D+C Development and Cooperation (No. 1, January/February 2001,
p. 12-14)

Development banks were founded in the 1950s and 60s to provide investment capital to the private sector. However, their funds were often used for the wrong purpose and did not benefit the poor. This was followed by the idea of 'rotating funds' with money from big donor organisations and NGOs which provided small credits but also missed their goal of sustainability. After the microcredit summit of 1997, the concept of commercial microcredit banks became popular - an idea which if properly organised can be both profitable and beneficial for the poor.

The founding of financial institutions in the developing countries whose target groups are supposed to be poorer people and, in particular, income-generating micro, small-scale and medium-sized enterprises, originated in the industrialised nations. Soon after Western "development policy" began in the 1950s and 1960s the donors noted that investment in infrastructure was insufficient to achieve growth. Reflecting on the experiences of Europe, state or mixed-enterprise development banks were founded in many developing countries with the support of various donors. The banks were to promote industrialisation as a substitution for imports, as well as farming, housing construction and regional development. Their common feature was that they combined the characteristics of a bank and a public authority. On the one hand, they managed loan holdings and handled payment transactions, and on the other they "promoted" development by non-repayable grants. Since these functions each followed a very different logic, the banks were required to undertake a difficult tightrope walk.

Exclusion of small borrowers

As a justification for the existence of state banks, even in liberal market economies people like to point out, and rightly so, that normal commercial banks would have scarcely any interest in the business of the "small fry", and that they also shun longer-term financing of investment. Since the publication in 1981 of the ground breaking article "Credit Rationing in Markets with Imperfect Information" by Joseph Stiglitz and Andrew Weiss, this restraint is also accepted in research and practice as "rational". A lender cannot beforehand tell the difference between good and less good borrowers, and must set a uniform interest rate for his credit offer. In order not to lose his cost-efficient and low-risk customers, meaning to avoid what the economists call "adverse selection", he sets the interest rate not as high as he would have to in covering his costs in the case of small borrowers, and "rations" his loans according to criteria such as reputation, collateral and business volume. Even in an otherwise completely liberalised model world, small borrowers remain excluded from formal bank loans even if they would be able and prepared to bear cost-covering terms. That applies to an even greater degree to women as borrowers because, other things being equal, in most countries of the world they have lower incomes than men and also are discriminated against in access to property rights.

Therefore, in microeconomic terms, the idea behind the founding of development banks is well-founded. However, the design of the institutional structures, including the governance structure, requires a fine balancing of the bank and public authority functions in order to reconcile efficiency, cost-covering and the promotion mission. All too often, the easy way out for all involved is to combine the negative features of bank and public authority, meaning linking profit-mongering and the exclusion of small borrowers with a subsidy mentality and politisation. As critical studies from the 1970s showed, following the initial euphoria, development banks seldom live up to their promises.

For the donor institutions, however, these banks are ideal counterparts in absorbing financial and technical assistance. Thanks to their banking function in payment transactions, they practically never have outflow problems. In addition, they can at any time produce from their broad portfolios the projects demanded by a donor or his client, such as a parliamentary committee. And promoting development banks also promotes the exports of the donors, meaning the industrialised nations.

An important point of criticism focuses on this "hidden" promotion of exports. This is that micro, small-scale and medium-sized enterprises mostly do not need a great deal of imports, and especially not so long as they are still building a trusting relationship with their bank to overcome the asymmetrical information mentioned above. So they need loans in local rather than foreign currency.

When favourably-priced foreign currency loans are available for projects which a bank, public authority or company would in any case implement or promote, these can be used for other purposes, such as for imports of consumer goods or other agreeable things which otherwise could not be afforded. So who can blame politicians, bureaucrats, bank directors or companies when they prove to be fervent supporters of the financing of development banks!

In addition, financial assistance for development banks contributes to maintaining "financial repression" in the developing countries. Since the separate studies of Ronald McKinnon ("Money and Capital in Economic Development") and Edward Shaw ("Financial Deepening in Economic Development") published in 1973, economists understand that term to describe a situation in which the interest rates of the formal financial sector are fixed administratively at a low level, that is, well below going market rates. Because domestic asset holders then have no incentive to make their money available for loans, they move it abroad and thus block the growth of the banking sector, which is important for the development of every economy. But the necessary reform of the interest rate structure must appear to governments to be not so urgent if there is an inflow of enough money in the form of capital assistance.

Critics of the development bank system did not have an easy task in asserting themselves against the concerted interest of individuals on both the donor and recipient sides. But the search for alternatives began on a broad front in the 1980s.

