Rural Finance Strategy

Inter-American Development Bank

Washington, D. C.

Sustainable Development DepartmentSector Strategy and Policy Papers Series

Cataloging-in-Publication provided byInter-American Development BankFelipe Herrera Library

Wenner, Mark.

Rural finance strategy / [by Mark Wenner].

p.cm. (Sustainable Development Department Sector strat-egy papers series ; RUR-104)Includes bibilographical references.

1. Rural development projects--Finance. 2. Rural developmentprojects--Planning.

3. Inter-American Development Bank. I. Inter-American Deve l-opment Bank. Sustainable Development Dept. Rural DevelopmentUnit. II. Title. III. Series.

630 W665—dc21

This document was prepared by Mark Wenner, financial specialist in theRural Development Unit of the Sustainable Development Department.The document was prepared under the technical supervision of AntonioVives. The following persons also provided valuable inputs: MargueriteBerger (SDS/MSM), Glenn Westley (SDS/MSM), Francisco Proenza(FAO/IDB Cooperative Program), Kim Staking (RE3/FI3), BibianaVásquez (MIF), Fernando Villamizar (RE2/EN2), René Cáceres (POL),Ruben Echeverría (SDS/RUR), Jaime Fernández (RE3/FI3), Ramon Fre-diani (RE1/FI1), Kurt Focke (RE2/FI2), William Armstrong (RE2/FI2),Edgar Carvajal (COF/CEC), Guillermo Arrivillaga (COF/CPE), TerryPowers (RE2/RE2), Julio Luna (retired staff), John Horton (RE2/EN2),Hugo Cohan (RE3/EN3), Michael O’Donnell (COF/CTT), Paul Trapido(COF/CHO), and William Green (EVO).

This strategy (GN-2123-3) was favorably considered by the Bank'sBoard of Executive Directors on June 27, 2001.

December 2001

This publication (Reference No. RUR-104) can be obtained from:

Rural Development UnitSustainable Development DepartmentInter-American Development Bank1300 New York Avenue, N.W.Washington, D.C. 20577

E-mail: sdsinfo@iadb.orgFax: 202-623-1708Website: http://www.iadb.org/sds/

Foreword

This document builds on Bank efforts over the past year to define a strat-egy to carry out the mandates of the Eighth Replenishment related to thedevelopment of rural financial markets. The 1994 Agreement for theEighth Replenishment of the IDB’s capital specifically calls for a com-mitment to reduce poverty and social exclusion through a “wide range ofactivities ...[including] rural development, job creation, particularlythrough the microenterprise and business sectors... [and] actions to boostthe production capacity of small farmers.”

The rural finance strategy is the result of an extensive process of back-ground research and external and internal consultation. Civil society or-ganizations, academics, the governments of the region, and institutionsactive in rural finance reviewed the profile and annotated outlines for thestrategy and provided comments. The document was also the subject ofconsultations with an interdepartmental rural finance strategy group,chaired by SDS/MIC and consisting of representatives from each of thethree regional departments, the Multilateral Investment Fund, variouscentral department divisions, and the Office of the Presidency. A paperon the lessons learned in IDB rural lending operations was also preparedto support this strategy.

The rural finance strategy is designed as a companion and complementto other technical and strategy documents, including Sustainable RuralDevelopment (GN-1909), Financial Markets (GN-1948-3), Microenter-prise Development (GN-1938-3), Agricultural Development in LatinAmerica and the Caribbean (GN-2069-2), Rural Poverty Reduction(GN-1995-5), and Renewing the Commitment to Development: Institu-tional Strategy (GN-2077-1), all previously considered by the Policy andEvaluation Committee of the Board of Directors .

This document puts forward the rationale, objectives, and areas of actionof the Bank’s rural finance strategy.

Carlos M. JarqueManagerSustainable Development Department

Contents

Executive Summary i

I. Introduction 1Purpose and ObjectiveHistorical LegacyCurrent Situation: Lack of Depth and Limited Access PersistThe Importance of Financial Sector Development

II. Bank Support for Rural Financial Development 4The Bank’s Lending ExperienceLessons LearnedTargeted CreditSector and Regulatory ReformInstitutional Strengthening of Financial IntermediariesProgram Execution: Bank Monitoring and Supervision

III. Problems and Solutions in Rural Finance 8General Problems in Rural Financial MarketsSpecific Problems to be Addressed in Rural Financial MarketsProposed Solutions

IV. The Bank’s Objective, Roles, and Strategy 17ObjectiveConsistency with Related StrategiesRolesStrategyActions to Remedy Problems and Relevant Instruments

V. Implementation 24PrioritiesProposed Action PlansTarget Countries and Sequencing of InterventionsOrganizational Implications and Recommendations

VI. Conclusions 28

References 30

Annexes 37

Executive Summary

Purpose and Objective of the Strategy

The principal purpose of this strategy is to orientthe operational staff of the Bank responsible fordesigning rural finance projects. In so doing, itcomplements and extends the financial marketsstrategy. The secondary purposes of the strategyare: to serve as a point of departure for discussionsbetween the Bank and member governments onthis topic; to help member governments designtheir own rural finance strategies; and to assist theBank management in understanding the issues andinstitutional implications of adopting and imple-menting the strategy.

The objective of the Bank’s rural finance strategyis to promote the provision of efficient, broadly-based, and sustainable rural financial services. Inorder to achieve this end, actions are being pro-posed in three areas: (1) creation of a favorableeconomic, legal, and financial regulatory environ-ment; (2) creation of sustainable and efficientfinancial intermediaries dedicated to serving ruralareas; and (3) promotion of new financial services,such as insurance, leasing and factoring, in thosemarkets where the first two actions are well ad-vanced.

The document is not specifically focused on agri-cultural finance but recognizes agricultural produc-tion and marketing as the significant part of mostrural economies in present-day Latin America andthe Caribbean. The rural, nonfarm sector is anincreasing by important part of the rural economy,representing a growing share of total rural incomeand employment. Accordingly, much of the docu-ment highlights issues such as the need to developfinancial services other than short-term credit(namely medium- and long-term credit, deposits,insurance, leasing, and inventory credit) that willspecifically enhance the productivity and expansionpossibilities of nonfarm service, processing, andmanufacturing enterprises.

This is one of the last strategy documents to beprepared by Management prior to the consolid a-tion and review of all strategies and policies man-dated by the Bank’s Institutional Strategy (GN-2077-1).

Background

Rural financial markets do not function properlyin Latin America and the Caribbean. Rural resi-dents, who account for 30 percent of the region’stotal population, have limited access to formalfinancial services, face a small array of financialproducts, and pay high costs for the financialservices that they can access. The underdevelo p-ment of financial markets has a negative effect onproductivity enhancing investments, income ex-pansion, and sectoral growth.

Financial markets do not function properly becauseof a triad of pervasive problems including unmit i-gated risk, imperfect information, and high transac-tion costs. In the past, interventions such as creditquotas and subsidized interest rates largely focusedon treating symptoms such as lack of access bysmall- and medium-scale farmers and businessoperators without an understanding of the underly-ing factors that shape rural financial markets andmake small- and medium-scale producers non-preferred clients. Consequently, the results wereunsatisfactory and new efforts are required toaddress the underlying problems.

Strategy

The rural finance strategy addresses the mainissues that hamper the growth and development ofmore complete and efficient rural financial marketsand how the Inter-American Bank can best promoteand support market-based reforms. The strategyfocuses on how to improve access to four specificfinancial services: credit, deposits, insurance, andpayments transfers. It is compatible with and is alogical extension of the Financial Market Strategy(GN 1948-3). The primary, but not exclusive, target

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group is low- and moderate-income rural entrepre-neurs involved in both farm and nonfarm produc-tive and commercial activities. As changes comesto Latin America’s rural areas, more of the ruralpopulation will depend on nonfarm activities. Inmany instances, nonfarm activities are and will bemore easily bankable than agricultural activities.Nonetheless, improved functioning of rural finan-cial markets is critical to support the modernizationof agriculture as called for in the strategy for theagricultural development in Latin America and theCaribbean (GN-2069-2), especially the develop-ment of efficient medium-sized farmers and theswitch from low-profit, lower yielding crops tomore high-profit, higher yielding crops. The im-provement of rural financial markets is also impor-tant in order to reinforce the growth of the nonfarmeconomy, a segment of the rural economy that isbecoming increasingly important over time in termsof its share of total rural income and employment.

The aim of the Bank's rural finance strategy is tosystematically remove the constraints on both thedemand for and the supply of financial services inrural areas, thereby allowing profitable interme-diation and risk-sharing. Because the Bank haspolicy-based lending and technical assistanceinstruments at its disposal, it has a comparativeadvantage in focusing on the enabling policyenvironment. The recommended sequence ofactions for the Bank (which depends on a suitablemacroeconomic environment, overall bankingsector strength, a high level of government com-mitment, and the presence of capable counter-parts), is to engage in the following four steps:

1. removing biases in sectoral economic policiesthat have reduced the profitability and com-petitiveness of rural economic activities;

2. removing biases in the legal and regulatoryframework that have increased the risk andcost of financial intermediation in rural areas;

3. strengthening and improving financial retailcapacity for rural financial services; and

4. help to introduce new products and servicesfor rural finance, once the policy environmentis favorable and a number of solvent and ca-pable financial intermediaries exist.

Taken together, these four steps help address theproblems mentioned earlier: unmitigated risk,imperfect information, and high transactions costs.The more favorable the particular policy andinstitutional setting is in a country, the greater thepossibility for simultaneous action in two or moreof these areas.

Implementation

During the period 2000-05, the strategy proposesthat each Regional Operational Department shoulddetermine which countries could benefit from amore proactive intervention by the Bank in the ruralfinance sector. The Departments should prepareaction plans, on rural finance for those countries tobe discussed with the authorities as part of thenormal country programming process, with the goalof including operations to implement the plan. Theaction plans will be based on diagnostic studies anddialogue with significant actors in member bor-rowing countries. Effective implementation willrequire a review of operating procedures andchanges in the way the Bank does its businessbecause its partners will be primarily private sectorentities.

Cost of Strategy Implementation

The Bank can make progress toward implement-ing the strategy with existing resources. However,full implementation may require the reallocationof staff and budgetary resources because the typeof operations being proposed will be labor inten-sive and therefore high cost.

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I. Introduction

Purpose and Objective

The main purpose of this strategy document is tohelp the operational staff of the Bank design andprepare rural finance projects that reflect thecurrent state of knowledge in development fi-nance. Other purposes are: (1) providing the basisof discussion and dialogue with private sector andpublic sector counterparts in borrowing membercountries interested in promoting rural finance orparticipating in Bank-sponsored rural financeprojects; (2) helping borrowing member govern-ments design their own rural finance strategies;and (3) helping Bank management understand theissues and the budgetary and administrative impli-cations of implementing the proposed strategy.The intended audiences are Bank staff and man-agement, government officials in member coun-tries, and the staff and management of financialintermediaries in borrowing member countries.

The objective of this strategy is to promote theprovision of efficient, broadly-based, and sustain-able rural financial services. In order to achievethis end, concerted actions will be needed in thefollowing areas: (1) the creation of a favorablepolicy, legal, and regulatory environment; (2) thecreation and strengthening of sustainable financialinstitutions dedicated to serving rural clients; and(3) in those markets where the first two objectivesare well advanced, the promotion of new andinnovative financial products and agricultural riskmanagement techniques (deposits, crop insurance,electronic cards, leasing, factoring, warehousereceipts, contract farming, and hedging instru-ments).

Rural financial markets have not functioned wellin Latin America and the Caribbean. The discus-sion below that follows centers on the historicallegacy, the current situation, and why better func-tioning markets are important.1

1 See Echeverría (2001) for a description of the rural

Historical Legacy

Between 1950 and the early 1990s, the countriesof Latin America and the Caribbean relied on agovernment-driven approach to serve the financialneeds of their rural sectors. The norm was of largetargeted and subsidized credit programs imple-mented through state-owned specialized agricul-tural development banks and private commercialfinancial entities. The objective was to improveaccess to credit for small farmers and thereby spuragricultural growth, expand income and reducepoverty. Despite substantial efforts and the best ofintentions, evaluations of credit programs spon-sored by various international development agen-cies indicate that results were less than expected.Neither was access to timely credit at reasonableterms by low-income rural customers substantiallyimproved nor were viable financial intermediariescreated. Accelerated growth and poverty allevia-tion goals remained largely unfilled. Developmentof other important financial services, such asdeposits and insurance, were neglected despitedemand.

Since the late 1980s and early 1990s, the majorityof countries in the region have initiated massivefinancial sector reforms which include the liberali-zation of interest rates; the liquidation of insolventbanks and the rehabilitation of others; the liquida-tion of some insolvent state-owned banks, thereform and conversion of others to second-tierinstitutions; the improvement of prudential normsand supervision; the reduction of legal reserverequirements; the elimination of targeted creditprograms; and the opening of the industry toforeign-owned banks.2 These changes have re-

development context in Latin America and the Carib-bean, in which the development of rural financialmarkets is an essential element.2 The IDB approved 13 financial sector loans and 18investment sector loans (many of which had finan-

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sulted in higher investment efficiency, greaterbanking competition, and a wider offering offinancial products and services. However, thesevisible improvements have largely benefited urbanresidents, and further innovation and reform arerequired to benefit rural res idents.

Current Situation:Lack of Depth and Limited Access Persist

Whereas some improvements have been made inurban financial markets, rural financial marketscontinue to be underdeveloped. For example,despite the general trend of increas ing economy-wide financial depth (as measured by M2/GDP)throughout the region in the 1990s, for 5 out 9countries with available data, the amount of creditto agriculture as a percent of agricultural GDPdeclined when comparing the pre- or early reformperiod of 1990-92 to the late-reform period 1994-96 (Wenner and Proenza, 2000).3 During this sametime period, agricultural output growth rates weregenerally positive, suggesting profitability andalternative sources of financing. Similarly, timedeposits and savings as a percent of GDP trendedupward for a majority of countries but for threecountries with disaggregated urban-rural data inthe mid 1990s, the amount of rural deposits as ashare of total deposits is minuscule and virtuallyconstant over time (less than 1 percent for Brazil,Chile, and Honduras). Based on recent surveysfrom seven countries, access rates to formal creditcontinue to be low (with the exception of CostaRica). Excluding Costa Rica (40 percent), theaverage rate was 10.3 percent. The predominantsources of credit continue to be the informal sec-

cial sector reform components) between 1990 and1998. Similarly, the World Bank financed 26 finan-cial sector adjustment related operations in LatinAmerica in the period of 1985-1996. See: Wenner,forthcoming and Financial Sector Reform: A Re-view of World Bank Assistance (1998).

