Figure 18.1 Theoretical links between finance and growth Source: Levine (1997: 691).
Radha Upadhyaya
This chapter examines contending approaches to the role of banking in the financial systems of developing countries, with a particular focus on sub-Saharan Africa (SSA). The chapter begins by discussing the role that finance should play in the process of development, and continues with a discussion of the debates pertaining to the relationship of finance and development. The discussion shows that mainstream economics has focused on demonstrating a long-term correlation between finance and growth and the need for financial liberalization. Both mainstream and heterodox schools agree that financial liberalization failed to provide the perceived benefits of revenue mobilization, although they disagree on the reasons for this failure. Post-liberalization, mainstream studies have focused on understanding the level of competition within African banking sectors whereas heterodox economists have focused on the micro-finance sector with little attention to the commercial banking sector in SSA.
The key role of financial institutions is intermediation—that is, transferring assets from savers to borrowers. Levine (1997) and Freixas & Rochet (1997) provide a review of mainstream studies on the causal link between finance and growth in terms of the functions of finance and the role of intermediaries in reducing information costs and transaction costs. Based on these theoretical and empirical links between finance and growth, it is commonly argued by mainstream economists that, due to adverse selection and moral hazard issues, information asymmetry and transactions costs can never be zero in any realistically defined financial market. Therefore, financial institutions are more efficient than individuals in transferring assets (Stiglitz & Weiss 1981).
Figure 18.1 summarizes the links between finance and growth from the mainstream perspective. It is widely agreed, especially in the mainstream tradition, that financial intermediaries reduce market frictions and provide certain functions that lead to growth. The main channels through which finance can facilitate growth are: first, by encouraging and mobilizing savings by providing a return on savings; second, by promoting the efficient allocation of resources because specialized
Figure 18.1 Theoretical links between finance and growth Source: Levine (1997: 691).
Table 18.1 Simplified balance sheet of a developing country bank
| Asset | Liability |
| Reserves | Deposits |
| Loans | Capital |
| Investments including government securities |
Table 18.2 Assets and liabilities at the bank and country level
| Asset | Liability | |
| Bank-specific level | Loans to customers | Deposits from customers |
| Country level | Private credit / GDP | Liquid liabilities / GDP |
financial institutions are more able to obtain information on borrowers, select projects, monitor ongoing projects, and ensure that contracts are enforced; third, by agglomerating capital that allows institutions to be more efficient in intermediation; and, fourth, by creating credit for firms and individuals that will generate employment and reduce poverty.
With specific reference to developing countries, the key role of finance is to encourage domestic resource mobilization. Tables 18.1 and 18.2 summarize a simplified balance sheet of a developing country bank and demonstrate how this translates into a national financial system.
In mor e developed financial markets, a bank’s balance sheet will include a variety of instruments on both the liability and asset sides. However, in a developing country, a bank’s balance sheet is relatively simple, with the main liability consisting of deposits and the main assets consisting of loans and investments in government securities.
As shown below, banking systems in SSA remain shallow and inefficient. Therefore, developing countries have relied heavily on external capital to fund development objectives (Serieux 2008).
Understanding the structural characteristics of SSA banking systems is essential in order to appreciate the challenge faced by these banking systems to fulfill the needs for resource mobilization.
There are two main measures of size (or depth) of a financial system: the ratio of liquid liabilities to Gross Domestic Product (GDP) and the ratio of private credit to GDP. The former is a measure of the monetary resources mobilized by banks; the latter is a measure of the ability of banks to channel resources to borrowers and therefore of the growth potential of financial intermediation. At a bank-specific level, these measures refer to the liabilities (deposit mobilization) and assets (lending) sides of individual bank balance sheets. The interest rate spread—that is, the difference between the average lending rate and the average deposit rate—is the most common measure of bank (in)efficiency. The spread is often interpreted as a premium on the cost of external funds, introduced due to informational and enforcement frictions (Gertler & Rose 1994; Honohan & Beck 2007).
