Financial Inclusion and Its Discontents

By Ingrid Harvold Kvangraven and Paulo L dos Santos, The New School for Social Research

1. Introduction

Financial inclusion has been embraced as an important development priority by a broad range of policy markers over the past decade. National governments, the G20, international financial institutions, and philanthropic foundations have all publicly committed themselves to strategies for financial inclusion in developing economies.[1] This commitment to financial inclusion has made microfinance—or access to credit and financial services for non-banked communities— the international development community’s most generously funded poverty reduction policy.[2] Advocates of financial inclusion justify this focus on the basis of a simple and seemingly intuitive line of reasoning: financial services like deposit accounts, savings, insurance, credit, and money remittances are often unavailable to low-income households, regions, and countries.[3] Where they are available, it is often only at prohibitively high prices.[4] Given that well-functioning financial systems are central to the functioning of developed economies, improvements in access to affordable financial services—notably through micro-credit and broader micro-finance initiatives—can make direct, independent contributions to better developmental outcomes for low-income households, regions, and economies. Hence the need to support financial inclusion.

Despite the influence of these arguments, a growing number of skeptics have questioned the purported benefits of financial inclusion, at least in the form presently pursued by its prominent advocates.[5] Skeptics have pointed to a large body of evidence that financial-inclusion, micro-finance, and micro-credit initiatives have, at best, failed to live up to their promises and,  at worst, have resulted in dramatic explosions in high-interest, oft predatory lending to low-income households, and in significant reductions in the welfare of borrowers and their communities.[6] If these critics are correct, the present focus by leading actors in international development on financial inclusion is misplaced, and fundamentally new thinking about the relationship between financial developments and broader improvements in economic performance is urgently needed.

This paper provides a summary review of the salient arguments in these debates. It contends that financial inclusion initiatives have indeed failed to live up to their promise, primarily because that promise was founded on the naive view that financial development will always and everywhere make positive contributions to growth. This view is naive because it fails to grapple with the complexity and context-specificity of the relationship between finance and the real economy in specific developmental experiences. It also betrays a common, and remarkably narrow, understanding of economic development as something primarily involving microeconomic, localized processes that may be promoted by commensurately small policies and interventions, like micro-finance, micro-credit, micro-enterprise, etc.[7] But poverty and underdevelopment are neither primarily caused by lack of access to finance, nor are they fundamentally micro-level, local problems.[8] In low-income communities, regions, or economies, there are manifold systemic obstacles to the development of transformative, high-productivity investment undertakings. Profit-driven intermediaries will not generally find it profitable to finance such enterprises. Without broader measures to address these systemic obstacles, the intermediaries promoted by financial-inclusion initiatives will largely focus either on financing the same type of low-value-added, labor-intensive undertakings that are already prevalent in those communities and regions, or on various forms of consumption lending.[9] Neither of these activities is likely to improve developmental outcomes; and consumption lending may often worsen the lives of borrowers and their communities. 

In light of these failings, the briefing points to an alternative, positive agenda in favor of the type of financial development that can contribute to positive developmental outcomes as part of broader national and international developmental strategies.

2. The Case for Financial Inclusion

As with many popular ideas in development, the World Bank has been in the forefront of  providing the salient analytical and policy arguments supporting advocacy for financial inclusion. It has itself identified financial inclusion as the “key” to achieving the World Bank Group’s goal of eliminating extreme poverty by 2030, and it has issued a call to action to achieve universal financial access by 2020.[10] Similar calls have been made by non-governmental and philanthropic organizations across the world, often in alliance with the World Bank.[11] The issue has become pervasive in discussions on development, as attested by The Guardian newspaper running its own blog hub on financial inclusion—sponsored by VISA.[12] In light of the World Bank’s prominence and influence in these debates, as well as its role in providing the analytical foundation for the argument for financial inclusion, it is appropriate to begin by considering the content and foundations of the World Bank’s interventions in support of financial inclusion provides a proxy for the larger discussion on micro-finance.

