The Role of the Financial Services Sector in Expanding Economic Opportunity Christopher N. Sutton and Beth Jenkins E C O N O M I C OPPORT U N I T Y SERIES Written by Christopher N. Sutton and Beth Jenkins Preface by Beth Jenkins Designed by Alison Beanland © 2007 The Fellows of Harvard College Acknowledgements The authors express their special thanks to all the individuals and companies who shared their experience and perspectives in the writing of this report, including: Frank Bakx (Rabobank) William Derban (Barclays) Sarthak Gaurav (Institute for Financial Management and Research) Gary Hattem (Deutsche Bank Foundation); Roberta Mokrejs Paro (Fundação Dom Cabral) Linda Murasawa (Banco ABN AMRO Real) Robert Osei (University of Ghana) Adam Popat (Standard Chartered) Chris West (Shell Foundation) Ali Zayad (Standard Chartered) The authors would also like to express a heartfelt thanks to CSR Initiative Director Jane Nelson for her considerable investments of time, energy, and intellectual insight. Jennifer Nash (CSR Initiative), Pip Murphy (Australian Charities Fund), Belinda Hoff (Institute for Responsible Investment at Boston College’s Center for Corporate Citizenship), Cheryl Young (Center for Development Finance), and Filippo Veglio (World Business Council for Sustainable Development) also provided thoughtful substantive and editorial input. Rights and Permissions The material in this publication is copyrighted. Quoting, copying, and/or otherwise reproducing portions or all of this work is permissible using the following citation: Sutton, Christopher N. and Beth Jenkins. 2007. The Role of the Financial Services Sector in Expanding Economic Opportunity. Corporate Social Responsibility Initiative Report No. 19. Cambridge, MA: Kennedy School of Government, Harvard University. Disclaimer The findings, interpretations, and conclusions expressed herein are those of the author and do not necessarily reflect the views of the Kennedy School of Government, Harvard University or the CSR Initiative’s various external collaborators within the Economic Opportunity Program. Printed on 100% post-consumer recycled paper. PHOTOGRAPHS: • Workers lay an oil pipeline, Kazakhstan © Oleg Nikishin/ Epsilon/Panos Pictures • Boy drinking water from a stand-pipe before Nestlé installed new water infrastructure in his village © Markus Bühler-Rasom • Rupee notes, Hendrik De Bruyne • Man selling straw hats and baskets, Photo Adventures, LLC • Iridimi refugee camp in Eastern Chad for Sudanese people fleeing the violence in Darfur © Sven Torfinn/Panos Pictures • Surgery in Kenyan hospital, Veronica Dana • Nicaraguan man’s hands show the stress of his labor picking coffee berries in a Costa Rican coffee plantation, Jeff Chevrier ■ Table of Contents PREFACE 4 Beth Jenkins, CSR Initiative, Kennedy School of Government, Harvard University 1. THE ROLE OF THE FINANCIAL SERVICES SECTOR IN EXPANDING ECONOMIC OPPORTUNITY 6 2. THE BUSINESS CASE FOR ENGAGEMENT 8 2.1 Mitigating and Managing Risk 2.1.1 Political and Regulatory Risk 2.1.2 Reputation Risk 2.2 Harnessing Opportunity 2.2.1 New and Expanding Markets 2.2.2 3. BUSINESS STRATEGIES FOR EXPANDING ECONOMIC OPPORTUNITY 12 3.1 Creating Inclusive Business Models 3.2 Developing Human Capital 3.3 Building Institutional Capacity 3.4 Helping to Optimize the “Rules of the Game” 4. FUTURE OPPORTUNITIES 18 5. CASE PROFILES 20 5.1 ICICI Lombard: Weather-Indexed Crop Insurance for Rain-Fed Farmers in India 5.2 Barclays: Adding Value through Traditional Microfinance Mechanisms in Ghana 5.3 ABN AMRO Real: Financing Eucalyptus Suppliers in Brazil 5.4 Deutsche Bank: The Global Commercial Microfinance Consortium 5.5 Citigroup: Remittance Models for the US-Mexico Market 5.6 South African Financial Sector Charter: Encouraging Inclusive Business Models 5.7 GroFin and Shell Foundation: Investing in SME Development in Africa 5.8 Standard Chartered: Agricultural Credit Cards in Pakistan END NOTES 37 40 Innovation in the Financial Services Sector REFERENCES The past fifty years have witnessed a “revolution” in global economic growth. Yet not everyone has participated in this revolution. More than 65% of the world’s population, over four billion people, still lives on the equivalent of less than $4 per person per day. Even worse, the world’s poor are severely constrained – and often completely lacking – in opportunity to do better for themselves. The business community has both the capabilities and the strategic, business reasons to play a major role in creating these opportunities. The CSR Initiative’s Economic Opportunity Series, a product of our Economic Opportunity Program, explores this role across a range of industries. For the poor, livelihood choices – in employment and entrepreneurship – are constrained by a wide range of interdependent obstacles, ranging from geographic isolation to market failures to political exclusion. This suggests that when we think about eradicating poverty, we should think broadly about creating economic opportunity. Economic opportunity is not, in itself, a solution; instead it is a context in which individuals can