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1.3 The Financial Systems Approach

Most old-paradigm programs were discontinued by the 1980s and replaced by the financial systems approach.[1] The term “financial system” covers all: 1) financial institutions; 2) financial markets and instruments; 3) legal and regulatory environment; and 4) financial norms and behavior. Building the system requires developments at three levels: 1) micro: understanding the financial needs and behavior of different clientele, building financial institutions, creating financial products and services; 2) meso: creating infrastructure needed for financial intermediation services; and 3) macro: creating conducive national policies and strategies, complementary non-financial services, and a supportive enabling environment.

Key elements of this new paradigm include:

1. Broadening the view of rural finance to include farming and rural non-farm activities;

2. Recognizing the importance of savings mobilization;

3. Believing market discipline of both financial institutions and clients is reinforced through market interest rates for both savings and credit;

4. Granting of loans in response to demand rather than supply targets;

5. Evaluating financial institutions for their viability rather than loans disbursed;

6. Recognizing successful finance depends upon favorable macroeconomic, agricultural, and financial sector policies, as well as an appropriate legal framework;

7. Accepting informal finance as complementary rather than usurious and harmful;

8. Believing financial sector reform is essential to improve performance and widen the outreach of financial institutions; and

9. Identifying useful roles for donors to assist in creating a favorable policy environment, improving legal and regulatory frameworks for rural financial markets, building institutional capacity, and supporting innovations to lower transaction costs and improve risk management.

The new paradigm reversed the objective of supplying cheap credit and focused instead on creating sustainable institutions, treating borrowers and savers as clients rather than beneficiaries, and pricing products and services to cover costs and risks. Long-term relationships with clients were encouraged by gradually increasing loan sizes consistent with repayment capacity. The use of credit lines was reduced by donors in favor of grants, loans, and technical assistance supporting product designs, institutions, and policies. The new paradigm contributed importantly to the successes of microfinance and its penetration into rural areas and agriculture.

  • [1] This summary draws from FAO/GTZ (June 1998), Yaron, et al. (1997), and IFAD (2010). The new approach was incorporated into the policies of international agencies in the 1990s (World Bank, 2003).
 
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