metadata: authors: 0: author: Gozzi,Juan Carlos
1: author: Schmukler,Sergio L.
2: author: De La Torre,Augusto
count: Latin America
docna: 0: docna: Innovative experiences in access to finance
            : market friendly roles for the visible hand ?
docty: Policy Research Working Paper
subtopic: Financial Intermediation,Financial Economics,Finance and Development,Inequality,Financial Sector Policy,Access to Finance
teratopic: Finance and Financial Sector Development,Private Sector Development
abstracts: cdata!: Interest in access to finance has
            increased significantly in recent years, as growing evidence
            suggests that lack of access to credit prevents lower-income
            households and small firms from financing high return
            investment projects, having an adverse effect on growth and
            poverty alleviation. This study describes some recent
            innovative experiences to broaden access to credit. These
            experiences are consistent with an emerging new view that
            recognizes a limited role for the public sector in financial
            markets, but contends that there might be room for
            well-designed, restricted interventions in collaboration
            with the private sector to foster financial development and
            broaden access. The authors illustrate this view with
            several recent experiences in Latin America and then discuss
            some open policy questions about the role of the public and
            private sectors in driving these financial innovations.
repnme: repnme: Innovative experiences in access to finance
            : market friendly roles for the visible hand ?
display_title: Innovative experiences in access to
            finance : market friendly roles for the visible hand
listing_relative_url: /research/2007/08/8115877/innovative-experiences-access-finance-market-friendly-roles-visible-hand
topicv3: Poverty m1326687 695,Financial Intermediaries m1326973 2196,Finance and Growth m1327404 1081,Access to Finance m1327464 1249,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development,Private Sector Development
no_of_pages: 82
author_keys: 0: author_key: 674337
1: author_key: 142794
2: author_key: 143858
model_extractions: WPS4326 Policy ReseaRch WoRking PaPeR 4326 Innovative Experiences in Access to Finance: Market Friendly Roles for the Visible Hand?

_Augusto de la Torre Juan Carlos Gozzi Sergio L. Schmukler_ The World Bank Latin America and the Caribbean Region Financial and Private Sector Development Unit and Development Research Group Macroeconomic and Growth Team August 2007
Policy ReseaRch WoRking PaPeR 4326

# **Abstract**

Interest in access to finance has increased significantly in recent years, as growing evidence suggests that lack of access to credit prevents lower-income households and small firms from financing high return investment projects, having an adverse effect on growth and poverty alleviation. This study describes some recent innovative experiences to broaden access to credit. These experiences are consistent with an emerging new view that recognizes a limited role for the public sector in financial markets, but contends that there might be room for well-designed, restricted interventions in collaboration with the private sector to foster financial development and broaden access. The authors illustrate this view with several recent experiences in Latin America and then discuss some open policy questions about the role of the public and private sectors in driving these financial innovations.

This paper—a product of the Office of the Chief Economist, Latin America and the Caribbean Region, the Development Research Group, and the Financial and Private Sector Development Vice Presidency—is part of a larger, Bank-wide effort to enhance the understanding of analytical and policy issues in access to financial services. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at adelatorre@worldbank.org, juan_carlos_gozi_valdez@brown.edu, and sschmukler@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Innovative Experiences in Access to Finance: Market Friendly Roles for the Visible Hand?**

Augusto de la Torre Juan Carlos Gozzi and Sergio L. Schmukler<sup>*</sup>

**JEL classification codes:** G18, H11, O16

**Keywords:** access to finance; financial development; development banks; public banks; Latin America

* Authors are with the World Bank. Gozzi is also with Brown University. We would like to thank all the people that helped us with our interviews and, in particular, Remigio Alvarez Prieto, Carlos Budar, Javier Gavito, Timoteo Harris, Miguel Hernández, Francisco Meré, and Jaime Pizarro. We are grateful to Aquiles Almansi, Asli Demirguc-Kunt, Patrick Honohan, and Marilou Uy (the study’s peer reviewers), who provided detailed and very useful comments. We also received useful comments and suggestions from Stijn Claessens, Carlos Cuevas, Giovanni Majnoni, Martin Naranjo, Guillermo Perry, Luis Serven, and Jacob Yaron. We would also like to thank Leonor Coutinho for helping us in the initial stages of this project and José Azar and Francisco Ceballos for excellent research assistance. The findings, interpretations and conclusions expressed in this study are entirely those of the authors and do not necessarily represent the views of the World Bank. E-mail addresses: <u>adelatorre@worldbank.org, juan_carlos_gozi_valdez@brown.edu, and sschmukler@worldbank.org.</u>
# **Innovative Experiences in Access to Finance: Market Friendly Roles for the Visible Hand?**

# **Contents**

|**1. Introduction**|**1**|
|---|---|
|**2. Conceptual Issues in Access to Finance**|**6**|
|Problem of Access vs. Lack of Access|6|
|Institutions and Access to Finance|9|
|**3. The Role of the Public Sector in Broadening Access**|**11**|
|The Interventionist View|13|
|The Laissez-Faire View|18|
|The Pro-Market Activism View|24|
|**4. Recent Pro-Market Interventions in Latin America**|**27**|
|Public Provision of Market Infrastructure|27|
|Structured Finance|30|
|Credit Guarantee Systems|32|
|Transaction Cost Subsidies|35|
|Public Lending|36|
|**5. Final Remarks**|**37**|
|**Appendices**||
|An Overview of Microfinance|41|
|BANSEFI’s Experience|43|
|NAFIN’s Reverse Factoring Program|50|
|FIRA’s Structured Finance Transactions|56|
|**References**|**66**|
# **1. Introduction**

Academic and policy interest in financial development has risen in step with the accumulation of evidence supporting the view that a sound financial system is not just correlated with a healthy economy, but actually causes economic growth.<sup>1</sup> By and large, the empirical work behind this evidence has used financial sector depth, typically expressed as the ratio of financial assets to GDP, as the “independent variable,” thereby implicitly assuming that depth is a good proxy for financial development.<sup>2</sup> This may be a justifiable assumption when it comes to empirical work, given the arguably strong correlation between financial depth and financial development, and considering data constraints. But it is clear that the intricate web of institutional and market interactions that are at the heart of financial development can hardly be reduced to a single dimension. It is financial development in all of its dimensions—and not just financial depth—which lubricates and boosts the process of growth. It is not surprising, therefore, that the discussion of finance and growth has naturally widened to consider other dimensions of finance that appear crucial to economic and social development. These include stability, diversity, and—the focus of this study—access to finance. Of these dimensions, access to finance is, so to speak, the “new kid in the block.”<sup>3</sup> Although a relatively new field, the study of financial development from the perspective of the breadth of access to financial services has mushroomed.<sup>4</sup> There are a number of factors that have contributed to this. First, there is some empirical evidence, albeit still limited, that the expansion of access may reduce poverty. Burgess and Pande (2005), for instance, find that a 1 percent increase in the number of rural banked locations in India reduces rural poverty by 0.34 percent (see also Department for International Development, 2004, and references therein).<sup>5</sup> 1 The literature on the finance-growth nexus is vast. Reviews of such literature can be found in a variety of forms that can suit all sorts of different tastes. A comprehensive review is found in Levine (2005). Rajan and Zingales (2001; 2003a), by contrast, provide shorter reviews in less technical language. Caprio and Honohan (2001) offer an excellent rendition that emphasizes the World Bank contributions to the empirical literature.

2 A notable exception is Beck, Demirguc-Kunt, and Martinez Peria (2005), who collect several indicators of banking sector outreach and find that outreach is associated with lower firm-level financial constraints, even after controlling for financial sector depth.

3 The study of financial stability is arguably a more mature endeavor that includes such well-researched topics as regulation and supervision, early warning systems, crisis prevention, crisis management and resolution, and monetary and financial sector linkages. The study of financial system diversity is arguably also a relatively more mature subject, inasmuch as financial sub-sectors (e.g., banking, capital markets, insurance, and pensions) are the object of specialized disciplines.

4 A large number of recent studies have focused on quantifying the lack of access of households and firms and trying to determine its causes. In the case of developing countries, these studies include: Kumar (2005) for Brazil; World Bank (2003a) for Colombia; Srivastava and Basu (2004) for India; Atieno (1999) for Kenya; Aliou and Zeller (2001) for Malawi; Caskey et al. (2004) and World Bank (2003b) for Mexico; Beegle, Dehejia, and Gatti (2003) and Satta (2002) for Tanzania. Halac and Schmukler (2004) present data for various Latin American countries. In addition, Beck, Demirguc-Kunt, and Maksimovic (2002), Francisco and Kumar (2004), IADB (2002), Tejerina (2004), and Schulhofer-Wohl (2004) analyze measures of access to finance for small firms.

5 A broader group of studies has shown a link between financial market depth and poverty reduction, but does not identify whether this is caused by a simultaneous expansion in the breadth of access, or simply by 1
Second, the interest in access also comes from the fact that arguments about the channels through which financial development may lead to growth often include accessrelated stories. Most prominent in this regard is the Schumpeterian argument, compellingly restated by Rajan and Zingales (2003a), that financial development causes growth because it fuels the process of “creative destruction,” and it does so by moving resources to efficient uses and, in particular, to the hands of efficient newcomers. What is relevant in this perspective is the access dimension of financial development—it is through broader access to finance that talented newcomers are empowered and freed from the disadvantages that would otherwise arise from their lack of inherited wealth and absence of connections to the network of well-off incumbents. In other words, financial development can stimulate the process of creative destruction—and thus the growth process—by expanding economic opportunities and by leveling the playing field, that is, by giving the outsiders and the poor a chance. It is on the strength of this type of reasoning that Rajan and Zingales (2003a) confidently say that “healthy and competitive financial markets are an extraordinarily effective tool in spreading opportunity and fighting poverty.” A third reason for the increasing interest on the study of access is the sheer lack of access to financial services in emerging economies, particularly when compared to the extent of access in developed countries. Recent World Bank country-specific reports suggest that more than 70 percent of the Latin American population lacks access to such basic financial services as a checking or savings account.<sup>6</sup> In industrial countries this statistic is typically below 20 percent.<sup>7</sup> By implication, the Latin Americans that have access to the more sophisticated financial services—long-term credit, mutual funds, insurance products, etc.—are truly few and far between.<sup>8</sup> The differences in access across countries are also illustrated by studies showing that firms in developing countries, especially SMEs (small and medium enterprises), use formal sources of finance much less than similar firms in industrial countries (see, for example, Beck, Demirguc-Kunt, and Maksimovic, 2002).

In light of the increasing awareness of the importance of access, not only among policymakers but also academics, this study aims at filling in one of the many gaps in this still emerging literature, by addressing specific issues related to access to finance. In particular, this study has two objectives. The first one is to discuss some conceptual issues in access to finance. The second one is to describe some recent experiences to broaden access to credit. These experiences seem to be driven by an emerging new view on the role of the public sector in financial development, which tends to favor restricted

> an increase in income levels that favors lower income sectors. Beck, Demirguc-Kunt, and Levine (2004), for example, find that in countries with higher financial sector depth the income of the poorest 20 percent of the population grows faster than average GDP per capita and income inequality falls at a higher rate. 6 See relevant references in footnote 3.

> 7 Household surveys that compile data on access to financial services across countries are surveyed in Peachey and Roe (2004) and Claessens (2005). The percentage of households without a checking account is estimated to be about 30 percent in Italy, 12 percent in the U.K., nine percent in the U.S., eight percent in Spain, and less than two percent in Scandinavian countries (Peachey and Roe, 2004).

> 8 One exception among credit services, however, appears to be consumer credit (including the micro variety), the access to which is broadening at a fast pace.

2
government interventions in collaboration with the private sector in non-traditional ways. We illustrate this new view with several recent initiatives in Latin America and discuss some open policy questions about the role of the public and private sectors in light of these experiences.

Among the wide set of products covered under the “financial services” label— including savings, payments, insurance, and credit products—we focus our analysis on credit services. We believe that, regarding issues of access, these services are the most interesting and challenging from an analytical point of view and from policymakers’ perspective, as the provision of credit entails many complexities that lead providers to exclude very diverse groups of borrowers.

We start by noting that the observation that a certain share of the population does not use financial services, which we identify as _lack of access_ , does not necessarily mean that there is a _problem of access._ This distinction has often been ignored or understated in the recent literature, even though the failure to recognize it can lead to the wrong policy advice. Lack of access is simply the fact that financial services are not being used. To conclude that this observation entails a problem is not easy, as there is no clear definition of what such a problem is. To conduct our study, we adopt a working definition of a problem of access to credit. In our definition, a problem of access to credit exists when a project that would be internally financed if resources were available, does not get external financing. This happens because there is a wedge between the expected internal rate of return of the project and the rate of return that external investors require to finance it. This wedge is mainly introduced by two well-known constraints that hamper the ability to write and enforce financial contracts, namely, _principal-agent problems_ and _transaction costs_ .

The institutional framework of the economy affects the ability of agents to deal with these problems and therefore has a significant impact on financial development and access to finance. In environments with weak institutions, agency problems tend to be mitigated through arrangements that rely on personalized relationships, group monitoring, and fixed collateral. These instruments work, by definition, within a circumscribed network of participants, excluding creditworthy borrowers that lack collateral and/or connections. In contrast, a strong institutional environment enables the expansion of arm’s-length financing by using impersonal contracts that rely on rules of general application, effectively freeing borrowers from the tyranny of collateral and personalized connections.

