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Rural Financial Intermediation of Ghana

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1.1 Background of the study

The rural sector comprises nearly 80% of Ghana's population of 18.5 million, with rural economic activities providing employment and incomes for an estimated 60% of rural dwellers (World Bank, 2001). At the same time, nearly 30 percent of rural inhabitants live below the poverty line. However, financial services remain significantly limited at present, mainly provided by informal groups and rural banks. After relatively successful macroeconomic and financial sector reforms, the absence of strong rural and micro finance institutions have continued to impede the attainment of rapid rural economic development. Existing rural financial institutions are often community-based, with strong socio-cultural linkages.

The rural banks in particular are characterized by broad-based shareholdings by community members and compared to the larger commercial banks, have a higher propensity to serve clients with low asset base, education and/or collateral, clients who otherwise would have little or no access to formal financial services. At the same time, there is an emerging network of specialized micro-financial institutions that are testing out international best practice methodologies and adapting them to Ghanaian microfinance context and situations. Given the dispersion of rural banks, the nature of community ownership, and rural client base, development of strong rural and micro finance institutions would provide a coherent framework for rural economic growth that would lead to lowered poverty rates and improved standards of living for a majority of the country's population.

Since independence the Government of Ghana (GoG) has made several attempts to promote rural development to improve the living standards of its rural people. The 1992 Constitution has made a firm commitment to rural development as part of its national strategy to improve the living conditions in rural areas through decentralization with the establishment of political and administrative regions and districts. As part of its poverty reduction strategy the Government in 2000 sought funding from the World Bank under the Rural Financial Services Project (RFSP) to promote growth and reduce poverty in Ghana by expanding the outreach of financial services in rural areas and strengthening the sustainability of the institutions providing those services.

The Rural Financial Services Project Objectives

The Rural Financial Services Project (RFSP) seeks to promote growth and reduce poverty in Ghana by broadening and deepening financial intermediation in rural areas through the following measures:

(i) strengthening operational linkages between informal and semiformal microfinance institutions and the formal network of rural and community banks in order to expand services to a larger number of rural clients;

(ii) building capacity of the rural and community banks, the principal formal financial intermediaries operating in rural areas, in order to enhance their effectiveness and the quality of services they provide;

(iii) supporting the establishment of an apex structure for the rural banking system to provide the economies of scale needed for these unit rural banks to address generic constraints related to check clearing, specie supply, liquidity management and training, etc. which have impeded growth of the rural finance sector; and

(iv) strengthening the institutional and policy framework for improved oversight of the rural finance sector.

1.2 Problem Statement

The search for a system to tackle the financial problems of the rural dweller started as far back as the 1960s under the Nkrumah regime. During that period, the need for a veritable rural financial system in Ghana to tackle the needs of small-scale farmers, fishermen, craftsmen, market women and traders and all other micro-enterprises was felt. The need for such a system was accentuated by the fact that the bigger commercial banks could not accommodate the financial intermediation problem of the rural poor, as they did not show any interest in dealing with these small-scale operators.

Governments attempt in the past to encourage commercial banks to spread their rural network and provide credit to the agricultural sector failed to achieve any significant impact. The banks were rather interested in the finance of international trade, urban commerce and industry. There was, therefore, a gap in the provision of institutional finance to the rural agricultural sector. The failure of the commercial banks to lend on an appreciable scale to the rural sector had been attributed to the lack of suitable security on the part of farmers and the high operational costs associated with small savers and borrowers. Another reason may be the centralised structure of the banking set-up, which, despite their many branches countrywide, is controlled by their Head Offices in Accra, making decentralisation ineffective. One disadvantage of this system was that a centralised institution is not able to compete with the local private money lender in local knowledge and flexibility.

More important still, the branch network of many banks covered mainly the commercial and semi-urban areas and did not reach down to the rural areas. Therefore, not only were rural dwellers denied access to credit from organized institutions, they could also not avail themselves of the opportunity of safeguarding their money and other valuable property which a bank provides.

It is the realization that the existing institutional credit did not favour rural development that led to the search for a credit institution devoid of the challenges /disabilities of the existing banking institutions but possessing the advantages of the non-institutional credit agencies. This institution was the rural bank.

1.3 Research Questions

The study sought to answer the following research questions:

i. Are there success cases in the provision of rural financial services?

ii. What are the challenges faced by the implementers of the Rural Financial Service Project (RFSP)?

iii. How many of the rural poor have gained access to the financial services from the Rural and Community Banks?

iv. What is the impact of the Rural Financial Service Project on the performance of the Rural and Community banks and what has been the profitability levels and shareholders fund of the rural banks?

1.4 Research Objectives

The primary objective of the study was to ascertain the extent to which the Rural Financial Service Project had been able to promote growth and poverty reduction by strengthening the capacity of those institutions providing financial services.

Other objectives for this study are as follows:

i. To identify the challenges faced by the RCBs under the RFSP.

ii. To assess the impact of the project on the growth and performance of the selected RCBs in terms of profitability, shareholders funds, total assets and deposits.

iii. To determine the access of rural poor to financial services.

1.5 Significance of the Study

The findings of this research may inform stakeholders: Government officials, policy makers, donor agencies, the World Bank and IMF of the importance of improving and strengthening the operational efficiency of the RCBs as an important intermediary in the provision of financial services to the rural areas to aid poverty alleviation. The recommendations, it is hoped, may encourage the formulation of appropriate policies and programmes to further develop these institutions with technical and financial assistance to lead the role of improving the quality of life of the rural dwellers.

Results will contribute to a better understanding of the evolving structure of rural financial services and provide an input to the financial policy made by policy makers especially Bank of Ghana.

1.6 Scope of the Study

The sampling area of the study covers 127 Rural and Community Banks in Ghana out of which five selected Rural and Community Banks in the Eastern, Ashanti and Greater Accra regions under the Rural Financial Service Project were considered as the sample size. These RCBs include Bosomtwe Rural Bank, Upper Manya Krobo Rural Bank, Ga Rural Bank, Nwabiagya Rural Bank and Dangme Rural Bank. The study looked at the financial performance of the Rural and Community Banks in Ghana between the period of 2002 and 2006 and also the impact of the RFSP on the selected RCBs. Impact was measured by growth in Profitability, Total deposits, Shareholders funds and access of rural poor to financial services.

