Finance Matters for Poverty Reduction and Attaining the MDGs: Recent Empirical Evidence
Finance Matters for Poverty Reduction and Attaining the MDGs: Recent Empirical Evidence
Finance is an important component of development, including for poor people. Indeed, recent empirical evidence has shown that a more developed financial system can help reduce poverty and lower income inequality. In addition to facilitating overall economic growth, finance can help individuals smooth their income, insure against risks, and broaden investment opportunities. Yet, access to finance is limited in many developing countries to a few individuals and firms. The purpose of this article is to explore the evidence that exists on what determines access to financial services, what barriers may hinder access and what policy measures can be taken to increase access.
Finance and Growth
Finance affects poverty and income distribution through several channels, the first being economic growth, which raises overall income levels and helps reduce poverty. Empirical studies have demonstrated that a doubling of private sector credit to GDP is associated with a two percentage point increase in the rate of GDP growth.[1] This additional growth in turn translates into lower poverty. Finance also helps reduce poverty through additional channels, specifically by reducing income concentration and enhancing income equality, leading to a further reduction in poverty.[2]
It has become the common view that finance can strongly affect the attainability of the Millennium Development Goals (MDGs) - finance refers here to direct access of poor people to financial services as well as to more generally inclusive financial systems. Finance helps people to achieve other development goals, such as education, which require poor households to be able to afford services, which in turn is facilitated by their access to finance.[3] Indeed, studies find specific impact of access to microfinance on reductions in child labor, increases in education, and better insurance against shocks.[4] However, it is not just direct access to finance or the specific forms of access that matter. In fact, recent studies debate the direct link between microfinance penetration and poverty eradication[5] and point to the more general need for efficient inclusive financial systems.
The ability of countries, firms, and individuals to make use of (new) growth opportunities can be another positive contribution to economic development and poverty reduction. Finance matters to firm growth, particularly of small and medium-sized enterprises (SMEs). While empirical evidence shows that SMEs do not "cause" growth, nor do SMEs alleviate poverty, evidence shows that the overall business environment accelerates economic growth, more so for small firms, and particularly for the entry of new firms. A business environment which includes sound property rights, proper contract enforcement, and ease of firm entry and exit is essential. But it is the additional requirement of a well-developed financial system that allows firms to operate on a larger scale, encourages more efficient asset allocation, and thus helps to level the playing field among firms and countries.[6] Because of unequal access, finance has been a barrier to entry; (loans have been allocated by connection and non-market criteria).[7]
There is also increasing evidence that the inequality of access to finance can be a problem not only in normal times but also in times of crisis. Research demonstrates that the cost of financial crisis has been allocated unevenly, with the brunt being borne by the poor. Evidence has shown that financial transfers during crises are large and can increase income inequality and tend to be very regressive.[8]
Because there is clearly a case that finance can have an important impact on the poor, we now need to try to understand what access to finance means; what the current usage of access to financial services is and what this shows about access; what the impediments are to access and how these might be changed; and what role governments might play in improving this.
Differentiation between Access and Usage
To better understand issues surrounding poor people's access to financial services, it is important to keep in mind how access and usage can differ. Access refers to the availability of the supply of financial services at a "reasonable cost", where quality and reasonable must be defined in some objective standard and costs reflect all financial and non-financial costs. Access thus only refers to the presence of financial services, but may say little about to what degree they are consumed. Usage refers to the actual consumption of financial services. In a standard demand-supply framework, access refers to the presence of supply (at a "reasonable cost") and usage is the intersection of the supply and demand schedules.
There is currently very limited data on usage of financial services by different income groups,[9] making it more difficult to establish the determinants or impediments to access to finance. Even basic questions like "is lack of access a result of low supply or is there a supply but low usage (implied demand)?" cannot be answered. As noted in earlier issues of Microfinance Matters, appropriate data first need to be compiled.[10] Nevertheless, based on the data available to date, anecdotal evidence and economic reasoning, some lessons can be drawn on how to facilitate access. These lessons can be categorized along the lines of reducing barriers to the efficient supply of financial services and a more efficient role of government.
Reducing Barriers to Enhance Supply and Improve Access
Explaining lack of supply falls into two areas: financial institutions' specific constraints rather than arising from the environment within which these institutions operate and overall institutional environment deficiencies. This distinction consequently breaks solutions down into institutional solutions and country actions.
