VERSÃO PRELIMINAR
BANKING ON TRANSFORMATION: FINANCING DEVELOPMENT, OVERCOMING POVERTY
Gary A. Dymski** September 6, 2003
1. Introduction and Overview This essay considers how a financial system can best contribute to a nation’s economic transformation – that is, to more rapid growth and reduced levels of poverty. Of course, this is an old problem, not a new one. This is not to say that this problem is easily solved. To the contrary, solutions have become more elusive with the passage of the years. The objective here is to examine the possibilities for Brazil by drawing on recent experience in the U.S. and South Africa. Making economic transformation viable in developing countries is first of all a structural problem. For households to prosper, firms must be strong. For firms to be strong, markets must be extensive and well-integrated – and both robust markets and strong firms require a robust and healthy financial infrastructure. Brazil is blessed with large markets and with a diverse population of firms. Its banks are sounder than those in many other developing nations. However, these banks have much lower loan/asset ratios than banks in most other nations; many firms are credit-starved. Further, Brazil has a severely polarized distribution of income and wealth. The tasks of the financial sector in Brazil’s development are then clear – it must both rededicate itself to providing credit to growing firms, and it must at the same time contribute to lessening poverty. This is already a daunting challenge. But adding to this challenge are three further factors. First, these firms exist to make profits for their owners. Second, much of Brazil’s financial sector is now foreign-owned; and all banks in Brazil are exposed to global competition. Third (and following the second point), there is already a lengthy institutional history in Brazil regarding efforts to build and sustain a structure of financial intermediation that enhances growth and reduces poverty. For example, any further steps along the finance-development path cannot ignore such factors as the recent disappearance of most of Brazil’s state development banks. So against the backdrop of global financial trends, increasing cross-border capital flows, and recent financial history, can a market-driven financial structure meet the dual objectives of enhancing growth and reducing inequality? A number of the leading
Prepared for the September 15, 2003 session of the Seminário Brasil em Desenvolvimento, at the Instituto de Economia, Universidade Federale do Rio de Janeiro. The author acknowledges the helpful comments of Antonio José Alves and Luis Fernando Paula on an earlier draft. **
Director, University of California Center in Sacramento, 1130 K Street Suite 150, Sacramento CA 95814
[email protected], Professor, Department of Economics (on leave 2003-06), University of California, Riverside
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classical and neoclassical authors on finance and development think the answer is yes. They argue that maximizing growth prospects for all economic sectors involves following the market path: in this view, profit-making opportunities will generate the creation of the diverse financial institutions that will best serve all social classes and all categories of business. Another view, rooted in the work of Joseph Stiglitz, is that profitability and sociallyresponsive financial behavior are consistent but fragile, and in particular vulnerable to interference from off-shore financial firms. Stiglitz-type models can explain phenomena ranging from the financing of major industry groups to the distribution of micro-credit finance in low-income communities. The many crises in global financial markets in recent years suggests that Stiglitz – the author of the recent best-seller Globalization and its Discontents – may be right. This paper argues that even the asymmetric-information approach of Stiglitz and this coauthors is not an adequate guide to praxis. For while debates among financial economists have centered on the role and extent of information in credit markets, other dimensions of the problem have been ignored.
First, the development/finance literature has focused attention on a representative standard credit market, with no attention to non-standard credit markets. That is, credit demand – notably the disparate composition of this demand – has been ignored.
Second, the received literature focuses solely on the provision of credit; there is no attention to the liquidity-provision role of banks.
Third, this literature pays virtually no attention to banks’ strategies – especially the strategies of the mega-banks that have been reshaping the commanding heights of the global banking industry.
Fourth, and linked to the inattention to bank strategy, is the lack of any attention to market power in credit and payments relations.
These overlooked dimensions are unnecessary if our only concern is to prepare ammunition for a sustained debate between Keynesians and monetarists (or New Keynesians and neoliberalists). But they are critical if we are interested in the dynamics of the real world. The differences between the organization and operations of standard and informal credit markets are extreme. Further, the transactions mechanism – the availability of currency and means of payment and the terms on which they can be obtained -- is critical in the real-world economy, especially for the lower-income households and smaller businesses that are the central concern of developmental policy. And arrangements that ease savings for lower-income households are one thing; arrangements that facilitate credit for them are another. Credit and payments arrangements often are interlinked; these are focused on the logic of survival – especially, with the problem of gaining access to a scarce pool of available currency. This is a very different concern than the problem of acquiring the means to successfully start businesses, to develop small-scale and part-time start-up businesses into larger-scale businesses, and so on. There can be little doubt that shifts in banking strategies have deep implications for the
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evolution of developmental possibilities. During the last twenty years, a bank merger wave has grown in intensity, fueled both by more severe banking failures and by banks’ strategic choices. In this period, one-size-fits-all banking systems (the U.S. norm prior to 1981 and the East Asian norm until the early 1990s) have become bifurcated (if not trifurcated) into relatively distinct – and usually spatially separated -- market segments. And when banks operate in economies with multiple market segments, their decisions on which financial services to sell, to which customer bases, have a differential impact on growth and on the speed and depth of asset accumulation within these segments. Further, these bank decisions endogenously affect the extent of market bifurcation itself. Finally, the focus of the literature on asymmetric information ignores the impact of asymmetric market power. While it is convenient to assume that asymmetric information alone distorts or shapes observed credit-market outcomes, the reality is that market power often matters – again, especially for lower-income households and for smaller businesses. In sum, received ideas about development and finance requires substantial modification if we are to face without flinching the full range of challenges confronting developing nations with large proportions of lower-income and impoverished citizens – that is, nations such as Brazil. A purely “market based” strategy will not suffice, because global financial competition does not favor banks’ support of growing enterprises, and at the same time unfettered financial-market dynamics are among the forces that are worsening income and wealth inequality. This doesn’t mean that the past – in the form of the Japanese main-bank system, or Brazil’s state development banks -- can be brought back. Neither does it mean that any market-generated system of financial intermediation will be socially functional. Whether any financial structure – that is, any national arrangement of credit and payments markets inhabited by diverse financial firms with differential market power – achieves or detracts from national growth and inequality-reduction goals is an empirical matter. Here we examine the evolution of contemporary financial practices in U.S. and South Africa. We will see that in these markets, current market practices are arguably undermining longterm growth and increasing inequality. The question of improving these outcomes then means altering behavior in financial markets -- changing the terms of market participation, controlling access to markets, using targeted subsidies in financial-market processes, or all of the above. But any of these steps is a serious one, involving a breach of the neoliberal commandment that “thou shalt not intervene in market outcomes.” Crucial questions arise: how to efficiently design subsidies? what resources to request from market participants? how to minimize mistakes? how defend such interventions politically? The beginning of wisdom is the willingness to model the development/finance scenario “whole.” This essay concludes by discussing some alternatives for building bridges between financial structures, poverty reduction, and growth, taking into account the recent experience of South Africa and the United States.
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2. Received Theories of Finance and Development Authorities on the role of financial intermediation in national economic development disagree on many core questions: Do traditional and non-market arrangements for credit and payment impede development? Must property rights and contracts be well defined, and risks and rewards efficiently allocated through the market – or can other arrangements be socially efficient? Is modernization of banking structures a prerequisite to economic growth? Disagreement also rages over how deeply government should be involved in credit flows, and the proper level and role of interest rates in credit markets. This section sets out the three principal approaches to finance and development: the Schumpeter/Gerschenkron approach; the financial deepening model; and the StiglitzWeiss framework. Schumpeter and Gerschenkron on finance and growth. Schumpeter’s ideas about entrepreneurial growth and finance launched writing on this topic.1 Schumpeter argued that the credit market can be a vehicle for liberating human capacities in the economic realm. He begins with the notion of a “circular flow” equilibrium, which he views as stagnant and as having low profits. For Schumpeter, growth comes when entrepreneurial innovations disrupt circular-flow equilibria. Innovation – by which Schumpeter means the commercial application of a new concept, which could be either a new product or a new process -- is discontinuous and catastrophic. A growing economy is a disruptive economy, prone to gales of “creative destruction.” The key prerequisite required for innovation is finance. Entrepreneurs generally will lack funds required to support their visions. They are unlikely to receive sufficient credit or capital from wealth-owners, who are innately conservative; so they must depend on bank credit. Only commercial banks have the power to create purchasing power above and beyond the level of savings out of current income. So bank financing is crucial both to put idle savings into the right hands and create the purchasing power needed to break out of the circular flow. Writing in the context of Austro-German industrial development in the late 19th Century, Schumpeter describes the money market as the engine room of capitalism. Gerschenkron’s landmark essay on “Economic Backwardness in Historical Perspective”2 also emphasizes the “sudden, eruptive” aspect of industrial development. He begins by disputing Marx’s contention that the past of an advanced country is the future of the underdeveloped one; citing the cases of France and Russia, Gerschenkron argues that productive industry can emerge precipitously in underdeveloped countries. He writes that the growth potential of available resources could be “greatly reinforced by the use in backward counties of certain institutional instruments and .. industrialization ideologies” (11) – especially, the banks. French industrial development got a great boost from new industrial banks such as Credit Mobilier, creating momentum that even “old wealth” banks such as Rothschilds were compelled to imitate. Gerschenkron views the industrial banking cartel as a successful paradigm; like Schumpeter, he relies heavily on the example of Germany’s universal banking model. 1
Joseph A. Schumpeter, “The Fundamental Phenomenon of Economic Development”, Chapter 2 of The Theory of Economic Development (1908). 2
This is chapter 1 of Alexander Gerschenkron, Economic Backwardness in Historical Development. Cambridge: Harvard University Press. 5
