In August, Reinhard "Harry" Schmidt sent me a thoughtful note about my book, of the sort authors are lucky to receive even once. It contained praise, yes, but also an intelligent list of conceptual realms I had missed or underemphasized, mostly having to do with the challenges of architecting durable financial institutions for the poor. The comment is apt and ironic since I conclude that institution building is precisely where the microfinance movement has achieved most. In my book, these ideas, to the extent I development them, come under the heading "development as industry building."
Harry was involved from the beginning (1981) with the German group Interdizciplinäre Projekt Consult (IPC). As I recount in chapter 4, its staff founded the ProCredit group of microfinance banks. Harry was, I believe, an important contributor to a German community of thought on microfinance, a community that included Claus-Peter Zeitinger, head of ProCredit, and J.D. von Pischke, who served as a bridge to American intellectuals from his post at the World Bank. Despite J.D.'s ambassadorship (i.e., writings in English), I think I have failed to learn as much as I could from the German thinkers and writers.
Like Accion International, ProCredit has long focused on building businesslike, financially self-sufficient institutions. And perhaps more explicitly than the Americans, ProCredit's philosophy derived from viewing institutions and industries as assemblages of actors each behaving in response to certain incentives. The challenge in building durable institutions and stable industries in order to deliver financial services to the poor lies in designing the regulations of the industry and the governance of the institutions so that incentives drive the actors in the right directions.
This intellectual movement was influenced by the work of Joseph Stiglitz and other creators of the economics of asymmetric information. Indeed, there isn't much in my book about this.
More concretely (and this is in my chapter 4), the movement arose in reaction to the failure of the subsidized loan programs for farmers in the 1960s and 1970s in Brazil, India, Indonesia, and other countries. Those programs were designed to lose money (being subsidized), so managers were not penalized for losses and often did not push hard for repayment. And since the loans were cheap and valuable, powerful families within villages exercised their influence to divert the credit from the intended, poorer recipients. The design of the programs created incentives that rewarded people for destroying the program.
In its formative years, IPC also observed problems in the operation of small, municipally backed savings banks it worked with in Peru, which it again traced to institutional design flaws that failed to counteract the incentive for officers of the bank to divert funds for personal uses.
Clearly Harry was someone to learn from. He pointed me to his work, including a 1994 book coauthored with Jan Pieter Krahnen whose title somewhat stunned me with its familiar phrasing: Development Finance as Institution Building. Beat me by 18 years. I ordered a used copy. Funnily enough, it bore Harry's autograph, along with a hand-written dedication (is it gauche to reveal this?) to Mark Flaming. I guess Mark was done with the book.
In the style of my post about Stuart Rutherford's history of ASA, here are my favorite passages from Development Finance as Institution Building.
On the danger of donors putting too much finance into budding microfinance institutions:
For commercial banks, the easy access to cheap funds further weakened the incentives to mobilize savings. For the development banks, the funds from the government, the central bank or donors were often the only source of loanable funds, and these “banks” were relegated to the position of the distributors of externally supplied credit and subsidies. The most important element of credit subsidisation was not the artificially low lending rate, but rather the fact that clever (and influential) borrowers had a good chance of avoiding repayment of their loans altogether. In the final analysis, financial repression leads to a small, inefficient and financially fragile banking system, the unavailability of credit for most potential borrowers, and a conspicuous lack of deposit facilities. (p. 20)
On the dependence of credit on law enforcement or informal substitutes:
Financial contracts such as loans cover a certain time span. The loan is paid out “now”, repayment is expected “later”. This difference between payment and repayment times creates a problem in contracting because the “motives” of the borrower change as time passes: Before he or she obtains a loan, the borrower wants to pay back at the agreed time because otherwise it would not be possible to obtain the loan. But once the loan is received by the borrower, his or her preference changes, and he or she would “rather not repay”. This is quite natural, and it is forseeable. If the lender is not stupid he anticipates this change of preferences, and the loan contract will not be concluded in the first place. Thus, both sides will initially be strongly interested in finding ways to prevent a subsequent shifting of preferences.
