FOCUS NOTE Development Finance Institutions and Financial Inclusion: From Institution-Building to Market Development S ignificant strides have been made in connecting the world’s low-income populations and micro and small businesses to financial services. Yet, after often deeply rooted in established practices and behavior of market actors, which are shaped by the information available to them, their capacity, and decades, there are still large gaps in access, use, incentives. These barriers are complex, making them product offering, and quality of services. Several more difficult to address than funding gaps. They segments remain overlooked (e.g., rural populations, require funders to address underlying problems women, ethnic minorities, smallholder families, that prevent markets from becoming more inclusive. specific business sectors, etc.). Many countries still Rather than strengthening individual market actors struggle with undeveloped financial systems—even (e.g., financial service providers [FSPs]), a systemic when excluded populations gain access to financial approach to financial inclusion requires funders to products and services, many financial offerings are set the right conditions for these actors to adopt poorly designed, understood, or used. In the past, new, more inclusive behaviors and to stimulate development actors assumed that access to capital uptake of the new behaviors beyond initial partners was the main barrier to scaling financial inclusion, and the duration of a funder’s intervention. Systemic but over time, local bank financing and savings change occurs when market dynamics have changed mobilization have increased, and foreign funding sustainably and result in a more inclusive financial continues to grow (including through microfinance services market. This approach requires being investment vehicles [MIVs]) (Soursourian and open to taking risk, being flexible, identifying new Dashi 2016). Other barriers that hinder financial investment opportunities beyond FSPs, and having inclusion include, among others, deficient market a willingness and ability to learn from failure. infrastructure, limited technological innovations, and restrictive policy and regulatory environments. Funding for FSPs Is Not the Stumbling Point CGAP’s “A Market Systems Approach to Financial Inclusion: Guidelines for Funders” (Burjorjee and DFIs play an invaluable role in developing financial Scola 2015) encourages funders to take a market markets and have been key to strengthening and systems approach to financial inclusion, arguing building FSPs that serve low-income markets. As that only a more systemic approach can make a seen in Figure 1, these FSPs are a niche “supplier.” No. 105 significant and sustainable contribution to financial DFIs’ financial inclusion commitments are heavily March 2017 inclusion (see Box 1).1 Applying a market systems concentrated on financing these retail FSPs (92 approach requires funders to understand the percent of commitments; see Figure 2), which helps Louise Moretto market system more deeply, taking into account to address FSPs’ funding constraints. When adding and Barbara Scola the interplay of different market actors and the capacity-building grants to FSPs (4 percent), 96 functions they perform (or fail to perform) in percent of DFI commitments are dedicated to the system. Key functions in the market system financing or strengthening the supply side in the for financial services include demand, supply, financial services market, and it is uncertain as supporting functions, and rules and norms (see to what extent other market barriers to financial Figure 1). The shortcomings of market systems are inclusion are addressed by DFIs’ interventions. 1 In this paper, “market development approach,” “systemic approach,” and “market systems approach” are used interchangeably in referencing changes to the financial services market. 2 Box 1. What is a market systems approach to financial inclusion? And as it is applied to DFIs? A market systems approach aims to catalyze systemic who encourage changes to incentives in the market change—change that is significant in scale and system that enable a broad range of market actors sustainable. The following are key features of a market to perform market functions more effectively. systems approach: • Incentives and crowding-in. In theory, DFIs play a temporary role in markets and should work toward • Consideration of the whole market system (not just crowding in market actors, including private the supply side). Overcoming barriers to financial investors. Crowding-in often requires setting the inclusion requires addressing underlying constraints right conditions (e.g., transparency) and incentives. in the market. The lack of providers serving low- income segments is often a symptom of underlying • Flexibility. Adopting a market systems approach problems that might be linked to an unconducive requires working with a broader range of market policy environment, a lack of understanding of actors and responding to dynamic changes in excluded segments, or misaligned incentives. financial markets. DFIs (and other funders) need to invest beyond prevailing business models; this • Facilitative interventions. DFIs—and other requires flexibility and a higher level of risk-taking funders—need to think of themselves as facilitators (e.g., innovator companies). See Burjorjee and Scola (2015). Our research suggests that DFIs can significantly but the group also advocated for policy and increase their contribution to financial inclusion by regulatory changes that ultimately created a (i) expanding their lens to thoroughly review how robust microfinance industry. Further, the NGO their interventions affect the entire financial system, became the country’s largest commercial bank, (ii) growing their risk appetite to test new business serving many remote communities (70 percent of models and delivery channels that help bring the its portfolio is classified as rural), and expanding poor into the financial system, and (iii ) leveraging to two other Asian countries (see the following their technical credibility to facilitate market section, “DFIs Deploying ‘Elements’ of a Market development.2 Effectively, DFIs would help drive a Development Approach: Mini-Cases”). more sustainable and dynamic market that ultimately presents them with new and more diversified This paper aims to show what a market systems investment opportunities, eventually benefitting the approach could look like by highlighting cases of private investors they seek to crowd into the market. DFI contributions to market development and by Several DFIs are considering broadening their scope addressing the challenges and requirements DFIs of activities and realize that they may need to take face and ways they can influence broader market more risks, but it is not clear how they will do so. change.3 Interviews were an important component of our research and recommendations; more than Deploying a market systems approach would help 40 industry experts, including those working in DFIs DFIs frame their investment strategy within the and MFIs, consultants, and digital finance experts, broader context of market change and higher DFI were interviewed. The paper promotes the idea additionality. Cambodia provides an early DFI that DFIs can and often should play an expanded example that preceded and resembles the modern role in promoting market development beyond day “market systems development” approach. In an investment-only approach (e.g., supporting Cambodia, a small group of coordinating DFIs and policy and regulatory changes and providing donors not only funded a promising microfinance advisory or technical assistance on critical market institution (MFI) in a risky undeveloped market, innovations). The market systems approach does 2 “Technical credibility” refers to many DFIs’ recognized expertise on finance, banking, legal, and other private investment-related matters, including overlaps in policy and regulations. 3 This paper discusses how DFIs pursued “elements” of a market development approach to address needed changes in how a particular market was functioning. It does not address how to measure the impact of market development programs. (CGAP is working on a separate market systems measurement handbook, which will go deeper on this topic.) 3 Figure 1. The market system and main market functions SUPPORTING FUNCTIONS Capital Coordination markets Infrastructure Information Skills & capacity SUPPLY CORE DEMAND Standards Informal norms Regulations Codes of Supervision conduct RULES AND NORMS Note: This diagram was adapted by CGAP from the Springfield Centre’s Making Markets Work for the Poor (M4P) framework, commonly known as a market systems development approach. The framework seeks to change the way markets work by addressing systemic constraints and engaging market actors to create large-scale, lasting benefits for the poor. not suggest that DFIs become more like donors are complementary to bilateral and multilateral (managing large grant programs) or that donors development agencies that provide predominantly become more like DFIs (setting aside sizable grants and loans to governments, and rarely work amounts of their budget for investments). Their directly with the private sector. DFIs’ government traditional and complementary roles remain intact, shareholders expect DFI investments and with the flexibility for different types of funders to interventions to have broad development impact. participate in specific market initiatives where they DFIs typically aim to deliver broader development have a comparative advantage. impact beyond the direct outputs created by their investees—including economic growth, inclusive DFIs’ Role in Embracing a markets, and improved policy environments. 4 Market Systems Approach However, DFIs face difficult trade-offs between development and financial returns and have Investing in development: Balancing been criticized for not sufficiently prioritizing financial and developmental returns development outcomes (Savoy, Carter, and Lemma 2016). Incentivizing commercial investors to invest DFIs’ mandate is to contribute to achieving in projects with high potential development impact development goals through investments in private- is core to achieving a DFI’s mandate, and can be sector companies that yield market or near market realized when DFIs invest early in new business financial returns. Their mandate and instruments models or help develop new market segments. 4 See Bortes, Sunil, and Grettve (2011). 