The Pitfalls of Relying on Public Policy to Drive Financial Inclusion
Uncle Sam can only do so much constrained by a shifting political environment
One of the most famous ideas in economics is that free markets are guided by an invisible hand that transforms individual self-interest into outcomes that are good for society overall. But as Adam Smith himself acknowledged, sometimes the invisible hand needs some handholding to do its magic [^1].
Let me explain what I mean. Imagine we’re in some parallel universe, and its about 200 years after Smith wrote “The Wealth of Nations.” A guy named Steve walks into several banks sure he’s onto a product that is going to be big. He asks for about $250K in working capital to build the first batch of models. The banks evaluate his small business and decide its just too risky and turn him down. Steve closes down his business and becomes an obscure painter.
In this alternate universe, the market would have done its job. Private banks decided it was not in their self interest to make a particular loan based on the information they had. But this outcome would have been a potential loss for society.
Why? Because in our actual universe the guy named Steve did get the loan he needed to build the first models of the Apple II computer and bring them to market in 1977. The rest of that story is of course history, but what’s worth noting is that the banks were indeed reluctant to give Apple a loan. Ultimately, Steve Jobs was able to secure a $250K line of credit from the Bank of America because he had help: a successful Intel engineer turned angel investor and employee #3 at Apple who went to the bank and vouched for him[^2].
This is what economists would call an externality — a cost or benefit for a third party that comes from a market transaction that isn’t accounted for in the price. In this case, the third party is society at large[^3].
Turns out there are lots of things in the world that are like this besides education. Think of infrastructure like roads, utilities like power, or the military which are all societally very important but which probably don't make sense for private organizations to try to solve using a commercial model.
Access to financial services like credit for small businesses and low-income consumers also has this feature as we've seen in my previous posts. It's important societally but is not profitable enough for financial institutions like banks to get excited about.
How do you solve problems like this? Well, typically we rely on the State. Either the government just directly provides the service or it incentivizes the private sector to do so.
Which brings us to the question, why doesn’t the government just step in and do the same thing for access to credit?
I should note here that I'm using credit here as a stand-in for financial services in general because the provision of credit is an essential financial service that encapsulates other basic financial services like deposit accounts or payments.
In this post, I’ll explore this question in two parts:
We’ll look at ways the government can and does intervene in providing access to credit.
Then I’ll take a look at the historical and political reasons why the government interventions have been constrained or difficult to sustain.
In my next post, I'll dive into how technology can — sometimes — break the impasse and make commercial models viable that were previously not. In particular, I’ll explore how the costs and benefits of credit are fundamentally altered in the embedded approach we take here at Vaya.
States can Intervene to Improve Credit Access
Governments Around the World Do Lend Directly
The short answer to the question of whether governments can lend is yes. In many countries — like Australia [^4], Canada [^5] and Germany [^6]— the state provides credit either directly or indirectly by incentivizing private sector banks usually for the reasons we are talking about.
An example of direct intervention is in India where the State Bank of India (SBI) is a major player in the banking sector. SBI holds about 23% of overall banking sector by assets and the government of India retains 57.5% ownership [^7].
A primary reason for the Indian government to hold onto such a significant share of the largest bank in the system is to maintain system stability and to drive economic development which includes supporting policies in alignment with government priorities like financial inclusion. Indeed, inclusion is such a big deal for the SBI that they include in their tagline: “Transforming [India’s] Banking Landscape with Innovation, Inclusion and Sustainability [^8].”
The US Has Also Tried Direct Lending in the Past
In the United States too, there have been at least a few historical experiences with direct government interventions financial services.
In 1910, President Taft signed into law the United States Postal Savings System (USPSS) which allowed the Post Office to take savings deposits [^9]. The program didn’t get into lending but was very popular during the depression when folks were afraid of banks failing. At its peak the system held $3.4B in deposits from nearly 4M people. It avoided competing with private sector banks by offering lower interest rates on deposits, and it ran until 1966. By that time private banks were much more stable and the existence of the Federal Deposit Insurance Corporation (FDIC) offered government deposit insurance to private sector banks [^10].