The financial inclusion interventions by the World Bank and others are broadly grounded in a series of research papers written in the early 1990s primarily by Bank staff about the relationship between financial and broader economic development.[13] These contributions point to informational problems and transactions costs inherent to financial relations—enterprises requiring external finance have knowledge lenders and equity holders do not generally have, which creates costs, conflicts of interest, and other problems that inhibit the flow of funds from investors or lenders to promising productive projects. The development of financial institutions and markets is seen to help in the reduction of these problems and costs. This in turn makes it more likely that innovative projects that drive economic development will be undertaken and that existing savings will be mobilized by the financial system.[14] The mobilization of savings is understood as distinct from the generation of savings, in line with Bagehot’s (1873) view that the principal obstacle to investment in an economy is not so much the savings rate but the ability of the “money market” to mobilize savings and allocate them to productive enterprise.

These arguments were deployed in the 1990s to support the development of securities markets,[15] and the liberalization of restrictions on the entry of foreign banks in developing countries.[16] More recently, they have been drawn upon to support financial inclusion in developing countries, primarily in the form of micro-finance and micro-credit initiatives, by a range of development organizations. Bank economists have argued that those initiatives contribute to the development of well-functioning credit markets. As such, they may encourage the establishment of new enterprises; increase the efficiency of the process of capital allocation by making it easier for households to support projects with potentially high returns; and enhance the generation of entrepreneurial ideas, since knowledge that good ideas are likely to be financially supported creates incentives for their development.[17] These initiatives can also reduce the growth of informal finance, which is typically expensive and often exploitative.[18]

In order to support these claims, a number of studies have used data from a broad range of countries to establish statistical associations between measures of access and usage of financial services and measures of economic and institutional development.[19] Despite the recognition by authors that their findings do not in any way suggest that financial access and usage cause better economic performance, the World Bank and others have published a range of reports and statements indicating that access to financial services can improve economic well-being and development.[20]

Finally,  this literature has treated financial inclusion as primarily a private, market-based affair, ignoring the role of public institutions. Advocates see a very limited role for states, dismissing the possibility of state-run development banks directly supplying financial services to low-income households, communities, or regions, on the basis that such banks are typically corrupt.[21] States are called upon to intervene only to ensure that market-based provision of financial services is effective and efficient.[22] According to the Bank’s 2014 Global Financial Development Report, the role of states in the promotion of financial inclusion should be centered on addressing “obstacles” like informational asymmetries and broader transactional problems likely to impair the smooth functioning of private credit markets.[23] This includes the creation of strong legal and regulatory frameworks, supporting the information environment, stimulating competition, and protecting consumers by promoting “financial literacy”.[24] As long as states address these issues, these contributions contend that market-based financial-inclusion, micro-finance, and micro-credit initiatives will result in positive developmental outcomes.

It is important to note that the intellectual thrust of these arguments is very much in line with a broader shift in economic thinking, according to which development is primarily a micro-level, and often local process. This shift is evident in the common view that development may be sufficiently advanced by policy promotion of things like petty enterprise, community-based organizations and the like, without much coordinated intervention aiming to effect structural economic changes in developing countries.[25] It is also evident in the increased belief that development policy should focus on “what works,” as established by Randomized Controlled Trials (RCTs) that by methodological definition can only tackle micro-level interventions.[26] Many of the documented failures of financial inclusion initiatives ultimately follow from this rather narrow and naive analytical framing of the process of economic development. 

3. The Problems

A growing number of critiques have challenged different elements of current arguments for financial inclusion along two broad grounds. First, the case for financial inclusion advanced most prominently by the World Bank relies on a naive view of the relationship between financial and real economic development sustaining them. Second, a growing stock of evidence concerning actual impact of micro-credit programs in developing countries belie facile claims that financial inclusion unambiguously results in positive developmental outcomes. We consider these two sets of arguments in turn.

a. A One-Size-Fits All View of Finance and Development

The most prominent arguments for financial inclusion effectively assume that there is a universal relationship between developments in financial markets and broader economic development.[27] As recently put by the World Bank,[28] “Empirical evidence at the micro and macro levels shows that inclusive financial systems are an important component to economic and social progress on the development agenda.” The evidence cited in support of this claim very much reflects its own “universalist” tenor.[29]

