Financial mechanisms

Correcting a fundamental lack of access to financial services is essential to reverse the economic problems plaguing developing nations. In order to cope with the conditions that make poor households, isolated rural areas and micro-businesses unattractive to traditional financial institutions, a number of original alternatives have evolved.

The financial sector in developing countries consists of three sub-sectors: the formal, semi-formal and informal sector.

The formal financial sector falls under banking law and regulation and supervision of financial authorities. It includes various kinds of banks (commercial, development, specialized, regional, cooperative), insurance companies, social security schemes, pension funds and, in some countries, capital markets.

The organizations in the semi-formal sector do not have a bank license and are generally unsupervised by the formal financial authorities though they may operate under particular laws and regulations. This sector includes credit unions, non-governmental organizations (NGOs) and microfinance institutions (MFIs). The semi-formal sector is mostly dependent on subsidies and assistance from governments or donors.

The informal sector is generally dominated by social structures, individual operators, ease of access, simple procedures, rapid transactions, and flexible loan terms and amounts. It includes local member-based organizations such as rotating savings and credit associations and self-help organizations. Last but not least, there are relatives, friends, and neighbors who lend in times of need.

In many developing countries the formal financial sector consists of a very limited number of institutions serving only 5%-20% of the population. This means that poor people in developing countries depend on semi-formal and informal financial intermediaries.

Alternative financial institutions
Alternative financial institutions (AFIs) have evolved to serve those neglected by the formal financial sector. They aim for social and financial returns, without maximizing profits. The Consultative Group to Assist the Poor (CGAP) points out that since regulators often do not consider some AFIs part of the financial sector, this can result in inferior supervision compared to commercial banks.

The key types of AFIs are:

• Specialized microfinance institutions (MFIs) - organized as NGOs or licensed non-bank financial institutions that specialize in innovative loan techniques
• Commercial bank MFIs - programs or departments created in commercial banks
• Financial cooperatives and credit unions
• Low capital rural and local banks
• State development and agricultural banks
• Postal and non-postal savings banks

Another option is supply chain finance, where in most cases farmers do not receive cash but inputs in kind, such as fertilizer, seeds, pesticides etc. One limitation of supply chain finance is that is does not finance the farmers as entrepreneurs, but only their particular crop. Most of the financing is short-term rather than the medium-term often essential for improving product quality and growing the business.

Scaling up is critical
AFIs must deal with the problems that make their customers an unpopular bet for formal institutions - high risk, small scale and complex or high costs due to poor infrastructure. On top of this, AFIs may lack adequate funding and need to pass on their high costs to customers.

A lack of a banking license can restrict an AFI’s range of services, and this can mean that if economic development occurs, an AFI can no longer properly serve - and so lose - their best clients. This is perhaps the key issue in providing comprehensive financial mechanisms to developing nations, the difficulty of providing solutions in scale.

The aims for economic development echo those of ecological or agricultural development - sustainability and a healthy environment. The World Economic Forum's 2005 Financing for Development Initiative report touched on a promising way forward for tackling these challenges. Their conclusion was that PPPs (Public-Private Partnerships) have substantial potential for adding scale, efficiency and innovation to development efforts aimed at the poorest in society.

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