1.7 Organization of the Study

In order to present a systematic and consistent research, chapter one introduces the background of the study, the problem statement, the research questions, the objectives, significance of the study, and the scope of the study. Chapter two which is the literature review which will throw more light on related studies and concepts of rural financial service project, financial intermediations in the rural areas, challenges of rural financial intermediation and traditional approach to rural finance. Chapter three deals with the methodology adopted in the collection data for the research, description of the field instrument, procedure and data analysis. Chapter four is the presentation of results, interpretation and discussion of the results.

Chapter five provides a summary of the study, the conclusions, limitations and recommendations of the study.



2.1 Introduction

Financial intermediation is a pervasive feature of all of the worlds economies. As Franklin Allen (2001) observed in his AFA Presidential Address, there is a widespread view that financial intermediaries can be ignored because they have no real effects. They are a veil. They do not affect asset prices or the allocation of resources. As evidence of this view, Allen pointed out that the millennium issue of the Journal of Finance contained surveys of asset pricing, continuous time finance, and corporate finance, but did not survey financial intermediation. Here we take the view that the savings-investment process, the workings of capital markets, corporate finance decisions, and consumer portfolio choices cannot be understood without studying financial intermediaries.

2.2 Importance of Financial Intermediaries

Why are financial intermediaries important? One reason is that the overwhelming proportion of every dollar financed externally comes from banks. In the United States for example, 24.4% of firm investment was financed with bank loans during the 1970 - 1985 periods. Bank loans are the predominant source of external funding in all the countries. In none of the countries are capital markets a significant source of financing. Equity markets are insignificant. In other words, if finance department staffing reflected how firms actually finance themselves, roughly 25 percent of the faculty would be researchers in financial intermediation and the rest would study internal capital markets.

As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy. The idea that banks monitor firms is one of the central explanations for the role of bank loans in corporate finance. Bank loan covenants can act as trip wires signaling to the bank that it can and should intervene into the affairs of the firm. Unlike bonds, bank loans tend not to be dispersed across many investors. This facilitates intervention and renegotiation of capital structures. Bankers are often on company boards of directors.

Banks are also important in providing liquidity by, for example, backing commercial paper with loan commitments or standby letters of credit. Banking systems seem fragile. Between 1980 and 1995, thirty-five countries experienced banking crises, periods in which their banking systems essentially stopped functioning and these economies entered recessions. (See Demirg-Kunt, Detragiache, and Gupta (2000), and Caprio and Klingebiel (1996). Because bank loans are the main source of external financing for firms, if the banking system is weakened, there appear to be significant real effects (e.g., see Bernanke (1983), Gibson (1995), Peek and Rosengren (1997, 2000)).

Basically, financial intermediation is the root institution in the savings-investment process. Ignoring it would seem to be done at the risk of irrelevance. So, the viewpoint of this paper is that financial intermediaries are not a veil, but rather the contrary. In this paper, we survey the results of recent academic research on financial intermediation (Gorton and Winton, 2000).

2.3 The Existence of Financial Intermediaries

The most basic question with regard to financial intermediaries is: why do they exist? This question is related to the theory of the firm because a financial intermediary is a firm, perhaps a special kind of firm, but nevertheless a firm. Organization of economic activity within a firm occurs when that organizational form dominates trade in a market. In the case of the savings-investment process, households with resources to invest could go to capital markets and buy securities issued directly by firms, in which case there is no intermediation. To say the same thing in a different way, non-financial firms need not borrow from banks; they can approach investors directly in capital markets. Nevertheless, most new external finance to firms does not occur this way. Instead it occurs through bank-like intermediation, in which households buy securities issued by intermediaries who in turn invest the money by lending it to borrowers. Again the obligations of firms and the claims ultimately owned by investors are not the same securities; intermediaries transform claims. The existence of such intermediaries implies that direct contact in capital markets between households and firms is dominated.

Why is this? is the central question for the theory of intermediation (Gorton and Winton, 2000). Bank-like intermediaries are pervasive, but this may not require much explanation. On the liability side, demand deposits appear to be a unique kind of security, but originally this may have been due to regulation. Today, money market mutual funds may be good substitutes for demand deposits. On the asset side, intermediaries may simply be passive portfolio managers, that is, there may be nothing special about bank loans relative to corporate bonds. This is the view articulated by Fama (1980). Similarly, Black (1975) sees nothing special about bank loans. Therefore, we begin with an overview of the empirical evidence, which suggests that there is indeed something that needs explanation.

2.4 Empirical Evidence on Bank Uniqueness

What do banks do that cannot be accomplished in the capital markets through direct contracting between investors and firms? There is empirical evidence that banks are special. Some of this evidence also attempt to discriminate between some of the explanations for the existence of financial intermediaries discussed below.

To determine whether bank assets or liabilities are special relative to alternatives, Fama (1985) and James (1987) examine the incidence of the implicit tax due to reserve requirements. Their argument is as follows:

Over time, U.S. banks have been required to hold reserves against various kinds of liabilities. In particular, if banks must hold reserves against the issuance of certificates of deposit (CDs), then for each dollar of CDs issued, the bank can invest less than a dollar. The reserve requirement acts like a tax. Therefore in the absence of any special service provided by bank assets or bank liabilities, bank CDs should be eliminated by non-bank alternatives. This is because either bank borrowers or bank depositors must bear the tax. Since CDs have not been eliminated, some party involved with the bank is willing to bear the tax.

Who is this party? Fama finds no significant difference between the yields on CDs and the yields on commercial paper and bankers acceptances. CD holders do not bear the reserve requirement tax and he therefore concludes that bank loans are special. James revisits the issue and looks at yield changes around changes in reserve requirements and reaches the same conclusion as Fama. Another kind of evidence comes from event studies of the announcement of loan agreements between firms and banks. Studying a sample of 207 announcements of new agreements and renewals of existing agreements, James (1987) finds a significantly positive announcement effect. These contrasts with non-positive responses to the announcements of other types of securities being issued in capital markets (see James 1987) for the references to the other studies). Mikkelson and Partch (1986) also look at the abnormal returns around the announcements of different type of security offerings and also find a positive response to bank loans. Tables 1&2 provide a summary of the basic set of results. There are two main conclusions to be drawn. First, bank loans are the only instance where there is a significant positive abnormal return upon announcement. Second, equity and equity-related instruments have significantly negative abnormal returns. James (1987) concludes, banks provide some special service not available from other lenders (p. 234).

