Development Discussion Papers - Harvard University filecommercial credit program, KUPEDES, and 11.2...

Harvard Institute forInternational Development

HARVARD UNIVERSITY

Development Discussion Papers

Financial Intermediation at the Local Level:Lessons from Indonesia, Part Two

A Theoretical Perspective

Marguerite S. Robinson

Development Discussion Paper No. 482March 1994

© Copyright 1994 Marguerite S. Robinsonand President and Fellows of Harvard College

HIID Development Discussion Paper no. 482

i

FINANCIAL INTERMEDIATION AT THE LOCAL LEVEL:LESSONS FROM INDONESIA

PART TWO

A THEORETICAL PERSPECTIVE


This paper constitutes Part Two in a three-part series, "Financial Intermediation at the Local Level: Lessons fromIndonesia." These will be incorporated into a forthcoming book; readers' comments are invited as input into the book. The three parts of the series are:

Part One - The Bank Rakyat Indonesia:Rural Banking, 1970-91 (October 1992)

Part Two - Financial Intermediation at the Local Level: A Theoretical Perspective (March 1994)

Part Three - Financial Intermediation atthe Local Level: A Policy Perspective(Forthcoming)

Harvard Institute for International DevelopmentHarvard University

One Eliot StreetCambridge, Massachusetts 02138


ii

ABSTRACT

The local banking system of Bank Rakyat Indonesia (BRI) constitutes the largest sustainable system of localfinancial intermediation in any developing country in the world. Known as BRI's unit banking system, the network ofabout 4000 unit banks and sub-units have, as of October 31, 1993, 1.9 million loans outstanding in their generalcommercial credit program, KUPEDES, and 11.2 million deposit accounts. Credit outstanding totals $886 millionwhich is fully financed by $2 billion of local savings. The KUPEDES long-term loss ratio is 3.1 percent. However,when the Indonesian government made the decision in 1983 to build this nationwide system of local financialintermediation which would be expected to run without ongoing subsidies, there were no successful examples to befound on a large scale in other developing countries. An important reason was that prevailing economic theories oftendid not take into account crucial socio-political realities of the local areas of developing countries. The result was thatwhen the models were applied, they frequently did not fit.

This paper, Part Two of a three-part series, explores the implications of the Indonesian approach to localfinance for economic theories of local financial markets in developing countries. Part One of the series (October1992) provided an overview of BRI's experience in transforming Indonesia's local banking system from a channelingagent for subsidized funds to a profitable system serving the local levels of the country nationwide. Part Three(forthcoming) will consider the policy implications of the Indonesian experience and will examine the possibilities fortransfer and adaptation of lessons learned to other institutions and countries; present examples of such adaptations willbe analyzed. Each paper in the series can be read alone; however the conclusions will be best understood if the papersare read together. Part One concentrated on rural financial markets. In Parts Two and Three, however, the discussionhas been broadened to include local financial markets in rural, urban, and peri-urban areas, incorporating householdsand small and microenterprises in all geographical settings. The present paper, Part Two, is divided into threesections. In Section I the argument is made that there is in process a paradigm shift in local finance, i.e., from creditdelivery to local-level financial intermediation. In this context, Section II reviews and critiques four main streams ofliterature related to local financial markets: (1) supply-leading finance; (2) informal commercial credit; (3) asymmetricinformation, moral hazard, and adverse selection; and (4) local-level savings. Drawing on the experiences of BRI andother financial institutions, and on the results of the literature review, Section III suggests a model of Local FinancialIntermediation (LFI) that helps to explain the reasons for the paradigm shift.

The LFI model draws from previous models of local finance, but highlights the shift from credit delivery tofinancial intermediation. It assumes a complex local financial system with formal and informal components thatinteract in multiple ways. Based on the assumptions provided in Section III of the paper, the model states that wellplanned and well managed financial institutions serving the local level can be both economically and sociallyprofitable. The LFI model assumes that the evolution of a more efficient formal sector serving the local levels ofdeveloping countries will include the development of conveniently located institutions that will: (1) lend widely at thelocal level at commercial interest rates; (2) maintain low default rates through knowledge of the markets and theclients served; (3) mobilize savings locally with deposit instruments appropriate for local demand; (4) provide loans atcommercial rates to low-income clients, substituting group lending and peer monitoring for collateral; and (5)establish a spread between loan and deposit interest rates that enables institutional profitability and sustainability forthe long-term. It is argued that the LFI model is widely applicable in developing countries.


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ACKNOWLEDGEMENTS

The research on which these papers are based was supported by the Ministry of Finance, Government ofIndonesia. The author is grateful to the Ministry of Finance and the Coordinating Minister for Economy, Finance, andIndustry, for the support provided and for the extensive information made available on development, banking, andgovernmentpolicy. She is deeply indebted to the Bank Rakyat Indonesia (BRI) and to Mr. Kamardy Arief, BRI President-Director(1983-1992), and to Mr. Sugianto, BRI's Director responsible for banking at the local level. She would like to thankthe Center for Policy and Implementation Studies in Jakarta, and the many people with whom she worked there ascoordinator of the rural banking group.

The author continues to be indebted to the many people acknowledged in Part One of this series. During theperiod since Part One was written, many others have contributed to her knowledge of local financial markets. Theseinclude: Ernst A. Brugger, William Burrus, Barbara Calvin, Martha Chen, Robert Christen, Michael Chu, MoniqueCohen, Matthew S. Gamser, Mohini Malhotra, Kimanthi A. Mutua, Sergio Ortiz, Franciso Otero, Maria Otero, MariaElena Querejazu, Elizabeth Rhyne, Richard Rosenberg, and Miguel Taborga. The author is grateful to Carol Grotrianand Pamela Baldwin for their helpful assistance in the preparation of this manuscript.


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TABLE OF CONTENTS

Page I. LOCAL LEVEL FINANCE: SHIFTING THE PARADIGM 1

A. LOCAL FINANCIAL MARKETS 2

B. FROM CREDIT DELIVERY TO FINANCIAL INTERMEDIATION 5

C. THE INDONESIAN EXAMPLE: A SUMMARY OF 15THE BRI EXPERIENCE

1. The Development of BRI's Unit Banking System 15

2. Four Questions about the Indonesian Example 16

II. THEORIES OF LOCAL FINANCIAL MARKETS: REVIEW AND CRITIQUE 30

A. PREVENTING SUSTAINABLE FINANCIAL INTERMEDIATION AT 30THE LOCAL LEVEL THROUGH CREDIT SUBSIDIES

1. Theories of Supply-Leading Finance 30

2. Supply-Leading Finance and Subsidized Credit Programs: 32 the Critiques

3. Subsidizing Financial Institutions in Order to Provide Credit at 35 Commercial Interest Rates: What Happens?

4. Summary: Credit Subsidies as A Triple Threat to Financial 41 Intermediation


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Page

B. UNDERMINING FINANCIAL INSTITUTIONS WITH THE 'IF 43IT'S NOT BROKE DON'T FIX IT' THEORY OF INFORMAL COMMERCIAL CREDIT

1. Informal Credit Markets: the Issues 43

2. The Size of Informal Credit Markets 46

3. Characteristics of Informal Commercial Loans 51

4. Informal Commercial Credit: Interest Rates 54

5. The Interest Rate Debates 59

6. The 'Many Lenders' Syndrome 63

C. USING COMMON SENSE TO OVERCOME ASYMMETRIC 70INFORMATION, MORAL HAZARD, AND ADVERSE SELECTION

1. Asymmetric Information 70

2. Overcoming Asymmetric Information Flows: Evidence from BRI 73

3. Overcoming Asymmetric Information Flows: Evidence from Other 77 Institutions and Countries

D. THE ROLE OF SAVINGS IN THE FINANCIAL INTERMEDIATION 78PARADIGM

1. The Low Level of Institutional Deposits: a Supply-side Problem 79

2. Voluntary Savings Mobilization: Multiple Benefits 82

E. CRITIQUE OF SELECTED LITERATURE ON LOCAL FINANCIAL 86

MARKETS: SUMMARY OF CONCLUSIONS


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Page

III. THE LOCAL FINANCIAL INTERMEDIATION MODEL 90

A. COMPARISON WITH OTHER MODELS OF LOCAL FINANCE 90

B. ASSUMPTIONS OF THE LOCAL FINANCIAL INTERMEDIATION 92MODEL

C. MODELS AND REALITY: IMPROVING THE FIT 96

REFERENCES 97


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PageLIST OF CHARTS

1. BRI Unit Bank Deposits and KUPEDES Credit Outstanding 20

2. Number of Loans in the BRI Unit Banking System, 1984-1993 21

3. Number of Deposit Accounts in the BRI Unit Banking System, 221984-1993.

LIST OF TABLES

1. Indonesian Consumer Price Index and Rupiah/Dollar Exchange 23Rates, 1970-1993

2. KUPEDES Credit in the BRI Unit Banking System, 1984-1993 24

3. Deposits in the BRI Unit Banking System. 1984-1993 25

4. Number of BRI Unit Banks 26

5. Household Borrowing in Three Indonesian Villages: 48Source of Largest Loan, 1980-1981


Part One concentrated on rural financial markets. In Parts Two and Three, however, the discussion has been1

broadened to include local financial markets in rural, urban, and peri-urban areas, incorporating households and smalland microenterprises in all geographical settings.

1

FINANCIAL INTERMEDIATION AT THE LOCAL LEVEL:

LESSONS FROM INDONESIA

PART TWO

A THEORETICAL PERSPECTIVE


Development Discussion Paper No.

March 1994

I. LOCAL LEVEL FINANCE: SHIFTING THE PARADIGM

When the Indonesian government made the decision in 1983 to build a nationwide system of local financial

intermediation which would be expected to run without subsidies, there were no successful examples to be found on a

large scale in other developing countries. An important reason was that prevailing economic theories often did not

take into account crucial socio-political realities of the local areas of developing countries. The result was that when

the models were applied, they frequently did not fit. It is for these reasons that the Indonesian experience in local

financial markets is reviewed in these papers in both theoretical and policy-related contexts. This paper constitutes

Part Two of a three-part series.

Part One (October 1992) provides an overview of the theoretical and policy implications of the experience of

Indonesia's Bank Rakyat Indonesia (BRI) in transforming its local banking system from a channeling agent for

subsidized funds to a profitable system serving the local levels of the country nationwide. The intent of this paper1

(Part Two) is to explore more extensively the implications of the BRI experience for economic theories of local

financial markets in developing countries. Other financial institutions are also included in the discussion, but the

emphasis is on BRI because it constitutes the largest sustainable system of local financial intermediation in any

See Germidis, Kessler, and Meghir (1991) for extensive discussion of the characteristics of the formal and2

informal financial sectors, semi-formal bodies, and the varied relationships among these.

2

developing country. Part Three (forthcoming) will consider the policy implications of the BRI experience and will

examine the possibilities for transfer and adaption among different institutions and countries. A variety of policy

reforms and institutional changes which can improve local financial markets will be suggested there. Each paper in

the series can be read alone without previous knowledge of the issues. However the conclusions will be best

understood if the papers are read together.

The present paper, Part Two, is divided into three sections. In Section I the argument is made that there is in

process a paradigm shift in local finance, i.e., from credit delivery to local-level financial intermediation. In this

context, Section II reviews and critiques four main streams of literature related to local financial markets: (1) supply-

leading finance; (2) informal commercial credit; (3) asymmetric information, moral hazard, and adverse selection; and

(4) local-level savings. Drawing on the experiences of BRI and other financial institutions, and on the results of the

literature review, Section III suggests a model of financial intermediation at the local level that helps to explain the

Financial Intermediation paradigm.

I. A. LOCAL FINANCIAL MARKETS

Local financial markets in developing countries are typically characterized by a mix of formal, quasi-formal,

and informal components. The formal financial sector in developing countries, incorporating both banks and non-2

bank financial intermediaries, covers a wide variety of institutions ranging from the Central Bank and Treasury

administration to the post office savings system and credit cooperatives. The formal sector, which includes banks,

insurance companies, social security schemes, pension funds (and capital markets in some countries, as in Indonesia),

is largely urban-based and organized primarily to supply the financial needs of the modern sector. In contrast,

informal financial markets serve multiple sectors, financing a wide range of income groups and geographical areas.

Characterized, in general, by personal relationships, individual operators, ease of access, simple procedures, rapid

transactions, flexible loan terms and amounts, and high interest rates for informal commercial credit, informal

financial markets are ubiquitous. They coexist at the local level with the formal financial sector, interacting with the

latter in numerous ways and in varying degrees. While informal markets are uncontrolled and unregulated by the

formal sector, it has long been recognized that these markets are not unorganized. Thus, informal commercial credit is

typically incorporated into the local political economy, with financial channels and market shares of lenders organized

accordingly. Also some informal lenders are financed through the formal sector, and some operate through

institutions (such as informal finance and investment companies). Informal markets are linked in a variety of ways

with the formal financial sector and with quasi-formal bodies. The latter are unlicensed and generally unsupervised

financial intermediaries which may, nevertheless, operate under particular laws and regulations. Some credit

cooperatives, credit unions, and various forms of credit societies and finance 'companies' in this category also provide

For example: "Savings and credit cooperatives and credit unions have a different legal status from one country to3

another. In some cases, they may be full-fledged legal entities regulated by government and can thus be considered aspart of the formal financial sector, as are co-operative banks in India, for instance. In other cases, they have whatcould be characterized as a more 'semi-formal' status: in Zimbabwe, for example, there is no full, obligatoryregistration or regular supervision of co-operatives, but their rules of functioning are laid down by law. Finally, thereare cases where the co-operative and credit union movements - even those which are government sponsored - areconsidered part of the informal sector, as in the Philippines. However, many, if not most of these organizations haveaccounts with banks where the collected savings are deposited, so that these funds are, in effect, introduced intoformal financial channels" (Germidis, Kessler, and Meghir, op. cit., p. 81).

Weiss (n.d.), p. 61. 4

Bell and Srinivasan (1989).5

See Bell (1993); Robinson (1988).6

3

facilities for savings and loans. Although quasi-formal financial bodies can play an important role in local finance,

they are outside the scope of this paper which focuses on the relation between informal commercial credit (from

moneylenders, commodity wholesalers, employers, etc.) and formal-sector financial intermediaries.

The formal-informal distinction is not a dichotomy but a continuum. Various kinds of financial intermediar-

ies (e.g., pawnshops, small-scale finance companies, cooperatives and credit unions) occupy positions on the formal-

informal axis which vary by country and even sometimes by region, as well as over time. Local financial markets in3

developing countries are best understood by analysis of their dynamics. In a paper on urbanization in developing

countries, Dieter Weiss wrote: "There is no clear-cut division between a 'formal' and an 'informal' sector. . . . The

complex reality could be better described as a continuum with sliding transitions." This is true as well for local4

financial markets in developing countries.

An important contribution of the recent literature on local markets is the demonstration of a variety of

complex interactions among markets beyond the price and income interactions traditionally incorporated in economic

theory. Transactions involving credit linkages with trade, land, and labor have been extensively explored. Different

local situations, of course, provide different kinds of market interlinkages. Thus, in competitive markets interlinked

transactions may serve to reduce risk, expand financial intermediation, and contribute to economic development at the

local level. For example, Bell and Srinivasan show that in commercialized areas of India important trade-credit

interlinkages between farmers and urban traders and commission agents developed as a result of the increasing

agricultural production made possible by green revolution technology. As they point out, these market linkages are

"not remnants of an old agrarian order" (as has often been assumed); they serve rather as mechanisms which permit

urban financing of the increasing marketable agricultural surpluses." However, the opposite can occur in5

monopolistic markets. Interlinked markets in parts of India provide a good example: land, credit, labor and

commodities markets converge in the person of the monopolistic landlord / cultivator / employer / moneylender /

trader. In some cases, the monopolies have been buttressed by subsidies provided by the formal sector to these multi-6

faceted local elites.

Hoff, Braverman, and Stiglitz, eds. (1993).7

Ibid.8

For a recent overview of the concept, see Germidis, Kessler, and Meghir, op. cit., Chapter 1.9

See Von Pischke (1991) for analysis of finance: (a) 'inside the frontier', i.e., institutional finance "organized on a10

formal, structured, hierarchical, impersonal and often centralized basis" (p. 1); (b) 'beyond the frontier' where "mostfinancial transactions are personalized and conducted directly, without intermediaries" (p. 2); and (c) at the frontieritself.

"The interpenetration between the two sectors [formal and informal] in terms of the operations and participants11

(lenders, borrowers, savers) involved, geographic location, the nature of activities, also results in a sometimessubstantial flow of funds - in both directions - between them" (Germidis, Kessler, and Meghir, op. cit., p. 13).

Ibid., p. 12.12

Ibid., p. 19.13

4

Hoff, Braverman, and Stiglitz have recently reviewed the ways in which growth in one market can affect the

operations of others, through effects on information, contracts, production decisions, etc. Many of these are positive;7

for example, interactions can reduce information costs and risks within particular markets. This occurs in various

ways: e.g., an increase in activity in goods markets generates interlinked trade-credit contracts which can serve as a

substitute for collateral, thus expanding the credit market; diversification of production reduces co-variance of risk

and seasonality of credit demands, thus increasing possibilities for financial intermediation, etc. Knowledge of such8

interlinkages is essential for improving local financial markets; however it appears that such information is rarely

requested or considered by policy makers.

Interlinkages between formal and informal finance have been analyzed in various ways: traditionally through

the concept of 'financial dualism', and more recently through: (a) the assumption of a 'frontier' between the two9 10

systems and emphasis on the sustainable outward expansion of the frontier between them; and (b) through a model of

mutual interpenetration of the two sectors involving their financial operations, overlapping participants, flows of11

funds, etc. The interpenetration model assumes that:

The informal sector . . . has beneficial effects which would disappear if its role was taken over by the formalsector. . . . It would always be more advisable to look for better linkage between the two sectors. For this tosucceed, both would need to evolve and change simultaneously." This model assumes further that:12

"Integration ['absorption of the informal by the formal sector'] and interlinkage [are] undertaken concurrently- and they involve both microeconomic and macroeconomic measures. Moreover, in a dynamic context,integration and linkage are sequential: linkage in the short term will bring on integration in the long term.13

Which of the various models best explains reality is of direct policy concern, as well as of theoretical interest.

There are crucial policy implications involved in these debates. Thus, assumption of 'financial dualism' tends to lead to

policies aimed at institutionalizing the informal financial sector; focus on the 'frontier' has a similar aim but a different

See Roemer and Jones (1991). Parallel market is defined there as "a structure generated in response to14

government interventions that create a situation of excess supply or demand in a particular product or factormarket"(p. 4). Following Roemer and Jones, black markets referto illegal markets; some are also parallel markets (including black financial markets for 'laundering money'), whileothers are not (i.e., cocaine, for which there is no legal market). Most parallel markets are black, but some are legal,e.g., the curb market in domestic credit which is encouraged in Taiwan (Ibid., p. 5).

Japan is a notable exception. The informal economy has been, in various ways, explicitly incorporated into15

Japanese economic planning since the Meiji Restoration of 1868. See Rosovsky and Ohkawa (1961) and Ohkawaand Rosovsky (1965).

5

strategy. The former leads to direct attempts to replace informal finance with formal; the latter to efforts to 'push the

frontier outward' in sustainable ways which incorporate into the formal sector selected aspects of informal finance.

The interpenetration model, however, emphasizes the evolution of multiple linkages of formal and informal finance.

In Section III of this paper, a model of local-level financial intermediation is developed. This model assumes

a local financial market which includes informal and formal markets, as well as parallel and black markets. The14

model incorporates changing components located on different axes: formality, scale, legality, etc. These combine in

different ways for different purposes; the linkages themselves are components of the model. Linkages occur vertically

as well as horizontally, i.e. national, regional, and local arenas are frequently linked through financial networks in

which formal finance is blended with and incorporated into informal, parallel, and black markets. These can be

illustrated respectively by arbitrage in the local credit market; institutional financing of the production of commodities

sold in parallel markets; and use of a combination of formal and informal financial channels to deliver payment from

urban drug buyers to their rural suppliers.

This paper explores ways in which the explanatory power of models can be improved by testing them in real

situations found in developing countries, and it suggests a model of local-level financial intermediation based on the

results of this process. Some countries and regions are too under-developed for this model to be useful, others too

advanced. However, much of the developing world is within the range in which the model presented here may be

helpful.

I. B. FROM CREDIT DELIVERY TO FINANCIAL INTERMEDIATION

During the first two-thirds of the twentieth century, small and microenterprises (SMEs) were largely invisible

- in government plans, economists' models, and bankers' portfolios. Beginning in the late 1960s, however, the role15

of these enterprises in the wider economy began to attract the notice of a few anthropologists, economists,

governments, and donor agencies. In part because of the international economic crisis of the 1980s, policymakers

have recently begun to realize that SMEs provide employment, create value added, provide essential goods and

services at relatively low prices to lower-income households, and contribute to social welfare and to national political

"The original concern with "small farmer credit problems" has become only a proxy (shorthand) for a16

preoccupation with difficulties of access to financial services by particular groups of society" (Gonzalez-Vega, 1993,p. 5). See also Otero and Rhyne, eds. (forthcoming 1994).

6

stability. It has become more widely noticed that, despite their frequent lack both of legal status and of access to

institutional finance, SMEs typically work on sound business principles.

In this context, increasing attention has begun to be given to the financing of such enterprises. In many parts

of the developing world, financial institutions supply only a very small fraction of the demand for financial services at

the local level. Most households and SMEs in most developing countries do not have access to institutional credit or

deposit facilities. There are, of course, differences among countries and regions, among rural and urban areas, and

among small enterprises, microenterprises, and households. However, these are considered together here because, for

the purposes of this discussion, they share one crucial characteristic: insufficient access to institutional finance.

The concern with the lack of access of lower-income people to institutional finance began in a sustained way

in the 1950s, but for several decades international attention to the problem was largely restricted to agricultural credit.

Over time, however, the issue that has emerged is finance for lower-income people of all types. Therefore, in this16

paper the term small and microenterprises (SMEs) is used as a proxy for small enterprises, microenterprises, and

households in developing countries - most of which do not have access to formal financial services. Typically, they

finance themselves, borrow from relatives, neighbors and friends, or borrow on the informal commercial credit

market - usually at high interest rates. Formal-sector financial institutions normally do not finance lower-income

borrowers, except when the institution acts as a channeling agent for subsidized credit programs funded by the

government and/or donor agencies.

The reasons that financial institutions generally have not provided financial services to SMEs, glossed as

above, include the following:

(1) It has been widely assumed that financial institutions cannot provide small loans profitably because of

transaction costs and risk.

(2) It has been observed that many subsidized credit programs serving the local areas of developing

countries have resulted in high arrears.

(3) It is widely believed that the risk to the financing institution is high because of asymmetric information at

the local level, and because financial institutions cannot compete with informal lenders who have better

information about local borrowers.

(4) It is thought that the informal commercial credit market works efficiently and helps the poor and that,

therefore, from a development perspective, there is no compelling reason to 'fix what is not broken'.

It should be noted in this context, that the Bank Dagang Bali (BDB), a private bank in Bali, preceded BRI in17

becoming a successful financial intermediary at the local level. BDB did so during the 1970s, although on a muchsmaller scale than the BRI accomplished a decade later.

The term unit bank has a special meaning in Indonesia. BRI's sub-district-level banks were originally called18

village units (unit desa); when urban units (unit kota) were added in the late 1980s, the term unit bank came to be usedfor all BRI's local banks, both rural and urban.Known as the unit banking system, it operates at the sub-district (kecamatan) level, serving the villages of each sub-district and selected urban neighborhoods; the unit banks are under the supervision of the BRI branch, regional, andhead offices.

BRI uses two measures of long-term arrears. Portfolio status measures present arrears as a proportion of present19

credit outstanding. Since current outstanding includes loans not yet due, long-term loss ratio (LTR) is considered themore accurate measure of the program's loan recovery. LTR is the ratio of the cumulative amount which has come duebut which has not been paid, to the total amount which has come due. As of October 31, 1993, the KUPEDESPortfolio status was 7.10 percent; the LTR was 3.13 percent.

7

(5) It is nearly universally assumed that a significant level of deposits cannot be raised at the local level, both

because of presumed 'undersavings' and because of the belief that the local levels of developing countries are

populated primarily by people who do not understand formal finance, who do not trust financial institutions,

and who would not deposit voluntary savings in formal-sector institutions.

(6) It is, therefore, believed that the financing of small and microenterprises would be unprofitable for the

implementing institution and would provide a continuing drain on government budgets and donor funds.

Institutional credit provided at the local level in developing countries has been primarily in the form of

subsidized credit programs that provide a limited volume of low-cost credit. Because these loans are typically below

market-rate, scarce, and desirable, they tend to be allocated to the local elites who have the influence to obtain them;

typically these programs suffer heavy losses. In general, such credit programs, despite their original intentions, have

not served as a major source of financing for SMEs.

However, the BRI, one of Indonesia's five state-owned commercial banks, chose a different approach to local

finance: profitable financial intermediation. During the 1980s BRI created a sustainable nationwide banking system

that operates at the sub-district level in both rural and urban areas; the system mobilizes voluntary deposits and

provides loans at commercial interest rates. In the process the bank demolished the assumptions cited above

concerning the difficulties widely believed to be inherent in local-level financial intermediation in developing

countries. BRI's system of banking for the local level, known as its unit banking system, began in 1984 in the17 18

rural areas of the country; it was extended to the urban areas in 1989. In the nearly ten years between December 31,

1983 and October 31, 1993, the unit banking system extended Rp 10.8 trillion in 12.9 million loans in its general rural

credit program (KUPEDES) offered at commercial interest rates. As of October 31, 1993, KUPEDES credit

outstanding was Rp 1.86 trillion (US $886 million) in 1.9 million loans; the long-term loss ratio is 3.13 percent. 19

There is also considerable demand for institutional finance among lower-income people in developed countries.20

This challenging topic, however, is beyond the scope of this series of papers.

8

Unit bank deposits in 11.2 million accounts totalled Rp 4.2 trillion (US $2 billion) on the same date (see Tables 1 - 4

and Charts 1 - 3).

During the 1980s, a number of other financial institutions showed that it is possible to lend to low-income

borrowers and to recover the loans (e.g. the Grameen Bank in Bangladesh; the Fundacion para la Promocion y

Desarrollo de la Micro Empresa (PRODEM) in Bolivia; the Asociacion para el Desarrollo de la Microempresa

(ADEMI) in the Dominican Republic; and the Badan Kredit Kecamatan (BKK) in Central Java (Indonesia).

However, what BRI demonstrated is that institutions can successfully provide lower-income households and

enterprises not only with loans but also with deposit services - and can do so profitably, on a large scale, and without

ongoing subsidies. By taking a financial systems approach to SME finance, BRI built a banking system that is both

economically and socially profitable, and that now serves as a model for institutions in other developing countries.

The widespread realization in the 1980s that SMEs contribute significantly to the economy converged with (and

helped to start) the BRI system of large-scale profitable financial intermediation among lower-income people. As a

result of this convergence, greatly increased attention has begun to be given to local-level finance in developing

countries worldwide. Recently a number of other financial institutions have begun to show interest in shifting from

credit institutions to financial intermediaries that both collect voluntary deposits and provide loans at commercial

interest rates.

The focus of this paper is on effective ways to reach the large numbers of people in the developing world

who want access to institutional financial services, and this requires institutional sustainability. The emphasis here,20

therefore, is on how financial institutions can deliver services profitably at the local level. However, it must be noted

that there are important roles for many different kinds of financial institutions at the local credit unions, non-bank

financial institutions, non-government organizations (NGOs), etc. Nevertheless, the massive demand for financial

services from SMEs in developing countries throughout the world can be supplied in sufficient volume only by

profitable financial intermediaries. SME finance needs substantially increased access to capital markets. While this is

likely to occur increasingly in the future as investors begin to understand that local level finance can be profitable,

commercial investors are not now major funders of SME credit. However, in developing countries characterized by

reasonable levels of macro-economic management and political stability, and by the absence of laws and regulations

that prohibit profitable financial intermediation, locally-mobilized savings is likely to be the most immediately

available substantial source of funds for SME loans.

