Conclusions
Recommendations

This paper was published in June 1995 by the FAO Investment Centre Division. The views, findings, interpretations, and conclusions expressed in this study are entirely those of the author and should not be attributed in any manner to the Food and Agriculture Organization of the United Nations (FAO). The designations employed and the presentation of material in this publication do not imply the expression of any opinion whatsoever on the part of the Food and Agriculture Organization of the United Nations concerning the legal status of any country, territory, city or area or of its authorities, or concerning the delimitation of its frontiers or boundaries.

1. There is virtual consensus on the need for expanding and strengthening microenterprises (MEs) in rural areas. This is in part due to the potential they offer for employment creation, poverty alleviation and a healthier economy in general, and in part due to recognition that the capacity of the agricultural sector to absorb the increasing number of rural people in more densely-populated countries and regions is very limited. One of the few alternatives to rural-urban migration (with all its attendant problems) is the promotion of MEs. The development of this sector is largely hindered by its limited access to formal credit which has been a persistent criticism of the financial system around the world (The World Bank, 1994). This limitation reflects rising concerns, both among policy makers and donors about the slow pace of rural financial market development. The last decade has seen the emergence of active financial and other assistance to MEs by both formal and informal financial institutions, aided by donor agencies including the World Bank, the Asian Development Bank, International Fund for Agricultural Development, Inter-American Development Bank and the United States Agency for International Development.

2. Even with a more diverse and competitive financial sector and a stronger flow of saving and investment stimulated by current policies for monetary deregulation, special measures will still be needed to improve financial services to MEs. The problem is a common one; such enterprises are usually perceived as uncreditworthy borrowers because of their riskiness, weak capital positions, non-existent credit history and lack of collateral (Binks, 1979). The deepening of rural financial intermediation and a more diversified provision of financial services to support the economic activities of rural communities in a cost-effective and sustainable manner therefore becomes critical.

3. Although several studies have been carried out in the past by the governments, donors and others, information on the functioning of the rural financial markets, particularly, of the informal financial institutions and schemes operated by NGOs, is still not widely known. The paper attempts a review of operational experiences with special focus on what does and what could work in developing rural financial markets. This review is mainly confined to experiences of microfinance institutions in Asian countries.

4. Definitions of size of the small firms sector vary a great deal, whether measured in terms of fixed investment, or turnover or the number of employees. For purposes of access to finance, microenterprises may be restricted to the band of enterprises employing less than 10 persons, though this should not be taken as a rigid boundary for it is in the nature of MEs that their variation renders rigid thresholds in any one measure both unhelpful and misleading. Many MEs highlight certain common problems: undercapitalization and low ability to command loan finance due to insufficient collateral, track record or financial expertise, lack of broad-based management skills, inadequate understanding of cash flow management and heavy dependence on local markets and a limited number of customers (Bradford, 1993).

5. For the purpose of this review, MEs may, however, be distinguished from medium enterprises. MEs are legally not required, like medium enterprises, to register under government legislation. They operate in unregulated and competitive markets characterized by free entry and exit, and many engage extensively in sub-contracting activities. They rely largely on indigenous resources, and use labour-intensive and adapted technology with skills mostly acquired outside formal schooling. In household-based units, a large number of part-time and piece-rate workers are women, on contract for large factories or middlemen. The subsector also contains self-employed women, in such businesses as tailoring, leather working, traditional cosmetics and print shops.

6. A perennial theme of small business representatives and government-sponsored committees of inquiry in United Kingdom (MacMillan, Bolton, Wilson) has been the notion of a finance "gap" in relation to small firm financing (Keasey and Watson, 1993). The availability of credit seems to be the binding constraint also in most developing countries (Lycette and White, 1989).

7. The lack of capital is the greatest constraint to the development of MEs (Kurwijila and Due, 1991), and its high cost is cited as a primary constraint to the expansion of enterprises engaged in non-formal activities (non-formal is defined as not registered with the local regulatory bodies).

8. Fixed investment may not be large, but the slow rate of turnover of the finished product necessitates significant amounts of working capital (Mazumdar, 1989). A 1987 survey by Lindholm and Mead concludes that working capital is a serious constraint. A 1984 study identified shortage of working capital as one of the major problems for the majority of women interviewed (Lycette and White, 1989). The inability to carry adequate stocks of raw materials causes discontinuities in production and sales, which, in turn, are quoted as a cause of low productivity.

9. A lack of finances was the primary constraint to enterprise expansion as evidenced in the leather industry in Sri Lanka or furniture industry in Tanzania (Levy, 1993). In general, informal sector enterprises find the banks unhelpful and unsympathetic to their needs, since unlike their formal sector counterparts, they cannot provide the necessary collateral (Sethuraman, 1977).

10. Limited access to the various sources of credit is seen as a more severe problem for women than for men. This difference is in part attributed to the particular credit needs of women. Their businesses require smaller amounts of capital than are customarily lent, and repayment and collateral requirements must be fairly flexible (Reichmann, 1989). An additional factor, evident in a number of developing countries, is the legal requirement that women can obtain loans from the formal financial institutions only if their husbands sign for the loan. Women borrowers receive smaller loans than men from the banks. But women are active primarily in those services, commerce and production activities which generate lower incomes and hence require smaller credit (Lycette and White, 1989). Therefore, it is not clear whether discrimination exists, preventing women from obtaining loans as large as those obtained by men or whether the women choose to borrow smaller size loans than men.

11. The problem of access to credit is exacerbated by the fact that the majority of small borrowers have had limited education. Borrowers need to have a reasonable level of literacy to understand loan conditions and sign on loan documents. There is thus a need to promote primary education for increased access by borrowers, particularly women, to credit.

