Can Financial Services Promote Stability in Fragile States?

Financial sector development in sub-Saharan Africa faces new and growing challenges, especially in fragile states. In this region, there are 20 countries currently considered fragile in one way or another – the highest geographic concentration of fragile states in the world. The concept of fragility is complex, and while there is no standardized definition, there is a set of characteristics that fragile states generally display: “poor governance, weak capacity and institutions, high risk of conflict and insecurity, disputed legitimacy, and poverty.”

These features create an extra set of challenges for financial inclusion and inclusive financial sector development in the region:

1. First, while poverty is decreasing, the concentration of extreme poverty in fragile states is likely to increase. As Sub-Saharan Africa grows, there is an imperative to ensure that benefits are shared and inequality does not grow.
2. Second, levels of financial sector development in fragile states are distinctly lower than in their non-fragile counterparts.
3. Third, situations of fragility do not follow clean patterns. While the field of development previously tried to focus on phases of intervention such as pre-crisis, active crisis, recovery, and post-conflict, current thinking recognizes the reality that countries facing situations of fragility do not experience clear-cut phases. Rather, they often exist in a complex crisis situation for protracted periods of time, requiring new thinking and approaches.

In Mercy Corps’ report commissioned by Financial Sector Deepening Africa, Financing the Frontier: Inclusive Financial Sector Development in Fragility-Affected States in Africa, we examined the impact of financial sector development on poverty and stability across sub-Saharan Africa, with global implications for regions facing similar challenges. The findings demonstrate that investments in the financial sector are critical not only for poverty reduction, but also as one of the best strategies for future investment in fragile countries. Despite this strong evidence of efficacy, institutional donors have been sluggish in prioritizing these kinds of market-focused responses.

Research provides important insights into the role financial services can play in stability and fragility. Four key lessons are emerging from our work on this topic:

First, the financial sector can influence fragility. Poverty rates in Sub-Saharan Africa fragile states are, on average, 20% higher than countries with comparable levels of economic development. The gap is widest for countries affected by repeated cycles of violence. Access to finance plays a crucial role in poverty and conflict cycles, as lack of equitable access to financial services can lead to underdevelopment and stagnation, exacerbating social and economic unrest.

Second, there is a link between fragility and displacement. Sub-Saharan Africa has the world’s highest refugee and internally displaced population – over 19 million people – and the numbers are rising due to new and ongoing crises in the Central African Republic, Nigeria, South Sudan, and Burundi. In Sub-Saharan Africa, financial market imperfections such as informational asymmetries and high transaction costs can be a source of fragility, especially for poorer populations. They also limit access to capital, which reduces the efficiency of capital allocation and intensifies income equality.

Third, there are differences across fragile states. Financial systems in Africa’s fragile states tend to be shallow, especially in terms of credit depth and supporting functions for consumer voice, lagging significantly behind the rest of Africa. They often face high levels of market distortion and mismatched incentives from donors and humanitarian interventions. In African fragile states, 80% of the population is financially excluded in Cameroon, Chad, DRC, Sierra Leone, and Sudan and over 90% in Burundi and Niger. However, on average, mobile money account usage is higher than in non-fragile countries at 12%. The demand for credit, especially for emergency and health needs, is twice the average of non-fragile countries.

Fourth, there are lower levels of risk tolerance and trust. Fragile states in Sub-Saharan Africa have lower rates of formal salaried employment (on average 12%) equating to high informality and income insecurity, which effects household consumption and production decisions. This results in a need for a wide-range of financial services to store funds, build assets, manage risks, and smooth consumption. In fragile states, individuals often become more risk averse and invest less.

What do these finding mean and how can they lead to specific actions to help broaden financial inclusion in the region? What role can donors and development actors play? 

• Invest in the foundations of inclusive finance – regulations and identity solutions: Donors and development actors should advocate and support risk-based approaches to tiered KYC (Know-your-customer) regulations to allow different level of financial transactions as an entry point into formal finance. This is especially important for remittances, payments, and mobile money. Consumer protection regulations for customer recourse to build trust in the formal finance system should also be a priority.
  
  Closely related is the need for proof of identity through a functional identification (ID). An ID, in its most basic form, is a prerequisite to access education, information, jobs, and financial services and typically required to facilitate KYC. In its more advanced forms, an ID, especially on digital channels, allows individuals to build authentic and verifiable information such as a credit history and unlock access to a wider range of financial products.
   
• Scale digital payment and remittances infrastructure: There are over 30 million African adults living outside their country of birth sending home over USD 40 billion in remittances, resulting in the largest aggregate flow to fragile states. These amounts will only increase with rising migration and forced cross-border displacement across Sub-Saharan Africa. There is a growing need and opportunity to use remittances and diaspora investments as financial strategies to increase savings and diversify risk. This has impact on both formal and informal financial sectors in fragile countries.
   
• Explore and further expand promising trends for donors and development actors in partnership with the commercial sector and national governments. This includes increasing flexible finance options for refugees and displaced populations, increasing the range of Islamic finance providers, supporting inclusive insurance, and increasing use of liquidity and guarantee facilities. Fragile countries also offer a unique entry point for impact investors in partnership with donors to support a pipeline of investments.
   
• Remember market system solutions are still relevant: While each fragile situation is unique and complex, using a market systems approach is an opportunity for donors and development actors to adjust tactics but adhere to several key principles: think long-term, do not ignore the informal sector, ensure a positive business case, carefully sequence interventions, and utilize a diverse package of smart aid instruments.