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Friday, July 10, 2009

Are Small Banks the Answer for Developing Countries?

This week at The Economist:

Justin Lin, the World Bank’s chief economist,... in his guest Economics focus column ... argues that developing countries should base their financial systems on small, local banks:

The size and sophistication of financial institutions and markets in the developed world are not appropriate in low-income markets. Small local banks are the best entities for providing financial services to the enterprises and households that are most important in terms of comparative advantage—be they asparagus farmers in Peru, cut-flower companies in Kenya or garment factories in Bangladesh. The experiences of countries such as Japan, South Korea and China are telling. Those countries managed to avoid financial crises for long stretches of their development as they evolved from low-income to middle- and high-income countries. It helped greatly that they adhered to simple banking systems (rather than rushing to develop their stock markets and integrate into international financial networks) and did not liberalise their capital accounts until they became more advanced.

Mr Lin concludes:

Leave the developed markets to worry about how to reform their highly evolved financial systems. To make sustained progress in lifting the weight of the extreme poverty that will remain after the crisis has subsided, low-income countries need to make their financial institutions small and simple.

Over the course of the next week, we will devote this blog to a discussion of Mr Lin’s column, posting responses from our correspondents, invited experts from the academic and policy worlds, and our commenters. We'll be collecting the entire series of posts here. Do stop by and contribute to the debate.

Here is the lead Essay: Walk, Don't Run by Justin Lin

Here are the responses so far:

Here is my response:

Small banks need help, by Mark Thoma: I agree with many of the points in the article regarding the potential that small and simple banks provide. But while small and simple banks can help to overcome many problems, by themselves they may not be enough fully serve the financial needs within developing countries.

There are two issues here. The first is to determine the types of financial products that best suit the needs of people and businesses within developing countries, and the second is how to best deliver those products to the people and businesses who could benefit from using them.

Small banks and microfinance of the type emphasised in the article can meet many of the financial needs in developing countries, for example the need that farmers have to borrow funds to purchase seed and fertiliser, and then repay the loans at harvest, can be met in this way. But other needs require more sophisticated financial products. The ability to hedge price risk through futures markets, the need for insurance against crop failure, the need to purchase farm equipment through pooling arrangements that share the costs among end users, and the problems brought about by seasonality require more sophisticated products and arrangements. The point is that not all of the financial needs in agricultural, small scale manufacturing, and services are simple, even in developing countries.

Can these more complex financial needs be satisfied, or are there important barriers within developing countries that prevent these products from being used?

One big barrier is, as noted in the article, the lack of information on the financial history and worthiness of potential borrowers. This information takes time to develop and that is where small banks can play an important role. First, they can develop relationships within the community that overcome this informational barrier. Local knowledge allows the bank to assess credit risk more accurately, and to more efficiently serve the needs of the community. Second, as small banks gain information about the credit histories and worthiness of people and businesses within their local areas, that information must be preserved and made available system wide so that more comprehensive systems can emerge (the article has good suggestions about how to begin this process).

There is a third way in which local banks can help, and that is for the small banks to be embedded within a larger financial system so that the small banks can make available products that local banks cannot provide on their own. It is not clear, for example, how price hedging and crop insurance can be provided solely through small local banks, hence the need for small banks to be part of a more comprehensive system.

Importantly, linking local banks to financial markets more generally does not require that the local banks give up the stability cited in the article as a reason for developing countries to prefer the small bank approach. The 7,630 community banks in the U.S. used as examples of the stability small banks can provide are fully integrated into the global financial system, but they have, quoting from the article, "so far been only mildly affected by the financial crisis as they continue to deal with the same small local clients that they have for years". Finally, a fourth advantage of embedding small banks in this way is that it also helps to set the stage for the development of more comprehensive and sophisticated financial markets as the countries develop over time.

But simply providing a link to larger financial markets with more diverse products is not enough. These products are complex, and borrowers must be able to trust that the lenders will not take advantage of their superior information about the characteristics and risks of these products.

While I believe that lenders will manage to overcome their asymmetric information problem and successfully determine who is, and who is not a good credit risk within the local communities they serve, I am less confident that borrowers can overcome their asymmetric information problem regarding the use of sophisticated financial services. I don't mean to imply that people within developing countries are less able to understand how complicated financial products work, or less able to understand how to use them safely than people in developed countries. But in many cases the knowledge of and experience with these products is fairly limited, and in any case the recent financial crisis in the U.S. shows that consumers in advanced countries often lack the information they need to fully understand the characteristics of some products such as mortgages. So this is a general problem.

The response in the U.S. has been to develop a Financial Products Safety Commission, and to take other steps to provide consumers of these products with the information they need to make good decisions. Developing countries need a small scale version of this, i.e. someone or some institution that people within the local community can trust to give them the advice and information they need to make informed decisions. Ideally, that would be the local bank acting as the conduit to these products, e.g. the bank or some other financial institution would pool local resources and purchase the required products in an agency relationship, but there is reason to doubt that the bank would act in the investors' best interests.

This is an area where, I think, information and coordination problem among small farmers and producers is severe enough so as to require some type of government or outside agency intervention to help. I agree that complex financial products can be problematic in the wrong hands, and that many people who could benefit from these products lack the information they need to use them safely, but I don't believe that this means people in developing countries should not have access to products that can expand their investment opportunities and limit risk. They should not be limited to only those products that small, independent banks can provide on their own. But small farmers, manufacturers, and service providers cannot overcome the failures that cause these markets to malfunction without help. Therefore, it is up to outside agencies or the government to either step in and create optimal market conditions through regulation and other means, which would likely be difficult given the severity of the problems that must be overcome, or to provide substitutes for the financial products the market cannot provide effectively, e.g. government price guarantees and government provided insurance against catastrophic crop failure, which shouldn't be as difficult. I don't mean that these activities shouldn't be guarded and cautious, but small and simple banks cannot, by themselves, fully meet the needs of the communities they serve.

    Posted by on Friday, July 10, 2009 at 10:03 AM in Development, Economics, Financial System | Permalink  Comments (6)


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