Rural Financial Intermediation of Ghana

unpolished fiscal In marchesediation of GhanaCHAPTER ONEINTRODUCTION1.1 background of the studyThe pastoral sector comprises nearly 80% of Ghanas population of 18.5 million, with farming(prenominal) economic activities providing exercise and incomes for an estimated 60% of hoidenish dwellers (World Bank, 2001). At the same time, nearly 30 percent of bucolic inhabitants live be beginning the impoverishment line. However, fiscal service remain significantly limited at present, mainly gived by informal groups and coarse trusts. After relatively successful macroeconomic and pecuniary sector reforms, the absence of strong coarse and micro pay institutions collapse continued to impede the attainment of rapid coarse economic development. Existing extinctlandish pecuniary institutions atomic modus operandi 18 often community-based, with strong socio-cultural linkages.The arcadian desires in particular are characterized by broad-based shareholdings by community m embers and compared to the larger commercial strand buildings, digest a higher propensity to serve clients with low plus base, education and/or col after-hoursral, clients who some a nonher(prenominal)wise would have petite or no access to formal pecuniary service. At the same time, there is an emerging interlocking of specialized micro-financial institutions that are testing out planetary best practice methodologies and adapting them to Ghanaian micro pay context and situations. Given the dispersion of uncouth banks, the nature of community ownership, and hobnailed client base, development of strong bucolic and micro finance institutions would provide a coherent fabric for rustic economic festering that would lead to lowered poverty range and reformd standards of living for a majority of the countrys population.Since independence the Government of Ghana (GoG) has made several attempts to crusade rural development to cleanse the living standards of its rural peopl e. The 1992 Constitution has made a firm commitment to rural development as part of its national st lay outgy to improve the living conditions in rural line of businesss by dint of decentralization with the substantiation of political and administrative regions and districts. As part of its poverty reduction strategy the Government in 2000 seek funding from the World Bank under the Rural pecuniary Services cypher (RFSP) to promote ingathering and reduce poverty in Ghana by expanding the outreach of financial services in rural areas and fortify the sustain major power of the institutions providing those services.The Rural Financial Services Project ObjectivesThe Rural Financial Services Project (RFSP) seeks to promote increment and reduce poverty in Ghana by broadening and deepening financial mediation in rural areas through the future(a) measures(i) strengthening operational linkages amongst informal and semiformal microfinance institutions and the formal network of rural and community banks in order to expand services to a larger number of rural clients(ii) building capacity of the rural and community banks, the principal formal financial intermediaries operational in rural areas, in order to enhance their effectiveness and the quality of services they provide(iii) supporting the establishment of an tip structure for the rural banking system to provide the economies of scale chartered for these unit rural banks to address generic wine constraints related to check clearing, specie supply, fluidness management and training, etc. which have impeded growth of the rural finance sector and(iv) strengthening the institutional and policy framework for improved oversight of the rural finance sector.1.2 Problem StatementThe search for a system to tackle the financial problems of the rural dweller started as far back as the 1960s under the Nkrumah regime. During that period, the need for a verit adequate rural financial system in Ghana to tackle the need s of small-scale sodbusters, fishermen, craftsmen, market women and traders and all other micro-enterprises was felt. The need for much(prenominal) a system was accentuated by the fact that the bigger commercial banks could non accommodate the financial mediation problem of the rural poor, as they did non show any interest in dealing with these small-scale operators.Governments attempt in the past to encourage commercial banks to spread their rural network and provide mention to the agricultural sector failed to achieve any significant wedge. The banks were rather interested in the finance of international trade, urban commerce and industry. There was, therefore, a gap in the provision of institutional finance to the rural agricultural sector. The failure of the commercial banks to lend on an appreci equal scale to the rural sector had been attri neverthelessed to the lack of suit suitable tri savee on the part of farmers and the high operational be associated with small n everthelessrs and borrowers. some other reason whitethorn be the centralised structure of the banking set-up, which, despite their many branches countrywide, is controlled by their Head Offices in Accra, making decentralisation ineffective. superstar disadvantage of this system was that a centralised institution is non able to compete with the local private m one and but(a)y lender in local knowledge