Thus, the events of the 1980s have shown that there is huge SME demand for institutional finance and that,

with an enabling macro-environment, financial intermediation at the local-level can be profitable. The new paradigm

- the shift from credit delivery to profitable financial intermediation - is of crucial importance for social and economic

development in the 1990s. However, if profitable financial intermediation is to become an integral part of the

development of many countries in the coming decades, it will be necessary to discard six prevailing myths that are still

See Adams (1978). 21

9

widely believed within many governments, banks, and donor agencies. These are summarized below and discussed

further in the paper; all have been shattered by the Indonesian experience.

Myth 1: In developing countries, SMEs are characterized by pervasive 'undersavings'.

This myth is based on the assumption that rural households in general and Small and

microenterprises in urban areas normally do not save - either, it is assumed, because they must consume

whatever they earn, or because they prefer to do so. This view was widely held in Indonesia before 1984. In

the decade before 1984, BRI's local banking system mobilized only $17.6 million dollars in voluntary

savings in its over 3600 unit banks; this was attributed by the government and the banks primarily to

'undersavings' at the local level. In the decade following, BRI profitably mobilized $2 billion of voluntary

savings in the system. The low level of deposits at the local level in Indonesia had not been a result of low

demand, but of poor supply.

Myth 2: Demand for financial savings instruments is low among SMEs in developing countries.

This myth is based primarily on three assumptions:

(1) Those who do save prefer non-financial forms.

(2) SMEs do not trust financial institutions. Therefore, if they have cash they keep it in the house or in

informal associations, such as ROSCAs.

(3) To obtain deposits from such sources, institutions must require forced savings as a condition of loans.

There is, however, considerable evidence for extensive savings at the local level in developing

countries, based on data collected worldwide for more than three decades. It has long been argued that

financial markets influence both the forms in which savings are held and the amount of potential

consumption which is diverted to savings. However, neither the extensive evidence nor the well-developed21

analyses available has so far had much influence on policy decisions affecting the development of local

financial institutions. Thus, the majority of institutional projects for rural finance in developing countries are

For discussion of the problem caused by the bias against rural savings, see Adams and Graham (1981); Vogel22

(1979, 1984b); Adams and Vogel (1986); Adams (1988); Von Pischke (1991). For an example of the assumptionsthat propensity to save is low in most rural areas and that rural savings mobilization is generally considered difficult,see Braverman and Guasch (1986).

See, for example, Lewis (1955); Leibenstein (1957); Higgins (1959); and Patrick (1983, extracted from Patrick,23

1966). For early dissenting opinions on supply-leading finance, see Li (1952), Mellor (1966), Penny (1983, extractedfrom Penny, 1968).

For discussion of the problems of subsidized rural credit programs, see, among others, Penny (1983, op. cit.;24

Adams (1971); USAID (1973); Donald (1976); Gonzalez-Vega (1976); Lipton (1976); Von Pischke, Adams, andDonald, eds. (1983); Adams, Graham, and Von Pischke, eds. (1984); Meyer (1985); Von Pischke, op. cit. For arecent review of the history and issues see Gonzalez-Vega (1993).

10

still concerned only with credit. It is widely assumed that rural inhabitants in general, and small and22

microenterprises in urban areas do not trust financial institutions and will not voluntarily save in them. It is

likely, however, that in countries with enabling macro-economic and political environments, low deposits in

financial institutions serving the local level demonstrate not lack of trust, but lack of appropriate institutions

and instruments. The supply constraint is not widely recognized; this, in turn, leads to severe underemphasis

of the importance of building financial institutions that serve the local level. These, of course, can be

sustainable for the long term only if they mobilize deposits, and this is usually assumed to be too difficult.

An important result of the neglect of savings is that the institutional loan funds available at the local

level generally cannot supply the volume of credit in demand. In addition, SMEs are deprived of the

opportunity to save in financial form with positive real rates of interest, and of the opportunity to leverage

credit with financial savings. For savers, appropriately-designed institutional deposit instruments usually

provide the only opportunity to combine security, convenience, liquidity, and returns. When BRI learned

how local markets operate and began to offer both credit and deposit instruments appropriate for local

demand, Indonesia's local-level banking system became profitable and sustainable. However, appropriate

institutions and instruments for mobilizing voluntary savings are not yet widely available at the local levels

of most developing countries.

Myth 3: Subsidized credit helps the poor by providing them low-cost loans for necessary productioninputs.

The assumptions about supply-leading finance that underlie subsidized credit programs are at23

marked variance with the social, economic, and political realities of local areas in developing countries; as a

result the lending programs tended to undermine their own goals. There is an extensive literature on the

problems caused by subsidized credit programs; nevertheless, the myth that credit subsidies are required for24

economic development still persists both in the minds of many policymakers and in the programs of many

developing countries.

See Akerlof (1970); Stiglitz (1975, 1986); Jaffee and Russell (1976); Stiglitz and Weiss (1981, 1983, 1986);25

Wilson (1980, 1987); Holmstrom (1982); Arrow (1984); Bester (1985); Braverman and Guasch (1986, 1989, 1993);Kotowitz (1987); Fry (1988); Floro and Yotopoulos (1991).

11

In fact, subsidized credit programs undermine SME finance and the development of sustainable

financial institutions serving the local levels of developing countries. Thus:

(1) Subsidized credit programs generally bypass SMEs since the credit is scarce and desirable and is,

therefore, typically allocated to local elites.

(2) Credit subsidies provided to borrowers discourage savings mobilization, since the spread between loan

and deposit interest rates is insufficient for institutional profitability. This, in turn, depresses the

development of profitable, viable financial institutions.

(3) The volume of capital available for lending is constrained and typically cannot supply demand. Many

SMEs must, therefore, either do without credit or borrow (usually at much higher interest rates, and total

cost) from informal commercial lenders.

Myth 4: Credit for small and microenterprises cannot be effectively administered by most financialinstitutions because of the problems caused by asymmetric information, moral hazard, and adverseselection.

A growing literature identifies moral hazard and adverse selection as intrinsic to the operation of financial

institutions operating at the local level. Asymmetric information is assumed to provide constraints on

institutional lending, and by extension, to limit the potential for financial intermediation at the local level.

These assumptions carry with them important - and seriously misleading - policy implications. In the context

of local financial markets, it has been frequently stated that informal lenders have information about potential

borrowers that enables them to select the low-risk applicants, leaving the risky borrowers to the financial

institutions. It is argued that, in contrast, financial institutions operating at the local level cannot observe

sufficiently the use of the credit they extend and cannot obtain adequate information about the quality of

potential borrowers (asymmetric information). It is, therefore, assumed that the institution charges higher

interest rates as a result, and that this may drive some low-risk borrowers out of the pool (moral hazard), thus

increasing the average riskiness of loan applicants and raising the probability of default in the lender's

portfolio (adverse selection). 25

While this can occur, it can also be prevented. Evidence from Indonesia and many other

developing countries shows that the moral hazard/adverse selection constraints postulated for institutional

lending at the local level in developing countries are not necessarily insurmountable; where they exist, they

Bouman (1989), pp. 122-24. Asian rural areas are the most densely populated in the world; given this view one26

would have to consider the rural economies of Africa and Latin America as farthing economies!

Von Pischke, Adams, and Donald, eds., op. cit., p. 8.27

12

can be overcome or substantially reduced. Thus, BRI and other financial institutions have been able to train

their staff to understand local markets and their interlinkages, and to participate in local information flows. In

these ways they have reduced or prevented problems associated with asymmetric information and moral

hazard/adverse selection. Yet the myth that asymmetric information is a basic attribute of local financial

markets, essentially unalterable by financial institutions, persists. If this were true, then why would the

governments of developing countries choose policies aimed at the development of sustainable financial

institutions serving the local level? In fact, most do not. The assumption that local credit cannot be

effectively administered by most financial institutions, especially by those operating on a large scale,

substantially curbs institutional incentives for the development of viable financial institutions. The many

counter-examples should be should be carefully studied by policymakers, governments, donor agencies, and

financial institutions.

Myth 5: Most rural economies in developing countries do not generate a sufficient volume of businessto be attractive to formal-sector financial institutions.

Summarizing succinctly the conventional wisdom on this issue, Bouman states:

Most rural economies of Asia can be characterized as penny economies in which moneytransactions between participants in the economy are very frequent, small-sized and measured, as itwere, in dimes and quarters rather than dollars . . . . Like many other businesses, banks survive onvolume and penny economiesdo not generate sufficient business volume.26

Many banks, however, would be quite happy to have BRI's unit banking system, with its $2 billion

in local savings (an unusually stable source of funds in over 11 million deposit accounts); its $886 million in

credit outstanding to 1.9 million borrowers; its 3.13 percent long-term loss ratio; and its 1992 profit of $41

million.

Myth 6: Informal commercial lenders meet the credit needs of small and microentrepreneurs and arecost-effective and beneficial to the poor.

It is widely believed that informal moneylenders provide credit in ways that are "cost-effective and

useful to the poor." Yet there is extensive evidence from developing countries worldwide that interest rates27

charged by informal commercial lenders typically range from 2 to over 35 percent per month; often these are

Interest rates in this range have been widely reported for rural areas of developing countries. See, for example,28

Reserve Bank of India (1954); Nisbet (1967); Ladman (1971); Bottomley (1975); Mundle (1976); Tun Wai (1977,1980); Kamble (1979); Marla (1981); Adams and Graham, op. cit.; Singh (1983, first published 1968); Wilmington(1983, first published 1955); Roth (1983); Chandavarkar (1987); Hossain (1988); Robinson (1988, 1992, 1993a,1993b); Bouman, op. cit.; Varian (1989); Von Pischke, op. cit.; Germidis, Kessler, and Meghir, op. cit.; Chen (1991);Floro and Yatopoulos, op. cit.; Aleem (1993); Siamwalla et al. (1993); Ghate et al. (1993). For a classic study seeDarling (1978), first published in 1925. Interest rates lower than this range are also reported, and the rates in someareas have decreased over time; see, for example, Tun Wai (1977, 1980); Chandavarkar, op. cit.; Fernando (1988);Bouman, op. cit.; Von Pischke, op. cit.

See Germidis, Kessler, and Meghir, op.cit., for a recent review of studies concerning the share of formal and29

informal credit in rural areas of developing countries. The predominance of informal over formal credit sources iscarefully documented there; see particularly Table 1.3 and pp. 39-49. See also Von Pischke, op. cit.; Hoff,Braverman, and Stiglitz, eds., op. cit.; and Ghate, et al., op. cit.

13

a flat rate (charged on the original balance). In general, the poorer the borrowers, the higher the interest rate,

since poorer borrowers have fewer options. While lower interest rates are also reported from some countries

and regions, flat rates in the 2 to 10 percent per month range appear most common among informal

commercial lenders in developing countries. It has also been widely reported that the volume of such credit28

is very large at the local level in developing countries. However, in Indonesia BRI lends profitably29

nationwide at 1.5 percent per month flat rate on the original balance, or about 33 % annual effective

interest rate: i.e. from 1/2 to 1/20 the rates charged by informal commercial lenders in Indonesia and

elsewhere. Nevertheless, the view that informal moneylenders are cost-efficient and beneficial to SMEs

continues to inhibit the development of financial intermediation in developing countries around the world.

This view also continues to contribute to the unnecessary but widespread condition in which the poor pay far

higher total costs for credit than would be required if

conveniently-located financial institutions made credit available to them at commercial interest rates.

The constantly-cited 'evidence' for these six myths is, on the credit side, the poor repayment records and the

losses sustained by most financial institutions operating at the local level in developing countries. On the deposit side,

the so-called evidence is the low level of deposits - a characteristic typical even of institutions that are successful in

their lending operations. However, the Indonesians found that the primary problem for both loans and deposits was

not on the demand side, but rather on the supply side. BRI's decision to offer credit and deposit instruments, to design

these to be appropriate both for local demand and for institutional profitability, and to plan and implement credit and

savings services together, had the following effects: (1) a much larger volume of capital became available for

productive investment; (2) the increased volume of capital has enabled many more households and SMEs to finance

their productive activities at substantially lower cost than is otherwise available to them (thus providing a powerful

incentive for timely loan repayment); and (3) the financing institution has become profitable and sustainable for the

long term.

It should be noted, however, that while a household may have only one KUPEDES loan, it is permitted multiple30

savings accounts.

14

However, the myths reviewed here have become self-fulfilling prophecies in many other developing

countries. Thus, in fact: (1) most local-level credit programs are unsuccessful, either in reaching the target population

or in recovering loans, or both; (2) most financial institutions serving local areas of developing countries are

generally unsuccessful in mobilizing savings (therefore even those that are successful on the credit side may not be

sustainable for the long term); and (3) in most developing countries there is little effective financial intermediation at

the local level. The bottom line is that the facts about the severe deficiencies in financial intermediation at the local

level are generally true, but the explanations provided are generally false. Some of these myths have been proven

wrong in a number of developing countries; all have been shown wrong by the Indonesian experience of the past

decade.

Thus, there is extensive evidence to show: (1) that SMEs save and can be induced to place savings in

financial institutions; (2) that subsidized credit rarely reaches the poor, but it does prevent savings mobilization,

thereby constraining the volume of credit available for lending; (3) that institutions can learn about local markets and

how to serve them, thereby overcoming the asymmetric information problem; and (4) that the poor can obtain credit at

much lower interest rates and total cost from conveniently located profitable financial institutions than from informal

commercial lenders.

Yet the argument continues to be made in policy circles that, since there is no significant demand for

financial savings instruments, why should priority be given to the development of financial institutions with savings

programs? The result is a continuing adverse effect on SME development, on savings mobilization, and on the

creation of sustainable financial institutions serving the local level.

In addition to removing six old myths, the financial intermediation model emphasizes six important points:

(1) Unlike subsidized credit, lending at commercial interest rates enables savings mobilization.

(2) With savings mobilization, credit can be made available to many borrowers, a far larger number than can

be financed by government or donor-subsidized funding.

(3) Assuming a reasonable level of macro-economic management and political stability, there are likely to

be many more savers than borrowers; at BRI the ratio of deposit accounts to loans is about 6:1. 30

(4) Most borrowers are also savers. They borrow for working capital and repay from income streams. They

also save simultaneously for emergencies and for unexpected opportunities, such as the purchase of raw

materials at a low price.

See footnotes 2 and 3 in Part One for references concerning the development of BRI's local banking system.31

Improved National BIMAS (an acronym for Bimbingan Massal, or Mass Guidance), Indonesia's nationwide rice32

intensification program, was begun in 1970-71.

15

(5) To be sustainable the institution must set a spread between loan and deposit interest rates that enables

profitability.

(6) Financial intermediation by formal-sector institutions can be both economically and socially profitable.

I. C. THE INDONESIAN EXAMPLE: A SUMMARY OF THE BRI EXPERIENCE

During the 1980s the BRI created a banking system to serve customers at the local level throughout

Indonesia. The system was discussed in detail in Part One of this series. Here, therefore, BRI's record will be only31

summarized and updated; the emphasis will be placed on selected aspects of BRI's system not addressed in Part One.

C. 1. The Development of BRI's Unit Banking System

BRI began to develop its network of unit banks in 1970; the system began as the credit component of the

national rice intensification program (BIMAS). Until the end of 1983, the unit banking system functioned primarily32

as a channeling agent for subsidized rural lending programs, especially the BIMAS program for rice intensification.

Credit at an interest rate of 12 percent per annum was provided, primarily for subsidized inputs supplied in kind by

the village cooperative; repayment was made in cash to the BRI. The loans, offered at low interest rates, were scarce

and desirable and therefore often allocated to rural elites who had influence locally. Poor program design, and

misguided implementation strategies soon combined to produce high arrears and declining participation which

continued until the BIMAS credit program was ended in 1985.

Savings accounts were offered in the unit banks beginning in the mid 1970s; however, with annual interest

rates set by the government at 12 percent for loans and 15 percent for most deposits, the system provided a

disincentive to the bank for savings mobilization. After more than a decade of offering savings accounts in the

country's more than 3600 'village banks' located nationwide at the sub-district level, deposits in the unit banking

system totaled only $17.6 million in June, 1983 (the date of the financial deregulation that made possible the major

changes that followed in 1984). With the exception of a few high-level policymakers, however, the poor deposit

record of the unit banking system was almost universally attributed by the government and the banks to 'rural

Bank Indonesia Jakarta dengan Pusat Penelitian Pembangunan Pedesaan dan Kawasan Universitas Gadjah Mada33

(1987).

16

undersavings', and to assumptions about the lack of trust in banks on the part of villagers, their lack of education and

consequent aversion to the use of financial institutions, and even their 'psychological inability' to make use of banks. 33

During 1983 BRI's unit banking system sustained a loss of $28 million, and the bank gave serious

consideration to closing down the system. During that same year, however, the Indonesian government began a series

of major financial reforms. The first of these, issued in June 1983, permitted banks to set their own interest rates on

most loans and deposits. With government encouragement and start-up financing, BRI responded with a program of

general rural credit (Kredit Umum Pedesaan, or KUPEDES) at market-based interest rates. KUPEDES offers credit

from Rp 25,000 (about US $12) to Rp 25 million (about US $12,000). The interest on KUPEDES loans, 1.5 percent a

month flat rate on the original balance (33 percent annual effective rate calculated on the declining balance), is from

one-half to one-twentieth the rates charged by local informal commercial lenders. The KUPEDES credit program was

planned in conjunction with a new program of savings mobilization designed specifically to meet local demand. A

series of pilot projects was conducted offering a set of deposit instruments with different ratios of liquidity and

returns, and featuring a fully liquid instrument, previously unavailable at the local level. The spread between loan and

deposit interest rates was set to enable institutional profitability. By 1986 both the credit and savings programs were

offered nationwide through BRI's unit banking system.

C. 2. Four Questions about the Indonesian Example

Four important questions about BRI's experience are addressed here:

(1) What were the important pre-conditions already in place when the system was introduced?

Three aspects of the wider environment stand out as crucial:

(a) Good, consistent macro-economic management and political stability

Had the BRI attempted to develop its local-level banking system in the mid-1960s instead of the

mid-1980s, it would undoubtedly have failed. With over 600 percent inflation in 1966 and sharply

decreasing real per capita income, falling production and investment, and a massive budget deficit, a

successful rural banking initiative would have been impossible. However, beginning in 1967 under the New

Order government, Indonesia has had over 25 years of sustained emphasis on economic development,

accompanied by political stability. A considerable share of the wealth gained from the oil booms of the

1970s was invested in the development of the country's rural areas, in turn creating rural demand for banking

services. Those investments laid the foundations for the achievements of the 1980s, including the attainment

17

of rice self-sufficiency, employment creation, real per capita income growth, and substantial rural

development. Inflation has been held below 10 percent since 1983, the period during which BRI developed

its unit banking system. Overall, during the 1980s major financial deregulations, and tax, trade, and

investment reforms strengthened the economy while permitting the development of a profitable nationwide

rural banking system.

(b) Client trust in the financial institution

BRI's unit banks, established nationwide in the early 1970s in order to dispense agricultural credit,

had made banking activities familiar to many rural people. Government deregulations in the 1980s permitted

the introduction of appropriate banking instruments which could both meet local demand and permit bank

profitability. Control of inflation and political stability contributed to the growing trust of the people in

formal financial institutions. In brief, most of BRI's clients trusted their bank.

(c) The knowledge of high-level policymakers about the negative relationship between subsidizedcredit and deposit mobilization

Many countries operate subsidized rural credit programs similar to those that have been offered in

Indonesia, with similar results: a limited amount of cheap credit is supplied to wealthier villagers; arrears are

high; and mobilization of deposits is depressed. However, since the credit subsidies tend to reach the rural

elites whom governments wish to retain as supporters, it is often difficult to dislodge these subsidies once

they are in place. Thus, BRI's unit banking system presently channels a government-subsidized agricultural

credit program (Kredit Usaha Tani or KUT) side-by-side with KUPEDES, BRI's own credit program. While

both KUT, which replaced BIMAS in 1985, and KUPEDES are both administered through BRI's unit

banking system, the KUPEDES program has lent out well over ten times the amount lent through KUT.

Nevertheless, the absolute amount of cumulative arrears is higher in KUT, despite the much smaller amount

of credit extended. However, what differentiates Indonesia from many other countries offering similar

subsidized credit programs is that a way was found to develop KUPEDES also and to permit it, via rural

savings mobilization, to provide credit to local borrowers far beyond that provided through the country's

subsidized credit programs. Where feasible, commercial credit programs and associated deposit instruments

can be substituted for subsidized credit programs. However, the Indonesian example shows that both can be

operated concurrently if continuation of credit subsidies is considered politically necessary.

(2) Why did the Indonesians decide to build BRI's local-level banking system?

The nationwide banking system operated by BRI at the local level did not occur gradually,

accidentally, or as a 'grass roots' initiative; it was planned and implemented as an integral part of the country's

economic development. In the early 1980s, the government anticipated a possible significant decline in the

18

real value of oil revenues, and began to seek alternative sources of government revenue and to undertake

wide-ranging financial reforms. The problem was critical because in 1984 - the year before the international

oil crash - oil and gas revenues still accounted for nearly three-quarters of Indonesia's dollar earnings from

exports. During the 1980s, therefore, major reforms were undertaken in finance, tax, trade, and investment.

Emphasis was placed on the rapid increase of non-oil exports, including export of manufactured goods. A

crucial aspect of this decision was the recognition that a competitive economy and new sources of investment

would be required. Accordingly, it was decided that the private sector must become responsible for a

significantly larger share of savings and investment than had been possible in the 1970s, and that the state

banks, instead of serving primarily as channeling agents for government subsidies, would be transformed

into commercial banks. A series of major financial reforms was then issued, designed in large part to

deregulate the financial sector. As part of the wider emphasis on deregulation, banks were given more

autonomy in decision-making and encouraged to expand their products and activities.

Within BRI, the unit banking system had ben operating at a substantial loss to the bank and to the

government. It was recognized that BRI's over 3600 unit banks either had to be closed down or transformed

from rice banks into real banks. For the reasons discussed above, the Indonesians decided to build the

banking system - beginning in the rural areas where the banks were located and later extending the system to

urban areas.

(3) Why did BRI, unlike other financial institutions serving the local level in developing countries,decide to emphasize savings mobilization?

Although in 1984 some suggested that KUPEDES could become self-sustaining even without

substantial local savings, that approach was rejected. There were four primary reasons that the government

and the BRI decided to plan and implement the credit and savings components of the program together:

(a) To encourage private sector savings and investment

The Indonesian government, concerned in the early 1980s about the possibility of a decline in the

real value of oil revenues, had begun to seek new sources of income growth, to encourage private sector

savings and investment, and to undertake major financial reforms. Under these conditions, it was decided

that extensive long-term funding for a nationwide credit program could not be committed from Bank

Indonesia, the Central Bank.

(b) To supply demand at the local level for credit at commercial interest rates

The idea behind KUPEDES was to supply the country's demand at the local level for credit at

commercial interest rates; it was correctly anticipated that this would eventually require a substantially

19

greater amount of financing than had been required for the total amount of all previous local-level credit

programs.

(c) To limit government risk

The risk was considered too high for long-term commitment of Central Bank funds. It was well

known that many local-level credit programs in Indonesia and in developing countries throughout the world

had a history of high arrears. There was no successful model of financial intermediation on a significant

scale at the local level that could be found in any developing country. Indonesia's economics ministers

recognized the potential for a large-scale banking system serving customers at the local level and supported

its introduction with government funding; they also recognized the importance of limiting government risk.

(d) To encourage local-level savings

As part of a wider policy of encouraging private savings, the government wanted to arrange for the

supply of what was accurately estimated as a large potential demand for savings in financial institutions at

the local level. It was thought that an approach which offered savings instruments designed to be appropriate

for local demand could generally provide customers with positive real returns while also building the long-

term viability of the unit banking system. Both results would contribute to economic development at the

local level, a primary aim of the government. For these reasons, extensive savings mobilization became a

crucial component of the overall plan for the unit banks. The decision was to create a banking system to

provide local-level financial intermediation nationwide. A banking system was important for the country,

KUPEDES was essential for the profitability needed for institutional viability, mobilization of deposits was

required for the support of KUPEDES, and the other activities selected for emphasis were those necessary

for successful management of the unit banking system.

0

1

2

3

4

5

Ru

pia

h in

Tri

llio

ns

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Year

Liquid Deposit Instruments Total Deposits KUPEDES Outstanding

BRI UNIT BANK DEPOSITS ANDKUPEDES CREDIT OUTSTANDING

Chart 1

Source: Bank Rakyat Indonesia* End of year totals, except that the 1993 totals are for October 31, 1993.

0

2

4

6

8

10

12

14

Num

ber

of L

oans

(in

mill

ions

)

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Year

Loans in each year Cumulative total

NUMBER OF LOANS IN THE BRIUNIT BANKING SYSTEM, 1984-1993*

Chart 2


0

2

4

6

8

10

12

Num

ber

of A

ccou

nts

(in m

illio

ns)

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Year

Liquid Deposits Total Deposits

NUMBER OF DEPOSIT ACCOUNTS IN THE BRIUNIT BANKING SYSTEM, 1984-1993*

Chart 3


23

TABLE 1

INDONESIAN CONSUMER PRICE INDEX

AND RUPIAH/DOLLAR EXCHANGE RATES,

1970-1993

Year Consumer Price Index Rupiah Exchange Rate

(CPI) per US $

(base year 1985) (annual averages)

1970 12.8 362.8

1971 13.4 391.9

1972 14.3 415.0

1973 18.7 415.0

1974 26.3 415.0

1975 31.3 415.0

1976 37.5 415.0

1977 41.7 415.0

1978 45.1 442.1

1979 53.3* 623.1

1980 62.9 627.0

1981 70.6 631.8

1982 77.3 661.4

1983 86.4 909.3

1984 95.5 1025.9

1985 100.0 1110.6

1986 105.8 1282.6

1987 115.6 1643.9

1988 124.9 1685.7

1989 133.0 1770.1

1990 142.9 1905.0

1991 156.1 1950.6

1992 167.8 2029.9

1993 181.9 2075.0

(Jan.-July) (Jan.-July)

* Before March, 1979, the Indonesian CPI figures were based

on an index which covered Jakarta only.

Source: International Monetary Fund and Bank Indonesia

24

TABLE 2

KUPEDES CREDIT IN THE BRI UNIT BANKING SYSTEM

1984-1993*

KUPEDES PERFORMANCE

(in billion rupiah)

Year Outstanding Total Loss Ratio** Status***

Credit Cumulative Long-Term Portfolio

Credit:

1984 111.1 172.0 0.98% 0.54%

1985 229.0 511.7 1.66% 2.08%

1986 334.3 995.1 2.23% 4.50%

1987 429.6 1593.0 2.56% 5.80%

1988 542.3 2300.8 3.23% 7.42%

1989 846.5 3467.4 2.92% 5.39%

1990 1381.8 5277.5 2.62% 4.12%

1991 1455.7 6960.2 3.29% 8.55%

1992 1648.5 8907.7 3.32% 9.10%

1993 1862.9 10785.9 3.13% 7.10%

Number of KUPEDES Loans

Year Outstanding Total****

Credit Cumulative

Credit:

1984 640,746 639,403

1985 1,034,532 1,631,366

1986 1,231,723 2,781,505

1987 1,314,780 3,918,163

1988 1,386,035 5,032,679

1989 1,643,980 6,412,126

1990 1,893,138 7,985,172

1991 1,837,549 10,094,963

1992 1,831,732 11,585,784

1993 1,854.869 12,856,670

NOTES: * The totals are for the end of each year; discrepancies are due to rounding. The 1993 totals are as of October 31, 1993.

** The Long-Term Loss Ratio is the ratio of the cumulative amount due but unpaid to the total amount due.

*** The Portfolio Status is the ratio of present credit outstanding to present arrears.

**** Because of BRI's accounting system, there are minor differences between the number of loans outstanding in a given year and the number attributed to the

cumulative total from that year.

SOURCE: Bank Rakyat Indonesia, November, 1993.