At the macro level, advocates have sought to make the case for financial inclusion by estimating statistical associations between measures of financial inclusion and broader economic activity using data from a range of different economies. But this type of estimation is only valid if the relationship between financial developments and macroeconomic outcomes is exactly the same across all countries and over time.[30] The Bank has already been sternly criticized for their over-reliance on cross-country estimations, which downplay the significance of the economic,  historical, and institutional specificities of each economy.[31] If the underlying relationships are not homogeneous across countries, this type of empirical work will  be one case  of garbage in, garbage out.

At the micro level, researchers associated with the Bank—like Cull et al. (2014)—have pointed to a series of RCTs concerning the impact of various financial-inclusion initiatives. But as the authors themselves rightly point out, findings established in RCTs “lack… external validity,” meaning that they say very little about what may happen in a different setting.[32] Yet this caveat did not prevent the World Bank and other proponents of financial inclusion from using the briefing by Cull et al. to support their claims that financial inclusion is universally capable of delivering positive developmental outcomes.[33] As with the claims founded on cross-country panel-data estimations, this is not an analytically valid conclusion

There is no reason to expect that all financial-intermediation services will have the same, universal impact on all economies, regions, or socio-economic strata. For instance, while credit extension can immediately improve the economic condition of borrowers and their regions, the durability and distribution of those gains depend not only on rates of interest, but also on purposes to which credit is put, particularly on whether it supports productive, speculative, or consumption undertakings.[34] Empirical evidence presented by Sarma and Pais (2011) similarly points to the fact that the relationship between financial access and human-development outcomes is highly variable across different countries. Some economies (like Iran, Thailand, and Turkey) have high measures of financial inclusion and low measures of human development, while others (Albania, Armenia, Peru, Mexico) have high measures of human development despite low measures of financial inclusion. This suggests the need for country and even community-specific consideration of the likely impact of individual financial services, including careful evaluations of the conditions and modalities of delivery under which each may be expected to make a positive contribution to specific developmental experiences. Instead of working along such lines, advocates of financial inclusion contend that well-regulated micro-credit and broader micro-finance initiatives will always, everywhere result in positive developmental outcomes.

b. What Advocates Leave Out

In addition to their poor analytical bases, advocacy interventions in favor of financial inclusion have often been less than forthright about empirical studies investigating the effects of those initiatives. A number of prominent studies dating back to the 1990s purporting to show that micro-credit programs have positive impacts in developing-country communities have been thoroughly debunked.[35] A comprehensive review of those studies funded and published by the British Department for International Development noted that “impact evaluations of micro finance suffer from weak methodologies and inadequate data,”[36] before concluding that “it remains unclear under what circumstances, and for whom, microfinance has been and could be of real, rather than imagined, benefit to poor people.”[37] This important study has not been reported in recent high-profile interventions advocating financial inclusion.[38]

Other studies have cast doubt on the claim that micro-finance interventions will consistently promote positive developmental outcomes. Karlan and Zinman (2009) and Banerjee et al. (2013) found no positive effects of micro-credit programs in Manila, Philippines, and Hyderabad, India, respectively, on measures such as borrowers’ incomes, access to medical care, and schooling. Influenced by many findings along these lines, the Bank’s own Independent Evaluation Office recently concluded that the link between access to finance and poverty alleviation is “neither certain nor well understood, given the evidence that, in spite of modest benefits, the promise of microfinance pulling millions out of poverty has not been fulfilled”.[39] Despite this intervention by its own independent watchdog, the World Bank continues to claim on its “Financial Inclusion” webpage that, “Financial inclusion is a key enabler to reducing poverty and boosting prosperity.[40]

If micro-credit initiatives cannot deliver improvements in the lives of the people and communities they target, the focus on them by international and development organizations represents a serious misallocation of the scarce resources that are devoted to developmental programs. But if those initiatives are in fact harmful to those people and communities, they pose a different and far deeper problem. Yet this is exactly what a growing multi-disciplinary literature on financial inclusion has  established in recent years.