3 Agricultural credit is a proxy for rural credit due tolack of fully disaggregated data. The decline in thesupply of agricultural credit per se is not an accuratemeasure of rural financial depth because, in the past,some part was believed to have been diverted tononfarm, urban uses.

tor, that is, friends, family, traders/suppliers, andmoneylenders (Wenner and Proenza, 2000).4

The Importance ofFinancial Sector Development

Historically, financial sector development hasbeen an important underlying element in overalleconomic growth and development for three rea-sons. First, financial sector development unleashesthe economic potential of increasingly greaterproportions of the population and accelerateseconomic growth through efficient intermediationand risk management. Countries with more devel-oped financial markets and greater financial depth(as measured by the ratio of M2 to Gross Domes-tic Product) have grown faster, other things equal,than countries with less articulated financial mar-kets. People who have not had access to the formalfinancial sector either because of low income,gender or social discrimination, or because theylive in remote locations represent a large andpotentially profitable market for financial institu-tions that can overcome the risk and transactioncosts of serving these segments. In the LatinAmerican and Caribbean countries, 30 percent ofthe total population is rural and a significant pro-portion is believed to be bankable but under-served.5 This untapped market represents both asubstantial social and private economic loss.

Second, the lack of adequate financial services anddeep financial markets hinders the formation ofnew enterprises and the expansion and moderni-zation of existing ones and contributes to incomeinequality. Those fortunate enough to have access

4 Some rural residents may not want to go into debt.However, a fraction of this group may not seekcredit due to adverse risk-return tradeoffs (i.e., col-lateral requirements several times the value of theloan amount) that can be made more favorable withappropriate policy and legal reform.

5 If the urban microfinance experience can be usedas a guide, the expansion of financial services willfirst benefit the upper poor. Some proportion of therural poor, simply will not be bankable and otherinterventions in education, health, and infrastructurewill help to increase income-earning potential.

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to credit and deposit services can increase theirincome faster than those that do not.

Third, improved rural financial intermediationcould directly reduce vulnerability and indirectlyalleviate poverty. For example, the widespreadavailability of monetized savings facilities couldallow poor households to withdraw savings duringcyclical downturns or unexpected idiosyncraticcrises and thereby improve household security andsmooth consumption. Currently, most rural sav-ings in Latin America are in-kind (livestock, grain

reserves, jewelry, inventories, land) and oftenpresent divisibility and illiquidity problems duringtimes of crisis.6 Thus, the greater availability ofthis financial service would reduce vulnerability towelfare reducing contingencies but not necessarilyraise income levels above the poverty threshold.

6 If the crisis is economy-wide or systemic in natureand results in massive currency devaluation and/orhigh inflation rates, access to saving services will notnecessarily help to maintain consumption levels. Theloss of purchasing power could be significant. Thisthreat underlines the need for effective macroeco-nomic management.

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II. Bank Support forRural Financial Development

The Report on the Eighth General Increase in theResources of the Inter-American DevelopmentBank states, “The objective...[of the growth strat-egy]...is to reduce social inequality by incorporat-ing fully the most disadvantaged strata of societyinto the modern economy...Since social and polit i-cal stability are indispensable conditions for cre-ating sustainable growth, all parts of society mustbelieve that they have a stake in the system and inthe country’s future.”7 The majority of the eco-nomically active rural population consists ofsmall-scale agricultural producers and small,nonfarm entrepreneurs. They tend to experience ahigh incidence of poverty (54 percent of ruralhouseholds) and enjoy only limited access toformal financial markets (less than 15 percent inmost countries). Access to credit and depositservices by poor persons by itself will not curepoverty, but given auspicious conditions andsustained access to financial services over time,their chances of escaping poverty increases.Therefore, the Bank has a role to play in fosteringthe development of rural financial markets.

The Bank’s Lending Experience

The Inter-American Development Bank has beenone of the leading sources of development assis-tance to Latin America and the Caribbean. TheIDB’s rural finance lending program between1961 and 1998 can be classified into three catego-ries: (1) targeted, subsidized agricultural credit formedium- and small-scale agricultural producers;(2) sector and regulatory reform; and (3) privateenterprise credit and financial intermediary devel-opment. In these categories, the IDB approvedUS$4.4 billion, US$4.2 billion and US$474 mil-lion, respectively, for a grand total of US$9.1billion. In comparison, the World Bank approved

7 Pages 2 and 13 of said document. ReferenceDocument No. AB-1683 April 12, 1994.

US$3.3 billion to be spent on agricultural creditprojects between 1961 and 1992 in the LatinAmerican and Caribbean region and USAIDinvested US$2.3 billion in rural finance between1961 and 1997 (See Annex 1).8

During the period 1961-89, the IDB disbursedover US$4.2 billion for global agricultural credit(GAC) through 131 operations. These credit pro-grams channeled resources, either indirectlythrough rediscount facilities or directly throughloans to state agricultural development banks andother specialized rural lending institutions, for on-lending to rural producers at preferential rates ofinterest. In addition, the Bank made credit avail-able to rural producers under integrated ruraldevelopment (IRD) operations which were multi-faceted projects attacking problems of rural pov-erty and underdevelopment in a specific region ofa country through simultaneous investments in anumber of areas, including, for example, agricul-tural extension, credit, marketing, infrastructure,and training. During the period 1961-96, 36 IRDoperations were approved totaling US$1.3 billion.Of these operations, 18 operations (in the periodof 1968-1981) had agricultural credit componentstotaling US$236 million. Both of these programswere characterized by subsidized interest rates.

In the late 1980s and early 1990s, the Bank’slending policy changed because of the poor per-formance of subsidized directed credit schemes.The new focus was on liberalizing markets andimproving investment efficiency. Three maininstruments—Financial Sector Reform Loans(FSLs), Investment Sector Reform Loans (ISLs),and Agricultural Sector Loans (ASLs)—were usedin a coordinated fashion to this end. FSLs helpedborrowing member countries to move towardmarket-based interest rates, increased banking

7 See World Bank, 1993 and USAID, 1999.

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competition, and strengthened prudential andregulatory frameworks. ISLs helped to liberalizetrade and investment regulations in order to spurprivate investment. ASLs removed price distor-tions that reduced the profitability and competi-tiveness of agricultural products, thereby makingrural producers more bankable. Some of theseloans included specific conditionality related tostate-owned agricultural development banks andother aspects of rural finance.

In the late 1980s and early 1990s, the Bank alsoused four other instruments which were targetedspecifically to improve access to credit by privateentrepreneurs: (1) Small and MicroenterpriseGlobal Credit Loans (MicroGlobals); (2) GlobalMultisectoral Credit Loans; (3) Multilateral In-vestment Fund Projects (MIF), and (4) SmallProjects.9 Since 1990, the rates of interest chargedto final clients have not been subsidized.

MicroGlobals were used to provide liquidity andto reduce funding risk as an incentive for partic i-pating financial intermediaries the borrowingcountries to serve the small and microenterprisesector. To date, 15 Microenterprise Global Loanshave been approved for a total of $594 million,and 13 are in execution. The limited availableevidence on these loans suggests that the over-whelming majority of participants in the Micro-Global programs have been urban-based financialinstitutions. The amount reaching rural producersis estimated to be about $21 million or approxi-mately 10 percent of the amount disbursed.10

Global Multisectoral Credit Loans were used topromote longer term financing and thus stimulateprivate investment. The programs were open to alltypes of clients. Some agroindustries and ruralenterprises benefited but, again, the majoritytended to be urban-based clients involved in

9This program was officially revised and renamedSocial Entrepreneurship Program in December1998.

10This estimate is based on a review of executingagency reports and conversations with project offi-cers involved in designing and supervising Micro-Global loans.

manufacturing and services. Out of the $3.6 bil-lion approved, an estimated 9 percent or $323million went to rural industries and producers.However, the programs played a vital role instrengthening second-tier institutions.

Another instrument that has helped rural clients isWindow III (The Small and Microenterprise Fa-cility) of the Multilateral Investment Fund (MIF),which dates back to 1993. The MIF has under-taken few rural finance operations (12) and theamount approved (US$21.6 million) is a modest5.2 percent of total MIF financing. However, thenumber of rural finance projects has increasedmarkedly in the last few years, suggesting anupward trend.

Lastly, the Small Projects Program (SPP), datingfrom 1978 and now renamed into the Social En-trepreneurship Program (SEP) has also benefitedrural producers. Fifty-two Small Projects providedfinancing to rural agricultural producers prior to1992, but the amount disbursed, $23.7 million,constitutes about 18 percent of cumulative SPPlending. Since the early 1990s, some 80 percent ofthe resources approved have been directed tomicroenterprise development, much of it in urbanareas but a fair amount rural based. Due to lack ofdata on client beneficiaries, it is difficult to deter-mine the exact share reaching rural clients. None-theless, SPP has been a laboratory in which inter-esting experiments have been tried. Several finan-cial intermediaries who received Small Projectloans have now matured and transformed them-selves into regulated financial entities. Some ofthese transformed financial NGOs are now ex-panding operations in rural areas.

Since 1985, Bank lending for direct support ofrural finance in general, and for agricultural creditin particular, has been declining (Annex 2). Thechange in credit flow patterns is due to a change inBank lending policy and the ongoing search forappropriate and effective financial technologiesfor large scale, rural intermediation that can bepromoted in the midst of liberalized policy re-gimes.

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Lessons Learned

The lessons discussed in this section are derivedfrom the review of 27 IDB rural finance projects,existing evaluation documents on the topic, andstaff interviews (Wenner, forthcoming). The les-sons are grouped into four categories, three basedon the purpose of the operation and one on im-plementation experiences. Those categories aretargeted credit, sector and regulatory reform,institutional strengthening of financial intermedi-aries, and program execution.

Targeted Credit

Targeted, subsidized credit programs, such as theGlobal Agricultural Credit and Integrated RuralDevelopment operations, tended to distort ruralfinancial markets, undermine the viability of manyparticipating financial intermediaries, discouragethe mobilization of savings, and disproportionatelybenefit higher income borrowers. Therefore, thesetypes of projects should not be promoted.

Targeted, nonsubsidized, wholesale credit pro-grams, such as MicroGlobals and MultisectoralCredit operations, played a role in promoting theexpansion and deepening of financial services tounderserved producers, but their role is limited.Those programs that succeeded in expanding ruralproducers’access to credit were carried out incountries with large agrarian sectors that hadintermediaries already present in rural areas.However, for these wholesale credit projects toavoid unintended negative effects, the interestrates charged to final sub-borrowers should be seton market terms (i.e., should cover operationalcosts ) and rates charged to intermediary institu-tions should be set at levels that do not underminetheir deposit mobilization activity. The Bank’sexperience has shown that small-scale borrowersare more sensitive to the nonfinancial costs of thetransaction (processing fees, travel costs, andincome lost due to delays in approval and dis-bursement) than to the financial costs (interestpayments).

The role of second-tier or wholesale institutionshas proven to be important in deepening financialmarkets. However, operations such as Multisecto-ral Credit Loans that strengthen second-tier insti-

tutions and channel resources through them mustbe carefully designed. Special care should betaken to avoid the negative effects of arbitraryallocation and pricing of long term resources thatcan undermine savings mobilization efforts andretard the development of secondary markets.

Guaranty funds were often used as a means ofreducing the default risk faced by private com-mercial banks in lending to medium-, small-, andmicro entrepreneurs in Latin America and theCaribbean. Typical models included having a thirdparty (i.e. a fund established by donor agenciesand national governments) guarantee individualloans made by a financial institution to a client orguarantee a portfolio (i.e. a set of loans made by afinancial institution to a particular class of clientswho meet certain criteria). These two models, theindividual loan guarantee and the portfolio guar-antee, proved to be ineffective. They were plaguedwith high transaction costs, heavy losses, lack ofadditionality, and moral hazard problems. Mostimportantly, private banks did not learn how toevaluate risk and thus were not prepared to servethe target population once the guarantee programexpired. Since the mid-1980s, a new model ofintermediary guarantees, wherein a loan or line ofcredit from a local bank to a nonbank microfi-nance institution is backed by an internationalorganization issuing a letter of credit or makingcash deposit, has shown more promise. Thismodel has been characterized by low rates ofdefault and losses and has succeeded in increasingaccess by nonbank microfinance institutions tocommercial loans. Though questions ofsustainability and the rate at which microfinanceinstitutions are graduating to unguaranteed lendinglinger, this intermediary model has value andcould be used in future operations (Young, et. al.,1997; Levitsky, 1993).11

Sector and Regulatory Reform

Experience with sector loans and with technicalassistance to promote reforms showed that atten-tion must be paid to the political economy sur-

11 IDB experience with guaranty funds for ruralfunds has been limited but the importance of themechanism warranted inclusion.

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rounding their implementation if these types ofinterventions are to be effective. In the past, vestedinterests benefited from the status quo. Therefore,new operations must be designed in ways that dealwith the threat of opposition to change that islikely to arise. The most telling instances havebeen attempts to reform state-owned agriculturalfinance institutions, which have generally failed.

Laws governing the creation, perfection, andenforcement of security interests, moveable prop-erty collateral and the attendant regulations andinstitutions have been shown to be in need ofimprovement. Small borrowers often lack securetitle to land or are unwilling to pledge it in a loantransaction; therefore, other formal collateralsubstitutes are needed. This element was missingthe first wave of reform operations.

The Bank’s experience has shown that rural fi-nance reforms have a very low probability ofsucceeding if included in complicated, multifac-eted sector operations. In order to promote changein rural financial markets, reform operations mustfocus more specifically on rural finance per se.

Institutional Strengthening ofFinancial Intermediaries

A number of MIF, MicroGlobal, and SPP opera-tions entailed activities to strengthen financialintermediaries. Experience shows that operationsthat contributed to the creation of sustainablefinancial intermediaries selected institutions thathad certain characteristics. The special character-istics of the institutions include strong leadership,a clear mission to serve the rural small and micro-enterprise sector, a businesslike approach, and aproven service delivery technology. Therefore, theprocess of selecting institutions for assistance is

crucial to success and the Bank must engage in arigorous analysis of their actual and potentialperformance prior to approval, and continue tomonitor performance.

Experience shows that innovations are needed infinancial service delivery technologies to lowertransaction costs and allow financial intermediar-ies to expand financial services in rural areas. Parallel interventions are needed to reduce thehigh degree of production and price risk in agri-culture. Such parallel efforts include appro-priateinvestments in physical infrastructure, improvedextension services, improved marketing, and anincrease in the provision of insurance services.

Building sustainable financial intermediariescapable of providing financial services to ruralclients is a slow process that requires a commit-ment over a long period (5-10 years). Rules orcustomary norms that prohibit granting of re-sources to the same group on multiple occasionsneed to be reevaluated.

Program Execution:Bank Monitoring and Supervision

The Bank’s project design and preparation processhas generally succeeded in identifying the con-straints and developing feasible solutions. How-ever, monitoring and supervision emerged in thereview as an area of recurrent weakness. Timelytechnical interventions by Bank personnel indifficult operations, especially those operationsinvolving complex policy and institutional re-forms, was sometimes lacking. Because so manyreforms needed in rural finance are of an institu-tional nature and the period needed to effectchange is long, high quality and sustained supervi-sion and monitoring by the IDB has been shown tobe important.

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III. Problems and Solutions in Rural Finance

To design optimal interventions, problems need tobe identified properly and appropriate prescrip-tions need to be developed. This section explainswhy rural financial markets are peculiar, what arethe main problems, and what are possible solu-tions.