12. The restricted access to credit implies that MEs rely basically on their own savings and/or informal sources of credit (see Box 1). There is considerable agreement in the literature that this is indeed the case. "Self-financing from plough-back of profits appears almost the sole road to expansion" (House, 1984). Similarly, Lycette and White observe on the basis of survey data from Haiti "family members and friends were second only to personal savings as the most important sources of start-up capital for women owners of MEs. Friends and relatives were also found to be crucial source of funds as businesses developed". In his comparative study of Sri Lanka and Tanzania, Levy concludes that the savings of the participating entrepreneurs were the dominant source of funds in both countries. A similar conclusion was reached on the basis of a 1983 survey in Lima (Thomas, 1992).

13. The above literature survey demonstrates that restricted access to formal credit is a primary constraint to ME development. The problem is especially acute for women and for prospective entrepreneurs with limited formal schooling. As a result, these entrepreneurs must rely primarily on their own - usually very limited - resources or on informal sources of credit to start a business or expand an existing business.

Development Strategy

14. The ME subsector has become an essential element in the development strategy of many Asian governments. As mentioned earlier, this recognition has initially emerged along with an increasing concern over capacity to absorb the growing labour force. Successive development plans thus recognized high labour intensities and strong inter-sectoral linkages of MEs, and set promotion of these enterprises with active financial assistance in both urban and rural areas as part of their plan objectives. An increasing interest has also emerged in MEs and their contribution to poverty alleviation without excessive fiscal burden, by making better use of private sector initiatives and market mechanisms. As governments make progress in reforming financial markets, there is a rising awareness of institutional constraints limiting access to credit by those such as small farmers, women and MEs which resort to informal means of financing. It has been recognized that while financial sector reforms are necessary, they are not sufficient in lifting this particular aspect of financial repression (see para 44); providing such credit access requires some fundamental change particularly greater innovation in lending techniques and instruments among the formal sector's financial institutions.

15. The heterogeneity of the socio-economic status of the rural people and the diverse nature and scale of their economic activities would imply that the demand for financial services by the micro-entrepreneurs may not be met by a unique financial institution or a uniform approach. The institutional mix, the product variety and the operational approaches must be compatible with the characteristics of different socio-economic categories if their demands for financial services are to be met satisfactorily. However, owing to high costs and risks associated with the early stages of rural financial market development, private financial institutions are unlikely to voluntarily play a major role in this process. Rural financial market development cannot therefore be left entirely to market forces, although the ultimate objective is to develop a market-driven financial system. The government also has an important role to play in the process. A well-formulated rural financial market development strategy is required to ensure that rural financial market development activities of different groups, particularly the potential small borrowers, government agencies, private sector, NGOs and the donors are carried out within a coherent framework with clearly defined objectives.

16. The past institutional approaches in several countries including Bangladesh, India, Nepal and Pakistan have not resulted in the development of financially viable rural financial institutions and a sound rural financial system. This is clearly evident from the financial performance of many specialized financial institutions including the Bangladesh Kurita Bank (BKB), Cooperative Banks in India, Agricultural Development Bank of Nepal, Agricultural Development Bank of Pakistan, as reflected in the high rates of defaults and the poor quality of their portfolios.

17. These institutions are unable to fully cover their operating costs and they depend heavily on large subsidies from the Government to continue their lending (see Box 2 and Table 1). These subsidies have benefited and continue to benefit, mainly the relatively well-to-do borrowers rather than the intended small farmers, who have only limited access to bank's programmes (Gonzalez-Vega, 1977).

18. Broadly, three types of institutional models can be identified: formal financial institutions including commercial banks, specialized financial institutions; semi-formal institutions including NGOs; and the traditional informal sources including friends and relatives, suppliers and moneylenders, which fall outside the legal and regulatory banking framework. A number of programmes have so far been implemented to provide MEs with access to credit. The Badan Kredit Kecamatan in Indonesia (see Box 3), the self-employed women's association (SEWA) in India now organized as a SEWA bank and the Grameen Bank (GB) in Bangladesh are notable examples of successful operations. Only a small number of commercial banks, for example, Bank Rakyat Indonesia and the Agrani Bank in Bangladesh, have extended credit to MEs. This raises questions about what type of institutions, programmes or mechanisms are best suited to meet the credit requirements of MEs.

19. The banking system is probably the only model capable of offering both credit and savings services to MEs because of its developed institutional structure and widespread branch network. The formal rural financial institutions are dominated by public sector banks. However, their programmes have failed to reach the majority of microentrepreneurs.

20. There is little doubt about the dismal performance of the traditional supply-led strategy of credit provision through the rapid spread of formal parastatal financial institutions. There is also general agreement about the remarkable success of semi-formal institutions such as BRAC and AKRSP, evaluated both in terms of outreach and financial sustainability (Yaron, 1994). The unique credit delivery mechanism from a different type of institution in Bangladesh (Grameen Bank) overcomes several operational shortcomings that traditional banks suffer from. Apart from the advantages of group lending and its joint liability requirement, the most important lesson is the operation of GB along sound banking discipline. GB's remarkable success can be attributed to a number of factors including functional and operational autonomy of the organization from outside, especially political pressures (GB has succeeded in keeping its autonomy from government, primarily by not being a conduit for government programmes); a well-trained staff; compulsory savings mobilization, a more rational effective rate of interest on loans; performance-based incentives for staff; and mandatory loan insurance (see Box 4). It should also be noted that the GB has an explicit social agenda to cater to the poorest sections of the non-agricultural population, with women making up a majority of its borrowers.

21. The poor performance of state-owned banks reflects a number of weaknesses in the current system. These problems are reflected in the low loan recovery rates. The responsibility of poor recovery and hence, the overall performance of banks is held back with a lack of an effective enforcement mechanism coupled with political considerations that undermine basic credit discipline. Banks' reliance on collateral, more a psychological than a real deterrent, has done little to improve the credit discipline while it has succeeded in rationing a vast majority of small borrowers from the formal system (Vogel, 1979).