25

TABLE 3

DEPOSITS IN THE BRI UNIT BANKING SYSTEM

1984-1993*

DEPOSITS

(in billion rupiah)

Year TABANAS SIMPEDES SIMASKOT Giro Deposito Other Savings

Total

1984 39.10 0.31 0 2.01 0.77 0 42.19

1985 63.60 5.13 0 13.83 2.15 0.15 84.87

1986 78.16 82.60 0 10.93 3.92 0.20 175.80

1987 79.55 182.60 0 12.46 12.71 0.18 287.53

1988 89.52 341.95 0 16.64 44.45 0.39 492.95

1989 113.58 699.77 0.86 26.27 117.33 1.33 959.12

1990 153.53 999.75 147.63 40.23 322.99 30.71 1694.83

1991 217.61 1334.13 283.89 54.75 566.21 83.87 2540.45

1992 301.91 1924.41 455.43 80.50 515.77 121.07 3399.10

1993 394.41 2551.44 609.28 127.09 423.89 63.73 4169.84

NUMBER OF DEPOSIT ACCOUNTS

Year TABANAS SIMPEDES SIMASKOT Giro Deposito Other Savings

Total

1984 N.A. 2,655 0 N.A. N.A. N.A. N.A.

1985 N.A. 36,563 0 N.A. N.A. N.A. N.A.

1986 N.A. 418,945 0 N.A. N.A. N.A. N.A.

1987 N.A. 969,160 0 N.A. N.A. N.A. N.A.

1988 3,292,808 1,641,797 0 43,344 15,216 4,873 4,183,983

1989 3,507,203 2,656,653 1,334 45,427 45,663 5,708 6,262,988

1990 3,331,521 3,503,553 270,509 50,843 104,718 10,732 7,262,509

1991 3,336,819 4,459,870 541,896 51,160 182,310 15,817 8,587,872

1992 3,475,220 5,504,396 753,590 54,503 147,632 17,953 9,953,294

1993 3,646,781 6,451,539 907,064 55,609 107,167 10,198 11,176,308

* The totals are for the end of each year, except that the 1993 totals are as of October 31, 1993.

Source: Bank Rakyat Indonesia, November, 1993.

26

TABLE 4

NUMBER OF BRI UNIT BANKS

1984-1993*

Year Unit Banks Unit Banks Total Unit Banks

Profitable Total Unit Banks to

Share of Profitable

1984 336 3,626 9.27%

1985 1,192 2,450 48.65%

1986 1,647 2,273 72.46%

1987 1,887 2,341 80.61%

1988 2,090 2,585 80.85%

1989 2,253 2,844 79.22%

1990 2,715 3,040 89.31%

1991 2,696 3,210 83.99%

1992 2,744 3,194 85.91%

1993 2,802 3,235 86.61%

* The totals are for the end of each year, except that the 1993 totals are as of October 31, 1993.

Source: Bank Rakyat Indonesia, November, 1993.

The relatively slow growth in KUPEDES lending during 1991 - 1992 shown in Table 2 was caused primarily by34

credit restrictions in BRI resulting from the government's "tight money policy" from June 1990 until April 1992(imposed in order to control inflation which had risen from below 6 percent in 1989 to about 9.5 percent in both 1990and 1991. By 1992, inflation was down to about 6 percent. Also, in some areas KUPEDES credit was slowed becauseof increasing arrears. KUPEDES arrears increased from late 1991 through early 1993, in part as a result of the tightmoney policy. Thus: (a) urban suppliers and buyers decreased credit to their local trade partners, resulting in cashflow problems and decrease in production; and (b) some KUPEDES borrowers, concerned that they might not receivenew loans, delayed payment on their old loans. Although the policy ended in April, 1992, there was a lag time untilearly 1993 before KUPEDES arrears decreased. Another major reason for increased arrears during this period was aprolonged drought followed by heavy flooding and a simultaneous sharp increase in pest problems in 1991 - 92; croplosses in many areas were high. However, the 1993 rice harvest was a good one and the effects of the tight moneypolicy had receded by early 1993. KUPEDES arrears have declined steadily since March 1993. The portfolio statusdecreased from an all-time high of 9.66 percent (3.35 percent long term loss ratio) in August 1992 to 7.10 percent(2.43 percent long term loss ratio) in October 1993.

27

(4) What are the results of the BRI unit banking system?

There have been three major results from the development of BRI's unit banking system.

(a) Institutional sustainability

The unit banking system, which had previously generated considerable losses for both the

government and the bank, became profitable in 1986. By 1989 all KUPEDES lending was more than

supported by local level deposits (see Tables 2-3 and Charts 1 - 3). From January 1, 1984 through October34

31, 1993, BRI extended Rp 10.8 trillion in 12.9 million loans in its KUPEDES program offered at

commercial interest rates. As of October 31, 1993, KUPEDES credit outstanding was Rp 1.86 trillion (US

$886 million) in 1.9 million loans; the long-term loss ratio is 3.13 percent. The low default rate is caused

primarily by three factors: a) given the relatively attractive credit terms, borrowers generally want the option

to re-borrow; b) BRI maintains a well-implemented policy of not relending to defaulting borrowers; and c)

a substantial financial incentive is provided for prompt payment. Unit bank deposits, which were Rp 16

billion ($17.6 million) on June 30, 1983 after a decade of operation, reached Rp 4.2 trillion ($2 billion) by

October 31, 1993. These funds are deposited in over 11 million accounts. BRI's unit banking system, which

was nearly discarded in 1983 because of its losses, made a before-tax profit in 1992 of Rp 84 billion (about

US $41 million), over two-thirds of BRI's profits that year.

(b) Provision of financial services at the local level

BRI's unit banking system provides financial services at the local level in a nationwide system,

reaching approximately one-third of Indonesia's households directly, and others indirectly through

supervision of 5240 active Badan Kredit Desas (BKDs), or Village Credit Organizations. BRI maintains

3235 unit banks and about 700 sub-units throughout Indonesia (Table 4); these are supervised by BRI's 325

See BRI (1990). This study, consisting of two surveys, was conducted by BRI's Planning and Research35

Department with Ann Dunham Sutoro as Principal Investigator. See also O'Rourke (1993).

28

branches located in the district capitals and major cities. As discussed in Part One of this series, loans and

deposits in BRI's unit bank system are distributed approximately in proportion to population distribution,

although KUPEDES arrears are higher in the Outer Islands than in Java and Bali (reflecting the difficulties of

building an effective supervision system in outlying areas of the world's largest archipelago). The BKDs,

located in Java and Madura and supervised by BRI, are traditional village financial institutions owned by

their respective village governments. A BKD provides financial services within one village, operating

usually on a weekly basis. BKD loans reach more lower-income borrowers than the BRI unit banks, and

their loans are typically smaller than those made by the BRI unit banks. BKDs also provide deposit services

in a system linked with the BRI unit banks.

(c) Contributions to social and economic development

Nearly 13 million KUPEDES loans have been made since the program began in 1984, and there are

11 million deposit accounts in BRI's unit bank system. As of October 31, 1993, the average KUPEDES loan

is $469; the average deposit account is $175. As of January 1993, 24 percent of the loans were below Rp

500,000 (about $242) and another 38 percent were between Rp 500,000 and Rp 1 million (about $484). As

of the same date, 86 percent of the unit bank deposit accounts were below $242, while 46 percent were

below $12. A 1988 KUPEDES Development Impact Survey found that of its 192 respondents, 92 percent

had never before received a loan from a bank or government agency. One-third reported monthly household

incomes of below $78. About one-quarter of the borrowers in the survey were women, although the35

benefit to women is larger since some women's enterprises are capitalized by KUPEDES loans taken by male

relatives. In 1989 BRI extended unit banking services to urban neighborhoods as well as rural areas. As was

discussed in Part One of this series, since urban units are net depositors to the system, it seems likely that the

unit bank system helps to counteract 'urban bias' in the economy.

BRI's first priority for its unit bank system was to create a profitable institution that could provide

financial services locally, and that would be sustainable for the long term. That goal was accomplished by

the late 1980s. Therefore, in the past few years BRI has been able to concentrate more systematically on the

provision of financial services to an increasing number of poorer clients. While the number of lower-income

clients served by the unit bank system is large in comparison with other Indonesian financial institutions,

there is still considerable scope both for reaching larger numbers of clients and for serving poorer clients.

With this end in mind, BRI recently reviewed its supervisory role of the BKDs and became more active in

encouraging BKD development and in creating linkages between BKDs and BRI unit banks. A 1992 survey

of 61 BKDs supervised by 25 BRI branches showed that 86 percent of BKD loans were below $100, while

The 1992 BKD survey was carried out by BRI; Thomas Kennedy was the principal person involved in36

conducting the survey and reporting on its results.

Some of the recently reactivated BKDs were capitalized by loans from other BKDs.37

29

54 percent were below $50. The average deposit account is about $12. BRI has undertaken to help the36

BKDs to increase their coverage, and in this connection about one-fourth of the total number of BKDs have

been recently reactivated. Most of these are capitalized by BRI loans. 37

In summary, BRI has demonstrated that it is possible for institutions to provide financial intermediation at the

local level profitably and sustainably, without ongoing subsidies. By taking a financial systems approach to local

banking, BRI built a banking system that supplies a large demand for financial services at the local level, that is both

economically and socially profitable, and that now serves as a model for other financial institutions in Indonesia and

in developing countries in many parts of the world. As will be discussed in Part Three of this series, the experiences

of BRI and of some other institutions are being successfully adapted (not cloned) to local financial markets in other

countries. There is considerable evidence emerging that the new paradigm - the shift from credit delivery to profitable

financial intermediation - will be a crucial component of social and economic development in the coming decades.

30

II. THEORIES OF LOCAL FINANCIAL MARKETS: REVIEW AND CRITIQUE

Four main streams of literature related to local financial markets are discussed here. These concern: (1) supply-

leading finance theory and subsidized credit programs; (2) informal commercial credit markets and market interlinkages;

(3) asymmetric information and moral hazard/adverse selection; and (4) local savings. The purpose is to use the conclusions

of the literature review, in conjunction with the experiences of BRI and other financial institutions, in the construction of

the model of local financial intermediation presented in Section III.

II. A. PREVENTING SUSTAINABLE FINANCIAL INTERMEDIATION AT THE LOCAL LEVELTHROUGH CREDIT SUBSIDIES

Developed in the 1950s, supply-leading finance theory assumed that economic growth in rural areas could be

induced through the financial system. As a result, financial incentives for the adoption of new agricultural technologies,

often in the form of subsidized credit, were provided to farmers in advance of demand. With the emergence of the green

revolution in the late 1960s and 1970s, subsidized credit programs proliferated rapidly in developing countries throughout

the world. In many cases, the approach was expanded to non-agricultural borrowers, both rural and urban. The arguments

of supply-leading finance theory are summarized below, as are also the reasons behind the well-documented failures of

credit programs that provide credit to borrowers at subsidized interest rates. The effects of subsidies to financial institutions

that on-lend to borrowers at or near market interest rates are also analyzed. Credit subsidies are seen as a triple threat to

the provision of sustainable financial intermediation at the local level.

A. 1. Theories of Supply-Leading Finance

Theories of supply-leading finance, as well as the extensive subsidized rural credit programs that reflected these,

emerged in response to post-World War II conditions. Extensive re-evaluation of the role of the state in economic

development accompanied the independence of many of today's developing countries. It was widely believed that the

governments of these newly-created nations held important responsibilities for the economic development of their peoples.

This approach, usually formulated and stated in explicit contrast to colonial policies, was a product both of Keynesian

economic thinking and of the post-war view that developing countries must pass sequentially through a series of stages

in order to achieve the status of developed nations. Emphasis was placed on the obligations of governments to play many

roles, including capital accumulation, investment planning, industrial development, agricultural growth, development of

infrastructure, and (in varying degrees depending on the country) in improving income distribution and increasing equity

more generally.

Thus, during the 1950s and 1960s, there was a growing assumption of responsibility for economic development

by the governments of emerging nations. By the late 1960s and the 1970s, this philosophy coincided with the rapid spread

of the new varieties of rice and wheat that ushered in the green revolution, and with the related issue of financing the inputs

See Mears (1981) for discussion of the shift to borrowing for production in Indonesia.38

31

for the new agricultural technologies. Traditionally, rural households borrowed primarily for consumption - in order to

subsist in pre-harvest seasons, for emergencies, and for social and religious obligations. In the 1970s, however, they began

to borrow increasingly for production expenses: first for agriculture, then for off-farm productive activities.38

Government priorities for economic development, combined with mandates of foreign donors for substantial

investment in Third World agriculture, resulted in a profusion of subsidized agricultural credit policies worldwide. These

were intended both to raise production and to improve equity. This strategy, disseminated worldwide during the 1970s,

arose in part from the early post-war view that economic planning leads to economic development. It also reflected three

assumptions that had been developed subsequently: (1) that rural areas of developing countries are critically important

for national development; (2) that it was essential for economic growth that the new agricultural technologies be adopted

rapidly and extensively; and (3) that the latter would frequently require substantial credit subsidies, since it was believed

that most farmers would need more capital than they could save.

Intervention by governments and donor agencies was seen as critical, especially since it had been widely observed

that private lending institutions did not engage in most types of rural lending because of the extensively-held (but largely

unexamined) beliefs that few rural households would be willing or able to pay commercial interest rates, and that institutional

loans in rural areas would be difficult to monitor. Another reason for the reluctance of private institutions to provide rural

credit, one less recognized by governments, was the proliferation of financial regulations that made it difficult or impossible

for financial institutions to provide credit profitably at the local level. Government intervention in rural credit markets

was advocated also because policymakers considered its implementation easier than that of alternatives such as land reform

or off-farm employment creation. In addition, it was thought that subsidized credit provided to farmers would help to offset

'urban bias', thereby improving income distribution and reducing regional disparity more generally.

The supply-leading approach to rural finance led, in the late 1960s and 1970s, to large-scale subsidized rural credit

programs in developing countries around the world. Since it was assumed that subsidized credit was required to stimulate

agricultural growth, agricultural finance came to be treated essentially as a crop input, its subsidies considered similar to

those provided for fertilizer and pesticides. Government intervention in rural credit markets, as formulated by many planners

of that period, was thus quite simple: large numbers of lower and middle-income farmers would receive low-cost credit;

using the new agricultural technologies they would produce more crops and increase their incomes. It was even believed

by many that the targeted farmers would 'graduate' from subsidized agricultural lending programs once their incomes had

risen.

The facts, however, did not substantiate the theories. By the late 1960s and early 1970s, serious difficulties with

subsidized rural credit programs had begun to become apparent; by the late 1970s, criticisms of the rationale behind these

policies filled the development literature. By the 1980s, increasing documentation had become available to show that

subsidized credit programs had not only served to prevent the provision of institutional financial services to most inhabitants

of rural areas, but had as well negatively affected provision of credit to SMEs in the burgeoning urban areas of developing

Penny, op. cit.39

Ibid., pp. 65-6. Commenting on the prevailing views among economists at the time, Penny wrote: "The weight40

of both expert and political opinion is against Galbraith and the few who share his views. But Galbraith, Li, andMellor are right, and government rural credit programs will remain ineffective until governments come to a betterunderstanding of the role of credit in peasant economies, and the attitudes of peasant farmers toward savings,investment, and debt" (p. 59).

For overview and bibliography, see Von Pischke, Adams, and Donald, eds., op. cit.; Adams, Graham, and Von41

Pischke, eds., op. cit.; Von Pischke, op cit.; Gonzalez-Vega (1993). See also references in footnotes 24 and 44.

32

countries throughout the world. Because of the relatively long history of subsidized rural credit programs, there is more

extensive information available about rural financial markets than about the financing of SMEs in urban areas. As is

discussed in Part Three of this series, however, the evidence from Indonesia and elsewhere indicates that the financing

of households and SMEs in urban areas need not require substantially different instruments or services from those used

in rural regions. Thus, while noting that for certain purposes, local financial markets in rural and urban areas may need

to be analyzed separately, they are considered together here because of their many underlying similarities.

A. 2. Supply-Leading Finance and Subsidized Credit Programs: the Critiques

Criticisms of subsidized credit programs and documentation of the reasons for their failures have proliferated

in the development literature for more than 25 years. Beginning in the 1960s, the new view of rural finance reflected a

more general shift in economic thinking away from planning models and toward microeconomics. The emphasis began

to be placed on analysis of the political economies and institutions in which development processes are embedded and

on which their results depend.

In an important paper published in 1968, D.H. Penny used Indonesian village data to test his hypothesis that "cheap

credit is unlikely to be a useful growth stimulus." He first summarized the rationale behind the views of supply-leading39

finance theorists, noting their two major assumptions: a) farmers need significantly more capital than they can afford to

save; and b) credit is, therefore, required for agricultural expansion. Penny studied eight villages in North Sumatra at

different stages of agricultural development, and came to the opposite conclusion. Drawing from his research among the

farmers of those villages, Penny argued that supply-leading subsidized credit programs are ineffective in stimulating

agricultural growth and typically result in poor returns (frequently adding inflationary pressures as well); and that "most

farmers do not have to be bribed with cheap credit to adopt profitable innovations if there is a satisfactory market for the

additional output."40

A new view of rural financial markets came to be formulated in the late 1960s and 1970s by Adams, Bouman,

Donald, Gonzalez-Vega, Graham, Penny, Vogel, Von Pischke, and others. Drawing from the experiences of a number41

of developing countries, these authors demonstrated specifically the distortions and failures which result from subsidized

rural credit programs.

Gonzalez-Vega (1976). 42

See Rhyne and Otero (1991); Costello, Stearns, and Christen (1991); Gonzalez-Vega and Chavez (1991);43

Gonzalez-Vega (1993); Robinson (1992, 1993a).

World Bank (1984 a). For discussion of high default rates in subsidized rural credit programs, see USAID, op.44

cit.; Donald, op. cit.; Vogel, (1979); Bangladesh Bank (1979); Adams and Graham, op. cit.; Eaton and Gersovitz(1981); Von Pischke, Adams, and Donald, eds., op. cit.; Adams, Graham, and Von Pischke, eds., op. cit.; Shaefer-Kehnert and Von Pischke (1984); Adams and Vogel (1986); Mosley and Dahal (1987); Adams (1988); Hossain(1988); Braverman and Guasch (1986, 1989, 1993); Von Pischke, op. cit.; Floro and Yotopoulos, op. cit. See alsoVogel (1981) for implications of the low delinquency rates found in Costa Rica; an important one is severe creditrationing.

33

As this new approach began to influence studies of rural credit programs in developing countries around the world,

evidence mounted rapidly that:

(1) Large-scale subsidized programs generally do not reach the middle and lower income households whoare, typically, their stated targets.

Because of capital constraints, subsidized loans are effectively rationed. As the low-interest loans are

scarce, and as they are considered by many borrowers to be desirable, their benefits tend to be captured by

wealthier and more influential rural households. Formulated by Gonzalez-Vega as the 'iron law of interest rate

restriction', it became clear that subsidized interest rates, combined with the relatively high costs to the lender42

of making small loans, ensure that institutional loans are routinely channeled to larger borrowers. The original

concern of both supply-leading finance theorists and their critics was with rural credit. However, it later became

evident that subsidized credit has had a similar effect in urban areas as well, i.e. the perpetuation of a policy

environment in which SMEs are typically unable to gain access to institutional credit. 43

(2) The diffusion of most agricultural innovations in developing countries does not depend on formal credit.

This became apparent from observation of the simultaneous agricultural successes and institutional credit

failures that occurred in many countries. Discussed in Part One of this series, Indonesia's subsidized BIMAS

credit program for rice intensification (1970 - 1985) provides a good example of this pattern.

(3) Subsidized credit programs usually have high default rates.

Government-subsidized loans have been widely reported to experience high default rates. A 1984 World

Bank study of 38 small farm credit institutions in Asia, Africa, and Latin America reported an average arrears

rate of 39.4 percent. In part because borrowers tend to be locally influential individuals, the lending institution44

typically puts little effort into collection and usually does not foreclose on collateral in case of default.

See Siamwalla et al., op. cit.45

Ibid., p. 179.46

Ibid., p. 160.47

Ibid., p. 165.48

Ibid., pp. 165, 179. 49

Blair (1984), p. 187.50

34

There are some exceptions to the generally high default rate experienced by subsidized agricultural credit programs;

rural credit in Thailand is a notable example. The government Bank for Agriculture and Agricultural Cooperatives45

(BAAC), the country's largest agricultural lender, provides credit to groups of borrowers at a subsidized interest rate (12

to 14 percent per annum). Most of the credit provided is for short-term working capital. The repayment rate for working

capital loans made by the BAAC is about 97 percent. However, loans made by the BAAC to cooperatives and then on-lent46

to farmers are reported to have a high default rate. Although the BAAC, which lends through farmer groups, provides47

a counter-example to the typically high default rates of subsidized rural credit programs, it has not solved other problems

connected with subsidized loans. For example, most BAAC credit, both that provided directly through farmer groups and

that provided to other financial institutions and on-lent to rural borrowers, finances demand for working capital from farmers

with above-average incomes. As Siamwalla et al. put it, "The BAAC has a preference for better-off farmers." As a48

consequence, institutional credit in Thailand is generally not available to lower-income rural borrowers who must pay

substantially higher interest rates for credit from informal commercial lenders. 49

(4) Subsidized credit, channeled to local elites, buys political support for governments. The difference between credit as agricultural input and credit as finance is well understood by borrowers

around the world, if not always by their creditors. Locally influential borrowers learn quickly to take advantage

of the below-market financing available to them. Such low-interest credit is used by local elites in many countries

for a wide range of business and household expenses, as well as for on-lending at higher interest rates. The

subsidies, which come to be expected by the recipients, tend to be difficult to dislodge once begun. "Subsidized

credit programs . . . maintain and even enhance the position of rural elites . . . . Low interest rates represent a

subsidy that (whether originally intended to do so or not) buys the support of constituencies". 50

(5) Most households and enterprises in developing countries are unable to gain access to institutional credit.

Capital for subsidized credit programs, whether from governments or donor agencies, is limited. Being

low-cost and desirable, such credit is not available to most households and enterprises in both rural and urban

areas of developing countries. Since most institutional credit is subsidized, most households either do without

See Adams and Nehman (1979); Robinson and Snodgrass (1987).51

35

commercial credit or borrow on the informal commercial market at much higher cost. In addition, when low

interest credit does reach small borrowers, it is often not at low cost. Thus, agricultural credit may be tied to input

packets that are designed for high quality, well-watered lands, but that are provided also to the cultivators of lands

for which the inputs are unsuitable. Indonesia's BIMAS program was an example; farmers whose lands were

inappropriate for the inputs provided were signed up for the program so that bureaucratic targets for BIMAS

participation could be fulfilled. In addition, there are frequently high borrower transaction costs of other kinds,

e.g., transportation, lost time, bribes, etc.51

(6) Subsidized credit depresses savings mobilization and prevents the development of sustainable financialinstitutions.

The low interest rates of subsidized loan programs discourage deposit mobilization. Lending agencies

are usually either forbidden to mobilize voluntary savings or do not do so because collection of deposits would

be unprofitable. As noted, before 1984 BRI was required by the Indonesian government to lend at a 12% annual

effective rate and to pay 15% annual interest on most deposits. Thus, BRI's local banking system, which already

operated at a loss, had no incentive to raise savings. In addition to the losses suffered by the implementing

financial institutions, this type of regulation has left many households in both rural and urban areas of developing

countries without access to institutional facilities for either credit or deposits. That the primary problem for

institutional mobilization of local deposits might be on the supply side has rarely been considered, except in

Indonesia. Rather, policy makers and international donor agencies concerned with local-level finance have

generally given unilateral emphasis to credit programs, usually subsidized ones. Yet financial institutions serving

the local level can be sustainable only if they raise deposits, and deposits can be mobilized only if financial policy

permits the profitability of the implementing institution. Large-scale subsidized credit programs undermine

voluntary deposit mobilization and therefore depress the development of sustainable financial institutions serving

the local level.

A. 3. Subsidizing Financial Institutions in Order to Provide Credit at Commercial Interest Rates: WhatHappens?

Some financial institutions, while themselves funded by low-cost credit from governments and donor agencies,

lend to borrowers at or near market interest rates. How do these subsidies affect the development of financial intermediation

at the local level? A number of the problems addressed above are obviated by institutions that provide credit to the borrower

at market rates, but the basic problem remains, i.e., capital constraint and non-sustainability of the financial institution.

See discussion of the Grameen Bank and comparison with BRI in Part One of this series. For discussion and52

further references, see Hossain (1988); Fugelsang and Chandler (1988); and Grameen Bank (1991). The 1992 dataused here are from Khandker (1993).

Khandker, op. cit., Table 5.53

36

These, in turn, result in unsupplied demand for institutional credit, with most lower-income households and SMEs

continuing either to forego credit or borrowing at the high rates of informal commercial lenders.

Three examples are reviewed here: the Grameen Bank (Bangladesh); the Badan Kredit Kecamatan, or BKK (Central

Java, Indonesia); and the Fundacion para la Promocion de la Micro Empresa (PRODEM) and BancoSol, the bank which

developed out of PRODEM (Bolivia). While these institutions vary considerably in institutional structure and philosophy,

all have been highly successful both in reaching their target population of low-income borrowers and in recovering loans.

However, they all have a relatively low level of deposits, derived primarily from forced savings required as a condition

of loans. Constrained by their limited capital, they cannot meet local demand and are not sustainable for the long term.

In general, financial institutions that are subsidized by governments and donor agencies have little or no incentive to

undertake the mobilization of savings at the local level - unless their governing boards and donors have the foresight to

instruct them to do so. Grameen, BKK, and PRODEM have responded in different ways to the opportunities and constraints

provided by the low-cost funds provided to them. The BKK influenced BRI when the latter began lending at market-based

interest rates in 1984; later BKK adapted lessons from BRI. PRODEM and BancoSol board members visited BRI and

the Bolivian institutions have adapted aspects of BRI's approach to local financial intermediation to their own conditions.

The institutions reviewed below represent types of financial institutions and different stages in dependence on

subsidies from governments and donor agencies. Both the BKK and PRODEM/BancoSol have been influenced by the

experience of BRI, and both are in the early stages of major efforts to mobilize voluntary savings in an effort to become

profitable and sustainable. Grameen, although very successful in lending to the poor and recovering the loans operates

on quite a different model and is still heavily dependent on subsidies.

(1) The Grameen Bank (Bangladesh)

The Grameen Bank, which began as an action research project in 1976, was established by the Bangladesh

government in 1983 as a specialized financial institution providing credit to the rural poor. In conjunction with52

its provision of financial services, Grameen also engages in other activities and information gathering on a number

of development issues, e.g., employment, contraception, education, tubewell use, nutrition, etc. In 1992 the

Grameen Bank had about 1.4 million members (94 percent women). In that year the bank disbursed $160 million

with a 94.6 percent loan recovery rate. The total savings mobilized as of 1992 is $87.5 million in savings; forced

savings are required as a condition of obtaining loans.

Grameen is well known for its excellent record in both lending to the poor and recovering its loans.

Arrears in 1992 were 3.6 percent. Preliminary results of a World Bank study indicate that there are correlations53

between participation in the bank's activities and increase in household assets, household net worth, female net

Khandker, op. cit.54

In 1992 the Grameen Banks's total subsidy was $10 million; there has been an 119 percent increase since 198955

(Khandker, op. cit., Table 5).

See Hossain, op. cit.; Grameen Bank, op cit.; and Khandker, op. cit.56

Khandker, op. cit., pp. 8-9. In 1991 and 1992 the bank also received financial subsidies (p.9). 57

Preliminary results from the World Bank study of the Grameen Bank currently in progress indicates that an58

annual effective interest rate of 33.7 percent would be required to eliminate the subsidy. This is very close to BRI'sinterest rate (33.3 percent).

In 1992 operating costs, including salaries, were 75 percent of Grameen's total costs (Khandker, op. cit., p. 8. 59

Although Grameen began its present banking services in 1983 and BRI in 1984, and although the number of60

borrowers in fairly similar (in 1992, 1.4 million at Grameen and 1.8 KUPEDES borrowers at BRI), the number ofdepositors at Grameen was 1.4 million, while there were 10 million depositors in BRI's Unit Banking System (11.2million in October 1993). As of the same date, Grameen had mobilized $87.5 million in savings, while BRI hadmobilized $1.7 billion ($ 2 billion in October 1993).

37

worth, and other indicators of poverty alleviation. However, Grameen is heavily subsidized. The annual interest54 55

rate on Grameen loans was 16.7 percent as of 1992 although, in combination with the forced savings required,

the effective annual interest rate to the borrower is over 33 percent, which is the same as BRI's annual effective56

rate.

