enable efficient allocation of funds; to monitor investments and exert corporate governance after those funds are allocated; and to help diversify, transform, and manage risk. When they work well, financial institutions and markets provide opportunities for all market participants to take advantage of the best investments by channeling funds to their most productive uses, hence boosting growth, improving income distribution, and reducing poverty. When they do not work well, opportunities for growth are missed, inequalities persist, and in the extreme cases, costly crises follow.

—and a well-functioning system needs broad access, as well as depth

Much attention has focused on the depth and efficiency of financial systems—and for good reason: well-functioning financial systems are by definition efficient, allocating funds to their most productive uses. Well-functioning financial systems serve other vital purposes as well, including offering savings, payments, and risk-management products to as large a set of participants as possible, and seeking out and financing good growth opportunities wherever they may be. Without inclusive financial systems, poor individuals and small enterprises need to rely on their personal wealth or internal resources to invest in their education, become entrepreneurs, or take advantage of promising growth opportunities. Modern development theories increasingly emphasize the key role of access to finance: lack of finance is often the critical element underlying persistent income inequality, as well as slower growth.

Thus, access to finance helps to equalize opportunities and reduce inequalities—

Earlier theories of development postulated that a rise in short-term inequality was an inevitable consequence of the early stages of development. However, it is increasingly recognized that inequality can adversely affect growth prospects—which implies that wealth redistribution can spur development. Despite the emphasis that financial market imperfections now receive in theory, development economists have tended to advocate the adoption of redistributive public policies to improve wealth distribution and to foster growth. However, since financial market imperfections that limit access to finance play an important role in perpetuating inequalities, financial sector reforms that promote broader access to financial services need to be at the core of the development agenda. Indeed, if financial market frictions are not addressed, redistribution may have to be endlessly repeated, which could result in damaging disincentives to work and save. In contrast, building inclusive financial systems focuses on equalizing opportunities. Hence, addressing financial market imperfections that expand individual opportunities creates positive, not negative, incentive effects. While theory highlights the risk that selectively increased access could worsen inequality, both cross-country data and evidence from specific policy experiments suggest that more-developed financial systems are associated with lower inequality. Hence, though still far from conclusive, the bulk of the evidence suggests that developing the financial sector and improving access to finance are likely not only to accelerate economic growth, but also to reduce income inequality and poverty.

—but the access dimension of financial development has often been overlooked

Access to financial services—financial inclusion—implies an absence of obstacles to the use of these services, whether the obstacles are price or nonprice barriers to finance. It is important to distinguish between access to—the possibility to use—and actual use of financial services. Exclusion can be voluntary, where a person or business has access to services but no need to use them, or involuntary, where price barriers or discrimination, for example, bar access. Failure to make this distinction can complicate efforts to define and measure access. Financial market imperfections, such as information asymmetries and transaction costs, are likely to be especially binding on the talented poor and on micro- and small enterprises that lack collateral, credit histories, and connections. Without inclusive financial systems, these individuals and enterprises with promising opportunities are limited to their own savings and earnings. This access dimension of financial development has often been overlooked, mostly because of serious data gaps on who has access to which financial services and a lack of systematic information on the barriers to broader access.

This report presents access indicators, evaluates impact, and provides policy advice

This report is a broad-ranging review of research work, completed or in progress, focusing on access to finance. The report presents indicators to measure financial access, analyzes its determinants, and evaluates the impact of access on growth, equity, and poverty reduction, drawing on research that uses data both at the firm and household level. The report also discusses the role of government in advancing financial inclusion, and these policy recommendations are stressed throughout the report. Although much remains to be learned, a significant amount of empirical analysis has been conducted on these issues over the past years. As with any review, taking stock of all this research also allows us to identify the many gaps in our knowledge and helps chart the way for a new generation of research in this area.

The report pays particular attention to the following themes:

Measuring access. How well does the financial system in different countries directly serve poor households and small enterprises? Just how limited is financial access? Who has access to which financial services (such as deposit, credit, payments, insurance)? What are the chief obstacles and policy barriers to broader access?

Evaluating the impact of access. How important is access to finance as a constraint to the growth of firms? What are the channels through which improved access affects firm growth? What is the impact of access to finance on households and microenterprises? What aspects of financial sector development matter for broadening access to different types of financial services? What techniques are most effective in ensuring sustainable provision of credit and other financial services on a small scale?

