Lessons of Experience No. 6: Financial Institutions

To prosper, developing economies must build strong financial sectors that operate successfully in a climate of rapid change. IFC shares its experience in financial markets investing and predicts future directions in the sector.

150 Pages | © 1998IFC | ISBN 0-8213-4343-2


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"Capital is made at home", wrote the influential Columbia University economist Ragnar Nurkse in 1953. His point is still true today. Most productive projects and enterprises in a country are financed locally and generate revenues in local currency.

Domestic capital formation is the driving force behind any country's development, and effective domestic financial institutions are one of its most important facilitators. They are the key channel between savings and investment, and their efficiency is a key determinant of a country's economic growth. At the same time, foreign investment has a critical role to play. Its presence often brings with it foreign technical know-how, competitive pricing, higher standards of disclosure and performance--all of which can promote the efficiency in local markets that is so important to economic growth. One must balance between too much and too little external exposure. See the chart below for an illustration of this concept:

To prosper, developing economies must build strong financial sectors that operate successfully in a climate of rapid change. Capital markets are being deeply affected by three major ongoing developments: the state's changing role, the globalization of markets, and urbanization/industrialization.

The global trend of narrowing the state's boundaries of economic intervention has affected the financial sector both directly (free interest and exchange rates, less directed credit, privatized banks, workouts of bad portfolios) and indirectly (more private borrowers/issuers, larger demand for private short- and long-term finance, increased volatility). Consequently, developing countries need long-term investment in privatized and restructured banks, start-ups of new private banks, modernized equity markets, and assistance with hedging mechanisms and derivative markets that can manage the risks of price volatility that often come with financial sector liberalization.

With today's globalization of money flows, corporations, financial institutions, and regulations has come rapid change in technologies and quick transfers of those technologies (both hard--e.g., computers-and soft--e.g., structuring of securities issues) throughout the world. Needs are arising in the developing world for over-the-counter equity markets to satisfy the financing requirements of small firms and for better regulation of new financial products. At the same time, more countries that have not yet received substantial private capital flows are starting to build up the financial infrastructure to begin receiving them and need help in structuring it in ways that allow them to benefit from globalization.

The demographic changes leading to rapid urbanization and the trend toward industrialization have also created a new set of needs for private housing finance, private pension fund managers, private life insurance, and long-term bond markets to support privately financed infrastructure. All of these developments will add necessary breadth and depth to developing world financial sectors.

Three Categories of Activity

Many developing countries can benefit from outside assistance in undertaking three major tasks: building financial infrastructure, improving the ability of small savers and investors to access financial services, and attracting international capital. To build financial infrastructure, many developing economies are addressing the following areas:
 

• promoting and regulating private sector financial institutions
• structuring and regulating investment funds, pension funds, insurance companies and other institutional investors
• mobilizing funds through intermediaries
• developing or refining policies regarding sectoral development and the role and regulation of private players
• creating or improving market systems and institutions.

Progress must be made at both the institutional level (mainly setting up new intermediaries or fund vehicles along with private partners and lending to intermediaries)--and at the regulatory level (usually through policy dialogue with government agencies or technical assistance projects on specific issues).

The essential lessons learned at the institutional level can be summarized in a few points:

1. Management and governance matter enormously.

2. Good banks need good borrowers. A sound portfolio is a sine qua non for financial intermediaries, and therefore risk assessment is one of the key skills required.

3. Thoughtful initial agreements save great pain later. Problems that may occur over the life of an institution must be anticipated as accurately as possible. Some of the issues to consider include: clarity of the role of the dominant owner; clarity of the government role as regulator or, in some cases, as part owner; the degree of eventual "indigenization" sought and plans to bring it about; and mechanisms for resolving disputes among owners on key issues such as strategic focus, investment limits, portfolio diversification, and arm's-length transactions.

4. The mobilization of local savings must not be displaced. When lending foreign exchange, care must be taken to structure covenants that add value by strengthening the intermediary. This can be done by meeting a need that the local market is not filling (often providing different products like liquidity facilities or longer term loans). It is also important not to distort local prices by lending at rates below those appropriate for the tenor, risk, and currency. The credit should not be "directed" so tightly that it discourages the most productive enterprises from being funded first.

In providing regulatory and technical assistance, it is essential to:

1. Work with the right local counterpart.

2. Create a level playing field among financial instruments.

3. Balance incentives to private sector participants so that outcomes are for the common good. Such actions are critical for a sustainable commercial system. Making this thinking clear to both private intermediaries and government officials can be a difficult process.