Table 18.3 presents financial depth indicators for SSA compared to other countries. While SSA financial systems have deepened since 2000, they remain shallow compared to those in other countries. Between 2000 and 2010, the ratio of private credit to GDP increased from 15 to 25 percent in SSA. In 2010, this ratio was 53 percent in upper-middle income countries and 130 percent in high-income countries. In the same year, the ratio of liquid liabilities to GDP averaged 37 percent in SSA, compared to 66 percent in upper-middle income countries and 120 percent in high-income countries. Furthermore, banking sectors in SSA are inefficient in terms of interest rate spreads. In 2010, the interest rates spread averaged 5 percent in SSA, compared to 3 percent in the East Asia and Pacific region and 2 percent in high-income countries. Moreover, banking sectors in SSA remain fragile with the ongoing occurrence of bank failures (Upadhyaya 2011).
In the following section we turn to the key debates and studies about finance and development, and financial liberalization. In particular, we consider a critical question: despite financial liberalization in SSA, why do most African countries still have a very poor record of domestic resource mobilization?
Both heterodox and mainstream economists claim that finance should lead to growth. But what is the evidence for this claim? Mainstream economists, for example, argue that “cross-country comparisons have shown the importance of a well-developed financial sector for long-term economic growth and poverty alleviation. Countries with better developed banking systems and capital markets enjoy higher growth rates” (Beck & Fuchs 2004: 1). They refer specifically to cross-country data that displays a positive relationship between financial development and growth.
Table 18.3 Comparison of financial depth indicators between SSA and other countries, 2000, 2005, and 2010
The existence of an interrelation between financial deepening and growth was recognized by Goldsmith (1969), who constructed a financial interrelation ratio and showed that this ratio grew with a country’s economic growth. However, Goldsmith was cautious in interpreting this interrelationship as causation.
Heterodox economists, like Goldsmith, argue that empirical studies on the relationship between finance and growth should be treated with caution (Harris 2012; Mavrotas 2005; Upadhyaya 2014). They question the idea that finance automatically leads to growth and often advocate for some form of state intervention in financial markets (Stein et al. 2002; Arestis et al. 2005). They note that conceptual mainstream studies on finance and growth are based largely on the work of McKinnon (1973) and Shaw (1973), who postulated a positive relationship between financial deepening and growth. The causal mechanism in the McKinnon-Shaw hypothesis stipulates that high (market-driven) interest rates will increase savings, which in turn increase growth. Therefore, it is insufficient to show that finance and growth are correlated; studies need to demonstrate that changes in interest rates lead to increased savings (Arestis & Demetriades 1997; Serieux 2008).
Heterodox economists highlight other cross-country studies similar to those cited above that failed to find support for the relationship between finance and growth, and therefore one cannot conclusively argue that finance always leads to growth (Ruziev 2006; Upadhyaya 2011; Harris 2012). For example, growth co-exists with negative real interest rates (Agarwala 1983; Khatkhate 1988). Similarly, single-country case studies also show ambiguous evidence. Four studies on Kenya, examining different periods between 1967 and 2005, find that savings are not responsive to real interest rate increases, and therefore conclude that financial development does not directly impact growth (Mwega et al. 1990; Oshikoya 1992; Kariuki 1995; Odhiambo 2008).
Two implications should be noted. First, the focus on growth equations and the need for economists to prove or disprove the relationship between finance and growth has masked the fundamental question: how and under what circumstances does finance actually lead to growth, and more specifically pro-poor growth which encourages development? Second, both mainstream and heterodox economists argue that financial intermediaries fulfill important functions that facilitate the growth. However, heterodox economists stress the complexity of the links between finance and development. Ruziev (2006: 90), for example, argues that
in general, a more cautious suggestion is that economic development can occur without financial deepening, and financial development may not always lead to economic development. The former centrally planned economies of the socialist camp reached a considerable degree of economic development without any financial deepening. Whereas, although some offshore centers have developed sophisticated financial systems, economically they are still underdeveloped economies.