22. Another important feature of the formal financial institutions is transaction costs (see below). Banks prefer to deal with large borrowers due to economies of scale in loan processing. Evidence shows that significant costs other than interest rate preclude access by small borrowers (Ahmad, 1989). The net impact of all these factors is a skewed distribution of credit to wealthy borrowers, a contradiction of the rationale behind subsidized and directed lending to "small men with small causes" (Adams and Nehman, 1979).

23. Credit Problems of Microentrepreneurs. In some cases, formal bank procedures discourage microentrepreneurs from applying for loans from banks. In other cases, the factor limiting access to bank credit is the small size of loans needed by MEs. Prevailing levels of interest rates also do not allow banks to lend to small borrowers because of high transaction costs (the paper work and staff time to process loan applications) involved in dealing with large numbers of small loans. The demand for credit by microentrepreneurs tends to be interest inelastic, because non-interest charges often represent a greater proportion of borrowing costs than interest on small loans. The borrower's transactions costs - transportation, lost time or income required to complete the loan transaction, special fees such as stamps - negatively affect a potential borrower's demand for loans. Collateral requirements are another major constraint to bank credit. This is a problem for many borrowers, who generally do not have clear title to land or other property that banks will accept as collateral.

24. If experience of Thailand and Bangladesh is anything to go by (for example, the Bank for Agriculture and Agricultural Cooperatives is to start allocating a significant proportion of its portfolio to non-farm rural enterprises; and the Agrani Bank in Bangladesh has already started a programme, albeit small, for MEs), there is hope that these positive changes would be absorbed by similar institutions in other countries. This would raise the question whether specialized agencies are universally required to provide small loans and deposit services to MEs.

25. There has been considerable interest around the world in bridging the formal sector banks with the semi-formal sector NGOs exploiting the comparative advantages of each. The informal and semi-formal sectors have a comparative advantage over the banks in lending small loans without collateral or in "relending" to women and poor borrowers. NGOs mobilize savings from their members but not from non-members which deny them access to large savers. They are therefore in a position to lend more than they can mobilize as deposits. Creating a link between NGOs and banks therefore ensures the comparative advantage of both sectors.

26. The ME schemes run by semi-formal institutions represent an arrangement which offers a link to the formal banking system. At least three different linkage patterns can be seen in operation. First is a model in which NGOs function as intermediaries, taking on themselves the resulting loan losses. An example of this linkage is found in the IFAD-financed Oxbow Lakes Small Scale Fishermen Project with BKB onlending funds through BRAC. The Bangladesh Bank provides IFAD funds to BKB at 6% and the ultimate borrower paying 15%. The interest spread of 9% is shared by BKB (2%) and BRAC (7%). There is not enough data to assess the adequacy of interest spread available to BRAC. Under the second model, the bank lends directly to borrower groups. NGOs assist borrowers with paperwork, analysis of proposals and so forth. They also "retail" loans from banks to beneficiaries, either charging the borrower a fee or receiving a subsidy for this service from the government. Women's World Banking is a good example of this credit model, operating in some 50 countries, and extending loans to women through commercial banks with the use of a guarantee mechanism. Several governments in Latin America have also set up mediating agencies along these lines. The Institute for Development of the Informal Sector (IDESI) in Peru is a well-known example.

27. Some institutions which have adopted this approach - like SEWA in India - experience resistance. The participating banks showed little interest in dealing with poor women. This may indicate that women's access to credit, even when they are assisted by NGOs, can suffer. Another problem is that this model does not allow the bank to learn about its customers when an NGO handles the loan application process and loan collections. A further problem is that unless an NGO can provide its services so as to generate revenue sufficient to cover its operating costs, its scale will be limited and it will be dependent on donor resources.

28. The third model operates with the NGO itself as a bank. Grameen Bank and SEWA started as NGOs but now operate as banks under special charters. Agha Khan foundation has recently proposed a rural development bank under the Agha Khan Rural Support Programme. There are several reasons for NGOs opting for banking charter. It would allow them (a) to obtain refinance from the central banks on the same terms as the commercial banks, (b) to mobilize deposits from non-members, and (c) to utilize members' savings for loans to other members, on a sufficient legal basis.

29. One notable feature of these organizations is that they target mainly non-agricultural borrowers with the specific objective of targeting the poorest of the poor. The success of this assistance, to a large extent, lies in the motivation and education of their staff and performance-based incentives offered to employees, as well as the removal of the government-borrower interface that has become entrenched in the formal credit system. In many countries, NGOs have been set up specifically for the purpose of lending to MEs and the poor or have added a credit component to their range of activities. The Bangladesh Rural Advance Committee (BRAC) is an example. Given its experience in working with disadvantaged groups, including women, BRAC is ideally suited to extend credit to the same population (see Box 5). However, these types of NGOs often lack the management capability necessary to expand a credit programme with broad reach. Their ability to mobilize deposits is also limited, causing them to raise all funds for both lending and operating costs from donations, compulsory deposits, interest and fees.

30. Typically, highly supervised lending along the lines of the GB model that most NGOs have shown to be successful are also high cost operations. In addition to the supervision and monitoring costs, these programmes involve considerable fixed costs for training credit staff, field workers and borrowers. Given the state of the existing formal financial institutions, it is unlikely that they will be able to provide all of these services in the short run. An effective solution would be to establish collaborative arrangements between the formal system and the NGOs, exploiting the comparative advantages of each: the formal system has wide branch network and excess loanable funds and NGOs have localized implementation and operational advantages.

