We mentioned that development finance plays an important role in expanding capital availability to finance economic growth and development, and these include, first, minimising the imperfections in financial markets and institutions in order to improve on the level of efficiency and, second, establishing alternative financial institutions or development finance institutions to provide direct capital in the market. These two forms of interventions need to be regarded as complementary and should be used in ways that achieve the objectives of development finance. Next, we discuss each of these interventions or strategies.

Interventions for correcting market imperfections

These are concerned with reducing the main sources of inefficiencies that introduce gaps in the required and available finance. Interventions for perfecting the financial market include measures that aim at improving the performance and functioning of the financial market and institutions in ways that enhance available financing for development. This is crucial given the important role financial markets and institutions play in facilitating the supply of funds for financing economic activities.

The following are some of the interventions aimed at improving the operation and performance of the financial markets and institutions:

  • Ensuring effective financial market regulation - the regulation of financial markets is necessary given their complex nature and importance in the economies they operate in. The regulation of the financial market ensures market participants are treated fairly and has implications for the performance of various financial institutions. The essence of regulating financial markets include protecting investors, preventing securities issuers from defrauding investors and hiding important information, promoting the stability of financial institutions, promoting competition and fairness in the trading of financial securities, restricting the level of activities of foreign entities in local markets and institutions, and controlling the level of economic activity.
  • Introducing risk management instruments - this includes the means by which market players share their risk with counterparties. It may involve the use of insurance contracts and financial derivatives such as forwards, futures, options, swaps, and swaptions.
  • Reducing cost of contracting and information processing - financial institutions handle huge volumes of transactions and tend to enjoy economies of scale related to contracting and processing information on securities. The low costs associated with contracting and processing would benefit investors and issuers of securities. Also, the ability of financial institutions to obtain information concerning potential borrowers and screening out bad credit risks helps in dealing with the problems in connection with adverse selection and moral hazards.
  • Providing efficient payment system - providing for payment mechanisms like cheques, electronic transfers of funds, debit cards, and credit cards enables financial institutions to transform certain types of assets (i.e. those that could not be used in making payments) into other forms of assets that can be used to effect payment. The financial market provides the means of making payments without using physical cash, and this is necessary for the effective and efficient functioning of the market.
  • Introducing financial innovation - attempts to reduce market imperfection also involve introducing financial innovation to improve on the level of efficiency in the financial market. Financial innovation entails the development of new financial products or services; the introduction of new processes or delivery systems that result in reducing costs and risks or providing enhanced services to meet the needs of market participants; and the emergence of new kinds of financial service providers. The financial innovation process involves changes in financial instruments, institutions, markets, and practices. More generally, financial innovation tends to affect the nature and composition of monetary aggregates by introducing new financial instruments or changing existing financial instruments. Financial innovations result in reducing the transaction cost associated with transferring funds from lower-yielding money instruments to higher-yielding ones. Thus, participants in the financial system are able to minimise their risk and maximise their returns.

Establishing development finance institutions

Development finance institutions (DFIs) are alternative financial institutions that are concerned with providing long-term finance (e.g. long-term loans, equity, and risk guarantee instruments) to promote private investment for economic growth and sustainable development while ensuring they remain financially viable. They concentrate mainly on areas that providers of conventional finance tend to avoid and on markets, which have limited access to sources of domestic and external capital. DFIs are said to occupy the intermediary space between public aid and private investment by focusing on high-risk investments in sectors that have limited access to capital markets. They are capable of raising huge amounts of capital from the global capital markets for providing loans or equity investment on commercial and sometimes-concessional bases (Dickinson, n.d.; Abor, 2017). There are multilateral, regional, and bilateral or country-specific DFIs (see Box 1.2).

BOX 1.2 Types of DFIs

Multilateral DFIs include private sector outfits of international financial institutions (IFIs), which are founded by a number of countries and are subject to international law. They are generally owned by national governments but sometimes with ownership participation by international or private entities. They tend to have stronger financing capacity and provide the opportunity for close cooperation between governments.

The regional DFIs are essentially part of multilateral DFIs, but they tend to focus on specific regions and are owned by the governments of those regions.

Bilateral or country-specific DFIs operate mainly in developing and emerging economies and have the mandate of providing longterm capital to finance the private sector, with particular value-added development objectives on a sustainable commercial basis. Bilateral DFIs may also include microfinance institutions, state development banks, community development finance institutions, microenterprise funds, and revolving loan fundts.

The traditional role of DFIs is to help address the failure or imperfections in financial markets. In the view of Dixit and Pindyck (1994), uncertainty significantly and negatively affects investment, which entails large sunk and irreversible costs and, where there is a choice, delaying the investment decision until additional information becomes available. The risks associated with such long-term investments tend to discourage private sector investors.