Alternatives to development
bank promotion

Committed politicians, bureaucrats, academics, consultants and NGOs in various countries around the world began to get down to serious work in forming a new policy. Their efforts were based on the declared principles of poverty alleviation and sustainability in institution-building in promoting micro, small-scale and medium-scale enterprises via the finance sector. The results were published in the World Bank's World Development Report of 1989.

In an initial step, so-called "integrated" rural and urban projects and programmes were equipped with their own "rotation funds", which were to finance employment and income-generating measures. However, due to their integration in projects focused on infrastructure measures such as slum clearance, irrigation, electrification, public health services and regional planning, they degenerated typically into drawing funds for project managements. That meant that a recipient mentality rather than a sustainable financial service provider structure came into being, and the mixing of loans and free gifts undermined rather than promoted a positive attitude towards market-conform financial relationships.

The Grameen Bank in Bangladesh is a special case. Here, the charismatic Professor Muhammed Yunus persuaded the government to place a state bank in the service of poverty alleviation, and for landless women in particular. The results are not undisputed, especially since the bank is still very dependent upon subsidies. But this institution shows that participation in the monetary economy is anything but a matter of course, and that emancipation of women as free economic citizens is a goal to which purely technological financial principles should perhaps be subordinated. The Grameen Bank has yet to stand the test of developing into a sustainable institution without a heroic head and without subsidies. Maybe it will really show how a poor country like Bangladesh can establish itself in the long term as a "funnel" for permanent development assistance transfers. But a final assessment does not appear to be possible at present.

The NGOs are another alternative to customary development banks. Donors like to promote them because they are close to the target groups, or at least are able to portray themselves so. In practice, however, they prove to be problematical partners when it comes to developing a durable formal finance structure in the interests of small borrowers. As committed left-wingers, NGO members and leaders usually take a sceptical stance towards the market and its "bourgeois" laws. They are seldom willing to act as bankers with all necessary toughness and assume the "ownership" of a financial institution. That applies to their international partners as well, particularly church organisations, and also to the Scandinavian, German and Dutch officials in bilateral and multilateral government institutions.

On the other hand, NGOs often are sponsored by big companies and conservative donors, especially those based in the USA and Switzerland, that for political reasons wish to "sell" the vision of a "bottom-up market economy" to rural smallholders as well as to small-scale traders and other workers in the urban informal sector, without being really interested in their wellbeing.

Critical evaluations show that in some cases NGOs can be persuaded to found financial institutions and also run them as sole or co-owners. But the success of such upgrading projects depends very much upon the consultants and donors, and above all upon the existence of a capable leader. They cannot, however, be regarded as a norm.

The commercial approach

The target groups and the academics advising them on-site noticed after a while, of course, that the big words were hollow. They realised that first and foremost it was a matter of the hidden agenda of the national and international financiers and not particularly about reducing poverty among the target groups. If the "frontier" of the formal finance sector was to be pushed downwards in the direction of the poor, what they really needed in financial services had to be made available to them. These were small, readily available operating funds and emergency loans and secure and worthwhile investment options for temporary financial surpluses. Since poverty was a mass phenomenon, these financial products had to be offered with a loan technology, meaning a form of organisation, that gave them a mass reach with as much saturation as possible.

The then prevailing pattern was "controlled investment loan", involving obligatory consultancy, subsidised interest rates and relatively large sums to push through innovations in the context of "pilot projects" which, however, due to limited subsidy funds, never got beyond the promotion of a few "pilots". So the reformers' diagnosis meant a radical change. But there were enough people on either side of the political "barricades" who became convinced by this plausible if hardly grandiose concept. As a self-supporting commercial system which nevertheless was in the interests of the target groups, it began to assert itself towards the end of the 1990s under the label of "commercial approach" or "new development finance". The system was finally reflected in the development cooperation concepts of the German Ministry for Economic Cooperation and Development (BMZ) of 1997 and 1998, and the thinking of the World Bank and the multilateral Consultative Group to Assist the Poorest (CGAP 2000).

After the fall
of the Berlin Wall

With the fading of utopic visions, empirically-based diagnoses gained ground and showed that precisely an unpretentious and reliable bank-customer relationship was the best contribution a bank could make to economic survival. In addition, they also demonstrated that in many cases a bank could in fact also help the target group of poor people, and particularly micro- and small-scale enterprises, to accumulate assets. Furthermore, it should be not only be mentioned but even emphasised that there were, and should be, public services of all kinds, including old age pensions, family allowances and similar transfers which counter poverty around the world. That was necessary to prevent microcredit programmes and similar bank services facing a demand they could not meet. Taking out a loan and servicing it with interest and repayment of the capital sum is always a burden for the borrower, and possibly a benefit only in so far as it enables a special opportunity for profit to be seized. For the poorest of the poor, transfers are called for, not loans and other bank or insurance services.