create their own solutions. It is a combination of factors that enables the poor to manage their assets in ways that generate incomes and options. Creating or expanding economic opportunity could rightly be considered a responsibility of governments toward their citizens. But in today's global market environment, various risks and opportunities provide reason for business to engage. One key reason, across industries, is for business to leverage its own comparative advantage in society. As Milton Friedman might say, “the business of business is business” – and this is exactly what gives firms the capability and credibility to expand economic opportunity. Business activity creates jobs, cultivates inter-firm linkages, enables technology transfer, builds human capital and physical infrastructure, generates tax revenues for governments, and, of course offers a variety of products and services to consumers and other businesses. Each of these contributions has multiplier effects on development. In developing countries, companies’ multipliers often fail to reach the scale or leverage of which they might be capable – often due to market failures and governance gaps. More deliberate management attention is required to unlock their full potential. The Economic Opportunity Series explores four key strategies companies can use to expand economic opportunity: Creating Inclusive Business Models Involving the poor as employees, entrepreneurs, suppliers, distributors, retailers, customers, and sources of innovation in financially viable ways Developing Human Capital Improving the health, education, experience, and skills of employees, business partners, and members of the community Building Institutional Capacity Strengthening the industry associations, market intermediaries, universities, governments, civil society organizations, and grassroots groups who must all be able to play their roles effectively within the system Helping to Optimize the “Rules of the Game” Shaping the regulatory and policy frameworks and business norms that help determine how well the economic opportunity system works, and the extent to which it is inclusive of the poor Preface Beth Jenkins, CSR Initiative, Kennedy School of Government, Harvard University THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 4 “Economic opportunity enables people to manage their assets in ways that generate incomes and options.” There is enormous variation in the roles companies can play, depending on their industries, their particular business models and relationships, and the contexts in which they operate. The industry reports in the Economic Opportunity Series explore this variation, offering more specific and detailed examples for different industry sectors. The research suggests, in general, that inclusive business models can be the most effective and sustainable ways companies can contribute. Complementary strategies such as developing human capital, building institutional capacity, and helping to optimize the “rules of the game” can also have significant impacts. These strategies are often used in combination with inclusive business models, to enhance both their commercial viability and their development impact. The research that has gone into this series also suggests that company efforts to expand economic opportunity can draw upon core business, philanthropic, and public donor funding, depending on the balance of business and social benefits expected, the likely timeframe for their realization, and the level of uncertainty or risk involved. Hybrid approaches are increasingly common. So is collaboration. Complex, systemic challenges like expanding economic opportunity present frustratingly frequent bottlenecks to unilateral action, corporate or otherwise. Even the best-resourced efforts eventually run into limitations on scale somewhere. Collaboration allows parties to share knowledge and information, pool scarce or diverse assets and resources, access new sources of innovation, create economies of scale, and enhance the legitimacy of the parties’ own individual activities. In addition to assembling the necessary resources and capabilities, collaboration can generate new capabilities and change operating environments in ways that create new strategic opportunities. The Economic Opportunity Series is part of a growing effort within the business and development communities to make the links between business activity and poverty alleviation. Experimentation and learning are happening fast. As a result, the series must be considered a work-in-progress, and readers are invited to share their experience and reflections with us. We look forward to being part of the dynamic growth and development occurring in this field. THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 5 Expanding Economic Opportunity Financial services are fundamental to economic growth and development. Banking, savings and investment, insurance, and debt and equity financing help private citizens save money, guard against uncertainty, and build credit, while enabling businesses to start up, expand, increase efficiency, and compete in local and international markets. For the poor, these services reduce vulnerability and enable people to manage the assets available to them in ways that generate income and options – ultimately creating paths out of poverty. 