31. Another positive feature is that many of the successful credit programmes have sought to overcome the limits to microentrepreneur's access to formal credit by adopting some of the features of informal sector lending. Several features make them more accessible to small borrowers: frequent and flexible repayment schedules, relaxed collateral requirements (including use of personal guarantees), use of information channels accessible to borrowers, simple loan application forms and procedures, and location of lending operations close to the activity of the operators. NGO successes could therefore serve as examples and their more innovative features embodied into large-scale public and private sector banking operations.

32. A significant number of NGOs provide loans and some are even mobilizing deposits. The results of studies carried out by Overseas Development Institute ^/ and others, however, raise serious questions about the sustainability of these operations. The operating expenses in one NGO credit programme in Uganda are reported to exceed 50% of the value of loan portfolio; record keeping systems are often dismal; some of the programmes do not levy interest on their loans and most of these organizations continue to exist simply because of donor support. Are these NGOs building sustainable and efficient systems to provide financial services? Are they doing something substantially different from informal finance? Do they operate because they are subsidized?

33. The informal sector serves a smaller, segmented market with almost negligible transaction costs. The personal nature of transactions alleviates informational problems that formal institutions face and the threat of sanctions discourages default.

34. Microentrepreneurs tend to rely heavily on their past savings, followed by informal sources of credit from family and friends. These sources are particularly important for business start-up capital. Moneylenders, pawnbrokers, suppliers and traders are also important sources of credit because they are close to the borrower and offer small sums of money mostly for short-term and immediate disbursement. The speed and ease of access to these sources are cited as the reason for dealing with them despite higher interest rates. In addition, the credit services of informal lenders are often linked to other services such as supplying raw materials or finished products for sale or marketing.

35. The drawback of informal credit, despite its usefulness for some purposes, is its high cost and lack of dependability. The linkage with other services such as marketing frequently channels the benefits of increased production to the moneylender. Few informal sources provide savings facilities. Participation in these institutions does not link microentrepreneurs directly to the mainstream banking institutions. Also the amount of credit available from these sources is limited and generally for short-term. Microentrepreneurs with good prospects of expansion must look elsewhere for larger, less costly and longer-term loans.

36. If formal lending to MEs is to be expanded, it would need to be made profitable and safe for the lending institutions. While a number of projects demonstrate that the poor are a better credit risk than the more conventional borrowers, lending banks remain reluctant to undertake small lending. As a result, specialized intermediaries like NGOs have been involved to forge a link with the formal banking system to channel loans to microentrepreneurs. In order to reach a large proportion of the population, the functional advantages of the informal sector should also be exploited for expanding credit flows on a commercial basis.

37. The successful development of rural financial markets is impossible to achieve without the long-term financial viability of the intermediary institutions and the financial services being made accessible to wider sections of the rural populations. The commercial banks cannot afford to make small loans at the prevailing low interest rates. Evaluations of both the Grameen Bank and BRAC Schemes indicate that landless groups are able to undertake profitable activities and repay loans (over 95% recovery rate) even at interest rates of 20% per annum. Lender's financial viability is based on simplified procedures which reduce administrative costs, interest rates which are adequate to cover operating costs and prevent capital erosion, reduced incentives for rent-seeking behaviour by well-to-do borrowers, and incentives in the form of repeat and increased loans to borrowers and performance bonuses to bank employees. Together these measures have produced an exceptional repayment record.

38. Interest rates are central to a sustainable rural financial system. Interest rates, like other prices, should be market determined to efficiently perform the basic function of resource allocation (McKinnon, 1973) and to best serve the purpose of helping the poor (Adams, et al, 1994). Capital is assumed to flow, in an undistorted market, to the most profitable investments.

39. Given the imperfect and incomplete nature of rural financial markets, it is difficult to establish a "market" rate of interest. To sustain the financial viability of the participating institutions, however, it can be argued that lending rates should reflect the costs of providing financial services in rural areas, which would include the cost of funds, a premium to cover default risk, administrative costs, plus a profit to ensure institutional sustainability. The inherently high transaction costs of rural financial intermediation, however, pose a dilemma. An obvious solution would be to introduce cost-saving innovations.

40. It is generally believed that the level of income influences savings more than the rates of interest on deposits. Thus, reducing real deposit rates should not present major problems. At the same time, higher real as well as effective interest rates charged, for example, by GB and BRAC have not been obstacles to increased lending to the poor. Also interest rates charged by informal lenders continue to be substantially higher than the real interest rates charged by the formal sector. Thus, there appears to be little justification for not liberalizing lending rates to allow banks the freedom to set break-even interest rates. That access to credit is more important to borrowers than the rate of interest is universally accepted (Adams and Fitchett, 1992 and Otero and Rhyne, 1994).

41. Savings mobilization is critical for financial market development. The failure of many credit projects particularly in the rural financial sector indicates that savings mobilization has invariably been neglected or has played a minor role. Savings will benefit a larger proportion of rural poor than credit provision. Innovative savings instruments and institutions which pay greater attention to deposit and savings mobilization are therefore crucial elements of rural financial market development. Integration of savings schemes contributes to the sustainability of rural finance programmes.

42. Government ownership or control of formal financial institutions and the availability of concessional donor funds offered in the past provided little incentive for deposit mobilization (Pischke, 1981); and emphasis on directed credit stifled financial market development. For any financial institution to maintain its growth and financial viability on a long-term basis, it would need to seek ways by which it will no longer be reliant on external sources of concessional funds and/or government subsidies to meet its administrative expenses. The institution should be able to mobilize its own resources on market terms, whether it be from rural savings or by borrowing from the financial markets at the prevailing rates of interest.

43. The success of GB and NGOs in deposit mobilization from landless households provides ample testimony of the thrift that rural people are capable of (Hossain, 1988). In the absence of convenient and safe facilities, households rely on traditional forms of savings which are often inefficient. For example, one form of saving is investing in items such as livestock which are subject to various types of risks resulting in capital losses. Accessibility to bank deposits offers an important service to individuals by reducing their demand for "non-productive", primarily consumption, credit in times of hardship. This indirectly helps reduce the default risk on loans taken for productive purposes, since loans are often diverted from its intended uses due to fungibility and lack of effective monitoring.