Development cooperation practicians on the ground and ideologically unbiased theorists alike came to these conclusions as early as the mid-1980s. But the ideological pressure did not ease until after the collapse of the East Bloc, when both the Communist threat and the utopia of the non-capitalist workers' and farmers' paradise disappeared.

So it is not surprising that shortly afterwards the practicians of both sides and the immediate representatives of the target groups got together with enlightened representatives of donors, consultants and academics to form an international coalition titled "New Development Finance". The Microcredit Summit of 1997 with Hillary Clinton had already leaned in this direction, even if it still sent no clear signal in regard to the issue of dependency on subsidies. But the donors gave a green light for a massive financial promotion. World Bank president James Wolfensohn promised that together with all the other summit participants he would go all out to ensure that by 2005 an additional 100 million families around the world would have microcredits.

The subsequent "Annual Conferences on New Development Finance", which took place at the University of Frankfurt/Main from 1997 to 1999, then developed into an important forum at which formerly diametrically opposed actors joined forces against the "ancien regime". According to their definition, "old" is everything which boils down to the demand of re-educating people and coupling loans with obligatory consultancy. In the long term, that results in dependency on subsidies, becoming hostage to the political games of influential national rulers and donors, and loses sight of the declared target group of the urban and rural poor. All this applies mainly to smaller countries which receive heavy international assistance. In India, Pakistan and Brazil, not to mention China, the conditions have their own rhythms and special features.

After the end of communism there was a new situation not only in the developing countries and the North-South relationship, but also and above all in Eastern Europe. Established donor institutions such as USAID and the Reconstruction Loan Corporation (KfW) were supplemented by the multilateral European Bank for Reconstruction and Development (EBRD), and what were soon to be called "transformation countries" lined up with the "classic" recipients of international development aid.

Internationally operating NGOs and consultancies with experience of the microcredit systems of developing countries were now also called for to assist the projects and programmes in Eastern Europe. The finance sector was perceived as the core of every market economy. At the same time, the donors soon recognised the importance of small to medium-sized businesses, trades, smallholders and all the many disparate micro and small-scale enterprises for employment and the supply of the population. However, financial services were not available to any great degree to cover their needs.

It could now be seen that payment transactions did not function without commercial banks, and that this shortcoming had a considerable negative impact on small enterprises. Going beyond microcredits, which until then had always been the main instrument of financial assistance, the focus was now on deposits, transfers and all the other financial services that were important for the target groups. "Microfinancing" gradually became the generic term for the orientation of financial sector measures to benefit the "small people".

"Downscaling" or
"starting from scratch"

By means of special loan programmes, which were kept separate from other portfolios, the external donors sought at first to persuade the existing banks to downscale their activities and address the newly emerging small to medium-sized businesses in the private sector. On balance, the result was rather meagre, for these programmes did little to influence the characteristics of the major Eastern European commercial banks. And every time some of them were privatised or had to be shut down due to financial rows or corruption scandals, it affected the special small enterprise portfolios regardless of how efficiently they were managed.

Besides using this channel via the big banks, donors also began building up loan programmes through NGOs and local chambers of commerce. The results here were also disappointing, for local implementing organisations are mostly unsuitable for a sustainable mass banking business.

But senior officials and executives at donors and consultancies soon had the idea of founding their own micro-finance institutes. "Starting from scratch", "greenfield banking" and similar terms began to make the rounds. The first "Micro-Enterprise Bank" came into being in Bosnia, and soon afterwards other micro-finance institutions (MFIs) were founded in Georgia, Albania, Kosovo, Haiti, Bolivia, Nicaragua, Mozambique and other countries, configured on local conditions and with varying partners. The World Bank subsidiary, International Finance Corporation (IFC), also took part, and in the summer of 2000 it began to set up a "Global Microfinance Capacity Building Facility", which led to further foundings.

Unlike customary development cooperation projects, which have a timeframe, the MFIs are open-ended, and consultants in the North also see themselves as long-term partners. In contrast, international development organisations are more and more becoming second-class partners from which local bodies must sooner or later separate themselves again to avoid being left in the lurch. After all, their cooperation has a time limit, and they will leave the country again.

In view of the challenges of globalisation, the German savings and cooperative banks should perhaps consider using their development projects to establish a network of longterm investments and thus fulfil their promotion mission in favour of the "small people" not only locally and nationally, but also globally.