Financial Sector Development and Poverty Reduction April 3, 2006
Structure of the Financial System The Financial sector is all of the wholesale, retail, formal and informal institutions in an economy offering financial services to consumers, businesses and other financial institutions It consists of financial intermediaries: (banks, insurance companies, finance companies, and credit unions) and financial markets: (money markets, stock exchanges, and foreign exchange markets) It can also include money lenders and microfinance institutions
A developed financial system performs five basic functions Provides safe repositories for savings; provides credit; mobilizes savings for investment Facilitates the trading, diversification, and management of risk Provides information on investment opportunities, and facilitates a more efficient allocation of resources in an economy Monitors borrowers and facilitates payments Facilitates trade of goods and services Improving access of both the private sector and the poor to these services is an important policy objective
Provides Safe Repository for and Mobilizes Savings Financial institutions provide account holders with a safe place to collect their savings FIs can mobilize savings for productive investment FIs facilitate capital inflows and remittances from abroad All of these stimulate investment in both physical and human capital, increasing productivity
Facilitate the trading, diversification, and management of risk Derivatives instruments allow companies and institutions to hedge financial risk Insurance provides an opportunity to pool risk and thus protect against losses (by pooling the resources of many to compensate for the losses of a few) Investment vehicles provide an opportunity to pool some of the risk associated with investing Securitization -- creating a financial instrument by combining other financial assets and then marketing them to investors allows banks to take illiquid assets and make them liquid Can facilitate development of a mortgage market
Provides information on investment opportunities and brings borrowers and savers together Financial intermediaries have economies of scale in information gathering, assessment and monitoring of investments Markets reduce the role of banks in the investment process, which can reduce the amount of political interference in the allocation of credit (banks are subject to regulation by the central bank) Local bond markets allow borrowers to use capital that is tailored to their assets and operations (can provide longer-term financing than banks) Access to finance and financial services allows small firms to grow, and facilitates the entry of new firms into a market
Other functions of the financial Monitoring borrowers sector Facilitating trade of goods and services by providing payment services and reducing transactions costs Facilitating payments such as remittances from workers abroad
What is Financial Sector Development? Financial sector development occurs when financial instruments, markets and intermediaries reduce the costs of information gathering, enforcement and transactions in an economy, thereby improving the provision of the five functions It can also mean expansion of the availability of a wide range of intermediaries and markets providing key services
Indicators of Financial Sector Development Efficiency and competitiveness of the financial sector may improve Range of financial services that are available is wide and may increase Diversity of institutions in the financial sector may increase Amount of money that is intermediated through the FS can increase Amount of private sector allocation of resources (rather than government-directed lending by state-owned banks) may increase Regulation and stability of the sector may improve Increase in the population able to access financial services
Structure of Financial System in Sri Lanka Wide range of institutions offering financial services Commercials banks dominate in terms of assets (22 of them, assets at more than 60% of GDP ) Two state commercial banks account for 42% of total comm. bank assets Private domestic banks were 43% of assets in comm. banking sector (2005) NPLs have been dropping steadily in the sector Market intermediation has developed with the capitalization of CSE Recent improvements in the payments system have increased use of noncash payments and reduced transactions costs
Key Insurance Indicators for Selected Countries (2003) Insurance density (US$) Insurance penetration (% of GDP) Total Life insurance Total Life Insurance South Asia Bangladesh 2.1 1.4 0.6 0.4 India 16.4 12.9 2.9 2.3 Pakistan 2.9 1.1 0.6 0.2 Sri Lanka 12.5 5.3 1.3 0.6 Other Asian countries China 36.2 25.1 3.3 2.3 Indonesia 14.5 6.4 1.5 0.7 Japan 3771 3003 10.8 8.6 South Korea 1243 874 9.6 6.7 Philippines 14.6 8.6 1.5 0.9 Singapore 1621 1300 7.6 6.1 Vietnam 6.7 4.1 1.5 0.9 Insurance density and penetration measure premium per capita and as percent of GDP, respectively. Source: Swiss Reinsurance Company (2004)
How is Financial Intermediation measured M2/GDP is a measure of financial sector depth: M2 measures the liquidity liabilities of the financial system: currency in circulation + interest bearing liabilities of banks and nonfinancial intermediaries divided by GDP The higher the ratio, the larger the size of the financial intermediary sector Private sector credit/gdp: the value of credits by financial intermediaries to the private sector divided by GDP The higher the ratio the higher the levels of financial services and therefore greater financial intermediary development