The most prominent example of financial inclusion resulting in highly adverse outcomes for its intended beneficiaries comes from the U.S. subprime debacle. Promoted and touted as a vehicle for financial inclusion,[41] the push for subprime lending resulted in a veritable orgy of predatory lending and fraud.[42] Profit-driven financial institutions not only relentlessly took advantage of vulnerable families, but also engaged in widespread fraudulent behavior, misinforming investors and regulators.[43] The devastating results of this behavior for borrowers (and the world economy) are well known.

Financial inclusion projects in developing countries don’t have much better track records. Mexican micro-lender Compartamos, a firm supported by the World Bank’s International Finance Corporation (IFC), gained notoriety by charging exorbitant rates of interest on loans to poor households, mostly poor women.[44] According to some estimates, the interest rates on some loans were as high as 195%.[45] On the basis of such rates, Compartamos sustained astronomically high rates of return on assets of 17 percent, which allowed it to make a 2007 IPO that netted original investors a gain of US$400 million.[46]

In Bangladesh, Karim (2011) has eloquently shown with eight ethnographic studies the degrading realities of drawing upon social interconnections between co-borrowers to enforce repayment: public humiliation, social stigma, and even home invasions by fellow villagers to appropriate basic possessions in lieu of loan repayments. Suicides by over-indebted recipients of micro-loans in the Indian state of Andhra Pradesh led to a mass popular backlash in 2010 against a rapidly growing micro-credit industry that came to charge interest rates between 25 and 100 percent.[47] In Bolivia, excessive microfinance lending resulted in  street protests and hunger strikes.[48] In South Africa, severe indebtedness among miners at the Marikana platinum mine contributed to a strike, which culminated in the police killing of 34 miners – the worst episode of state violence to date in post-Apartheid South Africa.[49]

These are only a few of a large, growing list of examples documenting the devastating effects of financial inclusion initiatives.  Despite the growing volume of this critical literature, and seriousness of the developments it documents, the World Bank and other advocates of financial inclusion have not explicitly acknowledged its findings. A recent, prominent Report by the World Bank and the Better than Cash Alliance—a coalition of influential business and philanthropic organizations, including the Bill and Melinda Gates Foundation, Citi and MasterCard— acknowledged these problems only implicitly… by calling on governments to promote “financial literacy.”[50] The emphasis on financial literacy places the onus on the general population to protect itself against predation, and not on states to identify, prosecute, and stamp it out, or simply not to support the expansion of financial services that are likely to result in predation. Unfortunately, it seems many prominent advocates of financial inclusion appear unwilling to engage meaningfully with the actual track record of many of the initiatives they support.

4. The Perverse Effects of an Incorrect Hypothesis

The documented adverse effects of many financial inclusion initiatives in developing economies are not accidental. They very much reflect the multifaceted realities of economic and social underdevelopment. By arguing that a lack of access to financial services is a key, binding constraint on economic growth, prominent proponents of financial inclusion are in effect downplaying the many non-financial obstacles to economic development in many low-income communities, regions, and countries. Yet it is precisely the fact that economically underdeveloped areas face these obstacles that has ensured many financial inclusion initiatives have had perverse effects on the economic and social well being of their intended beneficiaries.

Underdevelopment is a condition defined by a large number of self-reinforcing obstacles and constraints on the emergence of transformative productive projects that increase the productivity of labor. The poverty of communities, regions, and economies reflects and in turn conditions weak infrastructures, obsolete technologies, small domestic markets, comparative and absolute external disadvantages, a lack of labor-market and entrepreneurial skills, and a broad range of other factors inhibiting economic and social development. These are deeper and more stubborn problems than a lack of access to affordable financial services. A painfully obvious instance of this was recently discovered by World Bank researchers, who found that 80 percent of surveyed adults without a formal bank account in Africa pointed to their lack of money as the reason for not having such an account.[51]