4 “Additionality” and “catalytic” are terms that are drop in both debt and equity reflected in this figure often used to describe the nature of DFI funding and relates mostly to foreign exchange [FX] depreciation of the role it plays in market development. DFI funding the Euro during the period.) Equity investments have is considered “additional” when funds are invested been increasing—making up 20–40 percent of a few in countries, sectors, regions, capital instruments, or DFIs’ investment portfolios. Equity investments have business models where commercial investors have a higher prospect of driving impact and influencing not (yet) invested (Savoy, Carter, and Lemma 2016). market development through three leverage points It is considered “catalytic” if it crowds in commercial of equity: entry, governance, and exit (Lahaye 2016). investors, particularly local investors. Yet, both Nonetheless, most equity investors—private and descriptions refer to DFIs only as providers of funding public—are focused on the financial returns of their and understate the facilitating role DFIs can play as FSP investees and are less interested in the change suggested in the following. they might trigger in the market. The DFI financial inclusion approach In terms of investment targeting, nearly all of to date: Investment driven to FSPs the DFI commitments reported were exclusively for FSPs (92 percent). Investments in market DFI funding for financial inclusion has continually infrastructure, where financial returns are uncertain increased since 2007 when CGAP started collecting or lower, and other types of companies, such as annual data on cross-border funding, with DFIs FinTechs, that play an increasingly important role representing 42 percent of estimated cross-border in financial inclusion remain marginal (Figure 2b).9 financial inclusion commitments globally as of Roughly a third of DFI funding to FSPs is channeled December 2015.5 The average DFI commitment via intermediaries such as MIVs (referred to in for financial inclusion is $8.9 million and has been Figure 2b as “retail financing-indirect”). relatively steady since 2013. Depending on DFIs’ ownership, funding sources, and organizational TA for retail FSPs represents around 4 percent of structure, DFIs support financial inclusion in total DFI commitments. When the investments are different ways. The three predominant engagement combined with TA, TA funds primarily come from models are as follows:6 grants originated from several possible sources (internal budget line item, subsidies from third • Investments only. parties, and increasingly from collaborating TA • Investments combined with technical assistance (TA). 7 grants from the DFIs’ sister donor agencies or private • Stand-alone advisory services (generally for market foundations, for example). To date, the majority development purposes). 8 of this TA has been focused on FSP institution building, and experience to date suggests that this Not surprisingly, investments are the predominant “retail TA” rarely has a deliberate or pronounced engagement model, with debt funding being the spillover effect into the broader market. At one of primary investment instrument, followed by equity, the larger DFIs, when TA is directed at the investee and then guarantees. (See Figure 2a. Note that the level (e.g., an FSP), it charges advisory fee revenues, 5 The global estimate takes into account financial inclusion commitments reported to CGAP as of December 2015 by 54 funders (namely, public funders, such as donors and DFIs, and some large private foundations) (CGAP Funder Survey, 2015 data) and financial inclusion commitments (namely from private investors in MIVs) captured in the 2016 Symbiotics MIV Survey (2015 data). 6 The investment-only approach is the predominant DFI model (based on analysis of their funding survey responses with less than 5 percent allocated to noninvestments), since many DFIs source their funding from capital markets and need financial returns. For example, KfW raises 90 percent of its funding in capital markets and thus focuses on investments to ensure repayment of that capital (https://www.kfw.de/KfW-Group/ About-KfW/Arbeitsweise/Verantwortungsvolle-Refinanzierung/). 7 In this paper, TA refers commonly to strategic advice and other inputs, with a specific focus. Capacity building is used more generally to refer to knowledge- or skill-building efforts. TA and capacity building can be provided either directly by DFIs or contracted to third parties (more predominantly the latter). Funding for TA and capacity building can originate from various sources—internal DFI budget allocation, in conjunction with public donor programs, private foundations, and/or advisory fees charged by the DFI to the FSP or industry beneficiary. 8 Occasionally, advisory services may be FSP-specific and compensated in part by the FSP. 9 FinTech is defined as the use of technology and innovative business models in financial services (World Economic Forum 2015). Digital financial services have often been the result of FinTech innovation. 5 Figure 2a. DFI financial inclusion commitments and trends, by instrument Debt Equity Grant Guarantee Structured Finance Unspecified 10B 9B 8B 7B 6B USD 5B 4B 3B 2B 1B B 2009 2011 2013 2015 2009 2011 2013 2015 2009 2011 2013 2015 2009 2011 2013 2015 2009 2011 2013 2015 2009 2011 2013 2015 Source: CGAP 2016: International Financial Inclusion Funding Data (2015 data). Based on the largest DFIs reporting since 2009 to the CGAP International Funding Survey. Figure 2b. DFI financial inclusion commitments and trends, by purpose Retail financing - indirect Retail technical assistance 38% 4% Market Infrastructure Policy Clients Other 4% Unspecified Retail financing - direct 54% Source: CGAP 2016 International Financial Inclusion Funding Data (2015 data); data from 15 DFIs as of December 2015. “Retail finance” refers to financing to FSPs for their loan portfolio. Funders can finance these retail institutions directly or indirectly by channeling funds through intermediaries or wholesale institutions, such as apexes, investment funds, and holdings. “Technical Assistance” refers to efforts to strengthen retail providers to become more sustainable and deliver better and more responsible products (e.g., management and governance, IT systems, support to operations [e.g., training, transformation, etc.], responsible finance, product development, and research). TA can be provided directly to retail institutions or indirectly through networks or holdings. Not all DFI TA for financial inclusion is reported to the funder survey. 6 which at least minimizes the risk of crowding-out over time, especially during DFI organizational local TA service providers. restructurings. DFIs often get drawn into advisory services by their strong credibility in local markets, Standalone advisory services tend to focus on staff expertise, and a natural extension of their specific market development goals without an investees’ needs. Yet, when DFIs participate in investment component. This is the least common policy and regulatory change advisory services, engagement, since generally there is no direct there is a natural conflict of interest that they need financial return or link to DFI investments. Advisory to manage—this advocacy work will help expand may include TA (e.g., strategic advice) and capacity financial inclusion, but some will also perceive it building (e.g., knowledge building through as work to benefit the DFIs’ investments. Given trainings, workshops, or exchanges). DFIs may also other pressures—constrained DFI funding sources play an important coordinating role for developing for TA or overlap with their bilateral agencies that financial services markets (see the Tanzanian digital historically managed TA—they may revert back to finance case that follows). Advisory services can their investment-only focus and curtail important be targeted to strengthening a diverse range market development activities.11 While the prevailing of market functions and actors, such as policies, DFI model for financial inclusion is investment only, regulations, and industry standards; market each of the DFI investment cases featured in this infrastructure (e.g., payment systems); capital paper for their market development contribution markets; credit information systems; industry had an important TA component that was often associations; etc. Advisory services are funded by directed at market facilitation. Understandably, DFIs donors or occasionally from the DFIs’ profits or will continue to have a concentration of funding budget allocations. When market development in investments, and rather than suggest that DFIs becomes a measured DFI goal backed by senior need a major reallocation of their funding to TA management commitment, funding advisory and advisory services, the key is to ensure that DFI services from the DFIs’ resources is a rational investments are used to catalyze systemic change proposition. It is worth highlighting that there is in a market. Lastly, DFIs provide other important an important public-private interplay to consider nonfunding support for financial inclusion, such as on such advisory services. If DFIs opt to abandon leveraging their convening powers to bring market such work because of the lack of financial returns, actors together, advocating for best practices, development and private sector investments enabling policies and regulations, and promoting that view the market as too underdeveloped knowledge sharing. or risky for their capital could be hampered. To date, DFI funding allocations for market building Adjusting the DFI approach to more interventions at the policy, market infrastructure, fully promote market development and client levels have been small, representing approximately 2 percent of consolidated DFIs’ When market functions work more effectively, funding commitments. 10 Two DFIs had grant more low-income populations and businesses will allocations representing 12–32 percent of their be linked to the financial system, and DFIs will total funding and, not coincidentally, exhibited have more long-term investment opportunities in a more active market development approaches. broader range of companies in a more diverse and inclusive financial services market. These desirable In summary, there are different engagement models outcomes motivate DFIs to be more attentive to used by DFIs, and these models have changed market development needs and opportunities. 10 Even when considering DFIs’ support for investee-level TA (4 percent of funding) with estimated market-building advisory support (2 percent), the total commitment allocation of 6 percent for TA and advisory remains small. 11 For example, IFC advisory services, which were usually funded internally, switched to a more revenue-driven model, yet the sustainability of this model and services are under review again. 