Let's talk about Credit, SME Financing & Africa's $331 Billion Credit Gap.
Read the TL;DR version here:
In traditional African culture, credit is often associated with a lack of money, inherently seen as a bad thing. However, if you study more advanced economies, you'll realize that credit has played a huge role in bridging inequality and alleviating poverty.
Consider student loans, for example. People take these loans because they can't immediately afford tuition, but they want qualifications they believe will help them earn enough to repay the loans (plus interest) and improve their lives.
This credit system has single-handedly brought millions of Americans out of poverty and helped them elevate their family incomes and quality of life. Think of Barack and Michelle Obama, Kerry Washington (Olivia Pope in the TV show Scandal), and Oprah Winfrey: these are individuals who have benefited greatly from student loans and have been able to turn their lives around.
The same can be said for small business financing. You may not know this, but the founders of Starbucks, Under Armour, Airbnb, and Whole Foods started out by using credit cards and bank loans. Imagine if credit infrastructure wasn't available—the world would have lost out on some revolutionary products and brands. These businesses began as MSMEs and grew into what they are today. This is why the availability of credit is crucial for businesses, especially in the beginning phase.
MSMEs in Africa:
MSMEs (Micro, Small & Medium Enterprises) are the backbone of the African economy. Africa is estimated to be home to more than 50 million SMEs, providing over 60% of employment in the region and generating about 40% of African countries' GDP (Proparco, 2019).
Before we proceed, let's define MSMEs in the African context:
A micro-enterprise typically has fewer than 5 employees. They are mostly informal (not registered and untaxed) and are the most common type of enterprise.
Small & Medium Enterprises usually have at least 10 employees and are registered businesses that pay taxes.
If you're African, think about your parents or your uncles and aunts. Chances are that at least 50% of them run their own businesses that fall into these MSME categories. This prevalence isn't specific to Africa; it's common in emerging markets. Globally, about 95% of businesses are SMEs, accounting for approximately 60% of private sector employment (Ayyagari et al., 2011).
MSMEs are crucial to the African economy for several reasons. They create jobs, alleviate poverty, foster innovation, and drive social and economic development. This is why good governments give them so much attention and create policies to drive their growth and flourishing. This support is especially important given the volatile markets they operate in.
Unfortunately, market volatility isn't the only obstacle MSMEs face in their quest to build and grow. A major challenge is access to funding and financing. This SME financing problem isn't unique to Africa, but it's more intense here, largely due to the lack of proper credit infrastructure in most African countries.
Financing SMEs:
Generally, there are two primary ways to finance the growth of an SME:
Debt financing: Borrowing money from family, friends, and banks.
Equity financing: Selling ownership stakes (or stocks) in the company.
There are other funding methods that don't fit neatly into these categories, such as using personal savings, grants, and investments from family and friends. However, these options are usually one-off events and not sustainable.
Equity financing for most African SMEs is often not feasible due to several factors. It's expensive and strenuous. There's a limited number of venture capital and private equity investors in the market, and many investors seem more interested in tech-enabled businesses.
Regulatory requirements and infrastructural challenges make it inaccessible to the average SME, especially for initial public offerings (IPOs). This leaves debt financing as the more viable option—but is it really?
Debt financing involves borrowing money from a lender with the promise to repay the principal amount plus interest over a set period. While it sounds straightforward, there's a lot that goes into lending. Let's explore this further.
Lending from the Lender's Perspective
Before a lender can give a loan, they must evaluate the creditworthiness of the potential borrower. They do this by checking two main factors (World Bank, 2016):
Repayment capacity: The financial ability of the debtor to repay the loan according to the agreed terms. This is typically determined by considering the prospects of the SME's business and often the broader market segment in which the SME operates.
Repayment willingness: The willingness of the debtor to repay the loan. This is usually inferred based on the SME's historical repayment patterns in previous financial obligations, including trade credit, loans, and other forms of financing. Sometimes, payment performance in non-financial obligations (e.g., payment of taxes, utilities) is also considered.
For many lenders, repayment capacity can be evaluated based on the financial data available about their customers. However, evaluating repayment willingness is more challenging. The best indicator of repayment willingness is if someone has paid back a loan in the past, but you can't test this without giving them a loan first.
What makes lending in Africa even tougher and riskier is the lack of access to proper credit infrastructure. While Kenya and South Africa have more mature credit infrastructure, other countries still lag behind.
There are five key elements needed to make lending in Africa easier:
Better Credit Bureaus
Reliable Credit Scoring Models
Reliable National Identity Systems
Efficient Collection Systems
Strong Legal and Regulatory Frameworks, especially around Credit
The Role of Credit Bureaus:
A Credit Bureau is a company that tracks borrowing history. They collect information about credit accounts from lenders and other creditors, compiling it into a credit report. This report includes details like payment history, credit utilization, and any public records related to bankruptcies or judgments. Credit reporting agencies help lenders make informed decisions about loan approvals.
By assessing credit reports and scores, lenders can gauge a borrower's repayment capacity and willingness, which reduces risk. This is crucial, especially considering that repayment willingness is a major concern for lenders. Additionally, credit bureaus help borrowers track their credit history and score, allowing them to understand what type of credit they might qualify for.