2.5 Mechanisms to Improve Financial Intermediation

Recent developments in growth theory have stimulated renewed interest in the interactions of financial intermediation and growth. While most of the existing literature analyses the risk- sharing function of financial intermediaries, Raju Jan Singh, 1997 focused on the asset-valuation activity of banks. Following the early contributions of Goldsmith (1969), McKinnon (1973) and Shaw (1973), a general equilibrium endogenous growth model is presented, in which financial intermediaries increase the amount of accumulated capital, improve the mobilization of savings and enhance the efficiency of resource allocation.

As in Greenwood and Jovanovic (1990) and King and Levine (1993b), banks are shown to be able to improve their lending efficiency by evaluating projects. Unlike the models presented by these authors, the banks' evaluation capacity is not assumed to be exogenous. The ability of banks to gather the information needed to undertake this evaluation is linked to proximity, and the notion of geography may thereby be introduced. A link between proximity and faster growth rates can thus be shown, consistent with the observations of historians such as Cameron (1967).

Furthermore, Singh, 1997 showed that a bank can improve the efficiency of its lending by opening branches. A poor branch network would thus affect negatively the economic growth rate, as Cameron (1967) suggests in the case of France in the 19th century. By contrast, relaxing regulations limiting the setting up of branches would promote faster growth, as Jayaratne and Strahan (1996) observe in the case of the United States. The size of the financial sector is therefore not the only important variable; its structure and the distribution of its deposits matter likewise.

The model presented by Raju Jan Singh, 1997 could be extended in various ways. The contract offered by the bank to its potential borrowers could be enriched by the inclusion of other variables besides the interest rate. For instance, collateral requirements might be considered. Cash-flow or corporate net wealth could also be introduced as additional sources of information for banks. In this context, the proportion of entrepreneurs being evaluated might appear to be dependent on the size of the latter only, and not only on the proximity of a bank branch.

2.6 Effect of Financial Intermediaries

The finance-growth nexus can be theoretically postulated only within the endogenous growth framework. Financial intermediation, by reducing information and transaction costs, can affect economic growth through two channels; productivity and capital formation.

With regard to the first channel, it is generally argued that financial intermediaries by facilitating risk management, identifying promising projects, monitoring management, and facilitating the exchange of goods and services, can promote efficient capital allocation leading to a total factor productivity improvement (Levine, 1997). For example, Greenwood and Jovanovic (1990) shows that financial intermediation provides a vehicle for diversifying and sharing risks, inducing capital allocation shift toward risky but high expected return projects. This shift then spurs productivity improvement and economic growth. Diamond and Dybvig (1983) argues that households facing liquidity risks prefer liquid but low-yield projects to illiquid but high-yield ones, while financial intermediaries, through pooling the idiosyncratic liquidity risks, would like to invest a generous portion of their funds into illiquid but more profitable projects. Bencivenga and Smith (1991) argue that financial intermediaries by eliminating liquidity risks, channel households financial savings into illiquid but high-return projects and avoid the premature liquidation of profitable investments which favours efficient use of capital and promotes economic growth.

The impact of financial intermediation on growth through the second channel-capital formation-is ambiguous. Tsuru (2000) argues that financial intermediation could affect the savings rate, and then capital formation and growth, through its impact on four different factors: idiosyncratic risks, rate-of-return risks, interest rates and liquidity constraints. By reducing idiosyncratic risks and relaxing liquidity constraints, financial intermediation might lower the savings rate and negatively affect growth. By reducing the rate-of-return risks through portfolio diversification, financial intermediation might negatively or positively influence the savings rate, depending on the risk aversion coefficient (Levhari and Srinivasan, 1969). Finally, the development of financial intermediation might raise the rate of return for households savings, which also has an ambiguous effect on the savings rate due to well-known income and substitution effects. In addition, financial intermediaries efficiency amelioration could cut the financial resources absorbed by themselves, and raise the portion of households savings converted into productive investment which favors capital formation and growth.

In conclusion, the theoretical literature shows that the development of financial intermediation affects economic growth mainly through its impact on the efficiency of capital use and the improvement of total factor productivity, while its growth effect through the savings rate and capital formation is theoretically ambiguous.

2.7 Introduction to Rural Financial Services

Rural financial services refer to all financial services extended to agricultural and non-agricultural activities in rural areas; these services include money deposit/savings, loans, money transfer, safe deposit and insurance. Demanders/beneficiaries of rural financial services are mainly households, producers, input stockists/suppliers, traders, agro-processors and service providers. Rural financial services help the poor and low income households increase their incomes and build the assets that allow them to mitigate risk, smoothen consumption, plan for future, increase food consumption, invest in education and other lifecycle needs. These needs can be broadly categorized into working capital, fixed asset financing, income smoothing and life cycle events. Access to credit and financial services have the potential to make a difference between grinding poverty and economically secure life. Inspite of the importance of a savings account, 77 percent of Kenyan households have no access to a bank account (Kodhek, 2003). In the late 1990s, most mainstream commercial banks closed down some rural branches in order to cut costs and improve profits. The non-traditional financial institutions have emerged to fill the gap created by the mainstream banks which locked out low income and irregular earners.

