Research & Policy Briefs From the World Bank Malaysia Hub No. 10, Oct 2017 A New Role for Development Banks? Facundo Abraham Sergio L. Schmukler Do development banks have a useful role to play in providing finance or are they a potential waste of government resources? A new view sheds some light on this question and argues that, under certain circumstances, development banks can add value and play an important role in fostering access to finance. The Problem of Access to Finance an investment project that they would have otherwise financed on their own if they had the required resources. There is widespread consensus that increased access to Just because external finance is not used, it does not finance can boost economic development, reducing necessarily mean there is a problem of lack of access. For poverty and income inequality. Access to external finance example, agents might not demand external funds allows individuals to invest in human capital and new because they have sufficient internal resources or lack businesses to emerge, creating jobs and fostering produc- profitable investment projects. Problems of access to tivity growth. There is also a general agreement that not all finance (credit) are different from problems of access to firms and individuals have good access to financial services financial services such as bank accounts and payment (figures 1 and 2). services, and require different solutions. Considering the potential benefits of better access to Problems of access to finance typically arise from finance, a key question is whether the government should conflicts between lenders (principals) and borrowers promote it and, if so, how. Although this topic has been (agents), also known as principal-agent problems, and debated for a long time, there is still no agreement on what transactions costs. Principal-agent problems can arise role the government should play in trying to increase when creditors lack information about potential borrowers access to finance. Part of the disagreement comes from or under weak creditor protection laws (supposed to different perceptions on the nature and root of the prob- protect creditors and borrowers in case of default). When lem. these frictions are present, creditors might have difficulties A problem of access to finance exists when households assessing the quality of investment projects, monitoring and firms cannot obtain enough external funds to finance how borrowers spend the funds, and enforcing repayment. Figure 1. Share of Adults in the Bottom 40 Percent and Top 60 Percent Who Have Borrowed from a Financial Institution, by Region 20 19 18 17 16 14 14 14 13 12 10 Percent 10 8 8 7 7 7 6 6 6 5 5 4 2 0 East Asia and Europe and Latin America Middle East and OECD South Asia Sub-Saharan Pacific Central Asia and the North Africa Africa Caribbean Poorest 40% Richest 60% Source: World Bank Global Findex Database. Note: For each region, this figure shows the cross-country average of the percentage of adults (age 15 or older) belonging to the 40 percent poorest and 60 percent richest of the population that borrowed from a financial institution. Data are for 2014. OECD = Organization for Economic Co-operation and Development. Affiliation: Development Research Group, the World Bank. E-mail addresses: fabraham@worldbank.org, sschmukler@worldbank.org. Objective and disclaimer: Research & Policy Briefs synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Acknowledgement: This Research & Policy Brief summarizes the arguments in Innovative Experiences in Access to Finance: Market-Friendly Roles for the Visible Hand? by Augusto de la Torre, Juan Carlos Gozzi, and Sergio Schmukler. We received very useful guidance from José De Luna Martínez and Norman Loayza. Global Knowledge & Research Hub in Malaysia A New Role for Development Banks? Figure 2. Firms Identifying Access to Finance as a Major Constraint, by Region 45 42 39 40 36 33 34 35 32 29 29 30 28 24 Percent 25 22 20 20 18 18 19 14 15 13 12 13 11 10 9 5 0 East Asia and Europe and Latin America Middle East and OECD South Asia Sub-Saharan Pacific Central Asia and the North Africa Africa Caribbean Small Medium Large Source: World Bank Enterprise Survey. Note: For each region, this figure shows the cross-country average of the percentage of firms identifying access to finance as a major constraint, according to firm size. Firm size levels are 5− 19 (small), 20−99 (medium), and 100+ employees (large firms). For each country, data for the last available date were considered. OECD = Organization of Economic Co-operation and Development. Creditors might react to these difficulties by limiting and well-off households, the state must assume a direct lending, including to borrowers with profitable invest- role addressing market failures and allocating financial ments projects. On the other hand, lending involves trans- resources. In other words, the state should become a action and operational costs (such as keeping records or substitute for private intermediaries. maintaining bank branches). Creditors need to raise inter- est rates to cover these monetary costs. As a result, the Proponents of this view promote various instruments interest rate creditors require to finance projects might be through which the state can directly intervene in the finan- above the expected return of investment projects that are cial sector. One of the main instruments for state interven- profitable. A problem of access can arise when there are tion is state-owned banks. State ownership of banks allows profitable projects that do not receive funding but that savings to be mobilized for projects with high social returns would be funded – hypothetically − if transaction and and financial services to be made affordable to large parts operational costs