Previous Page Table of Contents Next Page

Chapter 8: Rural financial services


The purpose of this chapter is to examine the particular features of rural financial services that need to be considered in deciding what forms of, and approaches to, decentralization may be appropriate.


8.1 The nature of rural financial services

The risks of credit provision

Rural financial services are nowadays concerned with a variety of services including not only agricultural lending but lending to farm households for non-agricultural production and consumption purposes, loans made to non-farm rural firms, rural savings deposit services and other financial services such as insurance. However, this Chapter mainly focuses on the provision of agricultural credit.

Broadly speaking, the provision of credit in the form of loans allows uneven income and expenditure streams to be smoothed out. Credit provision is a private good as it is excludable and rivalrous. However, it is a different type of service to others discussed in this Sourcebook as a loan involves an exchange of access to resources now for an undertaking to repay at some future date. In effect, a property right in current consumption is exchanged for a property right in future consumption. From the lender’s point of view this involves two risks, namely, that the borrower will be unable to repay (the use made of the funds is less productive than anticipated perhaps due to unfavourable weather or lower market prices[56]) or that they will be unwilling to repay (opportunistic behaviour due to asymmetric information).

In total, the lending activity entails[57]:

a. Exchange of consumption today for consumption in a latter period

b. Protection against default risk

c. Information acquisition regarding characteristics of loan applicants (the screening problem)

d. Measures to ensure that borrowers take those actions that make repayment more likely (the incentives problem)

e. Actions to increase the likelihood of repayment by borrowers who are able to do so (the enforcement problem).

This risk of non-repayment means that the private sector is usually unwilling to provide credit unless collateral[58] is available or the lender has particular ties to the borrower. The high transaction costs associated with imperfect information (search, monitoring and enforcement), and risk, increase the costs of credit transactions and lower the effective demand. The dispersed nature of rural populations increases the transaction costs of servicing rural areas compared to urban areas for many credit providers. In principle, the government should be a more willing lender than the private sector as it is less risk-averse and has greater powers of coercion and hence ability to obtain repayment. However, it is generally disadvantaged relative to the private sector in terms of local knowledge and loyalty from borrowers, leaving it exposed to an adverse selection[59] problem and unwillingness by borrowers to repay loans.

8.2 The demand for and supply of rural financial services

8.2.1 The effective demand for rural credit

Many of the problems relating to rural financial services have derived from a misunderstanding of the nature of the effective demand for these services[60]. The first misconception was that farmers and other rural dwellers mainly needed credit for agricultural production purposes. In fact, an effective demand for credit, backed up by a willingness and ability to pay, can exist to smooth out a variety of situations where income and consumption streams are poorly phased. Credit for non-agricultural purposes may be as important as agricultural loans. Indeed, for many rural dwellers the most important reason for demanding credit is as a consumption loan to meet the costs of living in the months before the next harvest is due, not to purchase inputs to raise agricultural productivity. The second misconception was that the majority of poor farmers were too poor to pay for credit, that is, there was a need for credit but little effective demand. The evidence now is that poor households are both willing and able to service loans if they borrow for their own perceived needs and are adequately screened and monitored.

The paradigm of directed credit provision

These misconceptions led to agricultural credit policies during the 1960s and 1970s that were based on a paradigm summarized in Box 8.1. The policy implications of the paradigm were that:

Box 8.1 The paradigm of centralized and directed agricultural credit policies

  • Agriculture is a major source of livelihood and the main engine of economic growth in developing countries therefore the development of agricultural production is a public priority

  • Technology innovations and more input use are essential to increase production

  • Farmers need more financial resources to adopt technology innovations

  • Most farmers are poor, hence there is a gap in cash resources which blocks the adoption of new technologies and credit is needed to fill the gap

  • Agricultural production is a risky business; returns in agriculture are less than in the other sectors of the economy

  • Market interest rates reflect opportunities in other sectors: the market cost of money is too high for farmers to borrow for productive purposes

  • Government must intervene with subsidized lending (seeking no profit, amortizing high transaction costs, spreading the risk on a national basis)

  • Subsidies are justified if loans aim at specific government objectives

  • Therefore agricultural loans must be targeted to selected crops and technologies of interest to government

  • Loan repayment capacity is shown by viable crop/farm budgets models

  • To extend subsidized credit for specific purposes, specialized government financial institutions must be established and financed with public funds

  • Specialization advises that the savings collection and the lending function of financial intermediation are kept distinct

  • Since most borrowers in rural areas are small farmers (i.e. poor), low cost credit responds to poverty alleviation considerations as well

  • Subsidized credit also compensates farmers for high taxation of agriculture (such as price control on basic grains, export taxes, artificial exchange rates, etc.).