2.8 Financial Intermediation in Rural Areas

Financial intermediation is crucial for the development of rural villages. If these intermediations are used properly, they can help the rural residents increase their income. Likewise, banks and financial intermediaries may be able to recover expenses and make a profit by attracting deposits and granting rural loans. Several reasons are given in favour of financial intermediation. It is argued that rural financial markets (RFMs) reduce the cost of exchanging real resources. Financial intermediations also enhance a more efficient resource allocation. Firms and individuals may have different investment and consumption alternatives. Thus, some of them want to save at the time others plan to invest. Banks satisfy both desires. In addition, financial intermediation causes gains in risk management. Rural producers are typically subject to large variations in income and expenditure. Rural production heavily depends on the weather and price fluctuations. For example, expenditures may be heavy at planting periods while income is realized with harvest. Therefore loans and savings are important and inexpensive ways to manage at least part of households risks. Moreover, financial intermediation may allow a farmer to undertake larger investments. For instance, a loan may permit a rural producer to buy a tractor before being able to save enough money to buy one with cash. Likewise financial intermediaries can benefit large number of households by accepting their short term deposits and providing a fewer borrowers with longer-term loans. In fact, savers, borrowers and intermediaries gain from this transformation of term structures that take place through intermediation. In addition financial intermediaries that deal with borrowers as savers reduce the information asymmetry characteristic of RFMs. By observing the savings patterns of customers, they obtain information about the income and wealth of clients. By that banks are better able to assess the quality of borrowers and reduce default risk.

The drawback is that there is a general tendency for governments in less developed countries (LDCs) to interfere in RFMs. Thus few observers of formal RFMs in LDCs are satisfied with their recent performance. Markets are highly fragmented; they provide little services to rural residents; political interest interferes with RFMs operations; and official lenders are frequently on the edge of bankruptcy. RFMs in LDCs do not work like the classic competitive markets. On the contrary, some imperfections are characteristic of rural banks. These imperfections lead to a variety of problems. For example, the available information is imperfect or asymmetric. These are classic problems of RFMs. Borrowers differ in the likelihood of default. However, it is costly to determine the risk of default of each borrower. This problem is conventionally known as the screening problem or sometimes it is called the adverse selection problem (see Srinivasan, 1994, p. 15). Moreover, it is also costly to ensure that borrowers take actions that facilitate repayment. This situation is known in the related literature as the incentive problem or moral hazard problem. This problem turns out to be particularly severe when rural banks lend money at concessionary interest rates. That is the way most governments run credit programmes. If a farmer receives cheap money he will not display enough effort to ensure repayment. For instance, in the presence of high interest rates, borrowers may select investment projects that have higher potential pay-offs but a greater risk. These sort of economic activities (investments) require more effort from the borrower to be successful. Finally, it is also costly to enforce the credit contracts. This factor gives rise to the enforcement problem of rural financial markets. There is very little or no penalty in default cases in rural areas of LDCs. Therefore, seldom are the borrowers expected to be sanctioned for loan delinquency. Often it is found that some rural borrowers may be able but unwilling to repay. In addition, in many LDCs property rights are poorly defined so that actions against collateralized assets are ineffective. Governments of many LDCs often, for political reasons, engage in credit relaxation programmes, which diminish borrowers incentive to make their projects successful. Therefore, it is not surprising that government-run credit suffers from a tremendous default problem.

The final result is that RFMs have not developed as real and effective capital markets. In the absence of capital markets, individuals turn to moneylenders. The common belief is that moneylenders charge monopoly interest rates, which capture borrowers returns from credit. To overcome those problems innovative credit policy interventions are required. Some few new financial institutions are now being successful to combat market imperfections. Among such institutions are the Grameen Bank of Bangladesh and some of its replications. For instance, group lending allows the financial institutions to transfer risk and transactions costs to credit recipients. It also permits some banking firms to monitor borrowers with other borrowers.

2.9 Current evidence: what we know

2.9.1 Challenges to Rural Financial Intermediation

Hoff and Stiglitz (1990) and Besley (1994) have identified three major constraints to financial market development: information asymmetries between market participants; lack of suitable collateral; and high transaction costs. Risk related to agriculture, and to government and donor policies towards agriculture, should be added as a fourth major constraint to rural finance counting for the poor. Demirguc-Kunt and Levine (2004) noted that efficient contract enforcement, related to a supportive legal framework and robust internal operating systems in formal financial intermediaries (FFIs) is very important in the development of the financial sector and the economy as a whole. Constraints to the development of rural financial markets are discussed in more detail below. Information Asymmetry

This occurs when borrowers have more information about the out-turn of their investment and greater capacity to repay loans than lenders (Stiglitz and Weiss, 1981). FFIs usually attempt to reduce this problem by screening out high-risk borrowers from their track record (including credit performance, transactions on deposit accounts, cash flow statements and other accounts). However, in the case of most rural customers, this is not possible, because many keep no record of their transactions and/or do not use payment facilities of banks. In addition, access to borrower information is impeded by a lack of efficient transport, communications infrastructure and well-functioning asset registries and databases. Risk

High, and often covariant, risks in the rural economy are related to the dominance of agriculture, which accounts for a high percentage of Gross Domestic Product (GDP) (one third in the case of Africa) and employment (two-thirds in Africa) (UNDP Human Development Report, 2000). The long gestation period for many agricultural investments and the seasonality of output usually lead to uneven cash flow and variable demand for savings and credit. Agricultural production is largely dependent on the weather and the use of productivity-enhancing inputs is very low (both leading to yield or production risk), especially in sub-Saharan Africa where the average consumption of fertilizer is only 1015 kg per hectare, compared to about four times that on the Indian sub-continent (Pinstrup- Andersen et al., 1999). African yields are therefore very low and have risen only slightly since the 1980s (Badiane et al., 1997). Lack of credit is a major factor limiting the ability of smallholders to procure and use inputs. However, as noted by Yaron and McDonald (1997), sustainable provision of agricultural credit depends on the profitability of agricultural production and the extent to which yield, marketing and price risks faced by farmers can be managed (Onumah, 2003).

Crop marketing systems in many developing countries are inefficient and small-scale farmers have been exposed to even greater uncertainty regarding the marketing of their output as a result of the liberalization of agricultural markets since the 1990s (Coulter and Poulton, 2001; Hubbard, 2003). Most small-scale farmers sell the bulk of their output at harvest when prices are low and household income in rural areas is consequently usually low and variable. Small-scale farmers usually cannot defer sale of outputs as they lack storage facilities and they cannot access finance for consumption smoothing. On the other hand, traders in agricultural commodities, especially the rural assemblers who are the main link between producers and wholesale markets tend to be under-capitalized. While they often cannot access trade finance from financial institutions, they are usually required to offer trade credit to wholesalers and processors. This creates a liquidity problem and limits their ability to absorb (and store) the substantial surplus available during the harvest season. The consequent glut depresses farm gate prices (Onumah, 2002) and, in most developing countries, market instruments to manage price risks are not available (Coulter and Onumah, 2002).

