The importance of development finance

Access to finance is always a daunting topic as it addresses two basic issues. Financial exclusion occurs when those denied access have economic and social return on investment better than those with regular access. The second issue is the response to concerns of inequality and the need for better redistribution of wealth.

A key concern has always been the debate on the role of government. One paper by Dela Torre, Gozzi and Schmukler (2006), all affiliated with the World Bank, advocates restricted government intervention in collaboration with the private sector in non-traditional ways.

Opinion on the role of government is polarized in two highly contrasting but well established views: The interventionist and 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 broaden access to credit, as private markets fail to expand access. In contrast, the laissez-faire view contends that government 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.

The emerging middle ground which was labeled pro-market activism contends that there is a room for well designed, restricted government interventions to address specific market failures and help smooth the transition towards a developed financial system.

Some of the examples of promarket intervention are as follows: (1) Public provision of market infrastructure such as banking services through the post office and provision of electronic infrastructure to reduce operational costs for financial intermediaries; (2) Structured finance, a process where assets are pooled and transferred to a third party (special purpose vehicle) which in turn issues securities backed by this asset pool; (3) Credit guarantee systems as a means to reduce problems of access to finance while institutional reform is taking time to mature, in a market friendly way, minimizing their unintended consequences while at the same time promoting private financial market activity; (4) Transaction cost subsidies; and (5) Public lending, e.g. wholesale microfinance.

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. The move to promarket 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.

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. It is necessary to establish separate business units, with their own profit and loss statements, to implement new interventions and by creating sunset provisions when launching a new program.

The management of these institutions should also 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.

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.

The pro-market activism view adheres to the notion that government should help improve the enabling environment for financial markets. But it believes it is unwarranted for governments to remain disengaged from any direct intervention. There is room for well designed government intervention to address specific market failure. And what better way to handle this than through development finance institutions which must strive to be relevant in a volatile, uncertain, complex and ambiguous world.

DFIs need to realize that they need not compete frontally with the private sector banks as there is so much room to collaborate, catalyze, complement and capitalize on its bigger social mandate. There are gaps to fill and areas to cover, especially for the unbanked and under-banked. And there are policy initiatives that need to be supported, like this present administration’s build, build, build agenda. And there is imperative for pro-market activism by government in favor of the bigger number of small business entrepreneurs in the country that need affirmative action against the inherent biases of financial flows to them.

(Benel D. Lagua is Executive Vice President at the Development Bank of the Philippines. He is an active FINEX member and a long time advocate of risk-based lending for SMEs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)

benel_dba@yahoo.com