General Problems inRural Financial Markets

Rural financial markets do not function efficientlybecause production and price risk, imperfectinformation, and transaction costs are pervasive,underlying problems. In the past, public sectorinterventions, such as credit quotas and subsidizedinterest rates, focused on observable symptomssuch as lack of access by small-and medium-scaleproducers, without an understanding of the un-derlying factors that shape rural financial marketsand make small- and medium-producers non-preferred clients. Consequently, the results wereunsatisfactory.

The first root cause for poorly functioning ruralcredit markets is the combination of high levels ofproduction and price risk and limited mitigationtechniques. For example, rural agricultural pro-ducers and small-scale entrepreneurs who contracta financial obligation are subject to systematicvariability that may result in involuntary default.In the absence of adequate risk mitigation instru-ments (e.g., collateral, insurance, futures, etc.)financial intermediaries are forced either to wit h-draw from rural areas or to develop contract de-sign mechanisms that resolve the problems indi-rectly. Joint liability contracts or group credit isone such alternative. Group credit, however, im-poses high transaction costs on group membersand seems to work well only when certain condi-tions are met. Those conditions include regularmeetings that provide significant ancillary benefits(market intelligence, business networking, train-ing, etc.), existence of a high degree of social co-

hesion and loans whose size remains within themutual insurance capacity of the group. Charginghigher rates of interest to compensate for the highrisk also has a limit. It can induce adverse selec-tion wherein only the risky clients demand credit.

The second root cause for underdeveloped marketsis imperfect or asymmetric information. Informa-tion is costly to acquire and transmit, yet it is vitalin assessing and managing risk. Good informationcan serve as a partial substitute for lack of realcollateral and a means to prevent moral hazard.However, in rural settings the absence of formalcredit histories, the absence of a tradition of recordkeeping, and the heterogeneity of productionconditions complicate creditworthiness evalu a-tions and loan/insurance monitoring activities.

The third root cause is high transaction costsstemming from peculiarities in the physical andinstitutional setting. Rural areas are characterizedby high levels of poverty, spatial dispersion,marked seasonality of income, weak legal andcontract enforcement frameworks, poor physicalinfrastructures, and low levels of schooling. Thesefeatures increase transaction costs for both inter-mediaries and clients. Once transaction costs passa threshold, they stifle intermediation.

This combination of causes explains why formalintermediaries are less likely to be present in ruralsettings and are at a competitive disadvantage vis-à-vis informal intermediaries, who by virtue ofgeographic proximity and multi-stranded, eco-nomic and social relations enjoy information andtransaction cost advantages. Therefore, informalintermediaries tend to be more active than formalones. It also explains why small-scale producerstend to be non-preferred clients even in competi-tive formal markets. Higher income, larger-scaleproducers, those with traditional forms of collat-eral and established credit histories, tend to be thepreferred clients (Wenner and Proenza, 2000).

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Specific Problems to be Addressed inRural Financial Market

For the purposes of this strategy, five majorsymptomatic problems have been identified thatneed to be addressed. The major observable prob-lems are (1) limited access to short-term formalcredit, (2) market segmentation and lack of com-petition, (3) limited availability of medium- andlong-term credit, (4) paucity of operationallyefficient and sustainable financial intermediariesand (5) a limited array of financial services.

Limited access to short term formal credit can beattributed to (1) the low profitability of many ruralactivities; (2) the lack of traditional forms ofcollateral, namely titled land; (3) weak and costlyformal enforcement mechanisms; and (4) imper-fect information. Rural enterprises that do notgenerate sufficient margin to cover the financialcosts of a debt obligation are simply not bankable.In the past, fixed and unvarying prices for agri-cultural outputs, poor infrastructure that signif i-cantly elevated production and marketing costs,and export taxes reduced the profit margin ofmany rural enterprises. Today, many of the eco-nomic policy distortions (e.g., fixed prices andexport taxes) have been removed but poor infra-structure, the use of outdated technology, lack ofaccess to overseas product markets, competitionwith highly subsidized farmers in industrializedcountries, lack of awareness on the part of poten-tial clients about financial instruments, and over-valued exchange rates can be complicating factors.The lack of secure title to real estate and the will-ingness to mortgage it can be another deterrent,even in light of a viable investment project. Thehigh cost of en-forcing credit claims also detersformal intermediaries from being active in thesector. Lastly, the cost of gathering information ondispersed clients without a history of recordkeeping is still another constraint. This problemaffects most small-scale producers and entrepre-neurs.

Market segmentation refers to the commonlyobserved pattern that formal intermediaries tend toserve higher-income, well-collateralized clientswhile semi-formal and informal intermediariesserve clients with lower incomes and more collat-eral constraints. The overall small number of

financial intermediaries can lead to the exercise ofmonopoly power. The segmentation and lack ofcompetition results in inefficiency and unneces-sarily high rates of interest. Clients with identicalloan demand and risk profiles can receive differentterms and conditions depending on source offunding. Reasons for the segmentation and weakcompetition are fourfold: (1) inappropriate regu-latory frameworks that limit entry and productinnovation; (2) limited availability of risk mitiga-tion techniques; (3) costly and imperfect informa-tion; and (4) differential contract enforcementcapacity.

The limited availability of medium- and long-termcredit is a major constraint to agricultural andindustrial diversification, productivity growth, andenvironmental protection. This is so because manycrops are perennial, many soil and water conser-vation investments have long periods of gestation,and many types of machinery need to be amor-tized over a longer period. Proven microfinancetechnologies are short-term in nature and moreappropriate for commercial retail activities. Me-dium-and long-term credit is scarce due to macro-economic instability and the general absence ofeffective risk management tools in rural areas.Volatility in interest rates and exchange rates aswell as tendencies to tolerate high inflation ratescreates uncertainty and risk for long-term inves-tors and lenders. For example, fear of devaluationsand high inflation rates discourages domesticsavings, further reducing the supply of loanablefunds. These factors combined with the higherdegree of uncontrollable risk in rural lending andlack of risk mitigation tools (insurance, reinsur-ance, securizations, commodity price stabilizationschemes, vertical integration etc.) result in a ten-dency for intermediaries in the region to lendshort, if at all, to the rural sector. Rural nonfarmindustries and medium-sized farmers are partic u-larly affected by the limited availability of me-dium-and long-term credit. This class of producersis constrained in making fixed investments inplant and equipment, diversifying crop mixes,modernizing technological processes, and ex-ploiting high profit opportunities. As a result,segments that can be a vanguard in generatingemployment and productivity gains are stymied.

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In rural areas there is a paucity of operationallyefficient and sustainable financial intermediar-ies. 12 Quite a number of formal and semi-formalintermediaries active in rural areas are subsidydependent and removed from the efficiency fron-tier. This state of affairs is due to (1) inappropriategovernance and incentive structures; (2) weakbusiness management capacity; (3) excessivereliance on collateral-based lending technologiesthat increase transaction costs burdens for both theintermediary and the client; (4) vulnerability tocovariate risk due to limited portfolio diversific a-tion possibilities and small capital bases; and (5)continued donor sponsorship.

Limited supply of other financial services, such asdeposits, payment transfers, insurance, and leas -ing, hamper the ability of rural residents to bettermanage risk and liquidity. Often, rural clients areforced to use credit as a costly substitute for lackof access to insurance or liquid savings. Othertimes the dearth of formal financial institutions inthe country system complicates the paymentsclearing and settlement system. The result in eithercase is welfare-reducing and limits business de-velopment. The reasons why these financial prod-ucts and services have not developed are due to acombination of missing legal, institutional, andeconomic preconditions and the “free-rider” in-centive problem. For example, the limited reach ofcredit bureaus, the lack of recognition of floatingliens on inventories, and the non-deductibility ofleasing expenses for income tax purposes hamperthe wider use of credit cards, inventory credit, andleasing, respectively. Lastly, because many of theinnovations in the financial services industry canbe easily copied, innovators are discouraged be-cause the chances of recovering the high cost ofexperimentation are reduced (free-rider effect).

Proposed Solutions

In order to improve the functioning of rural finan-cial markets, actions are recommended in threebroad areas. First, efforts are needed to create apolicy environment conducive to rural financial

12 See MicroBanking Bulletin , July 1999. Few finan-cial institutions with sizeable rural portfolios reportand those that do receive mediocre ratings on institu-tional performance.

intermediation. More specifically, steps must betaken to improve the profitability of rural activ i-ties, reduce macro and sectoral risk for clients,improve information flows, and reduce legalimpediments to efficient and low-cost intermedia-tion and contract enforcement. Second, efforts areneeded to improve retail capacity, namely bycreating new financial institutions, forging linksbetween formal and informal financial institutions,and strengthening existing formal and semi-formalinstitutions. Third, efforts are required to encour-age the introduction and diffusion of financialservices other than credit, such as deposits, cropinsurance, commodity collateralized finance,hedging instruments, electronic cards, and leasing.These products would serve to better manage riskand liquidity and lower transaction costs. How-ever, these newer services, especially commoditycollateralized finance and hedging instruments,must be preceded by strong investments in cash-based agricultural marketing systems and im-provements in the legal and regulatory framework.

The enumeration of proposed solutions starts atthe general and overarching level and moves to thespecific and narrow. Several of the proposedactions are in the domain of the strategies on thedevelopment of financial markets and agriculturein Latin America and the Caribbean. However, theintent is to provide a holistic and integrated viewof rural finance issues and to set the stage for thepresentation of the rural finance strategy in thenext chapter.

Creation of a FavorablePolicy Environment

Macroeconomic Stability and Policy Consistency.A fair degree of macroeconomic stability andpolicy consistency are necessary conditions for thepromotion of deep, efficient, and competitive ruralfinancial markets. High rates of inflation andexchange rate instability are particularly detri-mental to the development of financial markets.Fiscal, monetary, and trade policies affect the riskenvironment faced by financial intermediaries aswell as the cost of funds. The crucial variables forfinancial markets are the central government=sdeficit, the inflation rate, the interest rate, man-agement of terms of trade risk, and the real effec-tive exchange rate. While there are elements be-

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yond the control of the government, such as capi-tal movements and terms of trade, central gover n-ments can pursue consistency in policies andstrengthen their countries’ability to cope withexternal shocks. Specific areas of action includeobtaining contingent access to foreign exchangefinancing, broadening the tax base, improving taxcollection efficiency, setting precautionary fiscaltargets, adopting budgetary rules that permit aquick response to external shocks, and adoptingthe use of medium-term budgeting.

Appropriate Sectoral Economic Policies. Neutralsectoral and investment policies are needed tolower transaction costs in rural financial interme-diation (improvements in communications, trans-port, electricity) and to increase profitability inrural economic activities (absence of economicpolicies that result in net transfers of income outof rural areas in general and agriculture in par-ticular). The principal areas of concern are publicinfrastructure investments, market based priceincentives for agriculture, and nonfarm incentivepolicies. Expenditures on rural infrastructure andsocial services (education and health) can increaserural productivity, lower marketing risk, and re-duce financial transaction costs. Unfortunately,rural areas historically have faced a disadvantagein the allocation of infrastructure resources andsocial spending. Agricultural taxation has dimin-ished with the advent of price and trade liberaliza-tion programs in the late 1980s. However, someLatin American and Caribbean agricultural sectorshave faced adverse terms of trade due in part toexternal shocks, weak macroeconomic manage-ment, and institutional and infrastructural weak-nesses. For example, many of the vital supportinstitutions in rural areas (marketing cooperatives,research institutes (agricultural sciences, plant andlivestock breeding, food processing technology,post-harvest handling, etc), and extension ser v-ices) have withered in recent years. Lastly, incen-tives for the relocation of industries and start-up ofother nonfarm business activities are needed inrural areas to diversify sources of household in-come and create backward and forward linkages.

Clarification of Property Rights (Titling). Lack ofsecure land tenure is a major obstacle to the provi-sion of medium-and long-term credit. Less than 50percent of the privately owned land in LAC is

titled and registered. Nonetheless, titling in not asufficient condition to improve access to credit.Other factors seem to be important, such as largerfarm size, higher levels of human capital, andproximity to major consumer markets. Therefore,titling efforts should be cautious and emphasizethe use of modern technology (satellite imaging)to reduce cadastral mapping costs, integrate titlingand registration procedures, issue universal re-quirements to register title; and modernize publicregistries.

A related and important issue is the recognition ofwomen’s rights to property acquired while in anofficial or common-law marriage. Efforts areneeded to study the impact of current laws andpractices and to determine what can be done toimprove equity and fairness in the disposition andpledging of assets.

Effective Legal Environment.An effective andreliable legal system is fundamental to the func-tioning of financial markets due to the intertempo-ral, promissory nature of financial transactions. InLatin America and the Caribbean, the securedtransaction framework is generally inadequate andpublic registries are weak. In many instances, thecost of creating, perfecting, and executing guar-antees can be prohibitive. For example, in someinstances moveable collateral is not readily ac-ceptable due to gaps in the law. In other instances,the lack of adequate enforcement of creditorclaims, partly an exogenous historical endowment(French civil law tradition) and partly due to theproliferation of overlapping laws in recent dec-ades, increases the risk and cost of rural financialintermediation. This higher level of risk and costdiscourages the entry of formal intermediaries intorural markets or outreach to more low-income,collateral constrained clients. Informal intermedi-aries remain dominant in rural areas in part due totheir willingness to accept a wider variety ofcollateral and because they have superior en-forcement capacity that is based on inter-linkedcontracts and monopoly power. This market powercan be exploited to extract rents in excess of rea-sonable risk premiums.

Adequate Regulatory Environment. The lack ofstrong and appropriate prudential regulation andsupervision in a liberalized setting increases the

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chances for banking crises, fails to protect inves-tors and savers, and introduces biases againstlending technologies that rely on reputation andsmall transactions, be it credit or deposit-taking.Thus, systematic actions are needed to correctinappropriate rules and weaknesses in supervision.Particular areas of concern regarding rural finan-cial intermediation are loan documentation, provi-sioning requirements, loan risk classification,sampling techniques, usury laws, rules on hours ofoperations, and entry requirements. Also, bypromoting the harmonization of accounting stan-dards, and transparency and openness in financialintermediaries through disclosure laws, the gov-ernment can lower barriers to entry, better saf e-guard the soundness of the financial sector, andprotect the interests of clients and investors fromexcessive risk taking and poor financial manage-ment.

One particularly important issue is the regulationand supervision of deposit-taking institutions. Thecost of regulating rural institutions will be highusing traditional techniques of supervision, be-cause the total number of financial institutionsserving rural areas, at least in the first stage ofdevelopment, will tend to be large, but each withmodest total assets. In the aggregate, rural, de-posit-taking, financial institutions may not consti-tute a systematic threat to the entire financialsystem but they will demand a disproportionateshare of supervisory resources. Therefore, theBank and other interested parties will have toexplore rating agencies, third-party regulationschemes and greater reliance on external auditsand delegated supervision in order to avoid over-taxing supervisory authorities and providing foreffective protection of small depositors and in-vestors.

