Government’s Role in Microfinance: What is the Optimal Policy Mix?

January 16, 2009    

Governments recently have shown a growing interest in microfinance. An increasing number of countries are adopting national policies and strategies for microfinance, and governments are funding a plethora of new projects at the retail level. This article explores the optimal roles government can play to foster permanent financial access for the poor.

What do we mean by government?
Domestic public actors that play a role to promote access to finance fall into three broad categories:

• Representatives of national and local executive branches (e.g., financial policy regulators and supervisors, telecommunications regulators, line ministry staff, heads of state-owned financial institutions, provincial governors, and other appointed officials)
• National and local legislative representatives (e.g., parliamentarians, mayors, and other elected officials)
• Members of unions, political parties, and other socioeconomic political organizations

What roles do governments play?
Our simple, though not perfect, framework synthesizes the menu of policy interventions for supporting inclusive financial access into three broad and sometimes overlapping government roles (the 3 Ps):

What is the ideal policy mix?
Because all roles are not equally effective and some interventions may actually harm financial inclusion (e.g., by discouraging private-sector delivery of services), governments need to be well informed of the risks and benefits of the specific interventions and tailor their use to specific barriers that impede permanent financial services for the poor. CGAP has identified global trends on the performance of several of these policy interventions. However, the optimal policy mix for a country will depend on its specific situation (e.g., stage of financial sector development, political regime, economic situation, etc.). The capacity of its public institutions and staff is also a key factor.

Protector and Provider Roles
Based on global analysis, we believe government’s role as Protector is the most essential, because it builds trust and addresses imbalances between customers and financial institutions. A country’s regulatory authorities have an important mission of developing appropriate prudential regulations or adapting existing banking regulations to protect the solvency of large institutions that collect deposits from poor people and, ultimately, to protect the savings of poor people. However, regulatory ambitions must be balanced with the capacity available in-country to supervise, especially when determining which organizations should face prudential supervision.

New protection challenges arise with the introduction of new products (e.g., home mortgages, consumer loans), delivery channels (e.g., branchless banking), and players (e.g., nonbank finance companies, telecommunication companies, retailers). Protective regulation must be proportionate or appropriately “light touch” if it is to protect consumers against serious abuse while not prematurely impeding access or innovation.

Other examples of effective protection include regulation to increase the transparency of the sector. In Cambodia, requiring MFIs to publish effective interest rates has increased client awareness of credit costs, fostered competition, and encouraged efficiency gains, all of which have contributed to significant drops in interest rates over the past few years.

From a global perspective, although performance of state-owned financial institutions and programs varies, we see engagement of government as direct Provider of financial services (especially subsidized credit) as one of the least efficient policy interventions for sustainable access. Recent World Bank data show state-owned banks operating in 73 out of 102 countries and comprising 15 percent of total banking assets. State-owned retail financial institutions (SORFIs) usually combine financial and policy objectives. Although these institutions typically are expected to at least break even, they often do not (because of policy objective challenges); they tend to perform relatively better on outreach than profitability. Many SORFIs have required massive periodic recapitalizations, demanding extensive public funding that could have served other policy purposes (e.g., health or education) or created incentives and support for private institutions to deliver pro-poor finance. A recent CGAP study of 26 SORFIs found that those institutions with stronger outreach often performed better financially. Having the state act as provider of financial services also may create unfair competition (e.g., by offering subsidized credit) and erode the payment culture (if collections are more relaxed). Although quantitative evidence is scarce, SORFIs may play a more positive role in providing payment or savings services than subsidized credit.

Recent CGAP research highlights the magnitude of government-funded programs at the retail level. With programs in over 50 countries, governments are a substantial source of funding in microfinance, possibly at levels equal to or, in some cases, much higher than funding from developed countries. Even though the announcements are often larger than the actual implementation, these programs could detract from sustainable access in their effort to increase outreach (De Montesquiou, El-Zoghbi, and Latortue 2008).

Promotional Role
Governments have many options to serve as Promoter of financial inclusion. This role is less familiar and warrants further exploration. Indirect promotion tools include policies and investments that benefit the microfinance industry while not focusing exclusively on it (e.g., promoting fair competition, strengthening the national payment system). Governments also may promote the microfinance sector more directly by developing a national microfinance strategy, establishing local wholesale facilities that provide MFIs with financial and technical assistance, or by supporting so-called priority-sector lending as is the case in India and Brazil. The jury is still out on the effectiveness and efficiency of these tools to address different types of access gaps.

Recent CGAP research shows that national microfinance strategies have increased dialogue among key stakeholders, promoted good practices in many cases, and helped assess the situation on access to finance. However, most strategies were found to be based on weak diagnostics that exclude key financial-sector actors. Many strategies adopt unrealistic action plans and are championed by institutions that may not have the full capacity, mandate, and/or power to coordinate the industry. The national strategy for the Kyrgyz Republic offers a positive example among the 29 national strategies reviewed by CGAP (Duflos and Glisovic-Mezieres 2008).

Although governments can play a useful role in financing microfinance institutions, many donors, investors, and practitioners voice concerns that Local Wholesale Facilities (LWFs) may create disincentives for the commercialization of microfinance by continuing to subsidize both strong and weak institutions, even after the sector is developed. While LWFs have boosted the early development of the sector in some countries, in some cases, these structures can create disincentives for saving mobilization by providing long-term subsidized loans. Their relevance may also fade as new investors and commercial banks become willing to provide finance. Bosnia offers a positive example, where good practice principles have prevailed as the sector matured.

Conclusion
International practice highlights the protector role of government as the most consistently useful for developing permanent access to finance. The prerequisites for successful provider roles by government demand deeper analysis, because many governments are seeking to work in this capacity.

Because many governments want to do more than protecting clients, it is useful for all stakeholders to consider further which promoter roles might be useful and effective. Governments could develop a vision of integrating microfinance into the broader financial sector and articulating complementarity between private and public roles in building inclusive access to finance. The vision being developed could explore ways to promote expanded access to commercial financing. Such a vision should be anchored in a solid understanding of the country’s stage of financial-sector development and key access gaps and obstacles, so that government can tailor interventions accordingly. A good diagnostic assessment that identifies barriers and institutional capacity should always precede selection of appropriate interventions.