One of the major differences between these two types of supplier is the mechanisms used for dealing with the screening, incentives and monitoring problems with the informal sector relying much more heavily than the formal sector on their intimate knowledge of their clients to overcome these problems. Figure 8.
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Informal financial markets have always existed in rural areas, but were ignored by government policy for a very long time. The agricultural credit paradigm Box 8. First, that the operators in informal financial markets do not share the same commitment as government to promoting agricultural production. Second, they would charge exorbitant interest rates which, allegedly, agricultural producers could not afford to pay.
In many countries and for almost 30 years, governments hindered the spontaneous development of informal financial intermediaries by occupying, through subsidized operations, the market space that informal operators could have exploited and developed.
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With few exceptions, the consequences of the centralized and directed approach to agricultural credit were catastrophic. A fair number of agricultural credit banks were liquidated during the s and early s across the world, when it became clear that governments could not afford to:.
In addition, the results achieved in terms of impact on agricultural production were rather modest. This situation has prompted the elaboration of alternative policies based on a very different paradigm. Liberal economics and decentralization principles inspire the reform of the rural financial sector. Box 8. Improve the transparency and accountability of financial institutions dealing with rural people. Two approaches to decentralization of rural financial services can be distinguished. One approach involves a drastic reform or restructuring of government-owned financial institutions operating in rural areas, by shifting power away from the centre and changing responsibility and accountability systems through a combination of deconcentration and devolution measures.
The other approach aims at diversifying the ownership of the financial institutions operating in rural areas. This objective can be achieved in three major ways:. Changing the capital structure of government-owned agricultural development banks by selling a controlling interest to the private sector.
Encouraging the development of private banks and by eliminating subsidies and liquidating, restructuring or reducing the scope of operations of banks retained in the public sector. Promoting and regulating the emergence of new types of grassroots-based rural financial intermediaries. Naturally, all these ways of diversifying ownership can be implemented at the same time. When many service providers operate in capital markets a multiplicity of services delivery channels, distributing the power and influence associated with the control of financial flows, is created.
Competition and a variety of policies, new financial technologies and products are introduced. In rural areas, the starting point for elaborating the policy implications of the new paradigm is a clear separation of the agricultural credit and the extension functions. Promoting the adoption of new agricultural technologies is the task of extension, not of credit. There is a strong case for governments to decentralize their rural financial services, let rural financial services develop in the private and non-profit mutualistic sectors and, where and when appropriate, reduce the overwhelming presence of public financial institutions.
The new role of government is thus support of institutional development, rather than promotion of targeted incremental crop production through financial intermediation. This new role embraces the setting of a favourable environment, the introduction of appropriate legislation, a regulatory role and, perhaps, financial and technical support to promote new organizations. Besides the measures outlined above related to reforming state banks and diversifying ownership, support to institutional development means that an enabling environment is created by enacting appropriate legislation to:.
Protect financial intermediaries from undue interference with their autonomous decision making processes and management of their affairs. All formal financial institutions are subject to these rules. Formal intermediaries are registered, must obtain a licence to do business and are required to operate in accordance with regulations issued by the national monetary authorities.
Their activities are subject to inspection by the Central Bank or a Superintendent of banks and financial institutions and they incur sanctions for non-compliance with the rules. The distinguishing feature that differentiates formal from informal financial markets regards the regulation and supervision of the intermediaries by the monetary authority. Informal intermediaries often are unregistered; they do not require licences and are they are not subject to Central Bank rules and inspections. As the importance of rural micro-finance institutions MFIs in the local capital markets increases see Section 8.
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The need then arises for government to deal with them in similar terms to those used for formal institutions. The monetary authorities thus increasingly assume responsibility for the supervision of their activities, with a view to sound management of money, rather than Ministries of Agriculture whose primary interest is agricultural production. Regulation and supervision may cause more problems than those they are intended to overcome. For example, regulations related to registration, licensing, and inspection may offer opportunities for interference and corruption and supervisors, in addition to their task of overseeing banks, may not devote enough staff and time to inspect adequately a large number of new types of small rural financial institutions.
Rules and controls of financial institutions normally:. Aim at sound and prudent banking practices and respect, by the management, of the law and of the by-laws of the institutions as set by the shareholders. Such rules deal with problems common to all financial institutions, and must be respected by all. Detailed regulations, however, differ depending on the nature of the regulated institutions. Manage the national money supply : this requires the continuous verification of the level of the financial aggregates such as money in circulation and volume of credit, and taking measures to influence their trend.
Protect the interest of depositors and the stability of the overall national financial system : this requires ensuring that the administrators of financial institutions act in accordance with the law and with sound banking practices. Accordingly, the main objectives of the rules and controls over decentralized rural financial institutions should be to ensure that:.