8.2.2 The supply of rural financial services

Unique problems of supplying agricultural finance

FAO/GTZ (1998b) discuss a series of special factors that are likely to influence the supply of agricultural finance. These include:

The formal sector

In most developing countries there are typically two types of suppliers or financial intermediaries[61]. The ‘formal’ sector consists of bank and non-bank financial institutions that provide intermediation services between depositors (or the government) and borrowers and, as they fall under the banking law, are regulated and supervised. As noted above, in the past these typically charged relatively low rates of interest that were usually subsidized by the government. The flow of funds in a typical centralized and directed agricultural credit system is shown in Figure 8.1. In many cases little attention was paid to voluntary savings mobilization in rural areas as small farmers, being poor, were considered to have a low propensity to save.

The informal sector

The ‘informal’ sector typically comprises private individuals - professional moneylenders, traders, commission agents, landlords, friends and relatives - who lend money generally out of their own equity and are not regulated or supervised by the national monetary authorities. One of the major differences between these two types of supplier is the mechanisms used for dealing with the screening, incentives and monitoring problems with the informal sector relying much more heavily than the formal sector on their intimate knowledge of their clients to overcome these problems.

Figure 8.1 The flow of funds in the centralized and directed agricultural credit system

‘Crowding out’ the informal sector

Informal financial markets have always existed in rural areas, but were ignored by government policy for a very long time. The agricultural credit paradigm (Box 8.1) excludes informal markets from playing a role on two grounds. First, that the operators in informal financial markets do not share the same commitment as government to promoting agricultural production. Second, they would charge exorbitant interest rates which, allegedly, agricultural producers could not afford to pay. In many countries and for almost 30 years, governments hindered the spontaneous development of informal financial intermediaries by occupying, through subsidized operations, the market space that informal operators could have exploited and developed. This has been defined as the ‘crowding out effect’ of government agricultural credit policy.

8.3 Appropriate forms of decentralization

8.3.1 Introduction

With few exceptions, the consequences of the centralized and directed approach to agricultural credit were catastrophic. A fair number of agricultural credit banks were liquidated during the 1980s and early 1990s across the world, when it became clear that governments could not afford to:

In addition, the results achieved in terms of impact on agricultural production were rather modest. This situation has prompted the elaboration of alternative policies based on a very different paradigm. Liberal economics and decentralization principles inspire the reform of the rural financial sector. Box 8.2 briefly states the new paradigm.

The major objectives of decentralization of rural financial services are to:

Box 8.2 The paradigm of decentralized rural financial services

  • Demand for credit is one thing, demand for agricultural technology is another: they may or may not coincide for individual borrowers

  • Borrowers are willing to service loans if they borrow for their own perceived needs

  • Banks must lend to creditworthy clients responding to clients’ independent assessment of their own requirements and preferences

  • Only those loan officers who know their clients well can effectively identify creditworthy borrowers

  • Market-determined interest rates ration the demand for credit and provide incentives for savings deposits

  • Competition among financial services’ providers improves efficiency and lowers the cost of lending

  • Access to local financial services/institutions reduces transaction costs to clients and improves lenders’ contacts with clients

  • Sustainable banking is based on savings mobilization

  • Financial institutions that offer local savings’ facilities at competitive and appropriate conditions are more likely to mobilize enough deposits to support a sound lending policy

  • Financial institutions which lend to creditworthy clients recover all the loans made, and can earn enough interest to cover their cost hence they are sustainable

  • Sustainable institutions will grow in the course of time

  • Sooner or later, non-sustainable institutions will fail completely

  • Prospects of profitability and sustainability and growth encourage private and voluntary sector enterprises to develop financial service institutions.

Reform of government-owned institutions

Two approaches to decentralization of rural financial services can be distinguished. One approach involves a drastic reform or restructuring of government-owned financial institutions operating in rural areas, by shifting power away from the centre and changing responsibility and accountability systems through a combination of deconcentration and devolution measures.