Public Subsidy

44. In theory, complete liberalization of financial markets without due regard to the realities of rural financial markets may itself not be a desirable goal (Stiglits, 1993). So long as the net social returns to efficient financial market operations are greater than the private returns in terms of the profitability of lenders, public sector interventions can be justified. This divergence is a result of "market failures" due to the information and enforcement problems inherent in credit markets. The private sector banks are practically absent in rural areas of many countries. Where they exist, deposits are mobilized and loans are given selectively to merchants and traders but none directly involving small farmers or small businesses.

45. Meeting the potential demand for credit from the poor is thus an arduous task. Lack of assets, low income and vulnerability all limit debt capacity, i.e. the size of loans that poor people can realistically service. The costs of loan appraisal, supervision and collection are all disproportionately high when loan amounts are small, particularly in sparsely populated areas with poor infrastructure. Inflation and weak legal systems are often further obstacles to sustainable credit provision. In such conditions, other poverty strategies that aim to promote savings to create employment or to improve public services, for example may be more effective poverty-alleviation strategies (see Box 6).

46. There are many long-established ways of providing credit to the poor even under adverse conditions. Moneylenders reduce risks and lending costs by their local knowledge of the creditworthiness of poor clients, and linking repayment to sale of crops or provision of labour. Rotating savings and credit associations (ROSCAs) enable members to mobilize large amounts while minimizing the administrative costs and risks. Institutional lenders have successfully utilized group guarantees as a substitute for collateral and used peer monitoring to reduce lending costs. However, moneylending may also be a mechanism for reinforcing inequalities of wealth while ROSCAs are often constrained by the savings capacity of members and group cohesion. Additional problems of risk arise where profitable lending requires complementary and coordinated investments in infrastructure training, new technology and social development.

47. In addition to these efficiency grounds, public sponsorship of poverty-focused credit may also be justified on equity grounds; though only under conditions that have proved difficult to satisfy. Firstly, the criteria for identifying those eligible for preferential treatment must be established. Secondly, lenders must demonstrate the willingness and capacity to deliver credit direct to the targeted categories: fungibility means that subsidies intended to boost lending to the poor may be diverted to other borrowers, or encourage administrative inefficiency. Thirdly, there should be no more cost-effective mechanism for achieving redistribution - for example through transfer payments, social service provision or employment creation. Where these conditions are absent, subsidized credit may also crowd out other sources of supply, depress savings and discourage financial innovation, thereby inhibiting more cost-effective growth in credit supply over the longer term. The complexity of these efficiency and equity arguments for and against selective subsidization of credit provides a rich agenda for research into the comparative performance of different financial institutions (public, private, and voluntary; formal and informal) in responding to different demands under diverse conditions.

48. A complex issue is how to deal with natural disasters and their impacts on both borrowers and lenders. Loan and interest forgiveness programmes approved in some countries are justified on social grounds in the face of natural disasters. The role of financial institutions is not however to carry out social or political programmes. In order to maintain financial discipline, disaster relief has to be separated from commercial operations altogether. This requires an appropriate institution. But virtually every crop insurance programme around the world has been a costly failure (Gudger, 1991). The basic problems, besides organization and management issues, arise due to co-variant nature of natural disasters, moral hazard and political intervention (Hazell, 1992). There is clearly a need for innovative insurance options that can overcome these problems.

49. On the lenders side, credit guarantee schemes in one form or another have been implemented in many countries without much success. On the cost-effectiveness of such a scheme, it remains to be determined whether there are gains to be had from yet another public sector intervention apart from burdening it with operational costs. Evidence from the Philippines, where such a scheme is in operation, is mixed (Bautista, 1991).

Formal-Informal Linkages

50. Financial sector reform, currently pursued by several countries in Asia, must make an effort to provide access to credit for the small farmers, MEs and women. While privatization of state-owned banks and opening new commercial banks should, to some extent do this, it is also necessary to promote further the expansion of the successful NGO schemes and innovative lending programmes. This raises a more fundamental question. Can improved access to self-sustainable financial services automatically result in poverty reduction? Can aggressively expanding microfinance institutions be relied upon to avoid earlier mistakes made under small farm credit programmes which resulted in default, indebtedness and demise of lending institutions? (Adams and Pischke, 1992).

51. The preliminary findings from the Ghana workshop on Financial Integration and Development in Sub-Saharan Africa indicate that a central problem for financial development in Ghana and Nigeria is to encourage institutional innovation to fill the "credit gap" facing small and medium enterprises, which lack access to bank credit but whose requirements exceed the limits of informal agents. Filling this gap may require incentives to the banking sector to develop smaller clients and establishment of conditions and support for informal and semi-formal institutions to move up to this market. Important steps to facilitate innovation in non-bank institutions in Ghana are the Non-Bank Financial Institutional Law and the Leasing Law. Non-bank financial institutions have developed specialized methods for dealing with the informal sector such as using savings deposits as collateral and gathering information on clients in the course of daily collection of deposits or loan repayments. Banks should be encouraged (and perhaps given incentives) to enter into closer relationships with informal agents such as Susu collectors and groups and NGOs, as mechanisms to mobilize deposits from and deliver credit to the household and ME sector. These agents can bulk up small savings at relatively low cost and could retail more credit to the informal sector if backed up by access to bank credit.

E. The Ingredients of Effective Financial Institutions

52. One of the key barriers to ME development and poverty reduction has historically been the inability of the operators to borrow for productive capital investment. Many experimental financial institutions have been set up to overcome this obstacle (see Box 7).

