What’s Keeping Us From Innovating in Rural Finance?

Formal financial services in rural areas have long been underdeveloped.  This is due to a combination of factors – dispersed clients, low levels of financial literacy among rural households, the high cost of delivering services (especially low-value transactions), and the perceived high repayment risk associated with lending to agri-dependent households, which make up the majority of households in rural areas. 

Besides a few cases in South and Southeast Asia, where in some places, rural population densities are high and supportive government policies and investments helped improve prospects for rural financial intermediation, most rural financial institutions in other developing regions over the last thirty to forty years have struggled to achieve scale and strong profitability, and to deliver a complete suite of financial services. 

Two women husking paddy harvested from the fields.

A recent exception has been the success of M-Pesa in Kenya, where the application of mobile communication technology has dramatically reduced costs and broadened access to payment services for rural as well as urban customers.

Even though 55% of the world’s population is rural, 70% of the world’s poor are concentrated in rural areas, and agriculture is the main livelihood activity of the majority of rural households, investments in agricultural and rural development have generally lagged. Public expenditures on agriculture as a share of GDP tend to be far less than proportionate given the real economic importance of agriculture in the economy. Meantime, empirical evidence indicates that agricultural growth is 3.2 times more effective in reducing poverty than growth in non-agricultural sectors. 

More evidence exists that clearly links greater financial depth and greater financial market efficiency to higher levels of economic growth and income equality. 

Today national policymakers and development agencies have shown renewed interest in agricultural and rural development.  They are responding to a confluence of interrelated opportunities and challenges.  On the positive side, incomes are rising in most regions and with it the demand for more food.  The global sourcing of horticultural produce and the growing popularity of high value organic food along with the improvement in logistical management and the application on new technology are creating attractive business opportunities. 

On the negative side, agricultural commodity price volatility, poor infrastructure in many regions, the lack of adequate policies and robust institutions, and the growing negative effects of climate change on agricultural productivity, among others, present challenges.

The question is how can formal financial services in general and agricultural credit in particular be successfully extended in a sustainable manner to rural areas? Clearly, agriculture is heterogeneous and complex.  The errors of directed, subsidized credit experiences of the 1960s and 1970s loom large and should be avoided. A new consensus is emerging on how to proceed.

Know your client

First, rural households have to be segmented and their desires, resources, constraints, and capacities well understood.  The financial services on offer have to provide a value to clients equal to or superior to informal mechanisms currently used, and they should be sustainable over time to permit continued benefits.   Rural households demand a range of products—payments, transfers, savings, credit, and insurance. To achieve strong uptake and scale economies, the products have to match household capabilities and needs, including variability of cash flows. During “lean times,” for example, households can seek loans, withdraw savings, liquidate assets, or reduce consumption.

For example, commercially oriented smallholders that have been integrated into higher-value agricultural markets and have a certain profile -- for example, those with proximity to a growing market, minimum farm size, use of irrigation or greenhouse technologies, improved input packages, forward contracts, or participation in tightly organized value chains including those with organic certification may represent  “low hanging fruit” for financial intermediaries interested in extending production credit. They will be much more attractive than subsistence oriented farmers who produce little or no marketable surplus.  On the other hand, households that are subsistence oriented but produce a surplus of staple food items that are sold on “open spot markets” may be attractive as clients of commitment savings and payment products but may be very risky as loan clients. 

Lower costs

Serving a large number of clients demanding small valued transactions due to limited income and scale of business operations implies high operational costs for financial intermediaries.  Therefore, innovations in both institutional arrangements (correspondent banking, value chain approaches, and other partner agent models) and the use of computer and informational technology (including fully digitalized management information systems, mobile telephony, tablets, geographical information systems, GPS mapping and tracking) are critical for making a difference in outreach and scale.  The high cost of delivering services, the riskiness of the environment, and the lack of competition tend to contribute to high loan interest rates, especially in Latin America and Sub-Saharan Africa.  Successful approaches to cost minimization and greater efficiencies should contribute to lower financial charges.

Manage risk aggressively 

Risk management is of preeminent importance in agriculturally dependent households. It can take many forms.   An integrated and layered approach that depends on good agricultural practices (GAP) as well as risk transfer mechanisms should be pursued to achieve sustainability. To date a host of pilots on weather based index insurance are underway, and a critical task is how to lower basis risk and overcome high startup costs.   Moreover, value chain development approaches that reduce marketing risk and product quality assurance through the provision of technical assistance services and intensive monitoring are proliferating.

In short, the view of rural finance as an extremely inhospitable and unprofitable area of development finance is melting as the willingness to understand the inner dynamics of rural households and rural economies increase.  Nonetheless, many challenges and information gaps remain and much work still has to be done to apply these insights and improve outreach and the depth of rural financial markets.

------ Mark Wenner works with the Capital Markets and Financial Institutions Division of the Inter-American Development Bank and has published numerous articles on rural finance topics and participated in a number of financing operations involving rural and microfinance organizations.