Therefore, there is no doubt that finance fulfills functions in the economy that lead to economic growth as discussed above. However, it is more important to understand the circumstances under which finance fulfills or does not fulfill these functions.
Proponents of the ‘finance and growth school’ advocate an end to ‘financial repression’ and a need for financial liberalization (McKinnon 1973; Shaw 1973). From this mainstream perspective it is commonly argued that financial repression in SSA results in negative outcomes for the following reasons: first, low nominal interest rates often lead to negative real rates, discourage saving; second, large government deficits crowd out private sector expenditure; and third, small, and oligopolistic financial sectors (relative to the size of the economy) dominate by intermediation in short-term financial assets. These negative outcomes formed the rationale for financial liberalization, which was undertaken in most African countries in the 1980s and early 1990s as part of the structural adjustment policies advocated by the World Bank and the International Monetary Fund (IMF).
Financial liberalization advocated by mainstream economists as well as the World Bank and IMF involves the following: a movement towards market-determined interest rates; greater ease of entry into the banking sector, to encourage competition; a reduced fiscal dependence of the state on credit from the banking system (to allow for greater expansion of credit to the private sector); and a movement towards equilibrium exchange rates and, eventually, flexible exchange rate regimes with open capital accounts.
Such a policy approach has enjoyed few successes and suffered numerous unambiguous failures. On the ‘positive’ side, liberalization has furthered the integration of developing countries into global markets. Financial liberalization in this regard means that governments are able to raise (or borrow) funds from international capital markets. Middle-income consumers, in particular, have benefited from a wider array of financial services offered by local and international banks. Finally, some developing countries pursuing financial liberalization have experienced lower rates of inflation due to higher interest rates (Epstein & Grabel 2007). On the ‘negative’ side, there is general recognition in the literature that financial liberalization has not generated the expected increase in saving and investment, an improvement in financial sector intermediation, and a reduction in interest rate spreads (Brownbridge & Harvey 1998; Nissanke & Aryeetey 1998).
Experience from African countries suggests that credit available to the private sector did not increase after financial liberalization; in fact, banks shifted their portfolios towards government stocks (Nissanke & Aryeetey 1998; Serieux 2008). Instead of lending long-term funds, banks maintained highly liquid short-term portfolios and, consequently, non-performing loans increased (Nissanke & Aryeetey 1998). Furthermore, it has been recognized that financial liberalization was accompanied by increasing instability and a higher incidence of bank insolvencies (Soyibo & Adekanye 1992; Brownbridge 1998; Brownbridge & Harvey 1998). It should be noted that bank failures are extremely costly to the economy as a whole, particularly as they disrupt the payment system. It has been estimated that the fiscal cost of bank restructuring between 1984 and 1993 for 11 SSA countries was between 7 and 15 percent of their GDP (Popiel 1994). Heterodox economists point out that the key failure of liberalization is the perennially low level of savings and investment in SSA. The shift in policy stance from high levels of government intervention in the financial systems of SSA between the 1960s and 1980s to more liberalized financial systems since the 1990s has not increased savings and investment (Serieux 2008).
Overall, it can be argued that financial liberalization has not fulfilled the claims of proponents from mainstream economic and international organizations. However, there is still a significant debate as to why the reforms did not bear fruit. On the one hand, mainstream economists argue that liberalization failed due to the incompleteness of reforms, poor sequencing, an absence of government action, and poor initial conditions (see, for example, World Bank 1994). Heterodox economists, on the other hand, recognize the complex nature of financial liberalization and its effects. In countries such as Ghana and Malawi, reform was gradual; yet there have been few positive changes in financial indicators and outcomes similar to those in countries where reform was more rapid (Nissanke 2001). Thus, some heterodox economists emphasize that liberalization was a response to not only severe economic crises and acute macroeconomic instability but also the fragmentation and segmentation of financial markets (Brownbridge & Harvey 1998; Nissanke & Aryeetey 1998). Given the contending explanations of the causes and effects of financial liberalization, we now turn to studies on bank competition in Africa, which provide country-specific analyses of financial liberalization.