Development of Enhanced Information Environ-ments. The use of information is key in all finan-cial transactions and at all levels, macroeconomic,intermediary, and household. However, imperfectinformation problems are more severe in ruralareas than in urban areas and greatly complicatethe functioning of rural financial markets. Gov-ernment can play a pivotal role in improving thequantity and quality of information on rural eco-nomic activity and financial intermediation. Forexample, the government can help promote the

creation of credit bureaus by the balancing privacyrights with the need for financial informationdisclosure laws, national policies that will permitunique client identification, and technology in-vestments in data handling and high speed trans-mission. The creation of credit bureaus with broaddatabases could help lower the costs of evaluatingcredit risk. More indirectly, the government canprovide private sector agents with valuable infor-mation that will help improve the production andmarketing of rural goods through periodic surveys;agricultural censuses; the systematic gathering anddissemination of commodity production, price,trade, transportation, and weather data; and studiesof cause and effect relations in agriculture andrural industry. For example, the development ofhigh quality databases could facilitate price andweather forecasting so that private parties couldengage in risk transfer activities (forwards, fu-tures, rainfall lottery insurance schemes) andefficient marketing arrangements.

Development of FinancialRetail Capacity

The strengthening of financial retail capacity is aclear and fundamental need. Specific areas ofconcern are governance incentives, quality ofbusiness management and technology/contractdesign in financial institutions. No particularinstitutional type has been dominant in terms ofperformance in the development finance litera-ture.13 Therefore institution-building interventionsshould be multipronged and guided largely bycountry context, the quality of available leader-ship, and the level of institutional commitment toachieving financial self-sustainability. Because ofthe presence of many state-owned banks in thefield, their proper role is discussed separately.Nonetheless, the goal is to extend the frontier offormal finance to incorporate rural areas based onprinciples of sustainability, efficiency, and signif i-cant outreach. Five interventions are possible: 13General institutional types are: (1) private com-mercial banks; (2) specialized banks (private andstate-owned); (3) nonbanks (finance companies,credit unions); (4) credit granting nongovernmentalorganizations and (5) community or member-ownedinstitutions (village banks, cooperatives, etc.)

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• Upgrade semiformal financial institutions toregulated financial intermediaries;

• Assist commercial banks interested in serv-ing low- and moderate-income clients;

• Link formal and informal financial interme-diaries;

• Restructure and reform existing financialinstitutions; and

• Create new financial institutions.

Each type of intervention has its advantages anddisadvantages. The choices, however, are notmutually exclusive but depend on context. Forexample, several semiformal, credit-granting,nongovernmental organizations (NGOs) havesuccessfully transformed themselves into regu-lated, formal financial entities (Prodem to Ban-coSol in Bolivia; AMPES to Financiera Calpia inEl Salvador; Ademi to BancoAdemi in the Do-minican Republic; etc.) and now serve rural areas.However, the transformation process is expensiveand requires very strong and capable leadership,competent and committed staff, and sustaineddonor support. Commercial banks interested inserving low-income segments of the market(downscaling) have significant advantages such aseconomies of scale and scope, good managementinformation systems, a staff that is well trained infinance, accounting, etc. However, downscaling isnot likely to be successful without a strong strate-gic commitment to the sector, a willingness toopen branches in low-income, rural areas, and anability to change corporate culture, staff recruit-ment practices, and technology in an effectivemanner. Linking formal to informal institutionssuch as private banks and credit-granting NGOs orbanks and agricultural input suppliers/food proc-essors/export-ers is a promising avenue but thelayering of costs, agency problems, effectivecoordination, and monopoly power can be issues.Existing financial institutions such as state-ownedagricultural development banks, cajas rurales, andcredit unions have a checkered past. Their at-tempts to address market failures have not alwaysbeen successful. Thus, care must be exercised indetermining whether reform, consolidation, orliquidation is the best course of action. Lastly, thecreation of new financial institutions, such asnarrow or specialized banks, again is promising.Nevertheless, the charter laws must be well de-

signed to create proper governance incentives,clear ownership rights, and appropriate capitalstructures. This route, while attractive because onecan begin anew, can be costly and take time tobear results. It may also conflict with currentmacrofinancial views that favor a consolidation ofbanks and the promotion of a few strong, universalbanks in Latin America. The issue ultimately willhave to be resolved at the country level throughdialogue and consensus building. In the shortterm, governments can use temporary incentivesto encourage commercial banks to enter ruralmarkets either directly through the opening ofbranches or indirectly via linkages to local finan-cial institutions or local agents. However, theseincentives should not be substitutes for actionsthat address underlying risk and informationproblems (improving rural infrastructure, policiesthat spur nonfarm businesses and increased ratesto farming, reforms of legal systems, etc.) thatwhen resolved will make rural banking moreattractive and sustainable in the long run.

The role of state-owned and managed financialinstitutions has diminished somewhat in recentyears, yet they continue to be dominant suppliersof credit to rural producers in several countries.These types of institutions have historically beenjustified based on claims of market failure; that is,the inability or unwillingness of the private ownedfinancial entities to act in a socially desirablemanner. However, the history of direct govern-ment interventions in financial markets, especiallythrough state-owned banks, has not been success-ful in terms of attaining institutional sustainabilityand targeting efficiency. The combination ofconflicts of interest in governance, moral hazard,and inefficient operations have led to significantproblems. Common problems included toleranceof high delinquency rates, high administrative coststructures, frequent turnover in leadership, polit i-cal interference in the loan approval process,pricing policies that contributed to decapitaliz a-tion, cumbersome operating procedures that in-creased transactions costs for borrowers, anddisproportionate concentration of the benefits inhigher income households, despite publicly statedintentions to the contrary.

While government interventions cannot be ruledout categorically and market failures cannot be

14

dismissed, safeguards should exist to prevent thesubstitution of a market failure with a governmentfailure. Governments should be able to defendtheir actions, including the continuance of first-tierinstitutions by proving that the market failure canbe removed in a cost-effective manner. First, ifthere are information asymmetries, the govern-ment (state bank or state run credit programs)must demonstrate that it has better access to in-formation at lower cost than the private sector.Second, if there are externalities, the governmentshould be able to quantify them and propose asolution that internalizes the costs. Third, if theprivate sector is unwilling to serve the financialdemands of a specific sector (rural), then thegovernment should solve the underlying rootcauses of the problem and not treat the symptoms.These conditions rarely hold and therefore, mem-ber governments should not view first-tier lendingoperations as a solution. They should instead focuson setting appropriate policies, ensuring properoversight, creating a favorable legal environment,and play a temporary role in helping to fosterlonger term financial markets through second-tierinstitutions that allocate the resources at marketrates (see Vives and Staking, 1997). While theselonger term principles are being pursued in accor-dance with the Bank's Financial Market Strategy(GN- 1948-3), in some exceptional areas such asthe rural sector, the IDB may channel resources tothose first-tier state-owned financial institutionsthat are able to meet certain criteria.14

As a practical solution to the politically unpopularproposal to dismantle state agricultural banks

14 Where private banks are unable to adequately sup-port the government’s rural development goals, theBank may support state-owned first-tier financialinstitutions on a transitional and exceptional basis.Such support must be shown to be cost effective andmust include explicit mechanisms to develop privatemarket financing sources. Eligible state-owned ex-ceptions must have technical justifications and soundmanagement and efficient operations marked bytransparency. They must be operating in the contextof an agreed plan to phase out any subsides or at leastshift them to on-budget operations that can functionwith private banks. They must have had regular andtransparent audits and a solid track record of financ-ing mid- and long-term projects.

without alternatives, member governments maywant to focus on developing linkages with formalurban financial intermediaries and semiformal andinformal intermediaries and providing technicalassistance and funding to mutualist-owned, sav-ings-led financial institutions in the short term. Inthe medium term, member governments may seekto encourage the formation of new, privatelyowned and managed equity-based, financial insti-tutions dedicated to rural finance and microfi-nance. In the long term, member governmentsmay attempt to attract commercial banks to extendout and penetrate rural areas when profitability hasbeen clearly demonstrated and competitive forceslead commercial banks to explore new niches.Temporary subsidies to defray the costs of estab-lishing branch networks may be provided. Theyshould make every effort, however, not to distortthe functioning of the market.

Promotion of Other Financial Servicesand Innovation

The promotion of other financial services wouldmore efficiently transfer risk and allow ruralclients to better manage liquidity. The principalimpediments to the expansion of these services aremostly legal and institutional ones. Thus, thedevelopment of new products will lag behind anddepend on the degree of success in strengtheningthe enabling policy environment and developingfinancial instit utional retail capacity.

Deposit Services. Several impediments need to beovercome to promote the voluntary mobilizationof deposits. First, if the country has weak macro-economic management then the regime imposestaxes on savers via high legal reserve requirementsand inflation. These policies result in low positiveand even negative real rates of return on savingsinstruments thereby discouraging savings mobili-zation. Second, ineffective supervision of deposittaking institutions or, in its absence, full and inde-pendent disclosure of risk jeopardizes the savingsof low-income, unsophisticated clients. Third,inadequate regulatory frameworks that, for exam-ple, do not permit flexible hours of operation tosuit the density of prospective clients and theirwork schedules (e.g., requirements to be open afixed number of days and hours, prohibitions onmobile banking units, etc.) make the capture of

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savings from low- and moderate-income ruralclients difficult because the costs may be too greatto justify an extensive branch network in ruralareas. Fourth, the lack of explicit deposit insur-ance as a last resort form of protection for smallsavers may influence the decisions of risk aversesavers. Fifth, the transaction cost of mobilizingsmall savings are high and there is concern withthe volatility of sight deposits, which is the prefer-ence of low-income individuals. At present servicedelivery technologies are not well developed andmarket research and product testing are needed. Incertain countries, however, the large flow of re-mittances to rural areas represents a potentiallyattractive business opportunity for intermediaries.If they can capture some of these flows as savings,a valuable service would be provided and fundingproblems diminished. Well-managed and eventu-ally well-supervised deposit-taking financialinstitutions have inherent advantages over credit-only financial institutions. In the past, probablytoo much emphasis has been placed on buildingcredit only institutions.

Insurance and Hedging Instruments. Property andliability insurance are important in reducing risksin rural financial intermediation. For farm house-holds and small business entrepreneurs, the avail-ability of formal insurance can protect againstunexpected output losses and damage to equip-ment and buildings. For financial intermediaries,clients with access to insurance can reduce creditrisk, especially crop insurance for farmers. In thepast, most crop insurance schemes have beenpublicly funded. They have generally not workedand private crop insurers have either been deterredby the publicly subsidized schemes or catered onlyto large, commercial farmers. The majority ofmedium- and small-scale farmers remain excludedbecause there are high administrative costs inserving them. Given this state of affairs, newschemes will likely have to be single-peril(drought, windstorm, hail, etc.) to avoid moralhazard and adverse selection problems and keeppremiums affordable. Geographic coverage wouldhave to be sufficiently wide so that the insuredthreat is negatively correlated.

In addition, other risk reducing instruments, suchas forwards, futures, options, and swaps, need tobe cautiously promoted. These other instruments

help to manage price and exchange rate uncer-tainty. In order for them to be more widely used ininternal markets by small- and medium-sizedagricultural producers, legal enforcement andcommunications infrastructure will have to beimproved and more commodity exchanges devel-oped. The challenge of thin or illiquid marketswill have to be overcome.

Commodity Collateralized Credit: WarehouseReceipts, Inventory Credit, and Accounts Receiv-ables. Input suppliers, feedlot operators, abattoirs,grain silo operators, processing plants, exporters,and manufacturing factories could play an evenmore significant role in granting credit to smallagricultural producers and small businesses if theycould better leverage their assets. Currently, manyof these operators receive loans from commercialbanks to finance working capital needs, but theamount is limited by the value of real estate col-lateral that can be pledged. If these operatorscould collateralize their inventories or accountreceivables, they could obtain more financing thatcould then be used to on-lend to smaller suppliersand subcontractors, hitherto largely excluded fromformal credit markets. Likewise, small businessescould pledge accounts receivable and directlyreceive financing from formal intermediaries.

At present licensed warehouses exist in severalcountries and issue negotiable receipts for agri-cultural commodities that can be endorsed, thusproviding the endorsee the collateral of underlyinginventory deposits in the warehouse and the possi-bility of financing. Current warehousing systems,however, are limited in scope and face little com-petition. They are plagued with uneven grading,inefficient storage procedures, high capitalizationcosts, and documentation that can be altered orcounterfeited without severe penalties.

The main impediments to more widespread use ofinventories and accounts receivable, are problemsin establishing a security interest at reasonablecost and gaps in the law. For example, accountsreceivable in many systems do not have legalstanding unless the underlying claim is reduced toa promissory note (pagaré), which is cumbersomeand not appropriate for trade finance (Flesig andde la Peña, 1996 and 1998).

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Leasing. In rural areas where medium- and long-term financing is particularly scarce, leasing ofequipment could became an attractive alternative.Unfortunately, it is still largely an urban phe-nomenon. In the last 30 years, leasing has grownrapidly in the developing world, particularly inAsia. In Latin America, slower growth is attribut-able to more volatile macroeconomic conditions,weak regulatory frameworks, and tax disincen-tives. In rural areas, leasing of farm and nonfarmmachinery and vehicles could represent a means toenhance productivity and lower marketing costs.Since the asset remains in the name of the lessor,repossession in the case of nonpayment is easier,reducing the expenses normally associated withdelinquency control. Common obstacles, however,are difficulties in calculating cash flow of ruralbusinesses, the requirement to have legal orders toenter the property of delinquent leasees, the lackof insurance for leased property that creates highdegrees of risk, and the inability of the leasee todeduct the leasing interest expense from pre-taxincome.

Electronic Cards. The use of debit, credit, andsmart cards promises to reduce transaction costsfor rural clients significantly. The obstacles thatcheck the widespread adoption of electronic cardsin rural areas are the following: (1) difficulties incalculating cash flows for the self-employed; (2)nonexistent credit bureaus or bureaus that containonly negative information on mostly large firmsand urban wage earners of limited duration; (3)postal services that are unreliable, complicatingbilling and payment processes; (4) low levels of

educational attainment in the rural areas of certaincountries that complicate adoption and use; (5)unreliable electric and telecommunication service;(6) and the use of competing and incompatiblenetworks and proprietary standards that limitclient access only to the machines of the issuinginstitution.

Payment Transfers. Cash is the most commonlyused payment instrument in the rural areas of lessdeveloped economies. In contrast, checks andelectronic payments (debit, credit card, GIROs,and wire transfers) are most in developed econo-mies. In rural areas of Latin America, the presentdearth of formal financial institutions and under-developed infrastructures, makes the use of debitand credit transfer payment instruments difficult.Large amounts of noninterest earning cash must beheld on balance for transaction purposes. Whilethe situation is acceptable for small valued trans-actions, it has disadvantages in large value trans-actions. In order to improve the efficiency of thepayments system, greater attention must be paid tolinking banks, using national postal systems, andpromoting the use of more checks and other pay-ments instruments. The situation should improvewith time and as a natural by-product of expand-ing the presence of formal banking institutions andtelecommunications, innovations in rural areas.

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IV. The Bank’s Objective, Roles, and Strategy

This section explains the objective, roles, and thestrategy for rural finance that the Bank shouldadopt based on generalized country settings. Italso discusses how the Bank could use variousinstruments to achieve its strategic goals.

Objective

The objective of the Bank’s rural finance strategyis to promote efficient and sustainable rural finan-cial intermediation. The Bank can achieve this byadopting a systematic approach: (1) creating afavorable policy and legal environment; (2) devel-oping financial retail capacity; and (3) promotingother financial services (warehouse receipts, creditcards, leasing, insurance, etc.) in those marketswhere the first two elements of the approach arewell advanced.