As part of President Lyndon Johnson's War on Poverty, the Economic Opportunity Act of 1964 provided loans directly to businesses through the Economic Opportunity Loan Program (EOLP) [^11]. The program made some 60K loans worth a bit of a $1B until it was shutdown in 1984 [^12].
The US Has Generally Relied on Regulations and Subsidies to Support Inclusion
Alternatively, governments can indirectly support small business lending by incentivizing private sector banks or compelling banks through various regulations.
One approach that is commonly used today is to subsidize the provision of credit to small businesses by providing access to lower cost capital or loan guarantees. This is how the Small Business Administration (the SBA) currently operates its flagship program in support of small businesses — the 7(a) program — which guarantees substantial portions (usually 70%+) of loans that lenders make to small businesses leading to higher approval rates and better loan terms for the small businesses [^13].
Historically, regulatory measures also compelled banks to provide services to smaller customers. For example, laws prohibited banks from operating across state lines. Indeed there were rules in many states that limited banks to one branch — what was called unit banking [^14]. As such, banks had to rely on their local communities for deposits and had to serve those same communities with loans and other services.
Shifting Politics Have Led to Constrained or Unsustainable Policies and Programs
The challenge with government interventions is that there's no guarantee of their continuity. As political winds change so can the policies of the state. Existing support for ongoing programs can erode or entirely new priorities can emerge. More fundamentally, even the view of what a bank is can change.
The Debates Jefferson and Hamilton had about Bank Regulation Foreshadowed the Policy Debates We’ve Had Since
In fact how to regulate banks is a debate that goes all the way back to Thomas Jefferson and Alexander Hamilton.
Jefferson was concerned that the economic concentration of power in banks could become a threat to democracy if left unchecked. He also didn't want deposits taken in Nebraska from farmers to be financing business interests in New York, for example. As such, he advocated for heavily decentralized banking and was strongly opposed to having anything that resembled a central bank [^15].
Hamilton on the other hand imagined that a growing economy like America would ultimately require centralized banking to finance large projects — like infrastructure or the common defense — beyond the capability of any one Bank . He also thought a centralized banking system would be essential for establishing a common currency and managing liquidity within the banking system as a whole [^15].
Banks Have Properties of Both Public Utilities and Private Businesses That Make Them Harder to Regulate
This debate has played out in policy over the years. At the heart of the debate is whether banks are more like private businesses or public utilities
On one hand like public utilities, banks respond to economies of scale that make them like natural monopolies. There is a strong public interest in credit and liquidity being available to everyone as we’ve covered before. Banks have systemic impact on consumers and the economy overall. Finally, banks rely on the taxpayer for the raw material they need to function [^15]. In other words, you and I are probably not going to deposit our savings into banks that are not covered by FDIC insurance. Banks also get bailed out if they are too “big to fail.”
On the other hand, banks do face competition and take risk like normal private businesses, and there is — as fintech companies have also shown — lots of room for innovation in products and services not super common amongst utilities [^16].
So which is it?
Well it’s likely that a bank a hybrid of public utility as well as a private business. The original social contract included that view. Banks were heavily regulated private businesses that received public support to operate. And in exchange, they supported public needs like a payments, liquidity, and yes financial inclusion even when it wasn’t super profitable to do so [^15]. The problem is that public policy struggles with this kind of nuance. Over time we gravitate towards one side or the other.
Hamilton’s Vision Won Out, but Maybe Jefferson Was Right
In banking, Jefferson’s view took the early lead but Hamilton's view gained the upper hand slowly over time. After going through several iterations in trying to establish a central bank, the Federal Reserve was established in 1913 [^17]. And the regulatory policies that restricted what kind of loan banks could do or where the could operate or how they could be were removed in waves of deregulation starting in the 1970s into the 1990s [^18].
Today, banks are more centralized and consolidated as a result, and with it has come the political influence that perhaps Jefferson expected.
One thing that I left out in the description of the USPSS and the EOLP above is that one of the key reasons they were shut down had to do with the strong opposition from the banking industry to those programs which generally translates to congressional opposition.
