No 5 How to develop the Financial sector for poverty reduction

Document Sample
No 5 How to develop the Financial sector for poverty reduction Powered By Docstoc
                POVERTY REDUCTION
Why this Note?

The financial sector represents the interface between the demand of
individuals, households and enterprises for financial services, and the formal
and informal institutions that meet these needs.

It includes a whole host of actors, including clients themselves, local
community-based groups that provide financial services, microfinance
institutions, post offices, insurance providers, money transfer companies, and
commercial banks. It also includes institutions that are involved in regulation
and supervision.

This Note recognizes the importance of a fully functional financial sector and
its central place in the promotion of economic growth, private sector
development and poverty reduction. It provides practical guidance on how we
can work with, and promote linkages between, the many actors in the financial
sector to reduce poverty and contribute to the achievement of the MDGs1.

How does financial sector development reduce poverty?

The financial services needed in poor households vary, according to a family’s
level of poverty, its skills, life cycle needs, and local market opportunities.
Savings are needed by poor families to prepare for major events such as
marriage, to finance basic health care, housing, children’s education, or to set
aside emergency funds. Access to insurance services helps households
better cope with risks to life and assets. Millions of poor families in the
developing world use small loans to make their living from a huge variety of
microenterprises or to help them cope with an emergency or short-term
economic down turn. Many poor families also greatly benefit from
remittances (money transfers from migrant relatives).

Overall, these services can help poor families benefit from economic
opportunities to build up incomes and assets to lift them out of poverty. In
other circumstances, financial services provide protection from sliding further
into poverty. All over the world, microfinance institutions not only provide key
services, but also play an important role in building up community-based
groups, local networks, and leadership skills, especially for poor women.

Many poor households would prefer wage employment in a formal business to
self-employment in informal enterprise. Small and medium enterprises
(SMEs) have the potential to create many new jobs, but SMEs are often
severely constrained by lack of access to capital. They are excluded by both
the formal and informal financial sector - the former deeming them too risky

    On impact on MDGs, see “Is Microfinance an Effective Strategy to Reach the MDGs”, CGAP 2003

HTN5: Developing The Financial Sector For Poverty Reduction                  10 December 2003
and the latter lacking the resources and systems to extend services to the

A functional financial sector reduces poverty indirectly, sometimes
dramatically, by promoting broad-based economic growth. Recent studies
point to a strong correlation between financial development and economic
growth2. An efficient financial sector promotes:

   Savings mobilization by supplying flexible financial instruments with
    attractive yields and different maturities;
 Efficient allocation of resources by providing investment choices and
    screening alternative proposals;
 Stronger investment by matching risks and rewards and by pooling, pricing
    and sharing risk;
A stable and acceptable medium of exchange and a reduction of the
inefficiencies of barter economies.

How is the financial sector failing the poor, and what can be done?

Traditionally poor households and micro and small enterprises have been
considered as high risk by the formal financial sector. A number of failures in
policy and regulation have restricted supply of financial services to the poor
and the SME sector. Some examples:

     Many governments in developing countries are over-reliant on domestic
      borrowing to finance fiscal deficits. In this way they absorb substantial
      deposits from commercial banks, and thus crowd out lending to the private
     Many policy makers have focused narrowly on lowering the cost of credit
      rather than increasing its accessibility, appropriateness, and timeliness.
     High entry barriers for new formal financial institutions and domination of
      markets by public financial institutions have weakened incentives for
      institutions to design suitable products for low-income customers and firms
      with limited assets.

The challenge is to set up a simple, transparent and predictable regulatory
mechanism that responds in proportion to perceived risk. More competitive
markets are needed that reflect a clear understanding of the respective roles
of government (as supervisor and regulator) and private banks (as the key
intermediaries in financial markets).

