“Exceedingly high interest rates”

It is sometimes said today that the US economy is finally improving and that Europe must no longer fear for the survival of the Euro, so the financial crisis is over. Is that so?
No, certainly not. The problems in North America and Europe have not been solved, and that has an impact on developing countries. That is the case, for instance, when banks from EU member country Spain withdraw funds from Latin America. The fear of substantial capital flows being directed away from developing countries is wide spread.

But didn’t developing countries and emerging countries fair surprisingly well in the crisis?
Yes, they did, and one reason is that many of them were well prepared. Latin America has learned the lessons of previous crises. The same is true of Asia. Things are a bit different in Africa because this con­tinent is not integrated into the world market to the extent that a global financial crisis would affect it much. In any case, banking laws and regulations are much more stringent in many Latin American countries. We should heed their example.

What do you have in mind?
My point is basically that, before the crisis, Europe and North America were no longer sufficiently paying attention to bank’s fundamental job, which is to provide the real economy with money. Instead, banks did a lot of things that did not serve that purpose but were geared to raking in high speculation profits and triggering massive bonus payments. In Latin America and Asia, that was not done to the same extent.

In Asia, government-run banks are quite in­fluential. Does that matter?
Well, every economy needs a healthy diversity of financial institutions, and the mixture normally ­includes municipal savings and loans, cooperative banks, large commercial banks and certainly also state-owned development banks. It is telling that France and Britain both recently established development banks along Germany’s KfW model. US President Barack Obama, moreover, wants to set up an infrastructure bank. Many developing countries and emerging-market nations have similar institutions or are considering establishing one.

But don’t public-sector development banks crowd out the private sector?
This is a very old debate, and the short answer to your question is that development banks are needed to develop markets. Consider microfinance, for instance. Right from the start, KfW and other development banks supported and promoted the growth of this sector. In doing so, they made sure that many poor people all over the world got access to financial services – and success was so convincing that many commercial banks are now offering poor people specific products too.
 
But certainly all banks need the same rules for otherwise competition cannot be fair.
Yes, in principle. But it does not make sense to force a small rural cooperative bank in a developing country to come up with the same kind of reporting demanded from a huge multinational bank based in an advanced nation. Doing so would make the small bank’s costs rise dramatically, and those costs would have to be born by its clients, who are comparatively poor. Nobody is interested in that happening. I think what really matters is size and business models and not applying different rules to institutions of a different legal nature. Some business models are quite plain and have proved rock solid over decades. They do not require the kind of oversight needed for highly complex and accordingly risky business models. We know, moreover, that the failure of a big bank can tear down the entire world economy, whereas small banks can be disbanded without any such impact.

What needs to be done to make sure that tax-payer money will not be spent again some time in the future to prevent the collapse of a bank that is too big to fail?
The international rules that are now being enforced basically force banks of systemic relevance to hold more equity capital. As a result their scope will shrink for leveraging their own capital with borrowed money, which means they cannot run the same kinds of risks anymore. One consequence of this policy, however, is that many banks are now reducing their total assets so that they won’t have to raise more equity capital. At the same time, we are seeing top managers finally pay more attention to traditional banking again. They used to frown upon this business in the past few decades because it did not lead to the huge profits that could be made in speculative investment banking. It is certainly healthy that banks are taking more interest in individual clients and small enterprises again in rich countries like Germany.

What can developing countries do to prevent capital from being withdrawn suddenly?
The best protection is sound economic policymaking plus good governance. Currently, there is a lot of liquidity floating around, with investors looking out for attractive investment opportunities. Nations that are marked by sound and reliable policymaking can benefit from this situation if they create a reassuring business climate. Sudden change is always discouraging. Indeed, several developing countries have seen capital inflows recently, and many of them have, for good reason, designed legislation to restrict merely speculative inflows.
 
What must a government pay attention to if it wants to develop its country’s financial sector – prudent legislation and good government?
Yes, both is always needed, but diversity also deserves attention in the financial sector. You require a market that offers all the services that enterprises and consumers need, including payment transactions and foreign exchange. Options for saving money and investing are relevant too, not least because deposits are a relatively reliable basis for a bank to hand out loans. Deposits cost much less than refinancing in capital markets. Ultimately, however, the capital market has to operate smoothly too. Otherwise, banks will exclusively buy their government’s bonds instead of financing small and mid-sized enterprises (SMEs)– and that kind of business model really thwarts private-sector development.

But SMEs tend to be difficult bank clients, because the sums they deal with tend to be relatively small, for instance ...
... and because many banks in disadvantaged countries don’t really understand how SMEs operate. They struggle to identify strengths and weaknesses, and bank managers fail to assess the risks accurately. In cases of doubt, they charge exceedingly high interest rates. DEG cooperates with financial institutions in developing countries when we give loans for private sector investments or act as shareholders, and important aspects of such engagements are the transfer of credit technology and conveying to our partners how to manage risks. We want our partners to do this job on their own in the long run – and they actually do so, once they understand how to control the risks.

Has microfinance become so strong that it no longer needs special attention by development policymakers?
It is true that microfinance has made tremendous progress in past decades. But a lot still needs to be done to make sure that vast majorities of people in developing countries get access to all relevant financial services, from bank accounts to consumer credit. This is still a huge challenge – not only, but especially in rural areas.

Bruno Wenn is chairman of the Management Board of DEG (Deutsche Investitions- und Entwicklungsgesellschaft). DEG belongs to KfW banking group and supports private sector investments in developing countries by providing credit and equity.
http://www.deginvest.de