were lower or did not exist. of the population. In addition to managing its own banks, this view proposes that the state should tightly control Under these circumstances, what should the state private banks. For example, the government can impose (through the government) do? What specific role can direct lending requirements, mandating private banks to development banks play in this context? This note summa- allocate a specific share of credit to specific sectors or rizes the two traditional, and contrasting, views about the regions. The state could also regulate interest rates, setting role of the government in promoting access: the interven- lower rates for priority sectors. tionist and the laissez-faire views. In addition, it describes an emerging third view, which seems to be motivating The prevailing consensus in the literature is that state recent development policies. This new view, proposed by intervention in the financial sector has mostly failed to de la Torre, Gozzi, and Schmukler (2017), recognizes that produce the expected results. Given the lack of disciplining development banks can have an important role in promot- devices, lax budget constraints, and difficulty in measuring ing access, although a selective one. their performance, public banks have many times lent to unprofitable companies, have been prone to political influence and corruption, and have had little incentives to Interventionist View address market failures in an effective way. Greater state The interventionist view emerged during the 1950s, a time participation in bank ownership is typically associated with when the prevailing consensus was that the state should lower financial development, slower economic growth, play a direct role in the development process. This view less fiscal discipline, and higher incidence of financial crises argues that market forces alone cannot overcome market (La Porta, Lopez-de-Silanes, and Shleifer 2002; IDB 2005; failures that result in problems of access to finance Beck, Demirgüç-Kunt, and Martinez Peria 2007; González- (Gerschenkron 1962). As a result, if the government wants García and Grigoli 2013). Other interventions, such as to expand finance beyond the selected group of large firms direct lending requirements or interest rate caps, have also 2 Research & Policy Brief No.10 been found to have significant costs in terms of efficiency Pro-Market Activism View and growth. In a context in which the two traditional views on the role of the state in promoting access are not fully satisfactory, a Laissez-Fare View new view has emerged in the middle ground between the By the 1970s and 1980s it became clear that state inter- two. This third view is not yet a coherent and fully articu- vention in the financial sector resulted in the waste of lated theory. Rather, it is based on experiences with resources and obstructed economic growth. Thus, innovative development policies over the last years. This academics and policy makers adopted an entirely opposing emerging pro-market activism view takes a more nuanced view on the role of the state in promoting access: the approach than the traditional approaches. laissez-fare view. It argues that the state’s main focus is to improve the This view argues that, due to incentive issues and enabling environment, but direct state intervention might governance problems, direct government intervention in be warranted to address market failures in the short term the allocation of financial resources can do more harm while institutional reforms are taking hold. In contrast to than good. As a result, the state should refrain from inter- the laissez-faire view, the third view recognizes that direct vening in the financial sector. Instead, the state should limit state intervention might be beneficial to address market its role only to improving the enabling environment, with failures that cause problems of access. But, opposing the the goal of mitigating principal-agent problems and reduc- interventionist view, this view sustains that state interven- ing transaction costs. This view contends that, under an tions should be highly selective. Rather than increasing the adequate environment, private agents would be able to use of financial services per se, interventions should target address problems of access on their own (Caprio and the underlying causes of problems of access. In addition, Honohan 2001; Klapper and Zaidi 2005; World Bank 2013). interventions should be cost-effective and should not displace the private sector, but rather work with it. In Implementing the laissez-faire view in practice requires particular, the state can play a catalytic role, addressing liberalizing the financial system on the domestic and inter- collective action problems (whereby no individual or agent national front, dismantling the structures promoted by the has incentives to solve common obstacles) and even interventionist view. On the domestic front, this includes partnering with the private sector in developing these privatizing state-owned banks, eliminating direct lending initiatives. Thus, policy intervention under this view programs, and deregulating interest rates. On the interna- requires some experimentation and learning by doing. tional front, countries should eliminate capital controls, such as restrictions on foreign borrowing and foreign A Role for Development Banks exchange controls. The withdrawal of the state from the financial sector needs to be accompanied by reforms that Development banks, and more generally public banks, create an environment that encourages private agents to could play a key role in implementing the pro-market activ- develop financial markets. These reforms include enhanc- ism view. Development banks can develop specialized ing creditor rights, promoting