The yield, marketing and price risks discussed here are usually covariant in rural areas, that is, large groups of farmers throughout a region face common shocks to their incomes as a result of fluctuations in the weather or unfavourable market conditions (Besley, 1994). This is a particular problem when agricultural activities are not diversified, but concentrated on a few crops or livestock activities. Lack of Collateral

Lack of collateral limits access to rural credit and is related to poorly defined property and land-use rights and weak land and property markets (see also the World Development Report, 2001). Enforcement Problems

Enforcement problems are common in many developing economies. That is, even when borrowers have assets that can be used as collateral, they are often not acceptable to banks because of the high cost and long delays in using judicial enforcement mechanisms (Fafchamps, 1996). FFIs in rural areas also have difficulty complying with systems and procedures intended to limit their exposure. This is due largely to weak institutional capacity. High Operating Costs

High operating costs are due to the small size of most rural peoples accounts in relation to the cost of service delivery. A low level of economic activity, low rural population density and poor infrastructure will also increase operating costs. Formal banking procedures and physical access difficulties

These factors constitute major barriers to the rural population. Procedures instituted by FFIs to reduce lending risks often constitute social access barriers to the rural population because of the predominance of illiteracy and the need for formal documentation (Goodland et al., 1999). To ensure sustainability in the face of high operating costs, banks often concentrate their branch network in urban communities, thus increasing physical access costs to rural clients. Weak Institutional Capacity

Weak institutional capacity of rural finance providers is related to the limited availability of educated and well-trained people in smaller rural communities. This is a particular issue for community-based institutions. Enabling policy environment

During the 1980s, the debate on the role of the state in rural financial development centred on how policy interventions (e.g. interest rates and sectoral lending controls) contributed to the underdevelopment of financial markets and the supply of rural finance (Fry, 1995). Another topical issue was the crowding-out effects of directed credit from state-owned banks. Recent literature suggests that macroeconomic policies can adversely affect the development of rural financial markets (Gonzalez-Vega, 2003), albeit in a less direct manner. Macroeconomic instability, often in the form of high inflation, is known to impede financial development (Khan, 2002) as it discourages saving in financial form. Monetary policy interventions to contain inflationary pressures usually through the sale of government debt instruments like treasury bills tend to reduce the volume of credit available to the private sector as well as raising the cost of borrowing (lending rates are linked to returns on the low-risk debt instruments such as government papers). The same effects are observed when public sector borrowing rises as a result of increasing budget deficits and/or increased credit requirements from state-owned enterprises.

Gonzalez-Vega (2003) argues that the state can play a supporting role in promoting financial sector development by making the enforcement of prudential regulations more robust, thereby engendering trust in financial intermediaries and encouraging savings. He adds that policies to promote competition and lower entry barriers to the rural financial markets will reduce fragmentation of the sector and contribute to its development.

Coulter and Onumah (2002) also note that policies affecting agricultural input and output markets affect rural financial markets. Ad hoc policies, often intended to manage food deficits, tend to lead to the unintended outcome of deepening market uncertainty, which results in a decline in real producer prices (Jayne et al., 1999). The uncertainty also makes inventory-backed finance for producers and traders unattractive to FFIs (Coulter and Onumah, 2002).

2.10 The Traditional Approach to Rural Finance

The traditional approach to rural finance, which was the dominant paradigm in the 1950s1970s, involved the supply of credit by governments and donors to the agricultural sector at concessional interest rates (often negative in real terms) through cooperatives and state-run institutions. The traditional approach did little to reduce the constraints on the rural financial environment. Instead, the focus was on addressing the effects of the constraints (i.e. the inadequate supply of finance to the rural sector, particularly for crop production). Based on the vicious cycle of capital formation, the traditional approach assumed that the savings potential in rural areas was so low that it was not worthwhile to mobilize savings or to offer savings facilities in rural areas. The vicious cycle could only be broken by channeling external funds into rural areas to help raise the low investment rate (Zeller et. al., 1997; World Bank, 2004). For this reason, specialized agricultural credit institutions were established to extend credit to specifically targeted agricultural investments. Usually the consumption credit needs of the rural households were ignored. As noted by Yaron et al. (1997), Heidhues and Schrieder (1997) and the World Bank (2004), subsidised credit programmes contributed little to growth in agricultural output or productivity. Only a small percentage of farmers had access to credit and they were usually the larger-scale farmers and wealthier members of the rural population. The poor had to rely on the informal sector for their financial needs. Fry (1995) and others including Gonzalez-Vega (2003), point out that these programmes also contributed to market distortions which hampered financial deepening in many developing countries.

2.11 Origin and Development of Microfinance in Ghana

Microfinance may be defined as the provision of basic financial services comprising mainly savings facilities and small loans to micro-entrepreneurs and other disadvantaged groups, especially women. Anim (2000) defines microfinance as the provision of financial services, not just savings and loans, to people with low incomes in both the rural and urban centers. Microfinance has actually existed for years not just in Ghana but the whole of Africa. It is reported, for example, that the first credit union in Africa was established in Northern Ghana in 1955 by one Canadian Catholic Missionary.

In Nigeria, microfinance dates back to the 15th century when sharing was being engaged in. The original Yoruba term susu is still in use. According to AfDB report (2005), microfinance has gone through four (4) distinct phases worldwide including Ghana. The first phase was the provision of direct subsidized credit by Governments starting in the 1950s, when it was assumed that lack of money was the ultimate hindrance to the elimination of poverty. The second phase involved the provision of microcredit to the poor mainly through NGOs. Sustainability and financial self-sufficiency were still not considered important. The third distinct phase began in the 1990s, with the formalization of microfinance institutions, while the fourth phase started in the mid 1990s, and has involved the mainstreaming of microfinance and its institutions into the financial sector. These developments appear to derive from the perceived failure of the conventional banking system to provide financial services to the economically disadvantaged persons who operate either in the rural areas or in the shanty areas of urban communities.

