Chapter 9. Financial Development and Inclusion in the Caribbean

Krishna Srinivasan; Inci Ötker; Uma Ramakrishnan; Trevor Serge Coleridge Alleyne

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Author: Mr. Krishna Srinivasan, Ms. Inci Ötker¹, Ms. Uma Ramakrishnan, and Mr. Trevor Serge Coleridge Alleyne

¹ 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Language:: English

Keywords:: BOOK; cost; bank; financial market; risk firm; financial system; participation cost; productive firm; Financial sector development; Collateral; Credit; Financial inclusion; Income inequality; Caribbean

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Abstract

Financial development, by providing agents with better market access, liquidity, and diversity of instruments, has the potential to unleash new growth sources and help countries reap the benefits of globalization and make the transition to higher income levels. Although Figure 9.1 simply shows a correlation, an extensive literature has documented the mostly positive impact from financial development on countries’ income levels and growth. Efficient financial systems help channel funds to productive uses, provide insurance against shocks, reduce information asymmetries, and can potentially alleviate poverty and inequality (Beck, Demirgüç-Kunt, and Levine 2004). Sound financial systems can also foster innovation and entrepreneurship through risk diversification (King and Levine 1993).

Introduction

Recent focus has also been on ensuring that gains from financial development are reaped across the population. This effort has brought into the spotlight financial inclusion and its promise of boosting growth while reducing poverty and inequality (Beck, Demirgüç-Kunt, and Levine 2007; Clarke, Xu, and Zou 2006). Financial inclusion helps mobilize savings, provides households and firms with greater access to the resources needed to finance consumption and investment, and helps insure against shocks. Financial inclusion also fosters labor and firm formalization—that is, it helps reduce informality—and has been positively linked with job creation, growth, and innovation (; Aiyagari, Demirgüç-Kunt, and Maksimovic 2007). These, in turn, boost government revenues and strengthen social safety nets.

The Caribbean region has many characteristics that may pose challenges to financial development and inclusion:¹ the countries’ small size and scale, prolonged low growth, high debt, and vulnerability to external shocks and natural disasters. While small scale does not appear to directly hamper growth in the short term (Easterly and Kraay 2000), it could foster relatively concentrated and small banking sectors, with weak competition and poor service delivery. However, some Caribbean countries have developed large offshore financial centers and others have undergone significant financial market development, particularly of their sovereign debt markets, to support large government borrowing.

Given the region’s challenges of high debt and exposure to external shocks, both of which hinder development prospects (Armstrong and Read 2003; Charvériat 2000; Greenidge and others 2012; Thacker and Acevedo 2010), a careful development of financial systems and expansion of financial inclusion could help generate sustained and inclusive growth (Holden and Howell 2009; Aghion and others 2005). Such development could also bring insurance benefits by helping the countries (at the aggregate level) and households (at the micro level) cope with shocks. Deeper financial systems promote diversification and growth and have been found to be linked to financial stability (Sahay and others 2015; Heng and others 2016).

Against this background, this chapter examines the current state of financial development and inclusion in the Caribbean from several different perspectives:

This inquiry uses the financial development index developed in Heng and others (2016) to examine the financial market and financial institution development in the region compared with the rest of the Latin America and Caribbean (LAC) region. This is a new approach using a broad-based index that improves upon the previous narrower measures of financial development such as the private-credit-to-GDP ratio, the ratio of liquid liabilities of the financial system to GDP, stock market capitalization as a share of GDP, and the market turnover ratio (Levine 1997, 2005).
Next, it examines the region’s level of financial inclusion for households and small and medium enterprises (SMEs), which are significant drivers of growth and employment. Data availability, however, constrains the analysis for the Caribbean to a narrower set of indicators.
It then uses a quantitative model based on Dabla-Norris and others (2015), calibrated for several Caribbean countries, to examine the trade-offs between inequality and growth when constraints to financial inclusion are loosened for enterprises.
Finally, it analyzes Jamaica to illustrate potential policy considerations in a country where several financial constraints are binding.

Stylized Facts on Caribbean Financial Development

Using the broad-based index developed in Heng and others (2016), the analysis examines the financial development of four large Caribbean countries: The Bahamas, Barbados, Jamaica, and Trinidad and Tobago. The index contains two major components: financial institutions and financial markets. Each component is broken down into access, depth, and efficiency subcomponents (Figure 9.2). These subcomponents, in turn, are constructed based on several underlying variables that track development in each area.