and flexibility.More historic still, the branch network of many banks covered mainly the commercial and semi-urban areas and did not reach down to the rural areas. thereof, not only were rural dwellers denied access to assent from organized institutions, they could also not avail themselves of the luck of safeguarding their funds and other valuable property which a bank provides.It is the realization that the existing institutional credit did not favour rural development that led to the search for a credit institution destitute of the challenges /disabilities of the existing b anking institutions but possessing the advantages of the non-institutional credit agencies. This institution was the rural bank.1.3 Research QuestionsThe study sought to answer the following research questionsi. Are there success cases in the provision of rural financial services?ii. What are the challenges faced by the implementers of the Rural Financial Service Project (RFSP)?iii. How many of the rural poor have gained access to the financial services from the Rural and Community Banks?iv. What is the impact of the Rural Financial Service Project on the consummation of the Rural and Community banks and what has been the profitability levels and shareholders fund of the rural banks?1.4 Research ObjectivesThe primary prey of the study was to ascertain the extent to which the Rural Financial Service Project had been able to promote growth and poverty reduction by strengthening the capacity of those institutions providing financial services.Other objectives for this study are as fol lowsi. To identify the challenges faced by the RCBs under the RFSP.ii. To assess the impact of the project on the growth and performance of the selected RCBs in terms of profitability, shareholders funds, total assets and baffles.iii. To determine the access of rural poor to financial services.1.5 Significance of the try outThe findings of this research may inform stakeholders Government officials, policy touch onrs, donor agencies, the World Bank and IMF of the importance of better and strengthening the operational efficiency of the RCBs as an important intermediary in the provision of financial services to the rural areas to aid poverty alleviation. The recommendations, it is hoped, may encourage the formulation of appropriate policies and programmes to further develop these institutions with technical foul and financial assistance to lead the role of improving the quality of life of the rural dwellers.Results forget hand to a better understanding of the evolving structure of rural financial services and provide an input to the financial policy made by policy wantonrs especially Bank of Ghana.1.6 Scope of the StudyThe sampling area of the study covers 127 Rural and Community Banks in Ghana out of which five selected Rural and Community Banks in the Eastern, Ashanti and Greater Accra regions under the Rural Financial Service Project were considered as the sample size. These RCBs imply Bosomtwe Rural Bank, Upper Manya Krobo Rural Bank, Ga Rural Bank, Nwabiagya Rural Bank and Dangme Rural Bank. The study looked at the financial performance of the Rural and Community Banks in Ghana in the midst of the period of 2002 and 2006 and also the impact of the RFSP on the selected RCBs. Impact was measured by growth in Profitability, Total deposits, Shareholders funds and access of rural poor to financial services.1.7 Organization of the StudyIn order to present a systematic and conformable research, chapter one introduces the background of the study, the pro blem statement, the research questions, the objectives, significance of the study, and the scope of the study. Chapter two which is the literature review which will throw more(prenominal) light on related studies and concepts of rural financial service project, financial intermediations in the rural areas, challenges of rural financial intermediation and traditional court to rural finance. Chapter three deals with the methodology espo aim in the collection data for the research, description of the field instrument, procedure and data analysis. Chapter 4 is the presentation of results, explanation and discussion of the results.Chapter five provides a outline of the study, the conclusions, limitations and recommendations of the study.CHAPTER TWOLITERATURE REVIEW2.1 IntroductionFinancial intermediation is a pervasive feature of all of the worlds economies. As Franklin Allen (2001) observed in his AFA Presidential Address, there is a widespread view that financial intermediaries c an be ignored because they have no real effects. They are a veil. They do not walk out asset prices or the allocation of resources. As evidence of this view, Allen pointed out that the millennium issue of the Journal of Finance contained surveys of asset pricing, continuous time finance, and corporate finance, but did not survey financial intermediation. Here we take the view that the savings- enthronement process, the workings of big(p) markets, corporate finance decisions, and consumer portfolio choices cannot be understood without studying financial intermediaries.2.2 Importance of Financial IntermediariesWhy are financial intermediaries important? One reason is that the overwhelming proportion of every dollar financed outside(a)ly comes from banks. In the fall in States for example, 24.4% of