Financial markets and productive development

Companies’ access to financing is a fundamental factor for the efficient allocation of capital and productivity. The situation in LAC in this regard is not encouraging.

Credit, relative to the size of the economies, is relatively low. Figure 2.11 shows that in LAC credit to the private sector was equivalent to 51 % of GDP in 2023, while in OECD countries it averaged 150 %. This not only indicates poor financial development in the region, but also suggests that firms and households have limited access¹.

Other indicators confirm this. Small and medium-sized enterprises (SMEs), which consitute almost all of those operating in the economy and account for around 70 % of salaried employment in LAC, face serious credit constraints. As illustrated in panel A of figure 2.12, in the region, about 15 % of commercial bank loans are directed to SMEs, while in the rest of the world’s regions they exceed 20 %, reaching almost 28 % in Europe. Also, SME lending in LAC is only about 5 % of GDP, significantly below the other regions, except Africa, where it is almost 3 % (panel B). By contrast, in Europe, SME lending is equivalent to 13 % of GDP, and in Asia-Pacific, almost 20 %.

Another sign is the interest rate differential paid by SMEs with respect to large companies. According to OECD (2024b) data, this is substantially higher in LAC than in developed countries. Figure 2.13 shows that for LAC countries, this differential ranges from 3.6 percentage points in Mexico to almost 20 in Peru. The average for these two countries together with Chile, Colombia and Brazil is 8.6. In contrast, the median for the sample of 36 countries included in the graph is less than 1 percentage point.

Limited access to finance is a significant obstacle to firm growth, preventing them from fully exploiting the efficiency gains from innovation². When companies, especially SMEs and young firms, face high borrowing costs and barriers to accessing credit, their ability to invest in new technologies, expand operations and even maintain their existing capital is limited. It also affects innovation decisions by limiting investment in critical complementary inputs, acquiring advanced machinery, hiring skilled labor or implementing new organizational practices³.

Figure 2.14 shows that R&D spending in LAC countries represents, on average, 0.31 % of GDP, with Brazil leading with 1.15 %. In contrast, the average for OECD countries is 2.3 % of GDP, with countries such as Germany, Japan and the United States above 3 %. Other innovation indicators show the same picture. For example, in terms of patent applications, LAC accounts for only 0.35 % of applications worldwide, while, by way of comparison, the region has more than 8 % of the population and about 7.3 % of world GDP⁴.

Of course, lack of access to financing is not the only cause of low innovation in the region, but it is a crucial factor according to the empirical evidence. Competition in the markets for goods and services, as well as cooperation between companies and participation in value chains, as will be seen below, are also determining factors.

Financial frictions are another element that reduces the entry of new companies⁵. High entry costs and limited access to start-up capital mean that only firms with sufficient internal funds or connections can enter the market. This reduces competition, allowing less productive firms to survive and thrive.

In essence, a financial system that does not function efficiently prevents capital from flowing, especially to the most productive companies with the greatest potential, which ultimately translates into lower productivity at the aggregate level.

Access to finance also affects the occupational decisions of individuals. When barriers exist and capital does not reach the entrepreneurs with the greatest potential, the economy suffers from an inefficient distribution of talent. This means that entrepreneurs with fewer capabilities, but with access to resources, end up operating less productive companies that demand less labor and capital. This is reflected in lower wages, which makes the option of being a salaried worker less attractive. As a result, more individuals seek to become entrepreneurs, generating a vicious circle that results in excessive and inefficient enterprises, many of which end up in the informal sector.

The relationship between informality and financial frictions does not end with their effects on workers’ occupational decisions. When firms lack the financial history or assets necessary to secure loans in the formal sector, they may choose to operate informally to avoid the costs associated with formalization.

Another adverse effect of financing barriers is that they hinder the expansion of companies into new markets and their participation in global value chains. In short, financial frictions have profound consequences on the productive fabric and productivity of companies and the economy as a whole.

Financial reform: greater access to credit and inclusion

To improve access to credit, especially for SMEs, and foster greater financial inclusion in LAC, it is essential to address the current shortcomings of the banking system. In the region, the banking system is characterized by high concentration and a lack of incentives to direct sources of financing to SMEs, which are perceived as riskier, forcing many of these companies to rely on internal or informal resources.

In this sense, it is crucial to implement policies that promote competition, transparency and efficiency. This implies, on the one hand, promoting the development of credit information systems that provide reliable information on borrowers, facilitating more accurate risk assessment by banks. This entails strengthening -or even creating- credit risk centers, such as credit bureaus, which collect and disseminate credit information on individuals and companies. By reducing the information asymmetries that characterize the financial system, these institutions promote greater access to credit, responsible indebtedness and a more inclusive and efficient financial system.