Given the major potential benefits of access-enhancing financial development, a relevant question is whether government intervention to foster financial development and broaden access is necessary and, if so, what form should this intervention take. While most economists would agree that the government can play a significant role in fostering financial development, there is less consensus regarding the specific nature of its intervention. Opinions on this issue tend to be polarized in two highly contrasting but well-established views: the _interventionist_ and the _laissez-faire_ views. The _interventionist_ view argues that an active government involvement in mobilizing and allocating financial resources, including through government ownership of financial institutions, is needed to 3
broaden access to credit, as private markets fail to expand access. In contrast, the _laissezfaire_ view contends that governments can do more harm than good by intervening directly in the financial system and argues that government efforts should instead focus on improving the enabling environment.

A third view is emerging in the middle ground, favoring direct government interventions in non-traditional ways. This view, which we denominate _pro-market activism_ , seems to be behind some recent experiences of public sector intervention. In a sense, this third view is closer to the laissez-faire view, to the extent that it recognizes a limited role for the government in financial markets and acknowledges that institutional efficiency is the economy’s first best. However, it contends that there might be room for well-designed, restricted government interventions to address specific market failures and help smooth the transition towards a developed financial system or even speed it up.

The main message of pro-market activism is that there is a role for the visible hand of the government in promoting access in the short run, while the fruits of ongoing institutional reform are still unripe. However, the government must be highly selective in its interventions, always trying to ensure that they promote the development of deep domestic financial markets, rather than replace them. Careful analyses to identify market failures and their causes should precede any intervention. And even if a market failure is identified, government intervention can only be justified if it can solve the failure in a cost-effective manner. There must also be mechanisms in place to prevent political capture that may undermine the temporary nature of the interventions or their compatibility with the long-run objective of institutional reform and financial market development.

We illustrate the pro-market activism view with a number of recent experiences in Latin America. This exercise shows that there are now several institutions in the region that seem to be moving in the direction of pro-market interventions. We do not attempt to undertake a comprehensive assessment of these interventions or to claim that they have been successful. Rather, we use them to illustrate how pro-market activism has worked in practice. Although all the experiences we described were driven by the public sector, in many cases they could have been implemented by the private sector. In fact an open question is whether direct government intervention is necessary or if, given the right incentives, the private sector would take the initiative. The analysis of these experiences shows that the pro-market activism view favors the use of a wide range of instruments. In some countries, the government has provided infrastructure to help private financial intermediaries achieve economies of scale and reduce the costs of providing financial services. This is, for instance, the case the electronic market for factoring services created by the Mexican development bank NAFIN and the electronic platform implemented by BANSEFI, another Mexican financial institution, to help semi-formal and informal financial intermediaries reduce their operating costs by centralizing back-office operations. Alternatively, in Brazil, the government has amplified the phenomenon of corresponding banking by making non-financial public infrastructure with a large geographical coverage, like the post office, available for the distribution of financial services. In other cases, the public sector has acted as an arranger in structured finance schemes, coordinating stakeholders, providing guarantees, and fostering financial 4
innovation, as illustrated by the structured finance products created by FIRA, a Mexican development financial institution, to provide financing to the agricultural sector. In other cases the instruments used have been similar to those promoted by proponents of the interventionist view (i.e., public credit, subsidies, and guarantees). However, pro-market interventions tend to differ from previous ones in important aspects of their design— especially regarding sustainability, time limits, governance, and transparency—and even in terms of their objectives, as they seek to complement and promote private financial intermediation, rather than replace it. This is the case of BancoEstado’s intervention in the microfinance market in Chile, which was designed to promote financial innovation and foster the participation of formal private financial institutions in this market. Other pro-market interventions using traditional government instruments include the FOGAPE guarantee system in Chile and the SIEBAN subsidy designed by FIRA to cover the initial costs of serving small borrowers.

We conclude with some open questions raised by these experiences that are key to understanding whether the pro-market activism view can constitute a viable alternative to broaden access to finance in developing countries. First, a relevant question is whether idiosyncratic experiences can lead to more general policy guidelines. The experiences we describe may be the result of a specific environment that favors government innovation and reduces the risk of political capture and may also be inherently related to certain characteristics of the development-oriented financial institutions that have implemented them. This raises the question of to what extent these experiences can be replicated in other countries. Second, the analysis of the experiences suggests that it might be necessary to rethink some institutional features of development-oriented financial institutions to ensure that interventions succeed in fostering private financial intermediation and broadening access. Some features that may be helpful in this regard include: separating subsidies from funding and functioning more as development agencies—with an initial endowment from the government but no annual budget allocations—than financial intermediaries; redefining their mandates in dynamic terms, so that institutions move on to new interventions once the market they were promoting becomes self-sustainable; and modifying the way in which their performance is evaluated, away from criteria based on the volume of guarantees or loans provides and towards indicators based in the amount of financial intermediation promoted. Third, the pro-market view poses certain risks. Pro-market interventions may reduce incentives for institutional reform and detract resources away from efforts to achieve institutional efficiency, which is the economy’s first best. Pro-market interventions may also lead to inefficient equilibriums due to the existence of path dependence in financial development. Furthermore, even if interventions are designed to be time-bound and government support is restricted to the provision of seed capital, the creation of vested interest entailed in any government intervention raises significant political economy issues, as the government may face pressure to provide additional financial support in the future. Finding adequate instruments to effectively minimize these risks is one of the most important factors for the success of pro-market interventions. Fourth, an open question is whether pro-market interventions are just short-term solutions to broaden access while institutions are taking time to build, or if there is role for these interventions even in countries with a good enabling environment. Finally, further research is needed to 5
understand the adequate roles for the public and private sectors in fostering financial innovation and broadening access.

The rest of the study is organized as follows. Section 2 discusses conceptual issues of access to finance, including the definition of a problem of access and the relation between access and the institutional framework. Section 3 describes the different views on the role of the public sector in financial markets. Section 4 illustrates the promarket activism view with a number of recent experiences in Latin America. Section 5 concludes with some final remarks.

# **2. Conceptual Issues in Access to Finance**

# **2.1 Problem of Access vs. Lack of Access**

Let us start by noting that the phenomenon that a certain proportion of the population does not use financial services, which here we identify as _lack of access_ , does not necessarily mean that there is a _problem of access_ . A _lack_ of access and a _problem_ of access are two very different things. This distinction, unfortunately, has often been ignored or understated in most of the recent literature, even though the failure to recognize it can lead to the wrong policy advice. As defined above, a lack of access is simply the fact that financial services are not being used. To conclude that this observation entails a problem is not easy, not least because that would require a clear definition of what such problem is. Additionally, even if we agreed on a definition, it is difficult to identify a problem of access in practice and isolate it from the mere lack of access. In other words, data might reveal an equilibrium outcome of lack of access, but this may reflect either supply or demand factors. For example, households and firms may be observed not to use credit simply because they may not need to borrow (either because they lack viable investment projects or because they find it beneficial to use internal funds to finance their investments). To complicate matters, the problem in some cases may be not the lack of access to credit but rather the imprudent access to it. Many financial crises have in fact originated in exuberant lending that did not internalize appropriately the risks involved. Hence, that some borrowers are observed to be excluded from credit may actually be a good thing, as their projects may not generate, under most states of the world, the returns needed to pay back the debt. Finally, what may appear to be a problem of access to credit for the disenfranchised poor may be mainly a problem of poverty. In such a case, the policy solution would not be to artificially increase the flow of credit to those segments of the population but rather to seek other means of reducing poverty.

One important obstacle in trying to define problems of access to financial services is that “financial services” is a label that applies to a very wide set of extremely heterogeneous products, including savings, payments, insurance, and credit products. These different classes of products have very different costs, risks, and production functions, and it is not feasible to work on a definition of access that groups them all together. In this study, however, we will consciously choose to narrow down our analysis 6
to problems of access to credit services only. We believe that, in what regards problems of access to financial services, this particular class of products is the most interesting and challenging from an analytical point of view and from policymakers’ perspective. Products belonging to other categories, like savings and payment services, are just some of the many services that the poor cannot afford to pay. On the other hand, the provision of credit services entails many more complexities that sometimes lead providers to exclude very diverse groups of borrowers.

To be able to conduct our study, we adopt a working definition of a problem of access to credit. In our definition, a problem of access to credit exists when a project that would be internally financed if resources were available, does not get external financing (from outside financiers). This happens because there is a wedge between the expected internal rate of return of the project (that is generated by the project’s fundamentals) and the rate of return that external investors require to finance it. This wedge is mainly introduced by two well-known constraints that hamper the ability to write and enforce financial contracts, namely, _principal-agent problems_ and _transaction costs_ .<sup>9</sup> Note that our definition abstracts from any factors that may affect the level of interest rates, and thus the opportunity cost of funds. For example, a lower interest rate stemming from a reduction in macroeconomic volatility will reduce the opportunity cost of funds, increasing the number of viable projects (i.e., those that would be internally financed if resources were available) and the amount of financial contracting. However, this will not necessarily reduce the wedge between the internal rate of return and that required by external investors. Although in this example there would be an increase in the observed use of financial services and arguably major welfare gains, it would not entail a mitigation of the problem of access according to our definition.<sup>10</sup> In effect, our definition does not focus on the number of projects that are viable or on the number of projects that are observed to receive external financing, per se. An increase in those numbers would of course be highly desirable and beneficial to society, but it is outside the scope of our definition. For us, as the share of viable projects that are able to obtain external finance increases, the problem of access is reduced.

The two fundamental elements that introduce the access wedge—principal-agent problems and transaction costs—while conceptually distinct, are tightly intertwined in practice. Let us now turn to a brief discussion of each of them.

Consider _principal-agent problems_ first. The classic principal-agent problems are adverse selection and moral hazard.<sup>11</sup> The adverse selection problem arises because high-

> 9 See Lombardo and Pagano (2002) for a simple model showing the impact of principal-agent problems on the equilibrium rate of return.

> 10 Note that our working definition also allows us to abstract from the level of competition in the financial sector. The market structure of this sector may affect the cost of financing faced by borrowers, but even in an monopolistic environment, in the absence of transaction costs and principal-agents problems, all projects that would be internally financed (if the resources were available) should get external finance. The level of competition in the financial sector, however, will affect how the profits are divided among borrowers and creditors.

> 11 The canonical analysis of principal-agent problems in finance is due to Stiglitz and Weiss (1981).

7
risk borrowers (not just those that may be unable to repay their debt under a relevant range of states of the world, but also those that might be unwilling to do so) are the ones that are more willing to look for external finance. A financer may be willing to provide financing to some projects/debtors by increasing the risk premium charged, but this approach can backfire at some point due to the adverse selection problem. This is because as the risk premium required by lenders rises, so does the riskiness of the pool of interested borrowers. High-risk borrowers are “adversely selected” by higher risk premiums. In effect, the higher the interest rate, the lower its usefulness and reliability for creditors as a device for sorting out the good projects/borrowers from the bad ones. The situation is one where the debtor may know ex-ante whether her project is good or bad, and may have incentives to window-dress the bad ones, but the creditor cannot screen the projects adequately because she cannot extract or verify this information. Faced with the risk of adverse selection, lenders will try to use non-price criteria to screen debtors/projects and ration and apportion credit, rather than further increasing the risk premium.

The moral hazard problem, by contrast, concerns the situation after the agent (e.g., the debtor) has received the resources (e.g., the loan) from the principal (e.g., the lender). The problem here is that an agent may have informational advantages and associated incentives to use the resources in ways that are inconsistent with the principal’s interests. Acting on such incentives, the agent may divert resources to riskier activities, strip and loot assets, or simply run away with the money, and the creditor may not have an effective way to monitor and prevent such behavior. Note, however, that the moral hazard problem can arise even when the agent does not have informational advantages over the principal—i.e., when information is symmetrically shared—if the principal faces high costs of enforcing the contract subscribed with the agent. Faced with the moral hazard risk, a principal (e.g., a financer) would try to find ways to align the incentives of the agent with its own. If unable to do so, principals may just not provide funding—i.e., curtail access.

Consider, next, _transaction costs_ . Even assuming that there are no principal-agent problems, a problem of access to finance may still exist where the transaction costs involved in the provision of finance exceed the expected risk-adjusted returns. Such a scenario may arise due to the inability of financial intermediaries to reduce costs by capturing economies of scale and scope. The result would affect disproportionately such outsiders as poor households and small enterprises, as providing finance to them could be rendered unprofitable by high costs per transaction. Cost barriers could also stem from deficiencies in institutions and market infrastructure that make it expensive to gather information on debtors/projects, value assets appropriately, and monitor and enforce contracts.

Problems of asymmetric information and transactions costs, furthermore, can generate first-mover dilemmas and coordination problems that make the expansion of access to certain groups of the population increasingly difficult. As an example, when an investor decides to start lending to a risky group of borrowers, such as small farmers, it will have to bare all the costs in case of default, while facing fierce competition in case of success, because its best borrowers, who now have a good credit history, will try to 8
obtain better lending terms from new creditors. Similarly, once a new lending technology is introduced and proves to be successful, it can be easily adopted by others, who will not share the research costs. Due to these dilemmas, research and investment in these areas will be below the social optimum, unless a coordinating device is introduced to distribute costs and benefits in an efficient way.

# **2.2 Institutions and Access to Finance**

The institutional framework of the economy affects information flows, transaction costs, and contract enforcement. Therefore, institutions can be expected to have a significant impact on financial development and access to external finance. A relatively recent and growing empirical literature has provided significant evidence in this regard, finding that countries with legal systems that enforce property rights, support private contractual arrangements, and protect the rights of creditors and shareholders have more developed financial systems (see Beck and Levine, 2005 for a review of this literature).