Intermediation Measures Sri Lanka 2002 2003 2004 M2/GDP 37.0 38.1 38.8 Domestic Credit to Private sector /GDP 28.6 29.9 31.5 World Development Indicators, World Bank
Intermediation Measures - M2/GDP Percentages 100 90 80 70 60 50 40 30 20 10 0 Cambodia India Indonesia Lao P.D.R. Sri Lanka Thailand 2002 2003 2004 Countries Source: World Development Indicators
Intermediation Measures - Dom. Credit to Private Sector/GDP 120 100 Percentages 80 60 40 2002 2003 2004 20 0 Cambodia India Indonesia Lao P.D.R. Sri Lanka Thailand Countries Source: World Development Indicators
What is captured in an Investment Climate Assessment? A standardized way of measuring and comparing investment climate conditions in a country Survey designed to identify obstacles to business development in a country and how these obstacles affect firm productivity An ICA was conducted in Sri Lanka in 2004: covered 543 establishments, 1,327 nonfarm enterprises, and 555 households not participating in rural nonfarm activities Results show that in both rural and urban areas cost of finance is an issue, and access to finance is an issue as well in rural areas
What role does the financial sector play in development? The financial sector can play an important role in reducing risk and vulnerability for private sector firms, individuals and households It can increase the ability of individuals and households to access basic services like health and education
What are the links between financial sector development and poverty reduction? The are two main ways that financial sector development can reduce poverty: By facilitating economic growth By providing the poor with services that help them to save and invest so they are better able protect themselves against unexpected shocks, generate longterm income opportunities, and smooth consumption
Financial Sector Development and Growth Majority of studies show a strong relationship between FSD and growth, especially in the long-run Many studies use M2/GDP and PSC/GDP measures of financial intermediation and look at their relationship with economic growth rates Studies show that countries with a higher percentage of financial intermediation also had higher growth rates
FSD and Growth Causality not always easy to show, but the link is there It may be that growth increases demand for financial services, which results in expansion of the financial sector Generally, it is believed that the impact of FSD on growth is more important than the impact of growth on FSD, particularly in developing countries The studies suggest that under-development of the financial sector is more likely to hold back growth in developing countries The longer the time period, the bigger the impact of FSD on growth
FSD and Growth Demetriades and Hussein finds evidence that FSD caused growth in: Honduras, Spain and Sri Lanka Growth caused FSD in: El Salvador, Greece, Pakistan, Portugal, South Africa, and Turkey There is bi-directional causality in Guatemala, India, Korea, Mauritius, Thailand and Venezuela
Small and Medium Enterprises are an important part of the economy and rely on access to finance to expand Access to finance allows SMEs to grow larger, and facilitates entry into business sectors SMEs in many countries are underserved by banks and non-bank financial institutions SMEs comprise more than 80% of all Sri Lankan businesses, and are a key component of the economy The ICS (2004) indicated 620,000 rural nonfarm enterprises, employing 1.5 million workers (20% of total labor force) contributed 12% of GDP (avg. size: 2.4 employees)
Access to Finance and Financial Services important for SME Development - Constraints Generally, access to finance for SMEs is constrained by high risk and high transactions costs associated with lending to SMEs by banks Where available, high cost of accessible finance is prohibitive, and loan applications can be complicated Interest rate ceilings discourage banks from lending to higher risk borrowers, which SMEs often are Other obstacles to SME access to credit: limited availability of credit information; insufficient procedures for debt recovery; lack of collateral registries
Obstacles to greater lending by commercial banks to SMEs Commercial banks do not have a large branch network in the rural areas hindering their reach out Small businesses are geographically dispersed, and lenders usually face greater costs in identifying potential borrowers, conducting due diligence, and maintaining contact with the borrower after a loan has been made SMEs are generally less knowledgeable than their larger counterparts regarding what is required to qualify for bank financing and often lack formal financial records (ICS 2004) Lack of market information and geographical isolation another important barrier to the success of small firms and reduces their creditworthiness
Payments and Remittances International Migrant remittances are a large source of external finance for developing countries Recorded flows to developing countries exceeded $US 125 billion in 2004 Second largest source of development finance after foreign direct investment In 2003, Sri Lanka had net workers remittances of 1.2 billion $US
Remittances Are one of the least volatile sources of foreign exchange earnings for developing countries in the 1990s Remittances generate positive effects for the economy by stimulating demand for goods and services Strengthening the financial infrastructure supporting remittances could generate additional savings for workers sending money home linking migrants to formal financial institutions can yield additional benefits by exposing them to a broad range of financial services (e.g., savings, credit, and insurance) that can help them manage their economic risks better.