The decision-making and accountability procedures of the organizations are in accordance with the law and with the by-laws of each organization and that management follow them properly, for instance, ensuring that accurate and timely banking records are kept, etc. Accounting and audit procedures are transparent, adequate, properly and timelessly followed by the management, and that shareholders have access to independent internal and external audit reports.
Lending and savings mobilization policies, procedures, and management are conducive to financial sustainability, and minimize the risk of fraud and loan delinquency.
Bank Corporate Governance: A New Paradigm
The elaboration of such rules, and the controls required for their enforcement, is not in the field of competence of Ministries of Agriculture, but is in the natural domain of the monetary authorities. Rules need to be established centrally, whereas controls can either be centralized or delegated. One option is for the central monetary authorities to take over direct responsibility for inspections of rural MFIs, as they do in the case of banks and other formally-established financial intermediaries. Another option is to delegate the control of decentralized financial service institutions to the apex body of cooperatives or MFIs.
The latter would, in turn, be directly controlled by the monetary authorities, and would be responsible to them for controlling their member MFIs. A special opportunity for delegation is presented when MFIs are promoted and supported by a commercial or a development bank. In these cases, the commercial or development bank, which is under the control of the national monetary authorities, will supervise in its own interest the operations of the MFIs that they help to develop. Subsidies would assist primarily with capacity building aimed at increasing the staff and managerial skills of the new institutions.
These subsidies may be justified on the grounds that institutional development and diversification of service providers are public goods that help to deal with financial market failures. They are not intended to fill gaps in operating income or interfere with interest rates and the free play of market forces.
Support activities eligible for subsidies would include:. Initial assistance in keeping adequate accounts and drafting balance sheet and income statements.
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Loans, but not grants, at market or near market terms to the new rural financial institutions, may also be justified providing banks follow normal risk assessment practices in making loans with a view to expanding their operations beyond the resources that they are able to mobilize by way of savings deposits. Governments may also support the start-up process of designing innovative credit guarantee approaches for banks FAO, b.
However, banks ought to assume a good share of the risk in order to ensure that they assess their clients effectively. Sustainability requires financial institutions, irrespective of their size and nature, to respect sound banking practices. They should not borrow funds that they may not be able to remunerate at market rates of interest. The market will determine to what extent MFIs are sufficiently creditworthy customers for higher level and larger financial intermediaries to lend money to them.
Deconcentration involves transferring the responsibility of operating as profit centres to local branches and sub-branches capable of expanding their outreach on a viable and sustainable basis. Full autonomy is granted to front-line managers to decide how best to achieve the objective. This approach has been successfully tested in Indonesia, where it turned a non-performing agricultural development bank, Bank Rakyat Indonesia BRI , into a viable and very dynamic provider of rural financial services Box 8.
The successful reform process was made possible by the favourable environment that had been established in Indonesia in terms of macroeconomic stability, a differentiated financial infrastructure, prudent deregulation and liberalization of the domestic market and of foreign trade. Strict adherence to principles of viability, self reliance, sustainability and broadening of outreach. After the reform, BRI mobilizes rural savings and lends out funds collected in the rural areas. However, a significant transfer of power has taken place, since local managers respond to local market signals and not to central government directives.
Because of the independence of decision-making in branch and sub-branch management, the reform of the BRI has resulted in a substantial devolution of responsibilities and resources. This involves new tasks at all levels and is not a simple deconcentration of functions and offices. Several new liberal governments have tried to privatize government-owned agricultural banks. In practice, there have been many difficulties due to the problem of capital valuation and to the poor expectations of profit from future operations.
Short of outright fraud, government banks are in financial trouble for two main reasons:. Excessive operating costs overstaffing, unprofitable branches, low staff productivity, wrong personnel policies, inadequate spread between active and passive interest rates, etc. Excessive operating costs can eventually be corrected by new management, provided labour legislation does not impose too much rigidity, but the poor quality of the loan portfolio may often be difficult to remedy in the short- to medium-term.
Thus governments are unlikely to find a buyer for take-over unless they clear the portfolio of bad loans. In some cases, the bulk of bad loans are held by bankrupt government enterprises. However, buying out delinquent debtors is a poor solution, because it does not establish an encouraging environment for making new loans. Transferring non-performing assets to a separate company responsible for recovering them has also been tried, but it did not always ensure the financial recovery of the original lender.
The second option involves the liquidation of non-viable government banks, coupled with allowing the entry of foreign capital and the encouragement of local private groups to form joint ventures with foreign banking groups. The rise of credit risk measurement and the credit derivatives market started in the early s and has grown ever since.
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