In environments with weak public institutions, contract writing and enforcement are difficult and publicly available information scarce. As a result, agency problems tend to be mitigated through arrangements between private parties that rely heavily on personalized relationships, fixed (preferably real estate) collateral, and group monitoring.<sup>12</sup> Relationship finance mitigates agency problems thorough contractual arrangements between private parties that raise the reputation costs of non-compliance and hence foster loyalty. In these arrangements, to use North’s (1990, p. 55) words, “parties ... have a great deal of knowledge of each other and are involved in repeated dealings ... [so that] it simply pays to live up to agreements.” This is why, for all of its potential drawbacks, related lending can be seen as way to cope with a deficient informational and contractual environment.<sup>13</sup> Collateral is another way of mitigating agency problems at all stages of financial development—by posting it, the agent puts part

> 12 The threat of violence and the resort to physical intimidation and punishment are also commonly observed devices—especially used by loan sharks—to deal with agency problems in financially underdeveloped markets.

13 Rajan and Zingales (2003a), for instance, argue (p. 34) that “insider-lending practices [are] a solution to primitive informational and contractual infrastructure,” and note that “historical studies indicate that lending to related parties reflects financial underdevelopment (...) rather than some cultural propensity towards being devious.” There is in effect a great deal of fascinating literature on how agency problems have been dealt with through relationship-based arrangements in earlier stages of financial development. For example, Greif (1993) provides an illuminating analysis of how the Maghribi traders were able to monitor agents involved in distant trading by forming a community of merchants who were mutually bound by a set of rules (the Merchant’s Law). Haber and Maurer (2004) analyze the rapid expansion in bank lending to the textile industry in Mexico during 1876-1911 which was mostly accounted for by lending to insiders. They show that due to certain rules of the game (which, inter alia, required lenders to have substantial own resources at risk, enabled minority shareholders to monitor controlling shareholders, and boosted reputation effects), such lending to insiders did not degenerate into looting or the misallocation of credit. La Porta et al. (2003), in contrast, illustrate the perverse incentives of related lending by showing that, in the Mexico of more recent times, related borrowers have been 33 percent more likely to default on their debts than unrelated ones, and that recovery rates have been 30 percent lower for related loans than for unrelated ones.

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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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is characterized by “path dependence” (North, 1990). Path dependence reflects the fact that institutional arrangements are self-reinforcing (although not always efficient) due to substantial increasing returns—the large set up costs of new institutions, the subsequent lowering of uncertainty and transaction and information costs, and the associated spillovers and externalities for contracting. An important corollary of path dependence is that an isolated legal or regulatory feature that may be functional under a given institutional matrix and at a given stage of financial development may produce unintended effects when transplanted to another institutional milieu.<sup>16</sup>

# **3. The Role of the Public Sector in Broadening Access**

Given the major potential benefits of access-enhancing financial development, a relevant question, especially in countries with underdeveloped financial systems, is whether government intervention to foster financial development and broaden access is necessary and, if so, what form should this intervention take.

Standard arguments for government intervention in the financial sector stress that financial markets are different from other markets because they rely heavily on information and produce externalities that cannot be easily internalized by market participants.<sup>17,18</sup> When information is asymmetric between lenders and borrowers and is costly to obtain, or when the social benefit of a project is higher than the private benefit, the market may fail to provide adequate financing.

Financial markets rely heavily on the production and processing of information, which is fundamentally a public-good, in the sense that it is non-rival in consumption (the consumption of the good by one individual does not detract from that of another individual) and non-excludable (it is very costly to exclude anyone from enjoying the good). As theory demonstrates, such goods are undersupplied in a competitive equilibrium. For example, investors may not find it optimal to screen and finance certain borrowers because, once these borrowers obtain a good credit history, they can get credit 16 Empirical studies suggest that legal traditions help explain cross-country differences in investor protection laws, contracting environment, and financial development (see, for example, Beck, DemirgucKunt, and Levine, 2003; Levine, 1998, 1999; and La Porta et al., 1997, 1998), with countries of English legal origin presenting better creditor and shareholder rights protection and more developed financial markets. This evidence suggests the existence of a high level of path dependence in financial development. However, other researchers reject the view that legal origin is a central determinant of investor protection and stress the role of politics in determining regulations and contract enforcement (see, for example, Pagano and Volpin, 2001; Rajan and Zingales, 2003b; and Roe, 1994).

17 Stiglitz (1994) discusses the main arguments for public intervention in the financial sector. Besley (1994) presents a critical review of the arguments for government intervention in financial markets, with a focus on rural credit. Also, see Zingales (2004) for a critique of the traditional rationale for government intervention based on Coase’s (1960) arguments and their application to financial regulation.

18 Another common argument for government intervention in financial markets is related to the need to maintain the safety and soundness of the financial system, given the large costs and externalities generated by financial crises. This argument, however, has been invoked to justify the need for government regulation and supervision, rather than direct public involvement in financial markets.

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from other investors, who will not bare the initial screening costs.<sup>19</sup> The failure to appropriate the returns of information causes financial intermediaries to under invest in information acquisition. The sub-optimal stock of information gathered by the financial sector leads to a sub-optimal level of investment: viable projects will be underfinanced (or not financed at all) due to the lack of adequate information. Similar effects are present when lenders invest in new credit technologies. While they will bare all the costs in case of failure, it is often difficult to prevent other investors from adopting the new technology once it has proven successful, reducing incentives for innovation.

Another reason for competitive markets to produce inefficient equilibrium outcomes is when the social rate of return of an investment differs from the private rate of return. Private financiers focus on the expected returns that they receive and therefore have no incentives to finance socially profitable but financially unattractive investments. Private banks, for instance, may not find it profitable to open branches in rural and isolated areas, because they fail to internalize the social benefits that may be accrued by the positive effects on growth and poverty reduction in these areas. Similarly, private creditors may find it unattractive to finance infant industries or industries that are not particularly profitable but are considered of national interest, such as airlines or oil refineries.

Finally, some financial instruments may need to achieve a certain scale in order to be profitable. This is the argument behind the protection of infant industries. The failure to coordinate efforts may lead to a prisoner’s dilemma type of game in which gains only materialize if all investors invest in one project simultaneously, and the one that invests alone incurs a large loss. In this type of game, without a coordination mechanism, no investment will take place in equilibrium.

While most economists would agree that some type of government intervention to foster financial development is warranted, there is less consensus regarding the specific nature of this intervention. Answers to this question tend to be polarized in two highly contrasting but well-established views: the _interventionist_ and the _laissez-faire_ views. The _interventionist_ view argues that an active public sector involvement in mobilizing and allocating financial resources, including government ownership of banks, is needed to broaden access to credit, as private markets fail to expand access. In contrast, the _laissez-faire_ view contends that governments can do more harm than good by intervening directly in the financial system and argues that government efforts should instead focus on improving the enabling environment, which will help to reduce agency problems and transaction costs and mitigate problems of access.

A third view is emerging in the middle ground, favoring direct government interventions in non-traditional ways. This third view is in a sense closer to the laissezfaire view, to the extent that it recognizes a limited role for the government in financial markets and acknowledges that institutional efficiency is the economy’s first best, but, as it will be explained below, it does not exclude the possibility that in the short run, while

> 19 Additionally, since the likelihood of default increases with the amount borrowed, further borrowing by the debtor may have a negative impact on the first creditor (Arnott and Stiglitz, 1991).

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institutions are taking time to build and consolidate, some government actions undertaken in collaboration with market participants may be warranted. This is the view of _promarket activism_ . We now turn to a more detailed characterization of each view.

# **3.1 The Interventionist View**

The interventionist view is a very old view, which was popularized by the import substitution policies of the 1950s and 1960s. This view regards the problems of access to finance as resulting from widespread market failures that cannot be overcome in underdeveloped economies by leaving markets forces alone.<sup>20</sup> For the proponents of this view, it is less important to gain an adequate understanding of why private markets fail than to recognize that they do fail, and badly. The key contention, therefore, is that to expand access to finance beyond the narrow circle of privileged borrowers—mainly large enterprises and well-off households—the active intervention of the government is required. The government is thus called upon to have an intense, hands-on involvement in mobilizing and allocating financial resources.

The interventionist view was closely related to the predominating thinking at the time about the role of the government in the development process. The early development literature drew attention to the constraints imposed by limited capital accumulation and argued that markets tended to work inadequately in developing countries (see, for example, Gerschenkron, 1962; Hirschman, 1958; Rosenstein-Rodan, 1943; and Rostow, 1962).<sup>21</sup> Consistent with these view, the growth strategies of most developing countries in the 1950s and 1960s focused on accelerating the rate of capital accumulation and technological adoption through direct government intervention. The role of the government was to take the “commanding heights” of the economy and guide resource allocation to those areas believed to be most conductive to long-term growth. This led to import substitution policies, state ownership of firms, subsidization of infant industries, central planning, and a wide range government interventions and price controls. Confidence in government intervention was, at least partially, based on its perceived success in expanding production during World War II and its role in the reconstruction of Europe and Japan. Moreover, memories of the Great Depression made policymakers skeptical about the functioning of markets.

The main instrument to broaden access to finance promoted by proponents of the interventionist view was the direct provision of funds through public, developmentoriented banks. As a result, public banks mushroomed throughout the world: by the 1970s, the state owned on average 40 percent of the assets of the largest banks in developed countries and about 65 percent in developing countries. Among developing countries there were large regional differences, with South Asia and Latin America presenting the highest share public bank ownership, reaching close to 90 percent of the

> 20 Gerschenkron (1962) was one of the first authors to argue that the private sector alone is not able to overcome the problems of access to finance in a weak institutional environment. 21 The arguments made by these early authors have been formalized in several theoretical papers (see, for example, Hoff and Stiglitz, 2001 and Murphy, Shleifer, and Vishny, 1989).

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assets of the ten largest banks in the former and around 65 percent in the latter (banks were fully government owned in transition economies). Public banks became key policy vehicles, used by governments to support the pursuit of their social and developmental agenda through the selective allocation of (often subsidized) credit. Consistently with the market failure rationale, public banks tended to focus on areas where private markets are typically missing, such as long-term finance, lending to SMEs, housing finance, and agricultural credit.

Theoretically, in underdeveloped economies, public banks may have advantages over private banks in dealing with principal-agent problems and transactions costs—as they might, for instance, be better able to access information and exploit economies of scale. The government could increase the number of viable projects that get financed through several means: (i) using privileged information or compelling the disclosure of information to lower the costs of screening and monitoring; (ii) forcing participation in insurance schemes to increase the expected return on the loan; and (iii) internalizing potential externalities and redistributing costs through taxes or government borrowing (Stiglitz, 1994).

Governments can cross-check information with income tax systems and other official records, or compel the disclosure of information that is not available to private investors. This gives publicly owned banks an advantage in selecting and monitoring borrowers, reducing the fixed costs of providing loans, and therefore reducing the breakeven rate of return of external finance.

The government can also help to solve the problems generated by externalities. As mentioned above, if the social rate of return of a project is higher than its private rate of return, private creditors may not be willing to finance it, even if it would be beneficial for society as a whole to do so. This happens because it is difficult for the private sector to internalize the social benefits that may be generated by the project. This instead can be achieved by the government, through the tax system (intra-generational risk sharing) or through government debt (inter-generational risk sharing).

In addition, government ownership of banks may increase public trust in the banking system, leading to more savings and deeper financial markets.<sup>22</sup> Also, if government-owned banks are more trusted by depositors than private banks, they will have an advantage in attracting deposits and will face lower funding costs (see Adrianova et al., 2002 for a discussion of the case of Russia).

Apart from the direct provision of credit through public banks, another widespread tool for broadening access in developing countries was the imposition of lending requirements, which obligated private banks to allocate a certain share of their loans (or even absolute amounts) to specific sectors or regions. In Brazil, for example,

> 22 Note that the government could also increase trust in the banking sector through adequate regulation and supervision of private banks, as well as through the creation of deposit insurance systems. Which type of intervention will have a larger impact in terms of increasing public trust in the financial system depends on the public’s perception of the government’s ability to provide incentives and monitor private banks relative to its ability to monitor its own agents.

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commercial banks were required to allocate between 20 and 60 percent (depending on bank size) of their sight deposits to agriculture. In India, 50 percent of bank deposits had to be invested in government bonds at below market rates and most of the remaining funds had to be directed to priority sectors like agriculture and small enterprises, with only about 20 percent of bank resources being freely allocated. In Thailand, bank branches established outside Bangkok after 1975 were subject to “local lending requirements,” mandating them to lend at least 60 percent of their deposit resources locally (Booth et al., 2001). Many countries also established refinance schemes, which allowed commercial banks to discount loans to selected sectors at preferential rates with the Central Bank. The rationale for these interventions is similar to that for the creation of public banks discussed above: private banks cannot internalize the positive externalities generated by some investments, and therefore, without government intervention, may fail to allocate enough funds to those projects with the highest social returns.

Another commonly used tool was the regulation of interest rates. Governments often established preferential rates for commercial lending to priority sectors, which were significantly lower than those on regular loans. In Colombia, for example, interest rates on directed credit were, on average, about 12 percentage points lower than those on nonpreferential credit over the period 1983-1987 (World Bank, 1990a). In the case of Turkey, this differential reached 36 percentage points between 1980 and 1982 (World Bank, 1989). A variation of this tool was the establishment of interest rate ceilings on deposits and/or loans, which could apply across the board or vary by sector or type of loan. Interest rate controls were expected to result in lower costs of financing and greater access to credit.<sup>23</sup> The extensive regulation of the banking sector resulted in a pervasive influence of the government on credit allocation in many developing countries. In Colombia, for example, directed credit accounted on average for 62 percent of total credit provided by commercial banks and financial corporations to industry and mining between 1984 and 1987 (World Bank, 1990b). In the case of Korea, the ratio of directed credit to total credit reached 60 percent at the end of the 1970s (Booth et al., 2001). In Brazil, government credit programs represented more than 70 percent of credit outstanding to the public and private sectors in 1987 (World Bank, 1989).