Remittance costs There are three basic types of remittance costs The cost of sending money (actual charge) Profit component (money transfer agents charging high fees, 13% on average) Foreign exchange component (often in the range of 3% points of remittance amount)
Workers Remittances in selected countries Workers' Remittances Net BoP, current US$(billions) 25,000 20,000 15,000 10,000 5,000 0 2003 Sri Lanka India Philippines China Bangladesh Mexico Morocco Country Name
Reducing Remittance costs Harmonizing electronic funds transfer systems and improving their efficiency could reduce the cost of remittances Supporting connectivity between domestic institutions and cross-border retail payment systems provide low-cost, safe, and efficient remittance transfers Regulatory regime has to strike a balance between curbing money laundering and general financial abuse and facilitating the flow of funds between migrants and families Encouraging funds to flow through formal channels, especially banks, would help in tracking any illegal use of funds
The role of microfinance in development and poverty reduction National concepts of microfinance vary Generally it means financial services for poor and low-income people: Savings Credit Payment transfers Insurance Total assets of microfinance institutions are very small relative to mainstream finance even in countries which have reached high levels of penetration With small relative total assets, MFIs not likely to crowd out mainstream financial services, although subsidized credit for SMEs can hinder development of commercially viable provides
Microfinance and poverty reduction While some MFIs have had a significant impact on poverty, others have been less successful, making it difficult to draw conclusions about the overall impact of microfinance on poverty reduction Most MFIs cannot mobilize funds on a large scale and pool risks over very large areas in the way that formal financial institutions can Also have limited coverage, less than 2% of the population in most countries
Role of Microfinance Scale: Achieving scale of individual institutions, rather than having a large number of MFIs seems to be crucial in ensuring that the sector has reached a large percentage of the population No countries where extensive coverage by lots of small institutions, but in countries with extensive coverage the industry is concentrated Cost and sustainability are the big issues for the microfinance industry
Microfinance in Sri Lanka Wide range of semi-formal institutions that are involved in microfinance along with a selected number of formal financial institutions, mainly publicly-owned, and informal lenders. The semi-formal include the National Development Trust Fund; 311 cooperative rural banks (CRBs) with about 1,196 outlets ; nearly 8,500 thrift and credit cooperative societies (TCCSs); Savordaya Economic Enterprises Development Services (SEEDs) ; about 970 Samurdhi Banking Societies; 200 microfinance nongovernment organizations. The main formal financial institutions participating in microfinance are the two state banks and the six regional development banks. Participation of private commercial banks in the sector is minimal with a few exceptions. In addition, there is a third category of informal lenders comprising savings and credit associations, input suppliers, traders, moneylenders, landlords, friends, and relatives.
