BUSINESS WORLD
Measuring Financial Market Access In Sierra Leone
By
Oct 10, 2008, 02:42

The national government and its international aid agencies commonly intervene in financial markets in Sierra Leone. These interventions use a substantial amount of resources and may have dramatic macroeconomic consequences. Over the past few decades, under the structural adjustment programme (SAP) of the IMF/World Bank, there has been a rising chorus calling for financial market liberalization.

The recommendation that credit markets be liberalized is based on simple and compelling economic logic: interest rate ceilings lower the supply and raise the demand for credit, leading to administrative rationing and associated rent-seeking behavior, while discouraging saving mobilization. This analysis and the consequent recommendations undoubtedly are substantially correct for the formal sector (although caution based on the theory of financial markets with incomplete information should be added).

However, the vast majority of financial transactions occur outside the boundaries of the regulated banking sector. An understanding of the economics of this informal financial sector is a prerequisite for satisfactory financial policy analysis. There exists a substantial and well-developed literature on the economic theory of credit markets and saving decisions in economies characterized by incomplete markets and imperfect information. This theory is directly relevant to informal financial transactions in the country.

In addition, there is a substantial body of empirical research, which provides descriptions of the institutional arrangements through which financial transactions are effected in Sierra Leone and indeed in Africa, and which permits some limited quantification of the relative importance of various institutional arrangements. Lacking, however, from most of the literature on informal finance in the country is an integration of economic theory with empirical observation.

This paper provides: (1) a brief review of both the relevant theoretical and empirical literature; (2) an account of the usefulness of the theoretical literature for interpreting the empirical research on informal finance in Sierra Leone; (3) brief notes on some of the implications of the economics of incomplete information and imperfect contract enforcement for financial policy in Africa; and (4) suggestions for a research program which integrates detailed empirical observation with relevant theory.

Resource transfers over time are essential in the seasonal agricultural economies of the rural areas of many poor nations. It is not surprising that much effort has been placed into attempts to understand rural loan transactions and the role of credit in the rural economy by focusing on this central aspect of credit transactions. This is not always the case. Prior to the 1970s, rural credit was often viewed as a direct input into agricultural production. As with any other factor of production, an expansion of the supply of credit would lead to an increase in agricultural output. Many researchers have noted that the moneylender is "an efficient fellow who provides a valuable service to his clients”. They pioneered the investigation of the structure on informal credit markets and in particular paid close attention to transactions costs and patterns of competition. Their work firmly established the notion that rural credit transactions occur in a market, which transfers resources across people and over time.

In addition to performing their core role in the inter-temporal allocation of resources, however, credit transactions reflect the economic environment within which they occur. In the rural areas of poor countries this environment is characterized by objective risk, with unpredictable variations in income as a result of weather and other exogenous processes. Complete insurance markets are absent, so credit transactions take on a special role in allowing resources to be transferred in response to income shocks. The environment also may be characterized by costly acquisition and asymmetric distribution of information.

Moral hazard and adverse selection therefore may arise, along with special organizational features that serve to mitigate or accommodate the problems caused by these information asymmetries. It will be seen that considerations of risk and information are central to the special character of rural credit transactions, and that an effort to focus exclusively on the transfer of resources across time will generally be misleading. The theoretical analysis of financial markets in developing countries has been transformed through the application of the theory of economic behavior under conditions of incomplete markets and imperfect information. A large number of researchers have explored the implications of imperfect information and incomplete markets for contractual forms in credit markets in low-income rural settings.

These deviations from the simple paradigm of competitive equilibrium seemingly provide a new theoretical foundation for policy intervention designed to correct market failure. Of course, an observation that a credit market is subject to moral hazard or adverse selection in itself does not provide an economic rationale for intervention to correct a market failure because the incomplete information equilibrium may be constrained Pareto efficient. Nor does economic theory generally provide sufficient guidance to predict the distributional or efficiency consequences of a proposed policy change. A rich set of empirical knowledge is required before such conclusions can be drawn. It is believed that there may be good arguments for intervention and some are based on market failure. However, as one begins to unpack each argument, there is a gradual realization that given the present state of empirical evidence on many relevant questions, it is difficult indeed to pinpoint when a credit market intervention is justified. There can be little doubt that empirical work, which can speak to these issues, is the next challenge if the theoretical progress is to be matched by progress in the policy sphere.