In the case of the USPSS there was general concern about government involvement ideologically, concern about the undermining of private banks, as well as private financial institutions. In fact, 59 bills between 1873s and 1906 attempted to create this program [^19]. But, all those bills died without even a vote due to political opposition fro the American Bankers Association. Ultimately, it took the Bankers' Panic of 1907 to generate enough support to overcome the opposition and get the USPSS going [^20]. By 1966 though, there was enough support again going the other way and the USPSS was discontinued [^21].
The EOLP similarly faced a range of opposition specific to it and to the overarching Economic Opportunity Act itself that led to its end in 1984 as I mentioned above.
In fact, we can see the same opposition manifest in our present time. Just last month, the the SBA sought congressional authorization for direct lending [^22]. Similar to its last attempt in 2022, this attempt too was rebuffed by industry pushback. According to the article:
“… direct lending has triggered similarly strong, similarly negative reactions from financial services trade groups. The National Association of Government Guaranteed Lenders has come out against it, along with the American Bankers Association, Independent Community Bankers of America and America's Credit Unions.”
Technology Might Fill the Gaps Left by Policy
In the present day then, while there continues to be advocacy for policy support for financial inclusion, practically we find ourselves in a world where there seems to be little appetite for strong state intervention in support for financial inclusion.
If commercial models aren’t really viable for solving for solving financial inclusion problems and the state is hamstrung by an ever changing political environment, what’s left?
Well, a potential third way is to innovate. The world does continue to change and evolve. New technologies come along, modifying existing behaviors or enabling new business models that change the profitability equation at the heart of commercial models. Maybe the cost of doing something goes way down (think selling stuff online once the internet came along) or the revenues from doing something goes way up making existing costs acceptable (think fracking).
Innovation may not always possible, of course, but when it comes to financial inclusion and especially access to credit for small businesses, much has indeed evolved to allow us to innovate and apply technology to revive commercial models. I’ll dig more into this next time!
Footnotes
[1]: https://onlinelibrary.wiley.com/doi/10.1111/ecaf.12592
[2]: https://www.mac-history.net/2020/01/30/how-the-founders-of-apple-got-rich/
[3]: https://www.imf.org/external/pubs/ft/fandd/2010/12/basics.htm
[4]: https://www.oecd-ilibrary.org/sites/7db4539a-en/index.html?itemId=/content/component/7db4539a-en
[5]: https://ised-isde.canada.ca/site/canada-small-business-financing-program/en/find-loan-your-small-business/helping-small-businesses-get-loans
[6]: https://www.make-it-in-germany.com/en/working-in-germany/setting-up-business/preparation-consultation/financing-funding
[7]: https://en.wikipedia.org/wiki/State_Bank_of_India
[8]: https://sbi.co.in/documents/17836/39646794/Annual_Report_2024.pdf
[9]: https://www.centreforpublicimpact.org/case-study/postal-banking
[10]: https://slate.com/news-and-politics/2014/08/postal-banking-already-worked-in-the-usa-and-it-will-work-again.html
[11]: https://en.wikipedia.org/wiki/Economic_Opportunity_Act_of_1964
[12]: The program faced several problems outlined as outlined by the Comptroller General in his Report to the Congress in 1980 which makes for generally fascinating reading https://www.gao.gov/assets/ced-81-3.pdf
[13]: https://www.sba.gov/partners/lenders/7a-loan-program/operate-7a-lender
[14]: https://www.federalreserve.gov/newsevents/speech/kroszner20060406a.htm
[15]: Baradaran, Mehrsa. *How the Other Half Banks: Exclusion, Exploitation, and the Threat to Democracy*. Harvard University Press, 2015. If you’re interested in this history of banking and financial inclusion in the United States, this author generally and this book particularly is a great read.
[16]: https://blogs.lse.ac.uk/politicsandpolicy/why-uk-banks-are-like-public-utilities/
[17]: https://en.wikipedia.org/wiki/Federal_Reserve
[18]: https://www.newyorkfed.org/medialibrary/media/research/epr/97v03n4/9712jaya.pdf
[19]: https://www.nber.org/system/files/working_papers/w25812/w25812.pdf
[20]: https://www.federalreservehistory.org/essays/panic-of-1907
[21]: https://academic.oup.com/jsh/article-abstract/52/1/121/4110186?login=false
[22]: https://www.americanbanker.com/news/sbas-push-to-revive-an-old-idea