Despite the theoretical advantages of government-owned banks in broadening access to credit, the general experience with public banking in developing countries has not been successful. Most empirical studies suggest that public banks tend to do more harm than good (see Barth, Caprio, and Levine, 2001; Caprio and Honohan, 2001; IADB, 2004; and La Porta, Lopez-de-Silanes, and Shleifer, 2002). In particular, these studies— typically based on cross-country regressions—find that greater government participation in bank ownership is associated with lower levels of financial development, less credit to the private sector, wider intermediation spreads, greater credit concentration, slower

> 23 Broadening access to credit was not the only reason for the imposition of interest rate controls and directed lending requirements. Strict control and regulation of the banking system was also supposed to give monetary authorities a better control over the money supply and provided the government with easily accessible resources to finance public expenditures (see Roubini and Sala-i-Martin, 1992).

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economic growth, and recurrent fiscal drains.<sup>24,25</sup> The perceived failure of public banking in developing countries contrasts with evidence suggesting that development banks played an important role in the rapid industrialization of Continental Europe and Japan (Cameron, 1953, 1961; Gershenkron, 1952).<sup>26</sup> While cross-country studies tend to find a negative or, at best, neutral impact of government bank ownership, it is necessary to consider that public banks are highly heterogeneous, both across and within countries. Detailed case studies highlight some success stories, such as the Village Bank system of Bank Rayat in Indonesia (Charitonenko, Benjamin, and Yaron, 1998) or the Bank for Agriculture and Agricultural Cooperatives in Thailand (Townsend and Yaron, 2001).<sup>27</sup> The prevalence, on average, of a negative impact of public banks in cross-country empirical studies can be explained by a variety of reasons. For starters, public banks in developing countries have frequently failed at reaching their targeted clientele, typically by wide margins, and even where they have done so, it has been at the expense of unduly high subsidy costs. Also, major incentive and governance problems in the operation of public banks have tended to surface, leading to such recurrent problems as poor loan origination and even poorer loan collection (thereby fostering a non-payment culture), wasteful administrative expenditures, overstaffing, plain corruption, political manipulation of lending with “clientelistic” motives, and capture by powerful special interests. All these factors have typically resulted in large losses and the need for recurrent recapitalizations, at very high fiscal costs. For example, in 2001 the Brazilian government absorbed the non-performing loan portfolios of two public banks (Banco do Brasil and Caixa Economica Federal) at a net cost of about 6 percent of GDP (Micco and Panizza, 2005). In the case of Turkey, the cost of recapitalizing the two largest public banks (Ziraat Bank and Halk Bank) in 2001 amounted to 15.5 percent of GDP (Fouad et 24 IADB (2004) revises the empirical evidence on the impact of public banks and finds that, while the results that government-owned banks have a negative impact are not as strong as previously thought, there is no indication that government ownership has a positive effect. It concludes that public banks, at best, do not play much of a role in financial development.

25 The interpretation of these findings in terms of causality is rather difficult, as the association between government participation in the banking system and poor financial development and macroeconomic performance could stem either from the need for more government intervention in countries with severe market imperfections that prevent financial development, or from a negative impact of public intervention on financial markets. Galindo and Micco (2004) try to address the problem of causality by using the methodology devised by Rajan and Zingales (1998) and find that government-owned banks do not promote the growth of those industries that rely more on external finance, nor do they promote the growth of industries that, due to reduced collateral, face more financial constraints. They conclude that what matters for growth is the development of private financial institutions.

26 Armendariz de Aghion (1999a) compares the successful development banking experience of Credit Nationale in France with the relatively unsuccessful more recent experience of Nacional Financiera in Mexico. She argues that the requirement to engage in co-financing arrangements with private financial intermediaries in the case of Credite Nationale and the type of government involvement (subsidized credit and loan guarantees in the case of France, direct ownership in Mexico) are among the factors that explain the contrasting results.

27 Following Yaron (1992), these papers use a comprehensive framework to evaluate the performance of development banks and their lending programs, mainly in terms of the outreach to their targeted clientele and the degree to which their operations are dependent on subsidies.

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al., 2005). In Mexico, the government had to recapitalize Banrural, a development bank providing financing to the rural sector, with about 1.1 billion U.S. dollars in 1999, even after having significantly downscaled its operations in previous years (Brizzi, 2001).<sup>28</sup> Moreover, it has been extremely difficult for public banks to break free from the inherent contradiction between their social policy mandates, on the one hand, and pressures to avoid losses, on the other. Public banks are charged with social policy mandates which, by definition, expose them to high-risk clientele and limit their capacity to diversify risks across economic and geographic sectors or across segments of population with different income levels. With subsidies typically hidden in below market interest rates, these institutions tend to incur low profits or losses—often magnified by weak risk management systems, wasteful administrative expenses, and vulnerability to political interference—and hence require repeated recapitalizations. To minimize operational losses and the associated fiscal costs, these banks are often placed under the same regulatory and supervisory standards as private commercial banks. This leads them to enter into less risky and more lucrative lines of business, in competition with private banks, reducing losses. However, this tends to be unsustainable as their activities become increasingly inconsistent with their social policy mandate, prompting political pressures to re-orient their activities towards meeting their mandate, which leads to a new cycle of losses and recapitalizations.<sup>29</sup> The experience with directed credit programs has also been unsuccessful in most cases (World Bank, 1989, 2005a). Although some East Asian countries like Japan, Korea, and Taiwan seem to have achieved some success with directed lending to manufacturing, in most developing countries the results have been poor.<sup>30</sup> Directed credit programs often failed to reach their intended beneficiaries. Within priority sectors, larger and more influential borrowers were favored. Lenders misclassified loans to provide credit to other sectors and borrowers diverted credit to other uses. One extreme example is the case of Korea, where an active market developed for borrowers with access to preferential lending to on-lend funds to firms without it. Directed credit programs were often used not to correct market failures, but to provide funds to politically-connected sectors and firms. Once directed credit programs were established, they created a strong constituency of beneficiaries, making it very difficult for governments to reduce their support to these programs, regardless of how inefficient or costly they were. The cost of subsidies on directed credit programs has often been substantial: in Brazil, for example, this cost was

> 28 Banrural is currently being liquidated. The World Bank has provided support of 505 million U.S. dollars to the Mexican government to replace Banrural with a non-bank financial institution, Financiera Rural. The total cost of government intervention in the rural financial system in Mexico, mostly through different development banks, during the 1983-1992 period has been estimated at approximately 28.5 billion U.S. dollars, 80 percent of which is associated with interest rate subsidies. The annual average of these costs represents about 13 percent of agricultural GDP (Brizzi, 2001).

> 29 This phenomenon is what de la Torre (2002) calls the “Sisyphus syndrome” of public banks.

> 30 See World Bank (1993) for a description of the experience of East Asian countries with credit controls. Also, Vittas and Cho (1996) try to extract the main lessons from the experience of these countries with directed credit programs. They conclude that these programs should be small, narrowly focused, and of limited duration. Several authors (see, for example, Cho, 1997; Santomero, 1997; Vittas, 1997; and World Bank, 1993) point out that the relative success of directed credit programs in East Asian countries was achieved at the expense of a slower development of more complete financial markets.

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estimated at between 7 and 8 percent of GDP in 1987. In Korea, the subsidy provided by directed credit was approximately 1 percent of GDP during the 1980s (Booth at al., 2001). Directed lending requirements in many cases left little power or responsibility on credit allocation to private banks, resulting in low investments in credit assessment and monitoring. Also, extensive refinance schemes at low interest rates reduced the incentives for financial institutions to mobilize resources on their own, leading to a lower level of financial intermediation.

Furthermore, direct government intervention in the operation of financial markets, through directed lending programs, interest rate controls, entry restrictions, and high reserve requirements, has been found to have significant costs in terms of economic efficiency and growth and to stifle, rather than promote, financial development. These policies were initially challenged by Goldsmith (1969) and later by McKinnon (1973) and Shaw (1973), who coined the term “financial repression” to describe them. Goldsmith (1969) argues that the main impact of financial repression is to reduce the marginal productivity of capital. Since interest rate controls keep rates below their equilibrium level, high quality projects with higher returns do not get financed. McKinnon (1973) and Shaw (1973) focused on two other channels. First, financial repression reduces the efficiency of the banking sector in allocating savings, as bankers do not ration credit according to price criteria. Second, by maintaining interest rates below their market equilibrium, financial repression reduces the savings level. These two channels have a negative impact on growth, as too little will be saved and those savings will not be allocated to the projects with the highest marginal productivity.<sup>31</sup> Financial development is also likely to suffer under these conditions, as the low return on financial assets encourages savers to keep their savings outside the financial system.

# **3.2 The Laissez-Faire View**

Over the last decades, mostly as a reaction to the mentioned problems of public banking and direct government intervention in the financial sector, a second, entirely opposite view has gained ground: the laissez-faire view. This view also stems from an increasing awareness of the role played by institutions and market infrastructures in financial development. The laissez-faire view contends that, due to incentive issues, bureaucrats will never be good bankers and that governments can do more harm than good by intervening directly in credit allocation and pricing. According to this view, although there may be market failures in the financial industry, these are not as extensive

> 31 A number of cross-country studies have attempted to measure the impact of financial repression on growth. Most of these papers use real interest rates (or variables based on threshold values of real interest rates) to measure financial repression, as controls on lending and deposit rates resulted in low or negative real interest rates in many developing countries (Agarwala, 1983; Gelb, 1989). These studies tend to find a negative relation between financial repression and economic growth (see, for example, Easterly, 1993; Lanyi and Saracoglu, 1983; Roubini and Sala-i-Martin, 1992; and World Bank, 1989). Galindo, Micco, and Ordoñez (2002) measure the extent of financial liberalization using indices based on financial system regulations and find that financial liberalization, mainly in the domestic financial sector, increases the relative growth rate of those industries that rely more on external finance.

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as assumed by proponents of the interventionist view and private parties by themselves, given well-defined property rights and good contractual institutions, may be able to address most of these problems. Additionally, the costs of government failures are likely to exceed those of market failures, rendering direct interventions, at best, ineffective and in many cases, counterproductive. Therefore, this view recommends that governments exit from bank ownership and lift restrictions on the allocation of credit and the determination of interest rates. Instead, the argument goes, government efforts should be deployed towards improving the enabling environment—e.g., providing a stable macroeconomic framework, enhancing creditor and shareholder rights and their enforceability, upgrading prudential regulation, modernizing accounting practices, and promoting the expansion of reliable debtor information systems (Caprio and Honohan, 2001; Klapper and Zaidi, 2005; Rajan and Zingales, 2001; World Bank, 2005a).

The laissez-faire view is consistent with the general shift on thinking about the role of the government in the development process over the last decades. The experiences of developing countries in the 1970s and 1980s showed that widespread government intervention in the economy, through trade restrictions, state ownership of firms, financial repression, price controls, and foreign exchange rationing, resulted in the waste of large resources and impeded, rather than promoted, growth. Confidence in the ability of the government to foster economic development diminished dramatically, as growing evidence showed that government failure was widespread in developing countries and in many cases outweighed market failure (see, for example, Krueger, 1990; Srinivasan, 1985; and World Bank, 1983).<sup>32</sup> This led economists and policymakers to conclude that constraining the role of the public sector in the economy and eliminating the distortions associated with protectionism, subsidies, and public ownership was essential to fostering growth.<sup>33</sup> Much of this vision was reflected in the so-called “Washington Consensus” and guided most of the reform programs during 1990s.<sup>34</sup> Governments focused on creating a stable macroeconomic environment by reducing fiscal deficits and improving monetary policies. In line with the objective of reducing the role of the state in the economy, countries privatized government-owned enterprises, deregulated domestic industries, eliminated quantitative restrictions and licensing requirements, and dismantled agricultural marketing boards and other state monopolies. Many countries also reduced tariffs and other restrictions on imports and liberalized regulations on foreign investment. In recent years, the focus of the reforms has turned away from macroeconomic stabilization and liberalization and shifted towards improving the institutional environment (World Bank, 1999, 2002), consistent with the growing empirical evidence

> 32 The theoretical literature also started to focus on the causes of government failure, such as rent-seeking and capture by special interests (see, for example, Buchanan, 1962; Krueger, 1974; Stigler, 1971; and Tullock, 1967)

> 33 The view that better policies would lead to higher growth was also motivated by endogenous growth theories developed by Lucas and Romer in the mid-1980s which imply that government policies can influence not just the income level, but also countries’ steady-state growth rates. This literature provided the foundation to empirical work based on cross-country regressions to analyze the effects of policies on growth, which was started by Barro (1991). Durlauf, Johnson, and Temple (2005), Easterly (2005), and Temple (1999) provide critical surveys of this literature. See also Rodrik (2005).

34 The term “Washington Consensus” was coined by Williamson (1990). See World Bank (2005b) for a review of the reforms during the 1990s and a discussion of their policy lessons.

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on the impact of institutions of economic development (see, for example, Acemoglu, Johnson, and Robinson, 2001; Easterly and Levine, 2003; Hall and Jones, 1999; and Rodrik, Subramanian, and Trebbi, 2004).

The failure of the financial repression policies led many countries to liberalize their financial systems, reducing direct government intervention in the allocation and pricing of credit. Financial liberalization was carried out both on the domestic and external fronts. Regarding the domestic financial system, liberalization policies included the elimination or downscaling of directed lending programs, the reduction of reserve requirements, and the deregulation of interest rates. On the external front, many countries lifted restrictions on foreign borrowing by financial institutions and corporations and dismantled controls on foreign exchange and capital transactions. Despite stops, gaps, and some reversals, the process of financial liberalization has advanced through much of the world over the last decades.<sup>35</sup> Countries in all income groups have liberalized, although developed countries were among the first to start this process and have remained more liberalized than lower-income economies throughout. In developing countries, the pace and timing of financial liberalization has differed across regions. In Latin America, Argentina, Chile, and Uruguay liberalized their financial systems in the late 1970s, but these reforms were reversed in the aftermath of the 1982 debt crisis, and financial systems remained repressed during most of the 1980s. Latin American countries carried out substantial financial liberalizations in the late 1980s and early 1990s. In the case of East Asia, the liberalization process was more gradual. A number of countries started slowly rationalizing their directed credit programs and liberalizing their interest rates during the 1980s and the process in many cases stretched for over a decade.

