Law and Finance in Emerging Markets - Essay Example

? TABLE OF CONTENTS Microfinance 2 Introduction 2 Characteristics of the Micro Finance 6 Drawbacks of Microfinance s 8 Background Study ofMicrofinance Institutions 10 Evidence on Finance and Growth 12 Innovations in Microfinance 19 Conclusions 22 Bibliography 24 Books 24 Articles 24 Websites 24 27 Microfinance Introduction Despite promoting access to finance to the poor, microfinance is not fully effective in alleviating poverty. Microfinance has achieved the distinction of being an invaluable advance in financial markets. Nevertheless, the extent of its influence in mitigating poverty is difficult to assess. This work deals with an analysis of the effectiveness of microfinance in reducing poverty. In this endeavour the back ground and characteristics of microfinance, the strengths and weaknesses of microfinance, impact of microfinance on poverty, and the various microfinance institutions and their governance have been discussed. Lastly, drawbacks in the working conditions of microfinance had been scrutinised. In addition, several innovations with regard to the alleviation of poverty, by promoting access to finance to the poor, developed by various countries, have been examined. Finally, conclusions were arrived at. The microfinance innovation has not been restricted to the developing countries. Europe has witnessed such innovations during the 19th century. For instance, the credit union notion was developed by Raiffeissen and his supporters. This initiative emerged from an earnest intention to break the stranglehold of the moneylenders over the rural populace and to better their lot. Such unions have burgeoned, since the 1870s, in the Rhine Province and other regions of the German States. This cooperative movement was adopted by the countries of Europe and North America, and finally spread to the developing nations. Poverty alleviation and enhancement of economic growth are objectives that can be realised by improving access to financial services. However, from the practical point of view, considerable difficulty has been experienced by the commercial banks, in providing better financial access to the poor and low income households.1 This situation has engendered certain financial innovations that provide more and better financial assistance. These innovations include; contract designs, product innovations, and regulatory policy. Recent developments in behavioural economics and randomised evaluation techniques have provided greater insight into improving financial access to poor and low income households.2 It is crucial to provide access to financial services, as the number of adult individuals without such access is of the order of 2.7 billion. The betterment of access to financial services enables families to create assets, countenance risks and defray regular expenses in a planned manner. Microfinance that addresses the genuine needs of the poor has the capacity to enhance family income.3 In addition, it improves the health and education of the children in the family, which in turn leads to less absenteeism from school. Access to finance for small market vendors has been discussed in the sequel. The provision of saving facilities to small market vendors enables them to maintain higher inventories of stock and thereby generate higher income. It is to be realised that microenterprises constitute the largest employer in many countries with low income. However, these entities frequently do not have access to credit and savings facilities, which has a detrimental effect on their growth.4 As such, this lack of access to financial services prevents microenterprises from investing in fixed capital, improving their turn over and employing the required number of staff. In addition, firms require savings, insurance and payment services. These services enable them to address risks in a better fashion and provide them with the required confidence to participate in new investments.5 As such, lack of access to finance markets causes many unwarranted difficulties to small firms. In general, the importance of financial delivery systems lies in their capacity to enhance efficiency, while mitigating the costs of public policy interventions. During the past few decades, several financial services providers for the poor have come to the forefront. Some examples of these financial services providers are; non – government organisations, cooperatives, commercial and national banks, insurance, post offices and telecommunication services.6 It is to be examined as to what constitutes poverty, its underlying causes and effective solutions. It can be surmised that low annual income level in a household denotes a state of poverty. Consequently, if the average income level can be increased, there would be a reduction in poverty.7 In addition, it is an undisputed observation that finance is generated to a much greater extent in the credit markets than the equity markets. This is especially true of the developing nations. In credit markets the dominant position is that of the bank. However, in a large number of such countries, the major problems are due to crony capitalism, directed lending and related lending. In addition, a major issue in the area of corporate governance arises due to banks being corporations, which in turn leads to loans being sanctioned to managers, politically influential persons and shareholders.8 Analysing credit markets from the legal