DFI assist in correcting risk perceptions, promoting favourable environment for private investment to thrive as well as providing social infrastructure and other activities that have positive economic outcomes. They tend to focus on developing countries with limited access to local and external capital markets by providing long-term finance for infrastructure projects in developing countries. DFIs facilitate private sector investment and provide risk guarantee that provide comfort for investors. They provide finance that is linked to the design and implementation of capacity-building programmes adopted by governments (te Velde, 2011).

DFIs also play an active role in financing small and medium-size enterprises (SMEs), which are often perceived as risky by other finance providers. In that case, they take the first mover advantage in markets with high growth potential. They often have a double bottom line: pursuing profit and pursuing development. On one hand, they invest for the purpose of generating returns, which enable them to undertake more investments. On the other hand, they facilitate the economic development of the countries they invest in (Dickinson, n.d.).

DFIs contribute by adding value to the economic development process. Dalberg (2009) mentions three ways by which DFIs do this:

  • 1 Investing in underserved projects types and settings - the business model of DFIs is designed so that they are able to invest in highly risky projects in developing countries. They have the capacity to tolerate high risk and make long-term investments, especially in areas where private investors consider risky to commit resources to.
  • 2 Investing in undercapitalised sectors - they specialise in investing in sectors such as agriculture, energy, the financial sector, and infrastructure, which are critical to driving economic growth.
  • 3 Mobilising other investors - they promote sharing knowledge, setting standards, and collaboration, which helps attract other investors. Their track records enable other investors to scale up their investment, and they also build local capacity in fund management.

Chapter 7 of this book provides a more comprehensive discussion of DFIs in the context of the global financial system.


During the past decade, the discussion about finance and development has started to change, by focusing more specifically on possibilities to improve financial inclusion - that is, on different measures to improve access to finance for unbanked people; see also Chapter 10 in this book. Even if financial development will lead to long-run economic growth, it is not clear at all that also poor people will gain a lot. Probably only if financial development operates on the so-called extensive margin, implying that it improves access to financial services by individuals who had no access to these services before, a process of financial development will be beneficial for the poor unbanked part of the society. If financial development operates on the intensive margin, and hence improves access to financial services only for those households and firms that already had access to finance, financial development will not help unbanked people and will likely increase inequality, at the least in the short run.

There is still an enormous lack of data regarding financial inclusion of poor people in the developing world. Fortunately, in 2011, the World Bank launched the Findex database, which is the world's most comprehensive database on financial inclusion around the world. The dataset covers more than 140 economies around the world, drawing on survey data. The initial survey round was followed by a second one in 2014 and a third one in 2017. The study shows that currently almost 70% of adults around the world have a bank account. Moreover, the study provides promising figures about a rise in financial inclusion in the last decade, also in developing countries, where bank account ownership increased from 55% to 63% between 2014 and 2017 (Demirgiic-Kunt, Leora, Dorothe, Saniya, & Jake, 2018). However, there are still considerable gaps in who has access to finance: women are much less likely than men to have a bank account; bank ownership is still much lower in developing countries than in the developed world, and especially adults with low education and without formal jobs are still often excluded from any financial services. Thus, a further increase in financial inclusion to provide access to financial sendees for still-unbanked poor people seems important.

Innovations in fintech are among the most promising developments in improving financial inclusion. Fintech refers to the emerging industry that uses technology to provide financial services. It is characteried as financial intermediation services delivered through mobile phones, computing devices using the internet, or cards linked to a secure digital payment system (Manyika, Lund, Singer, White, & Berry, 2016). The most widely adopted forms of fintech in developing countries, especially in sub-Saharan Africa, are mobile money and mobile financial sendees. Sub-Saharan Africa is even the only region where the share of adults with a mobile money account exceeds 10%. M-Pesa (see Box 1.3), a mobile phone-based money transfer service, launched in 2007 by VodafoneGroup pic and Safaricom in Kenya, was one of the first mobile network operators in sub-Saharan Africa. Mobile money accounts have now spread to new parts of sub-Saharan Africa, and the share of adults with a mobile money account has now surpassed 30% in various countries, such as Cote d'Ivoire, Senegal, and Gabon.