The financial liberalization process was accompanied by a significant privatization of government-owned banks, driven by fiscal considerations and the changing view about the role of the state in the economy.<sup>36</sup> From 1985 to 2000 more than 50 countries carried out bank privatizations, totaling 270 transactions and raising over 119 billion U.S. dollars (Boehmer, Nash, and Netter, 2005). Although the process started in higher-income countries, developing countries quickly followed suit. The privatization process intensified in the second half of the 1990s, with more than 60 percent of the transactions taking place after 1994. Although this privatization wave resulted in a significant reduction in government bank ownership, the presence of the public sector in the banking system remains widespread, especially in developing countries. In 2003, the government held controlling stakes in banks representing about 7 percent of banking sector assets in developed countries and about 19 percent in developing countries (Clarke et al., 2004). Furthermore, in 21 of the 73 developing countries for which information is available, the public sector controls more than 30 percent of total banking system assets, compared to only three developed countries where this is the case.

The laissez-faire view led to a barrage of reforms aimed at creating the proper institutions and infrastructure for financial markets to flourish. Governments tried to

> 35 See Williamson and Mahar (1998) for an overview of the financial liberalization process around the world. Kaminsky and Schmukler (2003) construct indices of financial liberalization for a large number of developing and developed countries.

> 36 See Megginson (2005) for a review of the empirical literature on bank privatization.

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mitigate principal-agent problems in credit markets by reforming bankruptcy laws and enacting new legislation regarding creditor rights. Many countries also tried to improve information sharing among lenders by fostering the development of credit bureaus. Credit bureaus make borrowers’ loan payment history available to different lenders, facilitating information exchanges and reducing screening costs. Credit bureaus also increase incentives for repayment, since borrowers know that their reputations will be shared among different creditors.<sup>37</sup> Governments tried to create a supportive environment for private credit bureaus by enacting credit reporting laws that allow the sharing of information among creditors and in many cases created public credit registries. Miller (2003) reports that 15 countries, including nine Latin American countries, have established public credit registries since 1989 and that several developing countries in other regions are actively considering similar initiatives. Private credit bureaus have also experienced a significant growth over the last decades, with approximately half of the private credit reporting firms around the world covered by Miller (2003) starting their operations after 1989. In some countries, governments also modified collateral laws and created registries for moveable property in order to allow these assets to be used as collateral, which was expected to benefit smaller firms that are less likely to own fixed assets.<sup>38</sup> Enticed by their potential benefits, governments also implemented several reforms aimed at fostering securities market development.<sup>39</sup> In particular, governments created domestic securities and exchange commissions, developed the regulatory and supervisory framework, and took important strides towards establishing and improving the basic infrastructure for securities market operations. The latter included reforms related to centralized exchanges, securities clearance and settlement systems, custody arrangements, and trading platforms. Moreover, many countries tried to improve corporate governance practices by introducing new standards in a number of different areas, including voting ratings, tender procedures, and the structure of the board of directors.<sup>40</sup> Some countries also improved accounting and disclosure standards and enacted new insider trading regulations.<sup>41</sup>

> 37 McIntosh and Wydick (2004) show that the total effect of credit bureaus can be decomposed in two separate effects (a screening effect and an incentive effect) and that credit bureaus can improve access to financing for the poorest borrowers. Empirically, Japelli and Pagano (2002) find that the presence of credit bureaus, irrespective of whether they are public or private, is associated with deeper credit markets and lower credit risk. Love and Mylenko (2003) find that the existence of private credit bureaus is associated with lower financing constraints, while public credit registries do not seem to have a significant effect.

38 In most developing countries, legal impediments restrict the use of movable property as collateral, as there is little or no information on whether other creditors have claims on the same asset and the repossession process is usually cumbersome (often exceeding the economic life of the movable good). In contrast, lending secured by movable property is widespread in developed countries, reaching almost 40 percent of total credit in the U.S. (Fleising, 1996).

39 See World Bank (2004a) for a description of the evolution of securities markets and related reforms over the last decades, with a focus on Latin America.

40 See Capaul (2003) for an overview of corporate governance reforms in Latin America.

> 41 Bhattacharya and Daouk (2002) find that 39 developing countries have established insider trading regulations since 1990.

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Despite the intense reform effort, access to finance does not seem to have increased significantly in most developing countries since the early 1990s.<sup>42</sup> While many countries experienced a strong growth in deposits, this growth did not translate into an increase of similar magnitude in credit to the private sector, as most of the additional loanable funds were absorbed by higher holdings of public sector debt (Hanson, 2003).<sup>43</sup> Similarly, the performance of domestic securities markets in many emerging economies has been disappointing (World Bank, 2004a). Although some countries experienced growth of their domestic securities markets, this growth in most cases was not as significant as that witnessed by industrialized nations. Other countries experienced an actual deterioration of their securities markets.<sup>44</sup> The general perception of lack of results from the reform process contrasts with empirical evidence suggesting that reforms did in fact have a positive impact on financial development. For instance, Djankov, McLiesh, and Shleifer (2006) find that improvements in creditor rights and the introduction of credit bureaus are associated with increases in credit to the private sector. Similarly, de la Torre, Gozzi, and Schmukler (2005) find that capital market-related reforms tend to be followed by significant increases in stock market capitalization, trading, and capital raising. The contrast between this evidence and the general perception may be explained by excessively high expectations at the beginning of the reform process.<sup>45</sup> The gap between expectations and outcomes may also be ascribed to a combination of insufficient reform implementation with impatience.<sup>46</sup> In effect, despite what many claim, key reforms were in some cases not even initiated, while other reforms were often implemented in an incomplete or inconsistent fashion. In many cases, only laws were approved, but they were not duly implemented, nor were they adequately enforced. Moreover, policymakers have been too impatient, often expecting results to materialize sooner than warranted. While the 42 From a more general perspective, Easterly (2001) points out that despite significant policy reforms, developing countries have on average stagnated over the last two decades. He argues that worldwide factors may have contributed to this stagnation and says that this evidence deals a significant blow to the optimism surrounding the “Washington Consensus.” 43 The increase in public sector debt holdings was driven by several factors, including central banks’ growing use of bonds as monetary policy instruments, post-crisis bank restructurings in several countries, and increasing fiscal deficits. In countries where banking crises where not massive and government deficits were limited, credit to the private sector grew reasonably well (Hanson, 2003).

44 Stock markets in many developing countries have seen listings and liquidity decrease, as a growing number of firms have cross-listed and raised capital in international financial centers, such as New York and London. Karolyi (2004) and Moel (2001) offer evidence on how the use of American Depositary Receipts (ADRs) can affect stock markets in emerging economies. Levine and Schmukler (2006a,b) analyze the impact of migration to international markets on domestic market trading and liquidity.

45 Loayza, Fajnzylber, and Calderon (2005) analyze whether the growth outcome of the reforms of the 1990s in Latin America can be interpreted as a disappointment. They estimate the expected impact of the reforms on economic growth using cross-country regressions and then compare the predicted growth rate of Latin American countries on the basis of the reforms with their observed growth during the 1990s. They find that most Latin American countries experienced growth rates consistent with the extent of the reforms and thus conclude that reforms had the predicted impact. However, the estimated pay-offs of the reforms in many cases are quite small, suggesting that initial expectations may have been overly optimistic. 46 Renditions of this view, in the more general context of assessing the impact of reforms on economic development, can be found in Fernandez Arias and Montiel (2001), Krueger (2004), Singh et al. (2005), and World Bank (1997).

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expectation of a rapid payoff may be justified with respect to some first-generation reforms, more complex second-generation reforms have long gestation periods.<sup>47</sup> Proponents of the laissez-faire view also point out that, even in environments where there are institutional deficiencies that negatively affect financial contracting, there has been some progress in expanding access. One example of this is the strong growth of microfinance in developing countries. Microfinance consists in the provision of financial services to low-income individuals and informal firms.<sup>48</sup> Microfinance institutions have developed several mechanisms to deal with principal-agent problems and help reduce the transaction costs of serving small borrowers (see Appendix 1 for a general overview of microfinance). Unsecured consumer credit, including credit card lending, has also experienced significant growth in many developing countries in recent years (see, for example, BIS, 2005a and The Economist, 2006), fostered by advances in information systems and scoring methods.<sup>49</sup> Although the arguments of the laissez-faire view are quite compelling and have attained widespread support, the associated policy prescription is not free of problems. Improving the enabling environment is easier said than done. Even if we knew exactly what needs to be done, and in what sequence, there is no denying that the actual reform implementation would be full of glitches and affected by the two-steps-forward-one-stepbackward phenomenon. But the reality is that we do not know with precision all that needs to be done, as there is no ex-ante formula to achieve access-enhancing financial development. Financial development is not amenable to one-size-fits-all or a “template” approach, not least because of its evolutionary, path-dependent nature, as noted above. A good enabling environment is in effect the historical result of a complicated and rather delicate combination of mutually reinforcing institutional innovations and market dynamics—which cannot be transplanted at will from one country to another. Hence, financial reforms that are partial, inadequately complemented, or wrongly sequenced may lead to dysfunctional yet self-reinforcing institutional hybrids, which may be subsequently hard to dislodge. Learning and re-learning will be needed along the way, including through the cleansing aspects of financial crises and the pressures of competition, in order to re-route the process of financial development.

Given these characteristics of the institutional reform process, considerable time will elapse before most emerging economies can develop an adequate enabling

> 47 In general terms, first-generation reforms concern those taken as part of the initial wave of efforts to regain macroeconomic stability while de-regulating the economy. In the financial sector, first-generation reforms focused mainly on liberalizing the domestic financial market and on allowing freer cross-border capital mobility. Second-generation reforms concern the subsequent wave of reforms that are, by and large, much more intensive in institution building. In the financial sector, these entail, for instance, strengthening prudential oversight and transparency, improving creditor rights systems, enhancing corporate governance practices and minority shareholder protection, modernizing market infrastructures, etc.

> 48 As CGAP (2003a) emphasizes, while microfinance originally focused on working-capital loans to microentrepreneurs, it has now expanded to include all sorts of financial services provided to low-income individuals, including savings, credit, insurance, and money transfer services. See also Honohan (2004). 49 This rapid expansion may create some risks in the absence of prudent credit policies, as illustrated by the case of Korea where a credit card lending boom, partially fuelled by tax incentives, led to significant losses (see BIS, 2005a and The Economist, 2003).

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environment and see any results in terms of broader access to credit. Even innovative solutions like microfinance that, at least partially, help to overcome institutional deficiencies are unlikely to broaden access significantly in the short term.<sup>50</sup> It seems rather naive to expect governments to remain completely disengaged from any direct intervention geared at broadening access during the long transition to a developed financial system. For one, governments are likely to face increasing political pressures to do something. As mentioned above, there is a growing disillusionment with the reform process of the 1990s as reforms have failed to meet the (possibly excessive) initial expectations. While it can be questioned whether this disillusionment is warranted or not, reform fatigue is in any case likely to boost pressures for government intervention. Second, in many countries governments are still so engaged in the financial system that a quick withdrawal may not be possible. Existing public financial institutions have institutional incentives to continue intervening in financial markets and in many cases closing them or significantly downscaling their operations may not be politically feasible or even desirable, given existing linkages among markets and institutional arrangements. Finally, one could reasonably argue that certain government interventions may help to smooth the transition towards a developed financial system or even speed it up, without distracting from the long-run policy objective of institutional reform.

If one thinks in terms of non-conflicting long- and short-run policy objectives, it is possible to rationalize some recent experiences of government intervention into a third, middle ground view, which we denominate _pro-market activism._ We now turn to the characterization of this view.

# **3.3 The Pro-Market Activism View**

The pro-market activism view is an emerging new view that rationalizes a series of recent government interventions. Given that this view is quite recent and just emerging it is difficult to accurately characterize it. It may be easier to understand it by contrasting it with the two well-established views described above. In contrast with the interventionist view, the pro-market activism view does not assume that market failures are widespread and that therefore direct government intervention in the allocation and pricing of credit is necessary. Much to the contrary, this view argues that markets can and do broaden access to finance and therefore the adequate role of the government is to promote the development of deep and efficient financial markets, not to replace them. This view recognizes that direct government interventions may be warranted in some cases, but argues that careful analyses to identify market failures and specify their causes should precede interventions. The observation that a certain group lacks access to credit does not constitute by itself an indication of a market failure and therefore cannot justify interventions in credit markets. Interventions should be directed at solving market failures underlying problems of access, not at increasing the use of financial services per se. And

> 50 Despite its strong growth over the last years, microfinance penetration is still quite low in most countries. For instance, Daley-Harris (2003) reports that the ratio of borrowing clients of microfinance institutions to the total population exceeds two percent in only eight countries and in most developing countries this ratio is below one percent.

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even if a market failure is identified, public sector interventions can only be justified if they can solve this failure in a cost-effective manner. According to the pro-market activism view, government interventions should be designed to complement or facilitate the development of financial markets through the adequate choice of instruments (subsidies, funding, etc.) and institutions (private financial intermediaries, NGOs, public banks). This view is well aware of the risks of government lending, and therefore favors a wide range of instruments beyond lending. If subsidies are deemed necessary to solve a specific market failure, they should be restricted to seed capital to launch a project or be limited by sunset clauses and in all cases must be transparently budgeted to avoid the price distortions that have characterized past government interventions in financial markets.