Zeller, Manfred and Sharma Manohor (1998) in a paper, attributed the neglect of the rural economy by the conventional banking system to the erroneous premise that, in the rural areas the rural women who earn incomes of less that US$1 per day are neither creditworthy nor able to save. These assumptions have been debunked with the emergence of rural micro financial institutions which are providing financial services to the rural people and have recorded remarkable trends of repayment of loans to prove and reaffirm the position that the rural women are creditworthy and have surplus earnings to save.

In Ghana, the microfinance sub-sector has since 1996 been engaged in a number of activities aimed at sharing in the micro-finance best practices and developing of micro-credit to the rural dwellers. This is indeed confirmed by Aba Quainoo (2006) that the Ghanaian economy has since 1980, seen an increase in public sector and donor financed programmes in micro-finance targeted at the rural women. The various types of institutions used for the delivery of rural financial services in Ghana, include informal suppliers such as money lenders, Susu collectors and Rotating Savings and Credit Associations (ROSCAs); semi-suppliers like NGOs and formal suppliers such as Savings and Loans Companies, Rural and Community Banks (RCBs), and Credit Unions. The increasing role of microfinance in rural development is a result of the recognition that micro-credit is a catalyst to the economic development of the rural areas of Ghana. The focus of micro-credit has been at targeting women because women are traditionally not served by the formal financial institutions. Again, a recent study by the World Bank (2001) indicates that about 70% of the 1.3 billion people living on less than one US dollar a day are women. Women often have proved to be more creditworthy and are more likely to have increased incomes in the households than men. Furthermore, access to financial services has empowered women to become more confident and more assertive.

Although the Government of Ghana is very keen in promoting the growth of the microfinance sub-sector, the regulatory environment required to harness and regulate the operations of the microfinance institution is non-existent. The MFIs have therefore been operating as they wish without any control. This has greatly affected the direction and growth of microfinance.

According to Salami (2001), The microfinance sector is fragmented with different institutions using different methods to serve different clients. The government through Ministry of Finance and Economic Planning (MOFEP) and the Microfinance and Small Loan Centre (MASLOC) has recognized the need for regulation and supervision of the micro-finance sub-sector and therefore in consultation with the Ghana Microfinance Network Institutions (GHAMFIN), has developed the Ghana Microfinance Policy Document (2006) to give a policy direction to the sector. This document is currently in draft form and being deliberated upon by all stakeholders before its acceptance, ratification and implementation.

2.12 History of Rural Banking in Ghana

The origin of rural banking in Ghana dates back to 1976 when the Bank of Ghana (BoG) initiated a move to establish rural banks with the expressed purpose of providing both commercial and developmental banking activities to meet the needs of the rural areas. Rural banks are thus established to provide banking service and credit to cottage industries, artisans, farmers and local individuals (Salami, 2001).

A rural banking system is to promote and expand rural economy in an orderly and effective manner, to place credit facilities on reasonable terms and within easy reach of the people of the countryside and generally to increase the productivity and income levels of the rural population. On the other hand, the main objective of rural banking is to mobilize and allocate loanable funds in the rural economy in a continuous way and to ensure that such funds are employed productively. Thus, in other words, the rural banking idea is to provide banking services and credit to the doorstep of the rural dwellers. According to Salami (2001), Before the origin of rural banks, there was barely any institutionalized financial intermediary in rural areas, notwithstanding the fact that the bulk of Ghanas population of 20 million (estimated at 76%) is constituted by rural dwellers whose main occupation is associated with agricultural activities regarded as the backbone of Ghanas economy.

This goes to buttress the fact that rural banking actually came to fill a gap in the provision of institutional finance to the rural agricultural sector. Rural banks are characterized as unit banks which are community-owned and are managed by the communities within which they are located. This promotes community identity with the banks and also encourages patronage and support from the communities they serve. Rural Banks were initially confined to a radius of 30km of their catchment areas. However, in their drive to mobilize financial resources, most rural banks have flouted this directive of the Bank of Ghana and have opened branches and agencies in the peri-urban areas of cities and towns. This has led to various questions by the public as to whether rural banks are not defeating the purpose for which they were established. Notwithstanding this criticism, empirical evidence has established that banks which embarked on the expansion drive to the periphery of the cities and urban areas are now the best banks with high deposits and are offering financial and social services to both communities.

According to Salami (2001), the primary objectives of the rural banks were to:

i. Extend and deepen rural financial intermediation to facilitate the payment system and to promote savings and investment process.

ii. Bring banking services to the doorsteps of the rural population to be able to monetize the rural economy and thereby reduce the size of money outside the banking system, that will in turn facilitate efficient money management by the BoG.

iii. Provide necessary institutional credit to the rural dwellers to enable expansion of farming activities and other income generating activities that would help to improve their livelihood and

iv. Act as instrument of economic development through provision of commercial loans to the local councils and town development for community projects like building of markets, schools, and health centres.

With the establishment of the first rural bank at the Agona Nyarkrom in the Central Region, the concept caught up with many communities and there was a phenomenal growth in the number of banks established by the end of 1997. By the year 1997 (i.e. a span of 21years), the number of the rural banks in the banking system was 130.

According to Dr. Salami (2001), the growth in the number of rural banks was explained in terms of the felt needs of the rural communities to take advantage of the newly created rural banking system that would offer rural dwellers banking services including credits and savings facilities. The mad rush in the establishment of the banks came with its attendant problems such as low capital base, poor management, the proper and appropriate appraisal process by the Bank of Ghana. These factors led to poor performance of rural banks and many banks were plagued with fraudulent practices leading to a large number of banks not being able to meet customers withdrawals. The Bank of Ghana therefore considered 18 rural banks distressed and withdrew their operating licenses in 1998. In 2000, the number of banks stood at 112 and this position has grown to 122 with 550 agencies and branches countrywide.

