World Development Report 2014: a missed opportunity?

Family in Guiuan, Samar, The Philippines, photo by Karlijn Morsink

The World Development Report is the flagship statement by the World Bank on development for the upcoming year. As someone who spends a considerable amount of time working on risk and insurance in developing countries, I was excited to see that the WDR2014’s title was ‘Risk and opportunity’. The ‘Opportunity’ part of the title is especially important because, to many, recent natural disasters and financial shocks have made ‘risk’ synonymous to ‘downside risk’, something that happens to systems and not to people. This is not the right way to think about risk, especially if we want to understand its link to opportunities. Risk is equally about ‘upside risk’ and the agency that people have to take advantage of opportunities.  It is thus about putting households’ decision-making under uncertainty at the center, allowing us to systematically think about practical policy options to better meet the needs of the poor. And what better way to do this than through the formal financial system?

Glancing through the contents of the WDR I was happy to find a chapter that was devoted to the financial system, distinct from the chapters on macroeconomic risk and global systemic risks. However, my initial excitement soon subsided as the policy recommendations coming out of the chapter on financial systems predominantly speak about the financial crisis and macro-prudential regulation, foregoing a systematic discussion of how financial services can stimulate poor households to take decisions that reduce risk-exposure and create equal opportunities in risk-taking.

While thinking about how this could have been done differently, I was reminded of a financial system’s primary function as described by Danthine and Donaldson: ‘the exchange of contracts and provision of services for the purpose of allowing the income and consumption streams of economic agents to be desynchronized’. Basically what they are saying is that a financial system comprising credit, savings and insurance institutions can create the necessary freedom for people to make decisions without a fear of being exposed to risk.

Given this function, if WDR2014 is about opportunities and development, then we might expect to see these questions addressed in a chapter on the financial system:

  1. How financial services can help individuals, households and enterprises’ take advantage of opportunities when making decisions in a context of risk?
  2. How financial services can create more equal opportunities in risk-taking?

Unfortunately, only 8 out of the 323 pages in the report discuss ‘some market-failure related issues’ about supply and demand that influence access to financial services by the poor (and half of those pages are taken up by figures or boxes with case studies).

What went wrong? Why does the chapter on financial systems have such an ill-fitting focus on macroeconomic stability?

Some hints may come early on in the report, where the authors announce they are going to use a holistic approach because ‘individuals can’t overcome the obstacles to risk management they face on their own’. Combining several layers of analysis, the report covers everything from lack of information, cohesiveness, and connectedness in networks, flexibility and formality in enterprise management, fiscal risk, financial bailouts and humanitarian crises and even presents a box titled ‘When risk aversion becomes loss aversion’.

It is true that individuals can’t overcome the obstacles to risk management they face on their own and we need to consider how they are embedded within social,  economic and political systems but this does not mean that we can’t have an analysis which focuses on household decision-making and still produce internally consistent and coherent policy advice about these systems. While the attempt to be comprehensive is admirable, the result is that the report tends to be more descriptive than analytical. It randomly cites prominent researchers such as De Weerdt and Fafchamps (2011), Karlan, Osei, Osei-Akoto, and Udry (2012) and Mobarak and Rosenzweig (2013) while their work deserves to be recognized as part of an important and growing literature, which systematically analyzes how we can learn from traditional approaches to risk-management, informal financial mechanisms and information asymmetries to redesign financial services which allow us to redistribute some risk away from the poor and make the financial system more inclusive. This should have been presented in Chapter six.

Unfortunately Chapter six remains stuck in its macro approach, concluding that supply is low because low-income households are a risky target group, demand is low and financial companies are risk averse.

But what can we do about it?

In what ways can we provide insurance to credit providers to incentivize them to provide credit to low-income households?  How can we collect more reliable data to aid the pricing of insurance products against aggregate losses? How can we combine financial services with preventive technologies to reduce the probability of losses of risky clients? What products complement and not substitute traditional credit, savings and informal risk-sharing groups? In what ways can flexible insurance premium payment mechanisms answer to low-income households irregular cash flows? How can we offer premium subsidies without creating perverse incentives for insurance companies to improve the value of insurance products? These are all questions which might have been addressed in this chapter, but were not.

This is a shame, as these are all questions that are important for redistributing downside risk in order to create equal opportunities in risk-taking. Especially because to date, the opportunities of risk are accrued predominantly by the world’s rich, while the consequences of downside risk disproportionally affect the poor.