Neoclassical economics assumes that increased competition will lead to lower costs and enhanced efficiency in the financial market. However, there is now a growing recognition, even within the mainstream literature, that assuming “competition is unambiguously good in banking is naïve” (Claessens & Laeven 2003: 4). It is argued that the information-intensive nature of banking implies that it is intrinsically less competitive than other sectors (Caprio & Levine 2002). Theoretically, an oligopolistic (or highly concentrated) banking sector can lead to more efficient market outcomes due to the economies of scale enjoyed by the larger banks, or to higher interest rate spreads and inefficiency due to collusive practices by the same banks (Buchs & Mathisen 2005). Therefore, contrary to the conventional neoclassical assumption, the link between competition and efficiency is not clear in the banking sector.
There is no doubt that SSA banking systems are highly concentrated, as shown in Table 18.4, where the bank concentration ratio is defined as the assets of the three largest banks as a proportion of the total assets of all commercial banks. While bank concentration ratios in SSA have fallen from 84 percent in 2000 to 72 percent in 2010, they are still high by international standards. In comparison, the 2010 bank concentration ratio for upper-middle income countries was 61 percent and for high-income countries it was 64 percent.
Despite the recognition that different countries may have different optimal levels of competition intensity (Vives 2001), empirical studies of African banking systems continue to follow a structure-conduct-performance (S-C-P) paradigm which assumes that a low level of competition is the main contributor to the poor performance of African banking. For example, using data from 13 African countries, Ncube (2007) argues that the oligopolistic nature of the banking sector is a key reason for high interest rate spreads. Furthermore, industrial organization studies show that not only competition is determined by concentration and market structure, but contest-ability is important (Baumol et al. 1982; Besanko & Thakor 1992). 1 Many empirical studies have measured competition defined in terms of contestability, generally following the seminal work by Panzar & Rosse (1987). The Panzar-Rosse model investigates the extent to which a change in factor input prices is reflected in (equilibrium) revenues earned by a specific bank. The model provides the H-statistic as a measure of the degree of competition, where a value between 0 and 1 (0 = monopoly and 1 = perfect competition) is regarded as monopolistic competition. Claessens & Laeven (2003) use this model to estimate the degree of competition in a cross-section of 50
Table 18.4 Bank concentration ratio in SSA and other countries, 2000, 2005, and 2010
| Countries | Year | Bank concentration ratio (%) |
| SSA | 2000 | 84.04 |
| 2005 | 77.17 | |
| 2010 | 72.80 | |
| Upper-middle income | 2000 | 64.43 |
| countries | 2005 | 64.10 |
| 2010 | 61.06 | |
| High-income countries | 2000 | 64.85 |
| 2005 | 64.00 | |
| 2010 | 63.63 |
Source: Author's calculation based on the World Bank Financial Indicators Database (Beck et al. 2000, 2009; Cihak et al. 2012).
developed and developing countries for the period 1994 to 2001. Some studies by mainstream economists continue to use this methodology, including Buchs & Mathisen (2005) and Mugume (2006) for the Ugandan banking sector, and Musonda (2008) for the Zambian banking sector. These studies report an H-statistic between zero and one. This seems to be the ‘default’ result of applying the methodology and therefore the usefulness of this model to measure a degree of competition is questionable. In the banking sector, like any other sectors in the economy, perfect monopoly or perfect competition are not likely. Furthermore, the model is based on several restrictive assumptions including that banks are operating in (long-run) equilibrium. It can thus be argued that while these studies are sophisticated in their application of econometric and panel data analysis, they ignore the actual nature of competition in the banking sector, in particular the social and historical factors that shape the reputation of banks and their impact on banking sector competition. If we are concerned with whether an increase in competition is associated with banking performance or not, a deeper understanding of the banking sector in the socio-historical context is more useful.
