15 August 2019

The Impact of Investing in Financial Systems: Reviewing the Evidence

If you are going to invest—specifically deploying public funds to make private sector investments—in financial systems and services to reduce global poverty, you must have answers to some pretty big questions.

For instance:

  • What is the point of a financial system, and why do people, firms and economies need it?
  • Why are financial systems in Africa and South Asia (CDC’s area of geographic focus) still underdeveloped (in terms of depth, breadth, efficiency, velocity, diversity, and cost)?
  • Why is there still such a large capital-access gap for small and mid-size firms?
  • What parts of the financial system need to be built up to increase the domestic capital pool and improve allocation?
  • What is the role of commercial investment in closing financial systems and services gaps?
  • Can commercial investment in financial systems boost inclusive growth and household and firm well-being (not just the financial system itself)?

Answering those questions—even understanding why these are still questions in 2019—requires some historical background.

The mid-20th century development consensus assumed the foundational role and importance of functional and stable financial systems and a well-managed national financial regime: development requires investment, investment requires capital, and acquiring capital for investment required both stable financial systems and the ability to manage and allocate that capital. Specifically, there was an assumed flywheel effect—once the basics of a stable and well-functioning financial system were set-up, the financial system would broaden and deepen to serve whatever domestic capital needs arose.

Aid agencies and related investment-focused institutions like CDC were founded on this consensus. The goal of CDC has always been to reduce poverty and accelerate development by boosting investment—private sector investment specifically. As the oldest Development Finance Institution, CDC was among the first institutions channeling capital into developing markets to help establish the ‘market infrastructure’ required for growth.

By the 1980s it was clear that investments and subsidies targeted at the financial system or banks (much less the large industrial firms they were created to serve) were not creating the flywheel effect. Large portions of developing economies were still starved of capital and financial services. There was a pervasive lack of access to financial services in developing countries for households and small enterprises, particularly the poorest households. The microfinance revolution took hold emphasizing the value for everyone of access to credit. The focus of investment and subsidy in financial systems shifted from the macro to the micro.

Despite the change in focus, the basic logic was the same. Investment in financial services for the poor would generate a flywheel effect, reducing poverty as more and more customers gained access to credit and used it productively. If anything, impact would be faster and more visible at the household level. Over time impact would expand and subsidy would become less necessary as institutions became self-sustaining, and larger banks learned the value and profitability of serving lower-income customers and firms. CDC was an active part of this shift, investing in microfinance institutions and in some cases helping “set up” banks.

Despite huge growth in microfinance, hopes of rapid progress in reducing poverty have not been realized. While many, many new customers are included and a number of microfinance institutions have reached impressive scale, the lives’ of customers do not seem to be significantly changing. Larger banks have not moved significantly to serve poorer customers or lend outside of their comfort zones. The vast majority of small firms still lack access to capital and financial services.

That’s the context in which we set out to review the theory and empirical evidence for investing in financial systems as a development strategy. The purpose of this effort was not just to aggregate the results of recent impact evaluations of specific financial sector interventions or investments, but to take several steps back and review the whole picture: theory, history, empirical evidence from macro- and micro- studies. It was an attempt to build an understanding that would help answer policy and strategy questions about whether, why, where and how to invest in financial systems if the goal was to make a lasting difference in people’s lives.

Today we’re happy to announce the publication of a Rapid Insight review of this work. The goal of CDC’s Rapid Insights is to guide busy impact investors through the relevant evidence, positive and negative, and provide actionable insight among a cacophony of voices. [i]

The conclusion is that investing in financial systems as a development strategy is supported by theory, history and evidence. However, to increase the development impact of investments in financial systems, including on poverty, investments should be:

  • Focused on improving firm and household wellbeing (not just expanding financial access or inclusion)
  • Designed to improve the financial systems overall ability to manage risk and allocate capital, taking into account the formal and informal tools in use (not just access to a specific financial product)
  • Targeted at specific, identifiable gaps in the current financial system, formal and informal, in a country or region (rather than ignoring the informal system, or simply assuming that everyone needs a product like microcredit)
  • Designed to boost human capital and capability of domestic participants in the financial system (rather than bypassing or ignoring the human element inside financial services firms, a particular issue with fintech enthusiasm)

 

This review is supporting CDC in how it should and could approach investing for impact in its markets. We hope it is similarly useful to other organizations that are focused on reducing poverty via investment in financial systems and services, and a useful complement to other recent efforts to document the evidence on various financial systems and services interventions.

[i] Later this summer, CDC will publish a more comprehensive “long read” based on the complete research review we undertook.

 

Author: Tim Ogden, NYU