Financial Sector Assessment

Scope of Analysis

The goals of financial structure analysis and development assessment for a country are to (a) assess the current provision of financial services, (b) analyze the factors behind miss­ing or underdeveloped services and markets, and (c) identify the obstacles to the efficient and effective provision of a broad range of financial services. The dimensions along which service provision must be assessed include the range, scale (depth) and reach (breadth or penetration), and the cost and quality of financial services provided to the economy. At a high level of abstraction, those services are usually classified as including the following:

• Making payments

• Mobilizing savings

• Allocating capital funds

• Monitoring users of funds

• Transforming risk

Thus, the ideal financial system will provide, for example, reliable and inexpensive money transfer within the country, reaching remote areas and poor households. There will be remunerative deposit facilities and other investment opportunities offering liquid­ity and a reasonable risk-return tradeoff. Entrepreneurs will have access to a range of sources for funds for their working - and fixed-capital formation; affordable mortgage and consumer finance will be available to households. The credit renewal decisions of banks and the market signals coming from organized markets in traded securities will help ensure that good use continues to be made of investable funds. Insurance intermediaries and the portfolio possibilities offered by liquid securities markets will help maximize the risk pooling and the shifting of risk at a reasonable price to entities that are able and willing to absorb it.

The scope of financial structure analysis and of development assessment is fairly extensive—as illustrated in the above list—and those structural issues cannot be simply broken into self-contained segments corresponding to existing institutional arrangements. Structural and development issues arise across the entire spectrum of financial markets and intermediaries, including banking, insurance, securities markets, and nonbank intermediation. They often demand consideration of factors for which well-adapted and standardized quantification is not readily available. Therefore, the challenge is to trans­late those wide-ranging and somewhat abstract concepts into a concrete and practical assessment methodology.

The suggested approach begins with a fact-finding dimension that seeks to benchmark the existing financial services provided in (and available to) the national economy—in terms of range, scale and reach, cost, and quality—against international practice. Such benchmarking should help pinpoint areas of systemic underperformance, which can then be further analyzed to diagnose the causes of the underperformance against realistic tar­gets. To some extent, the benchmarking can be quantified, but, in practice, quantification must be supplemented by in-depth qualitative information. The question being asked in every case is, if quality or quantity is deficient, then what has caused this deficiency?

Deficiencies will often be traced to a wide range of structural, institutional, and policy factors.

• First, there may be gaps or needed changes in the financial infrastructure, both in the soft infrastructures of legal, information, and regulatory systems and in the harder transactional technology infrastructures that include payments and settle­ments systems and communications more generally.

• Second, there may be flaws or needed adaptations in regulatory or tax policy (including competition policy) whose inadequacies or unintended side effects dis­tort or suppress the functioning of the financial system to an extent not warranted by the goals of the policy.

• Third, digging deeper, there may be broad governance issues at the national level, for example, where existing institutional structures impede good policy making (especially favoring incumbents over newcomers).

• Fourth, financial sector deficiencies may also be traced to problems in the country’s wider economic infrastructures, including the education, transportation, and com­munications systems. Furthermore, many developing countries are faced with the difficulty that effective finance requires a scale of activity that may be beyond the reach of small economies, populated as they are by a small number of small clients, small intermediaries, and small organized markets (see Bossone, Honohan, and Long 2002). An effective financial system, while contributing to wider economic growth and development, is also somewhat dependent on the wider economic environment—not least the macroeconomic and fiscal environment.

The most distinctive feature of financial structure analysis and development assess­ment is the focus on the users of financial services and on the efficiency and effectiveness of the system in meeting user needs. Policy reforms that benefit users and that promote financial development are generally favored in such analysis and assessments.1 The pro­posed assessment framework is also guided by the presumption, which is based on a sizable body of empirical evidence, that an effective and efficient financial system is best provided by market-driven financial service providers, with the main role of government being to serve as regulator and provider of robust financial infrastructure. Therefore, the establish­ment of a government-sponsored financial service provider is not seen as likely to be the first-best solution to deficiencies. Instead, the role and effectiveness of financial service providers are assessed regardless of whether they are government owned. Assessment has two phases: information gathering and analytical reporting.

Phase 1: Information-Gathering Phase

To reflect this focus on users and the services they require, the overall assessment needs to adopt a functional approach and not to be confined to a perspective that is based on existing institutional dividing lines between different groups of providers.2 Nevertheless, much of the information gathering will inevitably reflect those institutional divisions, not the least because national regulatory structures are typically organized along those lines (notwithstanding the trend to integrated supervisory agencies in several countries).

In addition, the adequacy of the legal, information, and payments infrastructures and of other aspects of the overall policy environment are central to the development assessment: each has relevance cutting across any single sector. Yet, information about the effectiveness of the infrastructures and about the unintended and hidden side effects of the policy environment is often obtained only by learning how each sector works. Likewise, the competitive structure, efficiency, and product mix of the various sectors can be explained only on the basis of an understanding of the design and performance of the infrastructures. So the information-gathering phase of the assessment needs to have a sectoral, as well as an infrastructural, dimension. Cross-cutting policy issues such as taxa­tion also need to be kept in mind. Finally, user perspective can be helpful, especially in identifying gaps in providing markets and services, as well as in discovering deficiencies in quality and cost that might not be revealed from analysis of the suppliers.

The information-gathering phase of the assessment is multidimensional. Typical com­ponents of the information-gathering phase may include the following:

• Quantitative benchmarking of the size, depth, cost and price efficiency, and the penetration (breadth) of financial intermediaries and markets, using internation­ally comparable data (section 4.2)

• Reviews of legal, informational, and transaction technology infrastructures (sec­tion 4.3)

• Sectoral development reviews, providing a more in-depth assessment of service provision, structure, and regulation (Sectors covered will normally include com­mercial banking and nearbanking, insurance, and securities sectors and may also include some or all of the collective savings institutions and of the financial aspects of public pension funds, specialized development intermediaries, mortgage finance, and microfinance. Those sectors need to refer to the functioning both of the industry [financial services providers] itself and of the regulatory apparatus [section 4.4].)

• Demand-side reviews of access to, and use of, financial services by households, microenterprises, small and medium enterprises (SMEs), and large enterprises (sec­tion 4.5)

• Reviews of selected additional cross-cutting aspects of the policy environment (for example, distorting taxation and subsidization of financial intermediation) and of implications for competition of cross-sectoral ownership structures (Those reviews also may mention missing product issues, thus focusing on whether key financial products—such as leasing, factoring, and venture capital—are available and iden­tifying the reasons for their absence [see section 4.6].)

Phase 2: Analytical and Reporting Phases

The relative importance of the components of the information-gathering phase and the scope of their analysis will vary according to country circumstances. This wide-ranging scope of information presents a challenge to assessors who must, in the analytical and reporting phases, synthesize the information to identify the major axes of needed policy reform and of infrastructural strengthening for stability and development. Segments of the financial system that are already active, but for which the benchmarking exercise suggests shortcomings, will deserve more-detailed attention. For segments that are missing or are not very developed, the discussion of needed policies can be confined to the level of broad strategy. How those components can be integrated into a policy framework is discussed in section 4.7.