The success of M-Pesa has shown the possibility of leveraging simple non-internet-based mobile technology to extend financial services to large segments of unbanked poor people. It also shows the importance of designing a usage-based and low-cost transactional platform that enables low- income customers to meet a range of payment needs. Fintech is very much associated with mobile money. Yet fintech also includes other applications,

BOX 1.3 M-Pesa

M-Pesa was a small-value payment and store of value system using ordinary mobile phones. It was designed to enable customers receive and transfer funds securely by using ordinary mobile phones. Customers can also use it to pay bills such as water and electricity and store their money. M-Pesa was an immediate success: at the end of its first year, it had registered 1.2 million customers in Kenya and had 19 million customers by the end of 2018. M-Pesa payments consist of person- to-person (P2P) payments, which form a bulk, and person-to-business (P2B), business-to-person (B2P), and recently government-to-person (G2P) and government-to-business (G2B) payments. M-Pesa opened the door to formal financial services for Kenya's poor. It introduced small accessible and affordable loans, increased the scope of payment services, and created more-affordable financial options for the poor. M-Pesa has now expanded beyond the borders of Kenya and by the end of 2019 became Africa's most successful mobile finance case, with 37 million active customers and 11 billion transactions across seven countries: the Democratic Republic of Congo, Egypt, Ghana, Kenya, Lesotho, Mozambique, and Tanzania.

M-Pesa has also enhanced access to other economic and social infrastructure via its associated new product developments. For instance, in Tanzania, it has been used by a nongovernmental organization (NGO) - Comprehensive Community-Based Rehabilitation - to support patients to pay for travel cost to health facilities. M-Pesa has also has enabled access to electricity for low-income households in Kenya and Tanzania. This is via a partnership-based system, M-KOPA, that allows households to acquire a solar-powered off-grid electricity kit and pay for it in small daily payments by using their M-Pesa account.

Source: Vodafone

like a distributed ledger technology (blockchains), which can interact with the Internet of Things (IoT) to lower transaction costs and ease financing and mobile payments.

In the literature, the terms 'mobile money', 'mobile financial services', 'digital payments', and 'digital finance' are often used interchangeably. However, there is a crucial difference in that 'digital' refers to services that require access to digital devices (internet), whereas, for instance, a simple text-based mobile phone can be used without accessing the internet.

Recently, a lot of research has been devoted to mobile money platforms and associated mobile wallet technologies, which enable the provision of financial services through a mobile phone. Initially, mobile money referred mainly to person-to-person money transfers. However, mobile phones and more generally digital financial services transacted via mobile money platforms are now also used to pay bills, save money, conduct person-to-business payments, and receive payments (wages) and for investments (Suri, 2017; Apior & Suzuki, 2018). Mobile phones are also increasingly used to send and receive international remittances. See Chapter 5 in this book for an extensive discussion on the role of international remittances. In sub-Saharan Africa, the sending and receiving of remittances has even become the main use of mobile money (Demirgiic-Kunt et al., 2018). Mobile money platforms thus potentially offer wide accessibility (Osburg & Lohrmann, 2017) and may serve as conduits for financing different sectors in the economy, such as SMEs and smallholder farmers. They may also help to include the unbanked in the financial system (Klapper, El-Zoghbi, & Hess, 2016) and induce positive effects on education, health, employment, productivity, and poverty alleviation.

While the success of M-Pesa seems to provide evidence for the potentially enormous role of fintech in enhancing financial inclusion and raising the living standards of unbanked people in the developing world, the development of fintech in many countries in Africa, South America, and Asia has been problematic. Even a replication of M-Pesa outside Kenya was often unsuccessful, especially in countries where a more advanced banking network was already available, such as in South Africa. Overall, the fintech sector in sub-Saharan Africa remains small (Yermack, 2018).

Indeed, there are several limitations and risks, which make it unlikely that fintech will in the short run induce a process of financial inclusion that will improve the living standards of the majority of the still-unbanked adults. An important prerequisite of a successful rapid fintech development is the availability of a sound communications infrastructure (Yermack, 2018). However, in most developing countries, only a rudimentary communications infrastructure is available, characterized by limited access to broadband internet connections and smartphone handsets. To promote adequate investments, a supportive regulatory framework is needed. Yet most African governments have so far taken a hands-off approach to fintech regulation. Even if fintech were to be widely promoted, it can ensure and promote inclusive growth only if it meets the needs of disadvantaged groups. The uptake and use of mobile financial services in many developing countries will be limited due to low reading literacy and digital literacy levels (Nedungadi, Menon, Gutjahr, Erickson, & Raman, 2018). There is also a risk that specific fintech services will not be provided to poor rural communities, to save costs (Ozili, 2018). Entire geographic areas might be excluded from new technologies, and the new world of data and information, as the success of particular forms of fintech, especially if big data is involved, crucially depends on the availability of data scientists, who may not be available in several developing countries. Much more research on the potential and limitations of fintech is needed. However, fintech will not likely be a panacea for raising the living standards of the unbanked population in the developing world in the short run.

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