In what ways are banks in developing countries different from banks in financially developed economies?IntroductionThe recognition that our world is firmly segregated alongside lines of disparate economic development has been the starting poin

Week 10: In what ways are banks in developing countries different from banks in financially developed economies?

Introduction

The recognition that our world is firmly segregated alongside lines of disparate economic development has been the starting point of the complex sociological field of development studies. It was American president Truman who, in his second inauguration speech in 1949, spoke of an ‘underdeveloped’ world that needed to be helped and lifted out of unfavourable living conditions (Dodds et al., 2002: p3). Development was from then on always, though to widely varying extents, embedded, aligned, or equated with economic development. The industrial revolution that had kick-started a far-reaching process of economic growth in Europe and the nowadays ‘developed’ world was considered a model path which – more or less – needed to be replicated in order to achieve similar developments. Within this framework, the financial sector gained a crucial importance. While scholars still hold different views on the gravity of a financial sector for economic development, its role in Western Europe’s and North America’s industrialisation cannot be underestimated, bearing implications for present development debates. In how far does the structure of the banking sector in developing countries tell us about their strategy for fostering economic development; and, are special responses needed for making credit and deposit more widely available to people in less developed economies?

This essay will first try to highlight theoretically the central role of a banking sector (or financial sector as a whole) for economic development. By providing a brief overview over the role banks play in developed countries, this paper will contrast these conditions with realities in ‘less developed countries’ (LDCs). Here, generally speaking, a different banking sector prevails; implying different rules and modalities for conducting savings and investment. Development banks have been of special importance when analysing the banking sector in LDCs. While pointing at the historical role development banks have played throughout the industrialisation in today’s rich countries, this paper will contrast the historical experience with development banks today. Special light will be shed on agricultural land banks, state-owned development banks, and multilateral development banks. By providing some case-studies and examples of these ‘different’, mostly non-commercial banks, this paper will also try to show their limitations. Developmental banks can only be as successful as sincere the aims and motivations of the government and other surrounding institutions are. Unfortunately, poor legal standards, weak accounting systems and a multitude of other shortcomings have prevented a universal success of these undertakings. However special the conditions in developing countries appear to be, effects of ongoing financial liberalisation and harmonisation efforts bear fruit. More and more foreign commercial banks move into LDCs, and not only into promising emerging markets, or newly-industrialising countries, but also into low-income countries. Are these commercial banks a viable alternative to developmental banks?

Banks and Economic Development

From: Levine, 1997: p691 – abridged by author

The above chart shows systemically in how far financial intermediaries (e.g. banks) and in a wider sense financial systems as a whole are of a crucial importance with regards to economic growth. Certain market frictions (that cause information costs, transaction costs) are soothed by financial markets and intermediaries. Their financial functions are - among others - to mobilise savings (hence to provide a framework under which people are willing to deposit their savings in a bank); they then allocate these mobilised resources as loans to willing debtors. By selecting only potential debtors whose investment or spending plans are deemed economically viable, they also facilitate risk management of these financial transactions. That is why besides resource allocation, banks also promote technological innovation, since unsuitable undertakings will not get an approval for a loan. This simplified model makes clear that without functioning financial intermediaries (e.g. banks), economic growth is hindered from reaching its full potential.

The Banking Sector in Economically-Developed Countries

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The Banking Sector in Economically-Developed Countries

Despite the diversity that exists between the different financial sectors within the developed economies of Western Europe and North America, there exist similarities and unifying features. Banks were and still are the first and foremost source of external funds used to finance businesses. In the United States, 61.9% of external funds to businesses are loans from banks (Mishkin, 2001: p184). Financial intermediaries (e.g. banks) are the primary source of funds because their operation successfully deals with and solves a number of problems related to financial interactions. As described in the chart above, financial intermediaries can soothe market frictions like information costs and transaction costs because of a number of reasons. Banks enjoy economies of scale and hence drive down the individual’s transaction costs. Also, their skills in collecting information provide that fewer of their loans default than it would happen in a non-bank environment. Asymmetric information in financial markets leads to two important problems that directly relate to banks in LDCs.