Studies have been carried out by both the orthodox and heterodox schools to explain the reasons for the failures of liberalization. However, there is very little work by heterodox economists to explain, in particular, why banking systems in developing countries remain shallow and inefficient after financial liberalization. It should be noted that heterodox economists concur that finance does fulfill key functions in the economy, but the main question is to understand which circumstances allow finance to fulfill these functions. It may well be that the current theories and models used to explain banking systems are suitable for a deeper understanding of real issues and problems. We now turn to alternative heterodox concepts that offer a better explanation of the banking system in developing countries.
Contemporary mainstream banking theory focuses on the role of banks based on the functions they fulfill in reducing market frictions or transaction costs (Freixas & Rochet 1997). Information asymmetry is the key source of transaction cost that a bank overcomes when fulfilling its intermediation and information function (Bhattacharya & Thakor 1993). Stiglitz & Weiss (1981) place information asymmetry at the heart of the lending relationship and incorporate interest rates and default rates into their model, in which banks try to maximize their profit by obtaining a margin between deposit and loan rates. Borrowers try to maximize their profits through their choice of investment projects. Due to information asymmetry, banks are unable to distinguish ‘good’ borrowers from ‘bad’ borrowers. Furthermore, due to adverse selection and moral hazard, the normal market clearing system does not work. It simply encourages riskier borrowers to apply for loans. Therefore, banks practice a rule of thumb in order to keep interest rates lower than market conditions warrant. This has also led to the policy prescription advocated by the World Bank to develop credit registries and improve the legal environment (Honohan & Beck 2007).
It can be argued that while these mainstream models are useful in explaining the occurrence of credit rationing, there is still a need to understand the actual process of information production and how banks bridge information asymmetry in a country-specific context. Furthermore, viewing the lending relationship in terms of information asymmetry is too simplistic. An alternative approach to understanding the lending relationship is the concept of knowledge creation during the process of credit creation, as discussed by Dow (1998, 2002).
Dow, drawing on the works of, in particular, Keynes, Shackle, and Minsky, criticizes the extremely simplistic way in which information is understood in the Stiglitz–Weiss model. Dow argues that the major flaw with the Stiglitz–Weiss model is that its key result is not based on information asymmetry between a bank and a borrower, but on two much stronger assumptions—that is, borrowers have perfect information on the riskiness of investment projects, and borrowers conceal the actual risk of the project (Dow 1998, 2002). 2 These assumptions are necessary to minimize the importance of the borrower’s risk and provide an explanation for credit rationing (Dow 1998). However, Dow’s organizational theory indicates that borrowers also face uncertainty about project outcomes and, therefore, they can be either over- or under-optimistic (Dow 2002).
Furthermore, the Stiglitz–Weiss model assumes that risk can be reduced once the information asymmetry between a borrower and a lender is bridged. Dow (1998), following Shackle (1972) and Keynes’ Treatise on Probability ([1921] 1973), argues that most knowledge is subject to uncertainty in terms of unquantifiable risk. 3 Therefore, according to Dow, the lending process should be seen as one in which both parties attempt to acquire or create knowledge in the uncertain world (Dow 1998, 2002). The application of this concept of knowledge creation to the context of credit market implies
that it is in the nature of the banks’ and borrowers’ risk assessment processes that a strong element of judgement be employed. This is not the result of borrowers’ intentionally concealing information in an opportunistic manner, but rather the nature of the process of knowledge acquisition in an uncertain world.
Dow 1998: 222
As such, if lending and borrowing are not simply a matter of information, we should examine how factors located outside the market affect the lending-borrowing relationship. The following discussion draws on the concept of knowledge creation combined with the embeddedness of social factors in order to understand lending relationships in developing countries.