Consistency with Related Strategies

The rural finance strategy is consistent with andclosely related to the financial market strategy(GN-1948-3) and the agricultural developmentstrategy (GN-2069-2).

The rural finance strategy extends the financialmarket strategy to a subsystem which shares somecommon characteristics with the general financialsystem but also has distinctive ones. Although thestrategies share common goals (such as the orderlydevelopment of financial market systems, thestrengthening of banks, the consolidation of re-forms started in the 1990s, and continued ration-alization of state intervention) there are slightdifferences in emphasis due to settings. Becauserural areas have distinctive characteristics such aslow population density, poorer infrastructure, andlower incomes, the rural finance strategy empha-sizes risk transfer mechanisms (such as crop in-surance and hedging instruments), the introductionof transaction cost-cutting innovations (such aselectronic cards), and financial contracts that donot require large pre-established amounts of col-

lateral or proven credit histories (leasing, com-modity collateralized lending, factoring, andcontract farming). Another area of differing em-phasis is the role of commercial banks in theprovision of financial services. In the short term,the rural finance strategy sees commercial banksas playing a more indirect role, for example, fi-nancing large agroprocessors who in turn engagein contract farming with small- and medium-sizedproducers. Commercial banks in the medium-tolong-term may become more active in the directprovision of rural financial services as bankingcompetition grows, as investments in infrastruc-ture lower transaction costs and as informationcapital is developed. Thus, the financial marketstrategy places emphasis on strengthening existingbanks and supervisory authorities, while the ruralfinance strategy recognizes the need to createinstitutional space for more types of financialinstitutions that will be dedicated to micro andrural finance and to better adapt supervisory prac-tices to the challenges of rural finance withoutjeopardizing the soundness of the entire financialsystem.

Similarly, the rural finance strategy is integrallyrelated to the agricultural development strategy.Rural finance will not thrive if the actions calledfor in the agricultural development strategy are notrealized. That strategy seeks to consolidate secto-ral economic policy reforms; modernize publicand private agencies that provide agriculturalsupport services; improve the functioning of landmarkets through the promotion of titling andleaseholds; and increased investments in educa-tion, social services, and physical infrastructure.All the actions in the agricultural developmentstrategy serve to increase productivity, lowertransaction costs, reduce investment uncertainty,and improve the profitability of rural productiveactivities. Conversely, if rural financial marketsare not better developed in the near term, much ofthe modernization and product diversification

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envisioned in the agricultural development strat-egy are much less likely to occur.

Roles

To achieve the stated objective, the IDB will haveto play the roles of catalyst and financier. It willalso have to collaborate with the public and pri-vate sectors in member countries. As a catalyst,the IDB may directly assist borrowing membergovernments by initiating dialogues to convincethem of the importance either of consolidating orstarting policy reforms that would lower the costof rural financial intermediation. As a financier,the IDB can directly help borrowing governmentsto finance reform projects and financial intermedi-aries who seek to improve retail capacity and tointroduce new financial products and services.Assistance can take the forms of knowledge shar-ing or the provision of financial resources.

The other two parties in the process of financialmarket development, the public and private sec-tors in specific countries, will have important rolestoo. In the future, the proper and rational role forthe public sector will be to focus on creating afavorable policy environment for rural interme-diation. The role of the private sector is in assum-ing more risk and providing the financial servicesdirectly. Until recently, the public sectors of bor-rowing member governments have been heavilyinvolved in the direct provision of rural financialservices.

Strategy

The strategy of the Bank will be to systematicallyremove the obstacles to efficient rural financialintermediation. As constraints on both the demandfor and supply of financial services are lessened,new products and new types of institutional ar-rangements will appear to exploit profit-makingopportunities. The Bank’s orientation should be toconstantly support and encourage private sectorinitiatives, especially in the areas of retail deliveryof services and product innovation, and not todisplace or to stifle such initiatives. Because thenumber of constraints is high and detailed knowl-edge is lacking in many specific areas, the ap-proach will have to be cautious and iterative. Inessence, the Bank should adopt a “learning by

doing” approach: initiating a number of pilotoperations, monitoring progress regularly, apply-ing lessons learned in larger scale projects, trans-ferring knowledge from one country to another,and modifying strategies and guidelines as neces-sary.

In order to maximize the impact of the Bank’slimited resources by attaining the rapid transfor-mation of the largest number of rural financialmarkets possible in the region, the Bank’s ap-proach should be to work in an integrated andphased manner in those countries with auspicioussettings and to be selective in the types of inter-ventions pursued in countries with less favorablesettings. Accordingly, the Bank should concentrateits resources in high potential countries that meetmost, if not all, of the following conditions: (1) astable macroeconomic environment defined as lowinflation, a low fiscal deficit, a sustainable currentaccount deficit, and a real effective exchange ratethat is not appreciating; (2) existence of a bankingsector with adequate liquidity, acceptable assetquality, and competition; (3) a political leadershipthat is committed to reforming rural financialmarkets; and (4) the existence of a willingnessand technical capacity on the part of the publicand private sectors to implement the reform pro-gram and to penetrate rural areas.

Countries will vary on these indicators, someindicators will be above average and others will belower. Some the indicators, such as the macroeco-nomic ones, could also change quickly due toexogenous shocks. Other indicators may changedue to endogenous factors, such as a change inpolitical leadership during the course of projectpreparation. Nonetheless, the strategy recom-mends following a logical and sequential order.First, if the prerequisites are met, Bank staffshould focus first on helping the borrowing mem-ber government remove biases in sectoral eco-nomic policies that reduce the profitability andcompetitiveness of rural economic activities.Second, Bank staff should attempt to strengthenthe legal and regulatory framework to reduce therisk and cost of rural financial intermediation andincrease opportunities for profitable interme-diation and competition. Third, once the policy,legal, and regulatory environment is fairly favor-able, the staff should focus on identifying and

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helping financial intermediaries committed to therapid attainment of financial and economicsustainability and the expansion of rural financialservices. Fourth and last, as the legal/regulatoryframework and institutional setting permit, theBank should help financial intermediaries intro-duce new financial products. The higher the de-gree of macroeconomic stability and lower thedegree of bias in sectoral and regulatory policiesthe greater the scope for simultaneous actions ona number of fronts. Conversely, the lesser thedegree of macroeconomic stability and the higherthe degree of bias in sectoral and regulatory poli-cies the greater the likelihood that Bank interven-tions, especially in support of financial intermedi-aries, may not succeed in the long run in creatingsustainable and viable entities. In these less thanideal situations, the Bank may focus on assistingpromising financial intermediaries, demonstratingviability, and building momentum for appropriatepolicy changes that would permit more wid e-spread replication or scaling up of the successfulinstitutional model. Nonetheless, working in suchsettings will be high risk.

Because countries differ, specific Bank actionswill have to be based on careful country diagnosesof the constraints present and the structure andperformance of rural financial markets. In orderto tailor the interventions to country settings, thestrategy is recommending the development ofcountry specific actions plans on rural finance.

Actions to Remedy Specific Problemsand Relevant Instruments

In this section, detailed actions will be recom-mended to remedy the major problems alreadyidentified and the appropriate instrument(s) toachieve the desired end. Annex 3 contains a sum-mary in matrix form. The discussion below will bedivided into three sections that correspond to (1)creating a favorable policy environment; (2) de-veloping private financial retail capacity; and (3)introducing new financial services and innova-tions. The actions proposed below are intended toserve as an aid for operational staff in providing aset of possible solutions when designing specificrural finance intervention programs. The typicalcountry will be beset by several, if not all, of thementioned problems. Thus, responsible staff will

have to exercise judgement in determining priori-ties and the feasibility of chosen interventions.

Action Area:Creation of Favorable Policy Environment

Problem 1: Lack of Access to Formal Short-Term Credit

Specific Actions: In order to improve access toformal credit, the Bank should prepare operationsthat (1) change the legal framework so that agreater variety of moveable collateral can be usedto secure credit transactions; (2) reduce the degreeof risk creditors face by improving the ease withwhich credit claims can be legally enforced; (3)remove biases in sectoral policies so that theprofitability and competitiveness of rural produc-tive activities are improved; (4) increase landtitling and registration efforts; and (5) improvethe flow and quality of information on ruralhouseholds, firms, and rural productive activities through investments in surveys, informationdissemination services, and the creation of creditbureaus. This enhancement in the availability ofinformation will serve to improve decision makingand reduce risk.15

Instruments: Three different types of instrumentscan be used—sector loans, sector facilities, andtechnical cooperation programs—depending onthe country context, the availability of resources,the degree of borrower country commitment, andthe quality of management talent involved in theproject.

Sector Loans: If the macroeconomic setting isfavorable, member government interest is high,and the key counterpart agencies are competentand well managed, the Bank may attempt a single,large-scale loan that addresses most of the con-straints identified in a diagnostic exercise. For

15 Note that the last three actions recommended falllargely within the purview of other strategies, e.g.Agricultural Development in Latin America and theCaribbean and Rural Poverty Reduction. Nonethe-less, we strongly urge that staff involved in design-ing rural fi;nance operations become aware of therelationships among Financial Market and Environ-ment Div isions and coordinate with them.

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example, a modified investment or financial sectorloan, called a rural finance adjustment program,could be proposed that sets disbursement condi-tions such as increased government spending onrural infrastructure, social services, and technol-ogy transfer; an improved legal framework for thecreation, perfection, and execution of securityinterests; the strengthening the judicial system toallow for the rapid arbitration or settlement ofcredit claims; and the creation of credit bureausamong other interventions. Obviously these op-erations will likely be prepared for very fewcountries. However, caution should be exercised.Because the time needed to effect long lasting andcomplex institutional change does not match theincentives implicit in the quick disbursing natureof the loans, the loan may be difficult to execute.Also, the Bank may not be able to approve manyof these types of operations given the establishedlending limits for sector loans.

Sector Facilities:16

Sector facilities are similar tothe sector loans but less ambitious in scope (up toUS$5 million per operation), and designed to takeadvantage of particular windows of opportunitiesor dynamic situations in member countries, wherethe traditional project preparation cycle may betoo long to exploit certain benefits. In such cir-cumstances, the Bank may opt to use this instru-ment to provide fast-track support to addressproblems of a cross-sectoral nature. Emphasis willbe placed on activities that are low risk, have highimpact, can be implemented rapidly, and are notoverly complicated to prepare.

Technical Cooperation Programs: If the macro-economic, political, and institutional setting areless favorable, the Bank may attempt to use indi-vidual stand alone Technical Cooperation (TC)operations or Multilateral Investment Fund (MIF)operations in a surgical fashion. These individual,smaller operations will have to be coordinated andsequenced so that over time, they can have a netsignificant impact. Correspondingly, the Bank

16 Note: Parameters have been proposed for Educa-tion, Health, and Trade sectors in document GN-2085“Proposal for New Lending Instruments”. Parametersfor rural finance subsector would have to be devel-oped.

must be constantly engaged in a policy dialoguewith the member government and keystakeholders in civil society, seeking to galvanizesupport for redress of remaining obstacles.

Problem 2: Financial Market Segmentation, In-efficiency, and Limited Competition

Specific Actions: In order to reduce financialmarket segmentation and inefficiency, the Bankshould prepare operations that (1) revise bankingand financial regulatory frameworks so that barri-ers to entry, transactions costs, and constraints totechnological innovation are reduced to a reason-able minimum that still serves to protect thesoundness and safety of the entire financial sys-tem; (2) promote linkages, mergers, and acquis i-tions between urban and rural financial institutionsto better diversify risk, and attain economies ofscale and scope; and (3) improve the variety ofrisk mitigation techniques available for the client(such as insurance, hedging instruments) and forthe intermediary (such as portfolio securization,intermediary guarantees, and emergency funds) sothat more intermediaries will be encouraged toenter rural finance profitably. Many of these riskmitigation instruments are underdeveloped due tolegal and policy impediments.

Instruments: The preferred instrument would bea series of Innovation Loans (ILs) and TechnicalCooperation (TC) operations that help the membergovernment identify anti-rural finance biases inthe legal and financial regulatory framework; thathelp to formulate new laws and regulations toremove the identified weaknesses; that strengthenthe institutions responsible for enforcement; thatbroker activities between interested urban-ruralfinancial institutions and that introduce other riskmanagement techniques.

Problem 3: Limited Availability of Medium-and Long-Term Credit

Specific Actions: In order to improve the avail-ability of long-term finance, the Bank shouldprepare operations that (1) provide temporaryaccess to external funds through second-tier banksto compensate for the lack of funding sources; (2)promote pension funds and the insurance industryas a means of increasing longer term sources of

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funds; and (3) promote the introduction of variableinterest rate contracts in countries that have at-tained macroeconomic stability so as to reducerisk for lenders.

Instruments: Two instruments can be used toimprove the supply of medium- and long-termcredit: MIF and multisector credit operations.

MIF Debt Instrument Purchases and IntermediaryGuarantees: One instrument would be a MIFpurchase (or partial intermediary guarantee) ofdebt instruments (bonds or commercial paper)issued by one or more banks in a particular coun-try committed to long term rural lending as asignal to large scale institutional investors such aspension funds and insurance companies. Theseactions would be consistent with the Bank’sattempts to spur the development of secondary andcapital markets.

Multisector Credit Loan : Another instrumentwould be a Multisector Credit Loan (MCL) thatprovides a line of credit to a second-tier bank thatthen allocates funds to first-tier banks for medium-and long-term lending on the condition that thecost of the line of credit is equal to the cost ofmobilizing deposits in the system. One caveat isthat the use of an auction allocation mechanism inthe case of small countries may lead to collusion.Another caveat is that a sense of dependencycould be created on the second-tier, especially ifthe pricing and allocation mechanism is arbitraryand implies subsidies. For example, the externalline of credit may distract efforts at improvingrates of domestic savings and developing securitymarkets, that in the long term, would allow firmsto access capital. Because agricultural lending,especially over the medium and long term, is quiterisky, efforts to create insurance products, hedginginstruments, and emergency standby funds shouldaccompany these interventions.

Action Area:Improve Private Financial Retail Capacity

Problem: Paucity of Operationally Efficient andSustainable Private IntermediariesServing Rural Clients

Specific Actions: In order to increase the numberand size of viable intermediaries, the Bank shouldprepare operations that seek to improve institu-tional retail capacity in private financial interme-diaries dedicated to serving rural clients. Specificoperations may consist of (1) equity investments,intermediary guarantees, and loans to financialinstitutions in order to increase the supply ofloanable funds; and (2) grants to financial inter-mediaries entering the rural sector to allow theacquisition of equipment, the training of staff andmanagement, market research, transfer of technol-ogy, upgrading of management information sys-tems, and the design of new governance structuresand drafting of laws to allow for the creation ofnew types of financial intermediaries; and (3) theestablishment of emergency funds to help with therecapitalization of well-managed institutionsadversely affected by external shocks.