The basic functions performed by rural banks in Ghana are to:

i. Provide current, savings and time deposit accounts

ii. Act as agents of other financial institutions in the country by rediscounting its papers and accept Bills of Exchange.

iii. Accept securities for safe-custody.

iv. Act as executors and trustees of wills of farmers and merchants in the rural areas.

v. Provide finance to small scale farmers, fishermen, rural merchants and industrialist in the catchment areas.

2.13 Legal Framework and Supervision of Rural Banks

Rural banks in Ghana are limited liability companies and therefore are registered at the Registrar of Companies under the Companies Code of 1963, Act 179. For the banks to operate as legal business entities, they have to obtain Certificate of Incorporation and a Certificate to Commence Business. They are also required to apply for and be issued with a license to operate as a bank by the Bank of Ghana under the Banking Law. The prudential regulation of the rural banks in Ghana thus comprises all laws and controls which the BoG employs to ensure compliance by relevant rural banks in their operations and activities.

This is necessary to ensure prevention of failure by institutions and of fraudulent dealings in the market (Anim, 2000). As a requirement, the BoG provides integrity to the financial institutions, including rural banks, which are able to honour their commitment. These functions are performed by the BoG through issuing of directives on primary reserve requirements, secondary reserve requirements and also undertake supervisory functions by inspecting and reporting to ensure that businesses remain sound and regulations observed and complied with.

The BoG therefore undertakes routine inspection of the rural and community banks at least once a year. Furthermore, due to the high priority that the BoG attached to the rural banking system, the BoG went beyond the supervision to actively nurture and incubate the rural banks and therefore a special department i.e. the Rural Finance Department was set up by the BoG to act as the defacto Head Office of rural banks in Ghana.

In November 2006, a special legislative instrument was passed by Parliament to give legal effect to ARB Apex Banks operation. This measure which was taken by Parliament formed part of the Governments strategy to improve the policy and regulatory environment of the rural banking sector.



3.1 Research Design

A research design is a master plan specifying the methods and procedures for collecting and analyzing the needed information. It is a framework or blueprint that plans the action for the research project. The objectives of the study determined during the early stages of the research are included in the design to ensure that the information collected is appropriate for solving the problem. The researcher must also specify the sources of information, the research method or technique (e.g. survey or experiment), the sampling methodology and the schedule and the cost of the research (Zikmund, 2003). A research design is the structure of the investigation so conceived as to obtain answers to research questions (Kerlinger, 1986). This is a quantitative study. Secondary data were collected on the research objectives.

3.2 Population and Sample

Choosing subjects for research is an integral part of the research process. The method used has implications for generalizing the research results (Cozby, 1989). A sample is a subset, or some part, of a larger population. The purpose of sampling is to enable researchers to estimate some unknown characteristic of the population. Three factors are required to specify sample size: variance or heterogeneity of the population, magnitude of acceptable error, and confidence level (Zikmund, 2003).

The population of the study is the 127 Rural and Community Banks in Ghana with five (5) selected Rural and Community Banks (RCBs) in Eastern, Greater Accra and Ashanti regions as the sample size and this selection was based on the financial performance of the Rural and Community Banks in the three regions under the Rural Financial Service Project. These RCBs include Bosomtwe Rural Bank, Upper Manya Krobo Rural Bank, Ga Rural Bank, Nwabiagya Rural Bank and Dangme Rural Bank.

3.3 Procedure

The researcher obtained an introductory letter from the University of Ghana Business School which was sent to the head office of ARB Apex Bank which is the mini central bank for all rural and community banks. This enabled the researcher to obtain permission to carry out the research work in the selected RCBs and also permitted the researcher to gain access to the various annual reports of the selected RCBs, journals of ARB Apex Bank, books and Articles of ARB Apex Bank. Prior notice was given to the Head, Efficiency & Monitoring Unit of the bank and the purpose of the study was well explained to him. A maximum of two weeks was allowed to retrieve all the necessary information requested for by the researcher.

3.4 Data Collection

Since this is descriptive study, the secondary data method was used to collect the needed information. A survey is defined as a method of gathering primary data based on communication with a representative sample of individuals. Typically, surveys aim to describe what is happening or to learn reasons for a particular business activity. Other survey objectives might include identifying the characteristics of a particular group, to measure attitudes, and to describe behavioural patterns.

The data for this research work was secondary and were extracted from the Annual Reports of the ARB Apex Bank, Efficiency & Monitoring Unit-ARB Apex Bank and the selected RCBs for a period of eight (8) years (2000-2007). Except the number of accounts of RCBs, all other data were measured in monetary units. Information from both international and local journals, articles, existing documents, and books were also reviewed to enhance the study.

3.5 Data Analysis and Presentation of results

Analysis is the application of reasoning to understand and interpret the data that have been collected (Zikmund, 2003). Statistics are simply tools used by the researcher to help make sense out of the observations that have been collected. Some statistical analyses are very simple and are used to help describe and classify the data. Other statistical techniques are quite complex and help the researcher make detailed inferences. For data to be statistically manipulated, it must be organized and quantified in some way (Riggio, 2000).

In this study, simple graphical presentations such as bar charts and linear graphs were used to give an overview of the results from the study.

Trend analysis was carried out on the profitability, shareholders funds and deposits of each selected rural bank since the inception of the Rural Financial Service Project (RFSP). Statistical Package for the Social Scientists (SPSS) (Windows Version 12.0, Chicago, IL, USA) and the Microsoft Excel 2003 were used as the softwares for the analyses.

3.6 Calculation of Performance Indicators

Percentage Change = CY-PY x 100


CY = Current year

PY = Previous year

Return on Capital ratio = PAT x 100


PAT = Profit after Tax

SF = Shareholders Fund



4.1 Overview of Rural and Community Banks (RCBs) in Ghana

On a macro level, the Rural and Community Banks in Ghana since the inception of the Rural Financial Service Project under the umbrella of the ARB Apex Bank have made remarkable progress as regards some of the major financial indicators. These are evident in terms of total assets, loans, deposits etc. as seen in Table 1 below. The total assets of all the RCBs as at 2002 recorded an amount GH 86.38 million by two years it has increased to GH 179.83 million. Stated capital was GH 1.41million in 2002 and by 2006 had increased to GH 9.35million, a growth rate of about 563.12 percent.

