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Rethinking financial education for the extremely poor

16.11.2015Arnold Wentzel, Lecturer in Economics and Education, University of Johannesburg

Almost 1 billion people live on less than $1.90 per day. Most of them live in Africa, which means that more than 40% of the continent's citizens experience extreme poverty. What is wrongly assumed is that improved financial literacy and education will improve their financial situation.

The OECD measures financial literacy along four dimensions: financial control, financial planning, choosing financial products and financial knowledge. It is taken for granted that anyone who learns how to budget, knows how to maximise financial returns and borrow prudently will improve their financial position.

Unfortunately, the financial conditions under which the extremely poor live are so different from the conditions assumed by conventional financial literacy that education based on it is both impractical and harmful. It assumes that the poor have small but fairly predictable income flows and expenses and that appropriate financial products are mostly available.

But as Collins, Morduch, Rutherford and Ruthven find in their book Portfolios of the Poor, the income flows of the very poor are not only small, but also highly volatile, and available financial products are too inflexible or unreliable; and that makes all the difference. If you live on less than $2 a day and you have no idea if that $2 will even come in daily, and even minor expenses can wipe out your income on any day, you need to exhibit considerable financial sophistication just to survive.

It is this sophistication that conventional financial education does not recognise. The extremely poor cannot employ strategies to optimise financial gains, but instead have to use strategies to keep their financial options open, even at the expense of gains. This is because they live under conditions of radical uncertainty, where events are inherently unpredictable. Under such conditions it is irrational to optimise since that tends to close down options and thereby limits possible responses.

To survive, the poor employ what is called 'robust satisficing' by Schwartz, Ben-Haim and Dacso. This means sacrificing wealth in order to guarantee a satisfactory outcome (survival) under the greatest range of uncertain conditions. For example, conventionally, financially literate people would never pay to save, yet the poor do it regularly through money guards and informal group savings schemes. This is discouraged by conventional financial education even though it is most rational thing to do if you want to stay alive in poverty.

Radical uncertainty requires: (1) access to flexible cash inflows that keep your options open; and (2) structures that hinder the unpredictable forces that close down your options. Money guards may be paid to keep money, but the cash can be accessed within minutes of a life-threatening event. And interest may not be received in a group savings scheme, but members disallow withdrawals forcing commitment in the face of urgent demands on small savings. Few financial products are designed to get this delicate balance right, and this means the poor often have to develop their own range of informal solutions.

Financial educators need to understand the unpredictable and severe conditions of extreme poverty and recognise the shortcomings of their advice under such conditions. If they are to help the poor they must learn from the poor, especially their sophisticated strategies to keep cash flow options open for as long as possible.

This by no means renders financial education worthless. As cash flows increase and become more predictable, conventional ideas become progressively more relevant. Different kinds of financial literacies exist for different conditions, and instead of teaching just one kind, we should teach how to transition from one to the other as conditions change.

_________________________________________________________________

This blog post is based on the study, Why Financial Education Fails the Extreme Poor, Social Science Research Network. 

About the Author

Arnold Wentzel is a lecturer in Economics and Education at the University of Johannesburg.

Can Financial Inclusion and Financial Stability Go Hand in Hand?

15.06.2015María José Roa Garcia, Researcher, CEMLA

Financial inclusion institutions in emerging countries are increasingly important as expansive savings and investment vehicles for households and the public in general. A large part of these institutions carry out financial activities that play the part of bank credit, but within a regulatory framework that is either non-existent or much more lax than that which exists for formally-constituted banking institutions. The same thing happens with regulation of new financial inclusion instruments - such as electronic and mobile phone banking - which in many countries is limited or non-existent.

In order to guarantee the stability of the financial system, it is necessary to do more than provide greater financial access to the population. The nature and characteristics of access and use, the so-called quality dimension of financial inclusion, is a key element in ensuring that greater access and use do not endanger financial stability. This dimension is related to the change in the nature and risk levels entailed by the new financial inclusion instruments and institutions, as well as new clients. Although concrete indicators still do not exist, it is commonly accepted that the referential framework to measure this dimension ought to take into account the existence of: i) adequate regulation and supervision of new financial inclusion instruments and institutions, ii) effective financial consumer protection policies, and iii) programs of financial education. In general, this dimension takes on greater relevance in more advanced stages of financial inclusion, when the problem of access is eventually resolved.