Diversifying ownership

The other approach aims at diversifying the ownership of the financial institutions operating in rural areas. This objective can be achieved in three major ways:

Naturally, all these ways of diversifying ownership can be implemented at the same time. When many service providers operate in capital markets a multiplicity of services delivery channels, distributing the power and influence associated with the control of financial flows, is created. Competition and a variety of policies, new financial technologies and products are introduced.

Each of these approaches will be considered in the ensuing sections.

8.3.2 The new role of central government

Different strategies, different actors

In rural areas, the starting point for elaborating the policy implications of the new paradigm is a clear separation of the agricultural credit and the extension functions. Promoting the adoption of new agricultural technologies is the task of extension, not of credit. There is a strong case for governments to decentralize their rural financial services, let rural financial services develop in the private and non-profit mutualistic sectors and, where and when appropriate, reduce the overwhelming presence of public financial institutions. Decentralized and private and voluntary sector financial institutions are better placed to respond to peoples’ preferences, to identify creditworthy borrowers, and to introduce effective mechanisms for savings mobilization. The new role of government is thus support of institutional development, rather than promotion of targeted incremental crop production through financial intermediation. This new role embraces the setting of a favourable environment, the introduction of appropriate legislation, a regulatory role and, perhaps, financial and technical support to promote new organizations.

Appropriate legislation

Besides the measures outlined above related to reforming state banks and diversifying ownership, support to institutional development means that an enabling environment is created by enacting appropriate legislation to:

The regulatory role

Financial institutions must operate within the framework of precise regulations that:

Regulating formal institutions

All formal financial institutions are subject to these rules. Formal intermediaries are registered, must obtain a licence to do business and are required to operate in accordance with regulations issued by the national monetary authorities. Their activities are subject to inspection by the Central Bank or a Superintendent of banks and financial institutions and they incur sanctions for non-compliance with the rules. The distinguishing feature that differentiates formal from informal financial markets regards the regulation and supervision of the intermediaries by the monetary authority. Informal intermediaries often are unregistered; they do not require licences and are they are not subject to Central Bank rules and inspections.

Regulation of rural MFIs

As the importance of rural micro-finance institutions (MFIs) in the local capital markets increases (see Section 8.3.4), their functions become diversified and not directly connected with agricultural production. The need then arises for government to deal with them in similar terms to those used for formal institutions. The monetary authorities thus increasingly assume responsibility for the supervision of their activities, with a view to sound management of money, rather than Ministries of Agriculture whose primary interest is agricultural production.

The promotion of rural MFIs raises questions such as:

Regulation and supervision may cause more problems than those they are intended to overcome. For example, regulations related to registration, licensing, and inspection may offer opportunities for interference and corruption and supervisors, in addition to their task of overseeing banks, may not devote enough staff and time to inspect adequately a large number of new types of small rural financial institutions. Rules and controls of financial institutions normally:

Such rules deal with problems common to all financial institutions, and must be respected by all. Detailed regulations, however, differ depending on the nature of the regulated institutions. The main objectives of the monetary authorities’ control over financial intermediaries are to:

Accordingly, the main objectives of the rules and controls over decentralized rural financial institutions should be to ensure that:

Responsibility for regulation

The elaboration of such rules, and the controls required for their enforcement, is not in the field of competence of Ministries of Agriculture, but is in the natural domain of the monetary authorities. Rules need to be established centrally, whereas controls can either be centralized or delegated. One option is for the central monetary authorities to take over direct responsibility for inspections of rural MFIs, as they do in the case of banks and other formally-established financial intermediaries. Another option is to delegate the control of decentralized financial service institutions to the apex body of cooperatives or MFIs. The latter would, in turn, be directly controlled by the monetary authorities, and would be responsible to them for controlling their member MFIs. A special opportunity for delegation is presented when MFIs are promoted and supported by a commercial or a development bank. In these cases, the commercial or development bank, which is under the control of the national monetary authorities, will supervise in its own interest the operations of the MFIs that they help to develop.

