of its own resources at risk, which aligns its incentives better with those of the principal.<sup>14</sup> In a context where collateral repossession is unduly cumbersome, opacity is high, accounting rules are unreliable, and asset markets are illiquid, financers will only accept fixed collateral, preferably real estate. Finally, in the case of group monitoring—a device extensively used in the context of microfinance—the agency problems are mitigated because the group is collectively liable for the failure to pay of one member, which encourages group members to police each other and to exclude the risky ones from participating (Morduch, 1999). Relationship finance, fixed collateral, and group monitoring do enable the broadening of access, but only up to a point, as they work, by definition, within a circumscribed network of participants, excluding viable projects/creditworthy borrowers that lack fixed collateral and/or connections.

In countries with a strong institutional framework, in contrast, the ability to solve agency problems and reduce transaction costs is facilitated by the forces of competition working in the context of a high quality contractual environment and efficient market infrastructures, fostering the incorporation of advances in information technology and financial engineering into financial contracts. This enables the expansion of arm’s-length financing; contracts that are impersonal in nature and that, therefore, rely more on transparency (e.g., broadly disclosed information and sound accounting) and enforcement rules of general application (i.e., not circumscribed to the participants of a particular contractual arrangement). Arm’s-length financing, which frees borrowers from the tyranny of collateral and personalized connections, requires the prompt and unbiased enforcement of private contracts by a third party (generally courts). Furthermore, in a high quality contractual environment financial contracts are designed much less to cope with or bypass bad public institutions (as is often the case in underdeveloped financial systems) and much more to take advantage of the opportunities opened by good institutions. Financial development, thus, engenders a robust process of chipping down of the barriers to access.

Institutional development can also broaden access through the reduction of transaction costs. For instance, sound frameworks for collateral repossession and corporate bankruptcy will reduce the costs of recovering value in the event of default. Similarly, reliable disclosure and accounting standards will reduce the costs of evaluating projects. Technological innovation also plays a crucial role in cost reductions, even where the contractual environment is still deficient. A case in point is the fast expansion of consumer and micro lending in emerging markets over the last years, which has been propelled by major costs reductions resulting from the intensive use of e-technology, scoring methods, and credit information systems.<sup>15</sup> The view that financial development is closely related to institutional development implies that, as any process of institutional evolution, financial development

> 14 See Rodriguez-Meza (2004) for a discussion of the role of collateral. IADB (2004) discusses the issue of over reliance on collateral in Latin America.

> 15 Credit scoring is an automated statistical technique used to assess the credit risk of loan applicants. It involves analyzing a large sample of past borrowers to identify the characteristics that predict the likelihood of default. Scoring systems usually generate a single quantitative measure (the _credit score_ ) to evaluate the credit application.

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