2.8. Formal financial
sector and Economic activities
The formal financial sector falls under the banking law and
regulations and supervision of financial authorities. It includes various kinds
of banks (commercial, development and specialized, regional, cooperatives),
insurance companies, social security schemes, and pension funds and some
counties capital markets.
In many countries, the formal financial sector is largely
urban-based and organized primarily to supply the financial needs of the
wealthier population and large co-operations.
Formal financial intermediaries, such as commercial banks
usually refuse to serve poor households and micro-enterprises because of the
high cost of small transactions, lack of traditional collateral, and lack of
basic requirements for financing and geographical isolation by doing so, these
institutions ignore the economic potential in talents and entrepreneurship of
this stratum of society. In many developing countries the formal financial
sector serves only 5%-20% of the population and the number of institutions are
very limited (Gallard A.O, 2003: 68).
However, the share of the formal financial sector in total
assets is about 95% this means that poor people in developing countries depend
on semi-formal and informal financial intermediaries for their credit needs.
2.9. Semi-formal financial
sector and Economy
The organizations in the semi-formal financial authorities;
nevertheless, they may operate under particular laws and regulations. This
sector includes credit unions, non-government organizations (NGOs) and Micro
Finance Institutions (MFIs). The semi-formal financial sector operates in urban
as well as rural areas and is mostly dependent on subsidies and assistance from
governments or donors and principally from central bank.
These contribute more significantly to rural and urban
employment and purchasing power that provokes the increment of social welfare
and economy in general. (Robertson, 2001: 162).
2.10. Informal financial
sector and Economic activities
The informal sector is characterized in general, by social
structures, individual operators, ease of access, simple procedures, rapid
transactions and flexible loan terms and amounts. It includes local
member-based organizations such as rotating savings and credit associations and
self-help organizations. Individual money lenders also are widely found in
developing countries. There are many types of informal money lenders including
shopkeepers, traders, and landlords.
Last but not least, there are relatives, friends and neighbors
from whom those in need can borrow, although primarily for emergencies or
special purposes rather than for going working capital needs. In this
situation, lenders tend to provide small loans at no or low interest, but they
may expect non financial obligations in return for their credit. (Robertson,
2001: 162).
2.11. Problems affecting
financial development in developing countries
One of the major factors affecting financial sector
development in developing countries and Africa in particular according to
Richard and Montiel (1999) is the regressive mechanisms of monetary control.
Many African countries choose to repress their financial systems by adopting
direct instruments of monetary policy hence preventing their financial sectors
from operating at their full potential. Monetary policy in repressive regimes
consists of imposition of high reserve requirements on banks as well as legal
ceiling on lending and borrowing rates. Interest rates are fixes at
unrealistically low rates that are often negative in real terms.
The consequence of this, is an inefficient linkage between the
supply of savings and the demand for investments. The failure to signal true
sacristy of capital and the flows of capital is created, and therefore
unnecessary low growth of the economic is initiated.
In addition to fixing interest rates, financial repression may
consist of introducing all kinds of regulations, laws and other forms of market
restrictions to bank behavior and other intermediaries. Restrictions are
imposed on the competition of banking industry by forming barriers to entry
into the banking system or through public ownership of bank. Restrictions can
also be imposed on the composition of the bank portfolio, by putting
requirements that banks engage in certain form of lending, as well as
prohibitions from acquiring other types of assets. It includes the imposition
of liquidity ratios, requiring banks to invest specific shares of their
portfolio in government instruments, as well as directed lending to specific
sectors, typically the export sector and agriculture.
Besides financial repression, poor macroeconomic policy
management has been noted as other serious obstacles to financial development
in developing countries (Richard and Montiel, 1999). Those policies include
among others; price controls, foreign exchange allocation, infrastructure
bottlenecks, overvalued exchange rates, and financial mismanagement. However,
Richard and Montiel (1999) believe that administered exchange and credit
allocation policies may not be easy to reform because of permanent balance of
payment problem and associated shortage of foreign exchange services.
African countries are also characterized by present potential
instabilities, wars, conflicts and nonconductive macroeconomic environment.
Such factors can increase the risk of breaking financial contracts and loosing
funds and hence discourage the flow of funds into such areas.
Richard and Montiel (1999) further argue that developing
countries have common microeconomic problems, which can hinder financial
development. In particular they focus on the weak bank management (including
lack of professional staff, inadequate capital, etc).
Furthermore, bank supervision characterized by over reliance
on external audits, outdated laws, lack of surveillance capacity, and
inadequate punitive control powers of central bank has received special
attention from researchers.
To summarize microeconomic obstacles to financial development
in Africa, Collier (1990) focused on the CAMEL framework (capital adequacy,
asset quality, earnings, and liquidity).
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