Is it Reasonable to Expect DFIs to Build Markets?

Previous posts in this blog series on the advantages of a market development approach to building financial services for the poor addressed the roles of a market facilitator like FinMark Trust in South Africa and donors. In this post we explore the role of DFIs. Beyond investing in individual MFIs, how can DFIs facilitate broader development of pro-poor financial service markets? Shouldn’t they do so as public investment organizations? I would argue yes.

A man is fishing in Bangladesh near train tracks

The mainstay of DFI activity in our field—providing debt and equity to individual retail MFIs and the microfinance investment intermediaries (MIIs) that finance them—might by itself contribute to market development. However, this is the case only if the analysis that goes into these demonstrations and the lessons that emerge about the success of their business models and their performance in serving previously underserved segments is shared more widely with the market.

Many DFIs would argue—correctly, in my view—that they play an important role by starting or selecting “market leader” MFIs that perform a number of critical market development roles. By building successful retail institutions, they help demonstrate the viability of base-of-the-pyramid customer segments (particularly MSMEs), show how profitable microfinance can also operate in a responsible fashion, and “crowd in” the private investment that is essential for the sector to grow. This argument is especially valid for equity investments (which have inherently greater “crowding in” benefits than debt financing and often are bundled with much-needed governance inputs) and for financing to early-stage “frontier” markets such as poorer countries, lower-income segments, or less well-served customers such as micro and small enterprises (MSEs). Market leaders contribute more to broader market development if they disclose detailed and timely information on their innovations and performance. DFIs should condition their funding on investees sharing performance data as early as possible rather than declaring it as a proprietary resource.

Furthermore, DFIs will contribute more to market development if they coordinate closely with local “facilitators” that undertake deep and ongoing analysis of a particular financial market and engage in information dissemination, provision of incentives to market players, and capacity building for providers, consumers, and policy makers. While DFIs can play a supportive role, few if any, are likely to be able to play this facilitator role themselves. They are rarely locally based. Nor do they have the funding instruments and incentives to provide continuous analysis and guidance to the market as a whole. Perhaps the most important barrier is that as investors in individual MFIs and MIIs, they cannot operate in a purely neutral fashion as a trusted third party, which is a defining characteristic of facilitators. DFIs certainly can and have supported deep diagnostics and provided valuable ongoing information to the market. They have also acted to improve the incentives for and capacity of diverse retail providers to innovate and behave responsibly. Examples include recent countrywide responsible finance efforts supported by DFIs including AFD, EFSE, FMO, IFC (in India as well as Bosina and Herzegovina), KfW, and the IADB-MIF. Support for development of market infrastructure such as improved credit information systems and improved policy and regulatory capacity also has bought salutary effects to microfinance markets around the world, the benefits of which extend beyond the partner MFIs in which the DFIs invest in those markets.

However, DFIs have three limitations in these roles. The most important limitation is the nature of their most dominant funding instrument. These broader market-building activities generally require grant funding or technical assistance resources that are not dedicated to retail investees. Not all DFIs have these resources, and those that do face limits in their ability to make them available beyond their partners. (Technical assistance support, for example, is often largely “tied” to investee partners.) The second limitation is the ability of DFIs to maintain deep—and local—knowledge of specific markets beyond that carried out for pre-investment due diligence. One promising model incorporates teaming up with others to support this role over time (one example of this is the MITAF microfinance facility in Sierra Leone that KFW co-funded with other donors). However, it is unrealistic to expect DFIs to act as neutral parties serving the best interest of the entire market, and the potential for conflict of interest is unavoidable when a DFI has both retail MFI investments and broader infrastructure or policy activities in the same market. DFIs that seek to contribute to market-building work hard, but we must acknowledge the inherent limitations—compared to, say, a FinMark Trust or FSD-Kenya, or even a donor sector-building initiative—in their ability to be perceived as fully independent and neutral.

A final constraint might be timeframe for results: how many DFIs will have the staying power and “patience to pursue impact” of these institutions created with the specific and sole intent of market facilitation?

The bottom line is that most DFIs would be challenged to function as pure facilitators, even if they tried. But as public entities with development as well as financial goals, DFIs should push the boundaries of how they can build strong markets and individual MFI partners. At a minimum, DFIs should work together with the various stakeholders with this mutual goal in mind. Early and expansive data sharing and close coordination with facilitators and other funders are essential.