The fundamental measures that should accompany greater access and use, in order that they not endanger stability, might seem to be related to those that were outlined after the crisis for the most advanced stages of financial development: prudential regulations, financial consumer protection policies and financial education. Nevertheless, the risks and frictions associated with financial inclusion are different to and less pronounced than those associated with financial development in its most advanced stages, as are the measures to be applied.

In this regard, it is important to specify what type of state intervention or regulation is necessary in the particular case of financial inclusion, rather than automatically applying measures derived from the financial crisis. The application of standards and other measures that guarantee financial stability might prove to be a setback to the inclusion processes, hence, a key element is the application of the principle of proportionality: the balance of risks and benefits in the face of the welfare costs of regulation and supervision of different financial inclusion instruments and institutions [1]. An example of the application of this principle is delegated supervision, which seems to be the most recommendable alternative, as in the case of federations and confederations for the supervision of cooperatives.

It seems fitting to conclude by highlighting the need to continue studying the potential links between financial stability and inclusion through the development of theoretical frameworks, evaluated with adequate empirical methodologies. The theoretical framework of traditional financial markets could be extended to give space to new, stability-endangering frictions related to greater access to and use of financial markets. In addition, there are enormous gaps in the information on financial inclusion institutions, given that a large part of them are outside the regulatory perimeter of state authority. It is also necessary that databases be developed that contain information on the nature of financial inclusion institutions and instruments, as well as regulatory and supervisory structures.


References
 

[1] Basel Committee on Banking Supervision (2015), Range of practice in the regulation and supervision of institutions relevant to financial inclusion, January. 

________

María José Roa is Researcher in the Economics Department at the Center for Latin American Monetary Studies, CEMLA (www.cemla.org). Her research is mainly on economic growth, financial inclusion, behavioral finance, personality psychology in economics, and financial education. She has been teaching for almost 20 years in different universities around the world. Her work has appeared in refereed international journals. She coordinates the Financial Inclusion and Education Program in Central Banks at CEMLA, and she is member of the Research Committee of the OECD/INFE. She is originally from Madrid, Spain, but she lives in Mexico City.

Gravatar: Excerpt from Facilitating SME Financing through Improved Credit Reporting

Constraints to SME Financing

18.05.2015Excerpt from Facilitating SME Financing through Improved Credit Reporting

Though the constraints are many, limited access to finance and the cost of credit are typically identified in SME surveys among the most important ones. (...) As a result of these constraints, SMEs (...) rely more heavily on informal sources of finance, such as borrowing from family and friends or from unregulated moneylenders.

One important element behind the SME "credit gap" is the information asymmetries between external creditors and SMEs. (...) However, it needs to be noted and recognized that there are several other micro and macro factors that also inhibit adequate external financing for SMEs (...). The most relevant of these other factors are described briefly below.

Some of the obstacles to SME financing are associated precisely to their own nature as smaller companies. This includes factors such as lack of critical economic size, and the somewhat informal and generally less sophisticated management of SMEs. In the first case, relatively small average loan volumes may not warrant the costs of targeted credit risk analyses that are required in the absence of more standardized and comprehensive credit data.

As for the second factor, from the perspective of lenders most SMEs lack the understanding of developing a coherent and acceptable business plan to underpin their credit/loan application, and if a loan is granted they often fail to provide robust updates or progress reports on the unfolding of the business plan.

Some macro factors that act as poor business enablers include lack of adequate legal and enforcement protections for creditors, like bankruptcy laws that favor debtors' rights in a non-equitable manner vis-à-vis creditor rights, weak definition of property rights that hinder pledging property as collateral, and in general weak contract enforcement. Problems like these tend to be more acute in developing countries.