Outside of mainstream economics, social factors figure prominently in understanding lending relationships. The sociological theory of finance, for example, suggests that access to credit is not based entirely on the net present value of a project and transaction costs (Uzzi 1999); instead, banking transactions are embedded in social relations. Embeddedness, in turn, leads to the development of trust between borrowers and lenders and, therefore, affects access to and the price of credit (Uzzi 1999; Johnson 2003). The embeddedness argument is based on the work of Polanyi (1944) and Granovetter (1985) who stress “the role of concrete personal relations and structures of such [social] relations in generating trust and discouraging malfeasance” (Granovetter 1985: 490). Uzzi (1999: 482) defines social embeddedness as “the degree to which commercial transactions take place through social relations and networks of relations that use the exchange protocols associated with social, non-commercial attachments to govern business dealings.”
In the specific context of lending relationships, therefore, social relations allow the exchange of knowledge and information and the development of trust between the lender and the borrower.4 Such knowledge creation and trust encourage lenders to disburse loans to borrowers on a basis that cannot simply be captured by price factors and transaction costs.
In this respect, it is worthwhile to note Uzzi (1999)’s interesting sociological study of formal banking following the embeddedness approach. Using a combination of methods—interviews of bank managers and survey data from 2,400 middle-market firms in the United States—Uzzi tests the impact of arm’s length ties versus embedded social relations between banks and borrowers. Arm’s length ties are characterized by lean and irregular transactions, which take place without prolonged human or social contact between parties. Uzzi finds that firms having embedded social relations, rather than arm’s length ties, with banks more likely to get funding at a lower interest rate. This argument is more nuanced than simply showing the importance of social relations in lending relations. That is, arm’s length ties and embedded relationships are complementary rather than mutually exclusive; one type of relationship helps overcome the limitations of the other type of relationship. Therefore, while a firm with embedded relationships with a bank is more likely to get funding, it is also equally likely to make an effort to repay the loan if the firm is also able to meet most financial criteria (Uzzi 1999). The corollary is that banks with a mix of arm’s length ties and embedded relationships are likely to have more capability of producing information and monitoring their borrowers.
There have been few heterodox studies examining banks in SSA. One study is Upadhyaya (2011), which analyzes qualitative data to understand the constraints banks in developing countries face when making lending decisions. This study concludes that some of the constraints include: the need to educate clients, particularly small and medium sized borrowers even on basic issues such as developing management accounts; the unreliability of financial information (therefore the need to compliment hard and soft information on borrowers); and, over-reliance by banks on name lending (that is, the process whereby the owners of the bank know the ‘names’ of borrowers as they are from the same community, and a loan is given purely on the perceived reputation of the borrower)—but this strategy is no longer working due to changing social relations.
Upadhyaya (2011) also shows that: changing social factors have a pervasive effect on the quality of asset portfolio of banks and this impact is complex and not unidirectional; to be able to effectively monitor clients, banks need to develop a mix of arm’s length ties and embedded relationships; embedded relationships should not be discouraged by regulation; and, while credit registries can be useful they do not replace the need for banks to really understand their clients.
Financialization is a concept that heterodox economists and scholars from a variety of disciplines have adopted to describe the structural changes in the advanced economies since the early 2000s (Zwan 2014). Studies of financialization interrogate how an increasingly autonomous realm of global finance has altered the underlying logic of the capitalist economy such that finance capital has come to dominate industrial capital and, consequently, the increasing fragility of economies has become global (Newman 2009; Zwan 2014). Zwan (2014) provides a useful schema of financialization in industrialized countries divided into three main groups: the emergence of a new regime of accumulation, the ascendancy of the shareholder value orientation, and the financialization of everyday life.
The concept of financialization has also been applied to emerging economies such as Brazil and Turkey. For example, it is shown that the liberalization of capital flows and the increased participation of foreign investors buying short-term Brazilian assets made it very difficult for the government to effectively manage exchange rates in Brazil; as a result, the Brazilian real depreciated, which was not in line with the fundamentals of the economy (Kaltenbrunner 2010). In the case of Turkey, there has been a historic rise in consumer credit driven by both supply and demand factors (Karacimen 2014).