firm authorizement was financed with bank loans during the 1970 1985 periods. Bank loans are the predominant source of external funding in all the countries. In none of the countries a re capital markets a significant source of financing. Equity markets are insignificant. In other words, if finance department staffing reflected how firms actually finance themselves, roughly 25 percent of the faculty would be researchers in financial intermediation and the rest would study internal capital markets.As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy. The idea that banks monitor firms is one of the central explanations for the role of bank loans in corporate finance. Bank loan covenants can act as trip wires signaling to the bank that it can and should intervene into the affairs of the firm. Unlike bonds, bank loans tend not to be dispersed across many investors. This facilitates intervention and renegotiation of capital structures. Bankers are often on fellowship boards of directors.Banks are also important in providing liquidity by, for example, backing commercial pap er with loan commitments or standby letters of credit. Banking systems seem fragile. Between 1980 and 1995, thirty-five countries experienced banking crises, periods in which their banking systems essentially stopped operation and these economies entered recessions. (See Demirg-Kunt, Detragiache, and Gupta (2000), and Caprio and Klingebiel (1996). Because bank loans are the main source of external financing for firms, if the banking system is weakened, there erupt to be significant real effects (e.g., see Bernanke (1983), Gibson (1995), Peek and Rosengren (1997, 2000)).Basically, financial intermediation is the root institution in the savings-investment process. Ignoring it would seem to be done at the encounter of irrelevance. So, the viewpoint of this paper is that financial intermediaries are not a veil, but rather the contrary. In this paper, we survey the results of recent academic research on financial intermediation (Gorton and Winton, 2000).2.3 The Existence of Financial IntermediariesThe most basic question with come across to financial intermediaries is why do they exist? This question is related to the theory of the firm because a financial intermediary is a firm, perchance a special kind of firm, but nevertheless a firm. Organization of economic activity inwardly a firm occurs when that organizational form dominates trade in a market. In the case of the savings-investment process, households with resources to invest could go to capital markets and buy securities issued directly by firms, in which case there is no intermediation. To theorise the same thing in a discordent way, non-financial firms need not borrow from banks they can approach investors directly in capital markets. Nevertheless, most impertinently external finance to firms does not occur this way. kinda it occurs through bank-like intermediation, in which households buy securities issued by intermediaries who in turn invest the money by modify it to borrowers. Again the obli gations of firms and the claims ultimately owned by investors are not the same securities intermediaries transform claims. The existence of such intermediaries implies that direct contact in capital markets amidst households and firms is dominated.Why is this? is the central question for the theory of intermediation (Gorton and Winton, 2000). Bank-like intermediaries are pervasive, but this may not require much explanation. On the liability side, demand deposits appear to be a unique kind of security, but originally this may have been cod to regulation. Today, money market mutual funds may be good substitutes for demand deposits. On the asset side, intermediaries may simply be passive portfolio managers, that is, there may be nothing special about bank loans relative to corporate bonds. This is the view articulated by Fama (1980). Similarly, Black (1975) sees nothing special about bank loans. Therefore, we begin with an overview of the empirical evidence, which suggests that there is indeed something that needs explanation.2.4 Empirical Evidence on Bank singularityWhat do banks do that cannot be accomplished in the capital markets through direct contracting between investors and firms? There is empirical evidence that banks are special. about of this evidence also attempt to discriminate between some of the explanations for the existence of financial intermediaries discussed below.To determine whether bank assets or liabilities are special relative to alternatives, Fama (1985) and crowd together (1987) examine the incidence of the implicit tax due to reserve indispensablenesss. Their argument is as followsOver time, U.S. banks have been required to hold reserves against various kinds of liabilities. In particular, if banks essential hold reserves against the issuance of certificates of deposit (CDs), then for each dollar of CDs issued, the bank can invest less than a dollar. The reserve requirement acts like a tax. Therefore in the absence of any specia l service provided by bank assets or bank liabilities, bank CDs should be eliminated by non-bank alternatives. This is because either bank borrowers or bank depositors must bear the tax. Since CDs have not been eliminated, some fellowship involved with the bank is willing to bear the tax.Who