Table 1: Some market & other failures and possible responses

    Market and other failures                         Possible Responses
    Incomplete information that financial             Demonstrate that financial services
    services to the poor can be profitable,           to the poor can be profitable e.g.
    and can overcome apparent obstacles               support the set-up of private
    such as transaction costs and lack of             investment funds and micro finance
    Adrian Wood and Strahan Spencer “Making the Financial Sector Work for the Poor”

HTN5: Developing The Financial Sector For Poverty Reduction                    10 December 2003
 information on borrowers                     institutions; lending to MFIs by
 Regulatory authorities      lack the         Increasing      dialogue      between
 capacity, information and incentives to      regulators and MFIs; Technical
 effectively regulate MFIs.                   assistance to regulators; Alternative
                                              regulatory models e.g. delegation of
                                              regulation to the private sector.
 Lack of collateral, or difficulties with     Non-traditional collateral including
 legal enforceability of loan repayments      loan guarantees. Legal reform e.g.
 or calling in of collateral                  property rights over land so that it
                                              can be used as a collateral
 Under-investment in knowledge of             Support            information-sharing
 best practice approaches, and in             networks, innovation and market and
 research     and     development on          impact research
 financial services to the poor
 Discrimination in local communities          Special studies and awareness
 against the poor, women and other            campaigns; Increased literacy and
 marginalized social groups limits            awareness;                Improved
 access to financial services                 communications and infrastructure

What is DFID already doing?

At the country level, DFID is increasingly taking a sector wide approach,
building on government priorities identified in PRSPs, or nationally agreed
priorities. We need to determine where best to intervene based on particular
country circumstances and DFID’s comparative advantage vis à vis others
active in the sector. For example, as chair of the Bangladesh donor co-
ordination group, DFID is supporting collective donor analysis to agree the
way forward for the next phase of microfinance development in Bangladesh.

DFID currently has multi-year investments of over £80m worldwide to
strengthen microfinance institutions and work with the formal financial sector
on pro-poor service delivery. The Financial Deepening Challenge Fund helps
implement and test alternative mechanisms to work directly with private sector
financial service providers, ( We are also working
with formal commercial banking institutions (eg. Equity Building Society in
Kenya, and Small Industries Development Bank of India) to promote linkages
between formal and informal sector providers, and to extend the reach of the
formal financial sector.

DFID sits on the Executive Committee of the leading multilateral donor
organization specialized in microfinance, the Consultative Group to Assist the
Poor (CGAP), ( This 29-member body seeks to improve the
practice and extend outreach of microfinance across the developing world and
to harmonize approaches to the industry.

Together with CGAP and UNDP, DFID supports the MicroSave-Africa
programme (, at the vanguard of efforts to test
new pro-poor savings, insurance, and loan products. DFID also supports
AfriCap (, an equity investment fund developing

HTN5: Developing The Financial Sector For Poverty Reduction        10 December 2003
emerging microfinance institutions in Africa. Collaboration with the
International Labour Organisation helps further the spread of microinsurance,
and financial service delivery in post-conflict countries.

What lessons have been learned?

   Mainstreaming financial services for the poor into the formal financial
    sector is essential to ensure improved competitiveness, sustainable
    service delivery, and advances in management and marketing skills, and
    in the application of new technology.

   Achieving scale and outreach is vital. Existing financial institutions can
    often be harnessed to deliver pro-poor financial services quicker and to
    greater scale than new institutions. This is the case for the National
    Microfinance Bank in Tanzania, and the Commercial Bank of Zimbabwe.

   Appropriate policies for regulation and supervision of informal
    institutions delivering pro-poor financial services are critical in
    maintaining innovative approaches whilst protecting depositors’ funds.
    Standards should reflect the different contexts and baselines in developing
    countries rather than aspire to developed country norms.

   Sustainability is key. Many governments and donors have pursued
    mandates, conditionality and subsidy to enforce financial services delivery
    to particular target groups or geographical areas. Only sustainable
    financial institutions can provide these services in the long term.

   Pro-poor financial service delivery is not a panacea. It can particularly
    assist those on or around the poverty line by reducing their vulnerability.
    But those that are not economically active, and the old and sick or other
    disadvantaged groups, may not be the appropriate target group for
    microfinance, but instead should be the focus for other forms of support.

