Megan Brooks
Access to banks and financial services is a significant issue in developing economies. The World Bank estimates that 1.7 billion people, mostly in poorer countries, lack access to basic financial services such as checking accounts and savings products. This lack of access can hinder economic development, reduce investment and employment opportunities, and distort capital allocation. Developing countries often rely heavily on banks for household savings and external finance for firms, with Latin American countries being a prime example. Various initiatives, such as the World Bank's financial inclusion efforts and country-specific programs, aim to address this issue. For instance, the Banco Para Todos program in Brazil increased the physical presence of bank branches and improved financial inclusion. Similarly, India implemented a $300 million project to expand access to microfinance services. These efforts are crucial for promoting inclusive economic growth and development in developing economies.
| Characteristics | Values |
|---|---|
| Financial systems in developing countries | Typically dominated by banks |
| Bank deposits | Most important form of household savings |
| Bank loans | Most important source of external finance for firms |
| Latin America | Commercial banks played a central role in the 1980s |
| Middle-income developing countries | Have access to capital on favorable terms |
| World Bank | Supports financial inclusion through financial sector expertise, country engagement and dialogue, financing and risk-sharing instruments, unique datasets and research capacity, and influence with standard-setting bodies and the G20 |
| World Bank projects | Kenya Jobs and Economic Transformation Project (KJET), India's $300 million project to scale up access to sustainable microfinance services, Jordan's "Innovative Startups and SMEs Fund" (ISSP), a $98 million loan |
| World Bank estimates | 1.7 billion people have no access to checking accounts or basic savings products |
| Banco Para Todos programme | Led to a substantial increase in the physical presence of bank branches and 'bank correspondents' |
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What You'll Learn
Financial inclusion and economic growth
Financial inclusion is pivotal to economic growth, as it brings individuals, families, and firms into the financial system, triggering consumption and expenses. It is a catalyst for achieving seven of the 17 Sustainable Development Goals (SDGs). Financial inclusion strengthens economic activity, boosts productivity, and lays the foundation for inclusive and sustainable economic growth. It also supports entrepreneurship and business growth, allowing small businesses to expand, create jobs, and drive economic development.
Financial inclusion is especially important in developing countries, where it can act as a driver of economic growth. In developing countries, banks are often the only nongovernment issuers of short-term liabilities such as commercial paper. This means that borrowers are restricted to the short-term market, which is dominated by banks. In Latin America, for example, commercial banks provided short-term financing during the severe economic difficulties of the 1980s.
However, the relationship between financial inclusion and economic growth is complex and varies depending on the level of economic and technological advancement of a country. While financial inclusion consistently correlates with economic growth, the magnitude and impact of this relationship vary between countries at different levels of financial development. For example, a study of 21 Asian countries from 2004 to 2019 revealed a significant positive long-term impact of financial inclusion on economic growth, with the influence being more pronounced in developing countries.
Despite the importance of financial inclusion, one-third of the world's population still lacks formal access to the financial system in the form of bank accounts. This situation is particularly acute in developing economies, where only 27% of adults hold a formal bank account. To address this issue, organizations like the World Bank are working to advance financial inclusion worldwide through various initiatives and collaborations. For instance, the World Bank supported the Government of Mexico in implementing reforms to narrow the gender gap for financial access, and it has also provided funding for projects in India and Jordan to improve access to finance for small businesses and startups.
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Transnational banks and debt
Developing economies have access to banks, but the financial systems in these countries are often dominated by them. Bank deposits are the most common form of household savings, and bank loans are the primary source of external finance for firms. Commercial banks, in particular, have played a central role in Latin America, providing short-term financing to countries facing economic difficulties.
The role of transnational banks in this context is complex. On the one hand, transnational banks can provide access to capital and financing for development projects in middle-income developing countries. Institutions like the International Bank for Reconstruction and Development (IBRD) offer favorable terms for borrowing, helping to catalyze private financing and promote sustainable development.
On the other hand, transnational banks can contribute to the debt burden faced by developing countries. The UN Economic and Social Council has requested reports on the activities of transnational banks related to the external indebtedness of developing countries, recognizing the need to address the stock and service of commercial debt. Developing countries often lack a voice in how global financial systems are run, and systemic inequalities further challenge their ability to manage debt.
To address these challenges, reforms are needed to make international economic governance more inclusive. This includes improving access to liquidity in times of crisis, providing more affordable finance and technical support, and creating a fair and effective mechanism to manage debt beyond the current G20 Common Framework. By empowering developing countries to manage their debt effectively and access sustainable financing, economic growth and development can be fostered.
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Microfinance and development
Microfinance is a strategy that provides small loans, financial services, and training to low-income individuals or groups who do not have access to traditional banking services. Microfinance institutions (MFIs) provide various services, including microloans, savings accounts, and financial education, primarily in developing countries. While microfinance has been promoted as a strategy for economic development and poverty reduction, there are arguments for and against its effectiveness.