Financial inclusion pursued independently of broader efforts to address the many expressions of underdevelopment and poverty will be at best ineffective. At worst, it will effectively become a “powerful institutional and political barrier to sustainable economic and social development, and so also to poverty reduction.”[52] Financial intermediaries operating in areas where transformative productive projects face manifold obstacles to their success will tend not to finance them. If they finance productive enterprise at all, they will lend to the type of low-value-added, labor-intensive activities that are already common in those areas. Given low incomes and small markets, this support for some enterprises will at best displace already existing similar enterprises.[53] At worst, it will promote borrowing by enterprises with very low chances of success, driving borrowers into bankruptcy and possibly into poverty or further into poverty in many cases.[54] A concentration of scarce development resources on this type of activity takes resources away from efforts aiming to support industrialization efforts that can enhance productivity by taking advantage of increasing returns to scale.  As such, it effectively contributes to the infantilization and persistent deindustrialization of the regions involved.[55]

But loans to low-productivity enterprises are not the primary thing most micro-credit lenders do in low-income communities and regions. Sinclair (2012) points to estimates that between 50 and 90 percent of all micro-loans finance consumption. In a Harvard Business Review article, Beck and Ogden (2007) report on a statement by John Hatch, founder of prominent micro-finance organization FINCA, that about 90 percent of loans are used for consumption purposes.[56]Along similar lines, Hulme (2000) found that would-be borrowers would often claim they needed micro-loans to finance production undertakings when what they actually wanted  was credit to fund consumption expenditures.

Consumption credit has very different micro- and macroeconomic effects than credit supporting productive enterprise. At the microeconomic level, consumption credit always contains an expropriatory element, as interest payments are made by borrowers from income they secure independently from the loan. This is in stark contrast to productive types of credit, which generally sustain projects that generate the income flows from which interest payments are made.[57] At the macroeconomic level, there are both theoretical and empirical reasons to believe this type of lending does not contribute to growth and economic development in the way that credit-supporting productive undertakings does.[58]

The overwhelming orientation to consumption lending by micro-credit operators in low-income communities, regions, and economies is to be expected. It reflects the specific economic and social realities of those areas, which fundamentally shape credit-market behavior and outcomes. On the supply side, the generally low profitability of productive lending will push competitive banks to rely on other business lines. Given recent innovations in banking technologies and practices, this will typically involve business lines in consumption lending, which can be profitable even in underdeveloped areas.[59]

On the demand side, underdevelopment often means that access to credit is the only way in which households in low-income areas can meet basic consumption and service needs. Hulme (2000) documents how micro-credit borrowers use loans for basic consumption goods to pay for school fees, or to pay for emergency medical care. Economic vulnerability, poverty, and desperation not only push many to engage with micro credit lenders, but may also ensure that the terms of engagement are at the very least disadvantageous to borrowers. Predation, usury, and otherwise abusive lender behavior will likely follow. The emphasis on development strategies that force low-income households and communities into credit relations order to meet their basic needs in housing, health, and education, helps condition adverse or even abusive outcomes. It also tends to shift attention away from alternative strategies centered on the direct provision, including by states, of those services.

It is fair to conclude from this review that financial inclusion has failed to deliver on its promises because those promises were founded on two analytical errors—the view that a lack of access to financial services is a key, binding constraint on the process of economic development, and the belief that the relationship between financial and broader economic development is homogeneous across countries, time, and developmental experiences. Initiatives that have sought to alleviate financial constraints without broader interventions to address the particular realities of underdevelopment experienced by specific communities, regions, or economies have often created situations where sophisticated, profit-driven enterprises are effectively taking advantage of some of the world’s poorest households.

This perverse outcome underscores the need for a better, more contextualized and case-specific understanding of the role of innovations in financial institutions and practices in the process of economic development. It also offers a striking example of the serious problems with the presently common, narrow tendency to frame the problems of economic development on primarily or even exclusively microeconomic terms.