The overall financial development index shows that all four countries—The Bahamas, Barbados, Jamaica, and Trinidad and Tobago—improved between 1995 and 2013, and their relative order remained unchanged (Figure 9.3). The Bahamas and Barbados have relatively high levels of financial development, while Trinidad and Tobago and Jamaica lag somewhat. The following provides more detail:

Overall financial market development in the Caribbean is driven by strong performance of the depth subcomponent (Figure 9.4). In fact, Barbados, Jamaica, and The Bahamas all figure in the top four in financial market depth in the LAC region, ahead of much more financially developed countries such as Chile, Brazil, and Peru. This strong performance is driven by debt issuances from several sectors: international issuances of the public sector (Jamaica is in third position for LAC), the financial sector (Barbados and The Bahamas are in the top three), and the corporate nonfinancial sector (where The Bahamas, Barbados, and Jamaica are the top three). On the other hand, Caribbean countries severely lag the rest of LAC in financial market access and efficiency, driven by relatively shallow equity markets with only a few issuers.
As for financial institutions, the Caribbean broadly compares favorably with the rest of LAC. Barbados has a high deposits-to-GDP ratio and a significant nonbank financial sector. The Bahamas surpasses the LAC average in both access and efficiency, thanks to strong performance in the number of automated teller machines (ATMs) and bank branches per capita and high levels of credit to GDP. Trinidad and Tobago is broadly on par with the rest of LAC in depth and efficiency although it lags in access. In all, these three countries have relatively good financial institutions, although with room for improvement. However, Jamaica lags behind its Caribbean neighbors in overall financial institution development, driven by low levels of physical access, low ratios of deposits and credit to GDP, high interest rate spreads, high operating costs, and a concentrated banking market.

Zooming in: Households and SMEs

The three key determinants of access to finance for households are (1) physical barriers (for example, long distance to a bank branch, poor transportation), (2) eligibility barriers (for instance, documentation requirements, literacy), and (3) affordability (such as minimum balances and fees). Although the last two determinants are at least as important as the first, physical access is a precursor to the other factors, especially in a region where mobile banking remains underdeveloped. Furthermore, data for the Caribbean on physical and eligibility barriers remain scarce and not comparable across countries. Thus, to maximize the sample of Caribbean countries, this section examines a measure of physical access to financial services (see Dabla-Norris and others 2015) constructed as a composite index that aggregates information on the presence of both ATMs and branches by geographical and population units.

Data suggest that about half of the Caribbean countries in this larger sample are “underserved” when compared with the LAC average (Figure 9.5). For the Eastern Caribbean Currency Union, small country size helps generate a higher level of measured access to financial services. The strong performance of Jamaica and The Bahamas is likely linked to proliferation of banking access points in tourism areas, illustrating a potential weakness with the measurement of physical access: ATMs and branches could be highly concentrated in some areas, leading to high measured access that does not necessarily reach everyone in the population.

The World Bank’s Enterprise Surveys show that the proportion of SMEs that identify access to credit as a major constraint is much larger in the Caribbean than in the rest of LAC (Figure 9.6). Nearly 40 percent of SMEs in larger Caribbean countries such as Jamaica and Barbados cite credit access as a major issue. However, the difference in the proportion of firms with credit access is striking— only 26 percent in Jamaica versus over 55 percent in Barbados. This difference reflects constraints that are local to the Jamaican economy (as discussed in section “Case Study: Jamaica”), combined with a history of support for SMEs in Barbados, including through programs such as the Barbados Investment Fund and the Export Rediscount Facility, which have supported microenterprises and SMEs in the tourism and export sectors.

Caribbean countries are aware of these constraints and some have begun to implement policies to ease them. For example, the central bank in Suriname has classes for the proprietors of SMEs to educate them on basic accounting and knowledge transfer. The country has also been quite innovative in using television series to promote financial inclusion (similar to South Africa). In Trinidad and Tobago, where SMEs have relatively good access to finance, the central bank offers booklets on money management, homeownership, budgeting, insurance, and consumer protection services, all of which are available to the wider public.

