0. Lecture 18: Financial Systems and Microfinance
Economic Development
Lecture 18: Financial Systems
and Microfinance

1. Overview Introduction Financial systems in developing countries
The role of central banks
Case Study: Hyperinflation in Zimbabwe
Alternatives to a central bank
Development banking
Informal banking
Reforming financial systems
The role of stock markets
Microfinance
Case Study: Grameen Bank

2. Introduction ‘Prudential regulation’
Real sector/economy v financial sector/economy
Which drives which?
Answer: Likely both!

3. Introduction Role of the financial sector: Payment services
Middle-man for savers and investors
Allocating credit efficiently
Distributing information
Managing risk
Increasing asset liquidity: ‘de-chunking’

4. Financial systems in developing countries
Monetarists v Keynesians
Monetarists:
Expand money supply => directly induce economic activity
Keynesians:
Expand money supply => increase amount of money for lending =>  interest rates =>  investment =>  economic activity

5. Financial systems in developing countries
Problems in developing countries:
Expanding/contracting money supply
Affecting interest rates
Why?
Coordination issues
Financial markets as ‘islands’
Multinational focus
Managed floating exchange rates

6. Financial systems in developing countries
Why? (cont.)
Foreign reserves a high proportion of finance
Currency substitution
Information gaps
Scarcity of funds
Low sensitivity to interest rates
Result?
Duel monetary systems (to varying extents…)

7. The role of central banks
Issue currency
Manage foreign reserves
Act as bank to the government
Act as reserve bank to commercial banks
Financial regulator
Monetary policymaker

8. The role of central banks
Problems in developing countries:
Human capital deficit
Credibility issues
Lack of political independence
Beholden to imprudent fiscal policy

9. Case study: Hyperinflation in Zimbabwe
Hyperinflation = inflation > 50% per month
Started in Zimbabwe in March 2007
1997 – 2007:
Cumulative inflation = 3.8 bn %
Living standards fell by 38%
Effect on savings, financial capital

10. Exchange rates: comparing the $Z with the Weimar Mark

11. Case study: Hyperinflation in Zimbabwe
Cause?
Government fiscal policy
Reserve bank has lost credibility, and thus ability to target inflation
Attempted solutions:
The denomination was changed
Inflation was declared illegal (!!)
Reserve bank continued to make declarations on its inflation targets...

12. Notes from the now defunct $Z…

13. Case study: Hyperinflation in Zimbabwe
Result?
Foreign currencies adopted illegally
Barter
...then foreign currencies adopted legally!
Possible solutions?
‘Dollarisation’
Currency board
Free banking

16. Alternatives to a central bank
Currency board
‘Transitional central banking institution’
Supranational central bank
Outsourcing
Pegging
Currency enclave
‘Open-economy central banking institution’
Activist banking

17. Development banking Activist banking = development banking?
Medium and long-term funds for industrial expansion
Supranational development banks
National development banks
Direct involvement in enterprise
…but not small loans

18. Informal banking Usury Income inequality Microfinance?
Rotating savings and credit associations?

19. Reforming financial systems
Financial liberalisation?
Money market price ceilings
Financial repression
Private efficiency v social efficiency

20. Reforming financial systems
Financial regulation: the Stiglitz list of market failures:
Lack of public monitoring
Institutional free-riding: overallocation and underallocation of funds
Bank failure induces a run on the banks
Missing insurance markets
Abuse of market power
Private v social returns
Investment information gaps

21. The role of stock markets
Do they promote economic growth?
Benefits:
Increased liquidity
Risk diversification
Role for government?
Reducing barriers to entry

22. Microfinance
Access to credit for investment: a way to help the poor ‘plug the savings gap’
Why not normal finance?
Administration cost
Lack of collateral

23. Case study: Grameen Bank
Background:
Muhammad Yunus (Banker to the Poor)
Nobel Peace Prize 2006
Grameen Bank (‘Bank of the villages’)
Now has assets worth $750m
Almost 25,000 employees

24. Case study: Grameen Bank
Features of Grameen Bank:
Group lending
Targets women (over 90%)
Targets poor villages and households
Small loans ($100 to $200)
Weekly repayments
Dual-purpose meetings

25. Case study: Grameen Bank
Positive matching:
Good-risk people want to group with other good-risk people
Risky people driven out
Peer monitoring:
Each member bears risk of all members’ projects

26. Case study: Grameen Bank
Drawbacks:
Pressure to choose overly safe investment projects
If one member has to default, all other members will want to default also
Partial solution to default problem is to lend sequentially to group members