These authors did not much discuss market interest rates or “getting the prices right”: they focused on the importance of getting credit to the right industries in sufficient volumes to feed the process of industrial innovation (or imitation). The question was, how to accomplish this. In the cases these authors emphasized, massive state intervention and/or support of industrial cartels was the mechanism. However, the link of German (and Japanese) state/industrial cartelism to repressive state apparatuses and to the slaughter of the second World War tainted this strategy. Financial deepening and the portfolio approach. In the 1950s, work on the portfolio model of financial market equilibrium began in earnest. This model suggested that an economic optimum occurs when asset-seeking agents obtain precisely the mix of assets they want to hold at a set of prices that induces deficit-spending agents to emit precisely that same set of assets. Gurley and Shaw, writing in 1957, applied this approach to the case of developing economies. They argued: “The financial system of the rudimentary economy is not congenial to rapid growth of real output because it fails to provide the array of financial assets that would stimulate saving and the array of financial markets that would allocate saving competitively to investment” (55). Figure 1: Financial Repression
S1
D1 S1
D1
R1
RT RF
Market for private-sector credit
Market for government debt (equilibrium at RT < R1)
The break here from Schumpeter and Gerschenkron is the idea that wealth-owner preferences should fundamentally steer credit allocation. That is, the allocation of available capital and credit should not be left to banks, however closely they understand the needs of industry; savers’ risk/return preferences should determine allocations.3 Interest rates then emerge as a key element in the financial structure/development equation: for those with excess income must be induced to buy assets and maintain their wealth portfolios. In this time period, many developing economies were keeping interest rates below the levels to which they would otherwise rise. For post-war financial economists interested in development, this would preclude “financial deepening” and slow growth. The key points 3
This result was shown by Fama (1980), under assumptions required for efficient market theory. 6
of the Gurley-Shaw analysis are seen graphically in Figure 1. Figure 1 suppose there is a restriction – not so much a usury cap, as an administered interest rate – that affects the credit market. The effect of this administered rate, RF, is to cause a shortage of funds in both markets. But the gap between supply and demand at RF is greater in the private market than in the government market. Government borrowing is kept relatively cheap in real terms. There are less savings than if interest rates equilibrated at R1 and RT; and a higher proportion of those savings that do occur are used to hold government debt than in a ‘free-market equilibrium’.4 Investment is low because too few funds are made available to the private sector. The financial markets are fragmented, and people hold less wealth, directly and indirectly, than they might. Entrepreneurs must rely too much on self-finance. In the short-run, the low domestic demand for assets encourages consumption. The required reforms in the financial-deepening model are that interest rates should be allowed to rise, and privatesector entrepreneurship should be encouraged, with state-sponsored activities cut back. Under these assumptions, domestic savings will expand, and funds will also flow in from abroad.5 Financial-market liberalization along these lines has become a familiar feature of World Bank and IMF prescriptions. For example, the 1989 World Bank development report supports liberalization as a strategy. The World Bank report includes this prescription: “governments should attack the conditions that made directed credit appear desirable—imperfections in markets or extreme inequalities in income—instead of using directed credit programs and interest rate subsidies.” And in turn, “liberalization should not be limited to the reform of the banking system but should seek to develop a more broadly based financial system that will include money and capital markets and non-bank intermediaries….[this makes] the system more robust in the face of external and internal shocks. Active securities markets increase the supply of equity capital and longer-term credit, which are vital to industrial investment.” Subsequent developments in the 1990s illustrated the World Bank/IMF dedication to these prescriptions for developing-economy financial markets. Even the Asian financial crisis, while it scared the players involved and led to a reconsideration of the links between poverty and financial opening, did not eliminate the core World Bank/IMF commitment to the idea that liberalization was the right course of action if done properly, and properly supervised. A critique of the financial deepening model. There are good reasons to be suspicious of liberalization in the name of financial deepening. Its historical legacy is a string of financial and macroeconomic collapses, as Stiglitz has recently documented.6 Financial markets in open economies have been notoriously unstable. And financial liberalization has almost invariably been associated with financial instability and panics – Latin America in the early 1980s, Mexico in the 1994-95 Tequila crisis, the East Asian 4
To see this last point, note the proportionate (horizontal) levels of demand for private-sector and government debt at RF, compared to the proportionate demands at the ‘equilibrium’ interest rates of R1 and RT. 5
These ideas are set out in Edward Shaw, Financial Deepening in Economic Development (New York: Oxford University Press, 1973) and Ronald McKinnon, Money and Capital in Economic Growth and Development (Washington, DC: The Brookings Institution, 1973). 6
Joseph Stiglitz, Globalization and its Discontents. New York: W.W. Norton, 2002. 7
crisis of 1997-98, the transition economies of Eastern Europe in 1998-99, and so on. This has led to some rethinking of the financial deepening model. Interestingly, some of the more thoughtful critiques have been penned by McKinnon himself. McKinnon wrote in a 1989 article, “In immature bank-based capital markets, .., there are limits to which interest rates can be raised without incurring undue adverse risk selection among borrowers (industrial and agricultural) and undue moral hazard in the banks themselves… without proper bank supervision, these limits could well be breached during some major attempt to disinflate.” (1989)7 Corbett and Mayer have articulated a complementary view, based on the idea of “a life cycle of growth for which different policies are relevant at different stages” of growth.8 These authors develop a “control theory of finance:” they assert that banks are crucial in early stages of development, when lenders need close control over inexperienced borrowers, possibly aided by international agencies; with time, national governments can establish “private financial institutions capable of overseeing the development of corporate sectors.” East Asian Experience and the Stiglitz-Weiss Model. Another reason to rethink the financial deepening model was the experience of several other East Asian nations in the post-War period. Borrowing heavily from German historical experience, Japan and other nations established bank-centered (as opposed to market-centered) financial systems with several common features: financial repression (setting interest rates below their ‘equilibrium’ levels, as in Figure 1); the channeling of consumer savings into the banking system; and the use of administrative guidance or governmental rules to channel savings into preferred investment outlets. These features were reinforced by these nations’ decision to deemphasize consumer markets, to make it difficult to import consumer durables, and to largely shut off access to foreign financial savings opportunities. In effect, consumers (in the formal sector) were left with relatively little to spend their money on. So they saved; and these savings, made available at low rates, were used to build up socially-needed infrastructure projects, housing (in some cases), and other investments. The financial-repression model is especially appropriate when rapid growth is desired but capital and resources are scarce and hence strategically important; and it is wellsuited to systems (like those in East Asia) that lack a set of strong, market-based investment and retail banks with experience in adjudicating among firms competing (at arms’ length) for capital and credit. Figure 2 permits us to contrast the “Asian” approach to financial repression with the neoliberal scenario. Figure 2: Financial Repression in the Asian Model
S
E2
7
Ronald McKinnon, “Financial liberalization and economic development: a reassessment of interest-rate policies in Asia and Latin America,” Oxford Review of Economic Policy 5(4), 1989, 29-54. Also see Ronald McKinnon, The Order of Liberalization: Financial Control in the Transition to a Market Economy. Baltimore: The Johns Hopkins University Press, 1991. 8
Jenny Corbett and Colin Mayer, “The assessment: financial liberalization, financial systems, and economic growth,” Oxford Review of Economic Policy 5(4), 1989, 1-12. 8
S E1
D D Primary market for credit
Curb market for credit
The “Asian” scenario here differs in several ways from that of financial repression (described above). One difference appears in the “primary market” graph. First, supply is not very interest-rate responsive. So there is little loss in potential supply of credit from restrictions on the interest rate. Second, credit is rationed in equilibrium. There is no presumption here that the worthiest borrowers “rise to the surface” – that those seeking to borrow at the highest interest rates are the most credit-worthy customers. The Asian model allocates credit among a pool of potential borrowers at the equilibrium interest rate (E1, in Figure 2). The borrowers chosen are industries targeted for investment by the government, and/or firms with established bank relationships and supplier networks. Firms and households shut out of this market are free to seek credit on the curb market – a cluster of small, grey – or even black-market venues for borrowing money.9 The curb market is used only by those with a severe need for liquidity and some collateral to back that need up. Barriers are created to the flow of household savings into this market (via, say, money-market mutual funds). This market equilibrates at a very high rate (such as E2 in Figure 2), high enough to discourage all but the desperate. The high curb-market rate is attributable to several factors – the small volumes of available funds, the monopoly position of those lending in the curb market, the lack of options for those forced to borrow in the curb market. Note that once controls over household savers’ disposition of their savings is loosened, this model will begin to break down. These Asian financial systems apparently defy the notion of market discipline in the allocation of credit. In the 1980s, however, a new theoretical approach explained how credit markets might equilibrate at an interest rate such that demand exceeds supply (as in Figure 2). Joseph Stiglitz and Andrew Weiss published the definitive statement of this approach in the American Economic Review in 1982. Whereas most markets involve transactions that involve only momentary contact between buyers and sellers, credit markets (and other markets, including those for labor services) involve buyer-seller interaction over a considerable period of time: a credit contract is not fully executed until the loan is repaid. Credit markets also involve principal-agent relations – that is, situations in which one unit (the principal) controls a scarce resource to which another unit (the agent) needs access – for example, credit, or a jobs. The principal may find it difficult to choose an agent, because she is informationally disadvantaged – she knows less about the capability and intended effort of her prospective borrower (employee) than the
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In East Asian nations, as in most countries around the globe, there are informal lending mechanisms, normally set up such as lending “circles,” to which households and even small businesses can turn when they need credit for purposes other than those supported in the primary credit market(s). It should be noted that the East Asian nations generally have created special financing mechanisms for social priorities such as housing construction and purchase. 9
borrower (employee) herself does.10 Principals may maximize profits by rationing credit when they cannot determine with much precision the true extent of credit risk among potential borrowers. There are two aspects of credit risk: first, moral hazard, involving how much effort borrowers are putting into repaying loans; second, adverse selection, involving how ‘good’ borrowers are. Lenders can address the first problem – getting borrowers to do their best to repay their debts – by imposing conditions such as higher collateral, contingent loan renewal, and performance covenants. Adverse selection, in turn, involves situations in which lenders know, even after using all available public information (such as standardized financial data) that all borrower subsets contain both “good” and “bad” agents. That is, the factors that make borrowers “good” or “bad” are unobservable – honesty, work ethic, family and other network resources, and so on.