origin perspective resulted in a focus that was based on the law of bankruptcy instead of the more relevant law of secured credit. Furthermore, the concentration was on reorganisation and not liquidation. Absence of land titles in a significant number of countries makes it imperative to focus on the law of secured credit. This is due to the non – availability of mortgages on land. Secured credit law has frequently proved to be flawed, due to the absence of self – help remedies and protracted court procedures.9 However, the judiciary in quite a few developing countries is weak. This renders the law of secured credit significant, as bankruptcy proceedings tend to be unreliable and time consuming. Credit registries in such nations, could provide a partial substitute for judicial proceedings. In these nations, legal origin is of significance for the efficiency of the rights of creditors. However, as demonstrated by reliable evidence, legal origin is not of much significance in the developing countries. Moreover, there is not much in common with regard to the law pertaining to credit markets in different countries. This has been clearly illustrated with regard to the UK and US bankruptcy laws, and the several disparities to be found in the transition countries with regard to secured credit law.10 This makes the situation of the developing countries, with respect to finance markets, vulnerable to the whims and fancies of the economically powerful entities.Prior to analysing the implications of microfinance with regard to financial accessibility to the poor, the characteristics of the microfinance are to be examined. Characteristics of the Micro Finance The presence of a favourable environment makes it possible to address the requirements of a sizeable section of society, via microfinance. Such benefit trickles down even to those occupying the lowest strata of society. Furthermore, there is considerable empirical evidence to assert that microfinance can prove to be beneficial to the poorest sections of society.11 However, lack of proper implementation of regulations by the institutions has rendered the situation, in reality, disadvantageous to the poor. All the same, to its credit, microfinance is being promoted by a number of competent institutions, such as NGOs, cooperatives, credit unions, finance companies and banks. These entities have developed and implemented novel techniques to provide credit, savings and other services to penurious clients. In the past, the NGOs had been the chief providers of microfinance.12 This has changed drastically, with several national and international banks, and financial institutions foraying into this area. Moreover, information and communication technologies have undergone vast changes. This has made it possible to mitigate the cost and risk of providing microfinance to the deprived. Some of the clients of microfinance consist of female heads of the house, small businesses, self – employed persons, displaced individuals, small and marginal farmers and people who are usually precluded from the traditional banking system.13 As such, microfinance has been assumed to cater to the needs of the downtrodden. Moreover, microfinance is governed by microfinance institutions. Hence, before arriving at any conclusion regarding the effectiveness of microfinance, weaknesses in the microfinance institutions have to be taken up for discussion. Drawbacks of Microfinance Institutions Microcredit, from its inception, has been presumed to possess the capacity to uplift the poor. It was believed that this result would be achieved due to the funding of the microenterprises of the poor and due to increase in their income. Several instances of people having benefited from microfinance have been cited in support of this contention.14 Nevertheless, there are serious misgivings regarding the overall effectiveness of microfinance, and the perceived benefits seem to have been exaggerated. It has proved very difficult to subject the impact of microfinance to scientific testing. For instance, a person who seems to have derived substantial benefit from microfinance could have achieved success, even in the absence of such assistance. In several of the cases, it was observed that the benefitted person had the necessary ambition and motivation to achieve success, which was independent of receiving a microloan.15 In this context it has been contended that the conclusion of the various studies that had attributed extraordinary success to microfinance was suspect. In fact the methodology and conclusion of these studies were subsequently found to be of dubious value and unreliable. Recently, some researchers employed randomised controlled tests (RCTs) to assess the impact of microfinance. In this strategy, two sufficiently large groups are selected and only one of these groups is provided with loans. Subsequently, the results achieved by these groups are compared.16 Such comparison, interestingly, revealed that the benefits were restricted to the short term. In the long run, there was no improvement in consumption or household income. However, several more tests have to be conducted, prior to arriving at any generalisation, regarding the long term benefits of microfinance. The benefit of microfinance is not restricted to merely increasing the income and consumption of the poor. As shown in various places, financial instruments are indispensable for the survival of those belonging to poor