Formal and Semi-formal Providers of Microcredit (December 2000) Average Balance Percent of Percent of (Rs.) number amounts Total formal 19,263 20.2 40.4 Bank of Ceylon 18,266 5.1 9.7 People s Bank 10,000 9.9 10.3 Hatton National Bank 41,031 0.5 2.0 Seylan Bank 22,000 0.2 0.5 Sanasa Dev. Bank 20,415 0.3 0.7 RDBs 40,000 4.1 17.1 Total Semi-formal 7,216 79.8 59.6 SBSs 6,345 16.7 11.0 CRBs 7,713 36.9 29.5 TCCs 11,258 12.9 15.1 SEEDs 2,827 12.3 3.6 Janshakthi 4,854 0.9 0.5 Total 9,652 79.8 59.6 Source: Charotinenko et. al (2001)
Insurance Protection for the poor Insurance is an effective means of reducing the vulnerability of the poor from the impacts of disease, theft, violence, disability, fire and other hazards It protects against loss by pooling the resources of many to compensate for the losses of a few The more uncertain the event, the more insurance becomes the most economical form of protection
Insurance for the Poor Regulation of insurance often hinders delivery of insurance to low income communities High capital requirements make developing products for low-income markets uneconomical for established insurers due to small premiums and high risks Management of insurance programs requires a high level of technical expertise, which can drive up costs
Constraints to Development of Insurance Schemes for the Poor Insurance schemes for the poor tend to be financially unsustainable due to high overheads, low premiums and high claims The majority of schemes rely on funds such as from donor contributions rather than those received from premiums to maintain sustainability What is the best way to over come this? Microinsurance provider to become an agent for an existing and established insurance company
Improving Access to Finance for SMEs Government policies for addressing uneven access often focus on state ownership of financial institutions, subsidizing or controlling interest rates, especially in agriculture These policies may not build the conditions for the market to expand services to underserved groups Public policy should concentrate on developing a conducive environment for bank lending through macro economic stability and a supporting legislative and regulatory framework, in particular strengthening creditors rights
Expanding Outreach of Banks to SMEs and Underserved populations Entering new market segments entail risks, the government could motivate banks participation into higher risk markets by defraying their cost of entry, e.g., through partial credit guarantees Government and financial institutions could partner in the development of new financial products better suited for small enterprises credit scoring, reverse factoring, and other export financing products; engage in joint efforts to modernize credit information systems to mitigate market information asymmetries; collaborate with the business community in the training and education of small entrepreneurs.
Access to financial services for the poor Enables them to accumulate savings for investments in health and education Engage in income-enhancing activities Helps them cope with shocks like drought or natural disaster or unexpected illness or death This reduces the probability that they will have to sell assets for income in a crisis
Access to Finance in Rural Areas In many countries, the rural poor have even less excess to finance than the urban poor Dispersed demand for services due to low population density High information and transactions costs linked to poor infrastructure (roads, telecommunications) and lack of client information (no personal ID or asset registries) Weak institutional capacity of rural finance providers
Agricultural finance Same constraints as rural finance In addition, seasonality of agricultural activities and long maturation periods for others result in variable demand for savings and credit, uneven cash flows, lags in between loan disbursal and repayments Risks linked specifically to farming, variable rainfall, pests and disease, price fluctuations Lack of usable collateral Supply chain finance could be used to address these problems
Does financial development always lead to poverty reduction? In some cases, growing financial sectors can lead to greater income inequality, usually in the short term, if access to financial services is not expanded equally across income groups Financial crises can hurt the poor more than the non-poor
The Importance of Financial Sector Literacy Increased financial education and literacy improves the understanding of consumers of financial products and services so they can be more aware of risks and make informed choices Better understanding of financial markets, products and risks improves function of financial systems Individuals need to ensure that they don t overborrow, how to finance home purchases, and how to ensure adequate savings for retirement Financial education and consumer protection are complimentary
The Importance of Financial Sector Literacy for the unbanked Financial education can lower costs to unbanked, underserved, and low income individuals and households Journalists can play an important role in education of underserved populations, and improving the understanding of those already in the formal financial system