Different funders are equipped with different funding instruments, which affect the way they support the development of inclusive financial markets. Bilateral agencies and foundations tend to use grants as their main instrument, whereas multilateral agencies work primarily through loans to governments and grants for technical assistance. Development finance institutions (DFIs) mostly provide debt, but are also able to use equity and guarantees, and some are increasingly providing grant funding. The ways instruments are used can have a profound impact on the market by displacing market-based activity. Their use should be aligned with what is needed in the market rather than requiring the market to adapt to the instrument.
Types of Funding
The majority of funding for financial inclusion has traditionally been in the form of debt ($13.8 billion of debt funding in 2013). Debt is often used to finance the growth of retail providers and is repaid to the funder within a predetermined time frame at concessional or market-rate terms. Loans can help build a repayment track record for future funding from local commercial sources. However, subsidized loans risk crowding out the development of local savings.
Multilateral agencies offer a particular type of debt funding, which is loans to government. These loans have longer maturity and can be used for several purposes such as on-lending to retail providers through apexes and strengthening the market infrastructure and policy environment. But direct lending to governments risks subsidizing functions that the local government or the market could provide on their own, and external funding may decrease incentives for the sustainable provision of these supporting functions.
Equity is the second largest instrument in terms of volume, accounting for $3.7 billion of commitments in 2013. By purchasing an ownership position in an organization, equity investors can offer a stable and long-term source of funding. Those investors with an active governance role can also play an important role in building the institutional capacity of market actors such as retail providers or those at the market infrastructure level, thereby influencing how markets develop. However, exits or the sale of equity stakes can be challenging. Responsible finance and responsible market development are key considerations when investors seek to exit responsibly. Not all funders can take equity stakes; it requires specialized skills for careful structuring and ongoing management of the investments.
Grants, which are transfers of resources that do not have to be repaid, made up $2.9 billion of commitments for financial inclusion in 2013. Grants have historically been used to build retail providers. They can underwrite the high costs of rolling out new products, expanding into new areas, or testing alternative delivery mechanisms. Funders must exercise caution when using grants though, as they may create dependency and can undermine incentives for raising deposits.
Guarantees make up the smallest portion of funding, accounting for $1.4 billion of commitments in 2013. Loan guarantees, which can be thought of as a type of insurance, protect investors against risks by backing a specified percentage of losses that may occur. In this way, loan guarantees reduce the risk of entry, thereby encouraging financial institutions and investors to lend to or issue bonds for retail providers in developing countries. Loan guarantees can build relationships between borrowers and lenders and help institutions enter new markets where they lack knowledge and techniques to manage credit risk. But they also may remove the incentive of the lender to monitor and collect loans. For guarantees to be effective, the institution receiving the guarantee must bear part of the risk.
As funders demonstrate their commitment to financial inclusion, they need to not only think carefully about what they support but also how they support it. Funders need to be cognizant of when and how different funding instruments can create the conditions that strengthen markets to serve the needs of the poor. Through its research, CGAP seeks to deepen the understanding of how and when different funding instruments can either advance or hinder progress on financial inclusion, given that one dollar in debt is not equivalent to one dollar in equity or grants.
Contact: Estelle Lahaye
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