Financial support

Expenditure of public money may be necessary to support new institutions of the ‘cooperative bank’ type, which emerge in the private or non-profit or mutualistic sector. Subsidies would assist primarily with capacity building aimed at increasing the staff and managerial skills of the new institutions. These subsidies may be justified on the grounds that institutional development and diversification of service providers are public goods that help to deal with financial market failures. They are not intended to fill gaps in operating income or interfere with interest rates and the free play of market forces. Support activities eligible for subsidies would include:

Loans, but not grants, at market or near market terms to the new rural financial institutions, may also be justified (providing banks follow normal risk assessment practices in making loans) with a view to expanding their operations beyond the resources that they are able to mobilize by way of savings deposits.

Governments may also support the start-up process of designing innovative credit guarantee approaches for banks (FAO, 1998b). However, banks ought to assume a good share of the risk in order to ensure that they assess their clients effectively. Sustainability requires financial institutions, irrespective of their size and nature, to respect sound banking practices. They should not borrow funds that they may not be able to remunerate at market rates of interest. The market will determine to what extent MFIs are sufficiently creditworthy customers for higher level and larger financial intermediaries to lend money to them.

8.3.3 Deconcentration and devolution

Deconcentration involves transferring the responsibility of operating as profit centres to local branches and sub-branches capable of expanding their outreach on a viable and sustainable basis. Full autonomy is granted to front-line managers to decide how best to achieve the objective. This approach has been successfully tested in Indonesia, where it turned a non-performing agricultural development bank, Bank Rakyat Indonesia (BRI), into a viable and very dynamic provider of rural financial services (Box 8.3). The successful reform process was made possible by the favourable environment that had been established in Indonesia in terms of macroeconomic stability, a differentiated financial infrastructure, prudent deregulation and liberalization of the domestic market and of foreign trade.

Box 8.3 Decentralization of the Bank Rakyat Indonesia (BRI)

The success of the bank is built on:

  • Strict adherence to principles of viability, self reliance, sustainability and broadening of outreach

  • Incentives to staff and clients which reward adherence to those principles

  • Turning the 4000 sub-branches into profit centres

  • Effective supervision of each profit centre

After the reform, BRI mobilizes rural savings and lends out funds collected in the rural areas. Government no longer contributes to the bank’s resources or subsidizes the cost of the decentralized units or branches. From the point of view of ownership, the bank’s capital is still fully controlled by the central government. However, a significant transfer of power has taken place, since local managers respond to local market signals and not to central government directives. Failure to satisfy local clients would affect profits, and this would have negative effects on the local sub-branch manager’s remuneration and career prospects. Because of the independence of decision-making in branch and sub-branch management, the reform of the BRI has resulted in a substantial devolution of responsibilities and resources. This involves new tasks at all levels and is not a simple deconcentration of functions and offices.

Source: Hans Dieter Seibel, University of Cologne, FAO TCI Workshop on Micro-Finance, 1998.

8.3.4 Diversifying ownership

Privatization of agricultural banks

Several new liberal governments have tried to privatize government-owned agricultural banks. In practice, there have been many difficulties due to the problem of capital valuation and to the poor expectations of profit from future operations. Short of outright fraud, government banks are in financial trouble for two main reasons:

Excessive operating costs can eventually be corrected by new management, provided labour legislation does not impose too much rigidity, but the poor quality of the loan portfolio may often be difficult to remedy in the short- to medium-term. Thus governments are unlikely to find a buyer for take-over unless they clear the portfolio of bad loans. In some cases, the bulk of bad loans are held by bankrupt government enterprises. However, buying out delinquent debtors is a poor solution, because it does not establish an encouraging environment for making new loans. Transferring non-performing assets to a separate company responsible for recovering them has also been tried, but it did not always ensure the financial recovery of the original lender.

Liberalization of the formal financial market

The second option involves the liquidation of non-viable government banks, coupled with allowing the entry of foreign capital and the encouragement of local private groups to form joint ventures with foreign banking groups. Naturally, private investors, particularly foreign capital, tend to be cautious given past experiences with nationalization and political interference with staffing and lending policy. However, in the short term, this option may not be a solution for rural areas because private enterprises usually invest in commercial banking in urban areas before expanding to rural areas. However, an important effect in rural areas would be to restore lending to viable crop purchasing, equipment and input trading enterprises. Part of the finance made available to input suppliers and traders is likely to be passed on to farmers in the form of suppliers’ credit.