credit information systems, knowledge and tools to address problems of access by modernizing collateral laws, and adopting international working closely with the private sector. As a result, they are accounting standards. well suited to detect unexploited opportunities and complete financial markets. For these and other reasons, Empirical evidence suggests that financial liberalization they might have an advantage in filling this role compared reforms have been successful in reducing credit to other government agencies, such as finance ministries. constraints and expanding access to finance. For example, country studies find that when capital controls are lifted However, adequately implementing the third view firms become less financially constrained, which increases requires that development banks are professionally investment and growth (Forbes 2007; Gupta and Yuan managed and independent. This entails changing develop- 2009; Alfaro, Chari, and Kanczuk 2015). Furthermore, ment banks’ institutional mandates and management several studies have found a positive link between practices. To impose discipline, these banks are also improvements in the legal rules and financial development subjected to hard budget constraints in the form of limited (de la Torre, Gozzi, and Schmukler 2007; Haselmann, initial capital and budgetary transfers. In addition, their Pistor, and Vig 2010; Nenova 2012). scope of action is limited to playing a supporting role to private agents, backing “market friendly” interventions However, financial liberalization has not been exempt that help actors in the private sector develop solutions to from risks. Empirical studies have shown that financial ameliorate problems of access. liberalization can increase financial fragility by increasing the probability that a country will face banking and The role development banks can have under the currency crises (Kaminsky and Reinhart 1999; Furceri, pro-market activism view is illustrated by several innova- Guichard, and Rusticelli 2012; Caldera Sánchez and Gori tive experiences in Latin America (de la Torre, Gozzi, and 2016). Hence, despite its benefits, the overall perception Schmukler 2017). For example, in Brazil, Caixa Econômica regarding the laissez-faire view is mixed. Federal (CEF) and Banco do Brasil set up large correspon 3 A New Role for Development Banks? dent banking networks in the 1990s by making agreements Conclusion with commercial businesses (such as post offices and New innovative initiatives in development finance suggest lottery houses) to distribute financial services through that a new third view about the role of the state in finance their outlets. These correspondent banking arrangements has emerged. This view goes beyond the debate of have proven to be a less costly alternative for extending whether market or government failures are more impor- financial services to underserved regions, compared to tant in determining problems of access. Instead, it recog- directly establishing bank branches. nizes the need to avoid one-size-fits-all strategies and In Chile, BancoEstado, the largest state-owned bank, argues that similar approaches might produce different provides credit guarantees to small and microenterprises results in different contexts. through FOGAPE (Fondo de Garantía para Pequeños Whereas this third view is clear conceptually, implement- Empresarios, the Small Enterprise Guarantee Fund). ing it in practice can be less straightforward. First, it might Although created in 1980, it became relevant in 1999 be difficult to determine when the state should intervene when it was reformed and relaunched. Since then, the beyond proving a good enabling environment and what scheme has been able to provide credit guarantees while type of intervention is more appropriate. It is often difficult sustaining good performance and financial stability. In to identify financing gaps and evaluate the impact of novel addition to providing credit guarantees, since 1996 interventions. The answer to these questions may only BancoEstado has operated a successful subsidiary that emerge once the intervention is underway and costs have provides microfinance services to low-income households been incurred. Second, once state intervention is ongoing, in a cost-effective manner. it is difficult to evaluate the success of these initiatives and decide whether an intervention should be changed or In Mexico, FIRA (Fideicomisos Instituidos en Relación terminated. Proper evaluation requires knowing how firms con la Agricultura, Agriculture-Related Trust Funds) is a would have behaved in the absence of the initiative, which development bank established in 1954 that historically is not observable. In addition, interventions can have provided credit to rural areas. In the mid-1990s, the bank multiple objectives, many of which are not easily quantifi- was reformed. Its new strategy became creating new able. A final concern is how to resolve the tension between financial and risk management instruments for financial establishing development banks that fulfill a social role institutions serving rural areas. Among them, FIRA has while maintaining their financial sustainability. If unre- promoted the use of structured finance (a complex finan- solved, this tension can lead to these banks behaving more cial instrument offered to borrowers with unique and like commercial banks. This could lead to a situation where sophisticated needs) to expand the financial access of the development banks simply extend financing that private agriculture, livestock, and fishing sectors. FIRA does not lenders would have given on their own (crowding out provide finance directly. Instead, it acts as an arranger, private lending). 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