1,2 The financial services sector is the largest in the world in terms of earnings, comprised of a wide range of businesses including merchant banks, credit card companies, stock brokerages, and insurance companies, among others. This report focuses primarily on large domestic and multinational commercial banks. These large firms have the expertise, reputation, and geographic reach to have significant direct impact and, through engagement and example, to change the way entire markets operate. They are using increasingly deliberate strategies to expand economic opportunity through business models that serve poor individuals and SMEs as clients. They are also developing initiatives to build human and institutional capacity and using their experience and influence to shape policy frameworks in the regions in which they work. Despite their potential, to date the impact of large commercial banks on expanding economic opportunity has remained limited in the developing world, where a vicious cycle of insufficient information, inappropriate products, inadequate infrastructure, and inflexible regulatory environments has kept costs, and therefore prices, high, limiting companies’ markets to clients within the top tiers of the economic pyramid. 3 One of the most critical obstacles to financial inclusion is informality. The poor often live and work in the informal sector, lacking legal ownership of land, homes, and businesses. Some one billion people worldwide live in informal settlements in urban areas alone, 4 meaning that they cannot use their land or their homes as collateral on a loan; often they lack addresses they could associate with a bank account or credit application. Entrepreneurs can face high fees, inefficient and sometimes corrupt procedures, and burdensome regulation that essentially make it too costly to incorporate legally, forcing many small and start-up enterprises to remain in the informal or extra-legal sector. The results are telling. Of 1.1 billion people in India, only 30 million are formally employed; of 8.8 million in Bolivia, only 400,000 are formally employed. 5 The remainder largely operate their own micro-enterprises without the legal recognition required to obtain traditional lines of credit, enforce contracts, or declare bankruptcy. THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 6 BOX 1 THE ROLE OF LOCAL FINANCIAL INSTITUTIONS While an in-depth discussion is outside the scope of this report, it is important to highlight the role that smaller, local financial institutions play in expanding economic opportunity. These firms have in-depth knowledge of local operating environments, which has enabled them to become a significant source of innovation in business models targeting low-income markets. In addition, local firms provide thousands of skilled jobs. 1 ■ The Role of the Financial Services Sector in Informality contributes to insufficient market information for financial institutions. Because most of the poor have never held checking or savings accounts, taken bank loans, or entered into legal contracts, it can be difficult and costly for commercial financial institutions to determine what assets they have, what kinds of services they might need, or what levels of risk they might represent. Banking system regulations, such as interest rate caps, directed lending, and high reserve requirements discourage them further still. 6 As a result, in developing countries, only 26% of citizens have even basic checking or savings bank accounts. 7 Worldwide, only one billion of 6.5 billion people have bank accounts. 8 In recent years, however, two major trends have drawn attention to the potential market opportunity associated with low-income individuals and small businesses, catalyzing increased innovation and experimentation around these challenges and enabling promising business models to emerge. First, against a backdrop of 30 years’ practical experience, widespread publicity around the United Nations’ International Year of Microcredit in 2005 and Muhammad Yunus’ receipt of Nobel Peace Prize in 2006 have increased overall public awareness of microfinance. Awareness has led to growing recognition of two important facts: • the poor are able to pay (often very high interest rates) for financial services, and • they present no greater credit risk than the average higher-income borrower. In fact, many microfinance institutions have better repayment rates than traditional commercial finance institutions. Increasing acceptance of microfinance has, in turn, laid the groundwork for an increasing focus on “meso- finance,” or small and medium enterprise finance – loans and investments larger than micro-loans, but smaller than would be profitable for a large, commercial financial institution to make. 9,10 Second, remittances from developed to developing countries, sent home by migrants, have reached sizes and growth rates too large for the major commercial players to ignore. The World Bank has shown that these flows totaled some $199 billion in 2006, more than twice the amount in 2001. And this figure includes only transfers through official channels. Available household surveys suggest that unrecorded flows through informal channels may add 50 percent or more to this estimate. 