The Bank can pursue several intervention options:(1) help semi-formal, financial institutions (i.e.,NGOs) upgrade to formal, regulated financialinstitutions; (2) help commercial banks reachsmaller scale clients “downscale;” (3) link formalfinancial intermediaries with informal financialintermediaries reaching medium and small ruralclients; (4) reform existing institutions such ascredit union movements, village banks, cajasrurales, and state-owned agricultural developmentbanks; and (5) create new institutions. The se-lected approach depends on country conditions.However, previous experiences suggest that it ispreferable for the Bank to encourage successful,credit-granting NGOs based in urban areas toexpand to rural areas and to promote the linking offormal institutions, such as commercial banks, toinformal and semi-formal intermediaries, such asfinancial NGOs, credit unions, and suppli-ers/traders active in rural areas, who can then on-lend to clients. Another preferred option would beto create new specialized institutions with propergovernance incentives and smaller minimumcapital requirements. The least preferred optionsare to encourage commercial bank downscalingand to reform existing institutions. Commercialbanks have been quite reluctant to enter ruralmarkets and attempts to reform state-owned banksand other existing entities have largely failed dueto serious management weaknesses, governanceproblems, and political interference. An important

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associated issue is one of regulation and supervi-sion of deposit-taking institutions. The cost ofregulating rural institutions will be high usingtraditional techniques of supervision, because thetotal number of financial institutions serving ruralareas, at least in the first stage of development,will tend to be large but each with modest totalassets. In the aggregate, rural, deposit-taking,financial institutions may not constitute a systemicthreat to the entire financial system but they willdemand a disproportionate share of supervisoryresources. Therefore, the Bank and other inter-ested parties will have to explore rating agencies,third-party regulation schemes and greater relianceon external audits and delegated supervision inorder to avoid overtaxing supervisory resourcesand providing for effective protection of smalldepositor and investor interests.

Instruments: The primary instruments that can beused are Technical Cooperation (reimbursable andnonreimbursable), Multi-phased Program Loans(MPL), Multilateral Investment Fund (MIF),Global Microenterprise Loans (MicroGlobals),and Social Entrepreneurship Programs (SEP).

Technical Cooperation. TC operations can be usedfor basic institutional strengthening activities.

Multi-Phase Program Loan. MPLs could be auseful instrument because support for one or a setof relevant support and intermediary institutionscould be sequenced and phased in over time basedon attainment of performance indicators suchsuccessful policy and legal reform, adoption ofnew technologies, institutional restructuring, etc.With a long-range plan in place, the advantage ofthis instrument is the promise of greater continuityand predictability of support over time based ontransparent and hithero agreed upon performancestandards. Oftentimes, institutional reform is slowand painstaking and this instrument would allowflexibility in the pacing without resorting “stopand go” measures that may rob the project offorward momentum.

Multilateral Investment Fund. MIF projects (loans, guarantees, equity investments, microfi-nance line of activity) have a wide applicabilityand should be targeted to the more mature institu-

tions that are interested in scaling-up activities andare close to attaining financial sustainability.

MicroGlobals can have a positive impact on ruralfinance if the participating regulated institutionsare already present in rural areas and have a strongcommitment to the sector. In general, Micro-Globals should not be expected to play a majorrole in transforming rural financial markets due toits broad targeting feature and the fact that the vastmajority of participating regulated entities areurban-based.

Social Entrepreneurship Program. The SEP alsohas a limited role to play due to scarce of funding.Given this reality, funds should be directed tothose institutions that can become sustainablewithin a short time horizon and disbursementsshould be made based on attainment of perform-ance benchmarks. The niche for SEP would be tohelp promising, nascent rural intermediaries, whoare not quite mature enough for MIF financ ing.

Action Area:Promote New Financial Servicesand Innovations

Problem: Limited Array of Financial Productsand Services

Specific Actions: To increase the number of avail-able financial products and services, operationsshould remove the legal and institutional weak-nesses that hamper the introduction and spread ofnew services and innovations. While action in thisarea should be cautious and in the context ofrelatively well developed financial systems andrural marketing production structures, some spe-cific actions would include (1) grants and loans tomember governments to help public sectorauthorities remove impediments in existing com-mercial, tax, banking and insurance codes topermit the wider use of warehouse receipts, ac-counts receivable, inventory credit, and hedginginstruments; (2) grants to intermediaries to assistthem in the transfer of technology, staff training,market research, and pilot testing of new products;and (3) equity investments, loans, lines of credit,and guarantees to intermediaries needing capital toexpand new services to rural clients. The Inter-American Investment Corporation (IIC) recently

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approved three innovative projects along theselines. One project in Mexico promises to finance10,000 mostly small corn producers throughwarehouse receipts and grain repurchase agree-ments. This project introduces financing plusmodern risk management techniques such ashedging and insurance for a clientele hithertoexcluded. Another project is an agency line ofcredit through the Latin American AgribusinessDevelopment Corporation (LAAD) to help financeexport-oriented, small and medium agribusinesses.The virtue of this arrangement is that the agricul-tural lending expertise of a corporation that knowsthe sector is captured and its impact scaled up.Lastly,

a multisectoral line of credit operation helps bankswith a presence in rural areas enter into medium-term lending and leasing arrangements.

Instruments: The preferred instruments are standalone Technical Cooperation operations, Innova-tion Loans, MIF microfinance line of activityoperations, and multifaceted MIF operations thatcombine technical assistance grants with financingto allow for the introduction and expansion of thenew financial services.

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V. Implementation

Priorities

The Bank’s number one priority, in collaborationwith member governments, is to create an ena-bling economic, legal and regulatory environment.The Bank has a comparative advantage in this areabecause it can use conditionality lending instru-ments to achieve desired changes and it can bringto bear knowledge acquired throughout the region.For relatively modest investments the probabilityis increased for achieving rapid and dramaticchange.

The Bank’s second priority is to build financialretail capacity in rural areas. The Bank needs totransfer appropriate service delivery technologyand help innovators and pioneers, because theprivate banking sector in the region perceives ruralfinance as particularly high risk and is averse toenter this segment of the market. To change thisperception, the principal challenge is to demon-strate that rural financial intermediation is indeedprofitable.

The number three and lowest priority is to intro-duce new financial products and services, onceprogress has been made on improving the legaland policy frameworks and some financial inter-mediaries dedicated to serving rural credit de-mands have developed and attained operationaland financial sustainability. 17

Proposed Action Plans

In order to implement the strategy, each RegionalOperational Department should determine whichcountries could benefit from a more proactive

17See Annex 4 for a detailed list of priorities underthe broad priority action areas. Bank operationalstaff should attempt, where possible, to follow thesequence, making adjustments for country specificconditions.

intervention by the Bank in rural finance. Forthose countries, over the period 2000-2005, theDepartments should prepare action plans on ruralfinance to be discussed with the authorities ofborrowing member countries as part of the normalcountry programming process. The goal is toinclude operations to implement the plan. Thereason is that the Bank must respect the preroga-tives of and recognize the heterogeneity in levelsof rural financial market development acrossborrowing member countries. The action plansshould consist of the following: (1) a diagnosis ofcountry specific rural financial market constraints;(2) a long-term plan to address these problemssystematically; (3) a prioritized list of projectinterventions, including pilot operations; and (4) aprovision for monitoring and evaluation of, atleast, the pilot operations. Furthermore, eachRegional Operational Department should then beresponsible for implementing two action plansduring the same period. Because of the complexityand uncertainty of the undertaking, pilot oper a-tions should be closely monitored in order todetermine what practices are viable, to inform thedesign of projects in other countries, to estimatethe cost of product roll-out or scaling up of opera-tions if the pilot is successful, and to help refor-mulate country specific and Bank strategies. Be-cause of the nature of the rural economy and thelow levels of institutional infrastructure in manyplaces, the time frames needed to assess the per-formance of the pilot operations may be in the 5-10 year vicinity.

Target Countries andSequencing of Interventions

The strategy recommends that the Bank target itsproject activities in countries with large ruralpopulations, both in absolute and relative terms,and sizeable agrarian economies. In addition,Bank staff could initiate “new financial product”pilot projects in countries with smaller ruraleconomies but relatively higher degrees of macro-

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economic stability and more developed financialmarkets. In order to contribute to improving ruralfinancial markets as rapidly as possible, the Bankshould focus on countries with relatively stablemacroeconomic indicators and relatively stablebanking systems. The Bank should then screencountries according to levels of government com-mitment to reform initiatives and the number ofcompetent and willing collaborating institutionsboth in the public and private sectors. The higherthe commitment and capacity, the greater thescope for Bank action in that country. If conditionsare fair to favorable, the Bank may be able towork simultaneously on three fronts: (1) policyenvironment; (2) retail capacity, and (3) newproducts. If conditions are less favorable, the bankmay have to work in a sequential manner, focusingon removing gross distortions and weaknesses atthe policy and institutional levels.

Bank staff will have to exercise judgement indetermining the sequencing of interventions andmaking the required trade-offs between the logicalorder espoused in the strategy and the practicalrealities of varying degrees of country develo p-ment, counterpart commitment, and technicalcapacity. Some general guidelines follow. If levelsof bias in the sectoral economic policies are highenough to reduce the profitability and competi-tiveness of a large number of rural economicactivities, staff should develop a comprehensiveprogram of policy reform contingent on a highlevel of member government commitment tochange and the existence of able counterpartagencies.18 If the level of bias and distortion ismoderate to low and a large number of rural ac-tivities are indeed profitable, Bank staff shouldengage in a simultaneous program of policy re-form to remove lingering policy biases and todevelop institutional retail capacity. If favorablemacroeconomic and sectoral conditions exist orreforms are underway, Bank staff should focus onremoving biases in the legal and financial regula-tory framework that increase transactions costsand risk for intermediaries attempting to servelow- and moderate-income clients. If the legal and

18 Some summary measures are nominal and effec-tive rates of protection, domestic resource costs, andproducer subsidy equivalents.

regulatory framework is inadequate but improv-ing, Bank staff may attempt to strengthen promis-ing financial intermediaries that meet the follow -ing conditions: (1) operate in an area with a den-sity of potential clients with viable investmentopportunities, especially with access to productiveinputs and output markets; (2) face unmet demandfor financial services; (3) face no civil unrest inarea of operation; (4) possess a leadership andstaff dedicated to achieving financial self-sufficiency and operational efficiency; and (5)possess knowledge of a proven service deliverytechnology or exhibit a willingness to adapt anappropriate one. Once a number of strong finan-cial intermediaries exist and the correspondinglegal and institutional conditions generally prevail(see Annex 5), Bank staff should promote theintroduction of new products.

Organizational Implicationsand Recommendations

The implementation of this strategy implies anumber of changes, most of which are applic a-ble to other types of operations and sectorstrategies as well. However, this section at-tempts to underscore the significance of the rec-ommended action for the full and effective theimplementation of the rural finance strategy.The first four items are particularly relevant tothe implementation of this strategy and the lattertwo are more general.

Improve Coordination. The Central and Re-gional Operational Departments will have toimprove communication and coordination witheach other as well as with other multilateral andbilateral development institutions, and with pri-vate and public sector entities in member coun-tries, in order to avoid duplication of efforts, toshare information and knowledge, and to betterexploit staff competencies. The work programwill entail activities in five broad areas: (1) re-search/dissemination; (2) dialogue/brokering;(3) project preparation; (4) training; and (5)project monitoring and evaluation. Economiescan be realized with effective planning and co-ordination. For example, the Bank could estab-lish a Network on Rural Development and RuralFinance comprised of Regional Operational De-partments, Central Departments, and Country

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Offices staff. The primary role of the Opera-tional staff would be to identify, prepare, andnegotiate projects. The primary role of the Cen-tral Department staff would be to evaluate, serveas a clearinghouse for information, and providetechnical support. The primary role of theCountry Office would be to broker relationshipswith the private sector, forge alliances, and su-pervise projects. Steps to improve incentives forcooperation among the three parts of the Bankshould be adopted.

Build a Critical Mass of Technical Staff. The Bankshould develop a critical mass of technical staffknowledgeable about a wide range of legal, eco-nomic policy, agriculture, business development,and financial issues in order to design, prepare,and monitor rural finance projects. Some of thetopics include: adequacy of civil and commercialcodes, adequacy of banking supervision andregulation frameworks, impact of sectoral andmacroeconomic policies on agriculture, hedginginstruments, insurance, leasing, organizationalrestructuring, strategic planning, governanceincentives, liability diversification, etc. Becausemany of the operations that will be proposed mayinvolve much more collaboration with the privatesector than in the past, prior experience of work-ing in that sector would help to enhance under-standing and facilitate the building of partnerships. Therefore, the Bank should inventory the skillsets of existing staff, upgrade these skill setswhere possible, and depending on the availabilityof resources either recruit new staff or hire con-sultants in order to fill critical skill gaps and con-stitute a core cadre.

Institutionalize Learning and Managing Knowl-edge. The Bank has to develop a more systematicway to learn from previous experiences and rap-idly incorporate those lessons into new operationsunder preparation because a wide variety of ruralfinance operations, especially pilot projects, arebeing recommended to suit varying country con-ditions. The better organization, sharing, and useof project evaluation information will serve toenhance project quality. In addition, an up-to-dateroster of consultants and identification of existingtechnical expertise within the Bank can help toeconomize costs and speed the transfer of know l-edge. A database on rural finance projects that

incorporates information on project impact andresults, not primarily process indicators, as well asreference information should be developed andmaintained by a Central Department.

Generate Country “Ownership” of Rural FinanceReform Program. Borrowing member countrygovernments will have to take “ownership” of anyintervention program and to commit to a processof sustained implementation. In the case of ruralfinance, this commitment is particularly importantdue to the cross-cutting nature of the issues. Mul-tiple actors and agencies are involved and setbacksin execution will have to be overcome by a num-ber of champions in different sectors. Bank staffcan help the process by helping government poli-cymakers develop a clear vision, by sharingknowledge gained outside the country, by pre-senting viable alternatives, and by identifyingstrong and capable advocates of reform and inno-vation in both the public and private sectors. Theprocess of taking ownership and building consen-sus can occur either through the normal program-ming cycle or through a more elaborate sequenceof events that begin with diagnostic studies, in-clude consulting key stakeholders, and end withthe formulation of a country specific rural financestrategy.

Brokering Relationships with the Private Sectorand Reducing Transaction Costs. The Bank has todevelop the capacity to react faster to regulatorychallenges and emerging crises in financial inter-mediaries, and to reduce the transaction costsimposed on clients that result from project ap-proval. Given the diminishing role of the state indirectly providing financial services and the strat-egy’s emphasis on private initiatives, it is logicalto assume that the private sector will play an evenmore dominant role in the provision of rural finan-cial services in the future. Thus, the Bank shouldchange its operational procedures and develop aclient-focused, entrepreneurial approach to doingbusiness. Otherwise, the Bank’s ability to forgesuccessful partnerships and leverage more invest-ment funds from the private sector will be under-mined. Therefore, approval procedures should bereviewed and the usefulness of each procedurequestioned. The current hierarchical system andmultiple layers of oversight inhibit rapid negotia-tion, information sharing, and deal making.