7 Figure 3 provides a high-level framework to help • Take more risk to broaden the scope of their DFIs apply a market-systems lens and consider other investments. DFIs should test and invest in engagements that move beyond an investment- innovators (new business models and delivery only approach. The framework analyzes DFIs’ channels) and market infrastructure companies engagements on two dimensions: (i) the level of the that help bring the poor into the financial system. intervention (i.e., provider or market level) and (ii) TA should be prioritized for investments that have the level of financial returns. The ultimate goal is for a high potential spillover effect on the rest of the each type of intervention to lead to market change. market. “Market infrastructure” and “innovators” are largely ignored despite the fact that these As evidenced earlier, DFIs’ engagements are engagement areas might yield moderate financial presently concentrated in the lower left corner of returns and are important to market development. Figure 3—FSP investments yielding proven financial • Leverage their technical credibility to facilitate returns. To maximize their contributions to market market development. DFIs’ role is about more than development, DFIs should pursue the following investments. For example, DFIs can be instrumental strategies relative to their three engagement models: to creating an enabling regulatory and investment environment for financial inclusion. They can • Review and identify how each of their investments play an active role in market development that is will affect the financial system and contribute to complementary to the role of donors, by leveraging needed market changes (screen and structure all their technical credibility, their access to high-level investments with this market lens). decision makers, and their collective influence Figure 3. A two-level analysis of DFI engagements in financial inclusion Spectrum of DFI Engagements Investment potential Policies, regulaƟons & Market-level noninvestment standards * Elements of both • Facilitate enabling policies Market-level intervention and regulaƟons • Create incenƟves for responsible finance standards, technical and business standards Capital markets* Market infrastructure* Knowledge building • Promote access to local • Enable emergence of • Make market informaƟon currency funding sustainable market available • Facilitate mobilizaƟon of infrastructure (e.g., credit • Share lessons on successes local capital (e.g., bond informaƟon systems, raƟng and failures issues) agencies, payment systems, • Coordinate with other training providers, funders and market actors associaƟons, etc.) Retail financial Provider-level service providers Innovators intervention • SƟmulate crowding-in and • Test disrupƟve ideas scaling-up • Provide early-stage capital • Leverage governance role (angel and venture capital) to encourage market • SƟmulate replicaƟon building • Consider market effects of partner selecƟon and exit Proven financial Moderate or uncertain No direct financial returns financial returns returns Note: FSP innovators, like ACLEDA Bank., fall under retail FSPs, and the goal is to help them generate a market spillover effect for change. “Innovators” refers to new business models or companies that may change or disrupt current market dynamics. 8 Table 1. Integrating market development into current DFI engagement models DFI Engagement Model Adjusted for Market Development Investments Review each to maximize contribution to market development. Investments and TA Take more risks and diversify the DFIs’ portfolio with investments in innovators and market infrastructure companies that need valuable TA. Advisory Use DFI technical credibility to facilitate market development. and power on market stakeholders to incentivize In addition to coordinating the upfront market studies and drive change. DFIs can connect investees to a and ToC, collaborating is key throughout a market network of resources that strengthen their institutions development approach, as many DFIs may be limited and growth. While donors (such as bilateral and in the range of roles and funding they can provide. By multilateral development agencies with grant funding collaborating closely with peers, donors, and market as their main instrument) might be more inclined and facilitators, such as Financial Sector Deepening (FSD) better equipped to play a broader market facilitation Trusts, DFIs can pursue a market systems approach role, DFIs are well-positioned to play an active role collectively that will lead to change (coordinating in the areas of “policies, regulations and standards” their individual strengths/roles to address market and “knowledge building” highlighted in Figure 3. functions and needs; see Figure 1). Collaboration was a key ingredient to several of the DFI market Whatever the DFI engagement model, each of the development cases presented later in this paper. strategies shown in Table 1 requires DFIs to ensure that all their interventions/investments apply a DFIs can enhance their market development value- “market lens” upfront.12 Systemic change to a market add by supporting several of the market-level should become the grounding point for all their interventions noted in Table 1 and by identifying financial inclusion engagements. DFI investments, upfront how each provider-level intervention will be TA, and advisory services would respond to the translated into meaningful market-level changes. market’s barriers, needs, and opportunities. DFIs do By extending their investments to a broader not have to fundamentally change their engagement array of partners or contributing to many of the models, but how they design and deploy these will aforementioned capacity-building efforts that would be different under a market systems approach. DFIs help develop these markets (either as part or separate will need a more thorough understanding of the from investments), DFIs can promote more efficient underlying constraints that prevent financial inclusion. development and scaling of financial markets. Market diagnostics need to be adapted to analyze all the critical market functions and the market actors Key challenges DFIs face in adopting performing those functions (e.g., suppliers, end users, a market systems approach policy makers and regulators, capital markets, etc.), including the capacity and incentives of market actors. A market systems approach requires DFIs to make Based on the market diagnostic, DFIs identify market decisions based on how they define success: gaps and their underlying causes, and then design a What is the balance between financial returns and Theory of Change (ToC)—a plan that maps out how development outcomes on their investments? the DFI’s interventions will address those constraints How should these be measured at the investee and make the market function in a more inclusive and market level? DFIs’ systems typically are way. DFIs should conduct such studies preferably in not aligned with achieving the market impact conjunction with other development actors—donors expected by government shareholders (e.g., their and DFIs. systems often lack metrics and accountability for 12 Many DFI investment proposals include a question on how the investment will have a market impact or create additionality. While this is good, it tends to be more of a one-off question or brief detail in these proposals (i.e., a check box verification). Under a market systems approach, market change would be the driver, and the focus of the investment proposals would be on how that investment will contribute to market change. 9 market development). The need for financial low financial returns on some financial market returns often discourages many DFIs from making investments, the current low-rate environment, and small investments, such as in market infrastructure currency volatility. companies where financial returns are often less • Discomfort with new business models and attractive. A market systems approach would technology. Most DFIs acknowledge the potential strengthen DFIs’ market focus and help them set of technology as a driver of financial inclusion, but up the supporting systems needed. It requires a more hesitate investing in FinTech companies or innovators intensive and broad sweeping market diagnostic because they fear the unknown.14 Even in areas upfront and the flexibility to engage with multiple where DFIs played an instrumental role developing market actors. While the long-term market market infrastructure, they face challenges investing development benefits might be huge (including in companies that formed from their efforts.15 a larger number and diversification of investment • Lack of local presence. Some DFIs lack country- opportunities, overlapping with DFIs’ investment level teams that intimately understand market mandates), DFIs are often not as equipped as donors needs and challenges and can more easily build are to deploy this approach. Several DFI challenges relationships with local stakeholders, which is were identified during the interviews: required for market facilitation. Highly centralized organizations where decision-making mostly takes • Low risk appetite, especially in the wake of the 2008 place at headquarters find it more difficult to adapt global financial crisis that limited DFI investments to a market development approach. and market development impact. • Limited or no access to grant funding that could By examining DFI cases that integrate some complement investments or be used to support elements of a market system approach, we highlight market-development initiatives. the requirements and recommendations for DFIs to • Internal structural rigidities. The push to make confront or work around these challenges. large, low-risk deals limits the ability to invest in newer, smaller, and more innovative companies DFIs Deploying “Elements” and untested business models. Tenors may be too of a Market Development short for investments that require patient capital, Approach: Mini-Cases and collateral might be an issue. Staff incentives are not aligned with market development, as The cases that follow briefly profile how DFIs played a they can’t experiment with investments or take critical role in bringing about market change beyond adequate risks, and in most organizations, failure is a specific FSP investment. The five cases are grouped considered highly negative and has consequences. by effective market-development themes. • Organizational silos. Several DFIs lack cross-cutting teams or internal coordination that would allow for Creating an enabling more comprehensive investments across sectors, environment through market including innovative or technology-driven business facilitation and coordination models that defy the traditional financial sector category used by most development organizations.13 ACLEDA Bank: An FSP investment • Pressure for financial returns. DFIs that raise driving market change funding in capital markets require sufficient financial returns to repay this funding. Realizing During the mid-1990s, three DFIs (FMO, KfW, and such returns is challenged by small deal size and IFC) engaged with ACLEDA, a promising Cambodian 13 For example, there are often separate teams for traditional financial institutions, financial inclusion, FinTech, and payments. 14 Some DFIs have dedicated FinTech departments, but these specialized teams tend to invest only in large, lower risk commercial deals that don’t necessarily overlap with serving low-income communities. 15 IFC has been the leader in developing credit rating services or credit bureaus globally, yet it made only one investment in such companies. The challenges to such investments are small deal size and burdensome DFI processes and procedures that tend to complicate decision- making and create delays at these start-up companies. 