There is now evidence that sustainable credit-based poverty reduction through ME and other developments is feasible. The prerequisites for their successful operation are:

• National economic policy should not prevent the institution from passing the full cost of credit on to the borrower;

• A system should exist for collection of loan instalments frequently;

• Positive incentives to repay must exist, either in the form of rebate for 100% repayment on time or in the form of a linkage between loan repayment performance and subsequent loan size in the form of performance-related pay for credit staff, or ideally all three;

• Arrangements for insuring the lender against loan default should exist, possibly through "compulsory saving" into a loan insurance fund;

• Systems should not be purely based on credit delivery, but should also require that borrowers participate in a savings scheme;

• A capacity for rapid diagnosis of problems and redesign of schemes should be available within the institution; and

• Local knowledge, staff continuity of intermediary.

53. These are necessary and not sufficient conditions: all of the successful institutions such as the Grameen Bank and Bank Rakyat Indonesia satisfied almost all of the conditions and many of the unsuccessful ones like ADBP can be seen to have failed because one or more of the conditions was lacking. It is to be hoped that application of the conditions described above and the learning of lessons from what is now quite a large number of successful prototypes, can now reduce the risks associated with the design of institutions lending to small farmers, MEs and women (The World Bank, 1994).

54. The BKK and BRI in Indonesia have not only made a large number of small loans but also offered safe savings facilities. Both have been profitable, unsubsidized and therefore sustainable institutions (see Box 8).

55. Demand-driven services are more sustainable and have greater outreach than the traditional supply-driven approaches. It makes good sense for financial intermediaries to design instruments and mechanisms that offer reliable long-term access to deposit and credit services. To ensure the sustainability of financial institutions, the emphasis should be on providing cost-effective and convenient services, offering demand-driven facilities, paying more attention to deposit mobilization, to the performance of financial intermediaries, to the lowering of transaction costs, to cost-reducing financial innovations, to building sustainable financial services, and to how policies affect the performance of the rural financial markets.

56. The following are thus important aspects to be considered in the development of rural financial markets so as to ensure sustainability (The World Bank, 1994):

1. Modalities for increasing linkage between financial (formal and informal) and non-financial institutions;

2. Risk management in the absence of acceptable conventional forms of collateral;

3. Cost-effectiveness and competitiveness of financial intermediaries in a private sector environment;

4. Capacity-building to improve the efficiency of financial services, outreach, and participation by women.

57. The above review indicates that access to formal credit for small producers and enterprises is very limited. Small lending involves disproportionately high transaction costs in loan management and information on the creditworthiness of borrowers is limited. Small borrowers like microentrepreneurs lack sufficient fixed assets to satisfy most banks' collateral formalities and the legal system is generally inadequate to provide redress in the event of loan default. When the premium for lending risk is added onto the interest rate on loans to MEs, the cost can be quite high.

58. The informal sector constitutes in many developing countries the most significant source of financial intermediation for small borrowers. The requirements for these borrowers are generally for short-term loans especially to meet working capital needs. Longer term loans are generally not provided by the informal lenders as both borrowers and lenders are small and the risks greater. Informal financial arrangements reduce transaction costs and freedom from regulation allows greater flexibility in fixing terms and conditions of loans; though formal sanctions available to institutional lenders are also not available to the informal sector. The risk to social standing and to raising future loans has acted as an effective incentive for repayment of loans. The informal sector is, however, characterized by limitations in its ability to mobilize savings and provide longer term or larger loans.

59. The crucial aspect of mobilizing savings to channel towards productive investment is not the institutional form of the intermediary, whether the intermediary is formal, semi-formal or informal, or whether it is privately-owned or state-owned. The basic issue is the cost of financial intermediation, ease and speed of access, the dependability of the lender and the capability of the intermediary to provide the appropriate range of services. Lessons learnt over the past three decades demonstrate that: (a) there is no unique financial institution that can provide adequate financial services in rural areas and (b) more emphasis ought to be placed on improving the process and reducing the cost of financial intermediation rather than just building new institutions; this would naturally involve more investigation into why existing institutions, formal, semi-formal or informal are not adequately providing the kinds of financial services that are necessary.

60. The dismal experience of small farmer credit programmes, managed by parastatal agricultural development banks, most of them subsidized, has highlighted the distortionary effects of subsidized credit and the consequent need to charge realistic interest rates, the importance of savings mobilization for improving resource allocation and enhancing the viability of lending institutions, and the futility of targeted loans to specific activities. There is increasing recognition that borrowers most value convenient and rapid access to credit more than its cost; simplified procedures can reduce lender transaction costs; and repayment incentives - in the form of group guarantees or repeat loans of larger size - can substitute for conventional loan screening methods and collateral requirements. Successful ME programmes incorporating these principles are few. There are nevertheless a handful of such institutions. The best known is perhaps the Grameen Bank in Bangladesh. The success of Grameen Bank suggests that group lending programme under joint liability can be effective in obtaining high rates of loan repayment. Indonesia's BKK is an equally promising rural credit programme which is aimed at individual borrowers. BKK units were intended to provide the speed and convenience of moneylenders while operating as commercial banks, with their presumed lower profit margin. Their loans were designed to meet the requirements of individual small entrepreneurs engaged primarily in petty trading, handicrafts, simple food processing and food preparation.

61. Development assistance has focused on subsidized credit as a means to expand credit flow to small borrowers. The track record is of limited success. Subsidized credit does not reduce transaction costs or minimize risk in lending. The challenge in servicing savers and small borrowers is to design financial services that would build sustainable financial intermediation as measured by high loan repayment and low administrative costs.