households. The formality associated with microfinance, in comparison to other financial instruments, makes it less popular with the poor. All the same, informal instruments are unreliable, in addition to having several other disadvantages.17 Moreover, a poor person in need of money may find that his investment in informal instruments is not immediately forthcoming, which defeats the very purpose of his having invested in that financial instrument. As such, Microfinance does provide the benefit of reliability, which could prove to be crucial for the economic survival of a poor family. Moreover, since microfinance is provided by reputed institutions, the providers of such assistance have been seen to be reliable. However, it is difficult for a poor person to avail of its benefits. For example, despite its latent potential, European microcredit suffers from being diverse. Such diversity can be attributed to the diversity in the Member States legal and institutional systems and the multiplicity to be found in the microfinance institutions. The outcome of this state of affairs is that there is considerable variation in the lending practices of the microfinance institutions.18 In fact, the parameters that come into play while providing financial assistance by these institutions vary with their nature, legal setup, working environment and capacity to implement efficient management principles. Background Study of Microfinance Institutions Any institution should work within the sphere of national policies. These connote what is preferred. The projected goals necessitate among other things, the enforcement of certain rules and codes of conduct. Institutions constitute a combination of rules and behavioural standards that prescribe the relations between agents and the organisations that enforce these tenets and codes of conduct.19 Obviously, an explicit institutional framework that is seized with alleviating poverty and promoting economic growth does not exist. Substantial trading in large public firms has been frequently observed in the UK. There is a correlation between the adoption of policies and the development of institutions. As such, institutional structure influences behaviour, which in turn could effect change in institutional structures. Policymakers, businessmen or members of the community are some of the entities that constitute builders of institutions. Some instances of public institutions are the corporate, collateral and bankruptcy laws, and the judiciary, tax collection agencies and regulatory agencies.20 Furthermore, under the aegis of public institutions, a significant number of private institutions have been observed to function. For instance, the private sector banks function under the aegis of the public law. Rules can be enforced either internally by the relevant parties or externally by some third party.21 Furthermore, informal institutions and private formal mechanisms achieve enforcement through their own members. The constituents of informal groups are individual agents, a familiar instance being the informal group of business associations in the area of mutual insurance. Such initiatives are all the more evident where the expenditure entailed reduces significantly, due to adoption of collective action.22 Furthermore, these initiatives have the added advantage of making the task of supervising the implementation of the applicable rules. Evidence on Finance and Growth Finance and growth are interdependent. There is substantial evidence that growth is promoted by finance. The relevant empirical evidence is to be found at the country, sector, and individual firm and household levels. Provision of finance at a greater level has been demonstrated to effect growth. Thus, the World Bank’s statistics show that a 2% increase in the rate of growth of GDP can be correlated to a doubling of private sector credit to GDP.23 Several ways exist for the growth of financial influences. For instance, growth is assisted by finance by collecting and merging funds, permitting the undertaking of greater risk in investments, allocating resources for the best productive use, supervision over the employment of funds, and provision of instruments for reducing risk. From the perspective of promoting growth, the efficient provision of such services proves to be more important than the nature of the entities providing these services. It would be an exercise in futility to attempt to identify a particular type of financial system as being more conducive to improving access to financial services, in comparison to the other financial services.24 As such, finance improves the distribution of income and reduces poverty, via several systems. The principal benefit of finance is that it promotes economic growth, which in turn improves the overall income levels. Specificity is achieved by finance as it distributes opportunity in an equitable manner. Several research studies have shown that finance is crucial for the smaller firms and poor households. As such, it has been discovered by researchers that income inequality is significantly reduced by financial development. At the same time it was noticed that the concentration of income resulted in higher poverty levels. Some researchers had found that microfinance mitigated poverty by reducing credit constraints, which in turn alleviated the child labour situation and insured against shocks. 