10 Table 2. ACLEDA’s innovations and impact on the Cambodian market ACLEDA’s Innovations Market Impact NGO transformation into a regulated Opened path for the creation of other regulated MFIs and financial institution with a license to adjustments to existing regulatory requirements and licensing. mobilize deposits from the public (2000)a The National Bank of Cambodia eventually created a new legal structure, Microfinance Deposit Taking Institution, for regulated MFIs. Introduction of SME lending Picked up later by other MFIs. Introduction of ATMs (2010) Other MFIs later added ATMs. Fund transfers (domestic and international) Using ACLEDA accounts, remittance pricing came down. Housing loans Only home improvement loans existed prior; housing loans replicated by other MFIs. Electronic banking (ACLEDA Unity) Payments and mobile banking services later picked up by other MFIs. Cash management and payroll services Other MFIs began offering such services. Customer service biometrics (efficient, Not yet picked up by other players. accommodate client special needs, security) Accredited banking and finance training AIB and its predecessor (ACT) have been training microfinance center (AIB); providing Bachelor’s and and banking professionals in Cambodia and regionally since 2011 Master’s degrees with nearly 400,000 professionals trained. a. With the support from the National Bank of Cambodia (NBC), ACLEDA transformed initially into a specialized bank that had relatively low minimal capital requirements. This was essentially a trial period for ACLEDA and NBC to experience MFI regulation, before ACLEDA later transformed into a commercial bank. MFI NGO operating in a weak financial system that Backed by the DFIs’ investments, TA, and advocacy lacked data transparency but in a country context of support (grant funded), ACLEDA went on to influence entrepreneurial and development potential. These the broader market by continuously introducing DFIs worked together, especially during the early product innovations that industry peers replicated investment period, with ACLEDA to advocate for (often guided by ACLEDA), actively leading the policy and regulatory changes with local officials microfinance industry association and promoting and to lay the groundwork to crowd in private industry coordination on needed policy and regulatory investment. They successfully supported ACLEDA’s changes, and serving as a best practice institution transformation to a regulated specialized bank (Table 2). ACLEDA has also institutionalized its and eventually to a commercial bank. Over influence on knowledge and capacity building for time, private commercial investors aligned with the broader market, by building a training institute ACLEDA’s mission were identified, and the DFIs (ACLEDA Institute of Banking [AIB]) for banking and exited ACLEDA Bank Plc., with some deploying business professionals nationally, regionally, and even their capital in other regional ACLEDA partners globally. Beyond managing Associate’s, Bachelor’s, and in underserved markets (e.g., Myanmar and Laos). Master’s degree programs, AIB hosts lateral learning Ultimately, ACLEDA became a global industry visits leveraging ACLEDA’s microfinance expertise for leader reputed for its strong social commitment, national, regional, and international visitors.16 innovative products and services, institutional strength with best practice governance and risk In short, DFIs took on a sizeable amount of risk to management systems, collaborative leadership invest in an unstable country with a weak financial shaping the Cambodian and other microfinance system and nascent microfinance sector. They markets, and a successful NGO-to-bank recognized ACLEDA as an MFI with a visionary, transformation that achieved impressive scale (with innovative, and collaborative leader who engaged nearly $4 billion in assets, 1.6 million depositors, with his peers and policy makers to significantly and 408,000 borrowers as of December 2015). contribute to market development. They provided 16 FMO and KfW provided funding support for the formation of AIB’s training predecessor (ACT) and for its industry capacity building. In 2015, AIB’s income fully covered expenses for the first time (ACLEDA entities who send staff to AIB for training account for the majority of demand/revenues at present, with an anticipation for increased income from other third-party entities going forward since AIB received its license as a Higher Education Institute in early 2016). 11 was attractive. Each of them also had other business Box 2. The DFIs’ reputation and motivations for collaborating on an interoperable credibility in the local market was critical to their influence system (e.g., the potential for increased transaction volumes across an integrated platform with standard DFIs provided ACLEDA with sizable financing for its growth, transformation, capacity building, and rules). The initial planning and buy-in process included product development plans, but what was arguably introducing the concept, setting up the project, and equally important to ACLEDA’s success was how the securing stakeholder buy-in, central bank support, DFIs engaged with policy makers and regulators to and donor funding. The first person-to person (P2P) construct an enabling environment for microfinance transformation, product diversification, and scaling. transactions became operational for the first two participating MNOs five months after this planning period. From February 2016, when all four MNOs had interoperability agreements in place, to September debt initially and ultimately equity financing to 2016, monthly mobile wallet transaction amounts have support ACLEDA’s transformation into the largest nearly tripled to US$72million.18 Cambodian commercial bank with a diverse product offering and broad client base that had a spillover IFC facilitated the interoperability process, acting effect into Cambodian and other regional Asian as a critical and neutral market facilitator between markets. The DFIs played a critical role in advocating the key market stakeholders (namely MNOs, banks, with ACLEDA to policy makers and regulators for the Bank of Tanzania, and other regulators being a new legal framework that would support the kept abreast of developments). The success of this commercialization and scaling of microfinance program is attributed to several factors: in Cambodia. This led to a new legal framework that later benefitted other MFI transformations. • The engagement of a neutral broker (IFC) that had no Their interactions with local policy makers and commercial interest and strong market credibility to regulators continued on a regular basis throughout facilitate the industry discussion on interoperability. their ACLEDA investments and helped improve the • The recruitment of payment systems experts from the industry’s governance capacity (see Box 2). cards, banking, and telecommunications industries. • The design of a clear plan, beginning with an in-depth Tanzania’s mobile market interoperability: market study accompanied by a highly consultative Effecting market change as a trusted process that maintained strong communications with facilitator key market stakeholders throughout the process. • Strong funding support and collaboration with the Digital finance is a well-recognized path for scaling Bill & Melinda Gates Foundation and FSD Trust.19 financial inclusion and serving remote communities and populations while possibly lowering transaction costs. The end result is that P2P interoperability is fully With four major mobile network operators (MNOs) functional, with all four MNOs participating since in Tanzania and a functioning mobile money market, February 2016. the country was ripe for developing an interoperable platform that would allow clients with mobile wallets IFC’s facilitating role covered several key from different MNOs to send and receive payments responsibilities, including the following: more conveniently.17 For participating MNOs, the promise of owning their destiny in terms of shaping • In-depth market analysis on interoperability. the design of interoperability (as opposed to being Considerable time was dedicated to consulting told how it would be done by regulators or vendors) with key market stakeholders, conducting a market 17 There are only a handful of countries with interoperable of mobile financial services, thus this was a true market innovation with the potential to scale such services. 18 Number of transactions rose by 239 percent and volume amount of transactions by 277 percent from February to September 2016, according to the Bank of Tanzania. 19 This case draws largely from IFC (2015) and interviews with members of the IFC Advisory Services team. 12 Box 3. Key take-aways from the ACLEDA and Tanzania interoperability cases There are quite a few important overlaps from the • DFI TA and advisory services played important roles ACLEDA and Tanzania interoperability cases: in building institutional and industry capacity, and such DFI support was funded in various ways.a • In both the ACLEDA and Tanzanian interoperability • In both cases, there was a clear work plan designed cases, DFIs’ credibility and power with local with the key market actors’ inputs and leadership regulators and market stakeholders helped them that guided the process and the DFI’s work (e.g., in to influence if not drive the market changes. ACLEDA’s case, the transformation feasibility study • In both cases, DFIs displayed how strong market identified key areas of needed DFI engagement, collaboration with DFI peers and key market players such as regulatory reform). can lead to more effective industry buy-in and change. a. Despite the success of IFC’s facilitating role, it should be noted that as this paper was written, IFC’s Advisory Services strategy was under review as part of the overall World Bank and IFC restructurings. At this time, it is unknown to what extent IFC will continue playing a crucial role in facilitating the development of digital financial services beyond its investment portfolio. demand study, reviewing the business model and The Tanzania interoperability case will influence its legal and regulatory implications, and sharing other markets. IFC is developing a series these findings with market players (this data of templates and toolkits for developing transparency ultimately helped align the various interoperability solutions that leverage the lessons parties around the value of interoperability). learned in Tanzania to inform market facilitation • Numerous workshops and trainings. IFC provided elsewhere. No IFC investments were made as part of capacity-building support around interoperability this market development initiative, mostly because for market players (including agent networks), to IFC’s interoperability work centered on creating ensure there was common industry understanding rules, governance, business models, and other and consensus around the terminology and intellectual property, as opposed to materializing implications. market infrastructure or new companies. 