In a sense, the pro-market activism view is closer to the laissez-faire view, as it contends that the governments’ main focus should be to forge ahead with the task of improving the enabling environment for financial markets. However, in contrast with that view, it recognizes that there might be room for well-designed, restricted government interventions to address specific market failures and help smooth the transition towards a developed financial system or even speed it up. According to this view, it seems unrealistic and possibly unwarranted in good logic for governments to solely focus on the enabling environment and to remain completely disengaged from any direct intervention to broaden access during the long transition to a developed financial system.

Thus, the main message of pro-market activism is that there is indeed a market friendly role for the visible hand of the government to promote access in the short run, while the fruits of ongoing institutional reform are still unripe. The important qualifier is, however, that the government needs to be highly selective in its interventions, always trying to ensure that they work with the market, never against it. Interventions should be relatively small and temporary, being terminated when the underlying causes of the problem of access have been removed. There must also be mechanisms in place to prevent political capture that may undermine the temporary nature of the interventions or their compatibility with the long-run objective of institutional reform and financial market development. Pro-market activism, moreover, favors a policy strategy that explicitly creates room for a process of discovery and learning-by-doing as the interventions are implemented, and may be useful to give the authorities a first hand understanding of what legislation or enforcement mechanisms are missing for certain innovations to take off. For pro-market activism, the ultimate goal is to foster the broadening of access in ways that simultaneously create financial markets where they are missing or enhance the functioning of the existing ones.

The pro-market activism view seems to be part of an emerging new way of thinking about development policies, based on the experience of the last decades. While still very far from providing a coherent clearly articulated thinking on development policies, this view tends to argue that, although a good enabling environment is a necessary condition for sustainable long-term growth, it may not be enough to initiate the development process and selective limited government interventions to address market failures may be required. This view is presented, for instance, by Rodrik (2002) who argues that “[t]he record suggests that an adequate growth programme needs to be 25
anchored in two strategies: an investment strategy designed to kick-start growth, and an institution building strategy (...)” Similarly, Zagha (2004) argues that reviewing the experience of the 1990s “confirms the importance for growth of fundamental principles: macro-stability, market forces in the allocation of resources, and openness” and also shows that “selective government interventions can contribute to growth when they address market failures, when and where they are carried out effectively, and are subject to institutional checks.” As mentioned above, this emerging view is still far from providing clear guidelines on development policies. It is a more nuanced view that calls for policy diversity, selective and modest reforms, and experimentation. In fact, its main characteristic seems to be the recognition of the need to avoid one-size-fits all strategies and to follow a more targeted approach taking into account country specificities. World Bank (2005b), for instance, argues that “there is no unique set of rules (...) [W]e need to get away from formulae and the search for elusive ‘best practices’ (...)” While a more nuanced approach to development policies may be necessary, this view runs the risk of degenerating into an “anything-goes” approach. The main challenge for this emerging view is translating its recommendations into specific operational guidelines for promoting development, without degenerating into a rigid blueprint.

The pro-market activism view, if warranted, must however recognize itself as a solution for the short run. It must understand the idiosyncrasies of institutional arrangements and market conditions in each country, and the specific ways in which access problems arise in that context, not only because well-designed and efficient institutions are the first-best solutions, but because guaranteeing that the eventual interventions under pro-market activism do not conflict with the long-run objective of institutional reform will crucially hinge on the quality and extent of such understanding.

For all of its potential appeal, pro-market activism raises many questions. Are there actually cases where government interventions do not displace financial market activity, but rather crowd it in? Can direct interventions indeed be designed so as to ensure that at least no harm is done? If a given government intervention is efficient, in the sense that it leads to greater, mutually beneficial financial contracting, why don’t private financial intermediaries take the initiative? Is direct government intervention necessary or, given the right incentives, private financial intermediaries would take the initiative? While it is very difficult to provide a definite answer to these questions, we will try to address them in the next section by analyzing how pro-market activism has worked in a number of recent experiences in Latin America. It is necessary to stress that we do not attempt to make a comprehensive assessment of these interventions or to claim that they have been successful. Rather, we use them to illustrate how pro-market activism has worked in practice and understand to what extent actual experiences have conformed to the stylized description of this view presented so far. This analysis will also help us to identify potential implementation problems, as well as pitfalls that must be avoided in the design of pro-market interventions.

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# **4. Recent Pro-Market Interventions in Latin America**

This section describes a number of recent experiences from Latin America that illustrate the approach of the pro-market activism view to government interventions. To guide the discussion, we group these experiences in terms of the type of instrument used in each case. However, most interventions are not as clear-cut in practice, as they tend to combine several instruments. This bundling of different instruments is in most cases the result of institutional design and incentives. An open question is whether these components can be effectively unbundled. The classification by type of instrument is used mainly for presentational purposes, to help depict the nature of the intervention under analysis and highlight the relevant policy issues. Two additional caveats are necessary before turning to the description of these experiences. In the first place, some of the instruments used in these interventions are similar to those promoted by proponents of the interventionist view (i.e., public lending, subsidies, and credit guarantees). However, pro-market interventions tend to differ from previous ones in important aspects of their design—especially regarding sustainability, time limits, governance, and transparency—and even in terms of their objectives, as they seek to complement and promote private financial intermediation, rather than replace it. Second, we focus on extracting the main policy lessons from these interventions, rather than on describing them in detail. Detailed descriptions of each experience are available in a number of appendices and several papers.

# **4.1 Public Provision of Market Infrastructure**

A traditional argument for government intervention in the banking sector is that private banks may not find it profitable to open branches in rural and isolated areas, and thus government intervention is necessary to provide financial services to residents of those areas. Underlying this argument is the idea that access to financial services generates positive externalities in terms of growth and/or poverty reduction (Burgess and Pande, 2005). This led to the creation of public banks to serve rural areas and in many cases also resulted in the establishment of regulations requiring banks to open branches in certain regions. In India, for instance, the government imposed the so-called 1:4 license rule in 1977. This rule stated that banks could open one branch in an already banked location only if they opened four in unbanked locations.

An innovative approach to increase the availability of financial services in remote areas has been adopted by the Brazilian government through the use of correspondent banking arrangements (see Kumar et al., 2006). Correspondent banking refers to arrangements whereby banks outsource services typically undertaken at branches, like receiving loan applications, making deposits and withdrawals, and paying invoices, to non-financial institutions with a significant network of outlets, such as convenience stores and supermarkets. This process significantly reduces the cost of providing financial services, enabling banks to reach areas where it might not be profitable to open branches. One could question whether direct government intervention is needed to promote this 27
kind of arrangements, as they can (and do) take place among private parties.<sup>51</sup> However, in many developing countries some of the largest networks of non-financial outlets are owned or regulated by the public sector. Therefore, in order to achieve a wide geographic coverage it is necessary for the government to allow financial institutions to use some of these networks to distribute their services. In the case of Brazil, lottery houses have been used by the federal savings bank Caixa Economica Federal (CEF) to distribute financial services. The right to provide banking services through the post office was granted to Banco Bradesco, the largest private bank in Brazil, through a public bidding process. The use of correspondents significantly reduces the cost of servicing remote locations. According to Kumar et al. (2006), initial investments for a correspondent outpost in Brazil can be as low as 0.5 percent of those for a traditional bank branch, and operating costs are negligible if existing employees and communication networks are used. This has resulted in a significant geographic expansion in access to financial services. While in 2001 29 percent of the municipalities in Brazil had no bank services (branches or bank service outposts), by 2004 all municipalities had access to these services, with 31 percent of them being served exclusively by bank correspondents.

Another example of a government intervention designed to help reduce the costs of providing financial services in unbanked areas for private financial intermediaries is the Mexican development bank BANSEFI (Banco de Ahorro Nacional y Servicios Financieros, _National Savings and Financial Services Bank_ ).<sup>52,53</sup> BANSEFI has the mandate of spearheading the development of semi-formal and informal financial institutions (called _popular savings and credit institutions_ ), including a variety of credit unions, savings and credit associations, cooperatives, and NGOS that serve regions where the presence of commercial banks is minimal or non-existent.<sup>54</sup> To this end, BANSEFI performs two tasks. First, it administers a one-off government investment subsidy (mostly financed by the World Bank) to help popular savings and credit institutions meet the criteria of sustainability, prudent risk taking, and adequate risk pricing necessary to become formal regulated financial intermediaries. BANSEFI provides these institutions with technical assistance and training to upgrade their governance, transparency, and management capacity to standards required for licensing. BANSEFI’s second task, which we view as the most innovative component of its operations, is to provide centralized back-office services like electronic transfers, liquidity management, clearing house

> 51 Even if direct government intervention is not necessary to promote correspondent banking, regulatory changes in several areas, including the use of electronic payment systems, account opening requirements, and agency relationships, may be required (CGAP, 2006). In the case of Brazil, for example, a number of Central Bank resolutions between 1999 and 2000 were key in the development of correspondent banking, by allowing correspondents to provide banking services, clarifying existing rules, and eliminating certain restrictions (Kumar et al., 2006).

> 52 BANSEFI was established in 2001 to replace PANHAL (Patronato Nacional del Ahorro), a governmentowned narrow bank that focused exclusively on mobilizing savings by capturing deposits, mostly among small rural clients, and investing these funds in government debt securities.

> 53 See Appendix 2, Coutinho (2006), and Taber (2005) for more detailed descriptions of BANSEFI’s operations.

> 54 BANSEFI has a second, separate mandate to promote savings by acting as a narrow bank, which it inherited from its predecessor, PANHAL. This second mandate may place it in competition with some of the popular savings and credit institutions it is supposed to support, generating some conflicts of interest (see CGAP, 2005a).

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services, debit and credit card services, and foreign exchange and derivatives transactions to the popular savings and credit institutions to allow them to capture economies of scale and scope that they may not be able to achieve individually. In the case of liquidity services, for instance, BANSEFI can consolidate the liquidity of all the participant institutions and invest it on their behalf in the commercial banking system, securing a higher rate of return than what the institutions could negotiate individually. BANSEFI is developing a technological platform to allow the sector to operate effectively as a network and to help institutions minimize operation and supervision costs. These centralized services are offered at fee and can be voluntarily contracted by the institutions. BANSEFI has also created a commercial alliance among several popular savings and credit institutions (L@Red de la Gente, _The People’s Network_ ) to share branches and facilitate the distribution of financial products.<sup>55</sup> This network uses a common technological platform to distribute financial products, helping to generate homogenous products that are offered under an umbrella trademark, significantly reducing distribution and marketing costs. L@Red de la Gente is also used to distribute several government programs and operates with traditional money transfer companies that use its network to distribute remittances. This increases the revenues of member institutions through distribution fees and helps to attract new customers and bring them into the financial system.

The BANSEFI-led program has made substantial progress in meeting its objectives, although there have been some delays in the process of upgrading and converting the popular savings and credit institutions into regulated entities. As mentioned above, government funding of BANSEFI was limited to the provision of seed money to finance technical assistance to the popular savings and credit institutions and build the technological platform to provide them with centralized services. BANSEFI was established with a clear sunset clause, which states that it will be, at least partially, sold to the popular savings and credit institutions once these institutions become formal regulated entities. The result of this sale will be a clear indicator of whether BANSEFI has actually added value by providing centralized services. The terms and procedures for this sale are currently under analysis (BANSEFI, 2006) and many sector representatives have expressed interest in taking part (CGAP, 2005a). See Appendix 2 for more details on BANSEFI’s experience.

Another example of electronic infrastructure provided by the public sector to reduce operational costs for financial intermediaries is the on-line market for factoring services developed by the Mexican development bank NAFIN (Nacional Financiera).<sup>56</sup> In many countries, small businesses find it difficult to finance their production cycle, since they lack access to bank credit and most buyers usually take between 30 and 90 days to pay. After delivery, sellers issue an invoice, recorded as an account receivable by the seller and an account payable by the buyer. Factoring is a type of financing in which firms sell their accounts receivable at a discount (equal to interest plus service fees) to a financial firm (called the factor) and receive immediate cash. Factoring is an asset sale,

> 55 This network is currently integrated by 68 institutions with a total of 1,170 branches, including 548 branches that BANSEFI inherited from PANHAL.

> 56 See Appendix 3, Naranjo (2005), and Klapper (2005) for detailed descriptions of this program.

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not a loan. There is no debt repayment and no additional liabilities on the supplier’s balance sheet. An alternative to ordinary factoring is reverse factoring. In this case, the factor only purchases accounts receivable issued by certain buyers. Reverse factoring reduces information problems, as the factor only needs to assess the credit worthiness of a specific group of large firms. A significant advantage of factoring, especially in developing countries, is that it does not require good collateral laws, just the legal ability to sell, or assign, accounts receivables.

NAFIN, a Mexican development bank, created an online system, called Cadenas Productivas ( _Productive Chains_ ), to provide reverse factoring services to SMEs. This program works by creating chains between “big buyers” and their suppliers. The buyers that participate in the program, large credit-worthy firms, must invite suppliers to join their chain. This reduces principal-agent problems by effectively outsourcing screening to the buyers, who have an informational advantage relative to financial intermediaries. All transactions are carried out on an electronic platform, reducing transaction costs, increasing speed, and improving security. Once a supplier delivers goods to the buyer and issues an invoice, the buyer posts an online “negotiable document” equal to the amount that will be factored on its NAFIN webpage. Participant financial institutions that are willing to factor this particular receivable post their interest rate quotes for this transaction. Finally, the supplier can access this information and choose the best quote. Once the factor is chosen, the discounted amount is transferred to the supplier’s bank account. The factor is paid directly by the buyer when the invoice is due.