11 Almost all multinational banks now have microfinance initiatives, and the challenge has become moving their commitments and activities into mainstream business operations where they can scale to match the enormous global demand. 12,13 Another challenge is to expand the focus from microfinance to meso-finance, roughly defined as financing in the $50,000 to $1 million range, which would enable small and start-up businesses to grow to levels where they could begin taking advantage of economies of scale and creating significant numbers of jobs. THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 7 2 ■ The Business Case for Engagement Why should large commercial financial institutions care about expanding economic opportunity in developing countries? They operate quite profitably as it is, serving high net worth clients, investing in government bonds, and providing services to established companies in other industry sectors. 14 Though these strategies have been sufficient thus far, more may increasingly be required. Industry trends, new technologies, rising citizen expectations, and government mandates that encourage the provision of financial services to underserved populations all challenge the traditional paradigm – presenting both risk and opportunity. 2.1 Mitigating and Managing Risk 2.1.1 Political and Regulatory Risk Given the critical role of financial services in expanding economic opportunity, a reluctant industry may be regulated or otherwise “incented” into expanding its markets by national governments. Examples have occurred in the United States, South Africa, and Brazil, among other countries: • US Community Reinvestment Act: In the United States, the Community Reinvestment Act of 1977, in part a result of public scrutiny and pressure applied to big banks by non-governmental organizations (NGOs), established explicit targets for lending in under-served communities. • South African Financial Sector Charter: Facing the prospect of government regulation, South African financial institutions worked with government and with communities to develop and adopt a set of principles that encourage the economic empowerment of under-served communities by setting targets and giving firms individual ratings based on their performance. • Community Reinvestment Legislation in Brazil: Changes in Brazilian government policy in 2003 require that financial institutions provide simplified, low-cost bank accounts for low-income people and put aside 2% of all demand deposits for microfinance operations targeting small (though not necessarily low-income) businesses. 15 By taking proactive approaches to increasing economic opportunity, individual financial institutions – and the industry as a whole – can minimize political controversy and the prospect of government regulation, while at the same time addressing a critical business and societal issue. 2.1.2 Reputation Risk Poor corporate governance, outsized executive pay packages, and white collar crime are significant sources of reputation risk for financial services firms today. As global wealth and income inequality simultaneously increase, business models that are perceived as “elitist” or “exclusive” may join this list. By exclusively serving THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 8 rich minorities in economies characterized by extreme poverty and inequality, banks run the risk of being perceived to perpetuate inequality – or even partly create it. There is by now a reasonably long history of negative publicity and activism by grassroots groups, advocacy organizations, and the media against industries and specific companies whose business practices are deemed unfair. Such campaigns are no longer limited to instances of negative impact. Firms that fail to create positive impact, in line with the expectations of society, are also subject to attack – witness the campaign for a living wage in the toy, apparel, and footwear industries. Groups increasingly couch their claims in human rights language, including economic and social rights such as the right to work and the right to an adequate standard of living. It is increasingly clear that public relations and philanthropy are inadequate strategies for mitigating this kind of reputation risk, as they do not address stakeholders’ core concerns: business models that currently exclude the majority of the world’s poor from access to vital services. As public awareness of the relationship between financial inclusion and poverty alleviation grows, this risk could increase. By incorporating economic opportunity objectives into their mainstream business strategies, firms can demonstrate both commitment and results, protecting or even strengthening their brands, reputations, and “licenses to operate.” 