62. The experience of the last decade demonstrates that a sound financial technology for credit delivery to MEs exists. The principles behind the emerging techniques for offering financial services to MEs are the same as those found in any financial system. The core principles would involve:

1. Knowledge of the credit market. Borrowers are willing to pay for access and convenience. The major need among small borrowers is short-term loans for working capital. Group lending can reduce administrative costs of lending to small borrowers. It provides economies of scale in lending to homogenous groups rather than geographically dispersed households. Borrower access is enhanced and transaction costs for the borrower are likewise reduced. Collateral requirements can be eliminated or reduced by group liability. Personal guarantors, contracts to supply products, liens on equipment financed, substantial equity contributions by the entrepreneur are some of the collateral substitutes which can be encouraged.

2. Market-based interest rates. Market-based interest rates provide for the financial sustainability of intermediating institutions. The market failure in rural credit markets may, however, require some form of supportive government intervention. As mentioned earlier, subsidized interest rate is not the answer. Instead a successful government role could involve accounting for the externalities associated with imperfect information. Among possible remedies are land titling performed at the local level. More broadly, effective extension service activities, improved transportation, distribution and communications infrastructure constitute legitimate government interventions, which would increase productivity and the return on investment. These interventions would reduce borrowers' risk of default.

3. Savings mobilization. Savings mobilization through interest bearing accounts is an effective tool, not only for asset accumulation but also for serving as collateral for loans. Infrastructure in the form of branch locations and mobile bank staff is an essential feature of this activity.

Application of these principles is the foundation for financial viability of a microfinance institution. These principles or policies can be implemented under alternative conceptual frameworks.

63. Linking the Formal and Informal Financial Sectors. One approach is to mobilize the respective comparative advantage of the informal and formal rural financial sectors. The informal sector brings to bear critical information on the creditworthiness of potential borrowers and relationship with the community that can promote timely repayment. The formal sector, meanwhile, can offer considerably more resources for lending than can the informal lenders.

64. Government Support of Formal and Informal Linkages. Governments can play effective supporting role to build or strengthen linkages between the formal and informal financial sectors. Specifically, governments can improve the ability of banks to reduce loan losses and establish clear property rights for borrowers. They can also set interest rates that reflect lending costs and use of local sanction to enforce repayment. Legal framework can also be improved to facilitate MEs' use of formal finance.

65. Role of NGOs. NGOs have the comparative advantage over civil servants as they are committed to poverty reduction, can tap private sector expertise and also bear much of the cost of providing technical services from other income. There are presumably two possible roles for NG0s - one would be simply to provide technical services to MEs and thereby enhance their credibility to the banks as borrowers; the other to serve as both a source of technical assistance and a financial intermediary. In the latter case, is some form of regulation necessary, so as to safeguard clients and banks?

66. Indonesian experience shows that it would be a waste of Central Bank resources to supervise small deposit-taking institutions by virtue of the fact that they do not participate in the clearing system. Their liabilities are thus not part of M1 and their failure would be highly unlikely to have any impact on monetary stability. The Central Bank should therefore monitor prudential standards in bigger banks. Even if one were persuaded to supervise these small NGOs, it must be based on a cost-benefit analysis of effectively supervising these organizations. The better approach is simply to try to educate the public to the reality that deposit takers can and do go bankrupt from time-to-time, which in any case cannot be prevented from happening by prudential regulation.

 ^1/ Based on weighted average return on fixed deposits of 5 years and over.
 ^2/ Consist of borrowings from SBP and international lenders.
 ^3/ Interest paid to SBP and on foreign borrowings is PRs616 million (FY87), PRs730 million (FY88), PRs1,074 million (FY89),  PRs1,350 million (FY90), PRs1,527 million (FY91) and PRs1,875 million (FY92).

Adams Dale W., Harlan Davis and Lee Bettis, 1972. "Is Inexpensive Credit a Bargain for Small Farmers? The Recent Brazilian Experience", Interamerican Economic Affairs, Summer, 1972.

Adams Dale W., 1973. "The Case for Voluntary Savings Mobilization: Why Rural Capital Markets Flounder", Small Farmer Credit, Analytical Papers, Washington: AID, 1973.

Adams Dale W., and Gerald I. Nehman, 1979. "Borrowing Costs and the Demand for Rural Credit", The Journal of Development Studies, January, 1979.

Adams Dale W., and Douglas H. Graham, 1981. "A Critique of Traditional Agricultural Credit Projects and Policies", Journal of Development Economics.

Adams Dake W., and J.D. Von Pischke, 1992. "Microenterprise Credit Programs: Deja Vu", World Development.

Adams, Dale W., and Delbert A. Fitchett, eds., 1992. Informal Finance in Low-Income Countries. Westview Press, Boulder, CO.

Adams, Dale W., Douglas H. Graham and J.D. Von Pischke, eds, 1984. Undermining Rural Development through Cheap Credit. Westview Press, Boulder, CO.

Ahmed, Kamal Uddin, 1994. "The Role of Supplier's Credit in the Marketing of Agricultural Inputs". Paper presented at the Workshop on Supplier's Credit Programme organized by the Crop Diversification Programme, Dhaka.

Ahmed, Zia U., 1989. "Effective Costs of Rural Loans in Bangladesh". World Development. 17(3): 357-363.

A.I.D, 1991. Mobilizing Savings and Rural Finance: the A.I.D. Experience. Agency for International Development.

Besley, Timothy, 1994. "How do Market Failures Justify Interventions in Rural Credit Markets". The World Bank Research Observer. 9(1); 27-48.

Binks Martin, 1979. Finance for Expansion in the Small Firm, Lloyds Bank Review. Oct. 1979.

Bradford Jane, 1993. Banks and Small Firms: An Insight National Westminster Bank Quarterly Review, May 1993.

Gonzalez-Vega, Claudio, 1976. On the iron law of interest rate restrictions: Agricultural Credit Policies in Costa Rica and in other less developed countries; Phd dissertation, Stanford University.s

Gonzalez-Vega, Claudio, 1977. Interest rate restrictions and income distribution, American Journal of Agricultural Economics, 59.