is this party? Fama finds no significant difference between the yields on CDs and the yields on commercial paper and bankers acceptances. CD holders do not bear the reserve requirement tax and he therefore concludes that bank loans are special. crowd together revisits the issue and looks at yield changes around changes in reserve requirements and reaches the same conclusion as Fama. other kind of evidence comes from event studies of the announcement of loan agreements between firms and banks. Studying a sample of 207 announcements of new agreements and renewals of existing agreements, James (1987) finds a significantly positive announcement effect. These contrasts with non-positive responses to the announcements of other types of securities being issued in capital markets (see James 1987) for the references to the other studies). Mikkelson and Partch (1986) also look at the abnormal returns around the announcements of different type of security offerings and also find a positive response to bank loans. Tables 12 provide a summary of the basic set of results. There are two main conclusions to be drawn. First, bank loans are the only instance where there is a significant positive abnormal return upon announcement. Second, equity and equity-related instruments have significantly negative abnormal returns. James (1987) concludes, banks provide some special service not available from other lenders (p. 234).2.5 Mechanisms to Improve Financial IntermediationRecent developments in growth theory have stimulated regenerate interest in the interactions of financial intermediation and growth. While most of the existing literature analyses the risk- sharing snuff it of financial in termediaries, Raju Jan Singh, 1997 foc apply on the asset-valuation activity of banks. Following the early contributions of Goldsmith (1969), McKinnon (1973) and Shaw (1973), a habitual proportion endogenous growth model is presented, in which financial intermediaries increase the amount of accumulated capital, improve the mobilisation of savings and enhance the efficiency of resource allocation.As in Greenwood and Jovanovic (1990) and King and Levine (1993b), banks are shown to be able to improve their lending efficiency by evaluating projects. Unlike the models presented by these authors, the banks evaluation capacity is not fancied to be exogenous. The ability of banks to gather the in formation needed to undertake this evaluation is linked to proximity, and the notion of geography may thereby be introduced. A link between proximity and faster growth rates can thus be shown, consistent with the observations of historians such as Cameron (1967).Furthermore, Singh, 1997 showed that a bank can improve the efficiency of its lending by opening branches. A poor branch network would thus affect negatively the economic growth rate, as Cameron (1967) suggests in the case of France in the 19th century. By contrast, reposeful regulations limiting the setting up of branches would promote faster growth, as Jayaratne and Strahan (1996) observe in the case of the United States. The size of the financial sector is therefore not the only important variable its structure and the dissemination of its deposits matter likewise.The model presented by Raju Jan Singh, 1997 could be extended in various ways. The contract offered by the bank to its potential borrowers could be enriched by the inclusion of other variables besides the interest rate. For instance, collateral requirements exponent be considered. Cash-flow or corporate net wealth could also be introduced as additional sources of information for banks. In this context, the proportion of entrepreneurs being evaluat ed might appear to be dependent on the size of the latter only, and not only on the proximity of a bank branch.2.6 Effect of Financial IntermediariesThe finance-growth nexus can be hypothetically postulated only within the endogenous growth framework. Financial intermediation, by reducing information and operation cost, can affect economic growth through two channels productivity and capital formation.With regard to the first channel, it is generally argued that financial intermediaries by facilitating risk management, identifying promising projects, monitoring management, and facilitating the exchange of goods and services, can promote efficient capital allocation leading to a total factor productivity improvement (Levine, 1997). For example, Greenwood and Jovanovic (1990) shows that financial intermediation provides a vehicle for diversifying and sharing risks, inducing capital allocation shift toward risky but high pass judgment return projects. This shift then spurs productiv ity improvement and economic growth. Diamond and Dybvig (1983) argues that households lining liquidity risks prefer liquid but low-yield projects to illiquid but high-yield ones, while financial intermediaries, through pooling the idiosyncratic liquidity risks, would like to invest a generous portion of their funds into illiquid but more profitable projects. Bencivenga and smith (1991) argue that financial intermediaries by eliminating liquidity risks, channel households financial savings into illiquid but high-return projects and avoid the wrong liquidation of profitable investments which favours efficient use of capital and promotes economic growth.The impact of financial