Constraints specific to financial institutions mostly relate to the non-profitability of small scale transactions. For financial service providers whether banks or microfinance institutions, the fixed costs in financial intermediation make providing services for small clients, by small institutions, and in small markets, hard. High transactions costs for small volumes, the fact that the underserved are new, not experienced in business, etc., the high costs for expanding reach (e.g., to establish rural branches), make it often unprofitable to cater to poor segments and for small amounts. Taking into consideration economies of scale, better cost management can lower unit cost and lead to higher outreach and more attractive prospects from institutions' perspective. Still, catering to low-income households with specific products will remain for many financial institutions a high-risk, high-cost proposition.
Similar constraints arise at the country level where many financial systems are often very small, hindering effective financial service provision.[11] If the scale for effective financial services provision does not exist in all countries, at least not among traditional financial service providers, what can be done? Evidence suggests that internationalization of financial services can help overcome some of these scale problems. Foreign banks not only improve financial system efficiency and stability, with large long run benefits, but also can enhance access. Analysis of borrowers' perceptions across 36 countries finds that financing obstacles are lower in countries with high levels of foreign bank penetration. This work reports strong evidence that even small enterprises benefit and no evidence they are harmed by foreign banks. The channels appear to both improved competition and direct provision of financial services by foreign banks. A Latin America-specific study finds that foreign banks with small local presence do not appear to lend much to small businesses, but large foreign banks' lending often surpasses large domestic banks.
Country-level constraints tend to be both macro and microeconomic in nature. The overall macroeconomic environment is often a barrier, especially for lending, as when prospects for profitable business and consequently viable lending are limited when there is macro instability. Even when a firm's business is viable, uncertain repayment capacity given volatile income and expenditure and high exposure to systemic risks (macro, other) often make it hard for financial institutions to lend. This weak macroeconomic environment can be exacerbated by weaknesses in the enabling and regulatory environment, such as poor quality of the legal system, limited availability of reliable information, poor payment systems, and weak distribution and other infrastructures. Limited competition can make financial institutions little interested in providing basic financial services. Absence of credit information, lack of collateral, difficulties in contract design and enforcement can make profitable lending hard. Empirical analysis supports the importance of these barriers.
Analysis on household access has been limited to date, but it has been found that access to microcredit for the poor/near-poor across-country is less with higher GDP per capita, and more with better "institutional" quality and larger market size. A poor quality main banking system higher spreads and high profitability-can also discourage microfinance institutions, suggesting that more competition in the banking system can foster microfinance institutions. In addition, access to savings can be a function of distribution networks (postal, savings and other proximity banks), suggesting that the barriers to establishing branches and ATMs should be kept as low as possible. In Brazil, some role has been found in wider branch networks, both of public and private banks, and a good mix of domestic and foreign banks distribution in determining access.
Analysis of small firm access, less limited to date, has found that the quality of the legal system, the quality of property rights and their enforcement and the availability of information are especially important for small firms' access to financial services. Small firms and firms in countries with poor institutions use less external finance, especially less bank finance. Protection of property rights increases external financing of small firms significantly more than of large firms, mainly due to more bank as well as more ample equity finance. Substitutes are imperfect, e.g., small firms do not disproportionately use more leasing or trade finance compared to larger firms, meaning small firms suffer from a lack of access as the alternative forms of finance are more costly or not available either.
Policies like interest rate ceilings, usury laws, and credit subsidies or targeted lending, all can contribute to a distorted enabling environment for financial intermediation. Heavy regulation in the forms of high minimum capital adequacy requirements, exorbitant compliance costs, and rigidity in chartering can endanger institutional environment. Regulations such as interest rate ceilings, usury laws, restrictions on lending, priority lending and credit subsidy policies, and other government interference distorts risk-return signals, and can thereby hinder access. Rigidity in chartering, (high) minimum capital adequacy requirements, limited degrees in funding structures, too heavy regulations and supervision, too strict accounting requirements, and high compliance costs can hinder financial institutions from operating efficiently. Costumer identification ("Know Your Customer"), AML/CFT, and other rules can be costly in terms of access to financial services, as was found in South Africa). Nevertheless, tradeoffs arise as regulations serve other public policy purposes.