An extensive menu of policies for fostering financial inclusion and development is available. What should guide policymakers when determining the right combination and sequencing of policies for their own countries? Given the risks of financial sector development happening “too fast” (see Heng and others 2016 for a discussion of these risks), how can policymakers ensure that policies that help one outcome (growth, for instance) do not generate negative outcomes (such as inequality or instability) in other areas? The next section uses a structural framework to provide a better understanding of some of these trade-offs.

Growth-Inequality Trade-Offs

This section uses a micro-founded structural model borrowed from Dabla-Norris and others (2015) to examine the implications for growth and inequality of relaxing various constraints to firms’ financial inclusion. This model features agents who are born with different levels of wealth and talent and who make choices between being workers or entrepreneurs. Agents can save without extra cost, but borrowing entails a fixed “participation cost.” Once that cost is paid, the total amount that the agent can borrow will depend on the collateral posted. The “price” of borrowing will be determined by the economy’s spread between deposit and loan interest rates.²

The model is calibrated for three Eastern Caribbean Currency Union countries (Antigua and Barbuda, St. Lucia, St. Kitts and Nevis) and five larger countries (The Bahamas, Barbados, Dominican Republic, Jamaica, Trinidad and Tobago). In the model, constraints to firms’ financial inclusion are grouped into three categories:³

Participation costs typically reflect banks’ high documentation requirements, which impede access to finance (for example, for opening, maintaining, and closing accounts, and for loan applications). Other barriers, such as red tape and the need for guarantors, can also be captured. These costs are modeled as fixed costs, capturing the fact that documentation requirements, while they might be somewhat more onerous for very large scale projects, do not directly grow with loan or firm size.
Borrowing constraints are proxied by collateral requirements that regulate the leverage of firms in the credit system. These collateral requirements depend on factors such as creditors’ rights, information disclosure requirements, and contract enforcement procedures.
Intermediation costs (for example, high interest rates and fees) can reflect information asymmetries between banks and borrowers and limited competition in the banking system.

The model’s key parameters are calibrated to simultaneously match the moments of firm distribution, such as the percentage of firms with credit and the firm employment distribution, as well as the economy-wide nonperforming loan ratio and interest rate spread.

As seen in Figure 9.7, when compared with advanced economies (which serve as proxies for the frontier), most countries in the Caribbean lag in these indicators. For example, only 48 percent of firms, on average, have access to credit in the Caribbean, about half of the advanced economy average of 95 percent.⁴ There are also significant differences across countries:

Constraints are especially severe in Jamaica, which has the highest intermediation cost and collateral requirements and the lowest proportion of firms with access to credit.
Two notable cases are those of Trinidad and Tobago and the Dominican Republic, with the lowest collateral requirements in the region and the most firms with access to credit. Nevertheless, interest rate spreads are high in both countries, reflecting inefficiencies such as the lack of a unified and modern asset registry, which exacerbates information costs for the lender. Thus, intuitively, firms can access credit and leverage up, but must pay dearly for it: price is used as a differentiating tool.
By contrast, The Bahamas has higher collateral requirements and very few firms with access to credit, but very low interest rate spreads. In this case, credit market entry costs are high—but leverage is kept at low rates, so funding is relatively cheap for those that can access it.

What are the effects on GDP and inequality of “removing” each of these constraints? To answer this question, three policy experiments are conducted:

Relaxing collateral requirements to the world minimum
Reducing participation costs to zero
Reducing interest rate spreads to zero

These policy changes are significant and would take time to phase in.⁵ For ease of comparison, each of the economies is modeled before and after the full transition, that is, we examine “steady states.” The numbers presented should thus be interpreted as cumulative changes to GDP and the Gini coefficient across several years, driven by the implementation of each of these policies alone. Across all countries for which the model is calibrated, the loosening of any of the three constraints generates positive effects on GDP (Figures 9.8–9.10), while only the loosening of participation costs generates lower inequality. Each of these constraints is discussed in detail below.