"During the period of 1986 - 91, borrowing at the subsidized rate (mainly from IFAD) and grants from differentsources accounted for more than 73 percent of its lending, while internal resources (member savings, depositsand reserve) accounted only about 18 percent . . . . In 1992 grants accounted for 35 percent and borrowing fromdifferent sources (mostly from IFAD at low interest rate) for 27 percent of Grameen Bank's financial assets." 57

The primary reasons that Grameen remains subsidized are (a) the relatively low interest rate on loans;58

(b) high operating costs caused in part by the fact that Grameen provides social services and training as well as

financial services to its members, and that the costs of member mobilization are high; and (c) its lack of emphasis59

on the mobilization of voluntary savings. Most of Grameen's savings is derived from forced savings from its60

members.

While effective as a lending institution for the rural poor it serves, the Grameen

Bank remains subsidized and has not so far achieved profitability or long-term sustainability.

See Patten and Rosengard (1991).61

The BKK long-term loss ratio is defined as cumulative amount overdue / cumulative amount loaned.62

Ibid.; see also Patten and Snodgrass (1991).63

See Glosser (1993) for discussion of the history of PRODEM and the beginning of BancoSol.64

38

(2) The Badan Kredit Kecamatan, or BKK (Central Java, Indonesia)

The BKK, a non-bank financial institution in Central Java, began in 1970, capitalized by a loan from

the Central Java Provincial Government. The aim of the BKK is to provide small, short-term loans to rural61

households in Central Java. During 1989 about $24.5 million was lent out in about 610,000 loans in 499 BKK

financial units; the long-term loss ratio was 2.14 percent. The net monthly interest rate, including forced savings,62

ranges from 2 to 3.5 percent flat rate on the original loan balance; the rate for most loans is above 3 percent. The

majority of BKK loans are provided to women. 63

As non-bank financial institutions, the BKK units were not permitted to collect voluntary savings until

1984 when, in conjunction with the wider financial deregulations in Indonesia, they were given permission to

receive public funds. Previously the units could collect only forced deposits made by borrowers as a condition

of receiving loans. In late 1987 nine BKK units began a pilot project in voluntary savings (TAMADES), modeled

in part on the Bank Rakyat Indonesia's SIMPEDES program that had begun in late 1984. At the end of 1989

BKK savings of about $2.7 million ($2.1 million in forced savings and $594,000 in voluntary savings) covered

11 percent of outstanding loans. Following the TAMADES pilot project, the Central Java provincial government

decided to expand the voluntary savings program. In addition, other Indonesian provincial governments are

beginning to adapt the BKK approach to conditions in their areas.

(3) Fundacion para la Promocion de la Micro Empresa (PRODEM) and BancoSol (Bolivia)

PRODEM, an NGO providing a non-profit credit program for microentrepreneurs in Bolivia, was

established in 1986 by ACCION International, a U.S.-based NGO operating in Latin America, and by a group

of Bolivian business leaders. Funding was provided by the U.S. Agency for International Development PL-48064

program, by international and Bolivian foundations, and by the Bolivian private sector. In 1984 ACCION had

conducted a feasibility study which indicated clearly that lack of access to credit was a problem for Bolivian

microentrepreneurs, and that the latter constitute a substantial part of the economically active population in Bolivia.

The primary aims of PRODEM were to provide credit to microenterprises, both rural and urban; to expand

employment opportunities; to increase investment in microenterprise development; and to help to raise the level

of income in this sector of the economy.

See Berenbach and Guzman (1992), and Glosser, op. cit.65

See Glosser, op. cit.66

Part Three of this series (Financial Intermediation at the Local Level: A Policy Perspective) analyzes aspects of67

the BRI experience that may be transferred and adapted to other countries and institutions, and contrasts these withfeatures of the BRI example that are more institution or country-specific.

39

PRODEM offers credit through what is known as the solidarity group credit methodology. Borrowers65

are required to form themselves into non-family groups of four to seven microentrepreneurs. The group members

are jointly responsible in case of default by a member of the group. As of December 31, 1991, PRODEM provided

$4.6 million in credit outstanding to over 22,000 microentrepreneurs. In 1991 the average loan term was 18 weeks

and the average loan size was $274; the interest rate was 4 percent per month and arrears were below 1 percent.

In 1991 it was clear that PRODEM had become successful in providing and recovering loans to

microentrepreneurs. However, PRODEM, like Grameen and BKK, is capital constrained. Studies by USAID

and PRODEM indicated that the PRODEM credit program reached less than 2 percent of estimated demand.66

Yet as an NGO, PRODEM was legally restricted from seeking funding from client savings, commercial debt,

or Central Bank loans.

Therefore, PRODEM's Board of Directors decided to open a private commercial bank serving

microenterprises. As a bank, other sources of funds could be mobilized, the volume of lending could be expanded,

and full financial services could be provided to clients. By early 1992 about half of PRODEM's approximately

$5 million in assets was transferred to the newly created BancoSol, in exchange for about 44 percent of the bank's

shares. The new bank was able to recruit additional investors, and BancoSol opened with about $5 million in assets

raised from both Bolivian and international sources. Members of the BancoSol's Board of Directors and bank

managers visited BRI, in particular to learn about the mobilization of voluntary savings. BancoSol started in

February 1992 with 73 employees in one regional office and one branch in La Paz; by December 1993 the bank

had grown to 245 employees in 4 regional offices and 20 branches. As of December 1993, BancoSol has about

$24 million in credit outstanding, about 8 times the portfolio it inherited from PRODEM ($3 million). During

this period, the number of borrowers trebled, from 14,446 in February 1992 to 44, 843 in December 1993. Arrears

remain low (2.5 percent in December 1993). The annual effective interest rate charged on loans in Bolivianos

is 54 percent (including a 6 percent commission); the annual interest rate on Boliviano deposits is 21 percent.

BancoSol also began providing dollar loans at an annual effective interest rate of 31 percent.

Forced savings, almost universally disliked by clients, are no longer required for loans. In August 1993

BancoSol began a pilot project testing new savings instruments in both dollars and Bolivianos. Some of the new

instruments and services were adapted from BRI; others were newly created by BancoSol. The bank's aim is67

to expand profitably its volume of services to meet a larger portion of the demand for financial services from small

and microentrepreneurs in Bolivia. The move from PRODEM to BancoSol was made because the directors of

Examples of other such institutions are: AVANCE in Costa Rica; Assessores Para el Desarrollo (ASPEPADE)68

in Honduras; Asociacion para el Desarrollo de la Microempresa (ADEMI) in the Dominican Republic; the SelfEmployed Women's Association (SEWA) in India; the Bangladesh Rural Advancement Committee (BRAC); and theKenya Rural Enterprise Project (K-REP).

Khandker, op. cit., p. 4.69

40

both institutions realized that this goal can be reached only if the implementing financial institution becomes a

profitable financial intermediary. Like BRI, BancoSol aims to become both economically and socially profitable,

and to be sustainable without ongoing subsidies. Realizing, however, that there is need for different types of

financial institutions providing services locally, PRODEM continues its services as a non-profit institution. Their

respective boards have decided that while PRODEM will continue to receive subsidized funding for its

development activities, BancoSol will operate as a commercial bank.

Grameen, BKK, PRODEM and other financial institutions that are funded by subsidized loans or grants and that

provide credit at or near market rates to SMEs have demonstrated clearly that their loans reach and benefit poorer people,68

and that the loans can be recovered by the lending institution. All, however, have been limited, in varying degrees, by

a relatively small amount of loanable funds in relation to demand; this is a direct result of continuing subsidies to the

institutions and the simultaneous lack of permission and/or incentives for the large-scale mobilization of voluntary deposits.

For example, one of the most fundamental differences between the Grameen Bank and BRI is the Grameen view

that "Savings is an integral part of lending." In contrast, BRI believes that appropriately designed deposit instruments69

constitute a crucial financial service in their own right. Therefore, at BRI loans and deposits are both integral parts of

financial intermediation. This raises another important contrast between Grameen and BRI. Grameen serves its members

primarily, while BRI serves the public. This is a critical distinction because BRI raises savings from anyone who wants

to save in any one of its unit banks located throughout Indonesia; the ratio of deposits to loans in BRI's unit banking system

is about 6:1. In contrast, Grameen mobilizes savings primarily in the form of forced savings from its members. Since the

bank's members are very poor, they are unlikely to have the savings necessary to capitalize the bank for sustainability.

Although Grameen is well positioned to mobilize voluntary savings from the public in the rural areas of Bangladesh, the

bank has not thus far done so on a significant scale.

In summary, some subsidized institutions (e.g. BKK) have begun to place greater emphasis on the mobilization

of voluntary savings, while others (e.g. PRODEM/BancoSol) have changed institutional structure in order to do so. Yet

other financial institutions remain heavily dependent on subsidies either because government regulations prohibit or make

unprofitable the mobilization of voluntary savings, or because, as recipients of low-cost funds, the institutions themselves

have not made savings mobilization a high priority. Under these conditions, such institutions can meet only a small fraction

of the demand in either rural or urban areas of their countries. There are crucial policy implications here for both donor

agencies and governments.

41

A. 4. Summary: Credit Subsidies as A Triple Threat to Financial Intermediation

Supply-leading finance, often well-intentioned but largely ignorant of local realities in developing countries, has

led to massive subsidized credit programs worldwide and to large losses for many implementing governments and donor

agencies. The opportunity cost has been even more critical. The development of sustainable financial institutions serving

the local level has been prevented there is a consequent lack of institutional finance available to SMEs in developing

countries. In summary, credit subsidies:

(1) Subsidize local elites at high cost

Most loans provided at subsidized interest rates reach local elites. The usual result of the emphasis on

subsidized credit is that the programs suffer high arrears, while the majority of households in the areas 'covered'

have little or no access to institutional credit. Even in instances in which governments and banks have been able

to recover subsidized loans, as in Thailand, the benefits of the subsidies have reached the better-off households.

In summary, subsidized credit provided to borrowers tends: (a) to be allocated to those who are able to qualify

for larger loans; (b) to create continuing expectations on the part of local elites for subsidies; (c) to bypass those

who need smaller loans (which can usually be obtained commercially only for far higher interest rates); and (d)

to result in high arrears.

(2) Depress financial savings, discourage institutional sustainability, and limit the supply of institutionalcredit available to lower-income borrowers

Credit subsidies provided to borrowers discourage savings mobilization, since interest rates for loans

are typically lower than the interest paid on deposits, providing a negative spread and a disincentive to the

institution to mobilize savings. This has an adverse effect, both direct and indirect, on rural households and on

SMEs in urban areas of developing countries.

Directly, the lack of institutional savings instruments prevents households and enterprises from the

opportunity to hold their financial savings in deposit accounts locally. Non-formal financial savings options at

the local level in developing countries tend to offer security or returns, but normally not both; in addition

restrictions are usually placed on liquidity, a crucial requirement for SME finance. Thus, for example, ROSCAs

usually offer security, but those that provide security normally do not provide returns. In contrast, some informal

or quasi-formal finance companies offer returns, but often with considerable risk to the depositor. In most formal-

sector financial institutions in developing countries, savings are usually in the form of forced deposits required

as a condition for credit. Thus, deposit instruments for voluntary savings in formal institutions are usually the

only mechanisms that can provide the saver with a combination of all four desired components: convenience,

security, liquidity, and returns. However, with the exception of Indonesia, appropriate instruments and services

for mobilizing voluntary savings are not widely available at the local level.

Uses for subsidized loans and grants that can help in the development of sustainable financial institutions are70

discussed in Part Three of this Series.

42

The indirect effect is that the lack of savings instruments appropriate for local demand constrains the

volume of institutional credit available at commercial interest rates, thus depriving many lower-income families

of institutional credit for productive enterprises. For the financial institution itself, mobilization of voluntary

savings is the key to long-term viability. The lack of savings mobilization, therefore, depresses the development

of profitable, viable financial institutions serving the local level.

(3) Limit borrower access and prevent institutional sustainability - even when the subsidies are providedto financial institutions that lend to borrowers at commercial interest rates

Financial institutions providing non-subsidized credit to their clients are themselves frequently subsidized

by donor agencies, foundations, etc. Institutions that receive low-cost funds over long time periods have little

or no incentive to undertake the mobilization of savings at the local level. Under these conditions, the institutions

are not sustainable for the long term. Institutions dependent on subsidies generally do not mobilize significant

amounts of deposits unless instructed by their boards and/or donors to do so (if necessary, by changing institutional

structure, as was the case with PRODEM/BancoSol). Typically, therefore, such institutions cannot supply much

of the demand from SMEs for financial services. As discussed below in Section II.C, most low-income borrowers

must borrow at far higher interest rates (and total cost) from local informal commercial lenders.

This triple threat can be overcome. Financial institutions that provide sustainable financial intermediation at the

local level are of different types and sizes. They include such diverse institutions as: BRI, a state-owned commercial bank;

the Bank Dagang Bali in Indonesia, a private bank; the Cameroon Co-operative Credit Union League (CamCCUL), a

cooperative; and the Caisse Commune d'Epargne et d'Investissement (CCEI), an investment and commercial bank in

Cameroon. Other institutions, such as BancoSol in Bolivia, are currently in the process of moving from lending institution

to viable financial intermediary.

In the case of financial institutions lending to low-income borrowers at market rates, there can be useful roles

for subsidies - both for start-up costs in the early stages of institutional development and in some continuing efforts such

as technology transfer, staff training, and institutional improvement in communications/computerization. Once an70

institution lending at market-based interest rates is established, however, the most important contribution its governing

body and funders can make is to phase out subsidies for on-lending and to encourage the transition to financial intermediary.

This, of course, pertains to institutions located in countries in which regulations do not prohibit institutional profitability.

Where there are regulations obstructing sustainable financial intermediation, the first priority for sustainable microenterprise

finance is financial deregulation.

Financial intermediaries serving the local level may be quite different in structure; however, they tend to share

a similar philosophy: that providing financial services to small and microenterprises and lower-income households is good

Von Pischke, Adams, and Donald, eds., op. cit.71

Von Pischke, Adams, and Donald, eds., op. cit., p. 8.72

43

business; that these are clients needing commercial credit, not beneficiaries requiring subsidies; that subsidized credit

normally does not reach the poor (and if it does, the method is not sustainable); that there is large demand among lower-

income groups for credit at commercial interest rates and for appropriate deposit instruments; that liquidity is the key to

local savings mobilization; that savings mobilization is essential for financial intermediation at the local level; that financial

intermediation is required for institutional sustainability; and that providing lower-income households with access to

institutional finance is a fundamental component of economic and social development.

II. B. UNDERMINING FINANCIAL INSTITUTIONS WITH THE 'IF IT'S NOT BROKE DON'T FIX IT'THEORY OF INFORMAL COMMERCIAL CREDIT

The critics of subsidized lending programs reached a number of major policy-related conclusions over a period

of several decades. These include the views that: (1) subsidized credit programs do not achieve their aims, are not cost

effective, and serve to redistribute wealth regressively; (2) there is more demand from households and firms at the local

level for deposit services than for loans; (3) informal commercial lenders offer services that are cost-effective, and "useful

to the poor"; and (4) the formal sector usually cannot compete at the local level with the informal credit market because71

of the latter's access to better information. The first two conclusions constitute crucial contributions to rural (and other

local) financial markets. It will be argued here, however, that the last two represent serious misconceptions still widely

held by theorists, policy makers, and donor agencies. As these views constitute continuing obstacles to sustainable financial

intermediation at the local level, as well as to SME development, they are addressed here at some length. Point (3) is

considered in this section (II.B), while point (4) is discussed in Section II.C which follows.

B. 1. Informal Credit Markets: the Issues

It is widely believed that informal commercial lenders meet the credit needs of small and microentrepreneurs at

reasonable cost and that their services are beneficial to the poor. Therefore, from a development perspective, it is assumed

that there is no compelling reason to 'fix what is not broken'. As Von Pischke, Adams, and Donald stated in the introduction

to their classic 1983 volume, Rural Financial Markets in Developing Countries, the operations of moneylenders:

are frequently more cost-effective and useful to the poor than those of the specialized farm-credit institutions,cooperatives and commercial banks that governments use to supplant moneylenders . . . . The emerging perspectiveis that informal financial arrangements are generally robust and socially useful . . . . Widespread use of informalfinance suggests that it is well suited to most rural conditions. 72

Bouman (1989), pp. 8-9.73

Von Pischke, op. cit., Chapter 8.74

Gonzalez-Vega (1993), p. 23.75

For recent examples, see Bouman, op. cit.; Von Pischke, op. cit.; and Hoff, Braverman and Stiglitz, eds., op. cit.76

For discussion of "the myth of the malicious moneylender," see Von Pischke, Adams, and Donald, eds., op. cit.,77

Part I; and Von Pischke, op. cit., pp. 174-87.

44

This assumption has become part of the conventional wisdom about rural financial markets. Bouman put it this

way:

. . . the role and strength of informal finance agents in small-scale rural economies and their subsequent importanceto low income households should not be underestimated. In these penny economies the informal sector has anumber of advantages over the formal one. It responds remarkably well to rural, particularly short term financingopportunities and allows low income people access to services not available to them elsewhere and at a relativelylow cost. It can do so because the informal sector is the natural environment for rural people. . . (emphasis added).73

In Von Pischke's 1991 book, the chapter on informal finance is entitled "Value for the People". Gonzalez-Vega's view74

is similar: "Most informal lenders provide valuable financial services at a reasonable cost to borrowers." 75

One result of this view is that, outside Indonesia, intervention in local-level financial markets has not been accorded

high priority by policymakers and donor agencies. This situation continues at present primarily because of the widespread

assumptions that: (1) informal financial markets are competitive and function well; (2) financial institutions serving the

local level normally cannot compete successfully with informal lenders because of the higher-quality information about

potential borrowers which the latter control; and (3) risk and transaction costs make credit delivered at the local level76

expensive for the lending institution, while high transaction costs for the borrower (transportation, bribes, the opportunity

cost of time) discourage all but high-risk borrowers from entering the institutional commercial credit market. It is assumed

that in local financial markets, the creditworthy prefer the informal credit market.

These hypotheses are re-examined here; in all cases different conclusions are reached. Why are these issues of

importance? There are two primary reasons: because evidence is available that refutes the hypotheses cited above, and

because the new paradigm has crucial implications for policy and development. Therefore, informal commercial credit

markets operating at the local level in a number of developing countries are reviewed below. Evidence will be provided

to support the following views:

(1) The dynamics of local-level socio-economic processes, political alliances, and associated information flows

frequently ensure that informal credit markets are not competitive. This occurs not because moneylenders are

necessarily "malicious," but because they are rational participants in the local economy. 77

See footnote 28 for references concerning interest rates charged by informal commercial lenders in developing78

countries.

Most authors reporting on informal interest rates do not state either whether these are flat rates on the original79

balance or effective rates on the declining balance, or whether and how the rates are compounded. However, itappears that informal lenders typically calculateinterest rates on the original balance of the loan, while there is a wide range of practices with regard to compoundingrates.

45

(2) Institutions can gain access to local information and can deliver credit locally at substantially lower interest

rates and at much lower total cost to the borrower than the cost of loans from most informal commercial lenders.

(3) By supplying local demand for deposit mobilization, institutions can increase significantly their volume of

loanable funds, and can provide: (a) deposit facilities offering security, convenience, returns, and liquidity (not

typically offered in the informal financial market); and (b) loans to SMEs at lower cost than are typically available

on the informal commercial market.

(4) Under these circumstances, SMEs often prefer institutional loans to those available on the informal commercial

credit market.

(5) Repayment rates are high because borrowers wish to retain the option to reborrow from conveniently-located

financial institutions offering instruments and services appropriate for local demand.

(6) Financial institutions can not only compete with informal commercial lenders, they can become both socially

and economically profitable by doing so.

Two sets of facts are important for the development of this argument.

First, there is extensive evidence from developing countries worldwide that interest rates charged by

informal commercial lenders typically range from 2 to over 35 percent per month flat rate charged on the original

balance. 78

In general, the poorer the borrower, the higher the interest rate, since poorer borrowers have fewer credit options.

While lower interest rates are also reported from some countries and regions, flat rates in the 2 to 10 percent per month

range appear most common among informal commercial lenders in developing countries. As discussed in Section B.279

below, the volume of such credit is large; informal credit plays is widespread at the local level in developing countries.

Based on the findings of CPIS field research from 1982 to 1990. Informal commercial lenders throughout80

Indonesia were observed to lend at flat interest rates ranging from about 3 percent to over 35 percent per month, withmonthly rates from about 6 percent to about 15 percent being most common.

46

Second, the Indonesian evidence demonstrates conclusively that BRI lends profitably nationwide at 1.5

percent per month flat rate on the original balance, or about 33% annual effective interest rate: i.e. from one-half

to one-twentieth the rates charged by informal commercial lenders in Indonesia. 80

It has thus been proven that a financial institution can provide large-scale financial intermediation at the local

level, profitably and without ongoing subsidies. BRI does so nationwide in the world's fourth largest country. By

establishing small, conveniently located banks and instituting simple procedures, BRI is able to provide borrowers with

relatively low transaction costs. By providing loans at far lower interest rates than most informal lenders are willing to

offer (for reasons discussed below), BRI has found large demand for its credit services. Repayment is high primarily

because borrowers wish to retain the option to re-borrow. By offering deposit facilities appropriate for local demand, BRI

has been able to finance its loans. By establishing an adequate spread between loan and deposit interest rates, BRI's

nationwide system of local-level banking runs profitably.

This is a system that is sustainable for the long term. Why was it not derailed by competition from the informal

financial market? The reason is that BRI sorted out which assumptions about informal lenders were correct (and learned

from them); which were false (and discarded them); and which were true but not immutable (and overcame them).

In other parts of this series of papers, the BRI experience is analyzed from a variety of perspectives, e.g., the

development of financial instruments, loan repayment, profitability, institution-building, etc. The emphasis in this section

of Part Two is on how BRI learned to compete successfully with informal commercial lenders, and on what was learned

about the nature of the informal credit market. Much of what BRI learned in Indonesia about informal lending appears

to be relevant to other developing countries. Nevertheless, the view that informal commercial moneylenders are more cost-

efficient and beneficial to lower-income households and to SMEs continues to depress the growth of institutions providing

financial intermediation at the local level in developing countries around the world. This view also continues to contribute

to the unnecessary but widespread condition in which the poor pay far higher total costs for credit than would be required

if conveniently-located financial institutions provided credit to them at commercial interest rates. For these reasons, the

Indonesian material is reviewed here in the wider context of informal commercial markets in developing countries.

B. 2. The Size of Informal Credit Markets

Local financial markets in developing countries are typically composed of various types of informal lenders, quasi-

formal bodies, and formal financial institutions. The same individual, household, or group may participate in more than

one part of the system at any given time; credit is typically fungible throughout the system. Informal lending is of two

main types: commercial (loans from moneylenders, traders, employers, commodity wholesalers, landlords, etc.), and non-

commercial (loans from friends, relatives and some forms of rotating savings and credit associations, or ROSCAs, and

See Bouman, op. cit., pp. 52-53. RESCAs are non-rotating savings and loan associations in which all members81

save. However, all members do not necessarily borrow, and some members may borrow repeatedly.

Feder, et al. (1993).82

Miracle (1973), excerpted in Von Pischke, Adams, and Donald, eds., op. cit., p. 214.83

Braverman and Guasch (1986), p. 1257.84

DPIS Report No. 2 (1983).85

See Bank Rakyat Indonesia (1990). See also references in the Rural Development section of Part One of this86

series.

47

'regular savings and credit associations', or RESCAs). These, however, are models; reality falls along a continuum.81

The focus here is on informal commercial lending; the non-commercial part of the informal credit continuum

is not discussed. Information about non-commercial informal credit is largely anecdotal, as are data about loans that fall

in the middle of the informal credit continuum (e.g., loans with interest payable partly in financial form, partly in social

and political obligations). It is, however, relevant to comment briefly that while non-commercial loans from friends, kin,

neighbors, etc. are common and usually carry no (or low) financial interest, they often entail other kinds of social, political,

and economic obligations. Also, the capital for such loans is usually limited; the amounts are often inadequate and/or the

terms inappropriate for production credit for agriculture, local industries, trade, or services. Non-commercial informal

credit tends to be available: for small amounts for short terms; for emergencies; or for special occasions and specific

purposes, e.g. land purchase, weddings, house construction for a young couple, etc. A recent study in China makes the

important point that credit from relatives and friends tends to be non-fungible, e.g., in China house construction cannot82

normally be halted in order to use a non-commercial informal loan provided for this purpose to meet cultivation expenses.

In 1973 Miracle estimated that over 90 percent of the total credit provided to the small farmers of most developing

countries was through the informal credit market although, as he noted, this share was declining. With development,83

institutional credit has become more important, but it has been well documented that informal lending has remained the

most important source of credit for most borrowers in rural areas of developing countries. Braverman and Guasch comment,

"With the implementation of development plans, official lending complements but clearly does not supersede informal

sources". 84

Table 5 shows the pattern of village borrowing in 1980-81 in three Indonesian villages; these studies were used

as background for policy recommendations concerning the development of BRI's local banking system. The results are85

similar to those reported later for other Indonesian villages. Outstanding loans were reported by 74 percent of the86

households in Village G in East Java; by 59 percent of the households in Village C in West Java; and by 36 percent of

the households in Village R in South Sulawesi. However, in none of these villages was the institutional credit component

greater than 20 percent of the total loans reported.

48

TABLE 5

HOUSEHOLD BORROWING IN THREE INDONESIAN VILLAGES:

SOURCE OF LARGEST LOAN, 1980-1981

East Java West Java Sulawesi

Village Village Village

South

Number of households

in village 775 760 711

Percentage of household

heads reporting

outstanding loans 76.6 58.9 35.8

Institutional credit 17.9 20.1 14.0

BIMAS 6.6 16.5 2.7

Bank/other 11.3 3.6 11.3

Other sources of credit 82.0 79.9 86.1

Traders 16.5 26.9 2.1

Relatives/friends 37.3 14.8 40.3

Other informal

commercial loans 28.2 38.2 43.3

Source: Rice Intensification: Development Program Studies Implementation Report 2 (December, 1983).

Ghate, op. cit.; Von Pischke, op. cit.; Germidis, Kessler, and Megir, op. cit.; Hoff, Braverman, and Stiglitz eds.,87

op. cit.

Von Pischke, op. cit., p. 173.88

Hoff, Braverman, and Stiglitz, eds., op. cit. 89

Braverman and Guasch, 1993, p. 54.90

Siamwalla et al., op. cit. 91

Ibid.92

Udry (1993).93

Feder et al., op. cit.94

49

Four volumes published in the 1990s address the issue of the size of informal credit markets in developing

countries; each is based on comparative material drawn from a number of countries. There is considerable evidence87

presented in these volumes, as well as in other writings, that the size of informal credit markets remains very large, and

that in general, the majority of loans made in developing countries are provided by the informal sector.

Von Pischke's estimate, made in his 1991 Finance at the Frontier, is that "formal agricultural credit . . . probably

does not reach more than 20 percent of farm households . . . in the majority of developing countries". 88

A 1993 volume, The Economics of Rural Organization published by the World Bank, documents the importance89

of informal credit markets based on comparative evidence from different countries. Citing a number of sources, Braverman

and Guasch state there, "It has been estimated that only 5 percent of farmers in Africa and about 15 percent in Asia and

Latin America have had access to formal credit; on average across developing countries 5 percent of the borrowers have

received 80 percent of the credit." Reporting in the same volume on an extensive study of rural credit in Thailand90

conducted in 1984-85, Siamwalla et al. find that "the credit needs of poorer farmers are still served by the informal market

or not at all." These authors state further that "almost 75 percent of those active in the credit market still used the informal91

sector; in many cases, those households also used the formal sector". However, 60 percent of the total credit reported by

sample households in the study was supplied by informal lenders (compared with roughly 90 percent in 1975). The

Thailand study also reports that the institutional credit reaches primarily farmers with above average incomes. Other92

studies in the World Bank volume report that a 1988-89 survey of four villages in northern Nigeria found that only 7.5

percent of all loans (by value) came from the formal sector, and that a 1987-88 survey of four counties in China showed93

that "total informal debts outstanding are at least as high as total formal debts and often considerably higher." 94

A third volume entitled Informal Finance, based on studies in South and Southeast Asian countries, concludes

that: "the share of rural informal credit [by volume], although declining in most countries, still accounts for about two-fifths

of total rural credit in India and Thailand, one-third to two-thirds in Bangladesh, and more than two-thirds in the

Ghate, op. cit., pp. 10-11.95

See Germidis, Kessler, and Meghir, op.cit.; see especially Table 1.3 and pp. 39-49. 96

Hussein (1983).97

Germidis, Kessler, and Meghir, op. cit., p. 43. The continuing decline in the percentage of debt owed by rural98

households to informal lenders in India was caused in large part by the rapid expansion of commercial bank branchesafter the bank nationalization of 1969. The number of branches quadrupled between 1971 and 1981. It should benoted, however, that the figures of declining debt owed to informal lenders refer to percentage of debt, not topercentage of borrowers. See Bell (1993) for an analysis of the reasons for skepticism about official reports of therapid decline of the Indian moneylender. As shown there, Indian moneylenders are still very much in business,although often in other guises.