Government Attempts to Increase Access
Governments can, and often have, tried to improve access. Government might try to encourage the use of a public infrastructure to potentially deliver private financial products. Specific interventions, such as the use of existing distribution channels (postal offices in India), can help increase outreach. While certainly this is an innovation that can affect access, it, like many innovative technologies, does not necessarily affect underlying regulatory or systemic distortions in the system. Increasing competition has proved to be beneficial and has the added benefit of improving the environment at the same time it is bringing in new technology and know-how.
Because there may be a supply of financial services without a demand for it (access but no usage), limited use of financial services does not necessarily reflect a systemic market failure at the country level. This is one reason why trying to broaden financial access may not necessarily be a public policy goal. While governments can foster a better environment through anti-predatory lending laws rather than usury laws and promote customer education, a proactive role for the government may not be efficient. Given political economy factors, government targeted efforts to broadening access may not relax credit and savings constraints, when there is a selection bias, i.e., those households or firms with good prospects anyway apply for credit. Subsidies cannot only distort markets, but evidence is mounting that subsidies are captured by the relatively well off, who often already have access. Priority lending requirements are neither the solution, but rather can also divert resources away from the lowest segments, often towards the less needy. Furthermore, there may not be any additionality, as clients that have access already move to new providers that are being subsidized. A balance of limited direct government stimulation and a string emphasis on proper regulation should be a goal.[12]
Conclusions
Over the last decade, finance has been recognized as an important driver of economic growth. More recently, access to financial services has been recognized as an important aspect of development and more emphasis is being given to extending financial services to low-income households. Although still early in the analysis, there is some evidence that access is improving. More empirical data is needed in order to better track and benchmark access progress. On the household side, there are some data on the use of microfinance that suggest there has been an expansion of access for households. Data here have to be interpreted carefully as increases may represent better coverage over time, rather than an expansion.
With better data one can know more about the benefits of access, the reasons why households and firms may (or may not) demand financial services, why financial service providers may (or may not) provide financial services, and, of course, the costs to society of providing greater access. In this context, there is an interesting opportunity for the international community to lead the way in better measuring access. Through better understanding, efficient models can be developed and better policy advice can be offered with the goal of increasing access to finance and thus improving development.
Finance Matters for Poverty Reduction and Attaining the MDGs Recent Empirical Evidence - To learn more about this author, visit United Nations Capital Development Fund's Website.
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By Stijn Claessens, Senior Adviser, and Neesham Kranz, Communications & Knowledge Coordinator, Financial Sector Vice Presidency, World Bank
Finance is an important component of development, including for poor people. Indeed, recent empirical evidence has shown that a more developed financial system can help reduce poverty and lower income inequality. In addition to facilitating overall economic growth, finance can help individuals smooth their income, insure against risks, and broaden investment opportunities. Yet, access to finance is limited in many developing countries to a few individuals and firms. The purpose of this article is to explore the evidence that exists on what determines access to financial services, what barriers may hinder access and what policy measures can be taken to increase access.
Finance and Growth
Finance affects poverty and income distribution through several channels, the first being economic growth, which raises overall income levels and helps reduce poverty. Empirical studies have demonstrated that a doubling of private sector credit to GDP is associated with a two percentage point increase in the rate of GDP growth.[1] This additional growth in turn translates into lower poverty. Finance also helps reduce poverty through additional channels, specifically by reducing income concentration and enhancing income equality, leading to a further reduction in poverty.[2]
It has become the common view that finance can strongly affect the attainability of the Millennium Development Goals (MDGs) - finance refers here to direct access of poor people to financial services as well as to more generally inclusive financial systems. Finance helps people to achieve other development goals, such as education, which require poor households to be able to afford services, which in turn is facilitated by their access to finance.[3] Indeed, studies find specific impact of access to microfinance on reductions in child labor, increases in education, and better insurance against shocks.[4] However, it is not just direct access to finance or the specific forms of access that matter. In fact, recent studies debate the direct link between microfinance penetration and poverty eradication[5] and point to the more general need for efficient inclusive financial systems.