25 Improvement in growth and the alleviation of poverty have been deemed to be of great significance. These objectives can be achieved by widening access to finance. Microfinance is one of the techniques for promoting such goals, and has the capacity to emerge as a major strategy for eradicating poverty. The Millennium Development Goals (MDG) of the United Nations had considered policies that improve access to finance as being vitally important to its success. Thus, during a conference in Mexico, in the year 2002, the wealthy nations and the developing countries came to an understanding regarding their obligations for achieving the MDGs. With this conference, it became evident that microfinance was to be promoted, especially when it was commercially viable. 26 The global markets should be employed by policy initiatives that aim to promote development and put an end to poverty. Technological breakthroughs, liberalisation of trade and the abolition of limits on capital flows, have brought about the unprecedented growth of global markets. In general, banking and investment markets do not have borders. This is in marked contrast to the regulators and their legal systems, which are limited by jurisdictional requirements. This situation resulted in the advent of an international system of regulation, in the area of international finance. Some of the regulatory entities are the IMF, World Bank and quasi – formal regulatory networks that incorporate an international focus. 27 This quasi – formal system of international regulators is led by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions. The Basel Committee on Banking Supervision has formulated a system of regulatory norms that pertain to the supervision of international banks. The objective of these entities is to address the challenges arising from the integrated international markets.28 In addition, there is a concerted effort to bring about the convergence of national regulatory mechanisms. Microfinance holds the promise of providing financial assistance to the low income households. It aims to do so, despite the absence of collateral security and the relatively steep transaction costs. This form of financial assistance can help poor households to engage in savings. This suggests that a focus on eradicating the constraints to saving could prove more beneficial than concentrating chiefly on credit. 29 The drawback to this seemingly exhilarating initiative is that it very difficult if not impossible to establish new institutions. Moreover, microfinance, by and large has been seen to provide funding for self ­ – employment activities. In general, the latter category of activities merely supplements the income of the borrowers and do not engender any basic change to the extant employment patterns.30 Microfinance seldom succeeds in generating new jobs. Moreover, it has not achieved any measure of success in areas with seasonal income patterns and low population densities. In the absence of specific legal accommodation and strong leadership, microfinance’s effect on alleviating poverty levels is doubtful. 31 The South Asian nations have assiduously addressed themselves to the task of developing their financial markets. This has principally been attempted via reform to their banking sector and capital markets, and financial liberalisation. A measure of financial deepening has been realised with regard to the financial markets of this region. However, a number of unresolved issues continue to persist. Some of these include the absence of legal underpinnings for commercial transactions and financial services, inability to apply best practices during the regulation and supervision of financial markets and institutions, and the restricted nature of the formal finance sector. 32 It would be extremely fallacious to contend that poverty reduction is chiefly achieved by implementing stringent usury laws and the promotion of microfinance firms. Mainstream financial depth is, per se, considerably correlated to lower poverty levels.33 This does not hold good for microfinance, which is complementary and not an alternative to mainstream finance, in the areas of poverty alleviation. Till such time as microfinance institutions do not grow to the extent required for sustainability, their similarities with mainstream finance will not be manifest. While promoting micro and mainstream finance, the objective of protecting the vulnerable from credit market abuses should not be overlooked.34 Lack of proper implementation methods made the microfinance institutions, inferior to the institutions of main stream finance. In addition, the absence of access to formal financial services compels the poor of the developing countries to resort to a limited set of informal financial services. The latter are beset with considerable risk and are in addition expensive. As a consequence, the poor have very few avenues to fully take part in markets, enhance their income and contribute to the growth of the economy.35 Some of the reasons behind this distressing situation are; governmental restrictions on banks, absence of adequate infrastructure in the financial sector, and the barely profitable or even loss associated with financing clients with low income. In quite a few countries, microfinance institutions provide financial services to the poor. Although some of these entities have achieved a measure of success in reducing poverty, there have been a significant number of such institutions that have had negligible influence in alleviating