Kessler, Lavigne, and Ullmo (1985), p. 27.99

Van Nieukoop (1986).100

Germidis, Kessler, and Meghir, op. cit., p. 43.101

Kessler, Lavigne, and Ullmo, op. cit., p. 6.102

Germidis, Kessler, and Meghir, op. cit., p. 43. In the Philippines, the 1970s were marked by massive103

subsidized rural credit programs; many of these were stopped in the late 1970s.

50

Philippines. . . .The proportion of the total number of informal loans, or households borrowing from the informal sector,

is higher in most cases than these volume-based estimates would suggest." 95

A fourth volume on formal and informal finance in developing countries, published in 1992 by the Development

Centre of the Organization for Economic Cooperation and Development (OECD), provides extensive documentation96

on the respective shares of formal and informal finance in developing countries. The conclusions are as follows (stated

as presented in the country reports): Bangladesh (1983): "all major studies since 1974" show a mean of 60 percent of

credit from informal sources, with a range from 30 percent to 90 percent; India: the percentage of rural household debt97

from informal sources was: 83 percent (1961); 71 percent (1971); 39 percent (1981); Korea (1985): informal credit98

accounted for 50 percent of the outstanding loans of agricultural households; Malaysia (1986): 62 percent of the loans99

to farmers were from informal lenders; Mexico (1985): formal credit accounted for 45-50 percent of agricultural loans;100 101

Nigeria (1985): based on a representative sample from two states, 95 percent of the loans to farmers were from informal

sources; Philippines: the percentage of rural household debt from informal sources was: 60 percent (1950s and 1960s);102

30 percent (early 1970s); 78 percent (late 1970s); Thailand (1988): 52 percent of the loans made to the agricultural103

Ghate (1988), p. 66. See also Siamwalla (1987). 104

Germidis, Kessler, and Meghir, op. cit., p. 42. A survey of Zambian farmers (Nagle, 1987), cited there,105

found that farmers obtained 16 percent of their financing from formal credit sources and 84 percent from their ownfunds and/or informal lenders.

Ibid., p. 42.106

For discussion of asymmetric information, moral hazard, and adverse selection as applied to local credit107

markets, see Section II.C of this paper.

51

sector were from informal sources; Zambia: 57 percent of farmers' loans were obtained from the formal sector;104 105

Zimbabwe (1986): 13 percent of the small farmers received credit from formal sources.106

Although circumstances and trends vary in different parts of the developing world, there is little doubt that informal

commercial credit plays a major role in financing development at the local level in many countries throughout the world.

It should be noted also that in some of the areas in which the volume of institutional credit has become higher than that

of informal credit, such as parts of India and Latin America, the majority of borrowers continue to receive their credit from

informal lenders.

Yet many Indonesians are able to borrow from BRI, a commercial bank, at a cost which is substantially lower

than that of credit available from informal lenders. Given the vast amount of informal credit that finances most of the world's

borrowers at what may be significantly higher cost than necessary in many areas, there are compelling reasons for

understanding both the demand for local financial services and the Indonesian solution to the supply problem.

B. 3. Characteristics of Informal Commercial Loans

Since the nature of informal credit markets has fundamental implications for both theoretical and policy issues

of local finance, an attempt is made here to summarize information derived from the literature and from the author's own

fieldwork (in Indonesia, India, Sri Lanka, and Bolivia). The conclusions stated below result from information derived

from a large number of sources; documentation is provided in later sections of this paper. It appears that informal

commercial lending at the local level in developing countries is often marked by most or all of the following characteristics:

(1) Creditor and borrower frequently engage in interlinked transactions, i.e, in addition to lender - borrower, they

are also linked as trader-supplier, employer-employee, landlord-tenant, etc. They may also be linked by kin and

political relations. This characteristic plays an important role in enabling lenders to overcome moral hazard and

adverse selection.107

(2) The lender typically has good information about the borrower (in many cases, such information is symmetrical

or nearly so).

Siamwalla et al., op. cit., p. 177. 108

52

(3) Flow credit tends to predominate, but stock credit is also provided. The distinction is made as in Siamwalla et

al. (1993). Loans with repayment periods of less than one year (usually for consumption or working capital)108

are termed 'flow credit' because the information most relevant to the creditor concerns the borrower's income flow.

In contrast, 'stock credit' (usually for long-term investment) refers to loans with terms of a year or more; the lender

is primarily interested in the borrower's assets and liabilities.

(4) Most flow credit is provided for relatively small amounts and short terms, usually from a few weeks to a few

months. These loans are normally made available within a short period, with little or no paperwork, and without

regard to the intended use of the funds. Collateral is often not required. However, especially for first loans or

in urban areas, loan security may be required (usually in cash or in the form of small valuable items such as jewelry

or heirloom cloth).

(5) For larger amounts of flow credit, and for most stock credit, the conditions are similar to those of smaller loans,

but generally with two exceptions: (a) borrowers are limited to those with whom the lender maintains extensive

interlinked transactions in other markets; and/or (b) collateral worth considerably more than the value of the loan

is required.

(6) People at all socio-economic levels participate in informal commercial credit markets, and many are both lenders

and borrowers. The poor borrow typically for consumption and production. The better-off borrow for more

conspicuous consumption; for investment; for purchase of scarce goods such as real estate, vehicles, and

construction materials (for which scarcity of supply may require that the stated prices paid from visible sources

be supplemented payments made from black market funds); and in order to obtain political opportunities and

favors.

(7) Borrowers tend to use one informal commercial lending source for relatively long periods of time, although they

may borrow simultaneously from friends, relatives, and the formal sector. This is a crucial point, the implications

of which are discussed in Section II.C.6 below.

(8) For the above reasons, default rates are normally low.

(9) Because of market interlinkages and co-variant risk, however, lenders may lose interest at times of collective shock

- drought, flood, pest attack, war, macro-economic shock, epidemics, etc.. For reasons discussed later in this

section, informal commercial lenders typically lend to borrowers who live and work nearby. Also, the same

For example, Siamwalla et al. comment on the availability of funds in Thai informal rural credit markets: "In109

our extensive interviews with informal lenders in Thailand, there is very little evidence that the volume of theirbusiness is constrained by the availability of funds. Besides many informal lenders are engaged in other activities thatcould not possibly yield the . . . return that they obtain from moneylending" (op. cit., p. 172). See also Aleem, op. cit.

53

individuals, in addition to being creditor and debtor, may be landlord/tenant, commodity wholesaler/supplier,

etc. Since the lender usually cannot diversify risk, lender and borrower are normally subject to the same external

shocks. Under such circumstances, loans tend to be rescheduled, and lenders may lose or forgive interest in order

to collect principal and to maintain ongoing economic relationships.

(10) Transaction costs for lenders include the cost of funds; the cost of collecting information about potential borrowers;

and the costs of extending, recording, and collecting the loans. These are generally higher for initial borrowers,

lower for repeat borrowers. For largerloans, bribes or political favors may also be required. Transaction costs

for borrowers include transportation and the opportunity cost of time; both tend to be relatively low.

(11) As noted, interest rates for informal commercial loans tend to range from 2 to 35 percent flat rate per month on

the original balance, although both lower and higher rates have also been reported. Rates from 2 to 10 percent

are those that seem to be most commonly reported; the same informal lender may charge different interest rates

to different borrowers. In general, poorer borrowers pay the highest interest rates. Interest rates are discussed

further in Sections II.C.4 - 6 below.

(12) Because of interlinked transactions, local politics, and the structure of information, the tendency is towards many

lenders operating in a given area, with a relatively small number of borrowers per lender. This point, together

with Point 13 below, are essential to an understanding of the operations of informal credit markets; they form

the subject of Section II.C.6.

(13) Entry of lenders into the market is usually relatively free. The constraint is rather on the number of borrowers

who fall within the sphere of influence and information control within which the lender can easily recover loans.

(14) Except in times of collective shock, loanable funds are usually not a scarce factor in the informal credit market.109

This is because of the common pattern of many lenders, each lending to a relatively small number of (usually)

repeat borrowers.

(15) However, because of capital constraints on the part of individual lenders whose business activities and risk are

usually not regionally diversified, the informal credit market may be inadequate at times of regional shock.

Braverman and Guasch, 1986, p. 1257.110

No attempt is made here to distinguish between flat and effective interest rates because reports are often unclear111

about whether the interest is charged on the original or declining balance. Whether interest is compounded is alsooften unclear in the reports. Where such information is specifically stated,it is cited.

See Robinson (1988); Bell (1993).112

See Feder et al., op cit.113

54

B. 4. Informal Commercial Credit: Interest Rates

Informal commercial credit is generally expensive for the borrower. Data concerning informal credit markets

are difficult to interpret because the markets have been studied in different ways, and reports cover different kinds of

transactions and different time periods. In addition, authors are frequently ambiguous about such matters as linked and

unlinked loans, and whether the interest rates cited are charged on the original loan balance or on the declining balance,

and whether interest is compounded. Nevertheless, the prevalence of high interest rates in informal credit markets is so

well documented that the literature is filled with debates as to why these rates are so high. Braverman and Guasch report

that, in contrast to credit provided by organized institutions, informal lending in rural areas is characterized by "higher

interest rates, with a median around 50% and a variance much higher than institutionalized credit rate." Among the110

reasons that have been suggested for the high interest rates charged by informal commercial lenders are: the opportunity

cost of funds, administrative costs, risk premiums, high default rates, scarcity of capital, insufficient collateral, borrowing

for consumption purposes, seasonal character of demand, low geographic mobility, low levels of borrowers' income and

education, and monopoly (or oligopoly) profits. The main arguments of the debates are reviewed in Section II.C.5; a

different explanation for the high interest rates is provided in Section II.C.6.

First, some examples of interest rates in informal credit markets in Asia within the past decade are provided

below. Despite deficiencies in the data, there is abundant evidence to demonstrate that informal interest rates are high111

in many areas of these regions (as is true also in other parts of the developing world). The examples are grouped into four

broad categories of informal commercial lending in order to facilitate discussion. As in other aspects of local finance, these

do not represent discrete types but rather points on a continuum. The discussion here does not attempt to cover all the

variations of informal financial markets; the focus is on selected clusters of components in these markets. In some areas

all four loan categories can be found together (parts of India), while in others areas none is common (parts of China).112 113

With the exception of the last type which is generally restricted to very undeveloped regions, the others are commonly

found in varying forms throughout much of the developing world.

(1) Short-term loans collected daily

Very high-interest, short-term credit is especially common in cities and among the poorest borrowers in rural

areas. There are many variations in this type of credit, and loans can be used for working capital or consumption, or both.

Von Pischke, op. cit., pp. 184-85. 114

Germidis, Kessler, and Meghir, op. cit., pp. 89-90.115

Ibid., pp. 89-90.116

Based on the findings of CPIS field research, 1982-1990.117

Interlinked transactions can be defined as those "in which all parties trade in at least two markets on the118

condition that the terms of all trades between them are jointly determined" (Bell and Srinivasan, op. cit., p. 73). "Suchinterlinkages assume economic significance when the prices of commodities transacted through interlinked marketsdiffer what their prices would have been if they were not interlinked" (Gangopadhyay and Sengupta, 1986, p. 112). For discussion of interlinkages among rural markets, see also Neale (1969); Bhaduri (1973); Bardhan and Rudra(1978); Bardhan (1980; 1984; ed. 1989); Braverman and Srinivasan (1981); Braverman and Stiglitz (1982);Braverman and Guasch (1984); Binswanger and Rosenzweig, eds. (1984); Hart (1986 b); Robinson (1988); Ray andSengupta (1989); Yotopoulos and Floro (1991); Floro and Yotopoulos, op. cit.; Hoff, Braverman, and Stiglitz, eds.,op. cit.

See Bell, op. cit., p. 197.119

55

An urban example is the Philippine informal finance system in which a street vendor obtains fresh produce each morning

at P 50 and repays P 60 each afternoon, and of a dried fish vendor who obtains dried fish for P 1000 and pays P 200 for

six days (the 'five-six terms'). Repayment rates in this Philippine system are reported to be high. Another variant found114 115

in India is the "Bombay merchants" (trader-moneylenders) who make consigned purchases of items, usually appliances,

and sell them to clients on an installment basis. The client normally pays 100 percent markup on the market price and repays

in daily installments. A more highly organized example of this general type of credit is found in many areas of Indonesia.116

Credit cooperatives such as KOSIPA (Koperasi Simpan Pinjam, or Savings and Loan Cooperative) and KOVERI (Koperasi

Veteran Republik Indonesia) dispense small loans at flat rates of 20 to 40 percent per month or higher, usually collected

daily. Borrowers are frequently landless laborers in rural areas. KOSIPA creditors interviewed typically claimed a 100

percent repayment rate, probably close to accurate since such lenders tend to be powerful in the community. 117

(2) Short and medium-term credit, with or without loan security

Credit with loan periods up to one year is typically used for working capital, but may also be used for consumption

expenses or investment capital, or for various combinations of these. Borrowers and lenders are frequently engaged in

interlinked transactions, i.e,, lenders provide credit to their produce suppliers, agents, employees, tenants, etc. Lenders118

generally face low risk in providing credit to such borrowers. Most borrowers, even those not linked to a lender by other119

transactions, borrow repeatedly from the same informal commercial lender; the reasons are explored in Section II.C.6 below.

Loan terms are often shorter than a year, and a borrower may take several loans sequentially within a single year. Loan

security may or may not be required; both collateral and loan terms depend primarily on the amount of the loan and the

relation between lender and borrower. Some examples of interest rates charged are provided below.

Floro and Yotopoulos, op. cit., pp. 75-76. 120

Ibid., pp. 86-87. 121

Ibid., p. 86.122

Siamwalla et al., op. cit., pp. 168-70.123

Bank Rakyat Indonesia, op. cit.124

Hossain, op. cit., p. 22.125

Aleem, op. cit., pp. 147-48.126

Ibid., p. 149.127

See Bell, op. cit.128

56

A 1984 survey of 111 borrowers and 16 lenders in 14 villages in three provinces in the Philippines investigated

the proportions of linked and unlinked credit and found that linked loans dominated the informal credit market, accounting

about 80 percent of the total volume of informal credit. Effective interest rates for informal lending in the overall study120

area ranged from 6.2 percent to 32 percent per month. As would be expected, marginal areas had higher average interest

rates than developed areas, and "unlinked loans have in general significantly higher interest rates . . . than linked loans".121

The effective monthly interest rate for informal unlinked loans was 19.2 percent; for linked loans the rate was 14.4 percent

per month. 122

Based on three major surveys (1984-87), Siamwalla et al. found average interest rates in rural Thailand to range

from about 2 to 10 percent per month. In Indonesia the KUPEDES Development Impact survey found that the average123

monthly interest rate charged to respondents by informal moneylenders in 1988 was 13.4 percent; for loans from commodity

wholesalers (usually working capital advances) the rate was 14.8 percent. In Bangladesh, Hossain estimated the average124

annual rate of informal commercial interest in 1982 to be 125 percent. Aleem's detailed study of the informal125

commercial interest rates paid by farmers in Sind, Pakistan, in 1980-81 reports that the average annual rate of interest

paid to informal lenders was 78.7 percent. Annual interest rates there ranged from about 18 percent to 200 percent (in

comparison with the subsidized bank rate of 12 percent). Aleem reports:126

There is a link between pricing distortions in informal credit markets and the Government's policy regardinginterest rates on institutional loans . . . . On average, about 30 percent of the informal lender's funds come directlyor indirectly from low-cost institutional sources. Indeed a major benefit to the lender from nonspecialization wasthe access trading activities gave him to low-cost and subsidized institutional credit.127

As in Pakistan, extensive arbitrage is reported in India. Moneylenders are reported to obtain significant amounts

of funds from subsidized loans and to on-lend at high rates to small farmers. There is wide variation of informal interest128

rates in India, depending on region, local politics, and degree of economic development and communication facilities.

Timberg and Aiyar (1984), p. 57; the study was of informal lenders in urban credit markets. See also Bouman129

(1989).

Roth (1983), p. 46.130

Robinson (1988). For references on bonded labor, see footnotes 136 and 141.131

Bell, op. cit.132

See Siamwalla et al., op. cit.133

See Robinson (1988).134

57

Thus, reported interest rates charged by informal commercial lenders in India range from about 2-4 percent per annum

above bank rates, through rates up to 300 percent per annum, and finally bonded labor in which the interest on the129 130

loan is repaid by the borrower's full-time work. It has been argued that supply of funds, informational problems about131

borrowers, and opportunity cost impose limits on arbitrage in rural India. It should be noted, however, that these limits132

apply to the credit dispersed by individual lenders, not to the number of such lenders in the system and thus not to the

aggregate amount under arbitrage.

(3) Long-term loans requiring collateral

Long-term loans (for periods of more than one year), are normally provided in larger amounts than shorter-term

loans and are typically used for investment capital. These are much less common than shorter-term loans; lenders tend133

to make only a few larger loans at any given time, and only to very well known customers. Interest rates appear to be

generally similar to those charged for category 2 loans, but collateral in the form of land, business assets, etc. is usually

required. When lender and borrower are engaged in active political alliances, political support may be required as part

of the interest payment. In some cases political support can substitute for repayment of part of the loan capital, in others

they may substitute for part of the interest payment. Loans made by political supporters to candidates for office or to

government officials may be repaid wholly or partially in political favors. 134

(4) Loans to force borrower default

Another type of loan with a de facto long term is found only in certain areas, usually in undeveloped regions.

In this case, the aim of the lender is not primarily to collect interest payment but eventually to force the borrower to default.

This aim may be accomplished either by charging high, and often compound, interest rates on a relatively small loan; or

by charging lower interest rates on a larger loan (or series of loans) than the borrower can afford. Either is likely to drive

the borrower to default. Through such default, the lender gains acquisition of mortgaged land; a cheap long-term supply

Attached labor refers to a system whereby a laborer takes a loan; his labor then belongs to his creditor until the135

loan is repaid (under a variety of payment systems). Bonded labor, a subset of attached labor, refers to thosearrangements between laborer and employer where the presumption is that the laborer's work cannot provide bothsubsistence and loan repayment within the fixed time period (as, for example when the laborer's full-time work paysonly the interest on the loan). For references on attached and bonded labor, see footnotes 124 and 129.

For a classic account of the use of the debt mechanism to acquire land, see Darling, op. cit.; see also Reserve136

Bank of India, op.cit.; Bhaduri (1977); and Roth, op. cit. For recent analysis, see Robinson (1988), and Floro andYotopoulos, op. cit. For the acquisition of attached labor through debt, see Government of India (1960); Kumar(1965); Harper (1968); Breman (1974); Indian School of Social Science (1976); Chaudhuri (1976); Mundle, op. cit.;Rao (1977); Sharma (1978); de Silva et. al. (1979); Vyas (1980); Bardhan and Rudra (1980); Marla, op. cit.; Kamble,op cit; Roth, op. cit.; Basant (1984); Binswanger and Rosensweig, op. cit.; Robinson (1988). For recent review of therelation of debt to price stipulation in the case of trader-lenders and producer-borrowers, see Bell and Srinivasan,op. cit.; and Floro and Yotopoulos, op. cit..

In India, such loans are found in Bihar, parts of Uttar Pradesh, Rajasthan, and West Bengal, and the Telangana137

region of Andhra Pradesh; however, loans of this type are rarely found in more developed areas such as Punjab,Kashmir, and Kerala.

Marla, op. cit., p. 4. 138

Roth, op. cit., p. 62. See also Sharma, op. cit.; and Robinson (1988). 139

58

of attached labor; or acquisition of monopsony power in setting commodity prices, i.e., the borrower must sell his produce135

at the lender's price even if other buyers are available. 136

These loans, common in parts of South Asia, are often illegal but nevertheless still fairly common in some rural

areas. A 1981 national survey of bonded labor in India concludes: "The moneylender does not demand any security;137

money can be given at any hour of the day or night; in most cases no formalities are observed . . . . The main interest of

the moneylender is to secure a source of cheap labour for himself, if possible, on a long-term basis." In a discussion138

of 'debt farming' in Bihar, Roth sees credit as a means to "capture a long term source of labour that is cheaper than is

available under the conditions of the open labour market".139

With the exception of this last type of loan, informal commercial loans frequently perform positive (if not ideal)

functions. They can help to finance agriculture, business, and trade activities both by serving as a type of bridging finance

available before formal credit can be obtained, and by reaching borrowers who are unable to obtain institutional credit.

Is it necessary, however, that the borrowers pay the high interest rates typically charged by informal commercial lenders?

As has been demonstrated in Indonesia, borrowers can pay much lower interest rates (and total cost) for credit delivered

at the local level, if profitable institutions provide financial intermediation in local financial markets.

The arguments in the debate over the reasons for high interest rates in informal commercial credit markets are

reviewed below. It should be noted that both sides justify the prevailing interest rates as necessary for the market to work

(although for different reasons). In Section II.C.6 this author suggests a different explanation for the high rates, and a

different conclusion about how the market works.

For references concerning interest rates in the informal commercial markets of rural areas in developing140

countries, see footnote 28 and Section II.B.4. For recent reviews of the debates, see Von Pischke, op. cit.; andGermidis, Kessler, and Meghir, op. cit.

For discussion of monopolistic and exploitive moneylending see among others, Darling, op. cit.; Thorner141

(1953); Gamba, op. cit.; Government of India, op. cit.; Economic and Political Weekly (1975); Mundle, op. cit.; IndianSchool of Social Sciences, op. cit.; Chaudhuri, op. cit.; Rao, op. cit.; Sharma, op. cit.; de Silva et al., op. cit.; Vyas, op.cit.; [Philippine] Presidential Committee on Agricultural Credit (1980); Marla, op. cit.; Kamble, op. cit.; Roth, op. cit.;Basant, op. cit.; Dhanagare (1985); Robinson (1988); Bell, op. cit.


See footnote 77 for references. 143

59

B. 5. The Interest Rate Debates

For at least three decades, there has been extensive debate about the reasons for the high interest rates commonly

associated with informal commercial credit in rural areas of developing countries. There are two main arguments.140

The first, and older, view is that informal credit markets are non-competitive and that monopolistic moneylenders

charge high interest rates, extracting substantial profits. A variant of the monopolistic moneylender is the lender whose

primary aim is not to extract the interest payments but to force the borrower to default. There is considerable evidence,

dating from at least the 1920s until the present, in support of the argument that some informal commercial lenders gain

monopoly profits, collected in financial form, land, or labor. 141

The argument that high interest rates result, at least in part, from informal lending monopolies was recently

summarized as follows:

Proponents of this view underline a number of particularities of informal sector lending to explain theemergence of such lending monopolies. First, moneylenders operate in areas where few individualshave a sufficient amount of loanable funds, while low geographical mobility restrains the entry of newlenders into the credit market, and makes it expensive for prospective borrowers to shop around foralternative credit sources. As a result, the number of potential lenders in a given area is limited, and thedegree of market power thus conferred on them may range from pure monopoly (one lender to a village)to some point short of perfect competition.142

The opposing view in the debate is that the informal commercial credit market is competitive, that the 'malicious

moneylender' is a 'myth', and that interest rates reflect real costs of loanable funds. Wilmington, Bottomly, Von Pischke,143

Adams, and others have argued extensively against the idea that significant numbers of private lenders exploit rural

borrowers through excessively high interest rates made possible by credit monopolies. In their attempt to refute the so-called

'myth of the malicious moneylender', their main argument has been that interest rates for informal commercial loans reflect

For discussion of transaction costs and arguments explaining the interest rates of rural lenders as a reflection of144

these, see Wilmington, op. cit.; Tun Wai, op. cit.; Singh, op. cit.; Bottomley, op. cit.; Adams and Graham, op. cit.; VonPischke, Adams, and Donald, eds., op. cit.; Vogel (1984 a); Adams and Vogel, op. cit.; Bouman (1989); Ahmed(1989); Von Pischke, op. cit. See Siamwalla et al., op. cit., for a critique of the 'idealization' of the informal creditmarket as represented in the literature that defends the high interest rates of rural moneylenders on the basis of hightransaction costs. For discussion of interlinked transactions, and of lender transaction costs in linked and unlinkedloans, see Floro and Yotapoulos, op. cit. and references in footnote 118. For discussion of the costs of credit layeringin informal credit markets, seeFloro and Yotopoulos, op.cit.

Von Pischke, op. cit., p. 179.145

Von Pischke, op. cit., pp. 179-84. The three studies referred to are Singh, op. cit.; Harriss (1983); Iqbal (1988).146

See references in footnote 141. 147

60

the lenders' transaction costs and that, therefore, most rural lenders are neither exploitive nor malicious. Rather, it is144

argued, they are to be considered providers of important financial services in rural areas at reasonable rates. Thus:

Field studies do not support the myth. Karam Singh . . . [in a 1968 study of a village in Northern India] estimated,using linear programming analysis, that monopoly profits approximated 9 percent of amounts loaned, while interestrates paid by borrowers exceeded 140 percent per annum.145

There are three different arguments in these debates that need to be disentangled.

(1) The 'malicious' moneylenders

The existence of 'malicious moneylenders' is not an issue of myth or reality; such lenders represent one end of

a continuum within informal financial markets. It has been extensively documented that some informal moneylenders

are malicious and exploitive, and that many are not. The latter provide useful financial services; the relevant question with

regard to them is not one of degree of malice, but one of degree of efficiency. Does the borrower need to pay such high

costs? This question is discussed below.

In order to refute the 'myth of the malicious moneylender' in India, Von Pischke uses the 1957 All-India Rural

Credit Survey as well as studies by three economists. Yet there is no lack of evidence of malicious moneylending in146

India: scores of micro-studies and central and state government reports have documented exploitive credit practices in India

for the last four decades. Lenders tend both to charge high interest rates which are often collected in labor and land use

as well as in financial form, and to prevent subordinates (employees, tenants, suppliers, etc.) from gaining access to

institutional credit. The purpose is generally to keep the borrowers indebted in order to increase land control, to insure147

a low-cost and available supply of labor and commodities, and to maintain political support (required from borrowers).

Such lenders are not a myth, but they are not ubiquitous either. The one aspect on which most observers and analysts agree

is that these practices decrease or disappear with development.

Wilmington, op. cit., p. 255.148

Bottomley, op. cit., p. 243.149

Von Pischke, op. cit., pp. 175.150

61

Increased commercialization, monetization, and availability of institutional credit have occurred widely in rural

areas of developing countries during the past three decades, but at different rates in different areas. Extremes may be found

within a single country (for example, in India 'malicious moneylenders' are far more prevalent in less-developed Bihar

than in better-developed Punjab). In addition, multiple forms of informal credit may exist in the same area since the

geographical availability of non-exploitative lenders may be superseded by political constraints which deny access to some

borrowers. The prevalence of exploitative lenders depends upon a variety of factors including the level of development

of the area, the income distribution, the availability of communication facilities, as well as historical, geographical and

political considerations.

(2) Transaction costs and risks for lenders

The issues of lenders' transaction costs and risk premiums have been hotly debated. Wilmington, Bottomley,

Von Pischke, Adams, et al. have rightly attempted to discredit the view that all moneylenders are malicious monopolists.

However, in order to do so they have insisted that the observed high interest rates are accounted for primarily by transaction

costs and risk. This view cannot be accepted as a general principle; in some cases it is true, in others it is not. Because of

the ways in which the argument has been made, however, the disagreements on the extent of transaction costs in informal

credit markets verge on the ludicrous.