Relaxing Collateral Requirements

The largest GDP gains accrue from lowering collateral requirements (Figure 9.8). The model predicts that total cumulative expansion of the Caribbean countries’ GDP could range between 10 and 20 percent if all collateral requirements were lowered to 50 percent, which is the lowest level of collateral across countries in the World Enterprise Surveys. The magnitude of the GDP gain across countries, however, depends on the levels of other constraints. For instance, Antigua and Barbuda and St. Lucia are the biggest gainers in the sample, driven by a combination of currently high levels of collateral and moderate constraints in other areas. Thus, when collateral constraints are loosened in these economies, firms can take full advantage since the other constraints are relatively benign. This is not the case in Jamaica, for example, because even after collateral requirements are lowered, firms still face high spreads and high participation costs.

Lowering collateral requirements will, however, exacerbate inequality. Although everybody benefits from borrowing more against the same level of collateral, productive firms in the economy benefit more because they have the most to gain from expanding the scale of their operations. Higher leverage leads to more investment for larger companies, which generates a higher scale of production, thereby boosting growth. These gains, however, accrue more to the top of the distribution (larger, wealthier firms), thereby worsening inequality.

Lowering Participation Costs

Reducing participation costs to zero also has a significant positive effect on GDP for all Caribbean countries, with average gains of about 7 percent (Figure 9.9). These gains are higher for countries where small enterprises account for a larger portion of the economy. For example, Barbados, where the largest 5 percent of firms employ only 22 percent of total labor (compared with an average of 39 percent of total labor in the other countries), reaps the highest GDP benefits from loosening participation costs. Moreover, these gains are also supported by low spreads and collateral requirements prevailing in the country, which allows the smaller firms to take full advantage of the credit market once they enter.

The participation cost, which is a fixed cost reflecting regulatory requirements, documentation, and red tape, is a more binding constraint for smaller firms (Krešić, Milatović, and Sanfey 2017), and therefore unambiguously improves inequality when lowered. In a sense, this is the most binding constraint on an extensive margin because it largely determines how many firms have credit access but not directly how much credit. The size of the impact on inequality, once again, depends on the way in which country-specific factors interact with financial sector characteristics. For example, the large reduction in inequality for St. Kitts and Nevis is driven partly by the dominance in the country of small firms (the largest 5 percent of firms employ only 32 percent of labor) whereas the strong effect for The Bahamas comes from its current low levels of participation.

Lowering Intermediation Costs

In this sample of countries, growth and inequality both are the least responsive to lowering the interest rate spread (Figure 9.10). Just as for collateral requirements, loosening this constraint mostly benefits those firms that already have access to credit, generating a positive impact on growth but a worsening of inequality. Contrary to collateral requirements, however, lower spreads make credit cheaper without directly expanding the amount of leverage; the impact is strongest among medium-sized firms for which these costs were a larger proportion of their profits. Thus, loosening this constraint does little to help the smallest firms that are currently outside the credit market for other reasons (for example, participation constraints)—hence worsening inequality—and does not significantly affect the most productive firms in the economy (which were already bearing the higher spreads), resulting in a smaller impact on growth.

Combined Effect of All Constraints

The analysis above, based on relaxing individual constraints, shows that the benefits come with trade-offs. Although the model suggests that relaxation of the collateral requirement will generate the highest increase in growth, it could also exacerbate inequality; lowering participation costs will also boost growth, but by a little less, and will reduce inequality.

So, what happens when all three constraints are loosened concurrently? The various constraints interact such that the joint effect on GDP is more than the additive effect of loosening each constraint in isolation (Figure 9.11, panel 1). Inequality also declines, on net, for most of the countries in the sample (Figure 9.11, panel 2). Note, however, that in this case the nonlinear effect may help exacerbate inequality (that is, loosening collateral constraints and spreads both exacerbate inequality, and their joint effect is stronger than the sum of their isolated effects).

Finally, and while not directly included in the model, stability factors should inform the decision about which constraints to loosen. Policies such as reducing collateral constraints and lowering participation costs, while beneficial for growth and inequality, could also expose the economy to instability. For example, high leverage levels and entry of lower productivity–higher risk firms into the credit market could increase nonperforming loans, which are already at relatively high levels in some countries. Thus, a strong regulatory and supervisory environment will be paramount to ensure continued financial stability as inclusion policies unfold.

Case Study: Jamaica

Facts

As discussed in the previous section, there is no “one-size-fits-all” solution to financial inclusion; the most binding constraints and drivers vary by country. This section takes an in-depth look at Jamaica and several of its constraints to examine potential policies. This case study could serve as a template for examining constraints to financial development and inclusion, and could be applied to other Caribbean countries as data become available.

