Financial Inclusion: Where the Formal and Informal Financial Systems Meet

‘Financial inclusion’ has become a popular topic amongst both policymakers and financial service providers.  Policymakers consider financial inclusion a worthwhile measure for its potential to provide economic growth and alleviate poverty.  For financial companies it represents approximately 2.5 billion potential adult worldwide customers who do not currently have access to formal financial services[1].  Given the recent financial crisis, however, is it really a good idea to incorporate the informal sector (the untaxed, unmonitored part of an economy) into a formal financial system that some considered insufficient, broken even?  Is there not a risk that the additional regulatory burden of a formal system would raise costs for the informal sector?  Would these costs inadvertently alienate the very customer-base the financial inclusion was intending to include?

To explore these questions further, the SWIFT Institute interviewed economist Dr. Guillermo Ortiz, Chairman at Grupo Financiero Banorte-IXE and former Governor of the Bank of Mexico, a highly regarded authority on the topic of financial inclusion.  What expectations should policymakers have regarding the development of financial inclusion models?

The formal financial system has set its sights on incorporating the informal sector into its fold but history has shown that this is not a straightforward process.  Dr Ortiz first became aware of the subject of financial inclusion as long ago as the late 1980s when, as undersecretary of the Treasury of Mexico, he visited Indonesia.  He saw for himself very resilient models of financial inclusion in practice throughout the villages and towns.  He returned to Mexico enthused by what he had seen and attempts were made to transform existing Mexican agricultural banks into operations designed to service all entrepreneurs irrespective of their sector.  It became apparent that the Indonesian models were not easily replicable in Mexico.  This was partly due to the difference in the population concentration (a densely populated Indonesia versus a sparsely populated rural Mexico).  In addition, there had been a long tradition of commercial decision-making within Indonesia, even prior to the introduction of the new financial systems.  This did not in exist in Mexico.  From this, Dr Ortiz learned that financial inclusion models could not simply be emulated and reproduced from one part of the world to another without prior and proper consideration of the socio-economic idiosyncrasies of each.

Fast-forward to 2013 and the world is running at a different pace. Technology advancements have closed many gaps in rural areas with massive strides in the development and availability of mobile banking [see recent paper on mobile money in Ghana].  We are also living in a world experiencing the worst financial crisis since the Great Depression.

We asked Dr Ortiz for his views on drawing the informal sector into what some consider a flawed financial system.  He appreciated the relevance of the question but was keen to highlight the essential differences between developed and emerging economies.  The developed economies, he explained, had created an overextension of the banking system in non-traditional ways.  Whilst financial innovation is considered useful and central to economic growth, the financial system in the developed world had become disconnected from the essential purpose of finance.  Many newly created economic products are disconnected from financial activity in terms of risk distribution.  Emerging markets, on the other hand, do not have a history of pushing the boundaries in the same way.  Dr Ortiz pointed to the Latin American crisis in the late 90s, where not one country suffered a severe financial dislocation similar to the levels that occurred in the developed economies in 2008.  The challenge for policymakers is to apply the correct regulatory coverage of financial markets, balancing between light-touch regulations, which let the market run efficiently whilst guarding against dangerous excess that can cause the market to spin out of control.

Assuming the formal system works in the way it is intended, then what of the additional regulatory costs the informal sector would incur upon incorporation into the formal system? Would these extra costs ultimately serve to turn away the customers the system had hoped to attract?  There are costs, Dr Ortiz admitted, in the form of paperwork and payroll taxes that small business for example are not well equipped to handle, but these need to balanced against the broader public policy issue.  The informal sector is comprised of an existing web of financing based heavily upon trust, yet the cost of finance is generally higher than the formal sector and productivity tends to be much lower.  The key is the introduction of incentives to balance out any additional costs and a provision of a service that ultimately is valued by its users.

For the future Dr Ortiz sees many signs towards increasing financial inclusion and penetration.  Over time, he foresees a reduction of rates being charged to small businesses and households and a removal of regulatory hindrances that create obstacles to financial inclusion.  We asked if he could anticipate examples where, because of the arrival of the informal system, the regulations and practices of the formal financial system would have to change.  Dr Ortiz agreed that there is an argument for loosening the bureaucratic requirements on paperwork originally created to deter money laundering.  One solution, for example, could be to create a much more liberal system for small transactions below a certain threshold.  In the meantime he suggested that policy makers focus on creating general guidelines outlining how to apply financial inclusion as well as the introduction of financial education, which he considers an essential ingredient in providing a stable market for all.

[1] Chaia, Alberto, Aparna Dalal, Tony Goland, Maria Jose Gonzalez, Jonathan Morduch, and Robert Schiff (2013). “Half the world is unbanked” in Cull, Robert, Asli Demirgüç-Kunt and Jonathan Morduch, eds. Banking the World: Empirical Foundations of Financial Inclusion (Cambridge: MIT Press).