Arguments that high interest rates are a result of high transaction costs

and risks include:

Wilmington (1955): Village merchants, landowners, and persons with no other occupation commonly lend moneyto small farmers in the developing world. Their interest rates tend to be very high, and they are often denouncedby intellectuals and city dwellers. But their costs and risks are also high, and their services are adapted to theirclients. 148

Bottomley (1975): The high cost of administering small loans and persistent repayment problems lead to highinterest rates in informal rural money markets in the developing world.149

Von Pischke (1991): The basic flaw in the malicious moneylender myth is that it interprets quoted lending ratesof interest, often of stratospheric heights, as evidence of monopolistic practices. High prices do not provemonopoly, however. How many observers would conclude, for example, that because a car costs more than abox of matches that the manufacturer or retailer of the car gouges consumers?150

However, the opposite view is taken by others:

Bouman, op. cit., p. 9.151


Long (1968), p. 276.153

Floro and Yotopoulos, op. cit.154

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Bouman (1987): Informal intermediaries . . . survive on the basis of competitiveness, financial viability and lowcost operations.151

Germidis, Kessler, and Meghir (1991) find explicitly that lender transaction costs in the informal sector are low

because of low overhead; low default risk; good, cheap information on the credit worthiness of potential borrowers; and

interlinked credit contracts:

Transaction costs in the informal sector are low (administrative expenses such as premises and overhead costsare low or non-existent) . . . Default risk is minimized by informal lenders in a number of ways. Information onthe credit worthiness of potential borrowers can be obtained easily and relatively cheaply, since lenders usuallylive and work in the circumscribed area of their financial operations, which also allows for effective follow-upon outstanding loans. Lenders employ an additional means of minimizing default risk: through interlinked creditcontracts, i.e. with ex ante or ex post tie-in arrangements established between the credit market on the one handand the land, labor, or product markets on the other, through the overlapping personae of moneylenders, landlords,employers, or produce dealers."152

Are the transaction costs and risks of informal commercial lenders high or low? The answer, of course, is both -

depending on the circumstances. Lenders' transaction costs can be expensive and lenders may price high when they cannot

diversify risk. Transaction costs and risks, especially for repeat borrowers, can also be very low. As Long pointed out

in 1968, There is considerable variation in informal financial markets:

In most Asian countries, the agricultural credit markets. . . are not classifiable either as fully competitive or fullymonopolized. Competition may prevail in one village market while the next is under the control of a single lender.Even within a village one borrower may have several sources of loans, while another lacking alternatives maybe forced to pay monopolized rates.153

Consistent with Long's argument, Floro and Yotopoulos (1991) demonstrate that lender transaction costs vary,

depending on a number of interlinked variables: the type of contract; the type of lender (farmer-lenders are distinguished

from trader-lenders in their aims and their preferred clientele); whether the loans are linked or unlinked to other transactions;

and the extent of layering in the informal credit market. 154

Singh, op. cit., p. 252.155

63

(3) 'Gouging' the customers

Von Pischke's car/matchbook hypothesis on consumer gouging cited above needs re-examination. The crucial

issue is not whether the seller of the car is, from the seller's point of view, 'gouging' the consumer, but whether the buyer

can do significantly better in another car market. As noted above, Von Pischke uses Singh's survey of seven lenders in

Amritsar District of Northern India in support of his argument that high interest rates are caused by high transactions costs

and high risk levels. In this example it is stated that monopoly profits approximated 9 percent of amounts loaned, while

interest rates paid by borrowers averaged 143 percent per annum "based on the principal loaned out for the season".155

This is a crucial point. A borrower who is paying interest of 143 percent per annum on the original loan balance

is paying eight times the BRI rate (1.5 percent monthly on the original balance). If Von Pischke's car buyer has purchased

a $15,000 automobile for $120,000, he or she could do much better with an alternative source of funding. It seems likely

that borrowers who are charged interest of 143 percent per annum are paying unnecessarily high rates - regardless of the

level of the moneylender's profit or degree of malice. This is an issue that underscores the shift from credit delivery to

financial intermediation at the local level.

"Malicious moneylenders,' transaction costs, and risk premiums can all be causes of high interest rates (in varying

degrees, depending on the circumstances). However, none of these, or even all of them together, explains satisfactorily

the widespread persistence of high interest rates in informal rural credit markets. Therefore, a different explanation is

presented below.

B. 6. The 'Many Lenders' Syndrome

Informal commercial lenders generally understand well that lending beyond one's sphere of influence and control

of information can lead to high defaults and thereby to a lowering of the quality of the loan portfolio. Therefore, the

constraint on lenders tends not to be availability of funds; the constraint is on the number of borrowers over whom the

lender can maintain sufficient control to minimize the default rate. The argument that will be made here is that: (1) informal

credit markets in Indonesia, as elsewhere, are usually not competitive; (2) local lenders in Indonesia generally do not lower

their interest rates in order to compete with BRI; (3) following BRI's success, other financial institutions began to offer

services at the local level, thus providing competition to BRI; and (4) formal-sector intervention in local financial markets

provides both institutional sustainability and competition, in the process furthering social and economic development.

Interlinked transactions among local markets (commodities, land, labor, credit, etc.), combined with local political

alliances, create information flows that are both channeled and constrained by local-level social processes. It is the networks

through which these interlinked transactions are conducted, and the associated political, business, social, and kin-based

alliances of the locality, that typically provide the information flows and controls that enable lenders to recover their loans

For early reports of the 'many lenders' operating in rural credit markets, each lending to relatively small156

numbers of borrowers, see Moore (1953); Government of Ceylon (1954); Wilmington, op. cit; Gamba, op. cit.; Bottomley (1964); Nisbet, op. cit. For more recent examples, see Siamwalla et al., op. cit. for Thailand; Aleem, op.cit. for Pakistan; Presidential Committee on Agricultural Credit, op. cit. for the Philippines; Ladman and Torico(1981) for Bolivia; Harriss, op. cit. for India; Bouman (1984) for Sri Lanka; and Varian, op. cit. for Bangladesh. Seealso Von Pischke, op. cit.; Bell and Srinivasan, op. cit.; and Floro and Yotopoulos, op. cit.

Siamwalla, et al., op. cit., pp. 161-62. 157

Aleem, op. cit., pp. 148-49.158

Ibid., p. 150.159

64

with relatively low risk. Local business networks and political alliances provide control mechanisms; they also provide

constraints that effectively limit the number of borrowers per lender.

The prevalence of loans linked to transactions in other markets is related to a widely reported, but little analyzed,

characteristic of local credit, i.e., informal commercial lenders typically provide credit to relatively small numbers of

borrowers (usually under 50, and rarely over 100, each). For example, Siamwalla, et. al. report from three surveys on156

rural credit carried out in Thailand between 1984-1987, one a national survey in six regions of the country:

Informal lenders are very thick on the ground . . . . [the number of borrowers per lender] ranges from one to forty-five borrowers, with the average loan portfolio being 36,000 baht (or $1,440) per lender.157

Informal credit markets tend to consist of many small monopolies or quasi-monopolies generated by the dynamics

of local level socio-economic processes and associated information flows. The dynamics of these markets are best explained

by monopolistic competition, except that in this case monopoly profits can be maintained over the long term. Lenders,

even over time, do not usually compete for the same borrowers. Established lenders typically do not want to increase their

share of the market, and therefore, are normally not induced to reduce their interest rates.

As Aleem points out from his study of the Chambar rural credit market in Pakistan:

Each lender in this environment is perceived by borrowers to be offering a different product; thus each faces adownward-sloping demand curve, which gives him some flexibility to price according to their own circumstances.Equilibrium in this model involves a distortion in the market; there are too many lenders in relation to the sizeof the informal credit market . . . . This observation of 'too many lenders' is not unique to the Chambar market.Similar observations have been made in studies of credit markets in other countries. 158

Thus, local politics, market interlinkages, and the structure of information transfers often serve to limit the number

of borrowers per lender, to impose a generally high level of risk to the borrower in changing lenders, and to maintain high

interest rates in the informal commercial credit market. Under these circumstances, of course, it is not surprising to find

that high interest rates are common in informal credit markets. As Aleem points out: "Because of these [information]

imperfections [in the market] the lender does not have an incentive to cut interest rates to increase his market share, even

when rates are well above his marginal cost of lending."159

Siamwalla, op. cit., p. 170.160

65

In their crucial arguments against credit subsidies, Adams, Von Pischke and others sometimes lost sight of the

difference between intervention and subsidy, and tended to assume that removal of formal-sector interventions would leave

behind local, informal competitive credit markets.

This critical literature [in Von Pischke, Adams, and Donald, eds. (1983)] stressed the distortions introduced bygovernment policies [for credit subsidies] and, in doing so, tended to idealize the informal credit markets thatdid exist or that might have existed in absence of the massive government intervention in the credit market. Therewas a presumption that an intervention-free rural financial market would approximate the perfect competitionmodel. 160

Removal of credit subsidies is essential for the development of sustainable institutions that deliver financial

services locally. Considerable evidence from many parts of the world suggests that local financial markets are best explained

by a variant of monopolistic competition. However, removal of the subsidies will not generally leave behind competitive

credit markets. It is important to note in this context that Indonesia began to have competitive credit markets at the local

level only after BRI's unit banking system became profitable, thus motivating other financial institutions to compete in

the same market. A crucial aspect of the Local Financial Intermediation model is that competitive credit markets at the

local level are generally not a product of the indigenous informal system, but rather a result of modern institutions providing

profitable financial intermediation locally.

Informal commercial credit in Indonesia is characterized by all the traits found in similar markets worldwide:

multiple lenders, market interlinkages, repeat borrowers, high interest rates, low default rates, etc. In Indonesia, local

moneylenders, traders, commodity wholesalers, and other lenders in the informal credit markets quickly recognized the

demand for production loans which followed the introduction of new agricultural technologies, markets, infrastructure,

etc. during the 1970s. As participants in the widespread economic growth occurring in both rural and urban areas, lenders

understood that borrowers would pay high interest rates because of high demand and lack of alternatives (Indonesia's

subsidized loans did not reach their target population any better than did subsidized credit in the rest of the developing

world).

As noted above, interest rates in informal commercial credit markets in Indonesia generally range from about

3 percent to over 35 percent per month, calculated as a percentage of the original balance. Flat rates from about 6 percent

to 15 percent per month appear to be most common, with loan terms up to one year. However, BRI lends profitably at

the local level with an interest rate of 1.5 percent per month on the original balance (about 33 percent annual effective rate).

The overall effect of BRI's loans on Indonesian informal credit markets is not known. However, lengthy interviews

conducted from 1988 to 1990 with 75 informal lenders who provide credit to linked borrowers showed a consistent pattern:

lenders did not want 'their' borrowers to take loans from other informal lenders, but over 90 percent were agreeable (often

helpful) in assisting their borrowers to obtain BRI loans. Lenders did not reduce their interest rates, nor did they attempt

to expand their share of the credit market; rather they used their increased liquidity to expand or diversify their economic

activities. Apparently informal lenders in Indonesia (many of whom are, themselves, formal-sector borrowers and savers)

See, for example, Nisbet, op. cit.; Gamba, op. cit; Robinson (1988); Aleem, op. cit.; Siamwalla et. al., op. cit.161

Darling, op. cit.162

Nisbet, op. cit., p. 81.163

66

do not generally consider financial institutions, at least not their own, as competitors. A small minority of those interviewed

(under 10 percent) opposed the idea that their suppliers/borrowers would borrow from BRI. These lenders feared that they

would not be able to maintain control over the volume and price of commodities provided to them by suppliers who were

no longer borrowers. However, most lenders took the opposite view. As they said, "BRI is not going to buy rice from

my suppliers." "My employees are not bankers so I don't think BRI will hire them away from me." "If BRI lends to my

suppliers, I can use the capital I save to open another shop."

Thus, the local political economy limits the number of borrowers per lender; such limits as there may be on the

entry of lenders into the market are, in general, a by-product of this process. For lenders, market entry is limited first by

access to borrowers operating within the area in which the lender holds political influence and controls good information,

and second by the number of individuals with whom the lender can maintain transactions in other markets. Under these

general conditions, lenders and borrowers tend to maintain long-term relationships. Borrowers face risks in changing

informal lenders and are widely reported to do so only rarely. Given the high level of the lender's information, there161

can be considerable risk to a borrower seeking a loan from another informal commercial lender. The new lender may refuse

to lend to the borrower because the risk of collection in another lender's territory may be considered too high, while the

old lender may learn about the attempt and, in order to set an example, may terminate previous interlinked contracts with

the borrower. Monopolistic competition and the inelasticities of rural credit markets, reported since the 1920s, explain162

the frequent reports of a wide range of interest rates charged at the same time in the same area. However, the extensive

evidence of monopolistic competition seems to have been largely ignored in the enthusiasm of the 1970s and 1980s for

the elimination of intervention in rural

credit markets (since assumption of a competitive informal credit market is essential to that argument).

Nevertheless, sporadic reports of what Aleem calls "too many lenders in the market" continued to appear from

many developing countries. Other examples of what is referred to here as the 'many lenders' syndrome are:

From rural Chile (1964-1965): "In all cases [moneylenders] lived and operated within their respectivecommunas [minor civil divisions], and their operations usually were found no more than 1 to 2 milesfrom a rural village or were confined to the rural neighborhood. Their effective geographic zone ofoperation, or their 'rural credit market area', then, is much smaller than the communa unit. The numberof moneylenders ranged from none to three, with a mean of one operating within a rural credit marketarea. In no case did a moneylender operate in an adjoining rural credit market area." 163

Government of Ceylon, op. cit..164

Reserve Bank of India, op. cit.. See also Robinson, op. cit., for similar findings in southern India in the 1970s.165

Gamba, op. cit..166

Tun Wai (1980).167

Aleem, op. cit., p. 151.168

Floro and Yotopoulos, op. cit., p. 75.169

Siamwalla et al., op. cit., p. 162.170

67

As Nisbet points out in that paper, similar findings concerning the inelastic demand for informal commercial loans

were reported from Ceylon in 1950-51, India in 1954, and Malaya in 1958. Based on a worldwide sample, U Tun164 165 166

Wai called attention to the importance of inelasticity of demand as an explanation for a substantial fraction of informal

interest rates. Recent examples illustrate the continuation of this pattern:167

From Pakistan (1980-1981): "Nearly two-thirds of the farmers interviewed [in villages served by the markettown of Chambar in Sind] said they would have problems in obtaining credit if their current lender were to refuseto give them a loan."168

From the Philippines (1984): A survey of 14 villages in three provinces showed that loans linked to other markets"dominate the informal credit market in our survey. They account for 79 and 82 percent of the total volume ofinformal credit advanced in the marginal and the developed areas respectively." 169

From Thailand (1985-1987): "In our 52-village survey [in Nakhon Ratchasima Province in 1985]. . . the modal number of lenders resident in the village is three, and the modal number of outside lendersis two . . . . Of the households surveyed in NR Province who reported some borrowing from the informalsector, about five-sixths reported that they borrowed from only one informal source. Many of these alsoborrowed from formal sources, but . . . formal and informal lenders are non-competing. A more tellingset of figures comes from our national survey [conducted in 14 villages in 6 regions of Thailand in 1987].Seventy-two percent of the informal sector borrowers in that survey reported that they had not attemptedto borrow from other informal lenders during the past three years."170

The implications of these findings have not been fully understood or incorporated into analysis of local financial

markets. For decades it has been reported from rural areas of developing countries in many parts of the world that informal

commercial credit markets exhibit many characteristics of monopolistic competition. In spite of these reports, however,

the tendency has been to assume that if there are many lenders, there must be substantial competition. Thus Bouman

comments in a 1984 paper on Sri Lankan rural finance: "One should not expect monopoly profits to be terribly important

Bouman (1984), p. 243.171

Ibid., p. 245.172

Aleem, op. cit., p. 149. 173

Credit layering refers to the practice by which a large informal lender provides loans to smaller lenders who, in174

turn, on-lend either to other lenders or to end-borrowers.

Von Pischke, op. cit., pp. 184-5.175

68

since there are few barriers to entry into informal financial intermediation and competitive forces generally prevail".171

Yet two pages later, he reports: "A money lender typically serves only 20 to 50 borrowers". 172

Aleem comments on his research in Pakistan: "In the study, the author was surprised at the large number of lenders

operating in the small market area." This should not be surprising, since it is normal. Informal commercial lenders, who173

generally serve a relatively small group of borrowers, tend not to compete or to compete imperfectly. The constraints that

prevent them from increasing their market shares operate even in the case of particularly influential lenders whose economic

and political activities extend broadly. High status at the local level is usually associated with additional obligations (e.g.,

lending or contributing in various ways to district-level political leaders, factions, alliances, kin groups, or political parties;

extensive responsibilities to one's own dependents and constituents, etc.). Such a creditor is unlikely to expand broadly

his or her direct lending, in part because of capital constraints and in part because of reluctance to lend in areas in which

political opponents may be active. Larger lenders who control wider areas tend to operate through credit layering instead174

of direct loans to end borrowers. The effect is the same: all the informal lenders have little incentive to reduce interest rates.

The pattern of numerous relatively small quasi-monopolies reflects primarily local information flows and lenders'

perceptions of their abilities to collect loans with low risk.

Yet this fundamental point is rarely understood. Von Pischke comments on the 'five-six terms' found in the

Philippines:

The annualized rate and compounded amount are ridiculously large . . . . The meaning of these rates is seldominvestigated. They must reflect something more than the traditional economic components of interest rates, whichare the cost of funds, administrative costs, risk, and profit . . . . Until further analysis is available, interest ratesbeyond the frontier [of institutional finance] cannot be fully interpreted. 175

These interest rates do reflect more than cost of funds, administrative costs, risk, and profit. They reflect the

fundamental relationship between informal credit, social structure, and information flows. Von Pischke comments further

on the 'five-six terms': "Monopoly profits of the sort implied by these examples would surely attract vigorous competition

Ibid., p. 185. Von Pischke comments: "Unanswered questions make informal financial market research an176

exciting dimension of frontier finance. . . . They also suggest the limitations of financial analysis and conventionaleconomic theory in providing a complete picture of informal finance . . . . Many of the insights that appear mostpromising have been developed by anthropologists and sociologists who take a professional interest in issues of riskand confidence. Yet, they are definitely on the sidelines when conventional economic and financial analysis is afoot.Those with an interest in the field can only hope to hear from them (Ibid., pp. 186-7.) This author agrees with VonPischke that more interdisciplinary dialogue is needed concerning local finance; this discussion attempts to move inthat direction.

69

that would severely erode returns." But they do not; the 'five-six' and similar terms are widespread and are accepted176

by the many borrowers who have no better options. A significant portion of the explanation lies, in many cases, in

monopolistic competition among 'many lenders'.

In summary, informal commercial lenders usually lend to borrowers with whom they are interlinked in other

markets. Lenders tend not to want to expand their market shares. This is because the risks of collecting loans outside

the relatively small area in which the lender is politically well connected, maintains interlinked transactions, and controls

information flows are perceived as too large. For the reasons discussed above, lower-income borrowers typically have

no other commercial credit options: (1) Outside Indonesia, formal-sector institutions rarely provide credit at the local level

at commercial interest rates; (2) Subsidized credit is usually unavailable to most lower-income borrowers; and (3) If a

borrower turns to another informal lender, he or she is likely to face substantial risk for similar credit terms. The local

political economy limits the number of borrowers per informal commercial lender; such limits as there may be on the entry

of lenders into the market are, in general a by-product of this process. Neither 'malicious moneylenders' nor transaction

costs and risk premiums fully explains the high interest rates in informal commercial credit markets, although either or

both can be relevant. The primary reason for the high interest rates is that the 'many lenders' engaged in monopolistic

competition, constrained by the political economy from lending outside their area of influence, generally do not want to

increase their share of the informal commerical credit market. Thus, they have little or no incentive to lower interest rates.

This widespread pattern provides an important reason for intervention in local financial markets; outside Indonesia,

however, the reason for intervention has rarely been understood. The cost of the misunderstanding is depression of the

development of financial intermediation in developing countries around the world, and the resultant, but unnecessary,

condition in which the poor pay far higher total costs for credit than would be required if conveniently located financial

institutions were to provide them credit at commercial rates. Economists, governments, and donor agencies have little

incentive to build systems of financial intermediation serving the local level if they assume that local markets are "penny

economies," that informal commercial lenders are effective in meeting the credit needs of SMEs and helpful to the poor,

and that asymmetric information, moral hazard, and adverse selection are intrinsic to the operation of formal financial

institutions operating at the local level. The first two of these assumptions have been discussed; the third, also incorrect,

is reviewed below.

Stiglitz (1986), p. 257.177

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II. C. USING COMMON SENSE TO OVERCOME ASYMMETRIC INFORMATION, MORAL HAZARD,AND ADVERSE SELECTION

Even in developing countries characterized by reasonable levels of economic growth and political stability, effective

systems of financial intermediation that serve the local level are rare -- unnecessarily so. What has constrained their

development? The policies providing subsidized credit and the unexamined hypotheses about "penny economies" and

competitive informal commercial credit markets have been discussed above. A third obstacle is the belief held by many

government officials, donor agency representatives, economists, and bankers, that financial institutions cannot compete

with the informal credit market. Given this perception, policymakers have little incentive to develop such institutions.

The assumption that the formal sector cannot compete with informal financial lenders is based on two

misconceptions. The first, addressed here, is the idea that credit cannot be effectively administered at the local level by

most financial institutions because of asymmetric information. It is assumed: (a) that loan applicants have better information

about their potential loan repayment than do their lenders; and (b) that informal commercial lenders have significantly better

information about potential borrowers than do financial institutions. What is not sufficiently understood is that assumption

(b) can be overcome by institutions that make an effort to do so, and that financial institutions can, and do, compete

successfully with informal commercial lenders.

The second misconception, discussed below in Section II.D., is that loans cannot be financed with deposits because

most SMEs will not or cannot save in financial form. The reasons that this is an incorrect assumption have been presented

in the literature for more than two decades; however, the issue is still widely misinterpreted by many economists and other

social scientists and -- judging from their policies -- by most policymakers.

Although the reasoning is quite different, both misconceptions share the underlying assumption that financial

institutions cannot operate sustainably at the local level in developing countries. A growing literature assumes these

characteristics to be intrinsic to the operation of local-level financial markets. This helps to perpetuate seriously misleading

policies affecting local financial markets in developing countries. Policymakers who believe that financial institutions

operating at the local level can neither raise deposits nor recover loans are unlikely to promote development of the

institutions that are required for sustainable local-level finance. It is, therefore, crucial for social and economic development

that these widespread assumptions be re-examined.

C. 1. Asymmetric Information

The theory of rural organization based on rational peasants in environments where information is imperfect andcostly provides a simple explanation for a wide variety of phenomena in LDCs . . . . This theory can be viewedas an important application of a more general paradigm, the "Imperfect Information Paradigm," which has beenuseful in explaining economic phenomena under a wide variety of settings. . . . in developed and less developedcountries. 177

See references in footnote 25. 178

Kotowitz, op. cit., p. 549.179

See Wilson (1987).180

Akerlof, op. cit.181

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The "Imperfect Information Paradigm" has been applied to local financial markets in developing countries by

a number of authors. In this context, it has been frequently stated that informal lenders have information about potential

borrowers that enables them to select the low-risk applicants, leaving the rejects to apply to financial institutions. In addition,

informal lenders are able to decrease their risk by engaging in interlinked transactions with their borrowers in other markets.

It is argued that, in contrast, financial institutions operating at the local level can neither observe the use of the credit they

extend nor obtain adequate information about potential borrowers (asymmetric information). It is assumed that the

institution charges higher interest rates in order to compensate for its risk, thereby increasing the likelihood of default (moral

hazard). Since low-risk borrowers may be driven out of the pool by the higher interest rates, the average riskiness of loan

applicants increases (adverse selection). 178

Moral hazard has been defined as "actions of economic agents in maximizing their own utility to the detriment

of others, in situations where they do not bear the full consequences or, equivalently, do not enjoy the full benefits of their

actions due to uncertainty and incomplete or restricted contracts which prevent assignment of full damages (benefits) to

the agent responsible". It is assumed that there are several possible reasons for such incomplete contracts, and that in179

the context of a competitive credit market, the most relevant is that of unequal information.

In general, adverse selection is assumed to occur in a market in which products of different quality are sold to

buyers who cannot observe the quality of the units they purchase. This information is controlled by the seller. The idea,180

developed by Akerlof in his well-known paper, "The Market for Lemons" which analyzes a stylized market for used cars,181

has been widely extended to other contexts including rural credit markets. Stiglitz and Weiss developed a model in which

banks are similar to the uninformed used car buyers; the borrowers, like the car dealers, are the informed. This model

assumes that while higher interest rates increase the return to successful loans, the higher interest charged may also increase

the default rate in the lender's portfolio through the adverse selection effect. This is assumed to occur because the high-

interest rates drive low-risk borrowers out of the bank's lending program, while only borrowers in the high-risk/high-return

category will be able to afford, and willing to accept, the high-interest loans. If increased interest rates thus lead to a decrease

in expected returns to lenders, then market-clearing interest rates may not be optimal and credit may be rationed.

The main problem with the Stiglitz-Weiss model is that it assumes a competitive credit market at the local level.

The main source of credit at the local level in developing countries is informal commercial lenders, and the informal

commercial credit market is better explained by a model of monopolistic competition. Even when formal financial

institutions enter the market, the assumptions of the "Imperfect Information Paradigm" do not necessarily hold. In Indonesia

many informal commercial lenders do not view BRI as their competitor, but rather as their banker. Such lenders are often

See Part One of this series for further discussion.182

For discussion of group lending, see Berenbach and Guzman, op. cit.; Stiglitz (1993). For institution-specific183

review, see Fuglesang and Chandler (1988), Hossain, op. cit., and Khandker, op. cit. for the Grameen Bank ofBangladesh; Glosser, op. cit. for BancoSol in Bolivia; and Siamwalla et al., op. cit. for the Bank for Agriculture andAgricultural Cooperatives (BAAC) in Thailand.

72

willing to provide reliable information about other borrowers. A BRI customer who recommends his suppliers/borrowers182

for KUPEDES loans is simply transforming old interlinked transactions into new ones. In developing countries, informal

lenders (and their information) are usually segmented. As in Indonesia, lenders may provide to their financial institution

information, and even recommendations, about creditworthy borrowers that they would not offer to other local informal

lenders. Financial institutions can not only gain access to good information flows about potential borrowers, they can gain

access to significantly wider information flows than can any one informal lender.

Asymmetric information might appear to explain the large-scale losses sustained by institutional credit programs

throughout many parts of the developing world. The defaults in those credit programs, however, are better explained by

the problems associated with the credit subsidies generated by supply-leading finance theory. The Indonesian evidence

indicates that the moral hazard/adverse selection constraints postulated for institutional lending at the local level in

developing countries are not necessarily insurmountable; where they exist, they can be overcome or substantially reduced.

Thus, BRI has been able to train its staff to understand local markets and their interlinkages, and to participate in local

information flows, and thereby to overcome or substantially reduce problems associated with asymmetric information and

moral hazard/adverse selection. Other financial institutions in developing countries have used similar as well as different

methods (e.g. solidarity group lending) to accomplish the same aims. 183

Despite the evidence, the belief persists that asymmetric information, as a fundamental characteristic of lending

at the local level, is unalterable by the financial institutions. Policymakers of developing countries who accept this

assumption would be unlikely to choose policies aimed at the development of sustainable financial institutions serving

the local level. In fact, this is just what happens. The assumption that local credit cannot be effectively administered by

most financial institutions, especially by those operating on a large scale, substantially curbs institutional incentives for

the development of viable financial institutions. Yet financial institutions can overcome the constraints postulated by

asymmetric information, moral hazard, and adverse selection.

In contrast to the Imperfect Information Paradigm, the Local Financial Intermediation model assumes that (1)

deposits can be mobilized locally and lent out profitably by financial institutions serving the local level; (2) institutions

can gain information about local market and can lend profitably at the local level; and (3) since indigenous credit markets

tend not to be competitive, it is sustainable financial institutions that transform local credit markets into competitive markets.

Stiglitz and Weiss (1981, 1983, 1986); see also Braverman and Guasch (1986), and Wilson, op. cit. 184

See, for example, Braverman and Guasch (1986).185

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C. 2. Overcoming Asymmetric Information Flows: Evidence from BRI

Models of moral hazard/adverse selection can be useful in a variety of circumstances; it cannot be assumed,

however, that these apply generally to local credit markets. In the informal financial markets of Indonesia, and elsewhere,

there are countervailing tendencies which must be considered. For example:

(1) The Stiglitz-Weiss model assumes that the financial institution will compensate for high risk by charginghigh interest rates, and that low-risk borrowers may be driven out of the market. If this leads to an increasein expected returns to the lender, market-clearing interest rates may not be optimal and credit may berationed.184

Informal commercial lenders are widespread in Indonesia. However, KUPEDES transaction costs to

the borrower are relatively low, and KUPEDES interest rates are from 5 percent to 50 percent of the interest rates

charged on the informal commercial credit market. In this context, KUPEDES interest rates are attractive, and

low-risk borrowers are unlikely to drop out of the program. Consequently BRI does not need to raise its interest

rates to cover risk, and does not do. The predicted decrease in expected returns to BRI is not found, and the

postulated credit rationing does not occur.