The ability of countries, firms, and individuals to make use of (new) growth opportunities can be another positive contribution to economic development and poverty reduction. Finance matters to firm growth, particularly of small and medium-sized enterprises (SMEs). While empirical evidence shows that SMEs do not "cause" growth, nor do SMEs alleviate poverty, evidence shows that the overall business environment accelerates economic growth, more so for small firms, and particularly for the entry of new firms. A business environment which includes sound property rights, proper contract enforcement, and ease of firm entry and exit is essential. But it is the additional requirement of a well-developed financial system that allows firms to operate on a larger scale, encourages more efficient asset allocation, and thus helps to level the playing field among firms and countries.[6] Because of unequal access, finance has been a barrier to entry; (loans have been allocated by connection and non-market criteria).[7]
There is also increasing evidence that the inequality of access to finance can be a problem not only in normal times but also in times of crisis. Research demonstrates that the cost of financial crisis has been allocated unevenly, with the brunt being borne by the poor. Evidence has shown that financial transfers during crises are large and can increase income inequality and tend to be very regressive.[8]
Because there is clearly a case that finance can have an important impact on the poor, we now need to try to understand what access to finance means; what the current usage of access to financial services is and what this shows about access; what the impediments are to access and how these might be changed; and what role governments might play in improving this.
Differentiation between Access and Usage
To better understand issues surrounding poor people's access to financial services, it is important to keep in mind how access and usage can differ. Access refers to the availability of the supply of financial services at a "reasonable cost", where quality and reasonable must be defined in some objective standard and costs reflect all financial and non-financial costs. Access thus only refers to the presence of financial services, but may say little about to what degree they are consumed. Usage refers to the actual consumption of financial services. In a standard demand-supply framework, access refers to the presence of supply (at a "reasonable cost") and usage is the intersection of the supply and demand schedules.
There is currently very limited data on usage of financial services by different income groups,[9] making it more difficult to establish the determinants or impediments to access to finance. Even basic questions like "is lack of access a result of low supply or is there a supply but low usage (implied demand)?" cannot be answered. As noted in earlier issues of Microfinance Matters, appropriate data first need to be compiled.[10] Nevertheless, based on the data available to date, anecdotal evidence and economic reasoning, some lessons can be drawn on how to facilitate access. These lessons can be categorized along the lines of reducing barriers to the efficient supply of financial services and a more efficient role of government.
Reducing Barriers to Enhance Supply and Improve Access
Explaining lack of supply falls into two areas: financial institutions' specific constraints rather than arising from the environment within which these institutions operate and overall institutional environment deficiencies. This distinction consequently breaks solutions down into institutional solutions and country actions.
Constraints specific to financial institutions mostly relate to the non-profitability of small scale transactions. For financial service providers whether banks or microfinance institutions, the fixed costs in financial intermediation make providing services for small clients, by small institutions, and in small markets, hard. High transactions costs for small volumes, the fact that the underserved are new, not experienced in business, etc., the high costs for expanding reach (e.g., to establish rural branches), make it often unprofitable to cater to poor segments and for small amounts. Taking into consideration economies of scale, better cost management can lower unit cost and lead to higher outreach and more attractive prospects from institutions' perspective. Still, catering to low-income households with specific products will remain for many financial institutions a high-risk, high-cost proposition.
Similar constraints arise at the country level where many financial systems are often very small, hindering effective financial service provision.[11] If the scale for effective financial services provision does not exist in all countries, at least not among traditional financial service providers, what can be done? Evidence suggests that internationalization of financial services can help overcome some of these scale problems. Foreign banks not only improve financial system efficiency and stability, with large long run benefits, but also can enhance access. Analysis of borrowers' perceptions across 36 countries finds that financing obstacles are lower in countries with high levels of foreign bank penetration. This work reports strong evidence that even small enterprises benefit and no evidence they are harmed by foreign banks. The channels appear to both improved competition and direct provision of financial services by foreign banks. A Latin America-specific study finds that foreign banks with small local presence do not appear to lend much to small businesses, but large foreign banks' lending often surpasses large domestic banks.
Country-level constraints tend to be both macro and microeconomic in nature. The overall macroeconomic environment is often a barrier, especially for lending, as when prospects for profitable business and consequently viable lending are limited when there is macro instability. Even when a firm's business is viable, uncertain repayment capacity given volatile income and expenditure and high exposure to systemic risks (macro, other) often make it hard for financial institutions to lend. This weak macroeconomic environment can be exacerbated by weaknesses in the enabling and regulatory environment, such as poor quality of the legal system, limited availability of reliable information, poor payment systems, and weak distribution and other infrastructures. Limited competition can make financial institutions little interested in providing basic financial services. Absence of credit information, lack of collateral, difficulties in contract design and enforcement can make profitable lending hard. Empirical analysis supports the importance of these barriers.