In terms of inclusion, a common characteristic of Latin America […] is that access to credit is often highly skewed towards larger companies. Therefore, small and medium-sized enterprises and households have much more limited access to credit.

Based on an interview with Carmen Reinhart

On the other hand, it is necessary to facilitate the entry of new financial institutions, including fintechs and credit unions, to diversify the market and offer more options to companies and the public.

The impact of fintechs in LAC could be significant in improving access to credit, especially for sectors traditionally underserved by conventional banking. Fintechs have the potential to democratize access to financial services through the use of innovative technology that reduces operating costs and allows products and services to be offered that are better adapted to clients’ needs.

One of the main advantages of these types of institutions is their ability to assess risk using non-traditional data, such as utility payment history or social network profiles, and alternative analysis methods. This allows them to assess the creditworthiness of SMEs and individuals with limited or no credit history, or insufficient collateral (Kelly et al., 2017). 

By operating at lower costs, fintechs can offer more favorable financing conditions. This translates into increased competition in the financial sector that manifests itself both directly, through rivalry between fintech institutions and traditional banks, and indirectly, by providing incentives for traditional financial institutions to invest in new technologies (Bakker et al., 2023).

There is evidence that this increased competition has been reflected in reduced interest rate spreads, making credit more affordable. In emerging and developing economies, as well as in LAC, an increase in digital bank activity is associated with a reduction in these spreads. Specifically, a one percentage point increase in the share of digital bank transactions to total bank lending is associated with a decrease in the interest margin of between 0.2 and 1.9 percentage points. In Brazil, where there is a large fintech presence, interest rate margins declined by approximately 13 percentage points between 2017 and 2020, and the increase in digital bank activity is estimated to have contributed to a 3-percentage point reduction in these margins (Bakker et al., 2023).

The impact of fintechs goes beyond this, as they are also contributing to financial inclusion. Digital technologies make it more cost-effective to attract and serve traditionally excluded populations, such as those in rural areas and low-income people, by overcoming geographic and other barriers and creating products and services specifically designed for the needs of these groups.

Data for Latin America and the Caribbean show that, indeed, fintech ventures are increasingly targeting segments of the population underserved by the traditional financial system. In 2023, «57.32 % of fintech companies target underbanked or unbanked individuals or companies”⁶,which represents a significant increase compared to the 36 % observed in 2021 (Finnovista and IDB, 2024)⁷. 

The partnership between traditional financial institutions and fintechs has also proven to be an effective strategy, allowing greater access to credit for individuals and companies, particularly SMEs, that would otherwise have remained excluded.

These partnerships allow leveraging the strengths of both types of organizations. Traditional financial institutions bring their brand, customer base, and access to funds, while fintechs offer technological innovation, modern information systems, and the ability to analyze large volumes of consumer data (Kelly et al., 2017).

One question that remains to be answered is whether the growth of the fintech industry effectively improves access to credit for businesses and consumers. Evidence presented in Berg et al., (2022) suggests that, at least in developed economies, fintechs have failed to significantly expand access to credit to borrowers underserved by traditional banking, except in specific niches. Other studies show, however, an improvement in access to credit in certain segments and markets⁸. Regarding companies, specifically, there is evidence that fintechs can improve access to financing, especially for SMEs

In the particular case of developing economies, fintechs have a greater potential to expand access to credit, as their banking systems often lack the infrastructure and resources for proper risk assessment. Therefore, fintechs, by using non-traditional data and methods, can have a greater impact.⁹. 

For this impact to be fully effective, governments and regulators in the countries of the region need to establish a regulatory framework that promotes innovation while protecting consumers and ensuring the stability of the financial system. This includes creating a competitive environment that allows these institutions to operate alongside traditional banking entities, thus promoting a more inclusive and dynamic ecosystem.

Box 2.1 delves into the necessary reforms to the regulatory and normative framework for a better development of the fintech sector.

Development banking as an alternative

Development banking can play a crucial role in improving access to financing for businesses by acting as a complement to private banks and credit unions. It can also boost the growth of SMEs, which are the engine of many of the region’s economies. Through support programs and financial products tailored to the needs of these companies, development banking can facilitate access to credit and promote the creation of jobs, investment and innovation. It can achieve these objectives through two traditional mechanisms: direct credit and guarantee programs¹⁰.

Direct credit consists of loans granted by development banks to companies. There are two main types of direct credit: loans to end clients and second-tier loans to financial institutions. In the first case, development banks grant loans directly to companies, while in the second case they are channeled through private financial institutions that act as intermediaries.