(2) Models of moral hazard and adverse selection, in the context of rural credit markets, generally assumethat loans featuring larger principals and higher interest rates are attractive to risky borrowers, therebyincreasing the probability of default. A frequently assumed corollary is that only borrowers in the high-185

risk category will take high-interest loans.

In Indonesia, the opposite occurs. The only high-interest loans normally made are those provided to

low-risk borrowers by informal commercial lenders. Such informal loans with high interest rates are usually made

for small amounts. First, informal commercial lenders (those who lend at high interest rates) rarely extend loans

with large principals. Second, most borrowers who take high-interest loans from informal lenders are from lower

or middle-income households (those who do not have better credit options); their loans are generally for relatively

modest amounts. Default rates tend to be low on high-interest loans because of the high level of information which

the lender has about the borrower, the prevalence of interlinked transactions, and the higher level of power at

the local level usually held by the lender in comparison with the borrower. Therefore, high-interest loans in the

informal credit market tend neither to be risky for the lender, nor to involve large principals.

Conversely, low-interest loans are subsidized and are generally provided by formal financial institutions

to local elites who - judging from the repayment rates on subsidized loans in Indonesia - tend to be high-risk

borrowers. Thus, BRI does not raise interest rates for loans with higher principals. In addition, the larger

KUPEDES loans are normally provided only to known low-risk borrowers who have good repayment records

See Bester, op. cit.; Stiglitz and Weiss (1986); Wilson (1987).186

For general discussion of this point, see Braverman and Guasch (1986), p. 1259.187

The problems of foreclosure in rural areas are perceived by bankers in other developing countries as well. See188

Vogel (1981) for discussion of a somewhat similar situation in Costa Rica.

74

for previous KUPEDES loans. Therefore, BRI's high principal loans are not risky. Because of the juxtaposition

of BRI's KUPEDES credit program with the monopolistic competition of the informal commercial credit market,

high-risk/high interest/high principal loans are in fact virtually nonexistent at the local level in Indonesia.

In summary, the proposition that, in rural credit markets, loans with larger principals are associated with

higher interest rates (and higher default rates) is not supported by the Indonesian evidence. In fact, higher interest

(informal-sector) loans are generally associated with smaller principals and low risk, while lower interest (formal-

sector, subsidized) loans are found in conjunction with higher principal/higher risk loans. This is consistent with

the workings of local politics found not only in Indonesia but in many developing countries: borrowers who

qualify for small loans pay high interest rates; those who qualify for large loans pay subsidized interest rates. What

is different about Indonesia, however, is that there are, in addition, nearly 2 million borrowers who pay market

rates for KUPEDES loans with principals from $12 to $12,000.

(3) Some variants of the moral hazard/adverse selection model assume that banks can compete in ruralfinancial markets by offering lower-interest/higher-collateral loans which will discourage high-riskborrowers.

It has been argued that collateral can signal creditworthiness and that lenders can use collateral

requirements in combination with lower interest rates to attract low-risk borrowers. In Indonesia, BRI normally186

requires collateral and provides lower interest rates than informal commercial lenders; the latter charge higher

interest rates and usually do not require collateral. Therefore both the higher-collateral/lower-interest rate and

the lower (or no)-collateral/higher-interest rate options exist. If the argument is correct, the former should

encourage low-risk borrowers and discourage those who are high-risk. There are two problems with this

proposition.

First, some low-risk borrowers lack access to the lower-interest BRI loans because of lack of collateral.187

The BKK of Central Java, which lends to lower-income borrowers at market rates without collateral, has shown

consistently that many lower-income borrowers are also low-risk borrowers. BRI's requirements of collateral

for most KUPEDES loans, however, excludes some low-risk borrowers. Increasingly, however, many of these

can borrow from the Bank Kredit Desa (BKDs), supervised by BRI. Second, high-risk borrowers familiar

with BRI's operations at the local level may not be dissuaded by collateral requirements. Because of cultural mores,

implementation problems, and concerns about both the short-term working conditions of the local staff and the

long-term success of the unit banks, BRI does not, in fact, foreclose on loan defaults in the unit banks, except

in extraordinary circumstances. Thus, defaulting borrowers were found commonly in BRI's subsidized BIMAS188

Bouman (1989), pp. 125-7; see also Von Pischke, op.cit.; and Germidis, Kessler, and Meghir, op. cit..189

There are, of course, exceptions to this general point; certain private banks have been active in rural areas for190

a long time. Thus, the Bank Dagang Bali has pioneered banking at the local level in Bali; the Bank Pinasaan has beenactive in rural areas near Manado (North Sulawesi), and the Bank Central Asia has vigorously promoted rural bankingin various areas, especially those characterized by successful commercial agriculture.

75

agricultural credit program, with their collateral intact. The same has been true of the government's other

subsidized credit programs. BRI's collateral requirements are not the reason for the low KUPEDES default rates.

Arrears are low because KUPEDES is the best available credit alternative for its borrowers, demand is high, and

customers want to retain their eligibility to re-borrow.

It is therefore not collateral requirements which typically lower default rates in Indonesia's local credit

markets. From the viewpoint of a borrower who possesses acceptable loan security, there is little difference

between the options: collateral is either not required (by informal lenders) or not at much risk (at BRI). In reality,

therefore, requirement of collateral does not prevent high-risk borrowers from preferring BRI's lower-interest

loans. In addition, higher-interest loans are unlikely to be available to risky borrowers because of the selectivity

of informal lenders, the source of such loans.

Thus, the low default rates characteristic of non-subsidized loans at the local level in Indonesia result

not from high collateral but from either: (a) relatively attractive KUPEDES interest rates offered in conjunction

with a well-implemented policy of refusing new loans to defaulting borrowers or (b) provision of credit by

informal commercial lenders, usually without collateral, to borrowers whom they know well and with whom they

frequently engage in interlinked transactions.

The concept of adverse selection as applied to local credit markets is based in part on the assumption that financial

institutions serving the local level cannot obtain reliable information about the creditworthiness of potential borrowers.

However, BRI and a small but growing number of other financial institutions have found effective ways to do so. Recent

studies of local financial markets have identified active formation of linkages between formal and informal components

of local credit markets as one of the important "new frontiers of financial technology". BRI's success owes much to its189

study of linkages - both those within financial markets and those among different markets - and to the use of this information

to expand its own banking system in particular, and Indonesia's local financial markets in general. BRI's interest in

expanding its knowledge of local markets was stimulated by the major government initiatives taken during 1988-90 with

regard to financial deregulation. Beginning in October 1988, several broad packages of financial reforms were issued;

these eased the requirements for opening new domestic banks and branches, provided banks with increased autonomy,

and generally encouraged expansion and innovation in banking. BRI, which had a virtual monopoly on banking in most

rural areas for over two decades, began to realize it might soon face serious competition. Since formal and informal190

financial markets are linked in multiple ways and since market interlinkages play an important role in local finance, BRI

made an unusual, but crucial decision to develop methods to obtain information about how local financial markets work

Vogel (1984 b). 191

See references in Section II.B of Part One of this Series.192

76

in practice, and how rural and urban financial markets are linked. In this context, BRI undertook to investigate ways in

which institutional financing could be linked with informal finance. To this end, a study of interlinkages among local

markets was begun in 1989; its purpose was to improve information about customers generally and about potential

KUPEDES borrowers in particular. The methods developed by BRI to gain information about potential customers made

use of opportunities generated by the bank's activities both in lending and in savings mobilization.

For example, discussions of adverse selection usually ignore depositors. This is in part because savings remains

"the forgotten half of rural finance" (and of all local finance). Yet BRI's KUPEDES borrowers are frequently also BRI191

depositors. From the bank's perspective, a savings account is not only a deposit; it is also valuable information. Since

there are about six times as many savings accounts in the unit banks as there are outstanding loans, there is considerable

information already available about potential borrowers. In addition to identifying the potentially creditworthy and

interested borrowers among its savers, BRI undertook direct attempts to overcome potential problems that might result

in adverse selection. Using formal-informal linkages, BRI staff learn from their own customers about the markets in which

the latter participate and about potential demand for the bank's services. The main forms of interlinked transactions that

are generally characteristic of markets in rural areas in developing countries are also common in Indonesia. Thus, credit

links to trade, labor, land, forward sales of crops, etc. have traditionally existed in many areas of the country. While192

there have been changes over time in the nature of the linkages, the system under which buyers provide working capital

credit to long-term suppliers continues, and has been adapted to new areas of the local economy. For example, distributors

of new types of manufactured products (soft drinks, cigarettes, cosmetics, processed foods, etc.) maintain long-term local

agents to whom they supply credit.

BRI has learned to encourage recommendations from their clients about potential customers among the latters'

suppliers and agents. Thus, an agricultural trader may recommend his suppliers; a soft drink distributor, her agents, etc.

Many recommenders said this provided them the opportunity to make available for new investments working capital which

was previously used for business-related loans. With present customers and local leaders serving as sources of information,

BRI branch and unit bank offices have been able to develop a systematic approach to locating new savers and identifying

new, creditworthy borrowers.

The principle underlying BRI's efforts to expand its financial services in these ways is that since local markets

are interdependent, an understanding of their interlinkages (and of their links with markets both in urban areas and in other

regions) can generate opportunities that benefit multiple participants. BRI benefits by gaining access to information that

permits increased lending to creditworthy borrowers; larger borrowers benefit from freed-up working capital previously

used for supplying credit to their suppliers or sub-agents who now receive KUPEDES loans, as well as by improving their

own relations with BRI; the recommended borrowers who receive KUPEDES loans benefit from increased access to

institutional lending.

See Lewin (1991) for discussion of ADEMI; Rose (1992) for SEWA; Otero (1989) for discussion of193

CamCCUL; and German Investment and Development Company Annual Report (1992) for CCEI.

77

Thus, BRI has learned to adapt for its own use the country's traditional informal patron-client relationships and

the transformations of these as they are found in contemporary Indonesian society. BRI's methods involve training and

providing incentives to its staff to learn about the local financial markets they serve and about the interlinked markets in

which their clients participate. This strategy, in combination with BRI's relatively low interest rates, its savings instruments

designed to meet local demand, and its convenient bank locations, has enabled BRI to reduce or overcome problems of

adverse selection. This is demonstrated by the high repayment rate and the profitability of BRI's unit banking system.

C. 3. Overcoming Asymmetric Information Flows: Evidence from Other Institutions and Countries

This series of papers is primarily about BRI. However, the ability of financial institutions serving the local level

to decrease or overcome adverse selection is such a crucial point that evidence from other institutions is summarized briefly

here. All the financial institutions cited below provide credit to SMEs and/or rural households, and all have very high

repayment rates. The Bank Dagang Bali (BDB), a private bank in Bali (Indonesia), preceded BRI in becoming a profitable

financial intermediary serving clients at the local level, although on a much smaller scale than BRI. The President-Director

of BDB and his wife started as informal commercial lenders; they developed a highly successful bank by adapting to the

formal sector their knowledge of informal commercial finance. Adverse selection was not a problem at BDB because the

bank understood its markets, knew its clients, developed its financial instruments to meet demand and to allow institutional

profitability, and trained its staff in customer service. Some of the services and instruments first pioneered by the BDB

were studied and adapted later by BRI. Like BDB and BRI, the Badan Kredit Kecamatan (BKK), makes loans to individual

borrowers in Central Java, solving the adverse selection problem through knowledge of clients and markets and provision

of competitive products.

Institutions with varying structures in other parts of the developing world have also overcome adverse selection

in similar ways, e.g., the Asociacion para el Desarrollo de la Microempresa (ADEMI), an NGO in the Dominican Republic;

the Self Employed Women's Association (SEWA) of India which serves poor women in three capacities: as a bank, a trade

union, and an NGO; the Cameroon Cooperative Credit Union League (CamCCUL); and the Caisse Commune d'Epargne

et d'Investissement (CCEI), a private investment and commercial bank in Cameroon. High repayment rates reflect both193

a high level of knowledge of local markets and of the institution's clients, and the adaptation of local mechanisms of social

control. For example both CamCCUL and CCEI have developed their credit programs in close association with the tontines,

the traditional informal savings and loan associations of Cameroon. The financial institutions both learn from and advise

the tontines. The same is true among the successful Indonesian financial institutions and the ROSCAs there (arisans), as

well among the Bolivian financial institutions and their ROSCAs (pasanakus).

For Grameen see Fuglesang and Chandler, op. cit.; Hossain, op. cit.; and Khandker, op. cit.; for BRAC, see194

Lovell (1992); for PRODEM and BancoSol see Glosser, op. cit.; for K-REP see Mutua (forthcoming); for BAAC, seeSiamwalla et al., op. cit. Some institutions, for example the Working Women's Forum in India, provide credit throughvariations of the peer group model. For discussion of solutions to the problem of adverse selection in rural creditmarkets implemented in other developing countries, see Vogel (1981); Mosley and Dahal, op. cit.; and Varian, op. cit.

See, among others, Adams (1973, 1978, 1984 c, 1988); Bouman (1977, 1984, 1989); Von Pischke (1978,195

1983, 1991); Von Pischke, Adams, and Donald, eds., op. cit.; Adams, Graham and Von Pischke, eds., op. cit.; Vogel(1984 b); Adams and Vogel, op. cit.

See references in footnote 22.196

In addition to references in footnote 195, see Howse (1983, first published 1974); Mauri (1977); Lee, Kim, and197

Adams (1977); Savings and Development (various issues 1977 - present); Bourne and Graham (1980); Miracle,Miracle, and Cohen (1980); Sideri (1984); Agabin (1985). See Kelley and Williamson, op. cit., for a study of house-

78

Some institutions have overcome adverse selection through group lending, e.g., the Grameen Bank of Bangladesh;

the Bangladesh Rural Advancement Committee (BRAC), an NGO presently seeking bank status; the Fundacion para la

Promocion y Desarrollo de la Micro Empresa (PRODEM) and BancoSol in Bolivia; the Kenya Rural Enterprise Project

(K-REP), an NGO providing credit to poor entrepreneurs in rural Kenya; and the government Bank for Agriculture and

Agricultural Cooperatives (BAAC) in Thailand. In these institutions, knowledge of the markets and clients are also194

emphasized; in addition peer group lending is practiced, i.e., loans are made to self-formed groups which provide mutual

guarantees.

The institutions mentioned above vary widely in structure, including state and private banks; commercial,

agricultural, and specialized banks; non-bank financial institutions; a credit union; and various types of NGOs. They also

vary considerably in geographical location, size, age, and purpose. Yet all have found ways to overcome adverse selection.

In addition, on the deposit side, BRI has successfully refuted the view that 'villagers cannot or will not save in institutions'.

As discussed in the following section, successful financial intermediation at the local level then becomes possible.

II. D. THE ROLE OF SAVINGS IN THE FINANCIAL INTERMEDIATION PARADIGM

A number of papers published in the late 1960s and 1970s demonstrated the distortions which had resulted from

subsidized rural credit programs. Many of the same papers also highlighted the potentially vital, but seriously neglected

role of rural savings in developing healthy financial institutions and in improving rural financial markets. However,195

'rural undersavings' remains a common assumption of governments and donor agencies, as does the belief that demand

for financial savings instruments is low at the local level in most developing countries. It is widely thought that rural196

households, as well as SMEs in urban areas generally do not save - either, it is assumed, because they must consume

whatever they earn or because they prefer to do so.

Yet substantial evidence collected worldwide for more than three decades has shown that there are extensive

savings at the local level in developing countries. A 1962 United Nations study showed that household savings made197

hold savings in Indonesia.

United Nations (1962); see Adams (1978) for discussion.198

Adams (1978), p. 548.199

Ibid., p. 550.200

Braverman and Guasch (1986), p. 1256.201

79

up one-half to two-thirds of total savings in seven Asian countries. During the 1970s and 1980s, substantial savings198

by both households and enterprises were reported from developing countries worldwide. Savings of various kinds (in

ROSCAs and RESCAs; in chit funds; in non-financial forms, etc.) have been widely documented from many areas of Asia,

Africa, and Latin America.

A number of economists have argued, as Adams put it, that "financial markets influence the forms in which savings

are expressed, as well as the total amount of potential consumption which is diverted to savings." Adams, Bouman, Vogel199

and others suggested that appropriate savings instruments providing positive real rates of return to the household can induce

rural people to put more of their savings into financial form; this, in turn, "may increase the average rate of return realized

by the household on its savings portfolio and induce the household to divert more of its income to S (savings-investment

activities)." However, with the exception of Indonesia, institutional savings at the local level in developing countries200

remains low. Voluntary savings, in particular, usually plays a minuscule role in an otherwise minor activity. The authors

of a 1986 review of rural credit in developing countries report: "Commercial banks and state-funded institutions have not

mobilized much rural savings. The estimate of the percentage of loanable funds from rural sources has ranged from 5

percent to 40 percent, with the median much closer to the former than the latter figure." 201

D. 1. The Low Level of Institutional Deposits: A Supply-Side Problem

There are three main reasons for the low level of institutional deposits at the local level. The first is that reasonable

levels of macro-economic management and political stability are required for the successful mobilization of deposits and

for the operation of sustainable financial institutions at the local level. Therefore, financial institutions cannot be expected

to operate sustainably at the local level in countries characterized by hyperinflation, continuing wars, or endemic and severe

civil strife. The second reason for low deposits is the existence in some developing countries of laws and regulations that

prohibit profitable financial intermediation. The third, closely related, is the lack of appropriate institutions and financial

instruments. Governments, financial institutions, and donor agencies have, in general, failed to understand that profitable

financial intermediation at the local level can be possible, and that low institutional savings is primarily a supply-side

problem. Thus, what is generally lacking in most developing countries is appropriate financial institutions and instruments

that are designed to supply local demand for financial services.

For identification of this issue as a problem, see Adams and Graham, op cit.; Vogel (1984 b); Adams and202

Vogel, op, cit.; Adams (1988); Von Pischke (1991).

80

Why are institutional deposits so low even in developing countries with enabling macro-economic and political

environments? Why are there often prohibitive regulations and a dearth of appropriate financial institutions serving the

local level? There are two major reasons: (1) the effect of credit subsidies; and (2) a pervasive lack of understanding of

local markets and their interlinkages, resulting in unexamined, and often wrong, assumptions about 'undersavings' and

low demand for institutional deposit instruments.

(1) The effect of credit subsidies on savings mobilization

The effect of subsidized credit programs is to leave most SMEs without access either to institutional credit or to

appropriate deposit facilities. A result of subsidized lending is that its low interest rates discourage the development of

viable financial institutions since organizations dispensing subsidized credit are usually either forbidden to mobilize savings

or do not collect voluntary savings because to do so would be unprofitable. The predominantly unilateral emphasis by

policymakers and international donor agencies on subsidized credit programs underlies the low level of institutional deposits

and the related difficulties in developing sustainable rural financial institutions. The problem is deeply entrenched because:

(a) voluntary savings mobilization is incompatible with subsidized credit; and (b) the latter is often seen as a mechanism

for obtaining support for the government and tends, therefore, to be difficult to dislodge once begun. The lesson from

Indonesia is that governments operating subsidized rural credit programs in developing countries should consider the option

of adding commercial credit/savings mobilization programs, even if replacement of the former by the latter is not deemed

politically feasible. Because of the capital constraints of the subsidized credit programs, commercial credit financed by

local deposits are likely to gain the major share of the market, as occurred in Indonesia.

(2) The lack of understanding of demand for deposit instruments

The view that demand for financial savings instruments is low among rural households and among SMEs in202

urban areas of developing countries is based on the assumptions that: (a) most households cannot or do not save; (b) those

who do save prefer non-financial forms; (c) SMEs do not trust financial institutions and keep any cash they may have in

the house or in informal associations such as ROSCAs; and (d) the only way that institutions can obtain savings from such

sources is through requiring forced savings as a condition for loans.

The argument is made in policy circles that, since there is no significant demand for financial savings instruments,

why should priority be given to the development of financial institutions with voluntary savings programs? As a result,

savings mobilization and the creation of sustainable financial institutions have not been encouraged either by the

governments of most developing countries or by most donor agencies. One consequence is that, outside Indonesia, few

financial institutions in developing countries provide appropriate deposit instruments at the local level, and few policy

makers, donor agencies, or bankers have made the mobilization of local savings a high priority for the finance of local

credit. This bias continues to be reflected in the literature, as well as in the policies of many developing countries and donor

Hoff, Braverman, and Stiglitz (eds.), op. cit. 203

81

agencies. For example, in the 200-page section on "Rural Credit Markets and Policies" in the 1993 World Bank volume,

The Economics of Rural Organization, savings is mentioned briefly on six pages - and in the rest of the volume not at all.203

Yet savings is fundamental to rural economics, as it is to economic development at the local level more generally.

Despite the fact that mobilization of deposits and development of sustainable financial institutions are

interdependent, and despite worldwide evidence showing the importance of savings to SMEs, most rural finance projects

in developing countries still provide only credit. The main reason for this lopsided approach to local finance is the

widespread assumption that the poor savings record of many local-level financial institutions demonstrates both

undersavings and a lack of demand for institutional deposit instruments. On the contrary, it is these unsupported

assumptions that are a primary cause of the lack of supply of appropriate deposit instruments. Although the supply constraint

is not widely recognized, low deposits usually demonstrate a lack of appropriate institutions and instruments. This, in turn,

leads to severe underemphasis on the importance of building financial institutions that serve the local level. These can

be viable only if they mobilize deposits - which is usually assumed to be too difficult! An important result of the neglect

of savings is that the institutional loan funds available at the local level generally cannot supply the volume of credit in

demand. In addition, SMEs are deprived of the opportunity to save in financial form with positive real rates of interest,

as well as of the opportunity to leverage credit with savings.

Non-formal financial savings opportunities at the local level in developing countries tend to offer security or

returns, but normally not both; in addition restrictions are usually placed on liquidity, a crucial requirement for local finance.

Thus, for example, ROSCAs typically offer security, but those that provide security normally do not provide returns. In

contrast, some informal or quasi-formal finance companies offer returns, but with substantial risk to the depositor. Local

savings deposited in formal financial institutions tend to be forced savings (a condition placed on loans that serves to lower

the credit amount and increase the effective interest rate). Yet appropriate deposit instruments for voluntary savings, rarely

available in formal institutions, are often the only mechanisms which can provide the saver with a combination of

convenience, security, liquidity, and returns.

Indonesia has demonstrated that secure, conveniently located financial institutions that offer credit at commercial

rates and a choice of deposit instruments providing different ratios of liquidity and returns can simultaneously benefit

households, groups, enterprises, the participating financial institutions, and the government. Yet institutional mobilization

of voluntary savings is not usually practiced by financial institutions operating at the local level in developing countries.

The negative effects of this omission are both direct and indirect. The former deprives clients of appropriate deposit

instruments and services, and prevents financial institutions from becoming sustainable for the long term. The latter

constrains the volume of capital available at commercial interest rates at the local level.


Floro and Yotopoulos, op. cit., p. 109.205

Ibid.206

For discussion of this issue, see Chaves and Gonzalez-Vega (forthcoming).207

82

As Germidis, Kessler, and Meghir comment:

The excessive reliance on external sources of finance and the resulting atrophy of domestic financialcircuits and markets also meant that the public authorities were foregoing the possibility of tapping thepotential sources of savings which are present in the developing countries. These are oftenunderestimated because the postulate that developing countries have a low or non-existent savingscapacity is, unfortunately accepted without question . . . . Yet even in the least developed countries, thereis a savings capacity that is often undetected and frequently neglected. 204

The critical role that can be played by voluntary savings mobilization in the development of financial institutions

cannot be overemphasized. For such institutions to provide sustainable financial intermediation, deposits need to be

mobilized locally and the spread between loan and deposit interest rates must allow for institutional profitability. Although

this is crucial, the point continues to be misunderstood. For example, Floro and Yotopoulos ask: "Liberalization of interest

rates is always the first target of banking deregulation schemes. Could it be that this emphasis, after all, is entirely

appropriate?" They comment further:205

"Liberalization of deposit rates sets off a competitive drive by banks for borrowing. Banks that have access onlyto relatively expensive money (along with those that are relatively inefficient in their operations) have an incentiveto charge the higher (than optimum) lending rates in order to break even. In the process they adversely selectrisks in their lending portfolio, and then become prone to default. 206

Interest rate liberalization is a sine qua non for profitable financial intermediation at the local level. If interest

rates are not regulated, savings mobilization can substitute for and even fully replace bank borrowing as a source of funds

for lending at the local level. It must be noted, however, that not all financial institutions serving the local level should

be permitted to mobilize voluntary savings, as appropriate prudential regulation and supervision are important for depositor

protection. Nevertheless, BRI has demonstrated that in a well-run financial institution, it is possible for savings to support207

an extensive program of lending at commercial interest rates - if the spread between lending and deposit interest rates is

set so that the institution has incentives to mobilize savings.

D. 2. Voluntary Savings Mobilization: Multiple Benefits

Well-designed and implemented, carefully supervised, institutional credit and savings programs serving clients

at the local level can contribute to local, regional, and national economic development, and can help to improve equity.

Financial savings are discussed here. Part One of this series analyzed non-financial forms of savings; see also208

Robinson (1993 a).

In general, the response in BancoSol is similar to that of BRI, but BancoSol is an early stage of voluntary209

savings mobilization and it is too soon to report significant results.

83

The benefits of profitable, sustainable financial intermediation at the local level may include the following, all of which

have been realized in the Indonesian case.

(1) Benefits to clients (households and/or small and microenterprises)

A set of deposit instruments that offers choices among different ratios of liquidity and returns provides substantial

benefits to clients. The indirect effect of appropriately designed deposit instruments is borrower access to an increased

volume of credit at a substantially lower interest rate than is typically available on the informal commercial credit market.The direct benefits are the opportunities to save in convenient, secure institutions in deposit instruments providing liquidity

and returns.

(a) Deposit instruments appropriate for local demand

SMEs tend to save for similar purposes and to have similar needs for deposit instruments. In Indonesia BRI

designed deposit instruments to supply each major type of demand. In Bolivia, it appears that SMEs save for similar reasons

as Indonesian SMEs; it appears that similar tyoes of deposit accounts can supply local demand. Many households and208

SMEs in both banks hold more than one type of deposit account. Reasons that SMEs save are common in many parts of

the developing world. Some of the most important are reviewed below, with the types of instruments BRI has found

appropriate for each type of demand. 209

(i) Emergencies. Saving for emergencies and unexpected investment opportunities is probably the

most common reason for saving; people save in case of family emergency and to make purchases of

supplies for their enterprises when prices are low. A fully liquid account is appropriate for this purpose;

in general no other type of deposit account will draw these savings.

(ii) Managing irregular income streams. Households with uneven income streams (from agriculture,

fishing, enterprises with seasonal variations, etc.) can save for consumption during the periods in which

income is low. Liquid, semi-liquid, and fixed deposit accounts can each be appropriate, depending on

the nature of the income stream. Multiple accounts, for example a combination of liquid and fixed deposit

instruments, are commonly selected for this type of saving.

(iii) Investment. Households frequently save for self-finance of long-term investments, such as purchase

of land, children's education, house construction and electrification, etc. Small and microenterprises

84

save for building construction and purchase of machinery, vehicles, raw materials, land, etc. Fixed deposit

accounts are commonly selected for this purpose, but semi-liquid and liquid instruments are also

sometimes used, e.g. for school fees. Selection depends on the nature and timing of the planned

investment, and multiple accounts are common.

(iv) Social and religious obligations. While the forms are different in different societies, saving for

life crisis ceremonies, religious holidays, pilgrimages, etc. is common throughout the world. Liquid,

semi-liquid, and fixed deposit accounts can all be appropriate, depending on the anticipated needs.

(v) Old age and disability. This type of saving has both direct and indirect forms. The latter may take

the form of saving for investment in children's education, marriages, etc., with the assumption that the

parents will be cared for in old age by the child or children thus supported. Fixed deposit accounts are

often used for both direct and indirect savings of this type, but other instruments are also used.