Ghate, Prabhu. Informal Finance: Some Findings from Asia. Oxford University Press for the Asian Development Bank.

Gudger, M., 1991. "Crop Insurance: Failure of the Public Sector and the Rise of the Private Sector Alternative". In Dennis Holden, Peter Hazell and Anthony Pritchard (eds.): Risk in Agriculture: Proceedings of the Tenth Agriculture Sector Symposium. The World Bank, Washington, D.C.

Hazell, Peter B.R. 1992. "The Appropriate Role of Agricultural Insurance in Developing Countries". Journal of International Development. 4(6): 567-581.

Hoff, Karla and Joseph E. Stiglitz, 1993. "Imperfect Information and Rural Credit Markets: Puzzles and Policy Perspectives". In Hoff, Braverman and Stiglitz (1993).

Huppi, Monica and Gershon Feder, 1990. "The Role of Groups and Credit Cooperatives in Rural Lending". The World Bank Research Observer. 5(2): 187-204.

Hossain, M., 1988. Credit for Alleviation of Rural Poverty: The Grameen Bank in Bangladesh, Research Report No. 65, International Food Policy Research Institute, Washington, D.C.

House, W.J., 1984. 'Nairobi's Informal Sector: Dynamic Entrepreneurs or Surplus Labour? Economic Development and Cultural Change, Vol. 32, pp.277-302.

Kurwijila, R. and J.M. Due, 1991. 'Credit for Women's Income Generation: A Tanzanian Case Study', Canadian Journal of African Studies, Vol. 25, No. 1, pp.90-103.

Khalily, M.A. Baqui and Richard L. Meyer, 1993. "The Political Economy of Rural Loan Recovery: Evidence from Bangladesh". Savings and Development. xvii(1):23-38.

Khandker, Shahidur R., Baqui Khalily and Zahed Khan, 1993. "Grameen Bank: What Do We Know?". Draft mimeo. The World Bank.

Keasey, Kevin and Watson, Robert. 1993. Banks and small firms; Is Conflict Inevitable? National Westminster Bank Quarterly Review, May 1993.

Levy, B., 1993. 'Obstacles to Developing Indigenous Small and Medium Enterprises: An Empirical Assessment', World Bank Economic Review, Vol.7, No.1, pp.65-83.

Lycette, M. and K. White, 1989. 'Improving Women's Access to Credit in Latin America and the Caribbean: Policy and Project Recommendations', in M. Berger, and M. Buvinic, (eds.). Women's Ventures: Assistance to the Informal Sector in Latin America, West Hartford, CT. Kumarian Press.

Mazumdar, D., 1989. Microeconomic Issues of Labor Markets in Developing Countries: Analysis and Policy Implications, EDI Seminar Paper No. 40, Economic Development Institute of the World Bank, Washington, D.C.

Maloney, Clarence and S.A.B. Ahmad, 1988. Rural Savings and Credit in Bangladesh. University Press, Dhaka.

McKinnon, Ronald, 1973. Money and Capital in Economic Development. The Brookings Institution, Washington, D.C.

Morewagae Boitumelo S. Monica Seemule and Henry Rempel, 1995. Access to credit for non-formal macro-enterprises in Botswana, The Journal of Development Studies Vol. 31, No. 3.

Otero, Maria and Elisabeth Rhyne (Eds.), 1994. The New World of Micro-Enterprise Reform: Building Healthy Institutions for the Poor. Kumarian Press, West Hartford.

Ong Marcia L., Dale W. Adams, and I.J. Singh, 1976. "Voluntary Rural Savings Capacities in Taiwan, 1960-70, "American Journal of Agricultural Economics, August, 1976.

Pischke J.D. Von and Dale W Adams, 1980. "Fungibility and the Design and Evaluation of Agricultural Credit Projects," American Journal of Agricultural Economics, November, 1980.

Pischke, J.D. Von, 1981. The political economy of specialized farm credit institutions in low income countries. World Bank Staff Working Paper No. 446, Washington, D.C.

Pischke, J.D. Von, Adams, Dale W. and Donald Gordon, 1983. Rural Financial Marketing in Developing Countries, Their Use and Abuse, The Economic Development Institute, The World Bank.

Rahman, Atiq, 1992. "The Informal Financial Sector in Bangladesh: An Appraisal of its Role in Development". Development and Change. 23:147-168.

Reichmann, R., 1989. 'Women's Participation in Two PVO Credit Programs for Microenterprise: Cases from the Dominican Republic and Peru', in M. Berger and M. Buvinic (eds.), Women's Ventures: Assistance to the Informal Sector in Latin America, West Hartford, CT. Kumarian Press, pp.132-60.

Sethuraman, S.V., 1977. "The Urban Informal Sector in Africa', International Labour Review, Nov./Dev.

Sethuraman, S.V., 1984, The Urban Informal Sector in Developing Countries: Employment, Poverty and Environment, Geneva: International Labour Office.

Stiglitz, Joseph E., 1993. "The Role of the State in Financial Markets". Paper presented at the Annual Bank Conference on Development Economics, May 3-4, 1993, The World Bank.

Thomas, J.J., 1992. Informal Economic Activity, Hemel Hempstead: Harvester Wheatsheaf.

Vogel, Robert C., 1979. " Subsidized interest rates and the rationing of agricultural credit in developing countries" in problems and issues of agricultural credit and rural finance, edited and published by the Bangladesh Bank, Dhaka.

Yaron, Jacob, 1994. "What Makes Rural Finance Institutions Successful?". The World Bank Research Observer. ((1):49-70.

World Bank, 1989. World Development Report, 1989.

World Bank. 1994. Development of Rural Financial Markets in Sub-Saharan Africa, World .Bank Discussion Paper No. 219.

World Bank, 1993. Handbook on Financial Sector Operations First Edition, Operations Policy Department.