5. A Broader Agenda

To develop a broader and more effective understanding of the types of financial institutions, practices, and relations that can make positive contributions to low-income communities, regions, and economies, it is necessary to start with an explicit understanding of the nature of the problem of economic development. Since Adam Smith (1776), economists have understood that general improvements in living standards require increases in labor productivity, and that it is the process of industrialization that can deliver those increases. The popular view that financial inclusion and microcredit initiatives are viable developmental strategies refutes this basic insight from classical political economy, in favor of the rather dubious, recent view that a sufficient “scaling up” of petty enterprise can deliver economic development.[60] It effectively condemns low-income communities, regions, and economies to non-industrial “development” paths with no obvious sources of growth in labor productivity.

The process of industrialization poses a series of difficult challenges for non-industrialized economies, including formidable competitive, financial, and political obstacles arising as a result of the prior industrialization of other countries and regions. Despite these difficulties, a number of economies have successfully caught up (and in some cases surpassed) the levels of development of earlier industrializers. In almost all such cases, states pursued explicit financial-sector policies that supported broader developmental efforts.[61] These policies were varied and context specific. As Chang et al. (2013) explain through their case studies of the industrialization processes of Japan, Germany, the United States, South Korea, Singapore, Finland, Italy, Brazil, and China, the role that finance played in successful development experiences differed across economies. What’s more, the role that finance played in individual economies changed as they each experienced structural transformations and the nature of their developmental challenges evolved.

Despite this specificity, we contend those experiences suggest three broad sets of objectives, capacities, and actions in the financial sphere that are likely to help the process of industrialization. We also argue that the merits of different financial inclusion initiatives will be most usefully understood within the terms of this framing of the question.

First, successful experiences of belated development have consistently relied on different forms of development finance, including targeted financial support for important developmental undertakings unable to raise funds on market terms.[62] Many undertakings in infrastructure, heavy-industry, research-and-development, export-oriented production, educational and broader social welfare investments pose combinations of high risks, prohibitive transactional costs, or low short-run direct returns that will often make them unattractive to profit-driven financial intermediaries. The development of mandate-driven financial institutions tasked with supporting such projects as a part of explicit national industrial policies is a vital part of financial development.[63] Depending on the economy in question, this may include agricultural banks, housing banks, credit-unions or cooperatives, community development banks, as well as traditional development banks for larger scale projects.[64]

Second, targeted financial support on preferential terms creates important rents. Development finance thus requires the establishment of sufficient measures of transparency and political independence to allow public financial institutions to award and withdraw these rents in line with their best technical assessment of the changing contribution to a national development strategy made by any particular undertaking.[65] This is an onerous requirement for many developing political economies and requires the development of polities and state administrative bureaucracies capable of subordinating particular propertied interests to a deliberately formulated national interest.

Third, the promotion, generation, and mobilization of savings has played an important role in processes of belated industrialization.[66] Savings allow households in poverty or with modest incomes to accumulate assets, which could increase their resilience before unforeseen crises. This resilience is particularly important in light of the present consensus against public systems of provision for basic needs in health, education, retirement-income, or housing.[67]

More significantly, the provision of savings services can help the mobilization of resources to support larger-scale undertakings for development. This is an area where financial inclusion efforts are widely acknowledged to make a positive contribution to developmental outcomes. Postal and savings banks with their far reaching networks played an important role in the economic development of Britain, the United States, Germany, and Japan.[68] Electronic payment platforms may provide many developing countries with a more effective and less costly, twenty-first century version of such banks.[69] All efforts along these lines require the development of deposit guarantee schemes to protect savers.

With significant support by regulators and development banks, the development of new, safe savings networks can also support the development a sustainable model for small-scale financial inclusion centered on cooperative, or community banks. They will encourage the accumulation of one’s own savings, which are a preferred form of finance for small entrepreneurs.[70] They may also engage in support for productive undertakings at below-market rates for excluded groups, including small and medium-sized enterprises, self-employed workers, peasants, women and those without collateral.[71] This support could be provided in line with broader industrial-policy objectives that seek to alleviate the non-financial obstacles to the success of the productive and entrepreneurial undertakings of these would-be borrowers.

On these broad bases we believe that an agenda for financial development and financial inclusion could make a positive contribution to equitable patterns of economic growth.

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