If financial policy analysis in Sierra Leone is to progress beyond on the one hand sophisticated theorizing based on inadequate empirical knowledge and on the other descriptions of extant financial institutions, we must conduct research, which is based on detailed observation guided by the theory of financial transactions when information is incomplete and enforcement of contracts is imperfect.

There is a growing recognition that increasing access to formal financial services has both private and social benefits. Extending the breadth of financial service availability in a given population causes economic growth and can improve income distribution. And the poor benefit disproportionately from financial development. Monitoring and measuring levels of access to formal financial services can therefore contribute to achieving goals of growth and poverty alleviation. In addition to helping policy makers, practitioners, researchers and the private sector more fully understand the current and potential supply and demand for financial services; more comparative data will also serve to provide lessons on enhancing access and motivate countries to reform their financial systems to encourage greater access.

Such measurement has to date been limited by scarcity of data as well as the lack of standardized tools for measurement. Measures of access fall into two broad categories, those based on the providers’ information, such as banks and other service providers, and those based on users’ information – individuals, households or firms. These indicators would form a core component of more extensive surveys of household financial access. Information from household surveys is nevertheless only one potential source for data on access indicators, and households constitute only one segment of users of financial services.

It is often pointed out that people may have access to financial services but may not wish to use them. Such voluntarily excluded persons it is argued should be included in measures of access even if they do not use financial services. However, the relationship is complex. Even among the ‘voluntarily excluded’, who claim to not want services, this may in reality be because such services are unaffordable, unsuited to their needs, or because the potential users fear that they will be rejected upon request. And among the ‘involuntarily excluded’ from services such as credit, some represent such poor credit risk that lenders cannot prudently serve them.

Due to the ambiguity and complexity in defining concepts of access that differ from usage, it is proposed that current users provide the basis for defining core indicators of access, defined with the objective of identifying and tracking the boundaries of exclusion. Another core concept concerns the boundary of the individual versus the household as a measure of response. While much theory and practice on household incomes and expenditures is centered on the household as a unit, the intra household power structure can often be complex and opaque and access cannot be assumed for all in the household if any one member has access. Using only the household as respondent also leads to the risk of losing valuable demographic data, on the users of financial services.

Indirect access through another household member may be as important as direct access. Even if the individual is the unit of response, it is desirable to measure both direct as well as indirect access to financial services through other family members. This prompts the incorporation of a sub index to measure indirect access. It is recognized that especially in poorer countries like Sierra Leone, it is sometimes difficult to isolate a single household member from the rest of the family unit, as a user of financial services. Although in some respects more difficult to measure, the proposed indicators below adopt the adult individual as the appropriate unit of response for survey data on financial access.Credit assumes special importance as it provides a means to smooth consumption, protect against shocks and in some cases, make productive investments, which lead to higher future income. Credit offers the means to make inter-temporal financial decisions – e.g., spend money productively now in order to be able to earn better later.

In addition to loans, credit facilities such as overdrafts or lines of credit are increasing in importance. Product distinctions may also serve as indicators of levels of access, e.g., whether loans are available for longer duration needs, such as mortgages, education, or vehicle finance. The core caveat is that these should be constructed on the basis of an aggregation of different sources of income rather than on the basis of a single question. The poverty dimension could be incorporated in a number of ways, e.g., (i) measuring access to persons below the poverty line, as defined for the country, (in terms of monthly income); (ii) the minimum wage, as defined for the country, or (iii) standard benchmarks, such as the proportion earning less than, e.g., $1 per day or $2 per day; or (iv) the bottom quintile of the sampled population. Of these, the first two are externally defined parameters, and must be specified for the country, and in some cases there are multiple poverty lines defined for each country, based on family size, community or ethnic group, etc. The second concept, of the minimum wage, is difficult to apply to the self-employed. The third is not country specific but will have very different implications depending on average per capita income. The fourth abstracts from additional external parameters and is proposed here. Note however that in Sierra Leone, the bottom quintile may capture an insignificant proportion of formally included among the adult population. Robustness checks may be needed to see whether a higher threshold, e.g. bottom third or lower half, would be more meaningful.