Interest rate
Figure 3: A Stiglitz-Weiss Model with Two “Types” of Borrowers D2(HR) S2(HR) S1(LR)
R2 D1(LR)
R1 Volume of credit 0
C1
C2
C3
Within every borrower subset, suppose that more borrowers want credit than the lender can provide (at that interest rate). The principal would like to use the price mechanism (raising the interest rate) to drive bad borrowers out of the market and lend only to the good. But this is not be feasible when good borrowers are more likely than bad borrowers to withdraw from the pool as the interest rate is increased. Figure 3 sets out a Stiglitz-Weiss credit market in which a lender is able to sort prospective borrowers into two groups, LR (low risk) and HR (high risk), thus creating two separate credit-supply curves, denoted S1(LR) and S2(HR). The vertical gap between these is due to the higher default probability that is assigned to the HR group.11 Borrowers are represented along two demand curves because the bank is able to 10
This difficulty matters when principal and agents are incentive-incompatible – that is, in a situation wherein one's gain is the other's loss. For an overview of this “New Keynesian” approach, see Robert J. Gordon, “What is New-Keynesian Economics?” Journal of Economic Literature 28, September 1990, pp. 1115-1171. 10
separate them into two pools before any loans are made. One pool contains “high risk” borrowers, another contains “low risk” borrowers – respectively, these demand curves are given by D1(LR) and D2(HR). We assume here that the criteria for separating borrowers is independent of any characteristic of the loan or other financial instruments that the bank may propose to the potential customers. For each borrower group, the bank then considers what volume of loans would maximize its profit (minimize its loss) for each possible interest rate. It chooses that interest rate and loan volume and interest rate for each customer group that will maximize its expected profits (in light of its funding costs, operating costs, and so on). In Figure 3, interest rate R1 is chosen for the “low risk” pool. Credit is rationed for these potential borrowers: the volume of credit demanded is 0-C3, but the volume 0-C2 is funded. Similarly, credit is rationed for the high-risk pool, with 0-C2 demanded and 0-C1 funded. Leaving some credit demand unfulfilled in each submarket can be interpreted as a strategic move by the bank: those who do receive credit must worry about whether it will be renewed; this induces them to repay if at all possible. In principle this game could continue to a tertiary loan market catering to even riskier customers, and so on. We might also imagine the high-risk credit market as clearing (that is, as equilibrating where supply equals demand). Suppose we define financial fragility for any borrower as the probability that income will be insufficient to cover outlays plus debt repayment.12 Then as the equilibrium in Figure 3 moves to the northwest, financial fragility increases, all things equal. The Stiglitz-Weiss model has been used in many different ways. Stiglitz and two coauthors used it to show that the 1980s Latin American debt crisis arose because penalties for non-payment were too low.13 But in subsequent years, Stiglitz became one of the most important defenders of the East Asian credit-allocation approach. He and various coauthors use this framework to argue that nations can use administrative guidance as efficiently as market logic in determining optimal credit allocations – their idiosyncratic national systems should not necessarily be dismantled. IMF economists are wrong to assume that all financial markets must work in one way (allocating credit through marketclearing market competition) to work well. Thanks to its plasticity, other development economists have applied this framework to a wide range of institutional settings. In these applications, the informational elements of the model are emphasized; other aspects of asymmetry – such as unevenly distributed market power or control of resources – are de-emphasized.14 For example, this model has 11
In the landmark 1981 paper by Joseph Stiglitz and Andrew Weiss, “Credit Rationing in Markets with Imperfect Information,” reprinted in New Keynesian Economics, Vol. II, edited by Gregory Mankiw and David Romer, pp. 247-276 (Cambridge: MIT Press, 1991), an almost identical diagram is used to illustrate how “redlining” arises in a city that has one neighborhood with less risky loan applicants, and another that has more risky loan applicants. The asymmetric-information literature on banking that was stimulated to a large degree by the Stiglitz-Weiss paper is summarized by Xavier Freixas and J.-C. Rochet in The Microeconomics of Banking (Cambridge: MIT Press, 1997). 12
This concept has been most fully developed by Hyman Minsky. See his John Maynard Keynes, New York: Columbia University Press, 1975. 13
Jonathan Eaton, Mark Gersovitz, and Joseph Stiglitz, "The Pure Theory of Country Risk," European Economic Review 30, 1986: 481-513 14
Note that the Stiglitz-Weiss model, while emphasizing asymmetric information, incorporates the idea that lenders have substantial power – not just to set prices, but to determine who has access to credit (given the presence of widespread rationing throughout credit markets). 11
been used to explain how microenterprise markets arise; Varian (1988) argues that the Grameen model of development banking relies on social pressure to solve the moralhazard problem involved in borrowing without collateral. The Grameen model links together several community members, who borrow sequentially, in such a way that the access to credit of one depends on the successful repayment of prior borrowers. In this manner, borrowers who have nothing to lose and who normally have an incentive to run away from debt obligations are induced to repay by the existence of prior social ties.15 3. Received Finance/Development Models Reconsidered So the literature on financial structure and economic development has encompassed a debate on the importance of ‘modernizing’ credit markets, on the appropriate roles of market forces and government intervention in credit markets, and on the implications of liberalizing financial markets and interest rates. Schumpeter viewed the money market as a fair arbiter in the marketplace; Gerschenkron asserted that state intervention to mold the market was acceptable – even mandatory. The financial-deepening model asserts the fundamental importance of freeing interest rates so as to shift resources away from government debt and toward risk-taking enterprises.16 The Stiglitz-Weiss model disagrees; it supposes that interest rates don’t clear credit markets, but instead stabilize below the point of supply-demand equilibrium. Thus, freeing interest rates may or may not have any effect on the level of interest rates and the composition of credit. If market allocation is not well developed, non-market allocation (as in the pre-liberalization Korean situation) may most efficiently identify successful borrowers.17 There isn’t even agreement on the need to modernize per se. For Gerschenkron and the financial-deepening model, modernization is fundamental. But the Stiglitz-Weiss framework explains that microcredit lending arrangements can enhance the growth of opportunities and household incomes – even in the absence of anything approaching ‘modern’ financial markets. A key problem that pervades this entire literature on finance and development, however, and which restricts its relevance to ‘real-world’ development challenges, is that fact that none of these models are “structural.” Structural, that is, in the sense of acknowledging that virtually all economies have dense and complex networks of markets, which operate interactively in different ways for different market participants. For one thing, the models developed in this literature have invariably focused on the “standard” or primary market; other parts of the architecture of credit markets are rendered invisible. The invisibility of informal markets is a particular problem, because these markets work very differently than primary markets. For example, the criteria for pricing and approving loans on the curb market is very different from those on the primary market. There have been virtually no applications of the Stiglitz-Weiss framework to the case of multiple credit markets in really-existing economies; applications of portfolio15
Hal Varian, "Monitoring agents with other agents," Journal of Institutional and Theoretical Economics 1988.
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In Figure 1, freeing the interest rate implies a shift from the controlled RF to a higher market rate, which might be R1. This would shift the demand for assets from the government-securities market to the private market. Government would pay more to support its debt, while more enterprises would be financed, at lower rates. 17
In Figure 2, freeing the interest rate might have no effect, since the “administered” rate might already be equivalent to a market equilibrium. 12
based financial deepening models have assumed that all markets work alike.18 The discussion earlier in this section, which attempted to apply this model to the case of two loan pools, was purely conjectural. In the literature, it is virtually impossible to find pragmatic applications by New Keynesian economists of the sort carried out here. Further, the models discussed above are partial depictions of the activities involved in banking. Banks’ operations are reduced solely to the credit function, with no attention to transactions. This is problematic because the transactions functions are very important, especially for lower-income households. Third, banking strategies are ignored. This matters because we have seen systematic shifts from one-size-fits-all banking systems (the East Asian norm) to bifurcated systems. Bifurcated systems exist and have always existed in most nations, but have not been modelled. Further, in making strategic shifts in credit and banking markets, banks can endogenously affect these markets’ supplydemand structure (see below). In the literature as it has developed thus far, insights about the logic of credit markets are based on either the idealized role of the entrepreneur in the Germanic system, on asset substitutability within a portfolio framework, or on the logic of asymmetric information. But other factors intervene before we get to these things – for example, market power matters. Further, it is assumed that the pure mechanism of asymmetric information – moral hazard arrangements etc. – work in the most informal markets just as they do for the most formal markets – or, equally, that those other markets that operate on other bases have no significant impact on broader economic dynamics. But arrangements that ease savings for lower-income households are one thing; arrangements that facilitate credit for them are another. Credit and payments arrangements often are interlinked; these are focused on the logic of survival – especially, with the problem of gaining access to a scarce pool of available currency. This is a very different concern than the problem of acquiring the means to successfully start businesses, to develop small-scale and part-time start-up businesses into larger-scale businesses, and so on. The restricted scope of the received finance/development literature has deep implications. First, the leading models that have shaped thinking in this area have created no theoretical space for incorporating the situation of the unbanked. This lacuna is significant: for recent years have seen many experiments in selling various subsets of financial services to the unbanked and to lower-income households; and no consistent theoretical framework for evaluating the social and economic efficiency consequences of these experiments currently exists. We review some of these new approaches below. A full evaluation of these experiments’ effects requires seeing the picture whole: otherwise, a solution for one problem (for example, a high-cost short-term loan that permits a matching of an erratic or lumpy stream of required payments with available revenues) may preclude attention to another (the availability of loans for wealth-asset acquisition and accumulation). The danger is that informal credit market arrangements that alleviate some market constraints may worsen others. 18
See the works by McKinnon (1974) and Shaw (1974) cited above. The portfolio model these authors use embeds the deep assumption that all assets are substitutable; so situations in which primary and other markets are fragmented fall outside these models’ scope. 13
4. Recent Trends in Banking: Customer-Base Bifurcation, Predatory Lending The remaining portions of this paper try to bridge some of these gaps between received models, banking strategies, multi-tier banking markets, and poverty. This will help us better understand the full impact of financial structures in developing economies, and how structural changes in banking systems might reduce poverty – or change its character. The Stiglitz-Weiss model and indeed virtually all of the other models of credit-market behavior are disembodied and simple. They do not take into account other strategic or behavioral considerations that may lie behind market outcomes. Here we summarize out some of my findings vis-a-vis recent trends in banking practices.19 These findings are specific to U.S. financial experience, though they have broader applicability. Prior to the 1980s, U.S. banks operated with long-standing geographic prohibitions: they could not expand their branch networks when market opportunities arose outside their market areas. A sustained period of banking distress began in 1981. The thrift industry collapsed; and many banks also experienced distress in the early 1980s due to credit problems ranging from Latin American loans, loans in oil-rich domestic areas, and loans for commercial real-estate and corporate mergers. Expansion-oriented commercial banks often received government assistance to take over failing or troubled thrift institutions.20 Meanwhile, banks were inventing new sets of strategies due to increasing pressures on both sides of their balance sheets: mutual funds attracted the savings of many wealthy and middle-class households; and many larger non-financial corporations began to borrow directly, at lower cost, in commercial-paper and corporate bond markets. Large banks were especially affected by these customer-base losses. Banks had two strategic responses to this dual attack. One response was the emergence of an upscale retail banking strategy. Banks using this approach identify a preferred customer base to which it can deliver both traditional banking services – short-term consumer loans, long-term mortgages, depository services – and non-traditional services such as mutual funds, insurance, and investment advice. This strategy has been under development since the late 1970s, pioneered by banks such as Citibank and Wells Fargo. Whereas cross-subsidies were previously extended between customer classes within product lines, cross subsidies were now implemented between product lines within customer classes. Fees and charges are reduced for desired customers who will purchase multiple banking services; fees are increased for customers using only basic banking services. A second and related response was a shift away from maturity transformation and 19
The Bank Merger Wave: The Economic Causes and Social Consequences of Financial Consolidation in the United States. M.E. Sharpe, Inc., Armonk NY. June 1999; and “The Global Bank Merger Wave: Implications for Developing Countries,” The Developing Economies. Special Issue on “M&A and Privatization in Developing Countries - Changing Ownership Structure and its Impact on Economic Performance,” 40(4), December 2002. Also see “Banking in the New Financial World: From Segmentation to Separation?” Arte, Candido Mendes University, Ipanema, Rio de Janeiro, Brazil, 1998. 20
This period of distress mergers paralleled a shift in regulatory philosophy. In the 1980s, many regulatory economists softened their criteria for monopolistic power – a market could be dominated by a few large sellers and still be competitive if remained ‘contestable.’ Weakened regulatory tests for market power permitted federal regulators to approve more mergers for a banking system they regarded as ‘overbanked.’ 14