poverty.36 This state of affairs indicates that it would be incorrect to declare that microfinance institutions have a substantial influence in reducing poverty. Moreover, such institutions labour under a number of disadvantages. For instance, they do not have the wherewithal to marshal adequate funds and combine risks over very large areas. This is in marked contrast to the formal financial institutions. In addition, the majority of the microfinance institutions enjoy a limited coverage. In fact, as demonstrated by some scholars, these institutions, in most of the countries, do not reach even 2% of the population.37 On the other hand, credit unions, and development and postal banks have a much larger number of clients. Nevertheless, the reach of these institutions is limited to a very small proportion of the bankable population. The outcome is that these institutions are unsuccessful in independently addressing the gap in the provision of financial services.38 This constitutes a major issue, which can be resolved only if the formal private sector institutions significantly increase the provision of financial services. In addition, the obstacles to this objective have to be identified and resolved to the extent possible. Development of the financial sector has the capacity to improve growth in the long term. This takes place due to the effect of such development on the progress of technology and influence on the accumulation of capital. As such, this transpires due to increase in the savings rate, availability of savings for investment, inflows of foreign capital, and optimisation of capital allocation between competing demands.39 The channels that influence overall growth are the same as those that access to financial services employs in order to mitigate poverty. This transpires due to enhanced investment and productivity, which in turn significantly improves income generation. The requirement is to concentrate on novel means of promoting wider formal sector provision, while eradicating barriers. In addition, regulatory reform has to take due cognisance of the extent to which private sector financial institutions have been provided with incentives and the freedom that they possess with regard to improving access.40 Innovations in Microfinance Since two decades, there has been significant progress with regard to outreach to the poor, via a variety of microfinance institutions. All the same, the situation is dismal with a mere 2% of the population in developing countries being clients of such institutions. This has effectively prevented access to credit, insurance services and savings, as far as the poor are concerned.41 To compound the troubles, there are few microfinance institutions that can boast of financial sustainability. It has been very clearly demonstrated that institutional innovation in microfinance coupled with bold experimentation in adapting various types of microfinance institutions to local environments, results in novel and promising approaches, such as village banking and the linkage model. These innovations were fundamentally dependent on the financial support provided by donors and the state and were not the outcome of market forces.42 The concentration had been on establishing cost effective microfinance institutions that were consistent with the market principles and could reach the poorer sections of society. As such, innovation stands to benefit tremendously if the private banking sector improves it involvement. For example, Professor Yunus of Bangladesh formulated a programme based on research and action, in order to solve the problem of the poor with regard to banking. His experimental credit programme, in this regard was implemented in hundreds of villages. This pioneer in microfinance, established a special relationship with rural banks, which enabled him to disburse and recover thousands of loans.43 However, the banks did not take over this exemplary project after its completion, on the grounds that the risk entailed in such credit was excessive and that this project would ultimately prove to be extremely expensive. Subsequently, better sense prevailed and the Grameen Bank was established in the year 1983, with the support of donors. This exemplary institution, as of the year 2001, had more than 2 million borrowers.44 Moreover, in Indonesia, the microfinance movement has been spearheaded by the Bank Rakyat Indonesia (BRI). It constitutes the largest microfinance institution in the developing world. It is state owned and provides facilities to around 22 million microsavers of microbanks. The latter have shown high profitability.45 Microfinance institutions have been seen to achieve some success in societies that incorporate strong formal institutions. These institutions frequently achieve lower profitability in their endeavour to promote better outreach and the economic development of the community. An important factor that affects microfinance institutions is corruption. The lower the corruption the lesser the overall costs to be borne by these institutions. Lower corruption has the outcome of lowering of loan impairment, which in turn promotes lower costs.46 It is to be borne in mind that microfinance is still in the incipient stage, Vis – a – Vis global finance. A considerable amount of innovation is required, in order to provide adequate access to financial services to people who are unable to access the traditional banking system. The unflagging