Micro-finance institutions

The most far-reaching objective of decentralization of rural financial services is to mobilize the potential of informal rural financial markets and to rationalize their operations. The operators in the informal market include all those intermediaries who are not subject to the regulations and supervision of the monetary authorities, such as money lenders, ROSCAS (rotating savings and credit associations), informal savings groups, informal safe-deposit providers, village level savings and loans associations, etc.

The third option, then, is to encourage the expansion of MFIs in the voluntary or mutualistic sector as rural financial intermediaries. The common feature of mutual or cooperative financial institutions is that their members own them. Members’ savings are mobilized and people appointed and controlled by members oversee the use of these savings. The cooperative nature of these institutions improves the chances that loans respond to the borrowers’ requirements. Moreover, the loans are made to borrowers who are well known to the institution and whose creditworthiness most members of the institution can easily assess. In this case, loan delinquency tends to be limited, since the social pressure to repay results from lending the members’ own hard-earned savings. Safeguarding of one’s own money is a much stronger incentive for repayment than a generic sense of duty or interest in becoming eligible for an additional loan. The social pressure for loan repayment in classical group-lending schemes of agricultural development banks, where it was the government’s (or the donors’) external funds rather than the members’ own money that was loaned, in general has not worked. Experience suggests, however, that even with own funds the group liability mechanism tends to weaken whenever the local financial institution becomes too large or a large share of loan resources is obtained from outside sources.

The role of NGOs

NGOs have played a significant role in promoting the development of informal rural financial services. Although NGOs continue to play an important role in promoting micro-finance in many developing countries, during the 1990s the growth of ‘decentralized financial systems’ has evolved far beyond what NGOs initiated. Professionalization and new actors coming into the picture have become determining features. Some NGOs play a role in implementing a deliberate rural financial services decentralization policy within the framework of more articulated initiatives promoted by private banks, local interest groups, governments and donors. The provision of both financial and non-financial support services, by the same or by different organizations, as well as sustainability of the provided services, have become main concerns. There are a wide variety of new approaches, policies, objectives, and actors. Broadly speaking, four types of actors promote the development of rural MFIs, besides NGOs acting on their own initiative:

A well-established network of micro-finance cooperative institutions can change the flow of financial resources in a very significant way. Figure 8.2 describes, in a simplified manner, the transfer of resources and of decision-making power in financial intermediation in the cooperative banking sector. The differences between the flow shown in Figure 8.2 and that of Figure 8.1 should be evident.

Figure 8.2 The flow of resources in a cooperative banking system

Apex organizations

The apex organizations of MFIs play a very important role. Accordingly, encouraging the emergence of such organizations is an important component of decentralization policy in rural financial markets.

Apex organizations help to provide a unified culture within member institutions, which is a feature of social cohesion and a factor of success. They also provide valuable technical support in the form of accounting, auditing, training and a central liquidity facility. They assist in securing lines of credit from commercial or development banks and manage the liquidity requirements by transferring funds from member MFIs with surplus deposits to member MFIs with an excess of effective credit demand. Last but not least, they can join together with other apex organizations to lobby politicians and influence government policy. The very special example of the Grameen Bank of Bangladesh, established by a private initiative specifically to finance poor rural people is discussed in Box 8.4.

Box 8.4 The Grameen Bank of Bangladesh

The Grameen Bank is owned by members to the extent of 92% of the its share capital, with the balance being owned by the government. The ownership structure classifies Grameen as a cooperative, but many other features differ considerably from those of savings and loans associations and their apex organizations. Grameen employs about 12,000 people and operates through over 1,000 branches across the country.

The Grameen Bank started in 1983 as a pilot project of the University of Chittagong with a small contribution from a local commercial bank, and the personal guarantee of its founder. By the end of 1995 the total membership had reached over 2 million, mostly rural women, and the total amount of outstanding loans were the equivalent of almost US$ 290 million. Savings mobilized from the membership are about half the total loan amount. In addition to collecting deposits and making loans, Grameen undertakes many activities which are not directly related to banking, such as educational and other social activities particularly in favour of women members, agricultural extension, seed and seedling distribution, etc. Loans are made to individuals joined together in groups of five, the group being jointly responsible for debt service. Loan repayment is estimated at 98%. Grameen does not impose conditions on the use of the loans it makes, so the actual distribution of loans by sector of activity financed is a good indication of poor people’s (three-quarters of them women) demand for credit in rural Bangladesh. A little more than half the loans are granted for production activities in agriculture, forestry, livestock, or fisheries; 20% are for agro-processing, 15% for petty trading, and about 8% for other purposes.