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Improve Quality of Project Supervision andMonitoring. The Bank has to improve the qualityof project supervision and monitoring across theboard in order to obtain more positive impacts andreplicable projects. Much of the Bank’s currentincentive structure favors a routine monitoring ofdisbursements and compliance with establishedcontracting and reporting procedures. Engineeringinstit utional change and policy reform is a labor-intensive effort wherein timely interventions canmake a difference between successful transforma-tion, mediocre muddling, or failed results. Moni-toring indicators should be developed that areimpact and results oriented, not just process-

oriented. In the case of rural finance projects, theinherently high degrees of complexity and riski-ness underscore the need for consistent and highquality supervision in order to improve thechances for success.

Resources Needed for Strategy Implementation.The Bank can make progress on implementing thestrategy with existing resources. However, fullimplementation may require reallocation of staffand budgetary resources. The reason is that theoperations being proposed will be labor intensiveand therefore high cost.

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VI. Conclusions

The Bank is justified in being involved in helpingto develop and restructure rural financial marketsin Latin America and the Caribbean due to theirunderlying importance in the process of economicdevelopment. Economies with well-articulatedfinancial markets tend to exhibit higher rates ofeconomic growth than economies with less devel-oped financial markets. While substantial progresshas been made in improving the functioning ofurban financial markets in the region in the lastdecade and a half, rural financial markets remainshallow, segmented, and noncompetitive. Ruralentrepreneurs, especially small- and medium-scalefarmers and small business operators, face moreacute problems in gaining access to formal finan-cial services than their urban counterparts. Be-cause 30 percent of the region’s population residesin rural areas and 54 percent of the rural house-holds are poor, the social and economic conse-quences of the urban-rural financial market dual-ism are non-trivial—constrained economic growthand limited poverty reduction potential.

The reasons that rural financial markets functionpoorly can be attributed to a triad of problems—asymmetric information, high levels of productionand price risk, and high transaction costs. TheBank’s strategy will be to systematically attack and resolve these problems so that profitable,market driven intermediation can occur. Actionsare recommended in three broad areas: (1) crea-tion of a favorable policy environment; (2) devel-opment of institutional retail capacity; and (3)promotion of other financial services and innova-tion. The Bank has a comparative advantage infocusing on the enabling policy environment. Inaddition, the Bank can and should promote inter-mediary institution building. Because no particularinstitutional type or service delivery technologyhas yet proven to be dominant, except for thelargely unsatisfactory experience of state-owedagricultural development banks, a wide variety ofexperimentation is suggested. In the case of state-owned financial institutions, given their checkeredpast, the option of reforming them as first-tier

institutions is not recommended. Support for theseinstitutions should be based on their conversion tosecond-tier entities or a move to operate accordingto market criteria. 19 Much effort will have to bededicated to building a new rural financial infra-structure and linking urban-based financial insti-tutions to rural based semi-formal and informalintermediaries. The process will take time andrequire sustained investment of resources. Lastly,the Bank should help intermediaries introduce newfinancial services and products such as savingsand insurance as institutional maturity, regulatoryoversight capacity, and the legal environmentpermit.

In designing a set of optimal interventions, theBank should proceed cautiously and build a con-sensus for action within member countries, tailorinterventions according to the level of develop-ment and the degree of commitment, and seek atall times to build safe and sound, market drivenfinancial systems. A cardinal premise is that ruralfinance will only thrive when the set of profitableand viable investment opportunities expands. TheBank’s actions in the rural finance area should becompatible and complementary to the actionsproposed in the financial market, rural povertyreduction, and agricultural development in strate-gies. The aim is to expand the frontier of formalfinance to serve hitherto unreachable clients in an

19 Where private banks are unable to adequately sup-port the Government’s rural development goals, theBank may support state-owned first-tier financialinstitutions on a transitional and exceptional basis.Such support must be shown to be cost effective andmust include explicit mechanisms to develop privatemarket financing sources. Eligible state-owned ex-ceptions must have technical justifications and soundmanagement and efficient operations marked bytransparency. They must be operating in the contextof an agreed plan to phase out any subsides or at leastshift them to on-budget operations that can functionwith private banks. They must have had regular andtransparent audits and a solid track record of financ-ing mid- and long-term projects.

29

efficient and sustainable manner. Large entrepre-neurs in rural areas already enjoy access to finan-cial services but small and medium-sized entre-preneurs do not enjoy great degrees of access.Improved functioning of rural financial marketswould stand to benefit all classes but especiallythe latter two. Small-scale entrepreneurs desireaccess to short-term credit and savings deposits inorder to expand output, smooth consumption overtime, and prepare for future expenses and invest-ments. The more dynamic small- and medium-sized firms will benefit tremendously from moreefficient risk transfer mechanisms (insurance andhedging), access to longer term finance that wouldpermit modernization and diversification, andfrom product innovations such as leasing, com-modity-collateralized finance, and electroniccards.

The Bank has a number of instruments that haveto be effectively coordinated in order to reducetransactions costs and to improve monitoring andsupervision. Four instruments are particularly

relevant to the task at hand: (1) the MultilateralInvestment Fund because of its flexibility; (2)Technical Cooperation grants and loans due to theimportance of technology transfer and knowledgecreation; (3) flexible lending instruments (Inno-vation loans, Multi-phase Program loans, andSector Facilities) due to their ability to supportexperiments, address cross-cutting issues, andprovide support over more than one project cycle,and (4) Multisectoral Credit Loans as a means toexpand the availability of medium- and long-termcredit, which currently is a critical constraint inrural areas.

To effect positive change, the strategy recom-mends the combination of these and other instru-ments in country-specific action plans, that in-clude a diagnosis of the particular rural financialmarket setting, proposed solutions, and a list ofprioritized projects. A program of implementationof action plans in the period 2002-2005 is beingproposed for those countries that would benefit themost from such a program.

30

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37

Annexes

Annex 1.Estimated Allocation of Agricultural Credit, Rural Enterprise Credit,

and Financial Market Reform Loans: 1961-1998

Annex 2.Rural Finance Operations: Estimated Allocations of Direct and Indirect Support

by Year and Type of Operation.

Annex 3a.Guidelines for the Preparation of Action Plans

Annex 3b.Guidelines for Strategy Implementation Plan

Annex 4.Implementation Priorities

Annex 5.Highly Desirable Conditions for Product Innovation

Annex 6.Results of Public Consultation Process

38

Annex 1Estimated Allocation of Agricultural Credit, Rural Enterprise Credit

and Financial Market Reform Loans: 1961-1998

Type of Operation Number ofOperations

Total AmountApproved

(US$ millions)TARGETED AGRICULTURAL CREDIT

Agricultural Credit Loans 131 4,205Integrated Rural Development Loans(Credit Components Only) 18 236SUBTOTAL 149 4,441

SECTOR AND REGULATORY REFORMFinancial and Investment Sector Reform Loans 31 3,637Agricultural Sector Loans 8 602Multilateral Investment Fund(Regulatory and Legal Reform) 13 13SUBTOTAL 52 4,252

RURAL PRIVATE ENTERPRISE CREDIT AND INTERMEDIARY DEVELOPMENTSmall Projects (Agricultural Credit) 52 24Small Projects (Microenterprise and Other Credit)1 182 84Multilateral Investment Fund (Rural Finance Projects)2 12 22Multisectoral Credit3 10 323Microenterprise Global Credit (Rural Lending)4 6 21SUBTOTAL 262 474

Source: Inter-American Development Bank Operational Departments Database.

1 The values represented are the sums of projects classified as Microenterprise, and Global Cred-its, Programs, Multisector, and Fishing. This sum is an overestimation of rural credit because theclassifications include client groups that are wholly urban-focused, wholly rural groups, and aswell as urban-based groups that on-lend for rural purposes. Due to limited information on thecomposition and of portfolios, a rural-urban disaggregation is difficult. 2 Six of twelve projects involve institutions with an exclusively rural focus. The total value ofthese six projects is $14.3 million.3 Nine percent or so of the total value of Multisectorial credit loans ($3.5 b) is estimated to havegone to support rural based industries and producers. However, the loans helped to strengthenmany second-tier institutions and develop medium and long-term credit, contributing to overallfinancial market development.4An estimated 10% of the total amount disbursed as of December 1998 (US$206 million). Of the15 Small and MicroGlobals approved, only 6 had intermediaries with rural loan portfolios.

39

Annex 2Rural Finance Operations:

Estimated Allocations of Direct and Indirect Supportby Year and Type of Operation

(US$ millions)

Type of Operation/Year 1961-1965

1966-1970

1971-1975

1976-1980

1981-1985

1986-1990

1991-1995

1996-1998

Total

DIRECT SUPPORTGlobal Agricultural Credit 122 151 248 459 1,625 1,600 0 0 4,205Integrated Rural Development(Agric. Credit) 17 37 161 22 0 0 0 237Small Projects(Agricultural Credit) 6 9 7 2 0 24Small Projects(Est. Rural Microenterprise) 10 6 16MicroGlobals(Est. Rural Allocation) 20 1 21MIF(Rural Intermediary Support) 15 7 22Total Direct 122 168 285 626 1,656 1,607 47 14 4,549

INDIRECT SUPPORT*Sector Loans 410 2,880 950 4,240Multisectoral Credit 39 106 1,587 1,853 3,585MIF (Regulatory Reform) 4 9 13Total Indirect 39 516 4471 2812 7,838GRAND TOTAL 122 168 285 626 1,696 2,123 4,517 2,826 12,387Sources: Inter-American Development Bank, Operational Database and Author's CalculationsNotes:

*Indirect Support: These operations help to create conditions favorable for rural intermediation ingeneral. Sector loans and MIF regulatory operations help to strengthen prudential and supervisoryframework. Multisectoral Credit operations help to strengthen second-tier institutions and extendmedium and long-term credit. Although a small percentage of rural clients are believed to havebenefited from direct access to medium and long-term credit under Multisector Credit operations,these operations were valuable in strengthening second-tier institutions. Therefore, the total sumis credited as indirect support.

Rounding errors exist.

40

Annex 3aRural Finance Strategy:

Guidelines for the Preparation of Action Plans

Action Area 1:Create a Favorable Policy Environment

Problems Causes Areas of Intervention Actions

Lack of collateral.

1. Support reform laws that aim tostrengthen and improve the legal frame-work for secured transactions that wouldpermit the wider use of moveable collat-eral.

2. Continue to support land titling andregistration efforts that would increase thenumber of persons who can pledge realestate as collateral.

Prohibitive Cost ofEnforcing CreditClaims

Simplify procedures and strengthen theinstitutions (i.e., public registries andcourts) responsible for verifying and en-forcing credit claims. Engage in reform ofjudiciary system and promote use of alter-native dispute resolution to lower costs ofcontract enforcement.

Use stand-alone TC and MIFoperations to reform securedtransaction’s framework andimprove enforcement capacity.

Coordinate and support efforts toinclude titling, reform of securedtransaction frameworks, and en-hancement of information envi-ronment in larger Bank agricul-tural, financial sector, and mo d-ernization of the state operations.

Difficulties in ob-taining completeand accurate in-formation in acost-effective andtimely manner.

Improve the supply, quality, and exchangeof data on rural households, entrepreneurialactivity, and production conditions. En-courage member governments to invest inrural censuses, household surveys, androutine gathering and publication of agri-cultural price and production data.

Use TCs and MIF operations tocreate and strengthen credit bu-reaus and promote private sectorgathering and dissemination ofmarket information.

Lac

k o

f A

cces

s to

For

mal

Fin

anci

al S

ervi

ces

Low profitabilityof many rural ac-tivities

1. Encourage member governments to in-crease investments in rural infrastructure,social services, technology transfer, andmarketing services to lower cost of pro-duction, transport, and marketing.

2. Encourage member governments to re-move remaining price and incentive biasesthat lower profitability and competitive-ness. Maintain vigilance to ensure thatthese biases do not reappear.

1. Use policy-based Sector Loanswith multiple components: (1)reform of sectoral economicpolicies, (2) reform of securedtransaction’s framework andproperty rights (titling, publicregistries, contract enforcement);(3) reform of financial regulatoryframeworks; and (4) enhancingthe collection and disseminationof information on rural produc-tion, prices, trade volumes, andhousehold/firm characteristics.(If conditions do not permit, usestand alone TCs and MIFs).

41

Annex 3a (cont.):Rural Finance Strategy:

Guidelines for the Preparation of Action Plans

Action Area 1 (cont.):Create a Favorable Policy Environment

Problems Causes Areas of Intervention ActionsInadequate legaland financialregulatoryframework thatlimit entry andinnovation andincrease cost ofrural financialintermediation.

1. Identify and remove biases in thebanking laws that limit competition.Promote the creation of narrowbanks.

1. Use stand-alone TCs and MIF op-erations to improve regulatory frame-works.

Limited avail-ability of riskmitigation tech-niques at boththe firm and fi-nancial interme-diary levels thatmake interme-diation morecostly.

1. Support private sector led effortsto introduce crop insurance and ex-pand access to property and casualtyinsurance in general.

2. Support the linkage of urban andrural formal intermediaries, includ-ing mergers and acquisitions, in or-der to diversify risk better.

Use RTC or MIF operations to trainstaff of rural institutions how to man-age operational risk better and to ex-periment with linking formal and in-formal intermediaries.

Fin

anci

al M

ark

et S

egm

enta

tion

an

d L

imit

ed C

omp

etit

ion

Differential en-forcement capa-bilities. Informalintermediarieshave advantagesover formalones. Thus, theyare more activein rural areas.

1. Promote formal-informal inter-mediary linkages(bank-supplier-farmer)to better exploit comple-mentary advantages (formal inter-mediaries have larger capital basesthan informal intermediaries butthe latter have better information andenforcement capacity).

2. Encourage formal intermediariesto mimic products offered by infor-mal suppliers such as Rotating Sav-ings and Credit Associations (RO-SCAs).

Use MIF resources to experiment withlinking, for example, a private com-mercial bank with a financial NGO ora bank with an agroprocessor/traderwho on-lend to smaller borrowers.

LimitedAvailabilityof Mediumand Longterm Credit

Low domesticsavings rates,macroeconomicinstability, lim-ited risk man-agement tools,and lack offunds.

1. Provide temporary access to ex-ternal funds to relieve the constraint.

2. Underwrite bond issues of banksinterested in lending long to ruralareas so that they can attract inves t-ments from Pension Funds.

Use Multisectoral Credit Loans to sec-ond-tier institutions who allocate fundsto first-tier institutions in a transparentmanner and use market-based pricing.Also, use MIF Guarantee operations tounderwrite investments in banks will-ing to lend long.

42

Annex 3a (cont.):Rural Finance Strategy:

Guidelines for the Preparation of Action Plans

Action Area 2:Improve Retail Institutional Capacity

Problems Causes Areas of Intervention Actions

Inappropriate gov-ernance and incen-tive structures.Tradition of directgovernment inter-vention.

1. Help member governments andfinancial intermediaries design gov-ernance and capital structures thatpromote solvency yet a social com-mitment.

2. Help national governments to ra-tionalize the role of state-owned in-stitutions and to aggressively encour-age the entry of privately owned in-termediaries into rural areas. Optionsinclude, privatizing first tier state-owned banks, offering temporaryoperational subsidies to private banksand successful urban microfinanceintermediaries willing to expandservices in rural areas, promotinglinkages between formal and infor-mal intermediares.

