Financial System and Economic Development: Central Banking and Microfinance
Classified in Economy
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- Financial System & Economic Development: Demand for financial services comes from activities of non-financial firms (real sector). Monetary policy in development: regulate economic activity and inflation, increase supply of money leads to an increase in loanable funds, more investments, and decrease in interest rates.
- Why is development different? Highly organized, economically interdependent, and efficient functioning (spatially fragmented) money and credit markets. Consistency and uniformity in interest rates across different sectors and regions.
- Constrained by the openness of their economies. (Pegging of currencies to USD + have to trade in well-accepted currency) (impossible trilemma of free capital flow/fixed exchange rates/sovereign monetary policy)
- Central bank conducts banking (to government/commercial banks), regulatory (financial institutions), supervisory functions (operator of monetary and credit policy). Economic (no provision of direct credit to government) and political autonomy (ability to select final objectives of monetary policy)
- Alternatives to central bank? A supranational central bank may be created to undertake the central banking activities for a group of smaller countries participating in a monetary union, perhaps also as a part of a customs union/Currency enclave might be established between the central banking institution in a developing country and the monetary authority of a larger trading partner
- Development banks are specialized public and private financial institutions that supply medium and long-term funds for the creation or expansion of industrial enterprises. (Provide loans to those projects that commercial banks refuse)
- Criticisms: excessive concentration on large-scale loans, need to focus on small entrepreneurs since they are excluded from access to credit at reasonable interest rates.
- Informal Finance & Microfinance: Why? No profit to be made for commercial banks by making small loans, informal borrowers also don't have necessary collateral to secure formal sector loans. Rotating savings and credit associations (ROSCAs): a group who collects a fixed amount of savings from each member then funds reallocated to one member randomly interest-free. Lending rates > Deposit rates
- Characteristics: Extreme variability of interest rates, those who make larger loans pay lower rates, credit limit is proportional to borrower net worth, rates of defaults are low
- Model:
- Motivation? Availability of credit is a binding constraint for microenterprise development. Microfinance: It is the supply of credit, saving vehicles, and other basic financial services made available to poor and vulnerable people who might otherwise have no access to them or could borrow only on highly unfavorable terms. MFIs: Specialize in delivering these services, in various ways and according to their own institutional rules. (e.g. a commercial bank can also be a MFIs as long as they provide credit to the poor)
- Group lending schemes: A group of potential borrowers form an association to borrow funds from a commercial bank, a government development bank -> lower rates
- With at least implicit joint liability, group members have a vested interest in the success of the enterprise and therefore exert strong peer pressure on borrowing members to repay on time.
- Pros Joint liability: Reduce adverse selection (distinguishing creditworthy borrowers) & moral hazard (encouraging diligent efforts + discourage absconding/faking bankruptcy due to social pressures) Cons: Low flexibility, loss of capital due to factors beyond control (natural disasters), peer pressure to undertake excessively risk-averse activities.
- Targeting woman borrowers in microfinancing -> decrease incentive to default without even actual joint liability due to intrinsic characteristics of woman.
- Subsidies and MFI (Inefficient use of government funds?) Microfinance Plus: using availability of credit may act as a medium to get them enrolled in health and education programs.
- Limitations: microfinance is necessary but not sufficient, but it needs to be complemented with other growth.