…the legal infrastructure is a device which helps borrower and lenders because it substitutes the initial genuine, but temporary preference to repay by the lasting desire to avoid trouble….But in some cases this solution…is not feasible. Therefore, those financial transactions or contracts which we call informal must, by definition, find other solutions. (pp. 44–45)
On the need for rules that align incentives:
A viable financial institution needs an adequate “constitution.” For this, two things are almost invariably necessary: the presence of a powerful and professional supervisory authority for financial institutions, and strict limitations on the discretionary power of the government system to use and abuse the facilities of the financial institutions. Therefore, a well-functioning supervisory body and restrictive rules for the government are the two elements of financial sector reform which would be most conducive to institution building. (p. 80)
On the donor's choice between providing finance to microfinance institutions and providing technical assistance such as training:
For a long time, the issue of “substance”—i.e. what kind of support—has been discussed in terms of the alternatives of financial versus technical cooperation….Financial support in the form of subsidized loans to the financial institution(s) under consideration has been regarded as the more important form of support, with technical cooperation mainly serving the purpose of ensuring that the funds are channeled to the intended beneficiaries. More recently, technical assistance for institution building has gained more recognition as an approach in its own right. In some cases, technical assistance projects are now supported by a component of financial assistance, which may take the form of a grant or a loan. There is no point in denying that provision of funds as grants or loans on favourable terms often has to be a component of a “package” which contains technical assistance for institution building as the main component. There may be several reasons for adding the financial component to the package. One is that there is simply a demand for loanable funds which cannot be satisfied in other ways. A second reason may derive from the bargaining power of recipient institutions in developing country vis-à-vis the donors from industry countries: Some financial institutions are such attractive partners for donors that they can request a price for permitting the donors to work with them and allowing them to pursue their development goals through this collaboration. The financial assistance, and in particular its grant component, is the price. Or, in other words, some partners in developing countries have to be “bribed” through a financial contribution in order to make them accept the technical cooperation. Note that there is nothing wrong with, or morally objectionable about, such “deals”. Finally, there may be reasons stemming from the donor side: Several important donor institutions are themselves under pressure to make sizable amounts of money flow to the developing world, and they tend to talk recipients into requesting and “absorbing” a credit or grant component. This is particularly true in the case of the donor institutions which are themselves banks and/or are forced to use up budgeted funds.
The serious drawbacks of “financial cooperation” are well known (Von Pischke, Adams, Donald, 1984; and in particular Vogel, 1986). Still, the first two reasons may make sense in some cases. But we think donors should restrict themselves as much as possible to providing technical assistance for institution building. (pp. 88–89)
On how financial self-sufficiency reduces vulnerability to political interference:
There are, of course, many good reasons for giving subsidies, gifts, etc. to poor people, but these welfare activities should always be clearly separated from any activity which even comes close to being “banking business”. Not only the target groups but also those who run target-group–oriented institutions must learn that banking is “tough”. It cannot be done otherwise.
Any institution which provides financial services must be structured and run in such a way that it can survive on its own. Why is the requirement that a target-group–oriented financial institution can cover its costs so extremely important? One part of the answer to this question has to do with considerations of allocational efficiency: Socially wasteful investment projects are not likely to be profitable for the investor. Financing such ventures is also not likely to be profitable for a financial institution. In this respect the requirement of cost coverage helps to avoid extremely (socially) inefficient investment decisions. However, in a distorted economy with a fragmented financial system, where external effects are common, this consideration does not apply at the margin: There may be projects which have a positive value for society but are negative for the investor and the financing institution, and vice versa. Cost coverage is, therefore, neither a necessary nor a sufficient condition for an efficient allocation of capital.
Consequently, the argument of allocational efficiency alone is not enough to justify the strict requirement that a financial institution must cover its costs. But there are also other arguments based on considerations of a political economy type: Heavy losses force an institution to seek financial support from powerful people. The support may be forthcoming as requested, but experience shows that it is obtained at a high price: in return for providing assistance, the helpful person, who in many cases is a politician, or a political institution will demand to have a say in the institution’s lending decisions. This kind of influence tends to undermine the financial institution and diverts its attention away from its target group (Von Pischke et al., 1981). (p. 96)
On the interplay of actors and incentives:
A suitable constitution clarifies the rights and responsibilities of at least four groups of actors: the management, the owners, a group of external monitors and the legal constraints which they impose and enforce, and the customers or target groups. Before discussing the details, it is necessary to point out the main structural threats to the stability, and even the survival, of a potentially target-group–oriented financial institution. They are all manifestations of incentive problems, or, more precisely, of a lack of properly adjusted incentives.
- Borrowers are quite naturally a threat to the stability of such an institution because they will always seek to avoid repayment.