A few studies have examined the effect of financialization on the poor in developing countries. Newman (2009), for example, investigates the influence of financialization on the structure of coffee value chains since the decline of the International Coffee Agreement in 1989 and the liberalization of coffee markets in countries such as Uganda and Tanzania. This study also demonstrates how the use of financial instruments for private risk management helps stabilize incomes for the largest downstream actors at the cost of producers in developing countries. At the level of retail financial markets, Krige (2012) links the rise of illegal Ponzi and legal multi-level marketing schemes in South Africa to both the context of post-apartheid South Africa, with its discourse of ‘economic empowerment’ and ‘entrepreneurship’, and the wider neoliberal policy in the context of financialization.
The studies discussed above imply that financialization as a concept needs a more nuanced understanding when it comes to developing countries, particularly those countries where the level of credit in relation to GDP remains low. There is some evidence from the Kenyan context that while the banking sector has deepened and become increasingly dominated by local banks, lending to agriculture and manufacturing sectors, which are key for the development of the economy, has been declining (Upadhyaya & Johnson 2015). Therefore, while agriculture represents 25.9 percent of Kenyan GDP, lending to agriculture as a proportion of total lending dropped from 8.7 percent in 2000 to 4.9 percent in 2012. Furthermore, lending to manufacturing dropped from 21.4 percent in 2000 to 13.5 percent in 2012. The growth in credit is due largely to increased lending to households—from 3.3 percent in 2000 to 24.6 percent in 2012 (Upadhyaya & Johnson 2015). It should be noted, however, that in developing countries not all lending to households should be considered as consumption or unproductive lending, as people leverage their borrowing to invest in productive areas, including agriculture and small enterprises (Johnson 2003). Nonetheless, the empirical analysis presented above raises concerns that the changing structure of lending does not reflect the stated goals of the country, which aim for manufacturing to grow at 10 percent per annum (Upadhyaya & Johnson 2015).
This chapter reviewed studies on banking in developing countries, with a focus on SSA. Most studies on this particular issue are conducted by mainstream economists and fall in two main categories: first, cross-country and single-country studies that attempt to show an empirical link between finance and growth. These studies are methodologically weak, as they do not attempt to reveal the country-specific mechanisms that channel finance into growth; second, single-country case studies employ the ‘structure-conduct-performance’ paradigm, which assumes that the poor performance of African banking is attributable to high levels of concentration and low levels of competition. These studies, however, do not explain why economies of scale in banking do not always lead to efficiency, and why economies of scale can lead to better reputation and stability that has a complex effect on competition in the banking sector. While heterodox economists have actively participated in financial liberalization debates, there have been only a handful of heterodox studies that attempt to understand banking sectors in developing countries. In order to fill this lacuna, we examined three concepts that are useful in providing a heterodox understanding of banks in developing countries: knowledge creation as opposed to information asymmetry, and the embeddedness of credit relations in social relations. These two concepts are useful insofar as we are concerned with the reality of lending relations in developing countries. The third concept, financialization, was examined to show that there is considerable room for heterodox economists to extend this concept to developing countries, as it pertains to the relationship between the banking system and development.
1 Competitive outcomes are possible in concentrated systems, and collusive actions can be sustained even in the presence of many firms. Therefore, it is the threat of entry—contestability—that is more important.
2 Although Greenwald & Stiglitz (1993) recognize that production is a risky process, this is not translated in their formal model, where it is assumed that borrowers face quantifiable measurable risk (Dow 1998).
3 Shackle (1972) criticizes the probabilistic approach to decision-making theory, and emphasizes that the use of probability relies on past events and therefore, by their nature, methods that rely on probability cannot adequately capture the future.
4 It should be acknowledged that when we use the term ‘trust’, we use it in a very narrow context of the relationship between the bank and the borrower. In the specific context of finance, we do not look at the development of trust between banks, which is also essential for the smooth functioning of the payment system.
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