So for the next WDR, even though I understand that taking a holistic approach which represents the views of all stakeholders is a low-risk strategy, what we really needs is a riskier approach: a report which applies a consistent analytical framework and uses it to identify the opportunities available to the development world to make progress on that years theme.

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3 Responses to World Development Report 2014: a missed opportunity?

  1. Martin Melecky says:

    Dear Karlijn:

    While your blog is interesting and provocative, I am afraid it is not well grounded and balanced. This could be because of selective reading of the referenced material. Let me share with you my reading of the material that you criticize. The WDR 2014 chapter on financial systems studies the tension between advancing inclusion of people in financial services and maintaining financial stability. The chapter is not about macroeconomic stability (macroeconomic stability is addressed in chapter seven of the WDR).

    The focus of chapter 6 of the WDR 2014, as explained in the text, is motivated by the fact that we have failed to advance financial inclusion in responsible and sustainable way. For instance, provision of credit to households that were not creditworthy planted the seeds for the 2008 global financial crisis. Further, provision of microinsurance without adequate consumer protection framework, including financial education about basis risk in insurance (compensations for damages are not always perfectly correlated with the actual damages), resulted in disappointments of people, low take-up and high drop-out rates from insurance schemes, and turned the schemes unviable. A small insurance scheme that tried to pool too much of covariate risk could also hurt people more than help, because of the false sense of mitigated risk.

    Chapter 6 of the WDR, however, is not only critical of the past and brings a number of concrete, implementable examples of policies that worked in developing countries to advance inclusion of people in using a range of financial instruments: payment services to savings, credit, insurance, capital market instruments, financial information, etc. It is unfortunate that you have entirely skipped pages 194-203 (10 pages) devoted to detailed discussion of the challenges for advancing financial inclusion for people to be able to pursue greater opportunities with greater resilience and flexibility. For your easy reference, I urge you to look at boxes:
    • 6.1 “Better than cash: Electronic payments reduce risk and costs” on how electronic payments can help people more efficiently and securely transfer remittances from across the world, help connect businesses and consumers to markets, and help integrate informal businesses into the formal economy;
    • 6.2 “Housing finance can improve household resilience and opportunities” on how housing finance can boost resilience of people to variety of shocks and aid social cohesion;
    • 6.3 “Innovative insurance mechanisms in Mongolia and Mexico” on how some countries effectively confront covariate risks of natural disasters that overwhelm communities and sometimes even states; and
    • 6.4 “Private pension insurance to confront the risk of income loss in old age” on how some countries struggle to find solutions for adequately managing the risk of income loss concerning their aging population, while others were able to find promising solutions.

    I trust that after reading, perhaps for the first time, the relevant section of chapter six, you will feel the need to nuance your blog post and provide your audience with more balanced and grounded criticism.

    I look forward to further exchanges of opinions on this exciting topic that both of us are passionate about.

    Best regards,
    Martin
    Core team member of WDR 2014 and lead author of the chapter on the role of the financial system.

  2. Kyla Wethli says:

    Karlijn,

    Let me add to Martin’s response by saying that, while I agree with much of your content, I found your title a little misleading.

    We agree very much on what you say about the upside of risk and the importance of greater access to financial services for the poor – indeed, these are points we emphasize in the Report. However, we take a much broader view of insurance. Rather than seeing insurance only in terms of the exchange of formal financial contracts, we see insurance as any mechanism that allows people to shift resources between good and bad times, or to those most in need in bad times. From this perspective, health and pension systems, as well as the informal networks of insurance provided by communities, also provide means for people to confront risk and make decisions with reduced fear of the potential downside of risk. In line with this, you will find discussion of insurance as a tool to manage risk in several chapters beyond the one on the financial system, including in the chapters on households and on communities.

    Beyond the specific material Martin references in the WDR 2014 on financial inclusion, you may also be interested in the World Bank’s Global Financial Development Report 2014, which will be launched this month and will focus exclusively on inclusion.

    Best wishes,
    Kyla
    WDR 2014 Core team member

  3. Karlijn Morsink says:

    Dear Martin, dear Kyla,

    Thank you very much for your responses to my blog post. I’m really pleased that WDR2014 is on the issue of risk, and I hope that the report will continue to generate interesting discussions like this one. Let me start by saying that I find the information that is currently in Chapter 6 of WDR2014 very important. We need to carefully think about the balance between advancing inclusion of people in financial systems and maintaining financial stability. A failure to do so may lead vulnerable households to fall deeper into poverty but may also threaten the potential of future markets. However, I do feel that the information in Chapter 6 is incomplete. It has a strong focus on macro- and microprudential regulation while I feel that asymmetric information and incentive problems with respect to the financial system are insufficiently addressed (anywhere in the report). This is important because the balance between the financial system and financial stability is so precarious. It should also be adressed because you yourself announce on page 11 of the WDR2014 report that the analytical framework used is based on the economics of decision under uncertainty. Under bullet-point 4 on the same page you mention:

    ‘Assessing the main obstacles that individuals and societies face in managing risk, including constraints on resources, information, and incentives’

    In the first five chapters the application of this framework is highly visible. While one would expect it to be especially relevant to a discussion of the formal financial system this is not what Chapter 6 presents.