NAFIN was responsible for the development, production, and marketing costs related to the electronic platform. It operates the system and also handles all the legal work. NAFIN requires all participating financial institutions to use its second-tier funding to provide credit through the system.<sup>57</sup> In fact, NAFIN does not charge a fee for the factoring services, but rather covers its costs with the interest it charges on its loans. NAFIN’s factoring program has been very successful, extending over nine billion U.S. dollars in financing since its inception in September 2001 and brokering more than 1.2 million transactions, 98 percent by SMEs. More than half of NAFIN’s second-tier lending in 2004 corresponded to the financing of factoring transactions originated from this program. NAFIN has entered into agreements with development banks in several Latin American countries, including Colombia, El Salvador, and Venezuela, to implement similar programs and development banks in other countries in the region are considering replicating this program. See Appendix 3 for more details on NAFIN’s reverse factoring program.

# **4.2 Structured Finance**

Structured finance can be defined as a form of financial intermediation based upon securitization technology.<sup>58</sup> In its simplest form, it is a process where assets are pooled and transferred to a third party (commonly referred to as special purpose vehicle

> 57 As discussed in Appendix 3, this seems to be the result of institutional incentives as NAFIN is a secondtier bank that is evaluated on the basis of its volume of loan disbursements.

> 58 Accurately defining structured finance is quite difficult, as even among market participants there is no agreement on exactly what it encompasses. See Davis (2005) for a survey of alternative definitions.

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or SPV), which in turn issues securities backed by this asset pool. Typically, several classes of securities (called tranches) with distinct risk-return profiles are issued.<sup>59</sup> Innovations abound in this market and several types of assets have been included in the collateral pool, ranging from cash instruments (e.g., mortgages, loans, bonds, credit card receivables) to synthetic exposures (e.g., credit default swaps). The structured finance market in developed countries has experienced significant growth over the last years (see BIS, 2005b). In the case of developing countries, although the volume of transactions has also increased significantly, structured finance markets are still small and underdeveloped.<sup>60</sup> Structured finance transactions involve a number of different participants. These typically include: the _originator_ , who originates the underlying assets in the course of its regular business activities or purchases them in the market; the _arranger_ , who sets up the structure and markets the securities; the _servicer_ , who collects payments and tracks the performance of the asset pool; the _trustee_ , who oversees cash distributions to investors and monitors compliance with deal documentation; and, in some deals, _financial guarantors_ , who provide guarantees for certain tranches.

FIRA (Fideicomisos Instituidos en Relación con la Agricultura, _Agricultural Related Trust Funds_ ), a Mexican development-oriented financial institution that provides second-tier funding to the agricultural sector, has recently promoted several structured finance transactions.<sup>61</sup> One of these transactions was designed to provide working capital financing to shrimp producers in collaboration with a large shrimp distributor called Ocean Garden.<sup>62</sup> The general structure can be summarized as follows. Shrimp producers sign supply contracts with Ocean Garden to deliver a certain amount of shrimp at a future date. Ocean Garden pays them a portion of these contracts in advance to provide them with working capital financing and subsequently transfers these credit rights to an SPV, which sells participations to investors. Ocean Garden not only acts as originator but also as servicer, being responsible for transferring payments to the trust fund once the producers deliver their production. To help align the incentives of the different industry participants and reduce adverse selection problems, shrimp producers, shrimp feed suppliers, and Ocean Garden provide liquid guarantees to cover the first credit losses. Shrimp producers and feed suppliers provide guarantees that cover the credit losses of each individual working capital loan up to 24 percent, whereas Ocean Garden provides a general guarantee that covers up to 25 percent of the total asset pool. Once these guarantees are exhausted, investors start facing credit losses.<sup>63</sup> FIRA not only acts as an

> 59 Some authors (see, for example, Alles, 2001, and BIS, 2005b) differentiate between securitization (which only involves the pooling and transfer of assets to a third party and subsequent issuance of securities) and structured financing (which also involves the creation of different classes of securities). In keeping with common usage, we use the term structured finance to refer to both types of instruments.

> 60 See Meddin (2004) for an overview of structured finance in emerging markets and the role it may play in fostering capital market development.

> 61 See Appendix 4 for a more detailed description of FIRA’s structured finance operations.

> 62 Ocean Garden is one of the main exporters of Mexican shrimp to the U.S. It handles approximately one quarter of Mexico’s shrimp production and has annual sales of about 250 million U.S. dollars. The firm was owned by the Mexican government and was recently privatized.

> 63 This happens when credit losses exceed approximately 32 percent of the total asset pool, see Appendix 4 for details.

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arranger in this transaction, but also as a financial guarantor providing guarantees to partially cover credit losses once the liquid guarantees from industry participants are exhausted. FIRA charges a fee for its services as arranger and also for the provision of the guarantees. FIRA requires all investors participating in this scheme, which are financial institutions, to use its second tier lending to purchase the securities issued by the SPV.

This structured finance transaction helps to solve principal-agent problems by outsourcing the screening of small producers to a large commercial firm that has an informational advantage relative to financial intermediaries. A significant problem in this type of transaction is that the originator may have incentives to include lower quality assets in the pool. Anticipating this possibility, investors who have less information about the quality of the assets may not be willing to invest or may ask for a premium to compensate them. In this particular transaction, the adverse selection problem is ameliorated by the fact that, since Ocean Garden signs supply agreements with the producers, it depends on the fulfillment of these agreements for its future sales and therefore has incentives to adequately screen and monitor producers. The adverse selection problem is further reduced by the fact that Ocean Garden provides guarantees to cover the initial credit losses. The pooling of working capital loans to several producers reduces transaction costs and also helps financial institutions to diversify their risk exposure, as they do not face the idiosyncratic risk of an individual producer. Also, financial institutions do not face Ocean Garden’s credit risk, as the supply contracts are removed from its balance sheet and their ownership is transferred to the SPV. This means that if Ocean Garden files for bankruptcy, the assets in the pool do not come under court jurisdiction. FIRA has been successful in using similar structured finance transactions to improve access to credit in several sectors (including wheat, corn, and sorghum production) by using large commercial firms as originators and the loans provided through this type of transactions now account for 5 percent of its total portfolio. See Appendix 4 for more details on FIRA’s experience with structured finance.

# **4.3 Credit Guarantee Systems**

Credit guarantee systems are mechanisms in which a third party, the _guarantor_ , pledges to guarantee loans to a particular group of borrowers. Credit guarantee systems reduce the lender’s expected credit losses—even if the probability of default remains unchanged—acting as a form of insurance against default. Public credit guarantee systems are widespread: according to a survey conducted by Graham Bannock and Partners, in 1995 there were at least 85 countries with some type of government credit guarantee program.<sup>64</sup> The largest and more established guarantee schemes are mostly in developed countries, including Canada, Japan, the U.S., and several European countries. The general experience with credit guarantee systems, especially in developing countries, has been poor to mixed, at best: most systems have depleted their reserves due to high

> 64 Graham Bannock and Partners (1997) find that in 14 countries there is no public credit guarantee system and in another 76 countries it is not possible to tell whether operating guarantee schemes exist. See also Herrero Calvo and Pombo Gonzalez (2001) for an overview of public credit guarantee systems around the world.

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credit losses and bad investment decisions and in many cases they have been designed to channel funds to certain sectors without due regard to loss rates.

There is significant debate in the literature regarding the role fulfilled by credit guarantees and the need for this type of government intervention (see for example, Green, 2003; Holden, 1997; Levitsky, 1997a; Rodriguez Meza, 2004; and Vogel and Adams, 1997). The most frequent cited justification for credit guarantee schemes is as a substitute for collateral where the collateral market operates imperfectly due to cumbersome and costly repossession processes, political difficulties in the realization of assets pledged by certain sectors, or uncertainty about the value of collateral, which lead to excessive collateral requirements.<sup>65</sup> However, one could reasonably argue that imperfections in the legal system should be addressed through improvements in collateral laws and enforcement mechanisms, rather than through direct government intervention (Holden, 1997; Vogel and Adams, 1997). Nevertheless, both strategies are not necessarily exclusive, at least in the short-term (Graham Bannock and Partners, 1997), and therefore collateral guarantee systems could help to reduce problems of access to finance while institutional reform is taking time to mature.<sup>66</sup> An alternative argument contends that credit guarantee systems work as subsidies to cover the costs of learning how to provide loans to a new group of borrowers by financial intermediaries. However, as Vogel and Adams (1997) point out, there is no evidence of public programs that have been able to eliminate guarantees after a certain period. Critics of public credit guarantee systems also argue that these schemes cannot decrease asymmetric information problems in credit markets, and are even likely to increase them. Public guarantee systems may increase moral hazard for both borrowers and lenders: borrowers that know that their loans are guaranteed by the government may not feel obligated to repay them and lenders may have fewer incentives for screening and monitoring borrowers, as guarantees cover their credit losses. An open question therefore is whether credit guarantee systems can be designed in a market-friendly way, minimizing their unintended consequences while at the same time promoting private financial market activity.<sup>67</sup> FOGAPE (Fondo de Garantia para Pequeños Empresarios), a state fund designed to provide partial credit guarantees to loans issued by commercial banks to small firms in Chile, has been considered a success story in terms of fostering market activity while minimizing the problems that have characterized previous guarantee schemes (Benavente, Galetovic, and Sanhueza, 2006 and Bennett, Billington, and Doran, 2005). FOGAPE was created in 1980 but remained relatively inactive until 1999, when the Chilean government decided to reformulate the program. The fund is administered by

> 65 Public credit guarantee systems have also been justified in terms of market failures, although the nature of these failures is usually not identified (Vogel and Adams, 1997). And even if a market failure is identified, it is not clear whether credit guarantee schemes are the best form of addressing it. One possible market failure could be the absence of credit insurance markets (Rodriguez Meza, 2004).

> 66 Benavente, Galetovic, and Sanhueza (2006) develop a theoretical model showing that under certain conditions, credit guarantee systems can improve access to credit for borrowers with viable projects that would otherwise be excluded due to lack of collateral, without increasing moral hazard.

> 67 See Levitsky (1997b) for a review of best practices in operating guarantee schemes. Bennett, Billington, and Doran (2005) analyze some recent successful experiences of credit guarantee systems in developing countries.

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Banco Estado, a public commercial bank, which charges a fee for its services. FOGAPE functions as a classical guarantee fund, sharing the risk of default on eligible loans and charging a guarantee premium. The commercial relationship is between FOGAPE and the banks. Banks select those loans that the wish guaranteed and FOGAPE only checks whether they meet eligibility criteria.<sup>68</sup> According to Benavente, Galetovic, and Sanhueza (2006), several features of FOGAPE’s operations have been key in reducing moral hazard problems. First, commercial banks share part of the risk of default, as guarantees only cover between 70 and 80 percent of credit losses. Second, and more important, to allocate the available guarantees Banco Estado conducts auctions four to six times per year among participating banks. Each bank has to submit a bid indicating the amount of guarantee it wants to receive and the maximum coverage rate as a percentage of lending. The bids are selected by the lowest coverage required until the total amount auctioned has been assigned; therefore the biding process determines how the risks are shared among FOGAPE and financial intermediaries.<sup>69</sup> Banks with high default rates on previously guaranteed loans can be permanently or temporarily excluded from participating in the bidding process (this has already happened in one case). This helps to reduce moral hazard, as banks that reduce screening and monitoring today lose profitable opportunities in the future. Also, the use of a bidding process increases competition among financial institutions. The risk share taken by commercial banks has increased from 21 percent in 2001 to 29 percent in 2003 (Bennett, Billington, and Doran, 2005). Third, the amount of FOGAPE guarantees each bank can obtain is limited: no bank can be awarded more than two thirds of the total rights auctioned. This also helps to reduce moral hazard, as the amount that can be gained by reducing screening and monitoring today is reduced. Following the bidding process, banks have three months to grant the corresponding loans.

FOGAPE used to charge a fixed commission of 1 percent of the credit guaranteed, but since June 2004 has increased it to a range between 1 and 2 percent, depending on the claims performance of each bank. Default rates on loans guaranteed by FOGAPE have been relatively low, standing at 1.05 percent in the second semester of 2005, suggesting that the provision of its guarantees has not resulted in lower screening and monitoring by banks.<sup>70</sup> FOGAPE is designed to be a sustainable fund, in the sense that fees and other income, such as returns on investment, should cover all administrative costs and claims. Government support should be restricted to the provision of start-up capital. Benavente, Galetovic, and Sanhueza (2006) show that fees charged have been roughly equal to guarantees paid and that the fund seems to be operating on a break-even basis with revenues typically matching expenses. However, it is still an open question whether FOGAPE can be sustainable in the long-run, as there is little evidence than credit guarantee systems can achieve sustainability, even in developed countries.<sup>71</sup>

> 68 The main eligibility criteria are related to borrower and loan size. Also, total exposure of the guarantee fund to each borrower through loans from all banks is limited to UF 5,000 (approximately 120,000 U.S. dollars).

> 69 FOGAPE establishes maximum guarantee coverages of 80 and 70 percent for long- and short-term loans, respectively.

> 70 In comparison, default rates for the banking system as a whole stood at 1.01 percent.