intermediation on growth through the second channel-capital formation-is ambiguous. Tsuru (2000) argues that financial intermediation could affect the savings rate, and then capital formation and growth, through its impact on four different factors idiosyncratic risks, rate-of-return risks, interest rates and liquidity constraints. By reducing idiosyncratic risks and relaxing liquidity constraints, financial intermediation might lower the savings rate and negatively affect growth. By reducing the rate-of-return risks through portfolio diversification, financial intermediation might negatively or positively influence the savings rate, depending on the risk aversion coefficient (Levhari and Srinivasan, 1969). Finally, the development of financial intermediation might raise the rate of return for households savings, which also has an ambiguous effect on the savings rate due to well-know income and substitution effects. In addition, financial intermediaries efficiency amelioration could cut the financial resources absorbed by themselves, and raise the portion of households savings converted into productive investment which favors capital formation and growth.In conclusion, the theoretical literature shows that the development of financial intermediation affects economic growth mainly through its impact on the efficiency of capital use and the improvement of total factor productivity, while its growth effect through the savings rate and capital formation is theoretically ambiguous.2.7 Introduction to Rural Financial ServicesRural financial services refer to all financial services extended to agricultural and non-agricultural activities in rural areas these services include money deposit/savings, loans, money transfer, safe deposit and insurance. Demanders/beneficiaries of rural financial services are mainly households, producers, input stockists/suppliers, traders, agro-processors and service providers. Rural financial services help the poor and low income households increase their incomes and build the assets that allow them to mitigate risk, smoothen consumption, plan for future, increase food consumption, invest in education and other lifecycle needs. These needs can be broadly categorized into working capital, fixed asset financing, income smoothing and life cycle e vents. Access to credit and financial services have the potential to make a difference between grinding poverty and economically secure life. Inspite of the importance of a savings account, 77 percent of Kenyan households have no access to a bank account (Kodhek, 2003). In the late 1990s, most mainstream commercial banks closed down some rural branches in order to cut costs and improve profits. The non-traditional financial institutions have emerged to fill the gap created by the mainstream banks which locked out low income and irregular earners.2.8 Financial Intermediation in Rural AreasFinancial intermediation is crucial for the development of rural villages. If these intermediations are used properly, they can help the rural residents increase their income. Likewise, banks and financial intermediaries may be able to recover expenses and make a profit by attracting deposits and granting rural loans. Several reasons are given in favour of financial intermediation. It is argued that rural financial markets (RFMs) reduce the cost of exchanging real resources. Financial intermediations also enhance a more efficient resource allocation. Firms and individuals may have different investment and consumption alternatives. Thus, some of them want to pull round at the time others plan to invest. Banks satisfy both desires. In addition, financial intermediation causes gains in risk management. Rural producers are typically subject to large variations in income and expenditure. Rural occupation heavily depends on the weather and price fluctuations. For example, expenditures may be heavy at planting periods while income is realized with harvest. Therefore loans and savings are important and inexpensive ways to manage at least part of households risks. Moreover, financial intermediation may allow a farmer to undertake larger investments. For instance, a loan may permit a rural producer to buy a tractor before being able to save enough money to buy one with cash. Likewise financial intermediaries can benefit large number of households by accepting their short term deposits and providing a fewer borrowers with longer-term loans. In fact, savers, borrowers and intermediaries gain from this transformation of term structures that take place through intermediation. In addition financial intermediaries that deal with borrowers as savers reduce the information asymmetry characteristic of RFMs. By observing the savings patterns of customers, they obtain information about the income and wealth of clients. By that banks are better able to assess the quality of borrowers and reduce default risk.The drawback is that there is a general tendency for governments in less developed countries (LDCs) to interfere in RFMs. Thus few observers of formal RFMs in LDCs are satisfied with their recent performance. Markets are highly fragmented they provide little services to rural residents political interest interferes with RFMs operations and official lenders are frequently on the edge of bankruptcy. RFMs in LDCs do not work like the