As shown in Figure 9.12, Jamaica’s financial development has been broadly stable albeit declining since the mid-2000s. Although development of financial institutions has been sluggish since 1995, financial market development improved until the 2008–09 global financial crisis. The stagnation of financial institution development in Jamaica is likely a legacy of the crisis experienced by the country in the early 1990s, which virtually halted growth of nonbank financial institutions (for example, insurance companies). The crisis had a severe impact on the country’s public debt, which in turn encumbered private sector balance sheets and crowded out private credit. The financial system, which had more than 100 institutions in 1995, became more concentrated, to the point where the two largest banks in 2015 accounted for three-quarters of the banking system’s assets.

Despite this history, financial inclusion indicators, especially for household usage of financial services, point to significant potential that could be tapped in Jamaica. Almost 78 percent of households report having an account at a financial institution, one of the highest rates in the world, versus only 47 percent in LAC. Furthermore, Jamaica is also a leader in the number of people who report saving at a financial institution and the proportion of households that use a debit card.

Nevertheless, this significant coverage blurs weaknesses in the provision of credit by the formal financial system. More than 30 percent of households report borrowing through informal channels (friends, family, or informal lenders)—one of the highest proportions in a region where informal borrowing is already high. At the same time, only 11 percent of households surveyed report borrowing from a formal financial institution.

According to the 2014 Global Microscope Survey, recent reforms have helped improve Jamaica’s environment for financial inclusion but results will take time to be realized. For example, the nascent credit bureau system will help lower intermediation costs, but weaknesses in information sharing between bureaus and other entities (such as tax administration, banks, and other lenders) imply significant gaps in use of the system. A registry for movable collateral has been established, and the new framework for electronic retail payment services will provide a boost to mobile payments. Nevertheless, prudential oversight and reporting requirements over credit unions and small micro-lenders (which play a significant role in the country and in the region more generally) could still be strengthened.

Quantitative Model

In addition to GDP and the Gini coefficient, the quantitative model discussed in section “Growth-Inequality Trade-Offs” also has implications for variables such as total factor productivity (TFP), interest rate spread, percentage of firms with credit, and number of entrepreneurs in the economy. A thorough discussion for all eight Caribbean countries would be voluminous; therefore, this section provides an example of how such an analysis could be undertaken using Jamaica— chosen because of its severely binding constraints.

Table 9.1 summarizes the outcomes for each of the abovementioned variables when each of the three constraints (participation costs, borrowing constraints, and intermediation efficiency) is loosened. A few dynamics in the model warrant attention:

Lowering participation costs (first row of Table 9.1) will lower the economy’s average productivity level as smaller (and less productive) firms enter the market. Note that while this is true in the model by assumption, this may not be true in practice as highly productive firms often remain outside credit markets and lower participation costs enable their entry.
Lower collateral constraints (second row) will increase average TFP (as productive firms become even larger), but with negative consequences for competition as the number of firms (proxied by entrepreneurs in the model) drops.
The loosening of both participation and borrowing constraints endogenously increases spreads (fourth column). In the first case, this increase is driven by the entry of less talented entrepreneurs whose firms are riskier. In the second case, the increased leverage of large firms concentrates credit risk in the economy; if any of these large firms fail, the lender will incur significant losses. These endogenous changes in spreads illustrate the need to combine various financial inclusion policies to achieve the desired final outcomes.

Table 9.1.

Effects of Loosening Constraints

Note: TFP = total factor productivity.

Table 9.1.

Effects of Loosening Constraints

	Variable
Constraint	GDP	TFP	Gini	Spreads	Firms with Credit	Number of Entrepreneurs
Participation cost
Borrowing constraints
Intermediation costs		0				0

Note: TFP = total factor productivity.

Table 9.1.

Effects of Loosening Constraints

	Variable
Constraint	GDP	TFP	Gini	Spreads	Firms with Credit	Number of Entrepreneurs
Participation cost
Borrowing constraints
Intermediation costs		0				0

Note: TFP = total factor productivity.