20 The • Consultations on demand and design with all Tanzania interoperability case underscores that key stakeholder groups played an important role DFIs can lead as important market catalysts without in building consensus. Throughout, IFC applied immediate investments, especially when third-party a business perspective to the consultations— funding is available to finance their advisory, broker ensuring that the business model design and role, and expenses (see Box 3). Nonetheless, the critical sharing of transaction fees made economic case raises some questions: sense to the key actors who actually led the conversations (thus stimulating project ownership • Do DFIs have the right incentives in place and authorship of the final plan). organizationally to support a noninvestment • Drafting the rules and standards for interoperability. approach (no investments and financial returns in IFC mobilized a team of regulatory, payments, the near term)? legal, and financial experts to advise local actors • In which cases are they better placed than other who were developing the standards and rules for funders to play a facilitator role? interoperability. The IFC team also conducted • Should such engagements be considered on an the financial modeling behind the design of an opportunistic basis (e.g., IFC had strong local interoperable system. Throughout, IFC engaged presence, expertise, and relationships with key as the central facilitator to a process driven by the market actors and companies) or become a more MNOs and two banks, which sought consensus standardized intervention, and if so, on what based on core business incentives. basis—when there is transformational market impact? 20 As part of the funding arrangement with Gates Foundation, others would have open access to this intellectual property. 13 Sharing risks by co-investing TCX provides an interesting example of DFIs with DFI peers: Addressing addressing a serious market gap and demonstrating foreign exchange risk a willingness to take risk on an innovative and complex fund that not only helps DFIs hedge their TCX: DFIs joining forces to build portfolio of local currency exposures but provides an an innovative market solution important mechanism for MIVs and private investors to make effective local currency loans to FSPs and Increasing amounts of foreign capital from other sectors. TCX has reached significant scale, international social investors (DFIs and private providing hedges for 1,733 transactions in over 50 investors) began pouring into the microfinance frontier market currencies and covering $4.1 billion in industry after 2000. This much-needed capital underlying investment transactions as of May 2016. In helped scale industry outreach globally but created the past 18 months, TCX provided important hedging serious FX risk for the FSPs who borrowed U.S. that made 10 local bond issues feasible (including dollar and Euro capital (accounting for over 70 three in Africa). By providing long-term hedges in percent of these international loans). There was illiquid markets, TCX is helping to reduce the volatility a serious market gap for available and viable FX in these markets, establish expectations for future risk mitigating tools called hedges. In 2007, an FX movements based on economic models (thus, innovative FX hedging fund called The Currency establishing early benchmarks for FX hedges), and Exchange (TCX) was created under FMO’s build local capacity among central bankers and leadership and with the investment support of finance officials with regard to these economic models more than 10 DFIs and a guarantee. TCX provides (a positive side effect of TCX’s work). Overall demand its international investors long-term FX hedges in for TCX’s hedges is growing, especially for larger and illiquid emerging capital markets by managing a longer hedges from the infrastructure and renewable large diversified pool of global currency exposures. energy industries. Per TCX’s CEO, it needs to grow TCX effectively converts investors’ hard currency sizably to meet increased market demand, requiring loans into local currency funding for FSPs, thus a near doubling of TCX’s initial capital to $1 billion. reducing FSPs’ vulnerability to market volatility. DFIs were crucial to this solution, with FMO hiring In terms of market development, the TCX case a specialized team to structure the fund, conduct highlights the following: an initial market feasibility analysis, and model TCX. Other DFIs quickly recognized TCX’s merit • DFI collaboration and group deals. DFIs are more in addressing a mounting risk in the industry, and comfortable and more efficient in deals where their they worked effectively as a group to finalize the peers are co-investing and creating an effective investment terms for TCX and to secure sizable risk-sharing mechanism.23 investment approvals. 21 Later, a specialized facility • Size matters to DFIs. Most market-level projects like for accessing TCX FX hedges was created for the TCX require significant capital and are attractive microfinance industry through MFX Solutions, a to DFIs looking for market-changing opportunities viable structure supported by guarantees from that absorb large amounts of capital.24 OPIC and the Omidyar Network. 22 Both TCX • Global structures can help resolve local market and MFX benefitted from TA grants provided issues. Creating a global fund was a good option that by donors to support FX capacity building and matched the DFIs’ “need for size” while responding tool development, trainings, market research, to local market gaps for FX hedging products. The and advisory services—both at the industry and alternative of DFIs making individual unhedged FSP levels. direct local currency loans to investees is more risky. 21 TCX not only provides FX mitigating instruments for the financial inclusion industry, but also for other development finance sectors. DFIs use TCX to hedge local currency assets that they have on their balance sheet. 22 MFX has closed hedges exceeding $1 billion of underlying notional investments. 23 Additional examples of DFI group deals and risk sharing include ACLEDA and MFI greenfield investments. 24 Size was also critical to make TCX’s business model viable, by diversifying large volumes of local currency exposures. 14 • Innovative investments are feasible for DFIs. Building data transparency: The risk appetite and incentive structures at Leading to market standards DFIs do not encourage direct investments in and cost efficiencies market infrastructure and innovators. TCX is an innovative business model that attracted DFI Remittances: Transparency and support because of its structure of diversifying reducing remittance costs in LAC27 the underlying FX business risks and providing valuable hedging services to DFIs and the private In 2000, the Multilateral Investment Fund (MIF), fund managers and investors they seek to attract a private investing arm of the Inter-American to financial inclusion. Development Bank, launched a 10-year initiative on remittances to Latin America and the Caribbean Presently, DFIs own 95 percent of TCX, which (LAC).28 Remittances were commonly recognized might raise questions regarding its long-term as a large and growing source of income and sustainability (while DFIs are currently TCX’s largest development for LAC. However, there was limited users and will continue to need TCX in the future clarity and data available on remittances, and their if they make local currency investments). TCX potential was tempered by high remittance costs. requires scale and diversification to function well, A standard definition of the term “remittances” and its projected returns are positive but low and did not even exist, and LAC central banks were sometimes volatile.25 Thus, TCX is most attractive not accurately tracking these flows. There were no to foreign investors that actively transact in these studies that analyzed either the costs of remittance developing markets and will benefit from access transfers or the impact of remittances once received. to TCX’s FX coverage—prominently, DFIs are the MIF developed a ToC based on assumptions that largest users today. DFIs’ ongoing TCX support is transparency could be transformational and that likely a long-term proposition (and protection for remittances could be used to help recipients become the DFIs’ portfolio). Many private entities benefit banked. MIF’s strategy based on this ToC set two from TCX/MFX hedging access, too (MIVs, FSPs, goals to be achieved by 2010: (i) reduce the average and other borrowers and lenders), and TCX plays a cost of remittances to LAC by 50 percent through unique match-making role for parties seeking local increased competition and (ii) increase the number currency risk exposures in many of these nascent of families receiving remittances through the financial markets. While the hope is that local capital markets system (with the implicit goal of linking them to other will become more liquid and deepen, so that long- financial products and services) by 50 percent. The term local currency financing becomes available first goal was surpassed, with remittance costs falling to FSPs, the reality is that local capital markets are 75 percent over the period; LAC now has the lowest slow to develop. In the interim, TCX plays a critical regional remittance costs globally.29 MIF’s second role in helping private and public investors transact goal remains a work in progress; remittances as a in these illiquid markets, and building local market lever to pull recipients into the formal financial system knowledge of its model and pricing.26 proved to be more complex than initially expected.30 25 TCX has yielded a positive internal rate of return to date. By its nature, TCX incurs FX gains and losses, and while it realized significant FX losses in 2015 (related to large emerging markets commodity and FX volatility), TCX has already recouped 70 percent of these losses. It also provided crucial FX protection to its DFI clients and others against this volatility, thus protecting their assets from losses. 26 In fact, in certain markets like Kyrgyzstan, there is anecdotal evidence being examined more closely by TCX consultants demonstrating that local banks began providing short-term hedges once they knew that TCX was in the market providing long-term transactions. 27 This information pulls from the 10-year program assessment (Hall 2010). 28 MIF is referred to as the innovation lab of the Inter-American Development Bank and the leading provider of TA to the private sector in LAC (www.fomin.org). It is an independent fund that can pursue high-risk investments and provides TA to its partners (http://www.iadb.org/ en/resources-for-businesses/multilateral-investment-fund,5763.html). 29 While MIF’s role in creating market transparency was recognized by many as contributing to lowering costs (increasing agent competition on the pay-out side and encouraging direct deposits into bank accounts), other factors likely played a role, too (such as competition on the sending side and lower cost technologies). 