Financial Cooperatives: A "Market Solution" to SME and Rural Financing

Abstract:     
In this paper we perform a formal analysis of the objective function of a financial cooperative (FC) to investigate to which extent they may be suited to finance SME under conditions of economic and financial reforms in developing countries. We also perform a less formal analysis on the nature and role of the "common bond" in the decision making process by FC. The formal model allows us to state that FC are financial intermediaries that are likely to be in a position to offer credit to business that may find it difficult to obtain financing by the stock banking system. Or at least that they will be much less likely to engage in credit rationing other thing equal than a traditional stock bank, making them financial intermediaries suitable for SME financing. The analysis of the "common bond" yields two results that allow us to qualify the result obtained from the formal model. The first one confirms that FC, as forms of corporate organizations specially adapted to specific niches of the market, may indeed be able to resolve some of the information asymmetries and high transaction cost problems that characterize credit markets for SME enterprises. However, this analysis also yields two other important conclusions that limit the generality of this result. The two limitations are: i) The success in promoting the establishment of FC is likely to be dependent on the level of spontaneous sociability that exist in the society. For those societies with a high level of spontaneous sociability promoting the establishment of FC may be a relatively easy task. The establishment of a network of FC may, however, be more difficult in societies with a low level of spontaneous sociability. ii) Given that the common bond plays a central role in giving the FC the competing edge to limit the problems of information asymmetry, transaction costs and moral hazard, not every SME is likely to have equal access to cooperative financing. A relatively close association to the community that is at the base of the cooperative's common bond will be a necessary condition for accessing FC financing. We draw a number of regulatory and policy implications of the modeling exercise.

Number of Pages in PDF File: 31

JEL Classification: G2, L3

working papers series