Challenges in the design of the financial system 1 Improving access to financial and payments services

In LDCs, only a minority of the population has access to banking services. The unbanked are largely women, the rural population and the urban poor (Demirguc-Kunt and Klapper 2012).¹³ Insufficient access to financial services for firms outside the main urban areas and for farmers considerably hampers the process of structural transformation and requires urgent action. Inclusive development in LDCs requires the creation of financial sector policies that allow the broader population and smaller firms and farms to better access of financial and payments services (EDAR 2015: ch.4).

New technologies based on internet and mobile-phone communication open new possibilities for financial innovation and inclusion (LDCR 2017: ch.6; EDAR 2015:

ch.4).¹⁴ The “mobile money” system M-Pesa, initiated in Kenya, is a good example of the deployment of innovative banking services with technologies that are accessible for LDCs. This branchless banking service enables users to make payments for purchases and to deposit, withdraw and transfer money with a mobile phone device (Jack and Suri 2011). In the longer term, the increasing use of debit and credit cards for electronic payments also has the potential to facilitate commercial transactions. Yet, the feasibility of such innovations will be influenced to a large extent by the availability of supportive infrastructure, in particular, telecommunications infrastructure and improved literacy in rural areas.

Alongside the development of new technologies, measures should be taken to encourage commercial banks to extend and densify their branch networks in rural areas. However, this may not be commercially viable until a certain level of economic activity is attained. Therefore, market-led processes cannot be solely relied upon for the development of inclusive finance (EDAR 2015: ch.4).¹⁵ Regulation or direct service provision by public development finance institutions will be necessary in most LDCs, including measures specially targeted at expanding women’s use of financial services.

Rural branch networks of national development banks and other public banks can be used to quickly and relatively cheaply extend the supply of financial services. Similarly, post offices could assume the role of payments service providers and savings collectors (LDCR 2009: ch.3).

1.2. The importance of bank financing for structural transformation

Difficulty in obtaining affordable credit is one of the binding constraints on current economic activity and investment in productive capacities (LDCR 2009: ch.2). Micro, and small and medium-sized enterprises (SMEs) are the most credit-constrained, especially if these are owned by women or located outside urban areas. In large part, these enterprises are informal, do not follow established accounting and auditing standards and are unable to meet the, often excessive, documentation requirements of banks (EDAR 2013: ch.3). Consequently, they have to mostly rely on family, friends and informal financial intermediation, including various types of microfinance institutions.

These sources of finance are of limited utility for investment in machinery and equipment, because they provide only relatively small amounts of credit with very short maturities and at high costs.

The challenge for governments is to facilitate the access of firms and farms to short- and long-term finance on reasonable terms, without endangering the stability of the

financial system. Facilitated access to cheap credit for micro and small enterprises in the formal sector would have the side effect of serving as an incentive for informal firms to formalize (m ch.I.C.3). In developing countries bank lending constitutes the most important external source of finance for firms, but in most LDCs only a few firms have access to a bank loan or a line of credit. On average, this is the case for only 23 per cent of LDC firms, compared 47 per cent of firms in more advanced developing countries and transition economies (World Bank 2018). The development of the banking sector must therefore be at the centre of LDCs’ efforts to build productive capacities (LDCR 2006: ch.6).

1.3 Alleviating credit constraints

Even when they dispose of ample liquidity, commercial banks in LDCs are often unwilling to lend to SMEs and for long maturities, because they perceive the risks involved in such lending to be too high or incalculable. To the extent that banks provide such credit, it is mostly subject to unfavourable terms, including high risk premiums, insufficiently long maturities and restrictive collateral requirements that potential investors are often unable to fulfil.

This leads to a shortage of liquid working capital, i.e. the difference between firms’ liquid assets and their current liabilities, which is one of the main reasons for the sub-optimal capacity utilization of SMEs. Easier access to and cheaper arrangements for short-term credit could alleviate the problem of working capital shortages and allow companies to operate more comfortably.

Insufficient access to long-term financing for many potentially dynamic manufacturing firms, as well as for agriculture and commerce contributes to chronically-low investment rates and slow structural transformation in LDCs (LDCR 2009: ch.2; LDCR 2014:

ch.6). The main sources of investment financing for the productive stock in LDCs are equity capital, when new businesses are being established and retained profits when enterprises aim to expand and upgrade productive capacities. These account for close to 80 per cent of productive investments in LDCs. The contribution of long-term bank lending as a complement to retained profits as a source of investment finance is much lower in LDCs (about 9 per cent) than in higher income developing countries and transition economies (about 21 per cent) (World Bank 2018).

Financing constraints for firms and farms in LDCs arise in part from difficulties in obtaining collateral for loans, particularly in rural areas. This is due to weak property rights systems for land and capital equipment (UNCTAD 2009: ch.II). The information asymmetry between borrowers and lenders is also especially pronounced in LDCs due to insufficient capabilities of many potential borrowers to file appropriate formal loan

applications and the lack of credit bureaus, credit and collateral registries, or credit-rating agencies (EDAR 2013: ch.3). These constraints should be addressed by governments, with an aim to create or strengthen credit-rating agencies. With the help of private sectoral associations, training in key areas of business administration, including banking relationships, should be provided to micro and small enterprises, female entrepreneurs and farmers. Moreover, mandatory collateral requirements should be better adapted to the capacity of these types of borrowers to provide such collateral.

Working capital constraints could also be alleviated by financial regulation that allows the private sector to operate with buyer’s and supplier’s credit and encourages the use of short-term financial instruments, such as promissory notes and bills of exchange that can be refinanced by the central bank.¹⁶

To remedy the problem of long-term financing by the banking system, a combination of regulatory, monetary and fiscal instruments is necessary. These instruments must be aimed at inducing private financial institutions to extend more credit with more favourable terms for investment in productive capacities, while discouraging lending for consumption and speculative real estate transactions (LDCR 2009: ch.2). In most LDCs an improvement of financing conditions will also require a greater role for public financial institutions, especially national or sectoral development banks (LDCR 2006: ch.8).

In principle, finance for working capital should come from commercial banks, while public banks are better suited to assume the risks of longer-term investment lending to innovative firms, where the creditor’s risk is inevitably high. However, there is also considerable scope for cooperation between private and public banks. Another possibility for long-term investment financing is to facilitate leasing arrangements to overcome the problem of a lack of collateral (EDAR 2013: ch.3).