30 According to MIF staff, there are a few successful cases nonetheless under this second goal, namely, a collaboration that propelled Bancolombia into the remittance market via its partnership with a Colombian housing cooperative COMFAMA. Bancolombia went on to refine its remittance product and become the market leader (roughly 50 percent of Colombian remittances) and more than half of the remittances they manage are now transferred into client accounts where they have a greater possibility of being deployed for other productive use (e.g., collateral for housing loans). 15 Some of MIF’s activities that ultimately led to a infrastructure. Led by the Advisory Services team at better functioning market included the following: its local country office, IFC established microfinance development programs that focused on policy and • Conducting a thorough market diagnostic upfront. regulatory changes, institution building, access to • Addressing policy and regulations by engaging rural populations, and the provision of not only micro- with central bankers on a common definition of but also small- and medium-enterprise (SME) loans. remittances and standardizing its calculation. In parallel, IFC focused on building needed market • Piloting remittance-linked products with FSP partners. infrastructure (namely, a collateral registry and credit • Engaging in knowledge and capacity building bureaus). Benefitting from approximately 20 years (organized over 45 conferences and roundtables). of long-term IFC support, China’s financial system • Conducting ongoing research and monitoring on is now more inclusive,31 the SME market has been local remittance markets. developed, and its micro and SME FSPs (namely, microcredit companies [MCCs]) are now better Having a long-term perspective from the start for funded. Today, IFC’s investments are increasingly this project was important for MIF as it focused on focusing on market innovator companies, including addressing fundamental constraints in the market. Ant Financial Services Group (an affiliate of the Given the broad transparency and capacity building leading e-commerce player Alibaba Group Holding), focus of this program, roughly half of the program and IFC is working with larger players in the financial funding was in the form of grants and the other half inclusion space, such as Postal Savings Bank China, to was in the form of investments in MIF’s FSP partners, focus on last-mile access in rural areas. where remittance pilot learnings were leveraged with other industry players, including in-country and In brief, IFC’s long-term strategic commitment and regional FSPs and other market stakeholders through structured work plans contributed to jump starting MIF’s annual conference. This case shows how data the Chinese microfinance sector, which now transparency can be transformational, by changing embraces new business models and investments providers’ incentives with credible information about in market innovators. IFC’s financial inclusion the size and opportunity of the remittance market in portfolio as of the end of fiscal year 2015 amounts LAC. This case also demonstrates how DFIs can work to over US$1 billion in investments in microcredit at different levels in a market (e.g., on policy and with companies, village and township banks, rural and FSPs) to spur change. commercial banks, nonbank financial institutions, and a mobile payment company. Tackling multiple market gaps: Policy, According to IFC’s development effectiveness infrastructure, innovators, team report summing up the program: the capital market . . . “Intervening simultaneously at the regulatory and China: A DFI’s multipronged policy levels, sector level, and institutional level and long-term commitment was a key factor for IFC’s success in promoting to market development access to finance in China, and it enabled IFC to have systemic impact. . . . A study by CDI [the It may be hard to imagine today, but in the 1990s, Development Impact Department of IFC] in China was weak on financial inclusion, with gaps at all fiscal year 2011 found that linking advisory and levels—policy and regulations, regional access issues, investment services increases the probability of weak institutions (FSPs), and a lack of basic market development success” (IFC 2013).32 31 China has made significant progress in financial access. Sixty-four percent of the population has an active account at a formal financial institution but it remains the second largest unbanked population in the world (12 percent of the Chinese population); access has been uneven, with 234 million people still excluded, particularly in rural areas (World Bank 2016). 32 IFC went on to separate its investments and advisory teams (investees continue to receive a combination of investments and TA when needed), and more recently, some advisory staff who were focused on policy and regulation moved to the World Bank while others who were focused on the private sector remained (and some staff seem to have responsibilities straddling both investments and advisory). 16 IFC’s contributions to transforming the Chinese • Agent banking knowledge building. Conducted financial system spanned all market levels and workshops with emerging payment companies included a combination of advisory services and and large telecoms to explore new business investments: models in agent banking. It organized study tours for People’s Bank of China (PBOC) staff to Brazil • Market facilitation. Assumed a critical market to study Brazil’s advanced agent-banking network, facilitator role by supporting market research (client and it hosted innovative payment companies and and market studies on the use of financial services), agent banking networks from India to demonstrate data sharing, coordinating policy priorities, managing how other private companies penetrated rural workshops, and supporting the development of new markets. business models and product innovations. • Consumer protection/responsible finance. • Policy and regulations. Advocated for commercially Conducted workshops with leading financial oriented MFIs; advised the central bank on institutions and government entities to promote developing regulations for “non-deposit-taking client protection. lending institutions,” which ultimately contributed • Rural cooperatives. Engaged global experts to to the formation of MCCs—now the prevalent conduct field visits and diagnostics in collaboration Chinese MFI model; and provided support and with PBOC and rural commercial banks with the advice on secured transaction reforms under aim to develop rural cooperatives. the Property Law and feedback to the Chinese • Postal Savings Bank of China. Made a $268 million Central Bank on draft regulations allowing foreign investment commitment to promote greater investments in Chinese banks.33 financial access, especially in rural areas. • Capacity building/advisory services for the • Women SMEs. In 2015, collaborated with Ant industry. Strengthened management, risk Financial Services Group and Goldman Sachs’ management systems, governance, SME lending, 34 10,000 Women project to launch the first and knowledge building through exchanges with internet-based, gender-finance lending program best practice Cambodian MFIs. 35 in China.37 • Market infrastructure. Advised on collateral registry and credit bureau development. Overall, IFC’s early advisory efforts to create • FSP institution building investments. Supported a viable microfinance industry helped build several greenfield MFIs and invested in several MFI investment opportunities for IFC beginning in types (as of June 2016, IFC had 12 MFI investments 2005. By allowing the local advisory team to drive of $187 million). 36 the building of the microfinance market, it is well- • Capital markets development. Directly engaged in recognized that market development happened the development of China’s capital markets, including quickly. (See Box 4.) The combination of a strong issuing IFC bonds in China in 2005 and providing a local team with good government relations and a partial guarantee on Ant Financial’s MCC’s asset- team of international experts was critical to the based securities in late 2015 to spur market interest pace of this market development. While many in other capital market financings for MCCs. market infrastructure companies developed over • Innovations. Helped develop FinTech for China the period (such as data-mining companies and risk through investing in innovative technology management companies that sell their information companies. to banks to help them make client decisions), 33 The China advisory work may be considered by some as an example of the potential DFI “conflict of interest” raised earlier in the paper, where advising on policy issues later resulted in sizable DFI/IFC investments. 34 IFC worked with the old MCC association (CMIA) to create risk management modules for the Chinese market. 35 Including trainings with ATC/AIB and meetings with the Cambodian National Bank regulation and supervision division. 36 According to IFC Financial Institutions Group. China team (September 2016). 37 This program is expected to help grow women’s small businesses online through a RMB 500 million loan. 17 services market, to more easily reach rural areas. Box 4. DFIs leading with advisory work From a funding standpoint, IFC’s advisory services An interesting take-away from the Chinese and were initially supported by donations and internal Tanzanian cases is that DFIs can lead with advisory IFC investment profits, while more recently, such services without investments (if they have the funding for it, as they did), and that such advisory advisory services are funded by a combination of services can lead to a future portfolio of investments advisory fees and investment income. (e.g., China case). IFC began advisory services in China years before it made its first FSP investment, Beyond the cases highlighted in this paper, there including advisory services on policy and legislation changes needed to ensure an enabling environment are many other examples of DFI investments and for financial inclusion and a flow of investments from influence that contributed to financial market both private and public investors. It is apparent from changes and that demonstrate the range of its current investment portfolio that this advisory projects and market influence that DFIs can have work proved instrumental in helping to develop the Chinese market. In Tanzania, it remains to be (see Box 5). seen whether IFC will eventually seek to translate its advisory work into new investments. Pursuing a market systems approach and opening IFC investments were concentrated at the FSP up new investments level. Investing in some of these companies has been a challenge since many are young and in a Interviews with industry players indicated that nascent stage of development, and yet, private they feel there are ample opportunities for DFIs Chinese investors are readily investing in them to incorporate a more systemic approach into their (IFC’s capital