Are small, local banks the solution for developing countries?

In the latest Economist Roundtable, Justin Lin Yifu, the Chief Economist at the World Bank argues that low-income countries (with economy reliant on small-scale manufacturing, farming and services firms) need to make small, local banks the mainstay of their financial systems. He feels that the size and sophistication of financial institutions and markets in the developed world are not appropriate in low-income markets. In other words, the structure of financial institutions and markets in many developed economies is inappropriate for many developing economies.

He draws attention to the experience of Japan, South Korea and China, which managed the transition towards higher income growth trajectory by adhering to "simple banking systems" (rather than rushing to develop their stockmarkets and integrate into international financial networks) and without liberalizing their capital accounts until they became more advanced. Even in the US, during the early labour-intensive phase of its economic development, local banks were dominant. Further, given the realtively mild effect of the financial crisis on America's large number of community banks, smaller banks are much more resilient when faced with such crisis. He writes,

"Microfinance companies and other non-bank financial institutions will play a more important role in financing poor households... stockmarkets are not the best conduit for providing finance to the small- and medium-sized businesses that characterise the early stages of countries’ economic development... gigantic banks... tend to serve relatively wealthy customers. Smaller domestic banks are much better suited to providing finance to the small businesses that dominate the manufacturing, farming and services sectors in developing countries... growth is faster in countries where these kinds of banks have larger market shares, in part because of improved financing for just these kind of enterprises."

He also points to the importance of instruments like credit registries (enable first-time entrepreneurs to document their personal credit histories and share them with lenders) and collateral registries (enable lenders to verify that assets such as property and vehicles have not already been pledged by the borrower to secure past loans) that lower transaction costs. Transparent and efficient court procedures to allow lenders to seize collateral, competition among small banks, and a regulatory framework that facilitate efficient exit and entry of banks are other important requirements.

Mark Thoma draws attention to the utility of sophisticated financial products like futures contracts and crop insurance to hedge price risk for farmers, and claims that a more appropriate model would be for the local banks to be embedded within a larger financial system so that the small banks can make available products that local banks cannot provide on their own. However, the problems of information asymmetry and difficulty in evaluating the risks of complex financial porducts, means that the markets should be regulated adeqautely and governments should themselves provide these financial products (like price guarantees for crops, crop insurance etc) wherever markets are likely to fail. He also writes that the local knowledge that allows local banks to assess the credit risks of individuals and firms more accurately should be preserved and made available system wide so that more comprehensive systems can emerge.

As Asim Khwaja writes, evidence that small, domestic banks have more smaller/local (profitable) clients and that growth is higher in countries with a greater share of small banks, does not conclusively prove that "small (banks) is better than big". There may be co-relations at work here - small, domestic banks may have more small clients simply because the larger banks have skimmed off the readily identified good borrowers (the large, established firms); higher growth countries may create room for more (smaller) banks and thus it is growth that produces an increase in the small bank share and not vice versa.

While advising the World Bank to avoid the area of banking and financial reform and focus instead on the more traditional anti-poverty projects, Tyler Cowen feels that if the larger financial institutions start to emerge naturally, from market forces, they should be encouraged.

Both Luigi Zingales, Ross Levine, Todd Moss, and Abhijit Banerjee stress on the importance of equity markets in mobilizing risk capital to fund new ideas and new ventures and promote entrepreneurship. Levine points to the need to "construct laws, regulations, and institutions that create a healthy environment in which financial institutions compete to provide the most useful credit, risk, and liquidity services to the 'real' economy" and thereby promote entrepreneurship, expand economic opportunities and lead to economic growth.

Banerjee also points to the examples of China, Taiwan and India which appears to suggest the inevitability of large amounts of loans getting written off and public monies ending up in private (or semi-private) hands, in the process of chaneling bank credit to smaller firms that would not have otherwise been seen as credit-worthy enough.

Banerjee also points to evidence in the context of bank lending to small firms that suggests that "large banks are less willing than small banks to lend to informationally 'difficult' credits, such as firms that do not keep formal financial records" They also find that large banks "lend at a greater distance, interact more impersonally with their borrowers, have shorter and less exclusive relationships, and do not alleviate credit constraints as effectively", and therefore favors small banks as being better able to collect and act on soft information than large banks.

Justin Lin also appears to have overlooked the several advantages that come with bigger financial institutions. Smaller local banks can compete with the branches of larger national banks, as is the case in India. Smaller banks are handicapped by their inability to assume larger risk due to their smaller portfolio and quantity of assets which limits their ability to diversify risks. As Abhijit Banerjee writes, they can become captive of a small group of investors or even non-investing political actors, who then use their leverage on the bank to steal the money of the depositors. Further, an increased number of smaller banks makes regulatory supervision more difficult to effectively enforce.