Caveat emptor: the Graduation Approach, electronic payments and the potential pitfalls of financial inclusion


By Paulo L dos Santos and Ingrid Harvold Kvangraven

The Graduation Approach to poverty reduction is inextricably bound up with programmes promoting financial inclusion. Proponents for the approach see it guiding a series of interventions that encourage poor households to ‘graduate’ into ‘mainstream development programmes’ which are centred on the provision of credit and other financial services (BRAC 2014). Indeed, the approach has been presented as a way to address the needs of those “too poor for microfinance services” (UNHCR 2014). The presumption is that the development and poverty reduction needs of ‘graduates’ will be well served by financial inclusion initiatives.

Recent interventions by influential development actors have sought to deepen the policy connection between graduation approaches and financial inclusion initiatives, including through the use of electronic payments systems (EPSs). The Ford Foundation and the Consultative Group to Assist the Poor (CGAP) recently called for ‘Graduation 2.0’ approaches that would establish and promote the “impact of financial services in the graduation approach and how Graduation Approaches are or could be synergistic with national financial inclusion initiatives, social safety nets and large-scale digitization of social transfers” (CGAP 2017).

This call parallels the efforts of the Better than Cash Alliance (BtCA) to promote the diffusion of EPSs in developing countries. Funded by Visa, MasterCard, Citigroup, the Gates Foundation and USAID, the BtCA advocates public investment in EPSs to facilitate their use to expand the reach of private suppliers of services in payments, savings, insurance and loans. This includes calls on governments to use EPSs to make cash transfer and broader social programme payments to encourage the financial inclusion of some households even before their graduation from extreme poverty.

The promotion of financial inclusion as a central tool in graduation and broader poverty reduction efforts rely on two widely cited propositions: first, the view that greater access to all types of financial services can universally (and in itself) contribute to poverty reduction and broader economic development; and, second, the contention that market-based provision of credit, savings, insurance and payment services by profit-driven agents is desirable over provision by state or mandate-driven firms such as postal or cooperative banks.

A recent study by dos Santos and Kvangraven (2017) has drawn on an extensive review of empirical and theoretical work to offer a critical assessment of these propositions and of broader policy calls for the expansion of EPSs to expand financial services to poor households. Considering the potential impacts of different financial services separately, the study raises serious concerns about efforts to expand volumes of lending to poor households, communities and regions. It also points to the important reductions EPSs can make to the costs of managing, safeguarding and sending money, while underscoring the vital role of government interventions in ensuring quality EPSs are universally available at low cost. Those arguments are directly relevant to debates concerning graduation approaches and their relationship to financial inclusion initiatives and EPSs.

Why credit often hurts poor people?

Influential organisations such as the BtCA have argued that EPSs can make a positive contribution to development by enabling, among other things, expansions of credit via electronic banks[1]. However, recent research has refuted the long-accepted proposition that enabling greater lending to poor people invariably reduces poverty and promotes development[2]. Influential and widely cited studies purporting to establish the positive effects of microcredit initiatives targeting poor borrowers in developing countries have been shown to suffer from deep methodological flaws, and to report findings that cannot be replicated[3]. Meanwhile, a growing body of evidence has documented how those initiatives primarily encourage consumption credit—often at annual rates of interest exceeding 100 per cent and under predatory terms—and not new types of productive enterprise.[4]

These perverse outcomes are not accidental. They reflect the realities of underdeveloped areas, where shortages of skills, infrastructure and markets, among others, create formidable obstacles to the development of new, higher-value-added enterprises. Without broader policy interventions to improve prospects for such enterprises, banks will not generally find it profitable to finance them. Low incomes, small markets and other constraints ensure that even where financial inclusion initiatives support the development of new enterprises, those firms typically displace previously existing ones, yielding no appreciable net benefits to the areas in question (Bateman 2010).

In contrast, lenders are often able to develop a profitable business in consumption lending in those areas, where many people struggle to meet basic consumption needs. Living with few choices and many privations, the wouldbe beneficiaries of microcredit are often driven into consumption loans that are usurious or predatory. In contrast to loans supporting new productive enterprises, these loans do not contribute to increases in borrowers’ income. However, they do impose interest payment burdens, through which lenders can appropriate entire portions of borrowers’ meagre incomes.[5] The long-term effects of this type of lending on development and poverty reduction are clearly negative. Yet in many settings where financial inclusion initiatives are pursued, the comparatively higher profitability of this lending ensures that it is precisely the type of credit lenders find most attractive.