is no longer needed). Currently, the activities and investments. Shifting their focus team is focused on expanding the agent-banking beyond the concentration on traditional FSPs to a network and developing the digital financial broader range of actors (e.g., market infrastructure, Box 5. Additional examples of DFI contributions to market development • Bosnian savings market. KfW promoted the creation industry capacity and commercial viability and scale of deposit insurance (market infrastructure), which and expanding product offerings. dramatically increased savings mobilization in • Market diagnostic. FMO funded UNCDF’s Shaping Bosnia and Herzegovina. Inclusive Financial Transformation (SHIFT) program, • Capital markets (policy and regulation). Several DFIs for a comprehensive market diagnostic in Malaysia. influenced the government of Bulgaria to create a Such market diagnostics are critical to mapping out securitization law and a new financial instrument. a market systems approach. • Venture capital ecosystem. MIF provided financing • African capital markets. KfW spearheaded the for a Brazilian program—INOVAR—that built the African Local Currency Bond Fund to promote the capacity of early-stage companies, fund managers, issuance of bonds and other market notes by FSPs and investors; built a venture capital association; and to equip them with long-term local currency and engaged institutional investors in their first funding. The fund invests in the issuances and private equity investments.a provides important TA to first-time issuers.b • Market scaling (microfinance holding companies • Rural market gap and risk. FMO manages MASSIF. and greenfields). IFC and other DFIs promoted The fund allows FMO to make riskier investments greenfield MFIs in underserved markets—building to support rural financial inclusion without incurring risk on its balance sheet. a. FINEP, the Brazilian Government’s Agency for Innovation, was MIF’s collaborator and INOVAR’s sponsor. INOVAR helped mobilize over $2 billion in investments over 12 years (http://hbswk.hbs.edu/item/creating-a-venture-ecosystem-in-brazil-fineps-inovar-project ). b. More recently, the fund is investing in other sectors, too, including housing, renewable energy, and agriculture finance. 18 Box 6. Key requirements for adopting a market systems approach • Deep market understanding (e.g., market diagnostics • Flexibility in funding a diverse set of companies. should analyze underlying constraints). • Close coordination with other funders to reinforce • Reframing of approach. Making market development collective impact. the center of DFI interventions. • Investment turn-around. Approval and closing • Risk taking. Market development is about change; processes need to be efficient and agile to meet change can be risky and unpredictable. fast-evolving market opportunities, especially for • Long-term vision and commitment because changing innovators (some DFIs are taking a harder look at a system is a long-term endeavor. this processing risk). innovators) and new business models would help 2. Introduction of DFI structures that allow financial markets modernize and become more more flexibility and risk. Various stakeholders efficient. As DFIs explore adoption of a market (including several DFIs) interviewed consistently systems approach, there are some key requirements called for DFIs to develop a window of reprieve to note (see Box 6). from their risk-adverse culture and systems to invest in promising financial innovation and From our DFI case reviews and interviews, the infrastructure companies. This would require themes and recommendations that repeatedly permission for smaller transaction sizes and higher emerged include the following: risk in the context of supporting innovations that address financial market barriers, disrupt the 1. Commitment and accountability to a market market, and improve the access and design of Theory of Change. Establishing a roadmap or financial services. Ideally, these DFI investments ToC for market development that is founded on would also crowd in private-sector investment for an upfront market assessment (ideally shared such companies. DFIs should create dedicated and coordinated with other DFIs and market pockets of money that license investment officers actors) will help DFIs to focus on the critical to support industry innovators and to take financial inclusion gaps in a country; identify, more risks.38 Some DFIs have developed special through a ToC, how their interventions will structures or off balance sheet capacities for lead to market change; and establish metrics supporting higher-risk market niche opportunities at the provider and market levels. These in underserved markets (e.g., FMO’s management metrics will help to create team commitment of the MASSIF facility that focused on rural and investment officer accountability for finance was funded by the Dutch government; deploying DFI capital that contributes to long- Proparco’s management of the Africa-focused term changes needed in local markets (e.g., Investment and Support Fund for Business in FSP investments must be linked to some type Africa [FISEA], which includes programs for rural of measurable market change metric; the DFI’s finance and social business funds, and was funded monitoring and evaluation teams should be by AFD). Both of these funds have the ability to engaged in designing and reviewing the market make small- and higher-risk investments, and metrics). The DFI’s strategic thinking around its each includes significant TA to address investee ToC should seek to create systemic change in capacity-building needs. the long run—attacking the underlying barriers to financial inclusion in conjunction with other Several donors and DFIs participate in external development partners. investment structures that provide funding to 38 Ideally with market risk returns to help attract DFI attention. 19 emerging or frontier markets, by blending private are several significant new market opportunities and public capital to enhance fund returns and for bridging the gap of financial inclusion. On the lower investment risk to attract private investors other hand, local policy makers and regulators to new areas. These types of investment structures are overwhelmed with the increasingly complex are commonly referred to as “blended financing” financial landscape, the need to keep pace and and have become a popular tool for attracting understand the features, and the opportunities private investors.39 In fact, many MIVs have used and risks of these innovations. The enabling this catalytic funding in their multitranche capital environment for financial services now cuts structures and have successfully engaged private across multiple sectors or industries—finance, investors into the lower-risk tranches. telecommunications, and retail, for example— when considering recent market innovations It is more challenging to find cases of DFI (e.g., retailers offering financial services, payment investments for innovative FinTech funds and platforms opening ways to digital finance). DFIs innovative companies. To date, a few DFIs have have strong credibility in local markets and can expressed interest but had difficulty getting use it to help integrate policy and regulatory comfortable with alternative FinTech models dialogue across these cross-cutting sectors and and risks. Long delays often ensued given between policy makers and FSPs, innovators, and cumbersome internal processes and investment other relevant actors—thus allowing innovations requirements. 40 Ultimately, and ironically, and promoting market changes more efficiently.42 private investors completely funded the first Shifting some resources from investments to more close of one industry pioneering FinTech fund enabling policy and regulatory change activities in the absence of any DFIs who had been will facilitate such market changes. (See Box 7.) approached.41 Progress is happening though, and the fund’s second close included two DFIs. Market assessments are a critical tool for informing FinTech fund managers view the DFIs’ investment this dialogue and analyzing the current market role as instrumental to driving greater scale by state in relation to the opportunities to expand attracting more private investors to FinTech financial services and identify the challenges to funds in emerging countries and reinforcing the promoting these market innovations. DFIs and social mission of these investments. their sister donor institutions should support market assessments that will help prioritize areas • 3. Enabling the market environment for of needed reform, so that important policy and innovation and change. In the past, the financial regulatory changes can be anticipated, including industry focus on an “enabling environment” for new market entrants and models. As in Tanzania helped to ensure that core financial systems and and Cambodia, DFIs can leverage their credibility regulations allowed FSPs to provide basic financial and global expertise to help guide regulators products and services on a sustainable basis to in these new areas. In the Tanzanian case, DFIs low-income communities. Fast forward to today to played a valuable facilitator role in several market the industry’s multitude of innovations, technology situations. Yet, other parties might also be well- advances, and new players and business models suited and considered (e.g., donors, FSD trust- in many financial markets. On one hand, there type entities).43 The Tanzanian case shows that for 39 In these cases, DFIs themselves need risk mitigating capital for their investments in high-risk/high-reward projects. For example, IFC has a Blended Finance Unit that combines donor funds with IFC funds, providing a risk cushion and allowing IFC to combine concessional money alongside its investments for advisory projects (e.g., climate change, agribusiness, some SME deals). 40 Eventually, some DFIs were able to digest the risks and were more constrained by their internal approval and closing processes that layered in complicating risk management rules and other restrictions, where flexibility was needed. 41 It is possible that several of these private investors took some comfort from the fact that the DFIs were close to completing their long internal investment processes, and thus felt comfortable investing earlier, according to one fund manager. 42 Depending on the situation, it might make sense for DFIs to consider close partnerships with local players in the policy space that are better positioned to conduct detailed and expert advisory services (e.g., the World Bank, a regional development bank, or other expert agency). 43 FSD trusts coordinate and manage various aspects and stakeholders of financial inclusion at a country or regional level. They have been structured in several African countries, for example. 