Analysis on household access has been limited to date, but it has been found that access to microcredit for the poor/near-poor across-country is less with higher GDP per capita, and more with better "institutional" quality and larger market size. A poor quality main banking system higher spreads and high profitability-can also discourage microfinance institutions, suggesting that more competition in the banking system can foster microfinance institutions. In addition, access to savings can be a function of distribution networks (postal, savings and other proximity banks), suggesting that the barriers to establishing branches and ATMs should be kept as low as possible. In Brazil, some role has been found in wider branch networks, both of public and private banks, and a good mix of domestic and foreign banks distribution in determining access.
Analysis of small firm access, less limited to date, has found that the quality of the legal system, the quality of property rights and their enforcement and the availability of information are especially important for small firms' access to financial services. Small firms and firms in countries with poor institutions use less external finance, especially less bank finance. Protection of property rights increases external financing of small firms significantly more than of large firms, mainly due to more bank as well as more ample equity finance. Substitutes are imperfect, e.g., small firms do not disproportionately use more leasing or trade finance compared to larger firms, meaning small firms suffer from a lack of access as the alternative forms of finance are more costly or not available either.
Policies like interest rate ceilings, usury laws, and credit subsidies or targeted lending, all can contribute to a distorted enabling environment for financial intermediation. Heavy regulation in the forms of high minimum capital adequacy requirements, exorbitant compliance costs, and rigidity in chartering can endanger institutional environment. Regulations such as interest rate ceilings, usury laws, restrictions on lending, priority lending and credit subsidy policies, and other government interference distorts risk-return signals, and can thereby hinder access. Rigidity in chartering, (high) minimum capital adequacy requirements, limited degrees in funding structures, too heavy regulations and supervision, too strict accounting requirements, and high compliance costs can hinder financial institutions from operating efficiently. Costumer identification ("Know Your Customer"), AML/CFT, and other rules can be costly in terms of access to financial services, as was found in South Africa). Nevertheless, tradeoffs arise as regulations serve other public policy purposes.
Government Attempts to Increase Access
Governments can, and often have, tried to improve access. Government might try to encourage the use of a public infrastructure to potentially deliver private financial products. Specific interventions, such as the use of existing distribution channels (postal offices in India), can help increase outreach. While certainly this is an innovation that can affect access, it, like many innovative technologies, does not necessarily affect underlying regulatory or systemic distortions in the system. Increasing competition has proved to be beneficial and has the added benefit of improving the environment at the same time it is bringing in new technology and know-how.
Because there may be a supply of financial services without a demand for it (access but no usage), limited use of financial services does not necessarily reflect a systemic market failure at the country level. This is one reason why trying to broaden financial access may not necessarily be a public policy goal. While governments can foster a better environment through anti-predatory lending laws rather than usury laws and promote customer education, a proactive role for the government may not be efficient. Given political economy factors, government targeted efforts to broadening access may not relax credit and savings constraints, when there is a selection bias, i.e., those households or firms with good prospects anyway apply for credit. Subsidies cannot only distort markets, but evidence is mounting that subsidies are captured by the relatively well off, who often already have access. Priority lending requirements are neither the solution, but rather can also divert resources away from the lowest segments, often towards the less needy. Furthermore, there may not be any additionality, as clients that have access already move to new providers that are being subsidized. A balance of limited direct government stimulation and a string emphasis on proper regulation should be a goal.[12]
Conclusions
Over the last decade, finance has been recognized as an important driver of economic growth. More recently, access to financial services has been recognized as an important aspect of development and more emphasis is being given to extending financial services to low-income households. Although still early in the analysis, there is some evidence that access is improving. More empirical data is needed in order to better track and benchmark access progress. On the household side, there are some data on the use of microfinance that suggest there has been an expansion of access for households. Data here have to be interpreted carefully as increases may represent better coverage over time, rather than an expansion.
With better data one can know more about the benefits of access, the reasons why households and firms may (or may not) demand financial services, why financial service providers may (or may not) provide financial services, and, of course, the costs to society of providing greater access. In this context, there is an interesting opportunity for the international community to lead the way in better measuring access. Through better understanding, efficient models can be developed and better policy advice can be offered with the goal of increasing access to finance and thus improving development.
Finance Matters for Poverty Reduction and Attaining the MDGs Recent Empirical Evidence - To learn more about this author, visit United Nations Capital Development Fund's Website.
Like this article? Share it with your friends
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