3. Invest in the training of managers,board of directors, and staff of ruralfinance institutions and expandlending capacity.

1. Use TCs and MIF operations tohelp member governments reviseexisting charters to correct weak-nesses (i.e., credit unions) and toformulate new limited charters andregulations that will improve in-centives for financial NGOs andallow narrow banks.

2. Use loans to help member gov-ernment privatize or liquidate first-tier state agricultural banks. UseMIF operations to explore privatemanagement contracts.

3. Use TC grants either as a standalone or parallel to MIF financingoperations (loans, equity, guaran-tees) to train staff, reengineer or-ganizations, and expand the lend-ing capacity of promising interme-diaries committed to sustainabilityand that serve all productive unitsin rural areas, not just agriculture.

4. Also use TC and/or administra-tive budget funds to conduct bestpractice research and disseminateresults in order to spur adoption ofproven industry practices.

Weak businessmanagement ca-pacity.

Support training and improved edu-cational opportunities especially inaccounting, finance, banking, andbusiness administration.

Use TC grants to transfer technol-ogy, train staff, and upgrade man-agement information systems.

Excessive relianceon collateral-basedlending technolo-gies.

Fund the transfer of appropriate tech-nologies especially for agriculturallending and microfinance.

Use TC grants either as a stand-alone or with parallel financing.

Pau

city

of

Op

erat

ion

ally

Eff

icie

nt

and

Su

stai

nab

leF

inan

cial

Int

erm

edia

ries

in

Ru

ral

Are

as

Vulnerability tosystematic shockssuch as badweather.

Support the creation of emergencyfunds for disaster loans that can pro-tect well-functioning rural intermedi-aries from uncontrollable threats.

Use a Standby Loan Facility toestablish emergency fund to helpintermediaries adversely affectedby natural disasters.

43

Annex 3a (cont.):Rural Finance Strategy:

Guidelines for the Preparation of Action Plans

Action Area 3:Promote New Financial Services

Problems Causes Areas of Intervention Actions

Missing legal, in-stitutional, andeconomic precon-ditions prevent thedevelopment ofnew services.

1.Address weaknesses in legal, tax,regulatory, and institutional frame-works that make new products un-economical to introduce. Simultane-ously ensure that there are sufficientrisk control devices.

2. Place heavy emphasis on im-proved regulation or rating of de-posit-taking institutions. For largersized institutions, some form of im-plicit or explicit deposit insuranceaimed at protecting small saversmay be advisable.

3. Promote the financial rating ofnon-regulated institutions and thepassage of disclosure laws, and ac-counting harmonization rules thatwould serve to improve transpar-ency in financial transactions.

4. Attempt to link existing financialinstitutions and post offices in ruralareas to improve payment systemefficiency and explore the use ofelectronic cards and radio technol-ogy as solutions to payment transferproblems.

1. Use MIF operations to makeappropriate reforms in civil,banking, commercial, and taxcodes.

2. Use MIF operations to sup-port market research, pilot test-ing, and scaling up of newproducts and services as well asimprovements in payment sys-tems.

3. Use TC grants and adminis-trative budget to design andimplement with strategic part-ners an information databasethat would allow for the moni-toring and evaluation of resultswith aim of replication in othercountries.

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Incentive problemsexist because of thenon-exclusionarynature of the inno-vations. Innovatorsbear high cost andimitators can reapbenefits withoutmaking the initialhigh outlays.Therefore, theamount of innova-tion is suboptimal.

Help financial intermediaries whoare experimenting with new prod-ucts in rural areas through subsidies.

Use TC grants to fund feasibil-ity studies, market research,transfer technology, and engagein product pilot testing. UseMIF equity operations to helpscale up new product opera-tions.

44

Annex 3b:Rural Finance Strategy:

Guidelines for Strategy Implementation Plan

Implementation Issues Action How to AchieveDeveloping an integrated, phasedapproach to resolving the inter-related problems encountered inunderdeveloped rural financialmarkets.

Undertake country level diagnostic stud-ies of rural financial markets and developcountry specific strategies with the activeparticipation of key national level andcommunity stakeholders.

Assemble joint Bank and bor-rowing country teams to undertakethe assignment when feasible.Otherwise hire consultants tocomplete the tasks.

Developing a consensus on acourse of action and a high de-gree of borrowing country of“ownership”.

Identify champions both in the public andprivate sector within borrowing membercountries who will be strong and ableadvocates of reform and innovation.

Charge Regional Department andField Office Bank staff with culti-vating contacts and engaging pro-spective “champions” in an ongoing dialogue.

Improving coordination betweenCentral Departments and Re-gional Departments, with othermultilateral and bilateral devel-opment institutions, and with theprivate-public sector entities inmember borrowing countries.

Develop a pipeline of operations and re-search/dissemination/training activities.The project activity focus should be inorder of decreasing importance: (1) legal,regulatory, and policy reform; (2) devel-opment of retail institutional capacity;and (3) promotion of new financial prod-ucts.

Establish a Network on Rural Fi-nance that includes Central De-partment, Regional Department,and Field Office staff should beformed to share experiences andinform each other of respectiveprojects under consideration. Rep-resentative of the Group should betasked with coordinating on aregular basis with other interna-tional development organizationsand private sector interest groups.

Building a critical mass of tech-nical expertise on the topic

Hire or contract more persons well versedin rural finance, especially the new styleof financial intermediation that is begin-ning to appear (subcontracting, bank-NGO-client linked lending, contractfarming).

Concentrate the additional exper-tise in Regional Departments andCountry Fields Office and chargestaff with developing new projectsand monitoring execution.

Brokering relationships with theprivate sector and reducing trans-actions costs imposed on pro-spective clients of the Bank andstaff of Bank attempting novelapproaches.

Simplify Bank procedures governing theapproval of Technical Cooperations, MIFprojects, and Loans. As private sectorpartners become more important in theprocess, the ability to forge successfulalliances will be diminished if the Bank isnot more responsive to client-partnerneeds and learns to play a catalytic role inmatching parties with complementaryneeds, facilitating the exchange of infor-mation, and leveraging financial re-sources.

First, canvass the opinions of op-erational staff and clients to de-termine bottlenecks and to quan-tify full processing costs, thenattempt to streamline approvalprocedures. Second, emphasize achange in client focus by delegat-ing more power to the operationalspecialists in Regional Depart -ments and Country Field Officeand encourage the staff to engagein and cultivate relationships withpotential private sector partners.

Emphasizing quality in executionof operations instead of numberand total value of approved op-erations.

Change the incentives in place that favorroutine monitoring and disbursementcompliance to a set that favor active in-volvement and partnership with clients insearch of high impact results. Engineer-ing institutional change and policy reformin rural finance is a labor-intensive effort

Provide proper incentives anddiscretion for operational staff tofollow-up and monitor projects.For example, tie merit pay to re-sults of projects in portfolio, givenspecial awards, provide training,and allocate more time to these

45

in which timely interventions can make adifference between successful goalachievement and mediocre or failed re-sults.

activities in staff workplans.Charge a Central Department withmonitoring the implementationand evaluation of the approvedaction plans.

Institutionalizing Learning andManaging Knowledge

Develop a systematic way to learn fromexperiences and rapidly incorporate thoselessons into new operations under prepa-ration. Projects that are likely to be pre-pared will be of an experimental or pilotnature and the Bank can enhance thequality of latter operations through timelyevaluation and application of learning.

Design projects with more clearlyverifiable performance indicatorsand technical staff along with con-sultants should engage in moni-toring and evaluation exercises.The information should be enteredinto a simple database that wouldallow ready access to other poten-tial users.

46

Annex 4:Implementation Priorities

(Descending Order of Importance)

Priority 1:Legal, Regulatory, and Policy Environment

Subpriority 1: Remove biases in sectoral economic policies that reduce profitability and competitivenessof rural productive activities.

Subpriority 2:Reform the secured transaction=s framework to allow for a wider variety of acceptableforms of collateral that can be pledged as surety. Continue with land titling and registrationprograms.

Subpriority 3: Improve the effectiveness of the contract enforcement apparatus.

Subpriority 4:

Remove biases in the financial regulatory and supervisory framework against character andreputation based lending, operational platform flexibility, and usury restrictions. Whilesecured lending is essential for the safety of any banking system, prudential norms shouldallow some flexibility for the use of sound lending techniques that rely on information andsocial capital, such as credit scoring and group credit.

Subpriority 5:Improve supervisory capacity by introducing new on-site sampling techniques, third andself-regulation schemes for institutions of a small asset size, and use of rating agencies fornon-depository institutions.

Subpriority 6: Reform banking and financial institution laws to allow for new types of limited charter andsmall capitalization rural financial intermediaries.

Priority 2:Institutional Retail Capacity

Subpriority 1:Reform governance and incentives within organizations with the aim of instilling a drive foroperational efficiency and financial self-sufficiency combined with a social commitment.Focus on private and me mber-owned institutions.

Subpriority 2: Improve management quality in financial intermediaries with sizeable rural portfolios.

Subpriority 3: Assist in the transfer of new service delivery technologies appropriate for a rural setting anda generally moderate- to low-income clientele.

Subpriority 4: Promote linkages between formal and informal intermediaries in rural areas and betweenurban and rural based financial intermediaries.

Subpriority 5: Provide financing to expand operations of high potential organizations.Priority 3:

Product InnovationSubpriority 1: Deposit MobilizationSubpriority 2: Commodity Collateralized Finance (warehouse receipts, accounts receivable etc.)Subpriority 3: Electronic cardsSubpriority 4: LeasingSubpriority 5: InsuranceSubpriority 6: Hedging InstrumentsSubpriority 7: Payment Transfers

47

Annex 5:Highly Desirable Conditions for Product Innovation

SelectedFinancialProducts

Policy, Legal, and Institutional Requirements

Voluntary SavingDeposits

• Liberalized financial sector (no interest rate ceilings).• Institution licensed, subject to reserve requirements, and regulated. Note: Member-owned institutions may be exempted but emphasis should

be placed on solvency and informal supervision or ratings.

NegotiableWarehouse

Receipts

• Warehouse Law (must provide legal protection for depositors andallows the co-mingling of various deposits in order to lowertransaction costs).

• Bonding and/or Insurance Fund Established to Protect Depositorsagainst Financial Failure of Warehouse.

• Uniform grades and standards exist (essential for impersonal a“paper trading” based on solely on commodity description).

• Adequate physical infrastructure(transport, drying, storage).

ElectronicCards(Debit,

Credit, Smart)

• Efficient and reliable communications infrastructure.• Functioning credit bureaus (case of credit cards).• Effective contract enforcement mechanisms.• Compatible networks and standardized equipment.

Leasing

• Ability for leasor to quickly and inexpensively reclaim propertyfrom leasee in case of delinquency.

• Availability and affordability of property and liability insurance.• Allowance for deduction of leasing interest expenses from pre-tax

income.• Allowance of depreciation to leasor.

Insurance (crop)

• Licensed and regulated insurance carriers.• Availability of reliable, low-cost information on specific perils and

yield loss correlations.• Availability of international reinsurance.

Hedging

• Country creditworthiness.• Liberalized Financial Sector (no exchange rate controls).• Financial, Civil, Commercial Codes that recognize hedging

contracts.• Absence of government actions that hamper development of

private sector risk management techniques, i.e., domestic pricestabilization schemes.

• Commodity Exchanges and Clearinghouses for transactions• Uniform Grades and Standards.• Adequate data processing and communications infrastructures.• Adequate transport and storage facilities.• Knowledge of how to analyze and quantify risk exposure and use

the instruments on the part of market participants, brokers, andfinancial analysts.

48

Annex 6: Results of Public Consultation Process

PersonMaking

Comment

InstitutionalAffiliation Country Summary of Prin-

cipal Points RaisedResolution ofIssues Raised

Relevant section or pagereflecting incorporation

of comment

FranciscoJavierDelgado

Banco deMéxico-FideicomisosInstituídos enRelación conla Agricultura(FIRA)

Mexico

1. Fundamental issuein lack of mediumand long- term creditis not lack of institu-tional supply, butpresence of risk.

2. Make more explicitthe role of comme r-cial banks.

3. Can work simulta-neously in three areas:policy, retail capacity,and new products.

1. Rephrased togive equal weightto lack of domes-tic savings, mac-roeconomic sta-bility, and riskissues.

2. Partially ac-cepted.

3. Accepted.

1. Paragraph 3.10 rewritten.

2. Paragraph 3.24 modifiedslightly.

3. See last paragraph on pg.iii of executive summary andparagraph 5.5. Was never animpossibility. Languageclarified.

RoqueMiranda

Instituto deDesarrolloSocial y Pro-moción Hu-mana (IN-DES)

Argentina

Recommends incen-tives for urban basedfinancial intermedi-aries to extent to ruralareas.

Partially Ac-cepted. See end of paragraph 3.24.

FranciscoRhon

CentroAndino deAcciónPopular

Ecuador

1. Too much empha-sis on agriculture.

2. Emphasize role forcooperatives andcredit unions.

1. Partially Ac-cepted.

2. Not Accepted.

1. See third paragraph ofexecutive summary.

2. Paragraphs 3.24 and 4.20provided a balanced treat-ment. Thrust of comment,generally not supported byempirical evidence. Theremay be individual countryexceptions.

DaleAdams

Retired OhioState Univer-sity Professor

USA

1. Historical discus-sion lacking.

2. Emphasize savingdeposits.

3. Emphasize Trans-actions Costs

1. Not Accepted.

2. Accepted.

3. Not Accepted.

1. See background paperentitled “Lessons Learned.”Has extensive discussion ofhistory of rural lending.Strategy document is not theappropriate place for longhistorical treatment.

2. Paragraph 3.29 rewritten.

3. Paragraphs 3.2-3.5 providea balanced asses sment.

49

J.D. vonPischke

President,Frontier Fi-nance

USA

1. Remove the word:“credit needs”. Itconnotes entitlement.

2. Chapter III is toooptimistic.

3. Make clear thatdonors should focuson “policy environ-ment” and let privatesector handle “down-stream” retail capac-ity.

1. Partially Ac-cepted.

2. Partially Ac-cepted.

3. Accepted.

1. Removed in most places.

2. The changes proposed areambitious but the wholedocument is caveated and nopancreas are purported, justrational, systematic actions.

3. Paragraph 4.8 has beenmodified to emphasis thepoint.

MarkSchreiner

WashingtonUniversity inSt. Louis

USA Extremely supportive. NA NA

DougPearce

Natural Re-sources Insti-tute

UK Extremely supportive NA NA

Consultation Process:The document was distributed by email to 23 prominent persons in the field of rural finance inboth English and Spanish, representing a cross-section of academia, finance, government, inter-national development organizations, and consulting firms. In addition, ACDI/VOCA, a U.S.based non-governmental organization, emailed the document to over 50 private and civil societyorganizations in Latin America and the Caribbean. Both language versions of the document werealso placed on the IDB website in April 2000 and availability was announced via DEVFINANCE,an internet user group with over 600 members dedicated to sharing information related to anddiscussing microfinance issues. A reminder notice was sent to the list of prominent persons andcivil society organization on June12, 2000. The official comment period was 45 days long, start-ing on May 12 and ending on June 26, 2000.