2.2 Harnessing Opportunity 2.2.1 New and Expanding Markets Shareholder value is determined in part by expectations about growth. While developed economies continue to grow, many developing economies are growing even more rapidly. Indeed, World Bank research shows that the developing economies will, as a group, grow faster on average than developed ones for at least the next 25 years. 16 This growth can be expected to bring hundreds of thousands, even millions of people into the formal financial sector for the first time. Inclusive business models could increase the potential even further. The opportunities include microfinance, meso or SME finance, and remittances. • Microfinance: Comparison of data from three authoritative sources, the Microfinance Information Exchange, the Microcredit Summit, and the Consultative Group to Assist the Poor, reveals that a core group of microfinance institutions reaches between 30 and 50 million borrowers worldwide. According to microfinance pioneers María Otero and Elisabeth Rhyne of ACCION, while it is impossible to gauge the full extent of global demand, “it is easy to determine that demand is much greater than current supply.” They put the potential market at several hundred million families at least. 17 In addition, demand exists for more diversified personal financial services beyond credit, including savings, bill payment, insurance, and more. • SME finance: In many developing countries, SMEs with fewer than 50 employees constitute 95% of all businesses. 18 And yet, SMEs in those countries contribute far less to GDP and employment than their developed country counterparts: 17% and 30%, respectively, compared with 50% and 60% in developed countries. 19 Part of the problem is informality, which limits SME access to productivity tools and market opportunities. However, with increasing attention to this topic – including the World Bank’s annual Doing Business rankings 20 – incenting countries to reform, progress is taking place. With key bottlenecks being lifted, the SME sector could experience significant growth and development, offering new and expanded markets for financial services firms. Many are already aggressively pursuing this segment, though THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 9 undoubtedly at the larger and better-established end of the spectrum (see Box 2). Within the donor and investor communities, the focus on smaller, newer, and otherwise higher-risk SMEs is intensifying, with pointed discussion of what is required to generate attractive commercial returns. 21 Remittances: As indicated earlier, international remittances doubled between 2001 and 2006, now totaling over $199 billion per year. In addition to international remittances, increased urbanization has led to growth in domestic remittances. Household surveys suggest that a significant percentage – up to 50% – of these flows still happen outside formal financial channels, suggesting additional market opportunity for commercial financial institutions. 22 BOX 2 SMALL AND MEDIUM ENTERPRISES (SMES) AN IMPORTANT NEW MARKET FOR FINANCIAL SERVICES A sampling of recent headlines includes: “Big banks now eyeing SMEs” VietNamNet Bridge, September 18, 2007 “Standard Chartered targets major growth from the SME sector” Middle East North Africa Financial Network, September 13, 2007 “ABN Amro turning to SMEs for future growth” Jakarta Post, Indonesia, August 23, 2007 “Citi aims for 20% growth in SME business” Malaysia Star, Malaysia, August 7, 2007 “HSBC’s SME banking business up 20% annually over three years” Channel News Asia, August 7, 2007 “US banks turn greenbacks flow towards Indian SMEs” Economic Times, India, July 23, 2007 2.2.2 Innovation in the Financial Services Sector Financial services firms have traditionally paid little attention to the poor because, by definition, the poor have limited assets. Informality, insufficient information, inadequate infrastructure and other barriers have reinforced the belief that serving the poor cannot be commercially viable, much less a driver of innovation. New, lower-cost business models have begun to challenge this conclusion, relying for instance on innovations in technology and utilization of existing retail channels. A wide range of examples shows the power of information and communications technology to reduce distribution and customer service costs, including the village ATMs of Citibank and ICICI Bank in India, and the mobile transactions services of Wizzit and MTN Banking in South Africa, SMART Communications and Globe Telecom in the Philippines, Celpay in Zambia and the Democratic Republic of Congo, and Vodafone and Safaricom in Kenya. Indeed, a recent study by the Consultative Group to Assist the Poor (CGAP) found that 62 financial institutions in 32 countries report using technology-based channels, ranging from ATMs, point of sale devices, and mobile phones, for transactions with low-income clients. 