> 71 Graham Bannock and Partners (1997) claim that in practice no government credit guarantee scheme has been found to be able to cover administrative costs and default claims with fees collected. There is some

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# **4.4 Transaction Cost Subsidies**

Access to credit by small borrowers, especially in developing countries, has usually been hindered by many difficulties, including lack of usable collateral, no credit histories, and no reliable records. Also, small borrowers usually seek to borrow small amounts, making the transaction costs of lending per unit too high. In developing countries these problems are compounded by deficiencies in institutions and market infrastructure that make it more expensive to gather information, value assets appropriately, and monitor and enforce contracts. As a result, small borrowers are usually excluded from the formal financial system. To address this problem, governments in most countries have provided loans to small producers, either through public banks or by using directed credit programs, at subsidized rates. As described above, interest rates subsidies have resulted in significant fiscal costs and have failed to improve access to finance. These subsidies just aim at increasing credit use, but do not address any of the underlying causes of access problems. Theory advocates that subsidies, if granted, should be targeted directly at the source of the distortion; otherwise, they create additional distortions that may lead to a worse outcome in equilibrium. In fact, interest rate subsidies have led to significant price distortions in financial markets associated with pervasive generalequilibrium implications.

An open question is whether subsidies can help to solve problems of access in a market-friendly way, that is, by fostering private financial intermediation without increasing distortions. In Mexico, the development agency FIRA has introduced a program called SIEBAN (Sistema de Estímulos a la Banca) to provide subsidies to cover the administrative and screening costs of serving small borrowers. This subsidy covers low-income rural producers that access credit from commercial banks, credit unions, or financial firms for the first time. The subsidy is a fixed amount that varies with the size of the loan, representing a maximum of 16.7 percent of the amount borrowed in the case of smaller loans, consistent with the idea of covering costs that tend to be relatively fixed. SIEBAN subsidies are portable by borrower (i.e., they can be used to obtain credit from different financial institutions), fostering competition. Financial institutions are required to provide borrower information to the credit bureau in order to help them establish credit histories. The subsidy decreases over time and has a duration of three years. The temporary nature of the subsidy is based on the fact that once borrowers have been able to establish credit histories screening costs for financial institutions should be significantly lower, eliminating the need for subsidization.

The provision of a subsidy like SIEBAN could be justified on the basis of one of the arguments mentioned above for the creation of public credit guarantee systems, that is, subsidizing the costs for financial institutions of learning how to provide loans to a new group, in this case low-income rural borrowers. However, SIEBAN has several design features that address the limitations of credit guarantees in achieving this objective. First, as Vogel and Adams (1997) point out, there is no evidence of public

> debate on this issue as Riding (1997), for instance, argues that the Canadian Small Business Loan Act , the Small Business Administration in the U.S., and the Loan Guarantee Scheme in the U.K. operate, in some cases, on a break-even basis.

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guarantee programs that have been able to eliminate guarantees after a certain period. In contrast, SIEBAN is designed to be temporary: after three years borrowers no longer receive any subsidy. Second, SIEBAN does not generate moral hazard. As discussed above, credit guarantee systems reduce incentives for financial institutions to screen and monitor borrowers, as the guarantee covers part of their credit losses. In the case of SIEBAN, there is no risk shifting to the public sector Financial intermediaries only receive a (relatively small) fixed initial subsidy and have incentives to adequately assess borrowers’ credit quality, since they face all the costs in case of default. Another important feature of SIEBAN is that it requires financial intermediaries to register borrowers in the credit bureau, consistent with the idea of reducing the information asymmetries that typically characterize small borrowers. An open question, however, is how effective SIEBAN has actually been in improving access to credit and whether small borrowers continue to receive credit once the subsidy ends. Also, the program is provided by FIRA, which finances it with the profits from other operations. To increase transparency, subsidies should be explicitly budgeted and separate from the provision of financial services.

# **4.5 Public Lending**

As described above, the general experience with the provision of credit by public banks has been negative, resulting in high subsidies, recurring fiscal drains, and retarding, rather than fostering, financial market development. Major incentive and governance problems in the operation of public banks have tended to surface, leading to poor loan origination and even poorer loan collection, wasteful administrative expenditures, overstaffing, plain corruption, and political manipulation of lending. An open question is whether there is any role for the provision of public credit in fostering financial development and if this type of intervention can be designed in a way that ensures that at least no harm is done.

Yaron, Benjamin, and Charitonenko (1998) argue that some experiences from Asia, such as the Village Bank program of the Bank Rayat Indonesia, show that public institutions can provide credit to rural producers in an efficient, market-friendly way and that subsidies are not necessary for the provision of financial services to these producers. They highlight the role of several mechanisms in increasing efficiency, such as shifting from disbursing credit to motivating loan recovery, establishing a hard budget constraint, increasing management autonomy, introducing innovative systems for both clients and employees to encourage repayment, and increasing staff accountability.

The microfinance lending operation implemented by Banco Estado, a public commercial bank from Chile, has also been considered a successful experience of provision of credit by a public financial institution (Benavente, 2006). Banco Estado decided to start lending to micro entrepreneurs in 1996 in order to foster the development of the Chilean microfinance market. At the time, no commercial bank was participating in this market and Banco Estado wanted to generate a demonstration effect. As discussed above, financial innovation in many cases can be hampered by the fact that once a new lending technology is introduced and proves to be successful, others can easily adopt it. Therefore, there is little incentive for lenders to invest in new credit technologies. In this 36
situation, as Besley (1994) argues, there might be a role for the government to subsidize innovation. A key factor for the success of Banco Estado’s microfinance program has been the implementation of a new organizational structure tailored to meet the needs of micro entrepreneurs. Banco Estado also established new incentive systems for employees. An important change in this respect has been the increase in the fixed portion of the remuneration of account executives, in order to reduce incentives to focus solely on loan disbursement. Banco Estado’s microfinance operations are managed by a separate business unit with its own profit and loss statement. The program was designed to be self-sustainable, without providing any subsidies. In fact, this program achieved break-even by the third year of operations and has remained profitable since then.

Banco Estado’s microfinance program seems to have been successful in terms of fostering innovation, as three commercial banks have now entered the microfinance market. The program has also had a positive impact on the micro entrepreneurs that have access its funds, helping their firms to expand, increasing formality, and improving business practices (Benavente, 2006).

# **5. Final Remarks**

One of the objectives of this study was to once more call the attention of policymakers, development institutions, and academics alike to the fact that there are many problems of access to credit in developing countries, generated by the difficulties of solving principal-agent problems and reducing transaction costs in weak institutional environments. As a result, the penetration of formal credit in most developing countries is low and banks are disengaged from many economic activities.

Given the major potential benefits of access-enhancing financial development, a relevant question is whether government intervention to foster financial development and broaden access is necessary and, if so, what form should this intervention take. As we discuss, answers to this question tend to be polarized in two highly contrasting but wellestablished views: the _interventionist_ and the _laissez-faire_ views. We describe a number of recent experiences in Latin America that illustrate an emerging third view in this regard, which we denominate _pro-market activism_ . This exercise shows that there are now several institutions in this region that seem to be moving in the direction of promarket interventions, but little is still known about their activities. It is difficult yet to evaluate the results of these interventions. We do not attempt to undertake a comprehensive assessment of these interventions or to claim that they have been successful. Rather, we use them to illustrate how pro-market activism has worked in practice. The analysis of these experiences raises a number of questions that deserve further study and that are key to understanding whether the pro-market activism view can constitute a viable alternative to broaden access to finance in developing countries.

First, an open question is whether idiosyncratic experiences can lead to more general policy guidelines. We believe that the experiences analyzed show that the government can play a role in broadening access to finance through restricted self37
sustainable interventions that aim to foster market activity, not replace it. However, one could reasonably question to what extent these experiences are the consequence of a specific institutional environment that favors government innovation and reduces the risk of political capture. Also, these interventions may be a result of certain characteristics of the public financial institutions that have implemented them, such as their management quality. A better understanding of these issues is key to determining to what extent these experiences can be replicated in other countries. As we have emphasized throughout this study, financial development is intrinsically linked to the institutional environment and therefore, government interventions that work under a given institutional matrix and at a given stage of financial development may produce unintended effects when transplanted to another institutional milieu. This suggests that interventions should be modified to take into account the idiosyncrasies of the institutional arrangements and market conditions in each country. A related question is whether, even if experiences can be replicated with some adjustments to local conditions, the government should try to create organizational capabilities to implement pro-market interventions where these capabilities do not exist.

Second, the analysis of the experiences suggests that it might be necessary to rethink some institutional features of development-oriented financial institutions to ensure that pro-market interventions succeed in fostering private financial intermediation and broadening access. In the first place, the move to pro-market interventions may require public financial institutions to separate subsidies from financing and to start functioning more as development agencies than financial intermediaries. Restricting government financial support to the provision of an initial endowment may help to reduce the distortions created by interventions, by forcing development institutions to provide their services at market prices—or at least at cost—in order to remain sustainable. Also, limiting the ability of these institutions to assume financial liabilities, including by taking deposits, may limit the potential fiscal costs of their interventions. Second, the mandate of institutions implementing pro-market interventions may need to be redefined in dynamic terms, not statically. This would provide incentives for these institutions to move on to new activities once the market they were promoting becomes self-sustainable. However, this might not be easily achieved, as public institutions may try to protect their franchise value by continuing to operate profitable and successful programs, even when public intervention is no longer necessary. This problem could be ameliorated by establishing separate business units, with their own profit and loss statements, to implement new interventions and by creating clear sunset clauses when launching a new program. Third, the management of these institutions should be devoid from political influence. The negative experiences with public banks in developing countries illustrate the high costs of political interference. Guaranteeing that public financial institutions are managed in an independent and professional manner seems to be a key factor for the success of pro-market interventions. Finally, the advent of a new approach to government intervention in financial markets may require new ways of evaluating the performance of development-oriented financial institutions. Most of the programs analyzed were implemented by first or second-tier public (development) banks that are evaluated on the basis of traditional performance indicators, such as the volume of loan disbursements or the amount of guarantees provided. These evaluation criteria generate incentives that could be inconsistent with the implementation of interventions that foster private market development. Evaluations based on credit growth, for instance, force development 38
institutions to combine more innovative market friendly interventions with the provision of loans, even if liquidity is not a constraint for private financial intermediaries. The bundling of more innovative instruments with traditional ones— such as second-tier lending, guarantees, and subsidies—motivated by the use of traditional performance indicators, makes it very difficult to analyze the individual merits of each instrument. Bundling also carries the risk of distorting prices and incentives. Fostering the proliferation of new market friendly instruments may require basing the evaluation of development-oriented financial institutions on a new set of indicators, including measures of the increase in financial activity generated by their interventions and indicators of their impact on economic activity and the socio-economic environment of the targeted population. These new indicators may be more difficult to design and estimate than traditional ones, and it may take time and a process of trial and error to find the correct indicators to evaluate each type of intervention.

Third, further research is needed to understand how to minimize the unintended consequences of pro-market interventions. First, the focus on short term-interventions may distract governments from the hard work of improving the enabling environment for financial markets, which is the first best according to the pro-market activism view. Institutional reforms may take a long time to yield visible results in terms of access and the possibility of obtaining some short-term results through pro-market interventions may reduce government incentives to forge ahead with reform efforts and may even divert resources away from those efforts. Although the pro-market activism view argues that institutional efficiency is the economy’s first best and considers direct government interventions as a complement, not a substitute, for institutional reform, it is not clear that the actual implementation of its proposals will not result in the diversion of government efforts away from achieving the economy’s first best. Second, given the existence of path dependence in the evolution of financial markets, the implementation of second-best solutions like those proposed by the pro-market activism view may lead to inefficient equilibriums. Direct government interventions, even if designed in a market friendly way, may lead to dysfunctional yet self-reinforcing institutional hybrids, which may be subsequently very hard to dislodge. Finally, the creation of vested interests entailed in any direct government intervention raises tricky political economy issues. Even if interventions are designed to be time-bound and financial support is restricted to the provision of seed capital, the government may face pressures to provide additional funds in the future or might be tempted to prop up programs or institutions with more favorable access to subsidies or public funds. This is one of the main challenges faced by promarket interventions. A number of instruments can be used to mitigate this risk. For example, the government could create sunset clauses by law with clear indicators of when the public sector should end its participation, or even fixed time limits, which raise the institutional costs of extending or propping up interventions. Of course, these types of clauses also reduce flexibility, but this may be a small cost to pay to avoid the recurrent fiscal drains that have characterized past public interventions in financial markets. The participation of multilateral organizations may also help to ameliorate political risks. However, in those cases where institutional incentives cannot be designed to effectively reduce this risk, the government should refrain from intervening.

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Fourth, an open question is whether there is a need for pro-market interventions in the long run. As discussed throughout this study, the economy’s first best is achieving a good enabling environment that allows financial markets to flourish. In this context, promarket interventions are seen as short-term solutions to broaden access while institutional reforms are taking time to mature and may even help to speed up the process. However, it is not clear whether once a good enabling environment is achieved there is a need for direct government interventions. If there are long-term market failures that even in a good contractual environment cannot be dealt with by private parties, there could be a role for pro-market interventions in the long run. The widespread intervention of the public sector in financial markets in developed countries suggests that this could be the case. However, one could question to what extent the persistence of these interventions is the result of political capture and self-reinforcing institutional arrangements that make it very difficult to dismantle them, even if they are no longer useful for fostering financial market development. Further research is needed to clarify this issue.

Finally, the experiences of pro-market intervention described raise the question of why, if a certain activity is profitable, the private sector does not take the initiative. As discussed, in some cases innovation in financial markets may be hindered by the fact that once a new lending technology is introduced and proves to be successful, others can easily adopt it. Therefore, there is little incentive to invest in new credit technologies and there might be a role for the government to subsidize innovation. However, even if some type of government support is necessary, it is not clear that this should result in a direct intervention by a public institution, as the government could subsidize innovation by private financial intermediaries. This also suggests that the government should exit the operation of innovative programs once the market they were promoting becomes selfsustainable. An open question in this regard is whether direct government intervention is necessary at all or if, given the right incentives, the private sector would take the initiative. Further research is necessary to answer these questions, but they suggest that there is an important role for collaboration between the private and public sectors in fostering financial development and broadening access.

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