- A lazy, self-serving or incompetent management may be unwilling or unable to pursue a prudent and efficient policy.
- Anyone who is in a position to act like an owner and determine the institution’s general policy may try to influence it in such a way that the orientation towards poorer target groups is lost.
- Regulators or bank supervisors may have no authority or only inadequate instruments, or may simply lack the motivation, to avoid the accumulation of deficits.
- Politicians in whatever role may try to gain influence and use the institution as an instrument to distribute “favours” to their followers and electorate.
- Anyone in a relevant position may threaten the institution’s survival by creating unrealistic expectations about the extent to which it can afford to be more socially receptive.
Everyone tends to regard a financial institution and, to a greater degree, a special credit programme or even a “revolving fund”, as a pile of money that is “up for graphs”. This way of looking at things is utterly realistic!...A carefully devised “constitution” which also clearly distinguishes roles is crucial in order to limit abuses. It contains checks and balances and assigns powers and responsibilities. (pp. 105–06)
Why the governance of an institution must include advocates for both bottom lines, financial and social (see Beth Rhyne on the lack of such balance in India 16 years later):
A development finance institution should not restrict itself to lending operations. It should also offer deposit facilities, not only because the target groups need such facilities, but also because it strengthens the system of checks and balances: Managers and directors of deposit-taking institutions are subject to a stronger degree of moral and social pressure, and also are often required to assume stricter legal responsibility if depositors’ money is at stake. Moreover, bank supervision, based on capital adequacy rules, diversification requirements and other forms of prudential regulation, is normally stricter—or for that matter, only applicable—if an institution accepts deposits. Furthermore, savings mobilization increases the autonomy of a financial institution and reduces its dependance on external functions.
Viewed from the other side, an elaborate system for the prevention of mismanagement, fraud, excessive risk-taking as well as overly lenient conduct vis-à-vis the clientele of the poor, is necessary to ensure that deposit business can be conducted with the general public. It is simply not acceptable, even with the most noble intentions of supporting poor people in mind, to put the savings of the same people at risk.
The interaction between managers, directors and supervisors and, indirectly, depositors will work in favour of institutional sustainability because it helps to ward off many of the common dangers to financial institutions. Sustainability is a necessary condition for assuring a permanent supply of financial services to the target group. In many cases, however, it is not a sufficient condition because a financial institution can be professional, efficient, stable, honest and even attractive place for poor people’s deposits, and still reduce its target group–orientation. This would be the case if the institution stopped lending to the target groups of the poor, for instance, because they are deemed to be too risky as borrowers. Actually, this is a common pattern of institutional development: A financial institution starts with target group–oriented lending; then it “grows up”, becomes more professional and learns about the hazards of lending to the poor, accepts deposits, is subject to regulation and, as a result, ends up lending to a less difficult group of borrowers from the upper middle class.
This raises the most difficult question: Which element of the constitution works to ensure that lending activity with the poorer target groups is maintained?
In [some] cases the continuity of the orientation to poorer target groups may be the consequence of the composition of the directorate and, to some extent, of the relevant regulation….
Who should be on the supervisory board or directorate? The common understanding in business is that the supervisory board represents the owners. But who are the “true” owners of a development finance institution which has typically been initiated by a government agency or an NGO, has received initial funding (including “equity”) from foreign donors, and whose good or bad fortunes have the most direct effect on the customers? The organizer/initiator, the provider of the seed capital and the target groups as the actual residual claimant/risk bearer could all claim to be the “owners” and thus the natural holders of board positions. Even if an “owner” were selected from among these three competing constituencies, it would not solve the problem because the supervisory board is more than a representative body for “owners”. It also has a monitoring function. The representatives of all three constituencies are normally not qualified at all to perform this function well. At least as far as efficiency and stability aspects are concerned, the monitoring function has to be delegated to some board members who are particularly qualified in this respect.
In view of these problems we recommend that the directorate be constituted in such a way that two functions can be performed at the same time. On the supervisory board there should be both, those who are experts in banking and in monitoring the management, and those who represent the long-term interests of the customers….The crucial factor is this: There must not be a clear preponderance for any one of the two functions, so that the directorate always has to fund a compromise between efficiency/stability and target-group orientation. It should be added that foreign donors definitely have a role to play in this context: they may act on behalf of the target groups and safeguard the latter’s long-term interests. (pp. 107–08)