classic competitive markets. On the contrary, some imperfections are characteristic of rural banks. These imperfections lead to a variety of problems. For example, the available information is imperfect or asymmetric. These are classic problems of RFMs. Borrowers differ in the likelihood of default. However, it is expensive to determine the risk of default of each borrower. This problem is conventionally known as the screening problem or sometimes it is called the adverse selection problem (see Srinivasan, 1994, p. 15). Moreover, it is also costly to ensure that borrowers take actions that facilitate repayment. This situation is known in the related literature as the inducement problem or moral hazard problem. This problem turns out to be particularly severe when rural banks lend money at concessionary interest rates. That is the way most governments run credit programmes. If a farmer receives cheap money he will not d isplay enough effort to ensure repayment. For instance, in the presence of high interest rates, borrowers may select investment projects that have higher potential pay-offs but a greater risk. These sort of economic activities (investments) require more effort from the borrower to be successful. Finally, it is also costly to enforce the credit contracts. This factor gives rise to the enforcement problem of rural financial markets. There is very little or no penalty in default cases in rural areas of LDCs. Therefore, seldom are the borrowers expected to be sanctioned for loan delinquency. Often it is found that some rural borrowers may be able but unwilling to repay. In addition, in many LDCs property rights are poorly defined so that actions against collateralized assets are ineffective. Governments of many LDCs often, for political reasons, engage in credit relaxation programmes, which diminish borrowers incentive to make their projects successful. Therefore, it is not surprising t hat government-run credit suffers from a tremendous default problem.The final result is that RFMs have not developed as real and effective capital markets. In the absence of capital markets, individuals turn to moneylenders. The customary belief is that moneylenders charge monopoly interest rates, which capture borrowers returns from credit. To overcome those problems innovative credit policy interventions are required. Some few new financial institutions are now being successful to combat market imperfections. Among such institutions are the Grameen Bank of Bangladesh and some of its replications. For instance, group lending allows the financial institutions to transfer risk and transactions costs to credit recipients. It also permits some banking firms to monitor borrowers with other borrowers.2.9 Current evidence what we know2.9.1 Challenges to Rural Financial IntermediationHoff and Stiglitz (1990) and Besley (1994) have identified three major constraints to financial market dev elopment information asymmetries between market participants lack of suitable collateral and high transaction costs. Risk related to agriculture, and to government and donor policies towards agriculture, should be added as a fourth major constraint to rural finance counting for the poor. Demirguc-Kunt and Levine (2004) remark that efficient contract enforcement, related to a supportive legal framework and robust internal operating systems in formal financial intermediaries (FFIs) is very important in the development of the financial sector and the saving as a whole. Constraints to the development of rural financial markets are discussed in more detail below.2.9.1.1 reading AsymmetryThis occurs when borrowers have more information about the out-turn of their investment and greater capacity to repay loans than lenders (Stiglitz and Weiss, 1981). FFIs normally attempt to reduce this problem by screening out high-risk borrowers from their track record (including credit performance, t ransactions on deposit accounts, cash flow statements and other accounts). However, in the case of most rural customers, this is not possible, because many keep no record of their transactions and/or do not use payment facilities of banks. In addition, access to borrower information is impeded by a lack of efficient transport, communication theory infrastructure and well-functioning asset registries and databases.2.9.1.2 RiskHigh, and often covariant, risks in the rural economy are related to the self-assurance of agriculture, which accounts for a high percentage of Gross Domestic Product (GDP) (one third in the case of Africa) and employment (two-thirds in Africa) (UNDP Human Development Report, 2000). The long gestation period for many agricultural investments and the seasonality of output commonly lead to uneven cash flow and variable demand for savings and credit. Agricultural production is mostly dependent on the weather and the use of productivity-enhancing inputs is very low (both leading to yield or production risk), especially in sub-Saharan Africa where the average consumption of fertilizer is only 1015 kg per hectare, compared to about four times that on the Indian sub-continent (Pinstrup- Andersen et al., 1999). African yields are therefore very low and have travel only slightly since the 1980s (Badiane et al., 1997). Lack of credit is a major factor limiting the ability of smallholders to procure a