The geographical distance of electronic banks from their borrowers in lowincome areas makes them even less likely than traditional microfinance institutions to engage in lending to new productive enterprises. This lending requires detailed knowledge of all aspects of the operations of the small borrowing enterprises. Proponents for traditional microfinance initiatives explicitly recognised this difficulty and pointed to existing social connections among borrowers and between them and local lenders as a basis for addressing it. It is not clear how electronic banks would overcome such thorny problems to support the development of new productive enterprises.

The likely focus of these lenders on offering credit to poor borrowers qua consumers is also clear in the BtCA’s proposals, which tout the prospect that electronic banks in low-income areas will be able to make loans collateralised by poor households’ income from cash transfers or foreign remittances.[6] This is a particularly problematic idea. It would ensure that fractions of precious money flows aimed at improving the conditions of some of the poorest households on the planet are diverted into interest payments on consumption loans. Policymakers would be well advised to resist calls for the expansion of such practices.

Delivering quality payments and savings services for all

While the prospect of EPSs being used to ramp up lending to poor people raises serious concerns, those systems can reduce the costs of sending and safeguarding money. They can also promote savings. Yet ensuring that these benefits are widely shared requires careful government intervention and policy

Markets for payment services are prone to uncompetitive behaviour. Payment systems are networks. Like languages or computer operating systems, their value to any given user depends on the number of total users. Consumers and merchants may be reluctant to switch to better or cheaper competing suppliers simply because fewer people use them, giving dominant suppliers of payment services the ability to abuse their position.[7] Both Visa and MasterCard have been accused by regulators and merchants in the USA and Europe of abusing their dominance of point-of-sale (POS) electronic payment systems to charge uncompetitive fees.[8] This raises concerns about uncompetitive behaviour in the significantly weaker regulatory environments of low-income economies. It is notable that the technologies the BtCA promotes still include the POS systems dominated by Visa and MasterCard,[9] even though that technology is widely seen as having been rendered obsolete by mobile and computer-based networks.

The uncompetitive tendencies inherent in markets for payment services ensure that there is an important role for governments to play. Depending on national conditions and capacities, there are at least three approaches they can follow to ensure that quality EPSs are available at low cost: first, governments may directly regulate the actions and prices of private suppliers; second, they may support the operation of a mandate-driven supplier that effectively sets the market price for payment services, leaving room for competitive private suppliers to operate profitably; and, third, governments may simply have central banks make electronic deposits widely available, as a new form of cash.

The resulting low-cost EPSs can also encourage savings. In this vein, they may function like postal banks, enabling modest wealth accumulation and asset acquisition by poor households and helping boost their resilience. These savings may also be pooled and used to support development projects.

Development agencies can provide valuable assistance by helping governments develop institutional capacities to regulate or run such systems, to identify valuable development projects that can be financed with electronic savings, and to design contracts allowing this financing to take place at minimal to no risk to savers.

Micro-level innovation is no substitute for systemic development policy

Well-regulated EPSs that offer low-cost payment services, encourage savings and are prevented from extending loans to poor people can contribute to development and poverty reduction. Yet such contributions will be modest.

The arguments promoting EPSs and financial inclusion embody a third, widely cited proposition: that smallscale technological or institutional innovations can by themselves contribute to significant reductions in poverty and to the broader economic development of low-income communities, areas or economies. This tendency to see microlevel innovations as development or poverty-reduction panaceas downplays the stubborn structural and systemic obstacles and deficiencies that define underdevelopment, and the need for joined-up national industrialisation strategies and broader social policies to overcome them.[10] Without such strategies and policies, even promising innovations and well-intended initiatives can yield unintended or even perverse results.

This understanding should inform policymakers and development practitioners to consider the likely impacts of all ‘graduation’ interventions aiming to make permanent, sustainable reductions in the depth and spread of poverty in developing economies.



[1] See BtCA et al. (2014, 7–9)
[2] See Karlan and Zinmann (2009), Banerjee et al. (2013) and Duvendack et al. (2011), for instance.
[3] As shown by Roodman and Morduch (2009) and Devendack et al. (2011).
[4] See Bateman (2010), Karim (2011), Roodman (2012) and Sinclair (2012), for instance.
[5] See dos Santos (2011).
[6] See BtCA et al. (2014, 7).
[7] See Gowrisankaran and Stavins (2002), for instance.
[8] See Mangelbaum (2012).
[9] See, for instance, BtWC et al. (2014, 15).
[10] See Gerschenkron (1962), Amsden (1992) or Chang (2002), for instance.

Photo by Rosenfeld Media

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