23 Interestingly, Wizzit and Globe Telecom provide financial services without associating with a bank or other financial institution, thus eliminating the need for the poor to hold bank accounts in order to pay bills, transfer funds, and deposit or withdraw cash. Another emerging low-cost business model for providing financial services to low-income clients can be found in the retail sector in Mexico, where Wal-Mart is providing deposits, withdrawals, transfers, and payments – going beyond consumer credit. Domestic retail chain Elektra and its banking arm Banco Azteca have already been in this business for a number of years. THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 10 [...]... process • financing THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 33 • ongoing business development assistance, and • exit If the parties decide against a second round of financing from GroFin, the fund will investigate and introduce the entrepreneur to mainstream financiers for further assistance, as needed.98 Results In addition to delivering attractive financial rates of return... lynchpins in the dynamic transformation of financial markets to offer expanding economic opportunity to the poor While individual firms must naturally choose the strategies most appropriate for them, strong collaboration capabilities will almost certainly be essential – both within the financial sector and beyond THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 19 5 I Case Profiles... credibility of the efforts with other important stakeholders It also allows them to develop new capabilities and, by changing the context for their efforts, uncover and even create new strategic opportunities 18 THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity In the financial services sector, engagement with microfinance institutions, international financial institutions,... INCLUSIVE BUSINESS MODELS 31 5.7 GROFIN AND SHELL FOUNDATION: INVESTING IN SME DEVELOPMENT IN AFRICA 33 5.8 STANDARD CHARTERED: AGRICULTURAL CREDIT CARDS IN PAKISTAN 35 20 THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 5.1 ICICI LOMBARD: WEATHER-INDEXED CROP INSURANCE FOR RAIN-FED FARMERS IN INDIA Background ICICI Bank is the largest private sector bank in India, and the second... similar insurance schemes, suggesting significant market potential and future profitability 22 THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 5.2 BARCLAYS: ADDING VALUE THROUGH TRADITIONAL MICROFINANCE MECHANISMS IN GHANA Background 5.1 Barclays is one of the largest financial services companies in the world, engaged primarily in commercial banking, investment banking, and investment... that the financial services sector is, in essence, in the business of expanding economic opportunity: this is the core value proposition of its products and services to clients Large commercial financial institutions are increasingly engaging and experimenting with ways of expanding that pool of clients to include lower-income individuals and entrepreneurs and SMEs This report suggests a number of opportunities... Supply chain finance Commercial financial institutions are also offering SME finance in collaboration with large firms in other industries – such as agribusiness, manufacturing, mining, and others – that are working with SMEs in their value chains Such relationships can help the financial institution with deal-flow, reducing the cost of identifying qualified borrowers and sometimes subsidizing interest... crop insurance, as it protects the farmers' overall income rather than the yield of a specific crop The major difference between the two lies in administration Because traditional crop insurance requires intensive site visits and administration, claims THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 21 settlements can take upwards of a year to be processed Weather-indexed insurance... for these firms to enhance the impact of their efforts: Engage in multi-pronged strategies for expanding economic opportunity While each of the four business strategies 1 for expanding economic opportunity outlined here is individually important, significant breakthroughs seem to require combinations of these strategies Because financial services are both the core business of commercial financial institutions... denominated in local currency A significant percentage of the remaining 40% consists of US dollar loans to dollarized economies in Latin America The mechanisms the GCMC uses to lend in local currency THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 27 have also had the result of helping to build stronger relationships between MFIs and local commercial financial institutions . opportunities. THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 18 In the financial services sector, engagement with microfinance institutions, international financial institutions, and. to being part of the dynamic growth and development occurring in this field. THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 5 Expanding Economic Opportunity Financial. alone. 25 THE ROLE OF THE FINANCIAL SERVICES SECTOR in Expanding Economic Opportunity 11 3 ■ Business Strategies for Expanding Economic Opportunity As we have seen, financial services help the poor