Loans granted directly to end clients usually have more favorable terms than those offered by commercial banks, such as lower interest rates and more flexible repayment terms. The effectiveness of this instrument depends on the ability of development banks to reach SMEs, which are often geographically dispersed. It also requires a wide service network and the ability to accurately assess the risk of each operation.

The reach of second-tier programs is usually greater, since they take advantage of the infrastructure and information of partner financial institutions to reach a larger number of clients, without significantly increasing the cost of financing. In this case, moreover, the credit risk is shared. Evidence suggests that this type of lending has lower default rates compared to direct development bank loans, which may reflect a more efficient client selection and risk management process.

On the other hand, guarantee programs are instruments designed to facilitate access to credit for SMEs, especially in contexts where they face significant barriers due to asymmetric information problems. These programs allow companies that do not have sufficient backing to guarantee a loan to access financing by purchasing guarantees to replace it. This insurance allows companies with potential, but perceived as high risk, to access credit with better conditions.

Although some studies show a positive impact of these public financing programs on access to credit and employment generation, the effects on investment, innovation and productivity are less clear. This is because the success of public financing depends crucially on good program design and implementation (Abadi et al., 2022).

A typical problem with this type of program is that the resources granted end up benefiting companies that do not face financial restrictions. In these cases, private credit is replaced by public financing, and access to resources for excluded companies is not improved. This type of problem could be avoided if the design of these programs prioritized the participation of companies that actually face credit restrictions.

In order to improve the impact of these programs, it is recommended that they focus on companies with growth potential and the capacity to use resources effectively, which implies an important challenge in terms of identifying companies not only with potential and capacity, but also with limited access to financing.

Complementing financial support with business development services, such as financial management training, diagnostics of management practices, marketing advice and internationalization support, can significantly amplify the positive effects of public financing programs¹¹. 

This combination of financing and business development services is crucial, as it enables SMEs to access capital and improve their internal capabilities. Implementing such programs in an integrated manner can therefore contribute to the sustainable development of SMEs.

An important aspect in the design of these programs is constant monitoring. Rigorous impact evaluations make it possible to measure their effectiveness, identify areas for improvement and optimize the allocation of resources. To achieve this, it is essential to ensure transparency in the beneficiary selection process and in the distribution of funds. 

Adequate monitoring of guarantee funds, for example, would not only help determine whether the program is effectively improving access to credit, but also whether it is sustainable in the long term. A common challenge in these programs is that banks may have incentives to bring their riskier clients into the guarantee programs, or else relax their efforts in selecting and monitoring beneficiary enterprises, which could result in higher default rates and affect the sustainability of the program.

These incentive problems also highlight the need to introduce in their design an adequate risk sharing between the development bank, the commercial bank and the participating companies. In addition, the implementation of penalty mechanisms for banks with high default rates and incentives for those with good performance can encourage banks to take an active interest in the credit quality of borrowers, mitigating moral hazard and program sustainability problems.

In order for development banks to fully comply with their function of improving access to credit, certain reforms are needed to optimize their operation, guarantee their sustainability and ensure their capacity to respond to the needs of the productive sector.

These reforms must ensure that development banks act as a complement to commercial banks and that they are capable of identifying the market failures that need to be overcome, as well as determining which instruments to use to support the productive development policies defined by governments. National development banks must also be able to identify sectors and activities with the potential to generate positive externalities in the economy, such as innovation, export diversification, the green economy and the development of value chains.

In this sense, these reforms should include the definition of a clear mandate to guide the actions of development banks and ensure their complementarity with the private sector. In turn, to ensure that they can fulfill this mandate, they must adopt good governance structures that guarantee their independence, technical capacity and financial sustainability. Only in this way will they be able to play an active role in the productive transformation of the region’s economies.

Indeed, development banks have a very important role to play, far beyond the financial one. They are the place where we learn from each other, where suddenly a country wants to carry out a project in a new area […], and that leads the bank to learn in the process of financing these types of activities. Once it learns, it can pass on that knowledge so that other countries can explore those same directions.

Based on an interview with Ricardo Hausmann

The role of the capital markets in financing

Beyond the role that access to credit plays in boosting productive development, another important aspect that must be taken into account in a comprehensive financial reform is the development of capital markets.

The region’s securities markets have significant growth potential, but realizing it requires specific reforms. One priority is to improve accessibility to the market itself. Reducing barriers such as high transaction costs and complex regulations can encourage broader participation, particularly from retail investors. In addition, promoting institutional investment from entities such as pension funds can inject much-needed liquidity. Developing deeper bond markets can also provide alternative funding avenues and complement stock market growth.