development of groups, villages, women and entrepreneurs, under the aegis of microfinance institutions necessitates access to better tools. This is a condicio sine qua non, and in addition, such institutions have to perforce be profitable and sustainable, if they are to prove beneficial to the poor and if they are to destroy the seemingly inexorable cycle of poverty.47 It has been generally noticed that an assortment of financial services have to be provided to the poor. Consequently, realisation has dawned that the mere increase in the paltry income of the poor is to be supplanted by the provision of a wide range of financial services. As such, the poor labour under the disadvantages of deprival of power and vulnerability. Therefore, it is very important not to lose sight of these elements, while analysing their problem.48 Conclusions The poor have to initially achieve a degree of security. This is a prerequisite for their growth and betterment. The poor have a vast array of financial needs, and the provision of flexible services that address these needs is indispensable, if it is to be relevant and useful for the poor. However, in matters of realisation of its objectives, microfinance is not successful to the fullest. Stringent regulation of the microfinance institutions and lack of knowledge among the poor made the system of microfinance a failure. This is because any meaningful innovation has to sincerely seek to reduce the cost of transactions for both the microfinance institutions as well as their clients. Moreover, access to savings services could be of greater importance to the poor than credit. Organisational functioning also affects the efficiency of microfinance. This can be attributed to the onerous nature of the task of collecting local data and mitigating poverty. Misgivings have been expressed in several quarters, regarding the feasibility of delegating this critical task to commercial organisations. There can be no resistance to apportioning donor and public funds to strategies aimed at bettering wellbeing and the efficiency of the market. The focus had been on implementing microfinance institutions that were cost effective, in conformity with market principles and were blessed with the capability of being within the reach of the poorer sections of society. As such, innovation stands to benefit tremendously if the private banking sector improves it involvement in this oft neglected sphere of activity. Thus, microfinance in its contemporary incarnation is exploitative, unstable and unsustainable. A major feature of microfinance is that it cannot be relied upon to achieve the good of all. Moreover, microfinance chiefly supports informal activities and most of these activities enjoy a low market demand. Some effect has been discerned with regard to impact on the poverty level of borrowers; however, this is due to the redistribution of income or short term income generation. As a result, it can be concluded that the overall effect of microfinance, in the area of alleviating poverty is negligible. Bibliography Books Johnson, S & B Rogaly, Microfinance and Poverty Reduction, Oxfam, 1997. Audretsch, DB, O Falck & S Heblich, Handbook of Research on Innovation and Entrepreneurship, Edward Elgar Publishing, 2011. Articles Claessens, S, 'Access to Financial Services: A Review of the Issues and Public Policy Objectives', The World Bank Research Observer, vol. 21, no. 2, 2006, pp. 207 – 240. Morduch, J, 'The Microfinance Promise', Journal of Economic Literature, vol. 37, 1999, pp. 1569 – 1614. Websites Avgouleas, E, International financial regulation, access to finance, systemic stability, and development, Brooks World Poverty Institute Working Paper No. 49, June 2008, retrieved 29 April 2012 . Dam, KW, Credit Markets, Creditors’ Rights and Economic Development, Social Science Research Network, February 2006, retrieved 27 April 2012 . Development & Cooperation – EuropeAid, Better access to finance for poor people, European Commission, 17 February 2012, retrieved 26 April 2012 . Does Microfinance Help Poor People?, CGAP, 2012, retrieved 27 April 2012 . Engerman, SL & KL Sokoloff, Factor Endowments, Inequality, and paths of Development Among New World Economies, National Bureau of Economic Research Working Paper No. 9259, October 2002, retrieved 23 April 2012 . Honohan, P, Financial Sector Policy and the Poor: Selected Findings and Issues, 2005, retrieved 30 April 2012 . Karlan, D & J Morduch, Access to Finance, retrieved 27 April 2012 . Morduch, J & B Haley, Analysis of the Effects of Microfinance on Poverty Reduction, NYU Wagner Working Paper No. 1014, 28 June 2002, retrieved 23 April 2012 . News & Broadcast, Microfinance and Financial Inclusion, The World Bank, March 2012, retrieved 27 April 2012 . Regional Policy – Inforegio, Special support instruments JASMINE – European Code of Good Conduct for Microcredit Provision, European Commission, 23 April 2012, retrieved 26 April 2012 . South Asia Economic Report, Financial Sector in South Asia: Recent Developments and Challenges, Asian Development Bank, May 2009, retrieved 30 April 2012 . The Importance of Financial Sector Development for Growth and Poverty Reduction, Department for International Development Policy Division Working Paper, August 2004, retrieved 30 April 2012 . Zeller, M, Promoting Institutional Innovation in Microfinance Replicating Best Practices Is not Enough, 10 January 2001, retrieved 30 April 2012 . Read More