Adverse Selection and Moral Hazard

Adverse selection refers to a situation that occurs before a financial transaction. Bad credit risks actively seek out loans more actively than others, because these debtors are very unlikely to pay back. Lenders might decide not to make any loans (Mishkin, 2001: p187). Moral hazard happens after the transaction and refers to the problem that people behave differently in case they are operating with someone else’s money. They take more risks which is undesirable from a lender’s point of view. Both adverse selection and moral hazard decrease the probability that a loan will get repaid. For a banking sector to work properly and to circumvent these problems, certain mechanisms must be put in place. Among other factors, these mechanisms highlight the most distinctive difference between banks in economically-developed countries and LDCs. They relate to different legislative frameworks prevalent in LDCs which have evolved over time. Mishkin (2001) states that tools to solve adverse selection and moral hazard problems ‘involve the private production and sale of information, government regulation, the importance of collateral, and the use of monitoring and restrictive covenants’ (p198). Obviously, all of these solutions require a functioning legal system and a certain degree of banks’ independence.

Common Problems in LDCs

As pointed out beforehand, a strong correlation between economic growth and the development of a sound financial sector is proven to exist (Roubini and Sala-i-Martin, 1995). LDCs show – of course to a varying extent – a legal system falling short of standards prevalent in economically-developed countries, making it difficult and sometimes impossible to solve problems like adverse selection and moral hazard. Two powerful tools by which this is done in developed countries are collateral and restrictive covenants. With these, a debtor is legally bound to act within certain limits set by the bank. However, in many LDCs, enforcement of these two tools can be sluggish, if not impossible (e.g. slow and cumbersome bankruptcy procedures to collect collateral). The problem of asymmetric information is at the centrepiece of the malfunctioning banking sectors in many LDCs. A nonexistent accounting standard makes evaluation of potential borrowers extremely difficult. Also, if the government shows a small degree of state autonomy and acts in favour of certain social groups, lenders might be blocked by the state to ‘foreclose on borrowers in politically powerful sectors such as agriculture’ (Mishkin, p199). Another common feature of banking operations in LDCs involves the nationalisation of banks, which often make them channelling their funds directly to the government, not to sectors that promise to translate loans into productive investment and hence higher economic growth.

Development Banks

An important feature of the banking sector in many LDCs is the existence of large development banks that put issues like economic development, poverty alleviation, adaptation of technology, etc. at the top of their agenda. One can differentiate between different types of development banks that have sprung up within LDCs or as part of international development assistance. Their economic rationale stems from historical experience, in particular the important role of development banks during the 19th century industrial revolution in Europe. Their positive effect upon development is however debatable and varies between different examples.

The idea of government sponsored financial institutions accompanied Europe throughout its history; with notable revivals taking place after the two World Wars, where the massive reconstructti0n effort was facilitated by generous state loans and guarantees, channelled into the economy by partially state-owned development banks, such as the Kreditanstalt für Wiederaufbau (KfW) in post-War Germany. In other parts of the world, the idea of a backing state served as a model for similar institutions. The Industrial Bank of Japan, which was founded in 1900, leaned upon the Crédit Mobilier experience. The importance of development banks in the process of economic development can be argued about, as their quantitative contribution to net credit provided within an economy has been comparably small. However, their qualitative effect has been widely acknowledged: ‘‘Probably the aggregate resources provided by the development banks have been small, but the fact that there were made available at particular times for strategically important enterprises and industries gave them a significance far greater than the amounts involved suggest’ (Diamond, 1957, p38 ff).

Today’s Development Banks in LDCs

While their main focus at the dawn of the industrial revolution had been the financing of risky businesses using new and unevaluated technology, development banks today are active in different spheres. First and foremost, the most striking difference is the notion of development lying at the heart of these banks. While they had been solely active within industrial development in today’s rich countries, development banks in LDCs work within a somewhat wider universe of development. Besides the promotion of industrialisation, poverty alleviation and gender-related issues can play a central role.

Important contemporary development banks are for instance agricultural development banks. They provide credit for a large proportion of the population that would otherwise not qualify for loans from commercial banks – the proportionately dominant demographic group of rural poor. Many of these development banks are still fully or partly state-owned, leading to various problems. Some observers even consider agricultural development banks as the ‘white elephants’ of development finance (IMF, 2000), that need either to be reformed or closed. The disenchantment comes from a majority of disappointing experiences. Because of state-ownership, certain economic principles do not apply, simply because the main motivation behind the operation of these banks is not driven by profit. In general, agricultural development banks focus on giving out loans rather than on accepting deposits. Of course, this practice ‘undermines [the banks’] self-reliance as well as their viability’ (ibid. p2), i.e. make them dependent on subsidies (Morduch, 1999). Thus, time has shown that most agricultural development banks are unsustainable. Many of them have either been closed down or are practically bankrupt, especially in Africa and Latin America.