interest-based income, and toward maturity matching, secondary market sales, and feebased income. Much of the revenue from upscale households takes the form of fees, encouraged by the growth of secondary loan markets and of banks’ involvement in household portfolio management. Large banks also shifted their focus in servicing business customers: for smaller businesses, they now provide primarily transaction services; for the larger firms that obtain their primary financing elsewhere, banks provide a variety of risk-management services--including financial derivatives, foreign exchange hedging, and contingent loan agreements (lines of credit). In the U.S., interest expenses have been a declining portion of banks’ overall expenses since 1982; noninterest income has been an increasing share of bank income since 1978. These shifts toward desirable up-market customers and toward fee-based services are mutually reinforcing: the customers most sought by banks are targeted for the receipt of standardized financial services – credit cards, specialized deposit and investment accounts, and mortgage loans. Both strategic shifts lead to bank mergers aimed at market expansion. Banks can initially increase revenues by identifying more feegenerating customers within their market areas, and then by serving more of the financial needs of their core customers. Once the existing customer base is saturated, growth depends on a spatial extension of the customer base. This can be done either by purchasing existing banks and the customers that use them, or by building new branches in other banks’ market areas. These two strategic options are substitutes. Mergers have been favored over ‘bricks and mortar’ expansion: the latter has been freely permitted in the U.S. only since 1994, and is generally more expensive than buying other banks’ branch networks. About half the 6,350 bank mergers in the U.S. after 1980 were indeed market-extension mergers, aimed at extending into new geographic markets. Fee-based banking leads banks to consider mergers aimed at product-line expansion. A bank seeking to generate fees by servicing financial transactions can expand its fee income by servicing more transactions or more elements of those transactions. So mergers with insurance providers, brokerages, investment banks, and others enhance the range of fee-generating activities. Acquiring firms can then offer “one stop shopping” for financial services, since they have purchased other firms’ expertise. Large banking firms have led the second phase of the U.S. bank merger wave because they have most aggressively pursued upscale-retail and fee-based strategies. As the U.S. equity markets peaked in 1999-2000, and then began to move sideways or even down rather than upwards, the pace of bank mergers cooled. Large banks in the U.S. also found that their “financial supermarket” strategies were flawed; often consumer banking was the anchor for positive cash flow, with activities such as investment banking and brokerage earning little or losing money. This led to a new turn, that is toward involvement in consumer credit markets that the U.S. banks had previously had little experience with – the subprime and payday loan markets. Beginning in the late 1990s, large banks purchased minority or controlling interests in many non-bank lenders in these markets. In effect, the banking markets have been bifurcating in the U.S. even while they have been evolving over the past several decades. On the one hand, the core functions of banking are themselves being transformed by banks' responses to the entry of new
15
competitors (and the availability of new technologies) for their sub-businesses. On the other, the reach of the “primary” banking system has contracted as standardized products have emerged, as cross-subsidy patterns have changed, and as the functions of bank branches have been redefined. Lenders' splitting of customer bases generates an oversupply of financial services for some, and a denial or costly provision of financial services for others. Households and firms excluded from lenders’ competition for customers are more exposed to the costs and losses of operating in a fundamentally uncertain environment. They are less able to make long-term contracts, pay more to execute transactions, and (in the case of firms) operate at smaller, less efficient scales than they otherwise would. Predatory Lending and Usury in the ‘Subprime’ Market. As noted, then, in the past four years the subprime or “predatory” lending market has come into its own. This market appears to be a relatively new phenomenon in American credit markets. It refers to loans made on the basis of household or business collateral, under terms and conditions that are exculpatory. These loans often lead to excessive rates of household and firm nonpayment, and thus to foreclosures and personal financial distress. The rates charged in these markets are often labeled usurious. We might pause for a moment and consider two definitions of this term. The first, from the Miriam-Webster Dictionary, appears on the first page of this report. Clearly, the term has no clear dictionary meaning, as it refers jointly to interest, excessive interest, and illegallyexcessive interest; that is to say, the definition is circular. Keynes related usury to the problem of fair returns on assets: The high rates of interest from mortgages on land, often exceeding the probable net yield from cultivating the land, have been a familiar feature of many agricultural economies. Usury laws have been directed primarily against encumbrances of this character. And rightly so. For in earlier social organizations where long-term bonds in the modern sense were non-existent, the competition in a high interest-rate on mortgages may well have had the same effect in retarding the growth of wealth from current investment in newly produced capital-assets, as high interest rates on long-term debts have had in more recent times. (John Maynard Keynes, The General Theory of Employment, Interest, and Prices, London: Macmillan and Co, 1936, page 241) This definition is clear: if the rate of interest charged on a loan exceeds the expected rate of return on the project financed with that loan, the rate is usurious. Clearly this is the case for virtually all loans made in the informal and second-tier markets. Such loans buy time, they trade getting by today for less wealth tomorrow. They involve a systematic decumulation process. This process can be justified on any number of grounds – the high risks associated with these populations, the shortage of cash in lower-income communities, etc. – but decumulation is what these sorts of loans generate. It is odd that Keynes regarded this as antiquated and historic; but then, he was a man of a certain class position. Keynes may have thought it unlikely that profound spatial distinctions in the distribution of wealth and income could arise now – note his prefatory phrase, "in earlier social organizations.” A visit to East Los Angeles or a Rio de Janeiro favela in our day might lead him to reconsider this phrase. In any case, we are a long way from 16
Gerschenkron’s and Schumpeter’s heroic lenders, providing a seedbed for sustained growth. Certainly, usury has been a fine art in credit markets since the dawn of modern commerce. But a new term seems warranted for this form of lending for several reasons. First, it involves two distinctive sets of practices. One is the aggressive telemarketing and sale of second mortgages based on demographic targeting – especially, the targeting of minority households that have traditionally been denied access to credit.21 The second is the payday loan – the practice of advancing workers a portion of the money they stand to earn from their paychecks. In just the past 4 years, payday loans have become common in check-cashing stores. In both cases, financing is often provided by large bank holding companies. Both these practices have heavily impacted the elderly, people of color, and minority neighborhoods Hence, the question of discriminatory intent or impact arises. Many lowincome and minority borrowers are obtaining loans at high interest rates and with very unfavorable terms from housing-related and payday lenders. Exploratory studies suggested that these loans had quickly grown into huge industries. For example, Canner et al. found that in 1998, subprime and manufactured housing lenders accounted for 34 percent of all home purchase mortgage applications and 14 percent of originations.22 The influence of these lenders is even more pronounced on low-income and minority individuals. According to Canner et al., in 1998, subprime and manufactured housing lenders made a fifth of all mortgages extended to lower-income and Hispanic borrowers, and a third of all those made to African-American borrowers. According to ACORN, subprime lending grew 900 percent in the period 1993-99, even while other mortgage lending activity actually declined.23 A nationwide May 2002 study of 2000 HMDA data by Bradford found that African Americans were, on average, more than twice as likely as whites to receive subprime loans, and Hispanics more than 40%-220% more likely.24 This evidence suggests that lower-income and minority borrowers are being targeted by these specialized – and often predatory – lenders. As noted, mergers and changing practices in consumer finance have led to ever more interpenetration between major banking corporations, finance companies, and predatory lenders. Consider the case of First Union Bancorp, which bought the Money Store in June 1998. First Union subsequently closed this unit in mid-2000 in the wake of massive losses. This may be linked to the shift in consumer finance toward a new revenue model: higher fees, paid upfront, for loans made on the basis of attachable assets. Since homes 21
A November 2001 study of California cities by the California Reinvestment Committee (CRC), using a borrower survey instrument, found that a third of subprime borrowers were solicited by loan marketers, and that minorities and the elderly are targeted in these marketing efforts. These loans often have onerous terms and conditions; in the CRC study, three in five respondents have punitive repayment penalty provisions, while 70 percent saw their terms worsen at closing. Other common abuses include high upfront fees and costly lump-sum credit insurance. 22
Canner, Glenn B., Wayne Passmore, and Elizabeth Laderman. "The Role of Specialized Lenders in Extending Mortgages to Lower-Income and Minority Homebuyers." Federal Reserve Bulletin (November 1999): 709-723. Also see Richard Williams, "The Effect of GSEs, CRA, and Institutional Characteristics on Home Mortgage Lending to Underserved Markets." HUD Final Report, December 1999. 23
Association of Community Organizations for Action Now (ACORN), Separate and Unequal: Predatory Lending in America. Sacramento, CA: California ACORN, October 31, 2000. 24
Bradford, Calvin, Risk or Race? Racial Disparities and the Subprime Refinance Market. Washington, DC: Center for Community Change, May 2002. 17
are most households’ primary asset, especially later in life when mortgage loans have been paid down, the growth of the subprime mortgage lending market is readily grasped. The logic of the payday loan industry is very similar – next month’s paycheck serves as a collateral anchor for this new form of lending. Some bank holding companies have purchased subprime lenders. Citicorp acquired Associates First Capital Corporation, which was then under investigation by the Federal Trade Commission and the Justice Department. Associates First represented a step toward Citi’s goal of establishing its Citifinancial subsidiary as the nation’s largest consumer finance company. This drew an immediate response from fair-lending advocates. For example, Martin Eakes, founder of the non-profit Self-Help Credit Union in Durham, N.C., commented, “Those of us who have worked on the community level have seen the abuses outlined in the F.T.C. complaint, and many of us believe that Associates is a rogue company and may alone account for 20 percent of all abusive home loans in the nation.”25
25
Oppel, Jr., Richard A., “U.S. Suit Cites Citigroup Unit on Loan Deceit,” New York Times, March 7, 2001. 18
5. Stiglitz-Weiss Markets in the Real World 1: The U.S. Case The development of a satisfactory theoretical model capable of meeting all the criticisms leveled above would take us well beyond the scope of this paper.26 Instead, we will make several key changes in the Stiglitz-Weiss framework as presented above. This will show how received models might be altered to more closely describe observed “real world” experience. We focus here on three changes. First, we suppose that multiple lenders are active in a given market, and not just one. Second, we assume that some or all loan applicants can migrate from one risk category to another. This can be explained as due to the social construction of creditworthiness – the fact that whether a given loan applicant is a viable borrower depends on numerous social factors -- that is, influences exerted on the applicant’s creditworthiness by her interactions with other economic units and with the surrounding spatial community. A loan applicant with a given loan project may or may not be viable, depending on the level of debt she carries, and also on the level of debt (and wealth) of the economic units in her neighborhood. Third, we allow explicitly for behavioral endogeneity: a lender’s decision on how many applicants to fund in a given (primarymarket) applicant pool determines the quality of that lender’s applicants in its other (secondary- and even tertiary-market) applicant pools. That is, its loan behavior affects the position of the demand curves in its credit markets. Note that the credit market in which a given lender is active may have more than one neighborhood. Figure 4 suggests the impact of these changes on the logic of the Stiglitz-Weiss credit market. As in Figure 3, borrowers are represented along two demand curves; but they are now connected by a ‘kink,’ which captures some implicit market dynamics. Consider the pool of potential borrowers before any loans are made. This pool consists of both “high risk” and “low risk” borrowers; hence, D1(LR+HR). The lender or lenders in this market know that borrowers of both kinds are in its applicant pool; however, the lender(s) cannot distinguish between LR and HR applicants. Also, lender(s) know that the distribution of LR and HR customers depends in part on overall lending volume and location. Suppose one lender, a bank, services D1. At interest rate R1, the pool of potential borrowers equals 0-C4; at R2 it equals 0-C3. The bank chooses a loan rate for its primary (low-risk) borrower market by evaluating its prospective profits as it varies the borrowing rate (along the “Y axis”). This involves estimating the mix of “high risk” and “low risk” borrowers at each interest rate. In this illustrative case, the bank maximizes profits by at loan rate R1, and thus has a loan volume of 0-C2. Thus far, the scenario is structurally identical to that in Figure 3. Now we come to the differences. Once loans are made along the lender’s low-risk supply curve S1(LR), this lender (or another one) opens its ‘second-choice’ loan market. The demand curve for credit shifts in (toward the origin, as shown) as those still without credit restate their demand, migrating from D1(LR+HR) to D2(HR). There could be “high risk” loan applicants who do not register their loan demand on D1, but who simply begin at D2; but there is also a migration of unsatisfied borrowers from D1 to D2. Bankruptcy laws, changing 26
The ‘thin’ conceptual basis of the Stiglitz-Weiss framework is discussed in Gary Dymski, “Disembodied Risk or the Social Construction of Creditworthiness?” in New Keynesian Economics/Post Keynesian Alternatives, edited by Roy Rotheim (Routledge, 1998). Pp. 241-261. 19
income levels, and other changes in household wealth/income status can move applicants from high-risk to low-risk status, and back; it is logical to assume (especially in the U.S. market) that economic units will seek credit first in the primary market. If they do not succeed, some share of these units will then shift their demand to D2. The lender(s) also switches to a higher-risk supply curve, S2(HR). The location of S2 depends on the location of S1 and on the equilibrium interest rate in the primary market, R1. In effect, both D2 and S2 result endogenously from the bank’s primary-market behavior. In the second-choice market, the bank goes through its profit-maximization exercise again, this time for the higher-risk prospective borrowers it now faces.