Other macro factors that recently are believed to have affected the ability and/or willingness of creditors, in particular from banks, to engage with SMEs include the restructuring of many national banking sectors after the financial crises that emerged in 2008, and the bank solvency regulations in the Basel II and more recently the Basel III Capital Accords. On the latter, several studies have found that the Basel III risk weighting approach to calculate capital requirements, which is basically the same as that of Basel II, encourages portfolio concentrations in assets like government bonds, mortgages and lending between banks. It also favors lending to companies with an external credit rating of A or above, practically all of which are large companies. When these methodologies to calculate capital requirements were introduced in the early 2000s with the Basel II Capital Accord, many banks started withdrawing from SME lending and reduced overdrafts, thus driving SMEs to alternative financing like factoring, securitized receivables, leasing and trade credit.

 

* If you find value in this excerpt, you may enjoy reading the full publication, Facilitating SME Financing through Improved Credit Reporting from the Report of the International Committee on Credit Reporting chaired by the World Bank.

Gravatar: Tracy Washington, Frederik van den Bosch and Laure Wessemius-Chibrac

How to grow businesses in fragile and conflict-affected countries

04.05.2015Tracy Washington, Frederik van den Bosch and Laure Wessemius-Chibrac

This post was originally published on the Devex website.

Fragile and conflict-affected countries have become a growing part of the development agenda, not least because of the impact of fragility and conflict on poverty levels, and vice versa. 

More than a billion people live in countries affected by fragility and conflict. The recently released Organization for Economic Cooperation and Development report, "States of Fragility 2015," emphasizes that reducing the poverty in these countries is an urgent priority. The 50 countries on the OECD's fragile states list are home to 43 percent of people living on less than $1.25 per day, potentially reaching 62 percent by 2030. Boosting economic growth and improving livelihoods in these markets is therefore essential. 

But where can jobs and economic opportunities come from? 

The government is a significant employer, but it cannot provide the dramatic job growth that is so badly needed. The private sector must play a role, in particular small and midsize enterprises, which offer the greatest potential for job growth. 

New, growing businesses provide more than just jobs - they offer essential goods and services to local populations, create jobs and give people a stake in peace and stability. But cultivating young businesses - the kind that are poised to grow steadily - is a very difficult proposition in fragile markets. 

To ramp up, or even simply to get started, these firms need "risk capital" - forms of financing, loans or equity that have a higher risk tolerance than bank loans. Risk capital is scarce in countries recovering from conflict or emergency. Even with the necessary financing, business owners still face an uphill battle, managing rapid business growth for the first time, while facing logistical barriers in their operating environments. 

Working toward solutions

The International Finance Corporation's SME Ventures program provides innovative solutions to these challenges. It has recruited new fund managers and invested in four risk capital funds in six fragile states: Bangladesh, the Central African Republic, the Democratic Republic of the Congo, Liberia, Nepal and Sierra Leone. 

Following a venture capital model, these fund managers then select, invest in and monitor new businesses. Eventually, the fund's share is sold, providing a financial return to the fund managers and their investors. 

But IFC's support goes beyond investment. SME Ventures also provides technical assistance to both entrepreneurs and first-time fund managers. The program works with the World Bank Group and local governments to promote regulatory reforms, setting the stage for the funds and their successors. Critical to the program is the financial support of - and knowledge sharing with - investment partners Cordaid and the Netherlands Development Finance Co., or FMO. 

Success in Liberia

One of SME Venture's success stories is logistics firm GLS Liberia. New business owner Peter Malcolm King launched the firm in 2011 with funding and technical support from SME Ventures' West Africa Ventures Fund. 

Today, GLS has grown to become the leading logistics company in Liberia, employing 37 full-time staff. It competes on par with foreign firms, has won the last five competitive tenders in Liberia, and plans to expand further to meet the vast needs for logistics in the country. 

During the peak of the Ebola crisis, for example, GLS handled incoming airfreight and successfully transported medical supplies from the airport, despite long distances and difficult roads. 

