Financial Sector Development in Africa: Opportunities ... - World Bank

The Potential of Pro-Market Activism for Finance in Africa: A Political Economy Perspective 183
light on how market failures can make providing credit to SMEs prohibitively
costly and less profitable than the alternative options of commercial
banks, such as those serving large corporations or governments.
Asymmetric information (especially adverse selection and moral hazard)
and enforcement problems add substantially to the transaction costs
for lenders. Because of such market failures, lenders need to spend
resources to screen and assess the creditworthiness of borrowers and
monitor them. In poor countries, these costs are particularly high because
SMEs often lack a credit history or formal and stable sources of revenue
or assets that can be used as collateral.
Moreover, private banks may not find it worthwhile to incur the high
costs of screening and monitoring SMEs because once these borrowers
have a good credit history, they can obtain credit from other lenders who
will not have to bear the initial costs for screening. This suggests that
information on creditworthiness is basically a public good, in the sense
that once it has been generated, it is very costly to exclude anyone from
using it. When the market fails to let banks appropriate the returns of
information about their costumers, banks will underinvest in the acquisition
of such information. 5
Besides asymmetric information, enforcement problems, and the public
good character of borrower information, high minimum efficient
scales in the provision of financial services may impede the functioning
of credit markets. Credit, like the provision of other financial services,
involves fixed costs and, to a certain extent, increasing returns to scale. If
financial markets are small, as in most African countries, the lack of
economies of scale substantially adds to the unit costs of transactions.
Low population densities exacerbate this problem. Moreover, high minimum
efficient scales increase market concentration, which eventually—
although not necessarily—reduces competition and increases prices. 6
High costs for providing credit that have a negative effect on profits
should be an incentive to innovate and find less expensive ways of providing
credit. Yet market failures reduce investments in credit market innovations
to a point below what is socially optimal: innovations are a public
good and therefore innovators bear all the costs in case of failure, but they
find it difficult to prevent other investors from adopting the new technology
once it has proven to be successful. Without the chance to internalize
more of the positive externalities they create, the incentive for private
banks to invest in socially profitable but financially relatively unattractive
innovations will remain low. This holds in particular where markets are
uncompetitive and easy outside options are available.