Figure 4: A Stiglitz-Weiss Model with Interlinked Borrower Classes Interest rate
D3((V)HR) D2(HR)
S2(HR) S1(LR)
R2 D1(LR+HR) R1 Volume of credit 0
C1
C2
C3
C4
In Figure 4, by construction, the bank determines that interest rate R2 maximizes its profits in this market. Then it makes loans equal in volume to 0-C1, leaving C1-C2 as a loan demand that remains unsatisfied even at this higher interest rate. This game could continue to a tertiary loan market catering to even riskier customers. In Figure 4, at least some of those who fail to acquire credit in the secondary market move on to a tertiary demand curve such as D3. D3 can be understood as a “very” risky credit-demand curve, D3((V)HR). This curve is shown as steeper than D2, reflecting the increasing desperation of unfunded loan applicants needing credit (and remaining in the market). Note too that higher-risk customers are more financially fragile than low-risk customers, by definition; and customers receiving credit along D3 are more financially fragile than those receiving credit along D2 (similarly for D2 and D1), all else equal. United States experience. The previous section discussed the shift of the U.S. banking system from a one-bank-fits-all to a segmented-market system. The trend toward customer-base bifurcation implies that different credit markets will open for customers in different segments of the market. This is precisely what is shown in Figure 4.
20
Institutionally, the emergence of Figure-4 type credit-market supply behavior has taken several forms. In some cases, the same lender provides credit in multiple sub-markets; it is very common, now, for banks to offer a variety of distinct credit instruments in each subarea (commercial, housing, consumer loans, and so on). Alternatively, credit is sometimes supplied by independent lenders in each applicant pool.27 In other cases, a bank (especially a megabank) makes loans in the primary market and provides funds or capital for one or more semi-autonomous lenders operating in secondary markets. An example here is the case of Citibank’s purchase of First Associates (discussed above). The combined effects of several trends – the shift of bank locations toward upmarket suburban areas, bank holding companies’ purchases of consumer-lending firms that have ‘predatory lending’ subsidiaries, the informalization of income-generation processes in lower-income and minority communities – is to drive a wedge between primary and second-choice lending markets. This wedge is spatially and institutionally defined. Because of the spatial concentration of lower-income and minority communities and the paucity of bank branches in these communities, financial services are increasingly delivered by formal banks in some places, but by informal institutions in others. The ranks of the unbanked are significant in the U.S. –as many as one in six households may lack a bank account.28 The unbanked use a combination of business services to meet their financial service needs – check-cashing stores, money-order and check-cashing facilities in ethnic grocery (and other) stores, finance companies, and pawnbrokers.29 It is tempting but misleading to view this situation as one in which lower-income customers enjoy the same sorts of financial services that upscale customers do, just at higher costs. John Caskey, for example, describes pawnbroker stores as the loan market for the poor.30 This suggests that lower-income households and firms in lower-income and minority areas enjoy the same types of financial services; and since financial services provide access to investment and savings processes, it suggests that these units have access to the same sort of savings and accumulation processes as do all other households. This should not be assumed. Figure 5 provides some insights into the consequences of this organizational shift in the financial sector. It shows a structurally segmented credit market, in which a spatial and product-market divide denoted S-S splits the market between the financial services available to privileged (low-risk) customers and the services available to other, “high risk” customers. In effect, what has happened here is that the customer-market division between low-risk and high-risk credit-market customers has been institutionalized.31 This divide, when it first emerges, corresponds loosely to rifts in these customers’ levels of 27
In this event, lenders’ maximization problems are nested (the second-choice solution depends on the primary market outcome, the third-choice on the second-choice market outcome, etc.). 28
There is controversy over whether more people are becoming unbanked over time. Statistics based on the triennial Survey of Consumer Finances, undertaken by the Federal Reserve Board, suggest that the number of unbanked is stable or slightly declining. Other surveys suggest that the number and proportion of unbanked households is growing. 29
The Bank Merger Wave (cited above) contains an empirical analysis of the financial infrastructures of different U.S. metropolitan areas as of the late 1990s. A paper co-authored with Lisa Mohanty, “Credit and Banking Structure: Insights from Asian and African-American Experience in Los Angeles,” American Economic Review Papers and Proceedings (May 1999, 89(2): Pp. 362-366) contains a statistical analysis of formal and informal banking facilities’ spatial location in Los Angeles. 30
See John Caskey, Fringe Banking: Check-Cashing Outlets, Pawnshops, and the Poor, (New York: Russell Sage Foundation, 1994), which pulls together the author’s research in this area. 21
income, wealth, and human capital. Over time, this loose correlation will become a tighter one. For one thing, those who are grouped into the high-risk market face higher rates and fees. For another, those in the high-risk market may be unable to maintain deposit accounts.
Figure 5: Segmented Mainstream and Predatory Credit Markets Interest rate
D3((V)HR)
S
D2(HR)
S2(HR) R2
S1(LR)
D1(LR) R1 Volume of credit 0
C1
S
C2
C3
C4
The inability of customers in the HR segment of the market to maintain deposit accounts has implications for the demand for credit on the left-hand side of S-S. Some portion of these customers will be cash-short. They will need to borrow to acquire the cash they need to meet payments obligations. The loans available to such customers fall into the predatory-lending category – that is, lending that generates an unsustainable debt burden. Such units are pushed further and further to the northwest in Figure 5, with a more and more inflexible need to borrow at any price. Such borrowers are not simply more and more financially fragile – they rapidly become Ponzi units, soaking up credit that simply goes to pay old debt. Borrowing to pay in this manner involves a perverted use of the credit market due to breakdowns in the payments mechanism. In this predatorylending scenario, the lenders’ incentives are to generate a high return in the short-run, as long-run sustainability is an impossibility. Clearly, this credit-market bifurcation has huge consequences for the accumulation of wealth and capital over time. In particular, residents of communities served primarily by the sort of credit-market arrangements shown on the left-hand side of Figure 5 will have great difficulties in amassing wealth and accumulating capital; things are quite different 31
This divide can be regarded as an institutional variant of redlining (that is, the differential treatment of bank customers based on their geographic location). Here, lenders may propose different loan types (normal and predatory) to customers based solely on the geographic locations of their offices, and on the socio-economic characteristics of different spatial areas, and not on potential borrowers’ inherent characteristics. This again illustrates the endogeneity associated with market definition in contemporary credit markets. 22
for communities served by the credit markets shown on the right-hand side of Figure 5. Consequently, the spatial divide in financial markets amplifies pre-existing differences in the distribution of wealth. Some portions of U.S. society use an efficient and responsive financial system to build wealth, while other segments’ wealth position is jeopardized by the contact with that same system. The question is, what to do about it? There are several options. One is to restrict the ability of predatory lenders to impose overly high interest rates on borrowers. This would, in principle, force lenders to make different strategic choices, offering products that do not sytematically lead borrower units into insolvency. To get some insight into the impact of interest-rate restrictions in highly unequal societies, we turn to recent South African experience. 6. Stiglitz-Weiss Markets in the Real World 2: Usury Limits in South Africa South Africa resembles both Brazil and the U.S. in certain respects: it is a highly unequal society, with inequality linked to a history of codified racial exclusion; it has a huge geographic expanse, with many different subareas; and its market arrangements range from the formal to the informal. The near-resemblances between the U.S. and South Africa end there. South Africa emerged from the apartheid era only in the early 1990s. It has had only a few years, and limited resources, with which to begin addressing this legacy of inequality. For example, Nelson Mandela’s government promised that a million new housing units would be built to address that desperate social need. A large enough fraction of that total was completed that Mandela’s administration could declare success regarding that objective. However, virtually all of those housing units were provided without a transfer of property rights; hence no secondary market for these homes has opened up. Given that many of these units have been built adjacent to or in African urban settlements in which claims to property are disputed at best, this new program has addressed a social need (inadequate housing for many South Africans) but not one of the nation’s core economic disparities – the virtual absence of wealth among most African South Africans. Adding to this situation is the dire problem of unemployment; among Africans in South Africa, the measured unemployment rate exceeds 40 percent. This has led to the informalization of market relations, which of course undercuts tax revenue streams and, in turn, infrastructure development and social-service delivery. We now turn to South Africa’s banking markets. Note first that these markets are segmented in much the way that was described for the U.S. case.32 At one extreme, a small group of major banks dominate the banking market in South Africa; as of December 2000, the six largest banks controlled 83 percent of market share. They operate in a conservative manner in loan-making – emphasizing the availability of collateral as a prerequisite for prospective borrowers -- and charge high interest margins on the loans they do make. Protected by extremely high bank-charter fees (an effective barrier to
32
Much of the information used to summarize the South African banking scenario was drawn from two reports by Penelope Hawkins: “Liberalisation, Regulation and Provision: The implications of compliance with international norms for the South African Financial Sector,” A Report prepared for the Trade and Industry Policy Secretariat, Johannesburg, South Africa, August 2001; and “The Cost, Volume, and Allocation of Consumer Credit in South Africa,” A Report prepared for the Micro Finance Regulatory Council, Johannesburg, South Africa, February 2003. Government reports were also used, as was information gathered during a series of interviews and conversations by the author during January 2003. 23
entry), these large banks have considerable market power.33 They are also protected by a reserve bank (South African Reserve Bank or SARB) that regards protection of the financial health of these banks as a principal policy objective.34 These large banks have ongoing relationships with an established core of South African firms, especially large firms engaged in export activity; but they provide little or no support for business startup or for small-and-medium enterprise financing. The interaction of a history of racial exclusion and major banks’ conservative lending policies produces a financial system more dramatically bifurcated than the one in the U.S. According to ABSA (a major South African bank) only 20 percent of South Africans had active banking relationships in 1999; as of that same year, only about 37 percent of South Africans had savings accounts of any type. There is a large overlap between the unbanked, unemployment, and informalization: according to a recent survey by First National Bank, 79 percent of the unbanked are unemployed, and have no recorded income.35 The picture that emerges is of dual markets: one set of borrowers that has the collateral and income/wealth levels to qualify for credit under the usury cap – either for housing, for personal credit (credit cards), or for other purposes; and another set of borrowers that borrows much smaller amounts. South Africa’s banks serve both kinds of markets; but they serve them in different ways and with different instruments. Given the absence of privately-owned wealth assets in much of South Africa’s urban (and rural) areas, the major banks do not provide integrated banking services in these areas; at best, these banks underwrite the provision of a partial set of financial services. Microcredit loans are one intervention of the major banks in lower-income areas. The large banks account for about half of these loans. It should be made clear at the outset that “microcredit” loans have no specific connotations in South Africa. The defining image of a microcredit loan is of Bangladesh’s Grameen Bank providing credit in small amounts to women who are starting businesses; but in South Africa, a microcredit loan is simply a short-term loan with a high interest rate, which can be used for any purpose (usually to resolve consumption/income mismatches). And so, the microcredit markets shadow the formal markets, in area after area of life. Consider the case of housing: mainstream markets provide loans under the usury-rate cap to those with stable, high-level incomes, for the acquisition of formal-sector residences; microcredit markets provide short-term money that can be used to buy fencing and barbed-wire to protect the perimeter of informal-sector (township) housing. As with predatory lending in the U.S., microcredit loans in South Africa are one market response to chronic cash shortages in lower-income households and communities. In effect, cash has a cost, measured by the microcredit rate (which, as in the U.S., can be astronomical on an annualized basis). Micro-loan arrangements have high risks of 33