What more can we do?

   Taking a sector-wide approach, preferably linked to PRSP contexts,
    is important. Supporting individual interventions without first taking a
    holistic, analytical view of the financial sector will not produce the
    magnitude and depth of lasting change we seek. We can do more to
    ensure that the development of a financial sector which benefits all parts of
    the economy is high on the list of government priorities.

    In Tanzania, DFID is working with a multi-donor trust to facilitate
    implementation of a broad sectoral strategy for financial sector development.
    This builds on the priorities established by government in the PRSP and
    National Microfinance Policy

   Coordination with Government and other international agencies has
    been, and will continue to be key. Emphasizing a collaborative approach

HTN5: Developing The Financial Sector For Poverty Reduction     10 December 2003
    (i.e. adhering to best practice and providing a consistent message to
    government, other donors and the private sector) as well as trying to co-
    ordinate, and where possible merge, interventions on the ground is

    In Southern Africa, FinMark Trust ( contributes to
    coordination of financial market development activities by working with a
    wide range of organizations active in promoting access to retail financial
    services - from government departments and regulators to banks, non-bank
    finance companies, and NGOs.

   We should seek ways to improve conditions for provision of formal
    banking services to poor people. For example, where state-owned
    banks in developing countries are prepared for privatization or
    restructuring, we should seek support from the International Financial
    Institutions, and the private sector, to increase services to poor people,
    exploring options beyond closing down existing branch networks to save

   Opportunities to encourage financial services other than credit are
    being overlooked. More poor people save than borrow, but agencies
    could do more to support institutions seeking to provide savings and other
    services such as money transfers, or insurance services.

   Supervision and regulation are vital to a healthy financial sector, but
    these should be appropriate, and encourage financial service
    delivery to the poor. Robust institutions are required for a strong financial
    sector, but room is also needed for innovation and greater outreach
    through graduated supervision that recognizes the scale of operations and
    risks to the financial sector. The Financial Sector Reform and
    Strengthening Initiative (FIRST) is a multilateral effort providing technical
    assistance to help countries address financial system weaknesses.

   We need to do more to understand, analyze, and support improved
    quality and quantity of financial services to SMEs. The SME sector is a
    vital driver of economic growth, yet the financial sector in developing
    countries too often still sees this target group as too risky. We need to
    work more with commercial banks to identify new ways to increase
    experience of profitable lending to SMEs.

    Credit Guarantee mechanisms offer one approach to encouraging the formal
    financial sector to lend to SMEs. DFID has supported guarantee instruments
    in Zimbabwe, Kenya, and China. Whilst results have been mixed, DFID’s
    experience in China is feeding into national government policy formulation
    on good practice in credit guarantee fund operations.

   We should further explore innovative financing mechanisms for
    working with the private sector, possibly by harnessing the 2002 UK

HTN5: Developing The Financial Sector For Poverty Reduction     10 December 2003
    International Development Act provisions, for example, through the use
    of loans, guarantees, and equity investments.

   The above suggestions on future steps are underpinned by experience
    that demonstrates that local financial institutions, including
    international banks established overseas, will provide financial
    services to the poor, and to the SME sector, given their core
    competence and the right incentives. More institutional examples are
    needed, along with wider dissemination of the lessons that financial
    services to the poor can be delivered profitably.

 For further information contact:

 Financial Sector Team
 Policy Division, DFID, London.

 This Teams belongs to the Pro-Poor Growth Cluster in Policy Division and
 has drafted this Note, which forms part of a series of short “How To Notes”
 intended to be of practical value to all those working on Private Sector
 Development agendas in DFID Country Offices and Regional Policy
 Departments. The series is being co-ordinated by PD’s Investment,
 Competition and Business Development Services Team, to whom comments
 on this Note and recommendations for further Notes should be addressed.

HTN5: Developing The Financial Sector For Poverty Reduction   10 December 2003

Shared By:
Description: No 5 How to develop the Financial sector for poverty reduction