Strengthening transparency and corporate governance is also crucial. This involves improving disclosure requirements for listed companies, ensuring rigorous compliance with international accounting and reporting standards, and incorporating environmental, social and governance factors into company disclosures. Establishing strong and independent regulatory bodies, with robust enforcement mechanisms, is essential to maintain market integrity and protect investors.

In general, good corporate governance facilitates access to financing, both from internal and external sources. In this scenario, the need to protect minority shareholders stands out.

Figure 2.15 shows how far the region lags behind in this regard. It shows that countries generally offer less protection to minority investors than more developed countries. This suggests the existence of significant gaps in the legal and institutional framework governing this important aspect of corporate governance.

This gap has profound implications for companies’ access to financing. When minority shareholders are better protected, capital tends to be allocated more efficiently, as investors feel more confident to invest knowing that their rights are guaranteed. Strong minority shareholder protection reduces the risk of majority shareholders or management abusing their power to the detriment of minority shareholders. This encourages the development of stock markets and allows capital to flow to companies with better growth prospects.

However, in order to strengthen the rights of minority shareholders, a clear and comprehensive legal framework must be established that explicitly defines such rights. These include, among others, voting rights, access to company information and the possibility of taking legal action against the company itself or its directors.

This legal framework must be complemented by strong and independent regulatory bodies, with powers to enforce regulations and ensure fair treatment of all shareholders, regardless of their shareholding. In addition, it is essential to promote transparent corporate governance practices, such as independent boards of directors and clear decision-making processes. Finally, accessible and efficient dispute resolution mechanisms should be in place to address conflicts between shareholders and the company, ensuring that minority shareholders have a fair and impartial platform to voice their concerns and seek redress.

Also critical to the development of capital markets, particularly debt markets, is the proper design of bankruptcy laws. These provide a key framework for dealing with insolvency, reducing uncertainty for both borrowers and lenders, and ultimately promoting the smooth functioning of the financial system.

Reducing risk and increasing investor confidence are the main ways in which bankruptcy laws support the development of capital markets. Well-defined bankruptcy procedures provide clear and predictable processes for handling insolvencies, giving creditors the assurance that their rights will be protected. This makes investment in debt securities more attractive, as lenders are more willing to provide capital when they have confidence in the ability of the legal system to handle companies’ financial difficulties.

In addition, effective bankruptcy laws allow for the efficient restructuring and reorganization of financially troubled companies. By providing a legal framework for them to negotiate with creditors and reduce their debt burden, these laws help prevent the unnecessary liquidation of companies. This preserves their economic value, maintains jobs and allows viable businesses to continue operating¹².

Figure 2.16 shows that countries in the region, in general, have less efficient insolvency procedures than more developed countries. In LAC, creditors recover about one-third of the debt in the event of insolvency on average, while in the OECD they recover 70 %.

Although there are differences among countries, some common reforms are needed in LAC to strengthen bankruptcy laws and make insolvency procedures more efficient. On the one hand, it is necessary to modernize and harmonize legal frameworks. This involves updating bankruptcy laws to reflect the complexities of modern financial instruments and cross-border transactions, improving efficiency and transparency in bankruptcy proceedings, and establishing specialized courts to handle cases effectively.

On the other hand, it is essential to strengthen creditor rights while ensuring fair treatment of debtors. Improving creditor protection in areas such as priority of payments and collateral enforcement procedures can increase investor confidence and foster debt market growth. At the same time, it is important to balance these protections with provisions for debt restructuring and rehabilitation to give debtors the opportunity to recover.

Another aspect of the capital market that can lead to improved access to financing for companies is the development of private equity and venture capital instruments. The former is aimed at more mature companies seeking to restructure or expand, while the latter is focused on early-stage ventures with high growth potential. For SMEs and young companies with difficulties in accessing traditional financing, these instruments serve as a complement and, in some cases, as an alternative to debt instruments. These mechanisms are appropriate to overcome the heavy requirements demanded by more traditional sources, such as the demonstration of income to qualify for credit or the exemption from paying interest at an early stage of operation, when there is usually a clear scarcity of liquidity (Álvarez et al., 2021).

Despite their advantages, these mechanisms have had little penetration in LAC due to information problems, the opacity of financial records and the lack of familiarity of entrepreneurs with these financing vehicles. To overcome these barriers, policies are suggested to encourage both their demand and supply.

On the demand side, the creation of databases of SMEs with the potential to attract investors can be promoted as part of the business services offered by government agencies or trade associations. The promotion of startup «accelerators» and «incubators» is another way of bringing companies closer to potential venture capital investors.

On the supply side, tax incentives can be offered to venture capital investors. On the other hand, direct investment or government co-investment in venture capital funds can serve as a catalytic instrument for the participation of private investors, which is key for the proper functioning of these funds.