The lending capacity of the Grameen Bank has received considerable support from the Central Bank of Bangladesh and external donors, particularly IFAD, by way of low interest loans, and also in the form of grants made by many bilateral donors. In addition, donors have contributed to the financing of the non-financial costs of the Grameen operations, which include an intensive animation of the members’ groups with weekly meetings coordinated by the staff of the Bank. It is estimated that the subsidy of these activities is roughly equivalent to one-third of the volume of savings mobilized by the bank.

The organizational structure and the procedures of the Grameen Bank provide, in themselves, an interesting example of decentralization. The structure is articulated around six levels: headquarters, zone, area, branch, centre and groups. 85% of the bank’s employees are posted at branch or centre level, 21% at area and zonal level, with less than 3% at headquarters. Groups are important in the decision-making process but are made up of members only. Administrative decisions normally taken by headquarters in most other banks are devolved to the zonal offices. The headquarters offices concentrate on policy elaboration, external resource mobilization and on training programmes. Branches are profit centres; each branch supervises 50 to 60 centres with each centre comprised of 6 to 8 groups of 5 people. Branch managers have complete autonomy of decision making on operational affairs and particular power over decisions about granting loans. Loan-processing procedures are totally transparent: all group members discuss applications at the compulsory weekly meetings and decisions are taken by consensus.

Source: The main sources of information on the Grameen Bank are Yaron et al. (1997) and Khander et al. (1995).

8.4 Conclusions

The paradigm of agricultural credit has changed fundamentally from a policy that promoted centralized and directed agricultural credit to one that supports decentralized rural financial services and rural financial markets and systems development. The new paradigm emphasizes the distinction between the supply-led finance of new agricultural technologies and the effective demand by rural households for credit that can be used for their own perceived needs. It advocates the decentralization of credit provision, the encouragement of competition between loan services’ providers to lower the costs and risks of lending, and the use of market rates of interest as a rationing device for credit allocation. It recognizes also the importance of mobilizing local savings through offering competitive interest rates and a variety of savings products and flexible procedures. In the new paradigm the role of the government is to support institutional development, rather than the promotion of targeted incremental crop production through involvement in direct financial intermediation.

Support to institutional development and decentralization involves reforming public development banks, privatizing institutions that can perform better in the private and mutualistic sectors, encouraging the growth of financial markets and the development of sustainable rural financial services. Subsidies can be justified for capacity building to increase competition. There are two approaches to decentralizing financial services in rural areas. One approach involves a drastic reform or restructuring of government-owned development financial institutions operating in rural areas. The other is to diversify the ownership and governance structure of rural financial institutions by changing the capital ownership of existing government institutions and/or by promoting the development of a multiplicity of financial services providers belonging to different owners. This includes the encouragement of the expansion of MFIs in the mutualistic sector.

The most far-reaching objective of decentralization of rural financial services is to mobilize the potential of informal rural financial markets and to rationalize their operations. This may lead to a fast growth of micro- financial institutions in the rural areas and it is important to find effective ways of regulating them. Providing appropriate methods are followed[62], considerable gains can be expected from decentralization and a sustainable network of rural financial services providers may emerge.

[56] It is important to appreciate that the borrower also faces a variety of risks in a credit transaction.
[57] Hoff and Stiglitz (1993).
[58] Collateral is an asset(s) offered by a borrower as security for loan repayment that will be surrendered to the lender in the case of loan default.
[59] Adverse selection was a term first used in the insurance industry to describe the phenomenon that as the premium for a policy rises there is a tendency for the best risks (those least likely to make a claim) to no longer find the policy worthwhile. This leaves the company exposed to the adverse effect of poorer risks, a higher probability of claims, and the potential need to raise the price of the policy again.
[60] FAO/GTZ (1998a and 1998b) contain extremely useful accounts of the changing perceptions of the nature of the demand for rural credit and the reorientation of policies that this has called for.
[61] Hoff and Stiglitz (1993).
[62] FAO/GTZ (1999) have recently provided a valuable source of information on better practices in agricultural lending.

Previous Page Top of Page Next Page