Main Policy Conclusions and Research Challenges

Clearly, there is not sufficient finance to support inclusive growth in LICs. It is not just the quantity of finance that matters, but also its maturity and cost. The quantity and the quality of finance in LICs are both problematic. There is insufficient finance, and that which is available tends to be short term, expensive, and not well suited to the needs of borrowers. This is especially true for small and medium-sized enterprises, ‘the missing middle’.

An area of focus of this paper has been the cost of loans, which remains high in many LICs. This restrains growth and fosters financial instability. Solutions have proved elusive. Numerous reforms to increase competitive pressure and efficiency in the banking sector have had little impact upon spreads. Identifying and addressing the determinants of reducing the cost of finance, for individuals and firms in LICs, including through greater transparency and possible regulation, such as capping interest rates is a crucial area of future research.

The structure of the banking sector is important. A first feature should be that the financial sector should be simpler, in the sense that, for example, the type of instruments used should not be complex or opaque, and thus the risks could be more easily assessed by the institutions themselves, and by the regulators. This facilitates that regulation itself should be simpler. Furthermore, simple arrangements and institutions that increase and share information, like credit bureau, can play a very positive role to both increase access to credit and to enhance financial stability.

Evidence suggests that a diverse set of banking institutions would improve both the quantity and quality of finance for different borrowers, and would therefore have positive impacts on inclusive growth and stability. As regards the latter, the benefits of diversification for reducing risk is well known, within institutions, but should also be applied across institutions. Further research and policy discussion seems necessary for the desirable composition of the financial system in LICs, for example the balance between public and private banks, large and small institutions, domestic and foreign, and between more universal banks and those focused on particular sectors such as SMEs.

While the potential for development banks to foster inclusive growth in LICs is significant, there are some risks. Our understanding of how to design and run ‘good’ development banks that can fulfill this potential while avoiding risks is growing, but remains at an early stage. The need for development banks is not new, but new challenges and what we have learned about successful development banks make this a new area of research in development finance. Focusing on LICs, where the need for development banks seems large, but the risks they create may also be large, seems a particularly important area of research.

Regulation is fundamental. If we know more about the types of financial institutions that are best suited to balancing inclusive growth and stability in LICs, it is necessary to design regulatory frameworks and other measures to encourage/support the emergence of these institutions. A second issue is how different types of institutions should be regulated and supervised in LICs. The benefit of a diverse set of finance institutions is that they can offer different services to different groups of customers. It is important that regulation is designed to support—rather than stifle—the services different financial institutions can provide. Furthermore, though regulation may be diverse, it should be equivalent, to avoid regulatory arbitrage. It should also be comprehensive, so all financial institutions providing credit are regulated, but such regulation should be proportional to the level of systemic risk different financial institutions are likely to generate.

A diverse mix of heterogeneous institutions is very unlikely to evolve naturally, or to survive if it does so. Understanding how regulation and other government policies can help support and maintain this process in LICs is another new area of research. Macroprudential regulation is an important area for regulation that has been mainstreamed since the global financial crisis. It requires better understanding on how domestic regulation interacts with the macroeconomic and external environment in a LIC setting, including which tools are most appropriate (whether, for example, focusing on domestic financial regulation or managing the capital account) to deal with this interaction such that stable, inclusive growth is supported.

Simply importing frameworks from developed and emerging countries, such as Basel II and III, is not the solution. If LICs are to use financial regulation to help strike the right balance between growth and stability, this will need to be designed explicitly for the circumstances of low-income countries. Again, more research is required.

We have focused more on the banking sector; however, capital market development, especially local currency bond market development, is also an important area, both for policy and research. Financial sector development is crucial for inclusive growth in LICs. However, financial instability can have devastating consequences, especially for poor people. How finance can help achieve the optimal balance between growth and stability in LICs, and the role that regulation should play in this, is among the most pressing development questions policymakers and researchers face. We hope to have contributed to an understanding of these issues with this book, by providing some answers, but many more questions.

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