6 key ingredients for success

Here are just a few of the ingredients that have helped SME Ventures grow businesses such as GLS Liberia: 

  1. An innovative, nimble model. The program invests not in entrepreneurs directly, but in fund managers who have a vested interest in carefully selecting and supporting the investee companies. While this model is not new, it is an unusual approach in fragile contexts, and IFC took the lead in recruiting the fund managers. 
  2. Focus on 'stars'. In contrast to larger-scale programs, SME Ventures finances one to two dozen firms per fund. These firms stand out from the pack, showing growth that outpaces other local SMEs. Dedicating attention to firms with the most potential requires time and flexibility, but offers tremendous rewards. 
  3. Combine financing and technical assistance. IFC, as part of the World Bank Group, offers wide-ranging support to new businesses: risk capital through a fund, technical and business support for the firm owners, and startup assistance to the fund managers, who in most cases are first-timers, learning to achieve global standards. IFC also works with local governments to introduce regulation that permits the fund's structure, which is often novel in these markets. 
  4. Create strong partnerships. Cordaid co-invested with IFC in WAVF while at the height of the Ebola crisis in 2014, and FMO invested in the Central Africa SME Fund from its inception in 2010. Not only did these investments strengthen the funds, but Cordaid also provided expertise gained from working with grant-funded resilient business development services for entrepreneurs in crisis situations, and results-based financing of public services in fragile countries. Their knowledge led to a solution during the Ebola crisis: zero-interest working capital loans to firms in Ebola-stricken countries to keep companies going during the crisis. 
  5. Implement peer learning and knowledge sharing. FMO hosted SME Ventures' annual knowledge sharing event in both 2014 and 2015, where fund managers were able to learn from others. IFC, Cordaid and FMO shared lessons in working with other funds in different markets. Such events enhance the performance of fund managers, and in turn benefit the investee firms. 
  6. Be patient. Startup firms require time to show their full potential, especially in fragile and post-conflict environments. SME Ventures' ability to take the long-term view is now bearing fruit, with follow-on funds planned and some exits expected in the near future.

The SME Ventures program does not only benefit the selected entrepreneurs, their fund managers or the investment partners. It also demonstrates to financiers globally that these markets contain growth potential, in turn multiplying the investment flows toward growing businesses in fragile and post-conflict countries. 

By pioneering this model, IFC and its partners FMO and Cordaid aim to transform the world's toughest markets.

 

Tracy Washington is the program manager of IFC's SME Ventures program. Frederik van den Bosch is the manager of MASSIF, Blending and CD at the Netherlands Development Bank FMO. 
Laure Wessemius-Cgibrac joined Cordaid as head of investment in June 2013.

Individually Tailored Financial Education: What Research Tells Us Is Possible

02.04.2015María José Roa Garcia, Researcher, CEMLA

The following post was originally published on the Center for Financial Inclusion Blog website.

In the past decade, a group of key empirical studies have argued that a lack of education and financial knowledge can lead individuals to miss opportunities to benefit from financial services. Some may fail to save enough for retirement, others may over-invest in risky assets, while still others miss out on tax advantages, fail to refinance costly mortgages, or even remain outside of the formal financial sector completely. These studies suggest that such behavior is based on the reality that making financial decisions has become increasingly complicated. At the same time, as a result of sweeping changes in the economic and demographic environments, individuals have become increasingly responsible for their own financial decisions and the consequences of such decisions over the long-term. Changes in public pension plans, an increase in life expectancy, and an increase in the cost of health insurance have placed on the individual the weight of momentous decisions such as whether to take out private retirement insurance, or how much to save. Easier access to credit, a general increase in the accessibility and complexity of products and services, and a number of other factors make a range of financial decisions more consequential - and harder.

Governments, financial services providers, and related stakeholders have responded accordingly in recent years developing financial education programs and initiatives, but the results have been mixed. The bulk of the evidence available confirms that, in general, the level of financial literacy throughout the world is very low, especially among the more vulnerable groups: those with very low education or income such as senior citizens, young women, and immigrants. The lack of financial literacy within these groups has proven to extend beyond economic effects and produce negative consequences on health, general well-being, and life satisfaction. Many of the programs that have been introduced were part of empirical studies that evaluated the impact of financial education programs on subsequent financial behavior. There are many such studies that show that financial education improves financial decision-making.