The cost of a bank charter in South Africa is approximately $25 million (approximately 10 times that for a U.S. bank charter). As of the end of 2000, foreign banks operated only 15 branches in South Africa. 34
Evidence of SARB’s success in this respect is that the contribution of the FIRE (financial intermediation, insurance, real estate, and business services) sectors to South Africa’s GDP has grown from 16.1 percent in 1993 to 20.3 percent in 2000. 35
Richard Stovin-Bradford, “It's a long walk to banking freedom,” Sunday Times (South Africa) Economics, Business & Finance. Pg. 4, July 20, 2003. This article reports that efforts are under way to revise overall financial-charter law in South Africa in a manner that extends the umbrella of transaction banking services. 24
repayment – not surprising, given their high rates. Often this leads to substantial loaninsurance costs for borrowers. Payments on this insurance can rival that on loans per se. Few of any of South Africa’s lending markets provide support for small business activities in the nation. The consumer credit market is, by contrast, an active locus of lender competition. Hawkins’ recent work on the structure and behavior of South Africa’s consumer credit markets reveals that these markets have many different ‘tiers.’ A distinctive feature of South Africa’s market situation is that its credit markets operate under a usury law. The usury limit is formula-driven; it currently stands at around 26 percent per annum. Only borrowers that are secure financially and that have wellestablished reputations and/or adequate collateral can hope to borrow in the ‘usurylimited’ market. The obvious point from South African economic history is that most of those in this fortunate circumstance were whites, while most of those who could not hope to borrow due to deficiencies in creditworthiness were coloreds and blacks. So access to the markets for these large and historically excluded populations would require either renouncing the usury limit or making an exception to it. This brings us to recent history. The sequence of reforms in micro-lending between 1992 and 2003 in South Africa begins with the 1992 Usury Act Exemption notice, which provided an exemption for all loans under 6000 Rand. This led to the growth of the cashloan industry (for consumption loans and emergency finance), to about R15 million by 1999. By 1999, a micro-lending industry had arisen with the following structure:
Four banks were providing micro-loans of 3,000-6,000 R, interest rates of 60%/ annum, using primarily payroll deductions. Most were housing loans, but this distinction disappeared.
Many cash lenders, often operating through franchises, making small loans repayable at the end of the month for 30% interest (360 per annum).
30 NGOs were focusing on micro-enterprise lending, with a smaller group doing housing lending. This was ‘development lending’ – loans of R500 to R3000, rates from 40-60%/annum.
In 1999, micro-lending was made conditional on registration with the Micro Finance Regulatory Council (MFRC), an autonomous industry oversight mechanism. Certain disclosure and consumer protection practices were also required. The Rand limit on exempt loans was raised to R10,000 (approximately $1,250). Consequently, many large banks entered the micro-lending market, sometimes through joint ventures; consumergoods retailers (furniture and clothing) entered also. Today, more than 1,300 lenders are registered with the MFRC. Figure 6 provides a graphical image of South Africa’s consumer credit markets under the usury cap. This graph differs in crucial ways from those explored above. As in the U.S. segmented-markets scenario, loan applicants don’t move between the primary and second-tier markets. For simplicity, customers are not shown as ‘sliding’ between market demand curves as in Figures 4 and 5. The key feature here is the usury cap, drawn as UU. By assumption, the second-tier markets equilibrate at rates over the usury cap; the primary market equilibrates at rates under the cap. Let us focus first on the primary market. Note that at the profit-maximizing interest rate
25
R1, some 0-C4 want money, but only 0-C3 are accommodated. The usury cap U-U does not “bind” in that it is above R1. U-U is above the point at which S1 and D1 meet; but the relevant interest rate is the one that banks set on the basis of their profit-maximizing criteria. If U-U were below R1, the normal operations of the market would be affected – in particular, banks’ profits in the primary market would be less than otherwise. Suppose the position of U-U and R1 were reversed in this graph, as a way of showing what happens when U-U binds. In this event, it could be shown that banks will lend 0-C3 when, ideally, they would like to lend more at a higher interest rate. Any event that adversely affects the creditworthiness of borrowers will have the effect of shifting S1 up, and of raising the equilibrium interest-rate level in the primary sub-market (or in any sub-market in Figure 6).36
Figure 6: A Stiglitz-Weiss Model with Two “Types” of Borrowers and a Usury Cap Interest rate
S3(RHR)
R3
S2(HR) D2(HR) S1(LR)
R2 U
U D1
R1
0
Volume of credit C0
C1
C2
C3
C4
Now consider the other portion of the credit market, which falls under the usuryexemption category. The second-tier market has several niches. Potential borrowers who are unable to access the primary market might try first to qualify as high-risk (HR) rather than, say, really high-risk (RHR). If they can, they will obtain credit by accessing lenders’ supply curve S2, borrowing at R2. If they fail, they must decide if they really need the loan even at a substantially higher rate (which will increase their financial fragility). If the answer is yes, they they’ll reconstitute their demand (as noted, the ‘migration’ of the demand curve as it moves leftward has been left out of this figure) and try for credit from 36
There is no way a priori to tell whether U-U is above R1. The test of this proposition is whether the banks would raise interest rates on their primary-market customers if U-U were removed. 26
the lenders in the really high-risk market (serviced by supply curve S3(RHR). If they succeed here, they’ll obtain credit at R3. We have mentioned that the usury-exemption clause has a great impact on the second-tier markets. What about the usury cap per se? The usury-capped part of the credit market is reserved for a limited portion of the market. Defaults in this market increase the share of the population that must operate in the exempt portion of the market. And because these small loans are unregulated, usurious rates can be charged as the credit-seeking and higher-risk population shifts ever further in a northwesterly direction. Note that changes in the level of the usury cap affect the distribution of creditseeking units between the capped and exempt portions of the market.. South Africa’s usury limits operate to define the same sort of spatial divide in its credit markets that has emerged as a result of banks’ strategic choices in the U.S. market. This divide in the U.S. can be attributed to a tangled socio-historical nexus involving income inequality, residential segregation, and redlining. The same is true for the South African situation. As such, both situations are objects of struggle. The South African spatial divide, however, can be defended as tracing out two market territories – one in which usury-law-conforming loans can be made, another in which they cannot. The Government of South Africa is currently debating whether to lift or systematically alter the usury cap. It is reasonable to surmise that a lifting of the usury cap would have the following effects. First, market rates may rise in the primary market (if the current usury cap ‘binds’). Second, the second-tier markets will grow in size, both on a per-loan basis and on an overall-volume basis. In effect, the second-tier supply curves in Figure 6 will most likely shift downward (and to the right). Third, default rates and riskiness may gravitate downward over time in the second-tier markets, to the extent that the artificial limit of R10,000 in this market forces borrowers to use sub-optimal amounts of money or to target sub-optimal expenditures. In effect, this would shift the second-tier demand curves to the right also. If the usury limit were lifted, a key question is whether lenders could retain their market power and thus their ability to extract significant rents in the credit markets. If they are engaging in usury in Keynes’ sense, such that they are emptying out the resources of their clients rather than engaging over time in a mutually-beneficial exchange with their clients, then faster is better, and the supply curves won’t shift. This question of market power is interlocked with the problem of barriers to entry in the South African banking market. 7. Making Transformation Viable: Summary and Policy Implications The problem of making transformation viable, as we have noted, is above all else a structural challenge. For ongoing businesses, an efficient transaction mechanism and access to the finance needed for operations and expansion are crucial needs. For those launching new business enterprises, technical support, start-up financing, and a means of conducting financial transactions are fundamental needs. For households, a mechanism for saving and access to the payments mechanism are fundamental. Behind this apparent commonality lies a diversity of actual circumstances: an optimal savings mechanism for a very rich household means access to global asset portfolios, whereas for a very poor household it means a place to store a small sum of local currency at a simple interest 27
rate; and similarly for businesses. And as our discussions of recent financial development in the U.S. and South Africa have emphasized, market forces are responding to needs at both ends of the market – the sophisticated wealthy household and established firm, and low-income businesses and people. We have characterized the situation as one of market bifurcation – the splitting of customer bases into distinct, if overlapping, groups. This has left us with a series of worried conjectures about the implications of processes of bifurcation in the credit and transactions-mechanism markets. First, we have explored the hypothesis that financial arrangements for lower-end customers are exploitative and unsustainable -- that is, aimed at deriving short-term profits from customers whose long-term viability is not protected. Second, we have hypothesized that the social spaces occupied by marginalized households and small businesses are becoming less and less secure, so that market divides are transformed into spatial and social divides. Third, we have conjectured that credit arrangements in lower-income communities are increasingly used to satisfy transactions needs due to cash shortages.37 If these conjectures are approximately right, then the growth process as a whole is being undercut by a dynamic of informalization to which the financial competition process as a whole, including foreign megabanks, is contributing. Opening banking markets to external competition will not stop this process – to the contrary, it may accelerate it. The received literature on development and finance, as we have seen, permits us to gain insights into many aspects of market processes in maturing economies. However, this literature helps us very little with these difficult questions. Its primary models focus on single markets, and usually examine credit-market questions with no attention to the transactions mechanism (from banks’ perspective, to liability-side dynamics). Further, this literature ignores financial firms’ strategies and market power. These limitations also mean that this literature pays no attention to the process of financial globalization. Overcoming these limitations in the finance/development literature will be the work of many years and of many researchers.38 But even while the process of economy theory development proceeds semi-autonomously, the economic development process must go on. In the remainder of this section, then, we draw out some policy implications of our discussion; this means building on our conjectures, knowing they are not verified conclusions. The conjectures set out above lead us to two principal concerns. First, are new arrangements for transactions mechanisms in lower-end credit and banking markets unsustainable for their users? We are particularly concerned about the emergence of exploitative interlinked transactions/credit arrangements. Second, what can and should be done to compensate for the effects of differential credit and capital flows to economic 37