Combined Effect of Joint Loosening

Recall from section “Combined Effect of All Constraints” that the effect of joint loosening of constraints is larger than the additive effect of loosening each in isolation. The path to this final effect may not be monotonic, however. As an illustration, Figure 9.13 plots the combined effect of reducing both collateral constraints and participation costs for Jamaica, and how the final values previously shown in Figure 9.11 are derived. The combined relaxation of participation and borrowing constraints ameliorates the latter’s effect on increasing inequality and produces an outcome that generates higher GDP (nearly 30 percent) with a decrease in the Gini coefficient of 0.06 (the circles in each panel indicate the point at which both constraints are fully loosened). GDP increases monotonically in every direction on the surface (panel 1). However, for inequality (panel 2), if participation costs remain above a certain level, any further loosening of collateral constraints could worsen inequality. Thus, policies to loosen collateral constraints should be phased in in tandem with steps to ease participation constraints.

Conclusions and Policy Implications

Caribbean financial systems are relatively well developed, but financial inclusion could be improved. Some countries have deep markets as a result of government debt while others have developed offshore financial centers with some positive— but limited—spillovers to domestic markets and smaller clients.

Financial development could be improved. The financial development levels of The Bahamas, Barbados, Jamaica, and Trinidad and Tobago remain in the mid range of LAC. There is scope for further financial development, but care should be taken to safeguard financial stability. Policies that may be pertinent for these countries include strengthening institutional and legal frameworks related to property rights and collateral registries, as well as improving the credibility of financial systems and deposit insurance, enhancing capital and liquidity buffers, and addressing balance sheet mismatches.

Policies to support SMEs are warranted. Key supporting measures include understanding the determinants of banks’ fees and charges, examining the existence of and eliminating predatory practices, and reviewing the adequacy of banking sector competition (including the framework for entry). As financial inclusion improves and more users enter the market, measures to reduce information costs (strong credit bureaus), efforts to reduce operational costs (using mobile networks and correspondent banking), and measures to improve the efficiency of courts and collateral recovery systems are necessary.

There is no silver bullet solution to easing financial constraints. There are trade-offs between growth, inequality, and financial stability; all should be considered when policies are designed. For example, even though policies aimed at lowering collateral requirements (such as strengthening the legal framework for managing and seizing collateral, reducing the size of collateral requirements, and creating modern collateral registries) are mostly beneficial for growth, they may also lead to higher inequality as marginal benefits accrue to the top of the distribution. In contrast, policies aimed at reducing participation costs (for example, lowering documentation requirements and reducing red tape and the need for informal guarantors to access finance) could help reduce inequality but may not yield comparable growth benefits.

Synergies from a multipronged approach. The joint loosening of multiple constraints is likely to yield larger returns (higher growth and lower inequality) than the sum of loosening several constraints sequentially. However, the transition to that final state may also entail temporary increases in inequality. Hence, tailored policies require a clear understanding of country-specific constraints, priorities, and timelines. Last, significant care should also be taken to ensure that a strong framework for financial regulation and consumer protection is in place to safeguard the benefits of expanded financial inclusion without jeopardizing financial stability.

Significant data gaps hamper analysis for most countries in the region. Good data are key to understanding the met and unmet needs of the users of financial services, their socioeconomic and demographic characteristics, and how financial constraints affect them. As an immediate first step, the Caribbean could focus on the collection of demand-side data to help diagnose problems, identify constraints, design targeted policies, and then monitor their impact.

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Caribbean countries included are Antigua and Barbuda (ATG), The Bahamas (BHS), Barbados (BRB), Belize (BLZ), Dominica (DMA), the Dominican Republic (DOM), Grenada (GRE), Guyana (GUY), Haiti (HTI), Jamaica (JAM), St. Kitts and Nevis (KNA), St. Lucia (LCA), St. Vincent and the Grenadines (VCT), Suriname (SUR), and Trinidad and Tobago (TTO).

For more details, please see Dabla-Norris and others (2015).

Note that although each constraint is described separately, the equilibrium outcome for each of them is endogenously determined in the model.

Note that Figure 9.7 plots the proportion of all firms with access to credit, which differs from Figure 9.6, which includes only SMEs.

The lowering of spreads and participation costs to zero should be interpreted as an idealized frontier to ease comparison. In practice, it is unlikely that all barriers to credit could be eliminated or that there would be a zero margin to financial intermediation services.