Nevertheless, a body of work has opened an intense debate over whether financial education and information can truly affect the financial behavior of individuals (see here, and here). In many cases, despite the availability of financial education, persistently high rates of debt and default, and low rates of saving and financial planning for retirement have been shown to persist. The empirical evidence obtained from surveys and experimental work often shows that individuals pay little attention to the information and that their capacity to process it is limited. Most of the empirical literature to-date indicates that traditional financial education - clients receiving information in a classroom style setting or through printed materials - does not necessarily translate into behavioral changes, especially in the short-term.

However, this research also showed opportunities in the way financial education information can be transmitted, particularly, methods that factor in psychological aspects such as individuals' cognitive biases are key to transforming financial behavior over the long-term. The existing information is often excessive and tough for individuals to process completely. These studies concluded that in order to improve individuals' financial decision-making ability, the financial decision-making process must be simplified, and barriers for processing information must be reduced. For example, this might take the form of narrowing the number of options available or delivering text messages that may influence behavior at key moments. The latter falls within a group of practices identified as behavioral "nudges" by organizations working with behavioral science, like ideas42. In short, current research indicates that with financial education, effectiveness is largely a question of taking into account the psychological makeup of individuals.

In fact, nowadays there is a broad consensus among psychological, social, and economic studies that cognitive characteristics affect social and economic behaviors. Notwithstanding this, these studies tend to conclude that cognitive characteristics only predict a small part of personal behavior. Non-cognitive or personal characteristics seem to have a role as significant as that of cognitive skills. B.W. Roberts, a leading personality psychologist, defines¹ personal characteristics as "the relatively enduring patterns of thoughts, feelings, and behaviors that reflect the tendency to respond in certain ways under certain circumstances." Psychologists have sketched a relatively commonly-accepted taxonomy of personal characteristics known as the Big Five: Openness to Experience, Conscientiousness, Extraversion, Agreeableness, and Neuroticism. The papers² of J. Heckman, T. Kautz, and their research team (2013) review the recent evidence obtained by economists and personality psychologists regarding how cognitive and personal characteristics can be used to predict educational attainment, labor market success, health, criminality, and financial decisions.

Interestingly, these studies show there is hard evidence that both personality and cognitive characteristics are not "set in stone" and can change over the life cycle. Specifically, while genetics have a significant influence, parents, education, and social environments shape individuals, especially in the early years. However, there is some evidence that personality traits are more malleable than cognitive characteristics at later ages.

Financial education intervention programs should thus be based on these results. In particular, measuring personal characteristics makes it possible to identify people who tend to show weaker financial habits - high rates of debt, high default, low rates of long-term savings, etc. - and design tailored interventions. In addition, researchers conclude that most successful intervention programs are not as effective as the most successful early childhood programs. Consequently, as changing behaviors is not simple, teaching healthy financial behaviors from an early age allows the foundations to be laid for the development of strong lifelong money management.

Given the importance of these factors in effecting change, here are a few points that the research suggests would help financial education become more effective in supporting adults and older people.

  • Personalized counseling
  • Opportunities to gain experience by putting lessons into practice A focus on small changes in financial behavior, taking into account the individual's disposition to change
  • Programs that acknowledge the individual's socioeconomic situation
  • Continuing and ongoing education, support, and motivation

As factors that influence behavior are increasingly understood, a major challenge remains to incorporate those features into the design and delivery of financial education programs.

María José Roa is Researcher in the Economics Department at the Center for Latin American Monetary Studies, CEMLA (www.cemla.org). Her research is mainly on economic growth, financial inclusion, behavioral finance, personality psychology in economics, and financial education. She has been teaching for almost 20 years in different universities around the world. Her work has appeared in refereed international journals. She coordinates the Financial Inclusion and Education Program in Central Banks at CEMLA, and she is member of the Research Committee of the OECD/INFE. She is originally from Madrid, Spain, but she lives in Mexico City.

 

 

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