4. Listen to all important constituents and provide adequate business incentives. This formula yields the most workable results. Regulatory regimes often fall short when the needs of the wide variety of players involved in the financial markets are not understood. For example, a securities law may look fine to a lawyer, but if brokers can't make money following the law, and registrars survive only on kickbacks, and custody isn't secure, then the market system is bound to fail. Distortions, promoted by government or agency lending, can create reckless borrowing and unsustainable commercial lending operations.

To improve access for small savers and borrowers to financial services, it is important to strengthen local intermediaries, since they are closer to the ultimate borrowers and savers and understand the risks better. Three types of activities are a natural choice:
 

• providing venture capital funds that pool investors' equity and place it under professional local management
• lending to local banks and credit institutions for onlending
• helping to establish leasing companies that create their own customer base of small or medium-size borrowers.

Lessons learned from participating in each of these activities include the following:
1. Venture capital funds need a minimum critical size to be able to support well-motivated management. Two-tiered structures in which the management company can be disciplined easily are preferable. A wary eye cast on feasibility studies will ward off a host of problems. Ensuring that managers have sufficient deal flow to be choosy is difficult to achieve in small countries or restricted regulatory environments. Timing is also key-IFC was about four or five years too early with venture capital in Spain and about eight years too early in Argentina. One must ask how many years too early many of the funds being considered for true frontier markets are, given the lack of exit mechanisms such as stock markets.

2. Lending to intermediaries for onlending is most likely to succeed if the intermediary has a commitment to building real expertise with small and medium-size enterprises (SMEs) and to term lending and has a ready pipeline of good borrowers. Programs are least successful when intermediaries are simply seeking general funding and intend to focus on the SME sector only for the duration of the program.

3. Leasing companies can be quite successful. They have been threatened when the regulatory regime allows banks to enter the leasing business that they fund with cheap deposits (often not paying depositors a positive real rate of return) but does not, in turn, allow leasing companies to take deposits from the public. Countries where specialized leasing companies dominate usually finance more of their fixed assets through leasing and have more successful leasing industries. This is important for small businesses that rely more on leasing for their financing than big companies do.

Attracting international capital can help close the gap between local savings and investment needs. IFC efforts in this area have concentrated on:
 

• policy advice and technical assistance
• portfolio investment funds
• private equity funds
• corporate debt funds
• fund management companies
• the Emerging Markets Data Base and index funds
• underwriting and the placement of securities.

A number of key lessons have been learned:

1. Foreign investment is responsive to information. Early efforts to promote foreign portfolio investment focused on providing information about markets, their regulation, and their financial returns to a wide international audience. This eventually paid off in the formation of the early country funds and in the creation of the IFC Emerging Markets Indexes, which were the first to track and benchmark emerging securities markets.

2. Foreign portfolio investment usually has an importance for market development far beyond the actual dollars invested. The presence of professional foreign institutional investors usually leads to healthy changes in market regulation, better disclosure, and more market services (such as custody, transfer agents, and registry).

3. Money flows to markets with the best regulatory environments or to markets that are seen to have exceptional return potential. Foreign portfolio investment has grown fivefold in the last decade, but more than 70 percent of that money still goes to only 12 mostly middle-income, high-population countries, and is still a relatively small portion of GDP in most. The challenge ahead lies in improving the domestic infrastructure and regulatory environments of other countries so they too can attract the international capital needed to fund productive business and to improve their market infrastructure.

Future Directions

The financial sector is one of the most dynamic and innovative of all the various components of an economy, out of necessity constantly remaking itself with new products and techniques. In the developing world, basic policies and regulatory institutions also are often quickly being remade. Therefore, the rate of financial sector change can be particularly speedy.

The new emphasis, at least for IFC, in the coming years will likely be in four main areas:
 

• Helping to create local currency vehicles for savings and investing, including debt market vehicles, local mutual funds for debt and equity, and local institutional investors such as private pension funds and insurance companies
• Introducing new products and helping authorities and private institutions adapt to globalization, including further work in securitization, derivatives products and regulation, and refinement of local securities market and banking standards to meet international norms
  
• Meeting the needs of a growing middle class and underserved small business sector, including housing finance, commercial microfinance institutions, and consumer credit information
  
• Assisting in creating and deepening bond markets, including advising regulators on specific issues such as securitization rules and bondholder claim aggregation; participating in multilateral efforts that include the World Bank, the International Monetary Fund, and others to encourage the issuance of term government paper to create yield curves; setting up credit rating agencies; investing in bond guarantee houses; helping to structure local securitized and unsecuritized bond issues; and providing guarantees in local currency for local debt instruments.