The current situation in Zimbabwe offers an extreme illustration of the consequences of cash shortage in a lower-income area. For details, see articles on this topic in the Zimbabwe Independent, August 1, 2003, and in the Zimbabwe Standard, August 17, 2003. 38
A good place to start in rethinking modeling conventions is the widely-held assumption that self-interested economic agents have the information they need to make informed choices. This efficient-market assumption lies behind the idea that financial-firm strategies are irrelevant, and supports the ideas that overseas intermediaries are perfect substitutes for domestic intermediaries, development banks are extraneous, and low-income financial arrangements (even when they appear to be predatory or exploitative) are welfaremaximizing. 28
agents of different types -- and specifically, for gaps in the credit and capital available to large versus small and startup businesses, and to higher-income versus lower-income households? If credit-market flows and banking services are undercutting growth and increasing poverty in some social spaces even while encouraging growth in others, what can and should regulatory and social-investment policies do in response? This is a topic on which many people disagree; an example here is the debate in Brazil over whether BNDES and other banks should systematically invest in the Northeast. In sum, then, the first concern focuses on the transactions/saving problem, the second on the credit/accumulation problem. Both focii involve the problem of the financial exclusion of lower-income people, of lower-income communities, and even of lowerincome regions. This sort of exclusion can take the form of discrimination on the basis of race, gender, or nationality; or it can be a programmatic tendency. There is a lot more recent market-based experience with the first question than with the second. So we start with the first concern. Lower-Income Transaction Services: Recent U.S. Experiments. The rapid rise of the payday loan industry in the U.S. indicates that there are profits to be made in resolving temporal mismatches between the availability of money and the need to spend it. Payday loans constitute one (unsustainable) way to resolve this mismatch. Others are being explored. Some credit unions are aggressively trying to attract the unbanked in their market areas as regular or at least irregular customers. Two interesting experiments of this type are the People's Community Partnership Federal Credit Union, housed in a storefront in a West Oakland shopping center,39 and Jordan Credit Union, with four branches in the Southern Salt Lake Valley which concentrate on reaching Hispanic residents.40 Both involve significant community outreach and member-education efforts; in effect, both subsidize these new- customer campaigns with revenues from their other activities. Market-based experiments are also underway. One new phenomenon that is taking hold in Southern states is the “pay card.” Employers deposit net earnings directly into employees’ pay-card accounts, enabling the use of “pay cards” in stores or at ATMs. One example is Hibernia Bank’s ATM-Pay accounts, which involve a $4 startup fee and a flat monthly charge of $1. These cards reduce costs for employers; for banks, they involve low operating expenses and also the opportunity to attract new customers.41 Sometimes bank competition for new customers (as noted, the ultimate prize in banks’ merger wars) generates these experiments; in other cases, competition by nonbanks seeking entry into banking provides the impetus. For example, Walmart Corporation has been attempting to use an industrial-loan subsidiary registered in Utah to open up proprietary banking services in its stores. It included among its motives the aim of offering banking services to those currently without them; whether this is true or not, banks are likely to react by seeking out new transactions-account instruments.42 39
Carolyn Said, “Banking on the little guy,” San Francisco Chronicle, September 2, 2003, B1.
40
Jenifer Nii “Credit unions courting Hispanics,” Deseret Morning News, August 9, 2003, B12.
41
Sarah Anderson, “Asset for ‘the unbanked’,” Sunday Advocate (Baton Rouge, LA.), August 31, 2003. In the Louisiana market area, Anderson found that both Bank One and Union Planter bank were also offering paycard accounts. 42
Steven Oberbeck, “Is Wal-Mart poised for banking?” Salt Lake Tribune, E1, July 27, 2003. 29
A key question is how far these new services for the unbanked can be extended. The use of a card-based transaction account service, once initiated, may suggest other uses. For example, Global Axcess Corporation announced on September 3, 2003 that it would establish the “Community Technology Network Project,” in cooperation with the U.S. Department of Housing and Urban Development. The CTNP would provide free or discounted financial services via debit and/or credit cards that could also serve as storage/gateway devices for healthcare services, digital access, internet training programs, and computer equipment layaway programs for low-to-moderate income individuals and families residing in subsidized or public housing. This program is being launched in six cities, with the aim of 1 million enrolled residents by year-end 2004. Another question regarding the expansion of financial services to the unbanked is that of political willingness. In South Africa and in many other countries, those outside the formal banking system greatly outnumber those inside it; in the U.S., the opposite is the case – and the unbanked often are members of marginalized and politically vulnerable groups. This problem of political willingness has come to a head in a current controversy over expanding banking services to lower-income Hispanic and Latino residents. Note first that competition for Hispanic customers is rising – both because a disproportionate number of Hispanics are unbanked, and because annual remittances from the U.S. to Mexico exceed $9 billion (those to Latin America as a whole, $24 billion). Whereas the remittance business has previously been dominated by money-order businesses such as Western Union, banks are now entering it. The largest banks are building cross-border partnerships – Wells Fargo and BBV/Bancomer, Bank of America and Santander Serfin, and Citicorp with its recent acquisition Banamex.43 The political turn involves most banks’ willingness to accept foreign-government-issued identification cards when opening accounts. This constitutes no problem for legal immigrants and resident aliens; but the case of non-resident aliens may run afoul of recent U.S. geopolitical concerns.44 Section 326 of the USA Patriot Act of 2002 specifies that financial institutions can only open accounts from would-be customers who have a U.S. taxpayer identification number, as well as a photo ID that proves their residency. The issue has been controversial even within the Bush Administration; the banks involved have pointed out that they stand to lose customers, turning many people out of inclusion in the banking system.45 The issue is now being reconsidered in the U.S. Congress. Political willingness has also affected other efforts to address banking inequities. Some years ago, a number of cities in California and elsewhere in the U.S. moved to restrict ATM fees. This movement was blocked by the Office of the Comptroller of the Currency (OCC), a federal agency that has oversight of nationally-chartered banks. Currently, the OCC has proposed a new regulation that will exempt these banks from state and local 43
HSBC, by contrast, which lacks a nationwide branch network, has purchased the finance company Household International and is using it to open up the Hispanic market. It also bought the Mexican bank GFBital. 44
The primary cards at issue are the Mexican matricula card and the Guatemalan Consular Identification Card. Recent articles discussing this situation include Ben Jackson, “Foreign I.D. Ban Seen Damaging Immigrant Biz,” The American Banker, Community Banking section, p. 5, July 24, 2003; Ari Weinberg, “Banks Seek Credit With Hispanics,” Forbes.com, July 30, 2003; and Ricardo Alonso-Zaldivar, “Storm Swirls Around Mexican ID Card Use,” Los Angeles Times, July 31, 2003, A-14. 45
Wells Fargo estimates that it has opened about 80,000 accounts since November 2001 on the basis of the Mexican matricula card and the Guatemalan Consular Identification Card alone. 30
laws on predatory lending. In effect, only state-chartered banks will be covered by these laws, creating an uneven playing field. This will both make state legislators reluctant to pass such legislation (since it will disadvantage state-chartered banks) and provide statechartered banks with grounds for overturning such legislation in legal actions. Lower-Income Transaction Services: Recent South African Experiments. Given its huge profits and huge risks, the microcredit market in South Africa is extremely unstable; at the same time, the potential profits from tapping into this very sizeable market are huge. Consequently, alternatives have begun to emerge at an accelerating rate. Debit cards are rapidly becoming common. These cards’ spread is linked to the assurances their issuers have offered to retailers. These cards are often offered with benefits and linked services, which can be extensive.46 Other experiments involves new types of ATM/retailer linkages. For example, First National Bank has opened 800 “miniATMs” which provide access to cash at local stores. Official and semi-official entities have also entered this scenario. Ithala, the wholly owned subsidiary of provincial development agency Ithala Development Finance Corporation, opened more than 173000 new savings accounts and advanced 3300 new home and home improvement loans in the year to March.47 Discussions have occurred over the feasibility of a cross-bank transactions-account service that could be government subsidized. The South African Government’s PostBank is also exploring new means of bringing the unbanked into the financial-service nexus. The PostBank has a mandate to enhance access to financial services. On July 31, 2003, PostBank announced its intention to add a network of 3,000 high-end ATMs to the 6,500 ATMs it currently operates. It hopes to attract more unbanked to its “SmartSave” account, but also wants to offer an expanded menu of services, including the selling of cell-phone minutes. The costs of these machines and their operations would be absorbed by fees attached to customer transactions. Clearly, there is a traffic jam of options here; this jam is especially sticky because PostBank has not revealed its plan, nor made any effort to coordinate with any of South Africa’s banks. Recently, South African banker and economist David Porteous told a South African reporter that while there is money to be made in serving the low-end market in South Africa, “[I]f everyone is going in different directions, this creates the risk of the low-cost initiatives splintering.”48 Credit Flows to Lower-Income Areas: Recent Experience. The question of the conditions under which a flow of financial investments into a marginalized region or community is itself complex. Some of my previous work has addressed this subject, especially at a macro-structural level.49 A summary of the conclusions of that work may be useful here. 46
For example, First National Bank of South Africa offers these benefits: free 24-hour medical assistance helpline, emergency evacuation and an ambulance service, guaranteed hospital admission, a legal assistance helpline and a telephone teacher advice service. 47
Nicola Jenvey, ”Ithala shines in low-cost market,” Business Day (South Africa), Economy, Business & Finance; Pg. 12, July 23, 2003. 48
Rob Rose, “PostBank plans extra ATMs to reach the masses,” Business Day (South Africa), Economy, Business, and Finance, P. 15. In addition to the options discussed in the text, BSI2000 Inc. has announced a pilot program for an optical-card system. An example of failed good intentions due to lack of agreement among principals is the recent effort in the United Kingdom to create accounts for the unbanked sponsored by six major banks. 31
Received models in urban economic theory are uniformly pessimistic about the potential size of local-market multiplier effects; this pessimism can be offset by deploying solidarity-economy approaches and by having a clear grasp of the structural challenge involved. As a macro-structural proposition, the fundamental problem of spurring new business growth in any lower-income region is to push dollars into that area, to hold them there to recirculate, and refresh the amounts lent by establishing links with the secondary market.50 Any area targeted for revitalization can be regarded as a small open economy with a current- and capital-account surplus. The structural conditions for balanced reproduction are different depending on whether net capital outflows are positive or negative. It is best to attempt to spur growth in a stagnant area with relatively few healthy businesses when that area is the subject of a surplus on capital account (net capital inflows). This surplus will both help finance whatever goods are required from other spatial areas and, if it is sizable, generate positive spillover effects. In sum, then, using credit flows to correct imbalances in wealth and income levels requires coordination and scale, as well as favorable local macro-structural conditions. The efforts of community-based advocates, indigenous business leaders, and others, have led to innumerable experiments in credit provision. These experiments have ranged from the financing of affordable housing, to small-business incubators, to revolving loan funds, to infant-industry supports, to business- and commercial-center development, to microcredit programs (in the Grameen Bank, not South African, sense of the term). Undoubtedly it is important to exploit local comparative advantages, and to attempt to identify and synergize industrial clusters.51 But it is at least as important to take advantage of all opportunities to coordinate and leverage available resources – and especially to focus government contracts, government program expenditures, aid monies, and any other available resources. Operating at a sufficiently large scale that the trajectory of the market is altered is also crucial; in this way, positive spillovers and multiplier effects can be captured.52 How to attain the required leverage and scale of intervention so as to affect market trajectories is, of course, the central question, and the most difficult one. One method was 49