Firstly, microfinance provides access to credit for people who would otherwise be excluded from traditional banking services. This access to credit can help individuals and small businesses improve their standard of living and become self-sufficient by providing them with the financial tools they need to start or expand a business. For example, a typical loan of $100 may not seem like much to some people in the developed world, but for many impoverished people, this figure is often enough to start or sustain a business or engage in other profitable activities. Through repayment, loan recipients also begin to develop a good credit history, which allows them to get larger loans in the future.
Secondly, microfinance can help reduce poverty by increasing incomes and creating jobs, particularly in rural areas. Successful microfinance initiatives, like those by the Grameen Bank, have demonstrated high repayment rates and significant positive impacts on communities. Microloans have the potential to enable entrepreneurs to create jobs and drive economic improvement. Additionally, microfinance institutions are often structured as financially sustainable social enterprises, meaning they can continue providing financial services to low-income individuals over the long term.
However, there are also criticisms of microfinance as a strategy for development. One of the main concerns is the potentially high interest rates charged by microfinance institutions, which may conflict with their original goal of aiding the impoverished. High interest rates can make it difficult for borrowers to repay their loans and may push them further into poverty. There is also a risk of over-indebtedness if borrowers take out multiple loans from different MFIs, especially in areas with market saturation where there are too many institutions competing for the same pool of borrowers.
Overall, microfinance can be an effective tool for economic development and poverty reduction in certain contexts. However, it should be implemented carefully and in combination with other interventions such as education and healthcare to ensure that it meets the needs and circumstances of the target population. Additionally, providing repayment flexibility in credit contracts can ease the credit constraint and offer insurance against income fluctuations.
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Role of banks in developing countries
Banks play a crucial role in developing countries, dominating their financial systems and contributing significantly to economic growth. In developing economies, bank deposits are the primary form of household savings, and bank loans are the primary source of external finance for firms. This dominance of banks is evident in Latin American countries, where commercial banks played a central role in the 1980s, providing short-term financing during a period of economic hardship.
One unique characteristic of banks in developing countries is their "franchise value." Banks have the exclusive power to issue liabilities that are accepted as a means of payment, making them the only non-government issuers of these short-term liabilities. This is particularly significant in developing countries with less-developed legal and accounting systems, where other institutions face challenges in issuing similar liabilities. As a result, banks become the primary source of short-term financing for borrowers who need to demonstrate liquidity to investors as proof of their solvency.
The World Bank, in collaboration with organizations like the G20, actively promotes financial inclusion in developing countries. They work towards ensuring that individuals and businesses have access to affordable and effective financial services, supporting inclusive economic growth. This includes providing financial resources, expertise, and technical services to middle-income developing countries to facilitate sustainable development projects and enhance resilience to economic shocks.
Additionally, the World Bank supports specific initiatives to expand access to finance in developing countries. For example, the India project aimed to increase access to sustainable microfinance services, and the Kenya Jobs and Economic Transformation Project (KJET) focused on green SME financing to promote the adoption of green technologies. These efforts contribute to the broader goal of financial inclusion and empower individuals and businesses in developing countries to access the financial tools necessary for economic growth and social progress.
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Financial fragility in Latin America
The Latin American debt crisis was preceded by a period of heavy borrowing from international banks, particularly in the 1970s. Low-interest rates and world economic expansion made this borrowing possible, but as the US and Europe tightened monetary policy to combat inflation, interest rates rose, and debt burdens became unsustainable. This crisis had a significant human cost, with citizens bearing the brunt of the fallout through a “lost decade” of economic stagnation.
Fast forward to the 2000s, and Latin America faced another wave of financial fragility during the Great Financial Crisis (2007-2009) and the COVID-19 shock (2020-2021). Research from Tilburg University shows that financial fragility increased during these periods, although it was mitigated by economic policies and interventions. The specific causes of this fragility included excessive risk-taking, weak regulatory enforcement, and exposure to sovereign debts.
Financial systems in Latin America, like many developing economies, are typically dominated by banks. Bank deposits are the primary form of household savings, and bank loans are the most important source of external finance for firms. This dominance of banks is partly due to the unique “franchise value of banks,” which allows them to issue short-term liabilities accepted as a means of payment. However, this also makes the region vulnerable to bank-dominated financial sector risks, such as those experienced during the Latin American debt crisis.
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Frequently asked questions
Developing economies do have access to banks, but the level of access varies. In some developing countries, the majority of people do not have access to basic banking services, while others have implemented policies to promote financial inclusion.
Limited access to banks in developing economies can stunt economic development by reducing investment and employment opportunities. It can also distort the allocation of capital, hindering talented entrepreneurs from starting or growing their businesses.
Several initiatives have been implemented to improve access to banks in developing economies. For example, the World Bank supported a $300 million project in India to scale up access to sustainable microfinance services. In Brazil, the Banco Para Todos programme led to a substantial increase in the physical presence of bank branches, improving financial inclusion.
Banks play a crucial role in developing economies by providing loans and financing for firms, which can foster economic growth. They also provide households with savings accounts, which are an important form of savings in these economies.