Table 1 Financial Indicators of RCBs in Ghana


2002 2003 2004 2005 2006

GH 'mil GH 'mil GH 'mil GH 'mil GH 'mil

Total Assets 86.38 127.54 179.83 226.08 298.75

Total deposits 66.70 94.92 136.33 168.80 226.46

Total Loans 22.56 38.44 56.77 77.52 115.10

Investment in Gov. Securities 38.32 52.47 71.96 83.06 84.63

Networth 10.77 12.04 24.09 32.09 38.53

Stated Capital 1.41 2.23 3.52 5.41 9.35

Profit Before Tax 3.75 6.48 7.74 9.20 8.87

Source: Efficiency & Monitoring Unit-ARB Apex Bank (2007)

The size of a corporate entity, like a bank, is determined by its total assets built up over the years. Figure 1 below shows that the size of all the RCBs in terms of total assets doubled in the year 2004 (GH 179.83 million) as compared to that of 2002 (GH 86.38 million). In 2005, the total assets were GH226.08million. From 2002 to 2006 the RCBs recorded a tremendous growth rate of about 245.86 per cent.

Another key performance indicator that provides a positive impact of the RFSP on the RCBs is total profit before tax. In the year 2002, profit before tax of RCBs was GH 3.75 million which rose to GH6.48 million in 2003. This witnessed a gradual increase until 2006 (GH 8.87 million) when it recorded a negative growth rate of 3.61 percent (see Figure 2) due largely to the sharp fall of interest rates experienced in the economy at the time.

Total Loans of Rural and Community Banks

Looking at the total number of loans given to customers most of which went to the rural communities, it could be said that the Rural Financial Service Project (RFSP) have had a significant impact on the financial performance of Rural and Community Banks. Figure 3 below display that between the year 2002 and 2003 the RCBs recorded about 70.41 percent increase in loans given to customers. In all the period of 2002 to 2006 recorded about 410.22 percent growth rate in total loans given by RCBs in Ghana to their customers.

Table 2 Total number of Accounts of RCBs in Ghana


2003 1,456,987

2004 1,720,731

2005 2,116,428

2006 2,493,004

2007 2,742,304*

2008 2,961,688 *

Source: EMU Reports of ARB Apex Bank, * = projected values

Prior to the setting of Rural Financial Service Project in Ghana, rural banks had various difficulties one of which was convincing the populace to open accounts with their respective banks. This was partly due to the fact that clients could only carry out transactions within the region in which the bank is located; making it difficult to transact both national and international businesses most importantly for the rural poor who depend on foreign remittances for a living. Again this was because the various rural banks found it difficult granting loans to customers due to lack of funds or capital.

The year 2003 recorded 1,456,987 bank accounts opened in all the RCBs, this increased to 1,720,731 in 2004 and continuously witnessed positive growth in the subsequent years (see Figure 4). This is confirmed by 31 RCB managers interviewed in 2006 under the RFSP Beneficiary Assessment who were of the opinion that the introduction of the Rural Financial Service Project have made the RCBs more competitive than the years before because it has increased their customer base and also improved customer confidence in their systems (GIMPA, 2006).

4.2 Challenges faced by Rural and Community Banks under the RFSP

The first objective of the study was to identify the various challenges faced by the Rural and Community banks in Ghana especially the ones that arose as result of the Rural Financial Service Project.

Table 3 Challenges faced by RCBs in Ghana

No. Challenges Faced By RCBs

1 Poor state of infrastructure in the rural areas especially lack of phone lines.

2 Weak internal control systems of some RCBs.

3 Inadequate monitoring visits by PCU and Apex Bank staff to RCBs.

4 A poor image of the RCBs due to the label "Rural".

5 The 5% compulsory zero interest deposits with the ARB Apex.

6 Lack of stand-by generators and servers for some RCBs.

7 Low quality of some cash counting machines and equipment supplied.

8 Difficulty in attracting corporate clients to enhance profitability & deposits

9 Inability to retain experienced and competent staff.

10 Restrictive legal framework.

11 Bureaucratic approval of loans above GH 20 million by the BoG.

12 Monitoring of the micro loans.

In undertaking the study, it was discovered that despite the fact that the Rural Financial Service Project has recorded many successes over the years there still exist challenges confronting the RCBs. Table 3 above shows some of the major challenges that were identified. One of the institutional challenges identified was the restrictive legal framework, which prevents Rural and Community Banks from moving to peri-urban and urban areas, where there are more deposits coming in and investment opportunities. Again, the RCBs find it difficult to retain experienced and competent staff due to low salaries and poor working conditions compared to other jobs leading to high staff turnover. Others include the cry of RCBs that it is unfair to send a 5 percent compulsory zero interest deposit to the ARB Apex Bank and the inadequate monitoring visits by the Project Coordinating Unit (PCU) and the Staff of ARB Apex Bank.

Determining the access of the rural poor to financial services especially women is another objective of the study, an analysis carried out by the Rural and Micro Finance Institution Performance Monitoring Unit of the Bank of Ghana showed that on the whole RCBs have made some progress as regards gender equity. Over the three year period from 2002 to 2005, the share of female depositors increased by 4 percent, the value of total deposits by female clients by 7 percent, the number of total female borrowers also increased by 2 percent and the value of total loans outstanding to female clients by 6 percent as displayed in Table 4 below.

Table 4 Evolution of RCBs clientele by Gender (2002-2005)

Narration 2002 2005

Male Clients Female Clients Male Clients Female Clients

% of Total individual depositors

57 43 53 47

% of Total deposits

61 39 54 46

% of Total individual borrowers

61 39 59 41

% of Total loans

63 37 57 43

Source: BoG, RMFI Performance Monitoring Unit & GIMPA 2006

4.3 Impact of RFSP on selected Rural and Community Banks

The second and fourth objectives of the study were to assess the impact of the project on the growth and performance of the selected RCBs in terms of profitability and shareholders funds and to assess the increase in total deposits of member rural banks respectively. This section is devoted to the assessment of the five selected Rural and Community Banks namely, Bosomtwe Rural Bank, Upper Man

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