Economic Development
Lecture 18: Financial Systems
and Microfinance
Life Impact | The University of Adelaide
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 1
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
Introduction
• ‘Prudential regulation’
• Real sector/economy v financial
sector/economy
– Which drives which?
– Answer: Likely both!
Slide 2
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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’
Slide 3
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 4
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 5
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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…)
Slide 6
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 7
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
The role of central banks
• Problems in developing countries:
• Human capital deficit
• Credibility issues
• Lack of political independence
• Beholden to imprudent fiscal policy
Slide 8
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 9
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
Exchange rates: comparing
the $Z with the Weimar Mark
Slide 10
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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...
Slide 11
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
Notes
from the
now
defunct
$Z…
Slide 12
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
Case study: Hyperinflation in Zimbabwe
• Result?
– Foreign currencies adopted illegally
– Barter
– ...then foreign currencies adopted legally!
• Possible solutions?
– ‘Dollarisation’
– Currency board
– Free banking
Slide 13
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Slide 14
Michael Cornish
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Slide 15
Michael Cornish
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 16
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 17
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
Informal banking
• Usury
• Income inequality
• Microfinance?
• Rotating savings and credit associations?
Slide 18
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
Reforming financial systems
• Financial liberalisation?
– Money market price ceilings
– Financial repression
– Private efficiency v social efficiency
Slide 19
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 20
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
The role of stock markets
• Do they promote economic growth?
• Benefits:
– Increased liquidity
– Risk diversification
• Role for government?
– Reducing barriers to entry
Slide 21
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 22
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 23
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 24
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 25
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Michael Cornish
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
Slide 26
University of Papua New Guinea
Lecture 18: Financial Systems and Microfinance
Slide 27
Michael Cornish
University of Papua New Guinea