(vi) Building credit ratings. Saving to build credit ratings and to leverage loans with deposits is of

particular importance for lower-income households and enterprises because they typically lack collateral

acceptable for formal loans. Different savers use different types of accounts for this purpose, depending

on amount of savings and anticipated time horizon.

(b) Liquidity

Of BRI's $2 billion in unit bank deposits, 76 percent is in liquid instruments. Rapid access to at least some of their

financial savings is considered essential by households and enterprises, and liquid deposit accounts are greatly in demand.

(c) Returns on deposits

Positive real returns on deposits are typically not available at low risk outside financial institutions. Where such

institutions offer appropriate deposit instruments,

the interest can be used by the household or enterprise as an income flow or as savings.

There are, of course, trade-offs between returns and liquidity. BRI found that if clients are informed that liquid accounts

are labor-intensive for the financial institution, and that therefore interest rates must be lower than on less liquid accounts,

they find this understandable and acceptable.

(d) Improved financial management

Many households and enterprises hold savings accounts and loans simultaneously. This strategy permits some

financial stocks to be held for emergencies, while loans, used for working and investment capital and in some cases for

consumption, are repaid from income flows. Institutional savers may also use their deposits to build credit ratings; in

The author has been told by numerous clients of both BRI and BancoSol that holding loans and deposit210

accounts has helped them to improve their household and/or enterprise management.

The day that BRI's SIMPEDES instrument permitting accounts to be held in the name of organizations was first211

introduced in one region of Indonesia, the author observed a street fight between members of a local association andthe treasurer of that organization. The former wanted the group funds deposited in the bank in the name of theassociation; the latter objected. When the members threatened to elect a new treasurer, the funds were deposited in thebank.

85

addition the deposits can be used as collateral for loans. A common misconception is that a particular individual, household,

enterprise, or association is either a borrower or a saver. Many are both. 210

(2) Benefits to local groups, organizations, and institutions

Deposit instruments which permit savings to be held in the name of associations can provide significant benefits

to the depositors. In Indonesia, BRI's provision that savings accounts may be held in the name of a group, organization

or institution opened a large new market for deposits derived from village treasuries, government offices, schools, religious

institutions, development programs disbursing funds for rural projects, and from a plethora of local organizations: e.g.,

employees', women's, youth, and sports associations; informal savings and loan associations; voluntary agencies, etc.

Previously the group's president or treasurer had held the organization's funds; the members of many groups, although

not necessarily the group leaders, preferred the new arrangement. Although not yet common in other countries, in211

Indonesia group savings accounts have been reported to improve the financial security of the group, to decrease

opportunities for corruption, and to improve the accountability and financial management of group funds. Institutional

savings also provides groups with the opportunity to earn returns on their deposits.

(3) Benefits to financial institutions

Deposits mobilized in conjunction with commercial credit programs enable sustainable financial institutions.

As noted, on October 31, 1993 BRI's KUPEDES program had 1.8 million loans outstanding which were fully financed

by unit bank deposits from 11.2 million savings accounts. In 1983 none of BRI's over 3600 unit banks was profitable;

by 1992 nearly all, other than the recently opened units, were earning profits (Table 5). Financed by local deposits,

KUPEDES supplies the increasingly large demand for local credit at commercial interest rates; the system is profitable

and sustainable.

(4) Benefits to the economy, development, and equity

Local savings mobilization benefits the economy directly by increasing the resources available for productive

investment. BRI's success in deposit mobilization permits the supply of a large demand for credit at commercial interest

rates which typically range from 5 percent to 50 percent of the rates charged by informal commercial lenders. While BRI

does not yet lend to most of the poorest households (which are still served at high rates by informal lenders), KUPEDES

loans do reach many lower-income borrowers, including numerous SMEs. As discussed above, BRI is presently making

See Section II.A.3 for references.212

For a recent overview of the concept, see Germidis, Kessler, and Meghir, op. cit., Chapter 1.213

Von Pischke, op. cit.214

Stiglitz (1986).215

Germidis, Kessler, and Meghir, op. cit.216

86

a sustained effort to reach additional lower-income clients, both directly and through the BKDs. Other financial institutions

in developing countries have demonstrated that lending to the poor can be both effective and low-risk (e.g, Grameen and

BRAC in Bangladesh; BKK and BDB in Indonesia; CanCCUL and CCEI in Cameroon; and PRODEM and BancoSol in

Bolivia). BRI has demonstrated that locally mobilized savings can support local lending.212

Savings mobilization at the local level is thus crucial for economic development in general, and for financing

lower-income households and enterprises in particular. Appropriate deposit instruments and services: (a) provide security,

liquidity and returns, and encourage self-finance of investments; (b) permit a large volume of credit to be offered at market

rates that are substantially lower than those otherwise normally available to most small and microentrepreneurs; and (c)

enable the growth of sustainable financial institutions; and (d) permit both social and economic profitability.

II. E. CRITIQUE OF SELECTED LITERATURE ON LOCAL FINANCIAL MARKETS: SUMMARY OFCONCLUSIONS

Four main streams of literature related to local financial markets have been reviewed here: (1) supply-leading

finance theory and subsidized credit programs; (2) informal commercial credit markets and market interlinkages; (3)

asymmetric information and moral hazard/adverse selection; and (4) local-level savings. The conclusions of this section

are summarized below in anticipation of Section III which reviews briefly other models concerned with local finance

(financial dualism, the financial frontier, the Imperfect Information Paradigm, and the interpenetration model)213 214 215 216

and then constructs a model of local financial intermediation. Six main conclusions emerge from analysis of the literature

reviewed here.

(1) Subsidized credit programs have negatively affected local financial markets in developing countries in manyparts of the world.

Subsidized credit programs tend to: (1) subsidize local elites at high cost; (2) depress financial savings; (3)

discourage institutional sustainability; and (4) limit the supply of institutional credit available to lower-income borrowers,

forcing the latter either to do without commercial credit or to borrow at much higher rates on the informal credit market.

Although BRI has demonstrated that commercial credit can be profitably delivered locally, there has been little voluntary

intervention by formal-sector institutions in local credit markets generally.

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(2) Informal commercial credit markets, rural and urban, tend not to be competitive.

Such markets are better characterized by a model of monopolistic competition, but one in which monopoly profits

can be maintained for the long term because lenders do not usually compete for the same borrowers. The reasons are:

(1) Informal commercial lenders usually lend to borrowers with whom they are interlinked in other markets.

(2) Established lenders tend not to want to expand their market shares because the risks of collecting loans outside

the relatively small area in which the lender is politically well connected, maintains interlinked transactions, and

controls information flows are perceived as too large. Larger lenders with control over a more extensive area tend

to operate through credit layering, to the same effect.

(3) Interest rates are usually high, ranging from 2 to over 35 percent per month flat rate on the original balance;

generally the poorer the borrower, the fewer the options and the higher the interest rate. Since lenders generally

do not want to expand their market share, they have no incentive to lower interest rates.

(4) Many borrowers have no other credit options, aside from family and friends, because: (a) if a borrower turns

to another informal lender, he or she is likely to face substantial risk for similar credit terms; (b) subsidized credit

is not available to most borrowers; and (c) institutional commercial credit is typically unavailable at the local level.

(5) The local political economy limits the number of borrowers per lender; such limits as there may be on the

entry of lenders into the market are, in general a byproduct of this process.

(3) Models of rural financial markets that assume that financial institutions are characterized by asymmetric

information, moral hazard, and adverse selection do not incorporate adequate understanding of how the markets

actually operate.

There are some rural financial institutions that are explained by this model. However, a crucial point has been

missed: moral hazard and adverse selection are not necessarily intrinsic the operation of financial institutions serving the

local level. Institutions can, and do, act to inform themselves about local markets. There is extensive evidence from many

parts of the developing world to show that with knowledge of how local markets work, financial institutions have been

able to reduce or overcome informational problems. Under these circumstances, not only does the financial institution

not have to raise interest rates to compensate for moral hazard, it can lend profitably at far lower interest rates than those

provided by informal commercial lenders. Accordingly, most borrowers want to retain the option to reborrow from the

institution, and therefore have a strong incentive to repay. Under these circumstances, financial institutions can not only

compete successfully with informal commercial lenders, they can develop out of, learn from, and even co-opt informal

lenders. BRI has understood that informal lenders and institutional clients are often the same person. As a class, informal

88

lenders might be considered formidable competition to BRI. However, they operate as individuals in an informal credit

market characterized by monopolistic competition. Given the reality of interlinked transactions, political alliances, and

information flows, local lenders may not wish to increase their share of the credit market. As BRI found, lenders with

interlinked transactions may, in fact, be relieved not to have to provide extensive business-related loans, preferring to free

up their capital for other purposes.

(4) The Indonesian experience has demolished the views that rural economies are "penny economies" and that they

do not generate sufficient business volume to be profitably served by banks.

BRI's Unit Banking System has $2 billion in savings and nearly $1 billion in credit outstanding, along with a 3.1

percent long-term loss ratio. Adams, Vogel, Von Pischke and the others were right about rural savings: it is extensive,

and outside Indonesia it has been 'forgotten' by governments and donor agencies. It has been demonstrated that a low level

of institutional savings should not necessarily be interpreted as lack of propensity to save, or as a result of impediments

in the socio-economic structure, or as evidence of distrust of or 'psychological aversion' to the use of banks. It may simply

reflect poor banking instruments and lack of knowledge on the part of the bankers concerning the workings of local financial

markets. BRI found that the lesson that had to be learned was that SMEs are often relieved to be able to save in financial

institutions. Among the main reasons are: (1) security, which is related not only to possible theft but also to the multiple

claims on ready cash which exist in local settings; (2) positive real returns; and (3) the view that financial savings are an

appropriate way to hold funds from lumpy income streams and to save for specific purposes.

The Indonesian experience indicates that savings mobilization and financial intermediation serving the local levels

can be successful, assuming: (1) reasonable levels of macro-economic management and political stability; (2) economic

development and monetization at the local level; (3) laws and regulations that permit spreads between lending and deposit

interest rates that financial intermediation that can be profitable for the implementing financial institutions; and (4) well-

managed institutions that operate each unit as a profit center, that understand local markets, that offer financial instruments

appropriate for local demand, and that provide staff training and incentives for performance.

Effective savings mobilization and volume of lending appear to be the main factor differentiating BRI from the

other financial institutions that lend successfully at the local level. The two are directly related; it was the savings that made

the large volume of lending possible. BRI's decision to combine savings and credit and to plan and implement them together

is of critical importance for economic development because the much larger volume of capital available for lending enables

many more SMEs to avoid the high interest rates generally charged by informal commercial lenders at the local level in

many developing countries. As demonstrated in Indonesia, well-designed and carefully implemented savings programs

can contribute to local, regional, and national economic development, and can help to improve equity.


89

(5) One reason that financial institutions serving the local level are not sustainable without subsidies is that they

combine financial services with social services.

There is no question that banks serving lower-income clients and social service organizations are both necessary

for development and for poverty alleviation, and that the aims of both types of institutions are compatible and

complementary. The issue is whether one institution can or should do both. On the one hand, there is room for different

types of financial institutions and service organizations at the local level in developing countries. On the other hand, for

large-scale development the financial intermediation paradigm has a crucial role to play, and it does not incorporate either

ongoing subsidies or direct social services.

The 'many lenders' syndrome and the consequent inelasticities of rural credit markets were reported in the 1950s,

but seem to have been largely ignored subsequently, in part because of widespread emphasis on the elimination of

intervention in rural credit markets. Removal of interventions, however, leaves most lower-income households and

enterprises with the choice of borrowing at high interest rates or not borrowing (except for credit which may be available

on occasion from family or friends). As a recent study of rural credit in developing countries worldwide concluded, "The

informal sector's clients are usually the small and poorer borrowers who must choose between higher-cost informal credit

and no credit at all". The appropriate policy conclusion is, therefore, not to abandon intervention but to redesign its role217

and to make financial service delivery sustainable. A number of financial institutions have demonstrated that institutional

credit at commercial interest rates can be profitably delivered to lower-income households and enterprises, but it is the

financial systems approach that has demonstrated that this can be done sustainably.

(6) It is the formal sector, not the informal sector, that makes local financial markets competitive.

Indonesia's indigenous credit market is not competitive; it is best described as monopolistic competition. However,

BRI's success in financial intermediation has engendered - as might be expected - extensive competition from other financial

institutions of many types.

See footnotes 9 and 10 for references.218

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III. THE LOCAL FINANCIAL INTERMEDIATION MODEL

A simple model of Local Financial Intermediation (LFI) for developing countries is presented here. This model

assumes that the local economy is monetized or partially monetized, and that it is embedded in a larger political economy

that provides reasonable levels of macro-economic management (including control of inflation) and political stability.

Local financial markets are complex, and the analysis here does not attempt to cover the multiple variations found in

different countries. However, the LFI model can help in explaining the central tendencies of local financial intermediation

and in focusing on crucial policy options. Some developing countries and some regions may be either too economically

and technically advanced or, conversely, too under-developed for the LFI model to be applicable. Nevertheless, much

of the developing world is within the range in which the model presented here may be useful.

The LFI model assumes that the local economy has the following characteristics: (1) there is significant demand

for financial services, both for credit and savings; (2) the local financial market includes formal, informal, parallel, and

black markets; (3) these markets are interlinked; (4) financial markets are linked with other local markets (e.g., commodities,

land, labor); (5) there is an extensive supply of informal commercial credit and a low supply of opportunities for financial

savings that provide both returns and liquidity; (6) the local financial market is linked with regional and national financial

markets.

For the sake of simplicity, however, the model itself includes only the operations of formal financial institutions

and informal commercial credit markets. Thus the LFI model excludes: (a) non-commercial informal credit (from relatives,

friends, etc), usually characterized by small loan amounts, irregular availability, and no (or low) financial interest charges;

(b) quasi-formal financial intermediaries whose status on the formal-informal continuum varies from country to country

(e.g., credit unions, cooperatives, pawnshops, etc.); and (c) the activities of parallel and black markets, although some of

the flows of funds from these markets is captured in the formal and informal financial markets in the model. All of the

above play important roles in local finance, however, and should be included in a more complex model.

III. A. COMPARISON WITH OTHER MODELS OF LOCAL FINANCE

The LFI model differs from two earlier models: 'Financial Dualism', and the model that assumes a 'Frontier' between

formal and informal financial systems. Financial dualism assumes that the formal financial system and the informal218

financial system exist side-by-side, the former serving the 'modern' sector and the latter the 'traditional' sector. However,

reality is too complex for this model to be useful except to define the ends of the continuum. More recently, the Financial

Frontier model has postulated a frontier between institutional finance "organized on a formal, structured, hierarchical,

impersonal and often centralized basis" and informal financed located 'beyond the frontier' where "most financial

Von Pischke, op. cit., pp. 1-2.219

See discussion in II.C.I and references in footnote 25.220

Germidis, Kessler, and Meghir, op. cit., pp. 12, 13, 19.221

91

transactions are personalized and conducted directly, without intermediaries." This model places emphasis on analyzing219

the sustainable outward expansion of the frontier. However, the location of the frontier depends not so much on where

the participants are, but on who they are, and with whom their financial transactions are conducted. Modern finance now

reaches certain people even in remote villages, while the urban 'informal sector' makes use of informal finance on the streets

outside the Central Bank. The frontier is dynamic in both space and time, and the links between formal and informal finance

are themselves components of local financial markets.

Thus, an individual can be inside and outside the frontier on the same day in the same village. He collects payment

on informal loans he has made and he then makes a payment to the local bank on his formal loan - part of which he may

have used to capitalize his informal loans. Another kind of example is that of a farmer who wants to purchase a tractor;

his selection of financing can depend on the availability of the tractor. If the tractor is easily available, the farmer may

make use of formal financing (especially if he can obtain subsidized credit). However, if tractors are in short supply, the

farmer may purchase one from a parallel market in smuggled goods, using informal financing. Alternatively, the farmer

might purchase a tractor at the official rate using formal-sector credit and then add, from informal financing, the extra

amount actually required to take possession of the tractor. It is not only individuals who participate in multiple financial

markets, but institutions as well. For example, this author has visited bank branches in which banking transactions occur

in the front room, while the back room is reserved for illegal lottery pools. This is viewed locally as a simple way to make

up shortfalls in bank assets and to augment low formal-sector salaries, while meeting client demand for financial services.

On a larger scale, local, national, and international drug traffic and other black markets result in transfers of large volumes

of funds in both directions between the informal and formal sectors. While the financial frontier is a useful conceptual

tool, its analytical power is limited because, in reality, local finance is political, mercurial, and multi-dimensional.

The LFI Model differs also from the Imperfect Information Paradigm, as the latter has been applied to local

financial markets. As discussed above, this paradigm is also useful under some circumstances, but the constraints that220

are assumed to prevent the formal sector from expanding in local financial markets can be overcome. Therefore, the LFI

model incorporates solutions to the constraints postulated in the Imperfect Information Model.

It is the Interpenetration Model (IP) that provides the starting point for the LFI model developed here. The IP

Model assumes: (1) that the formal and informal financial sectors are linked and that they complement each other; (2) that

for better linkage between the two sectors "both would need to evolve and change simultaneously;" (3) that "integration

['absorption of the informal by the formal sector'] and interlinkage [are] undertaken concurrently - and they involve both

microeconomic and macroeconomic measures;" and (4) that "linkage in the short term will bring on integration in the long

term." The IP Model thus emphasizes the evolution of multiple linkages of formal and informal finance. The LFI model221

shares with the IP model the idea that "by transforming both sectors - in other words by 'institutionalizing' to some extent

Ibid., p. 200.222

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the informal savings and credit sector and by 'deformalizing' the formal sector - that a new and more efficient formal sector

will appear and evolve". The LFI model attempts to indicate possible directions for the development of the new and222

more efficient formal sector.

III. B. ASSUMPTIONS OF THE LOCAL FINANCIAL INTERMEDIATION MODEL

Unlike previous models of local financial markets, the LFI model is not primarily a model of credit, but of financial

intermediation at the local level. It assumes a complex local financial system with formal and informal components that

interact in multiple ways, generating complementarity and redundancy, monopoly and competition. It assumes also that

well-planned and implemented interventions in the system can improve social and economic development at the local

level. This model of local finance, applicable to a number of developing countries, includes the following assumptions:

(1) Informal commercial credit delivered at the local level is usually characterized by monopolistic competition,

frequently linked in varying degrees with monopsonistic rural markets in commodities, land, and labor.

(2) The informal commercial credit market is not normally constrained by shortage of capital, although this may

occur in particular areas or at particular times, e.g., at times of collective shock.

(3) Informal commercial lenders typically provide loans within a circumscribed locality in which they participate

in local business networks, retain political alliances, and maintain access to local information flows. In addition

they frequently minimize risk further by lending to borrowers with whom they conduct other transactions

concurrently. These requirements limit the number of low-risk borrowers available to a particular lender and

generate the pattern of 'many lenders' operating in a local market area.

(4) Most informal commercial loans are for relatively small amounts and short terms; they are normally made

available quickly with little formality, and are usually (but not always) unsecured.

(5) Except in times of collective shock (drought, flood, epidemics, war, etc.), default rates on the informal

commercial credit market tend to be low because of interlinked transactions, long-term relationships, good

information, and the local proximity of borrower and lender.

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(6) Because of the risks to borrowers of changing lenders (with whom they usually have multiple ties), borrowers

tend to use one informal commercial credit source for relatively long periods of time, although they may borrow

simultaneously from friends and relatives and/or from the formal sector.

(7) Established informal commercial lenders generally do not want to increase their market shares because it is

considered too risky to lend outside the area controlled through interlinked transactions, political influence, and

access to information flows. Such lenders generally charge high interest rates, and are not normally induced to

lower these rates.

(8) Interest rates on the informal commercial market tend to range from about 2 to over 20 times non-subsidized

bank rates; the most common informal commercial rates are from 2 to 10 times bank rates. In general, the poorer

the borrower, the higher the interest rate on the informal commercial market, since the poor have fewer options.

Both high transaction costs to the lender and high risk premiums may contribute to the high interest rates in the

informal commercial market, although there is considerable variation in these. Transaction costs to lenders may

or may not be high, and lenders may or may not earn positive economic profits, depending on local conditions.

The primary explanation for the high interest rates in the informal sector is the prevalence of monopolistic

competition.

(9) The many-lender local credit market is not fully explained by the theory of monopolistic competition, which

assumes the possibility of positive economic profits in short-run equilibrium, but not in long-run equilibrium.

The many lenders in a local credit market may earn positive economic profits in a system which is in long-run

equilibrium. However, profits are capped by constraints on the number of low-risk interlinked borrowers available

to particular lenders.

(10) Larger informal commercial lenders with influence in a wide local area tend to operate through credit

layering. Rather than providing credit directly to many borrowers whom the lender does not know personally,

he tends to provide credit to subordinate lenders with whom he also has interlinked transactions; the latter then

on-lend to other lenders or to end-borrowers. For the reasons discussed above, these lenders also normally have

no incentive to expand their share of the credit market or to lower interest rates.

(11) Non-formal financial savings opportunities at the local level tend to offer security or returns but not both;

in addition restrictions may be placed on liquidity. Where formal financial institutions do not offer deposit

instruments designed to supply local demand profitably, local savings is typically kept in cash in the house, in

informal associations such as ROSCAs, and in non-financial forms (gold, animals, raw materials, construction

materials, etc.).

94

(12) Financial institutions receiving subsidized funds do not emphasize voluntary mobilization either because

they are prohibited by law or regulation from profitable financial intermediation or because, as the recipients of

low-cost funds, they have no incentive to mobilize local savings.

(13) Subsidized credit programs depress savings mobilization and prevent the development of sustainable financial

institutions. Many formal financial institutions serving the local market are funded primarily with subsidies. They

are, therefore, typically capital constrained and unable to supply local demand.

(14) Financial institutions that on-lend subsidized funds at below-market rates tend to reach local elites instead

of the poor; loan recovery is often poor.

(15) Financial institutions that on-lend subsidized funds to target groups of poor borrowers at commercial interest

rates tend to reach the poor through group lending programs in which the groups provide borrower screening

and monitoring; loan recovery is often good.

(16) Assuming that the regulatory environment permits profitable financial intermediation at the local level,

financial institutions that are trusted and conveniently located can provide financial services profitably at the local

level if the spread between loan and deposit rates is set appropriately and if the financial instruments offered are

suitable for local demand.

(17) An institution that mobilizes savings and lends profitably at commercial interest rates has an incentive to

lower interest rates, where possible, in order to increase its market share. When such institutions enter the market,

a much larger proportion of local demand for financial services can be supplied. The growing volume of

institutional lending permits financial intermediation over a wider area; this, in turn, helps to protect against the

effects of regional shock and provides economies of scale which lower unit costs of operation.

(18) Formal-sector financial institutions collecting voluntary savings and providing credit at commercial rates

can overcome the problems of asymmetric information because: (a) institutions are usually not subject to the same

local political constraints as informal lenders; and (b) institutional staff can learn to understand local markets

and to obtain reliable information about prospective borrowers.

(19) Institutional default rates can be kept low if: (a) the cost to the borrower remains significantly below the

cost of a loan from the competition (primarily the informal commercial market) so that borrowers want to repay

in order to remain eligible to re-borrow; (b) the financial institution trains its staff well; and (c) incentives are

provided to staff members for good performance.

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(20) Local residents who are given the choice between institutional and informal loans in which the former are

provided at significantly lower cost than the latter (and which can be obtained with reasonable convenience) will

tend to choose the institutional loans. Those ineligible for institutional loans because of lack of required collateral

or for other reasons will continue to borrow from informal lenders.

(21) Local residents given the opportunity to place financial savings in secure institutions with convenient

locations and to select from deposit instruments offering different ratios of liquidity and returns will tend to place

some savings from stocks and some from income flows in such institutions.

(22) In well-functioning financial institutions offering loan and deposit instruments appropriate for local demand,

there will normally be a larger number of deposit accounts than loans outstanding.

(23) Ongoing subsidies to the financial institution are unnecessary since, assuming low default rates, spreads

can be set which offer attractive interest rates and also enable institutional profitability. Where considered

politically necessary, subsidized lending programs can be offered concurrently with commercial credit programs.

Since the former are capital constrained, while the latter are supported by locally mobilized deposits, the non-

subsidized credit can gain a substantially larger share of the credit market.

(24) A partial substitution effect thus occurs, with institutional loans replacing credit previously supplied through

informal commercial markets. Borrowers receiving commercial institutional credit typically pay substantially

lower interest rates and total costs than those borrowing on the informal commercial credit market.

(25) Financial institutions operating locally on a commercial basis can be both economically and socially profitable

and can operate successfully on a large scale.

(26) Where competitive local financial markets exist, these are normally a result of formal-sector participation

in the market.

(27) There is room in local financial markets for many types of finance, e.g. informal commercial lenders,

cooperatives, credit unions, private banks, state-owned banks, etc. However, the largest share of the market will

be held by those financial institutions that engage in profitable financial intermediation at the local level.

(28) Profitable financial intermediation at the local level by commercial institutions benefits the clients, the

institution, and social and economic development more generally.

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(29) The LFI model applies broadly to many developing countries.

(30) Local financial markets in widely differing economies and cultures incorporate important underlying

similarities. For this reason financial institutions in very different developing countries can learn successfully

from one another.

III. C. MODELS AND REALITY: IMPROVING THE FIT

The LFI model draws from previous models of local finance, but highlights the paradigm shift from credit delivery

to financial intermediation. The LFI model shares with the Financial Frontier model the view that the frontier between formal

and informal financial sectors is dynamic and that integration between the sectors is both inevitable and desirable; it assumes,

however, a more complex frontier. It shares with the Imperfect Information Paradigm the view that local financial markets

are characterized by asymmetric information, but assumes that moral hazard and adverse selection can be prevented by

financial institutions whose staff understand local markets. With the Interpenetration model, LFI shares the assumptions

that the formal and informal sectors are linked, that they complement each other, and that their interlinkages both precede

and generate their integration.

The LFI model assumes that the evolution of a more efficient formal sector serving the local levels of developing

countries will include the development of conveniently located institutions that: (1) lend widely at the local level at

commercial interest rates; (2) mobilize savings locally with instruments appropriate for local demand; (3) provide loans

at commercial interest rates to low-income clients, substituting group lending and peer monitoring for collateral; (4) maintain

low default rates through training institutional staff to obtain reliable information about clients and markets and providing

incentives for them to do so; and (5) establish a spread between loan and deposit interest rates that enables institutional

profitability and sustainability for the long-term.

The Local Financial Intermediation model has crucial implications for social and economic development in a wide

range of developing countries. Part III of this series will address the policy implications of this model. Present transfers

of information among different countries and financial institutions, as well as the adaptation of financial instruments and

services from one institution to another will be discussed. Finally, the process of adaptation and its relation to development

will be analyzed.

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REFERENCES

(Note: only references cited in Part Two of this series are cited here. A more extensive bibliography is provided

in Part One.

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(1973) "The Case for Voluntary Savings Mobilization: Why Rural Capital Markets Flounder", in USAID (1973),Vol. 19, pp. 309-34.

(1978) "Mobilizing Household Savings through Rural Financial Markets", Economic Development and CulturalChange, Vol. 26, No. 3, pp. 547-60.

(1984) "Do Rural Savings Matter?" Studies in Rural Finance, Economics and Sociology Occasional Paper No.1083. Columbus: Ohio State University.

(1988) "The Conundrum of Successful Credit Projects in Floundering Rural Financial Markets", EconomicDevelopment and Cultural Change, Vol. 36, No. 2, pp. 355-67.

___________ and Nehman, Gerald I. (1979) "Borrowing Costs and the Demand for Rural Credit", Journal of DevelopmentStudies, Vol. 15, No. 2, pp. 165-76.

___________ and Graham, Douglas H. (1981) "A Critique of Traditional Agricultural Credit Projects and Policies",Journal of Development Economics, Vol. 8, No. 3, pp. 347-66.

___________, Graham, Douglas H. and Von Pischke, John D., eds. (1984). Undermining Rural Development with CheapCredit. Boulder, CO: Westview Press.

___________ and Vogel, Robert C. (1986) "Rural Financial Markets in Low Income Countries: Recent Controversiesand Lessons", World Development, Vol. 14, No. 4, pp. 477-87.

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