See, for example, Gary Dymski, “Business Strategy and Access to Capital in the Inner City,” Review of Black Political Economy 24(2-3): Winter 1996. Pp. 51-65; Gary Dymski, “Access to Capital and Inner-City Revitalization: Urban Policy after Proposition 209,” in Back to Shared Prosperity: The Growing Inequality of Wealth and Income in America, edited by Ray Marshall. Armonk, NY: M.E. Sharpe, 2000. Pp. 374-86; and Gary Dymski, “Can Entrepreneurial Incentives Revitalize the Urban Inner Core? A Spatial Input-Output Approach,” Journal of Economic Issues, June 2001, 35(2): 415-22. 50
This last element – refreshing of lent funds through a secondary-market mechanism – has been the hardest to achieve. It can be hoped that examples such as the Community Reinvestment Fund of Minneapolis, which operates as a secondary-market intermediary for community-development financial institutions, will be adopted elsewhere. 51
This is the central point of Michael Porter’s essay, “The Competitive Advantage of the Inner City,” Harvard Business Review, May-June 1995, p. 54. 52
These conclusions are based on studies of the Grameen Bank’s microenterprise program in Bangladesh, of the South Shore Bank’s success in Chicago, and of the successful development coordinated by Chinese American banks in Los Angeles’ San Gabriel Valley. See Gary Dymski, “Financing Strategies and Structures of Impoverishment: The Grameen and South Shore Models,” mimeo, Department of Economics, University of California, Riverside, February 1996; Gary Dymski and Lisa Mohanty, “Credit and Banking Structure: Insights from Asian and African-American Experience in Los Angeles,” American Economic Review Papers and Proceedings, May 1999, 89(2): Pp. 362-366; and Wei Li, Gary Dymski, Yu Zhou, and Maria Chee, “Banking on Social Capital in the Era of Globalization: Chinese Ethnobanks in Los Angeles,” Environment and Planning A. 33(12), 2001, Pp. 1923-48. 32
implemented in the Asian main-bank system – that is, resources were simply collected centrally and then directed centrally into agreed-on industries and spatial areas. A variety of means were used to insure competition for the available funds, but within the context of a “command” approach. Another method is to induce lenders to provide the requisite lending, either through incentives or through regulation of their activities. The prevailing example of inducement arrangements for banks is, perhaps, the U.S.’s Community Reinvestment Act (CRA) of 1977, together with the 1975 Home Mortgage Disclosure Act. These two acts provide information on the geographic distribution of mortgage lending, and also a means for community-based groups to get lenders to ‘come to the table’ to discuss their patterns of credit allocation and their loan instruments. The CRA itself is a relatively weak legal vehicle – it requires active participation from a mobilized popular base to have any effects on banks’ decisions. An approach that has been explored in the U.S. and in other countries involves partnerships among government, lower-income people (or the groups that represent them), and banking institutions. An interesting example pertaining to the unbanked comes from Canada. In Toronto in October 2002, RBC Bank partnered with community-based organizations to offer a service called “Cash and Save;” this fund. This partnership also operates the Social and Economic Development Innovations (SEDI); SEDI supports 10 LearnSave sites at which people can build up personal savings, have their savings matched by a federal contribution, and put it toward education or entrepreneurship options. The Macro Context of Micro Initiatives. Our focus has centered, in the main, on “micro” initiatives and mechanisms. It is important to keep in mind, And we must keep in mind that macro context is a crucial determinant of what is feasible and possible. It is completely fundamental that a robust and growing macroeconomy is a pre-requisite for putting in place effective micro initiatives. At the same time, a robust macroeconomy is not the only requirement for achieving prosperity among lower-income households or in lower-income spatial areas. If it were the only such requirement, then this entire discussion concerning mechanisms for broadening transactions mechanisms and credit flows would be extraneous. That is not, of course, the view taken here; though it is the view of some. Consider this quote from Chris Hart, chief economist at South Africa’s ABSA bank. Hart noted in an interview that the focus should be shifted away from large South African banks’ policies vis-a-vis the unbanked and toward the general levels of prosperity in South Africa; he noted that there was not enough focus on the real problem, which is unemployment: "Increase the general levels of prosperity and with an increase in income will come an increase in bank accounts."53 Conclusions Regarding to the Case of Brazil. Structurally, Brazil’s financial situation can be regarded as somewhere between the situations of the U.S. and South Africa. Like the U.S., Brazil’s banking market has been undergoing rapid changes – it has seen the influx of many foreign banks and numerous mergers, some of which involved the virtual disappearance of the state developmental banks. Like the U.S., there remains a robust banking market, with substantial competition for “upscale retail” customers. Like South Africa, Brazil’s commercial banks largely minimize their exposure to credit risks; indeed, 53
The quote appears in “Banks urged to find alternatives to woo unbanked,” by Rochelle McCauley, Business Day (South Africa), Economy, Business & Finance, p. 12, August 12, 2003. 33
Brazil’s average loan/asset ratio of about 35 percent is among the lowest in the world. And Brazil’s proportion of unbanked population, at approximately 37 percent, equals that of South Africa. And as in both South Africa and the U.S., there is inadequate credit for small and medium enterprises. Given this in-between situation of Brazil, the policy recommendations that follow from this paper are these:
First, regarding households: provide balance-sheet stabilization and a secure savings mechanism for those in the bottom two-thirds of the income/wealth distribution, and provide access to opportunities for accumulation of wealth and savings for the upper third. That is, bring the unbanked into the banking system; and expand the extent of financial options for those who are already in it.
Next, regarding business development: reduce barriers to credit and capital markets for at least targeted sectors of the small and medium enterprise sector.
Finally, develop policies that correct problems of discrimination or imbalance in the distribution of credit and financial services across regions within Brazil, or across urban areas within Brazil’s cities.
The balance between living expenses and earnings streams is precarious for so many households in Brazil that financial competition has concentrated on this area. As in the U.S. and South Africa, the intermixing of credit and transactions arrangements is common – even for those with bank accounts and stable employment. These arrangements take many forms, including debit cards, secured credit cards, lines of credit, and loans against paychecks. These innovative instruments represent some combination of the expansion of U.S. – style mainstream consumer credit markets, on the one hand, and of predatory –l ending (South African “microcredit”) arrangements, on the other. That is, these innovations all walk the line between easing living circumstances and deepening the extent of financial fragility. This market is so potentially deep that it is affecting the financial trajectory of the nation; the government statistics agency IBGE recently estimated that loans against paychecks could reach as high as 2.5 percent of Brazil’s GDP. As in the U.S. and South Africa, this competition involves domestic banks, nonbanks, and overseas banks, often in combination. Financial arrangements for the unbanked majority in Brazil, which have traditionally involved arrangements such as pawnbrokers and agiotagem (curb-market lenders), are now a growth industry. Lemon Bank, for example, offers credit and debit cards and savings accounts to the unbanked. Its minimum amounts are tiny, and checking services are available without annual fees. Lemon Bank is a spinoff of an online Argentine financial services company, Patagon, which was bought in 2002 by the Spanish bank Santander. Lemon Bank, which has 3,600 access points, many in favelas and in drugstores, is about to launch a media campaign aimed at opening 100,000 new accounts by year’s end. With so much attention to households’ transactions/credit nexus, the marketplace has overlooked other areas of need within Brazilian finance. Two such underdeveloped areas are mainstream consumer and small-business markets, especially for longer-term credit. The private markets are moving cautiously, if at all, in these markets. The difficulties faced by Santander and HSBC when they attempted to establish retail credit operations in 34
Brazil are taken by many to demonstrate that such markets are not feasible. But why not? One reason, as noted, surely is macroeconomic stagnation; another is the deterioration of real wages and the polarization of the wage structure. And another factor, as discussed above, is that credit-market arrangements that have predatory features (such as excessive interest rates) undercut the terrain available for “mainstream” (non-exploitative) credit arrangements, because they deepen financial fragility for households and firms,. The Brazilian government’s own banks, Banco do Brasil and Caixa Economica, offer short-term credit arrangements that are somewhere in-between mainstream and predatory. This brings us to three other areas of unmet credit need – small-scale finance for business startups; large-scale investments, especially aimed at overcoming regional inequality; and capital for the creation and expansion of larger-scale businesses, especially in areas of technological innovation. The first of these needs has been assigned, in Brazil, to government - and NGO - sponsored microcredit funds and programs. Now that regional development banks have been sold off, the second and third needs are virtually the exclusive concern of the Brazilian government’s development bank, BNDES, and its investment-capital bank, FINEP. As the above discussion of credit flows to lower-income areas illustrates, this is too much weight for these institutions to lift alone. At a minimum, the cooperation and focused efforts of the private banking sector, and of foreign banks in particular, are needed. Legislation like the U.S.’s Community Reinvestment Act could be helpful in spurring private-sector efforts in this direction, and in the development of innovative strategies for using credit and banking services to stabilize lower-income areas and regions. The government’s requirement that 2 percent of all assets be invested in microcredit is a step in the right direction. However, it is not a sufficient policy. As I have discussed elsewhere (see The Bank Merger Wave, cited in note 19), banking is a heavily subsidized and protected area of economic transactions. This creates special social obligations, especially in areas and with people that have historically been subject to social discrimination. It is not enough that banking sectors in developing economies – that is to say, all economies -- be profitable and stable; for as we have seen, this can be achieved via policies that deepen financial fragility in the broader population, and that undercut the terrain of primary credit markets and feed the informalization process. An expansionary macroeconomic environment would be helpful in reversing these trends, as the ABSA economist noted. But an expansionary macroeconomic environment is not sufficient. Banks are not bystanders to the micromarket processes that occur within the macroeconomic environment, whether good or bad; banks constitute a crucial component of the economic infrastructure. The Schumpeterian role is not pre-given; it can be played, or abandoned. There is no doubt that banking on transformation – finding ways to use credit and capital flows to enhance asset accumulation, to reverse informalization (or at least to socialize it), and to make households more income-secure and less financially fragile – poses a deeper and deeper challenge. But if those engaged in banking do not wrestle with this challenge, stable growth cannot be envisioned.
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