However, there are also positive case-studies of agricultural development banks in LDCs. One more or less successful example is the Grameen Bank of Bangladesh, which has been in the vanguard of the microfinance movement. By providing micro credits to the rural poor without requiring any collateral, the Grameen Bank has shown to be a cost-effective weapon against poverty. It has introduced several innovative features that guarantee high repayment rates that are not significantly below the levels of Western commercial banks. The Grameen Bank has pioneered group-lending contracts with joint-liability, reducing problems related to moral hazard and adverse selection (Morduch, p230). Much of the success of the Bank however relates back to its financial structure. It is dependent on subsidies and without them it would incur losses. Consequently, even successful agricultural development banks are not necessarily commercially viable. Nevertheless, as the Grameen Bank example shows, agricultural development banks – as a development project, reliant on international or national subsidies – can provide poverty-alleviating services to normally non-bankable groups of the population.

Foreign Commercial Banks: A viable alternative?

The entry of foreign commercial banks into LDCs has been a direct effect of an ongoing liberalisation effort within the international capital markets and also of a related deregulation of domestic legislation within many LDCs. Due to the fact that free movement of internationally-acting banks is a relatively new phenomenon with regards to LDCs, it is questionable whether their arrival bears unambiguously positive implications for economic development. However, recent findings suggest that international bank entry tends to strengthen LDCs’ financial systems and lower the probability that a banking crisis will occur (Schmukler, 2003: p22). Nevertheless, it is necessary to add at this point that the intrusion of foreign banks into LDCs is not a universal development and only appears to happen in a limited number of countries, most commonly in so-called ‘emerging markets’ or newly-industrialised countries. However, an ever-growing number of less-affluent developing countries are able to attract the entry of foreign commercial banks into their economies as well.

Interestingly, not only big global banks tend to operate increasingly within these ‘untapped’ markets of LDCs, as an example from Kyrgyzstan, one of the five Central Asian states, can show. This special example sheds light at the diverse image one is confronted with when studying the impact of foreign banks on the economic performance of LDCs. In Kyrgyzstan on the one hand, the international NGO community usually disposes of the services of a medium-sized Turkish bank (DemirBank), whereas on the other hand large parts of the business world use a Kazakh bank for their financial transactions. Due to a lack of an adequate domestic banking sector, these two foreign banks have gained a crucial role when it comes to channelling of investment into this poor country.

It becomes especially interesting to scrutinise the impact of foreign banks when taking into account their lending to small and medium enterprises and business operations in these countries, widely recognised as the driving force behind strong and sustainable economic growth. Here, country-based evidence points at the importance of size of the foreign banks. ‘Small foreign banks lent considerably less to small business than small domestic banks’, whereas ‘large foreign banks actually appear to lend more to small businesses than large domestic banks (…)’ (ibid. p22). Hence, the impact of foreign banks towards the economic development of LDCs can be widely regarded as positive. Besides the important fact that in relatively poorly-developed economies they can be viewed as an important substitute to lacking domestic financial intermediaries, there are other positive impetuses: Competitive pressure created by foreign bank entry can also lead to improvements in overall financial efficiency caused by lower operating costs and smaller margins between lending and deposit interest rates (ibid.). Case studies from Argentina and Mexico (Dages, Goldberg, Kinney, 2000) also imply that diverse ownership has positive effects on the overall stability of credit in times of financial instability.

Conclusion

This paper has tried to show that the banking sector in LDCs is different from its counterparts in the developed world, despite the fact that a swift generalisation is of course not desirable due to the complexity of realities in different LDCs. Among the key features in LDCs are an often malfunctioning commercial bank sector and the existence of development banks. The commercial bank sector is hindered from functioning properly due to poor legal standards. Insufficient accounting standards, state-ownership and other factors contribute to problems of adverse selection and moral hazard. Among the most prominent examples of development banks are microfinance institutions like agricultural development banks. While the majority of these banks has proven to be unsustainable, some successful examples could show that – operating within a development notion – their existence is justified and also beneficial. Large multilateral banks account for a large chunk of credit provided within LDCs, but as they mostly assist governments exclusively, they are not banks in the classical sense.

Banks are important driving forces behind economic growth, as the theoretical part in the beginning of this paper tried to show. Access to loans and deposits is one of the key prerequisites for sustainable economic development. Banks play the most central role in this financial intermediation. That is why the promotion of a firm legal environment for the operation of banks can always be seen as promoting development as well. The recent influx of foreign commercial banks into LDCs is an important pillar of the development of a sound financial sector in LDCs.

Bibliography:

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Dages, Goldberg, Kinney, ‘Foreign and Domestic Bank Participation in Emerging Markets: Lessons from Argentina and Mexico’, Economic Policy Review (Federal Reserve Bank of New York) 6 (September): 17-36
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