20 Box 7. DFIs supporting innovative financing structures Social impact bonds (SIBs). DFIs are supporting Partners Ltd. (BPL), a financial institution that invests innovative financing structures in several markets. SIBs in promising young South African SMEs that need or “pay for success” contracts are financial instruments capital but not necessarily equity investments. The that link investor returns to successful social outcomes. structure fixes preferential or minimum repayments The transactions are often intermediated by NGOs during an initial period and recoups the difference or contracted to achieve the social targets, and the deferred amounts over the later years via a mechanism results-based repayment derives from a government or linked to the SME’s revenues (or other company public finance source (which reaps savings from these variable). This model has opened up SME financing, improved social outcomes). Originally more common and IFC and other DFIs (Norfund and Proparco) have in England and the United States, international SIBs are helped replicate the model in three other African now under construction in several countries and are countries. These debt and quasi-equity instruments often referred to as development impact bonds (DIBs). are designed to allow investors to reap the upside of The Inter-American Development Bank is supporting their investments without the exit risk and to allow the development of a SIB underway in Mexico to help borrowers to enjoy low initial payments on financing.b single mothers increase their resilience and income to Both SIBs and the revenue-sharing model are attracting break out of poverty. SIBs may become an effective private capital to fill market gaps—financing shortfalls in model for attracting private capital to tackle societal capital access to SMEs—and creating a potential source issues, by placing a financial value on social outcomes of sustainable financing to combat community issues. and raising funding for preventive engagements.a From a market systems approach, it will be important Revenue-sharing. In South Africa, a long-term to link these transactions to broader market needs and growth capital model often referred to as a royalty or explore the potential for replication in other markets. revenue-sharing model was developed by Business a. A few examples of SIBs have been structured on recidivism, employment, foster care, and health-related issues. b. BPL, a financial intermediary in South Africa, developed the model. The precise structure varies and is flexible to the SME’s needs—debt, quasi-equity, or equity. Over time, IFC has made an equity investment directly in BPL See https://www. pacificcommunityventures.org/wp-content/uploads/sites/6/2016/03/casestudy_bpl_v3FINAL.pdf and http://www.fomin.org/ens/Home/ News/PressReleases/ArtMID/3819/ArticleID/3317/New-fund-to-innovate-the-way-SMEs-are-financed-in-the-region.aspx. facilitation to be done effectively, DFIs must be more intentionally leverage financial inclusion as seen as neutral and must have technical credibility, an enabler of other development goals. local knowledge, long-term engagement, strong 5. Incentives to pursue market development relationships, and local presence. and create accountability. At a high level, DFI government stakeholders need to more 4. Combining or linking DFI financial inclusion and effectively implement their development FinTech teams. As noted, there is huge potential mission and ensure that DFI senior management to improve financial inclusion and accelerate incorporates processes and structures that systemic market changes with FinTech innovators. target market development: setting goals, Yet, the financial inclusion and the FinTech measuring impact, and extracting lessons from teams at some DFIs often do not collaborate, engagements, for example. DFI investment and opportunities for financially excluded teams need incentives to adjust their current populations may be overlooked. Introducing engagement models on financial inclusion to processes that link, or combine, these two ensure that all of the DFI’s investments are put teams should accelerate DFIs’ market-changing through a market development screening process financial inclusion investments. At present, and later monitored for market development industry opportunities that fall between these metrics; establish portfolio allocations for two groups have a difficult time engaging DFIs innovators and market infrastructure companies in productive dialogue. Efforts should be made that address gaps in market development (e.g., to create or strengthen the links between the transparency and more efficient processing); financial inclusion team and other cross-cutting and employ DFI technical credibility to facilitate teams (e.g., payment team) or related sector market development (either in an advisory teams (e.g., climate finance or agriculture) to capacity or by leveraging its abilities to convene 21 Box 8. Creating accountability for market development: MIF’s investment approach To shift toward a market development approach • Investment proposals. Early in the process, to their investments, DFIs need to ensure that proposals must address how a market development investment processes, staff incentives, and need is met by the investment. Investment accountability mechanisms are aligned with officers should propose metrics for measuring the this approach. MIF’s system has some of these investment’s market impact. accountability mechanisms: • Development effectiveness department. Screens • “Systemic impact” requirement. Requires that and ensures impact (it reviews the proposals and the investment or project influences other market metrics proposed by investment officers). players (e.g., being adopted by others, creating • Monitoring Systems. MIF has a periodic impact scale beyond the investee, or creating change in monitoring report that assesses progress against the market ecosystem or regulatory framework). the market impact metrics established at the investment origination. market actors). The DFI “potential” for more benefit a larger group of market stakeholders. market-level impact is not realized in most If DFI TA funds are restrictive, DFIs should cases, as investment officers often operate with coordinate with partner donor agencies to fund a short-sighted deal-making logic that may not these identified areas for market development. look beyond the end of the next fiscal year. DFIs can also tap into the expanded access to Investment officers should be fairly incentivized, private, third-party funding, especially from compensated, and held accountable for reaching large private foundations focused on market- market development objectives (and not for level interventions (e.g., the Bill & Melinda Gates volume and return alone). Investments should be Foundation and the MasterCard Foundation). monitored for their market impact. For example, at MIF, investment officers’ proposals must Our research showed that DFIs with access to address how each investment will add value to capacity-building grants were more engaged the market (see Box 8). Another measure that in market-level interventions. This was true for DFI senior managers might consider is placing each of the featured cases (e.g., MIF through incentives to encourage financial inclusion an allocated budget and IFC through donor portfolio investments in other and innovative support for digital finance). These DFIs also areas outside the FSP concentration. Also, as tended to have more accountable market impact DFIs exit their FSP investments, care should be goals designed at the onset of the program taken in terms of “responsible exits” that analyze and monitored throughout (e.g., MIF’s impact any potential damage to the FSP or market. 44 framework and IFC’s Advisory Services Plan). 6. Access to TA funding can enhance DFI market impact. When DFIs had access to a TA and 7. Stakeholder collaboration: A critical ingredient advisory budget that could be used for market to market change. DFIs will make better development or when they had a technical investments and maximize their market influence advisory team, they were able to promote when they collaborate with key market actors valuable market studies, data transparency, (FSPs, policy makers and regulators, market standard-setting, policy and regulatory work, infrastructure companies, and innovators) and capacity building, and infrastructure market their development partners (donors and peer development (e.g., LAC remittances, Chinese DFIs). Beginning with a shared market assessment financial infrastructure, interoperability in and dialogue on market gaps and strategies for Tanzania). It is worthwhile for DFIs to consider coordinated investments and/or other support, setting aside some TA funding that is targeted at the prospects for market change will be greater specific market development needs and that will when there is a shared vision and coordinated 44 See Lahaye (2016) and Rozas (2014). 22 execution for investments and other support, such delivery channels that disrupt markets and help as the creation of benchmarks for investments in bring the poor into the financial system. Promoting emerging business models. The TCX and ACLEDA this market systems approach does not require cases are examples of DFI coordination and expanding the DFIs’ “instruments,” but rather collaboration. focusing on the how these instruments are used to maximize DFIs’ contributions to catalyzing As DFIs attempt to apply the recommendations systemic change in a particular market. As shown outlined in this paper, they need to address some by the cases presented, DFIs’ investments and internal issues—namely, clear directives from intermediations overlap with a market systems DFI senior management to pursue dual goals of development approach, and the results clearly concrete market development alongside financial suggest the potential for DFIs to play a more active returns and the development of more accountable role in applying this approach and realizing optimal monitoring and evaluation systems to ensure staff “development returns.” alignment around market development objectives. References Conclusion Bortes, Cristina, Sinha Sunil, and Anders Grettve. 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No. 105 March 2017 Please share this Focus Note with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP website at www.cgap.org. CGAP 1818 H Street, NW MSN IS-700 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org The authors of this Focus Note are Louise Moretto and Barbara over 40 interviewees and industry correspondents (experts © CGAP, 2017 Scola. The authors thank Greta Bull, Heather Clark, Mayada El- from DFIs, donors, fund managers, investors, and advisers). The Zoghbi, Xavier Faz, Juan Carlos Izaguirre, Alice Nègre, Matthew authors thank these individuals collectively for their insights and Soursourian, and Michael Tarazi for their contributions to this interest in this paper. Focus Note. This paper benefitted from invaluable inputs from The suggested citation for this Focus Note is as follows: Moretto, Louise, and Barbara Scola. 2017. “Development Finance Institution and Financial Inclusion: From Institution-Building to Market Development.” Focus Note 105. Washington, D.C.: CGAP. ISBN 978-1-62696-077-0