    Martin, I agree that providing low value financial services to the poor will make them more vulnerable in the short-term and threaten financial stability on the long-term. Yes, provision of credit to households that were not creditworthy contributed to the 2008 global financial crisis; and yes, high levels of basis risk in index insurance due to imperfect correlation between indices and actual yields have led to low value of products. In fact, there is one study which finds that for 270 index insurance products under the Indian Weather Based Crop Insurance Scheme (WBCIS), the probability of receiving no claim despite total crop loss is 1-in-3. For the already poor households taking up these products this increase in variability of outcomes due to basis risk in index insurance (versus the decrease in variability for traditional indemnity insurance) is not acceptable. And as you rightly mention, neither would an increase in variability caused by insufficiently large risk pools for insuring covariate risk be.

    There are indeed many examples of failed low-value financial products. One important way to respond to this is with sound macro- and microprudential regulation (e.g. consumer protection). However, the boxes you carefully describe in your comment (pages 194-203 of the report) clearly show that there are also many examples of innovative financial products that have been able to achieve high value, often following processes of incremental learning or ‘trial-and-error’.

    So there is indeed a tension between setting the boundaries (through regulation) of a ‘space’ in which financial institutions can operate but simultaneously allowing sufficient freedom for them to learn and develop high-value products. The examples of high and low-value products are, in this respect, just illustrative. What we should be thinking about is how we can create a framework that advances the process of financial inclusion with high value products. The growing literatures on ‘(formal and informal) financial services for the poor’ and ‘the economics of decisions under uncertainty’ provide such a framework, which goes a step further than concluding what factors cause supply or demand to be low or suggesting macro- and microprudential regulation. It analyses informal systems for providing access to finance for the poor and tries to understand how and to what extent these meet their needs. It then attempts to draw lessons from these informal systems to address challenges with formal financial services such as high basis risk and asymmetric information problems, often suggesting ways in which formal and informal services may be complementary. We have seen this process for credit and savings where much has been learnt from ROSCAs (e.g. tontines in Cameroon; tanda in Mexico). See for example Stiglitz and Weiss (1981), Besley and Coate (1995), Banerjee, Besley and Guinnane (1994) and Ghatak and Guinnane (1999). More recently we are also seeing this process repeat for literature on insurance for the poor where lessons are drawn from informal risk-sharing structures (e.g. iddir in Ethiopia; jatis in India). See for example Mobarak and Rosenzweig (2012), Dercon, Hill, Clarke, Outes-Leon and Tafesse (2013) and de Janvry, Dequiedt and Sadoulet (2013).

    If the examples in the boxes on pages 194-203 had been discussed in terms of the analytical framework based on the economics of decisions under uncertainty (the proposed framework on page 11 of WDR2014) then they could have been more than examples of low and high value financial products. The example in Box 6.1 on electronic payments could have been understood in terms of prevention of ex-post moral hazard or enforcement problems in credit contracts, potentially suggestion alternative policy solutions such as dynamic incentives. The example in Box 6.3 on innovative insurance mechanisms could have been understood in terms of historical failed attempts to offer indemnity insurance to uninsured, vulnerable farmers because of asymmetric information problems, which index insurance can overcome.

    Kyla, I hope you see that I agree completely with your definition of insurance as ‘more than formal financial contracts’. If we want to offer higher value financial products we actually need to learn from these informal systems. Therefore I was very hopeful after Chapter 3 and 4 where many informal systems for transferring risk over time and states of the world are discussed. Thank you for the reference to the Global Financial Development Report 2014. I believe it is now published and can be found here.

    Creating inclusive financial markets with high value products is a long process of incremental innovation. Establishing that demand and supply are low among the poor is insufficient; we need to analyze, with a coherent framework, how we can do better and allow financial institutions to experiment to incrementally improve products, in a responsible way.

    Looking forward to future interactions.

    best wishes,

    Karlijn Morsink