Adopting policies to broaden access. What is the government’s role in building inclusive financial systems? Given that financial systems in many developing countries serve only a small part of the population, expanding access remains an important challenge across the world, leaving much for governments to do. Not all government actions are equally effective, however, and some policies can be counterproductive. The report sets out principles for effective government policy on broadening access, drawing on the available evidence and illustrating with examples.

Box Outline of this report

This overview introduces the main messages of the report, pulling together theory, data, and analysis. It then presents the key policy implications of this material and highlights some of the challenges in the implementation of these recommendations. It concludes with directions for future research.

Chapter 1 starts with analyses of the theoretical models that illustrate the crucial role access to finance plays in the development process, particularly its influence on both growth and income distribution. Then the chapter examines various data sets to assess the ability of both firms and households to access financial services, to identify barriers to access, and to provide an empirical foundation to better understand the welfare impacts of broader financial access.

Chapter 2 focuses on the ability of firms, particularly small firms, to access financial services. It investigates not only the implications for growth and productivity for individual firms, and the economy at large, but also the impact that restrictive financial access can have on the structure of the economy. The chapter also explores which aspects of financial sector development matter for access to external finance—looking at banks, markets, and nonbank finance, and focusing especially on the role of foreign banks.

Attention turns to households and microentrepreneurs in chapter 3, which examines whether an emphasis on financial sector development as a driver of economic growth is consistent with a pro-poor approach to development. After reviewing the theory, empirical evidence at both the micro and macro levels is presented. The chapter then analyzes the barriers to access and how they can be overcome, with particular consideration given to the promise and limitations of microfinance.

An analysis of the government’s role in facilitating access to financial services is presented in chapter 4. The chapter starts with a discussion of the important role that institution-building must play in improving access in particular and financial development in general. It then turns to measures to boost market capacity, improve competition and efficiency, and regulate against exploitative and imprudent practices. This is followed by a discussion of the impact that governments can have by owning or subsidizing financial service providers; as an example, the case of government-backed credit guarantee schemes is looked at in some depth. Before concluding, the chapter considers key issues in the political economy of access.

The first step to improving access is measuring it—

While data on the financial sector are often considered to be readily available, systematic indicators of access to different financial services are not. Indeed, access is not easy to measure, and empirical evidence linking access to development outcomes has been quite limited because of lack of data. Existing evidence on the causal relations between financial development, growth, and poverty is consistent with theory. However, most of the evidence comes either from highly aggregated indicators that use financial depth measures instead of access or from micro studies that use financial or real wealth to proxy for credit constraints.

—but the paucity of data presents methodological challenges

One of the key problems in assessing financial inclusion is that—unlike indicators of financial depth—an analysis of aggregated data sets has limited value. Simply knowing how many deposit accounts there are, for example, does not reveal much. Some individuals or firms may have multiple accounts, while others have none; moreover, regulatory authorities generally do not collect data on individual account holders. Therefore the best data would be generated by census or survey, which would allow researchers to measure financial access across subgroups. Few such surveys exist for households, however, and the data sets that are available are often not compatible from one country to the next.

In the absence of comprehensive micro data, researchers have sought to create synthetic headline indicators, combining more readily available macro data with the results of existing surveys. These headline indicators indicate that households around the world have limited access to and use of financial services: in most developing countries less than half the population has an account with a financial institution, and in many countries less than one in five households does (figure 1).

Figure 1 Proportion of households with an account in a financial institution

Note: Figure shows the highest and lowest national percentages, as well as the median and quartiles, for the countries in each region.

Source: Honohan (2006).

Survey data on the access of firms to finance are more plentiful—although there are concerns about the representativeness of the surveys, particularly with regard to the inclusion of the informal sector (which is larger than the formal sector in many countries). Survey data indicate that less than 20 percent of small firms use external finance, about half the rate of large firms. And in three regions, at least 40 percent of firms report that access to and cost of finance is an obstacle to their growth (figure 2).

Figure 2 Percentage of firms reporting finance as a problem

Note: Figure shows the percentage of firms reporting access to finance or cost of finance as a severe or major obstacle to firm growth.

Source: Investment Climate Survey (ICS) responses by enterprises in 76 countries, grouped by region.

Identifying barriers to access: physical access, eligibility, and affordability

Why do large proportions of the populations in many developing countries not use financial services? Identifying the barriers that prevent small firms and poor households in developing countries from using financial services not only helps researchers understand the reasons for financial exclusion but also