AN ALTERNATIVE APPROACH TO RURAL FINANCIAL INTERMEDIATION: The Philippine Experience By: Meliza H. Agabin Jorge Daly Occasional Paper Implemented by: Chemonics International Inc. August 1996 August 19, 1996 Dear Colleague: During its twenty-one year history, Chemonics International, a professional services firm working exclusively with developing countries, has published occasional papers of interest to policy makers, professionals, and field practitioners. This year’s occasional paper focuses on current approaches to rural financial institutional development. Our authors, Meliza Abgabin and Jorge Daly, argue that a holistic or systems approach to rural financial intermediation is essential if viable financial institutions are to emerge and prosper in the thousands of presently unserved or under-served rural communities and secondary and tertiary cities throughout the world. In addition, they argue that a for-profit, locally owned and managed small scale business model offers the most efficient institutional vehicle for the delivery of affordable and sustainable financial services at the community or municipal level. Forty-four years of rural banking experience in the Philippines provides the empirical foundation to support the thesis that Drs. Abgabin and Daly advance. We believe the power of the report’s message flows from the convincing fusion of these two fundamental principles that together form a systematic strategy for the development of rural financial markets. We hope you that you enjoy and find useful An Alternative Approach to Rural Financial Intermediation: The Philippine Experience. Sincerely, Thurston F. Teele President Chemonics Inc. ACRONYMS ACPC Agricultural Credit Policy Council CRB Cooperative Rural Bank CFIEP Countryside Financial Institutions Enhancement Program DBP Development Bank of the Philippines DCB Davao Cooperative Bank DOSRI Directors, officers, stockholders and related interest HYV High yielding variety KB Commercial bank LBP Land Bank of the Philippines LO Loans outstanding M99 Masagana 99 NBFI Non-bank financial institutions NCR National Capital Region PDB Private development bank PKB Private commercial bank PNB Philippine National Bank RB Rural bank RBAP Rural Bankers Association of the Philippines SBL Single borrower limit SGB Specialized government bank SSLA Stock Savings and Loans Association SWS Social Weather Stations TB Thrift bank TBAC Technical Board for Agricultural Credit TC Transaction costs i INTRODUCTION The economic development of low-income countries is hampered by an inability to bring adequate financial services to vast numbers of rural microentrepreneurs in a timely fashion and at reasonable cost. This failure reinforces market segmentation, prolongs economic inequality, precludes marginalized rural producers from taking advantage of opportunities created by economic reform, and limits the expansion of nationwide financial markets. To this day, despite the efforts of governments, multilateral development banks, and development practitioners in general, an effective solution to this problem is not in sight. Rural financial markets remain underdeveloped, largely because of the legacy of glaring failures in government-led programs. The record shows that such programs, riddled by large and politically condoned loan defaults, were not sustainable and in fact worsened income distribution, because they were coopted by large rural producers who benefited from subsidized loan rates. Furthermore, they were carried out under a policy framework that was generally unfriendly to the development of finance. These programs left the vast majority of rural entrepreneurs with only the empty promise of access to credit or the services of informal lenders. After much prodding from the international donor community, many low-income countries have launched far-reaching reforms of their financial markets, including liberalization of interest rates, lowering of reserve requirements, privatization or liquidation of hopelessly decapitalized state banks, and reform of bank legislation—all clear pre-conditions for the development of rural financial markets. The multilateral donors have also taken steps to ensure that policy makers of low-income countries are exposed to the positive lessons offered by some Asian countries, most notably Indonesia and Thailand. These two countries have demonstrated that it is possible for financial entities to expand their services to marginalized rural clienteles. Indonesia’s Bank Rakyat Indonesia (BRI) and Thailand’s Bank for Agriculture and Agriculture Cooperatives (BAAC) are two shining examples. These state-owned entities have identified small rural households and producers as their market niche, adapted their financial technologies to the rural market demand profile, developed suitable financial instruments, and, most notably in the case of BRI, followed pricing policies that favor self-sustainability. While these measures are steps in the right direction, neither financial policy reform nor maximum exposure to the financial technologies and managerial strategies of BRI and BAAC can guarantee countries success in developing their rural financial markets. Financial market reform, especially in countries that endured long periods of “financial repression,” often falls far short of significantly expanding the supply of financial services to rural microentrepreneurs. In this context, large, urban-based commercial banks cannot possibly shoulder the task of providing financial services to rural entrepreneurs. They lack information on the clientele and do not operate with appropriate financial technologies. Recognizing this impediment, multilateral donors have devised programs to encourage commercial banks to “downscale” their operations in search of profitable opportunities offered by a lower-income clientele. At best, however, this approach takes time to implement and requires a highly competitive banking sector that forces banks to seek new market niches. Even then, commercial banks must go through the process of adapting their approach to microentrepreneurs. In addition, in countries riddled by severe financial dualism, commercial banks will first exhaust options in the urban consumer market or in international operations before attempting a serious downscaling strategy. iii Another strategy has been to upgrade the capabilities of nongovernmental organizations to cater to a marginalized rural clientele. In principle, these entities may be transformed into small banks, ridding themselves of their traditional social orientation to pursue profit goals. Unfortunately, there is little reason to expect that the vast majority of these organizations—which have proliferated in low-income countries in response to the failure of credit unions and state-owned banks—can engineer such a successful transformation. In several countries bank legislation must be amended to make a transformation possible. Even so, upgrading is a daunting process, especially in entities staffed by people who adhere more to social goals than to cold banking logic. A complete overhaul is necessary, an undertaking that is extremely costly and almost invariably relies on donor support. Purpose and Significance of this Study The impact of development assistance programs that promote downscaling of commercial banks and upgrading of NGOs is uncertain and at best limited, because success is likely to be limited only to some “pilot projects” whose chances for wide dissemination are suspect. An alternative approach to rural finance is proposed in this study based on the strategy that the Philippines initiated in 1952. Unlike current downscaling and upgrading strategies, the Philippine approach to rural finance emphasizes the design of special legislation to provide incentives for private investment in as many rural banks as possible. It is a systemic approach, not in the least because the newly established units, like any other commercial bank, must adhere to prudential norms and be subject to supervision. The Philippine experience demonstrates significant outreach and appropriate financial technologies, but, unlike the large, state-owned BRI and BAAC, it is grounded in the operation of hundreds of small, independent, privately owned rural banks tailored to the specific market profile of rural areas. After several years in which the survival of most banks hung critically in the balance because of a series of ill-advised policy interventions discussed in the body of this study, the system has shown signs of vitality and growth since 1992. The purpose of this study is to demonstrate that the Philippine approach to rural finance improves on the strategies currently in vogue and thus offers a better chance of solving the problem of underdeveloped rural financial markets. The approach is little known outside the Philippines and is generally dismissed by development practitioners who associate it with the near collapse of the system in the 1980s and the generous transfer of resources needed to keep the system afloat. Unfortunately, this association misses the larger picture: the principles and institutional components of the Philippine approach are sound. The misguided policies that almost obliterated the Philippine rural banking system can be dispensed with. But the principles provide the basis for solving the problem of rural finance and mitigating the effects of severe market segmentation. As this study will hopefully demonstrate, the Philippine experience is rich and offers valuable lessons for policy makers in