While South Africa and Kenya have more mature credit bureaus, countries like Rwanda, Namibia, and Nigeria are working to catch up. However, they still face challenges with data accessibility, completeness, and credit scoring/rating.
Credit Scoring:
A major benefit of credit bureaus is that they provide data to help lenders better estimate a borrower's creditworthiness, often through a credit score or rating. For individual borrowers, it's usually a 3-digit number (typically between 300 and 850). For businesses, it can be either a 3-digit number or a letter grade (e.g., AAA, BBB-).
Your credit score is crucial because it determines how much lenders will be willing to lend you, at what interest rate, and for how long. If lenders believe the credit scores generated by available credit bureaus are incorrect, it can be problematic for borrowers. This is why many digital lenders create their own credit scoring systems.
Know-Your-Customer (KYC) Practices:
The challenge with digital lenders creating their own credit scoring systems is that it requires exceptionally strong Know-Your-Customer (KYC) practices. KYC is the process of verifying a customer's identity and understanding their financial activity. It's crucial in preventing fraud and money laundering.
Ideally, KYC would require a business to collect and verify a customer's name, date of birth, address, and national identification number. For lending, companies would ideally collect additional information about income, employment, and financial status. The same applies to small businesses.
However, KYC verification is expensive. Financial institutions have to pay for every piece of information verified, which adds up when done for multiple customers. A 2016 survey by Thomson Reuters reported that South African financial institutions spent an average of US $30 million on KYC processes yearly. More recently, it was reported that the Central Bank of Nigeria's new KYC regulations for fintechs could cost the industry upwards of $1 million.
There are ongoing debates about what constitutes the right KYC data to collect. Is social media information too intrusive? Should KYC be built on SIM card-based identification? KYC is a crucial but challenging aspect of the banking and lending industry.
Debt Collections and Regulatory Frameworks:
Debt collection is another critical aspect of lending. It's the structured process of retrieving overdue debts from the debtor. With the rise of digital lending in Africa, we've seen an increase in aggressive and unethical collection practices, where debt collectors intimidate and threaten debtors' families and friends to recover payments.
This highlights the need for strong legal and regulatory frameworks. The Central Bank of Kenya & Central Bank of Tanzania, for instance, has been proactive in creating laws and regulations that protect debtors from loan sharks and aggressive debt collectors. Nigeria, on the other hand, has been less proactive in this area.
Human beings have a natural tendency to seek their self-interest, which is why regulations are important. If a country wants to develop its credit infrastructure, investments must be made in laws that protect both lenders and debtors from taking advantage of each other.
The SME Credit Gap in Africa:
Now that we have some context about lending and credit infrastructure, let's return to the issue of SME financing in Africa. The SME funding gap in Africa is enormous and widening. In 2013, the African Development Bank (AfDB) estimated it at US $140 billion. By 2018, the International Finance Corporation (IFC) estimated it had grown to US $331 billion. If we project this growth rate, the gap could be around US $782 billion today. The bottom line is that this gap is huge and only getting bigger.
You might wonder, "Why don't banks just loan people the money?" The answer lies in everything we've discussed about lending from a lender's perspective. Assessing a borrower's creditworthiness is a significant challenge, and traditional banks are not in the business of giving away money.
Moreover, the high operational costs of processing these loans, including extensive credit evaluations and collateral assessments, make them unprofitable for traditional banks. This is why they often shy away from SME lending.
Small businesses are often seen as more unstable, informal, and harder to value. Consequently, traditional banks tend to have stringent collateral requirements for SME loans. This creates several issues. Collateral is usually a physical asset like landed property, but getting an accurate valuation can be very challenging in many African contexts.
As an African, you know that anything requiring legal or governmental administrative support can be a huge headache. There are issues around verifying ownership, as documents can be falsified in some African countries for the right price. If a borrower defaults, will the bank be able to sell the property and recover the remaining loan? These issues make collateral requirements for SMEs austere, ultimately hindering their ability to acquire loans from traditional banks.
This is why Microfinance Institutions (MFIs) have become so popular in the MSME community. MFIs provide financial services to low-income individuals or those who don't have access to typical banking services. They usually offer small loans (microloans), savings accounts, insurance, and other financial products to help people build or expand small businesses and manage their financial lives.
Their value proposition centres around supporting people who are underserved by traditional banks and services, and they've been able to do that successfully for micro businesses. In fact, the microfinance industry in Sub-Saharan Africa (SSA) has been growing rapidly at a rate of over 10% per annum (Chikalipah, 2017a).
Unfortunately, recent empirical studies have shown that most SMEs are no longer able to benefit from microfinance loans and schemes because they are considered "too large." Furthermore, in recent years, microfinance institutions have focused increasingly on commercialization and, inevitably, profitability.
This noted mission drift is significant because microfinance institutions originally started as not-for-profit organizations. Their original mission was to alleviate poverty, promote economic development, and empower marginalized communities. The shift towards profitability has raised concerns about the ethics of the services they provide, especially their loan services.
With this mission drift has also come a repackaging of their products. Microfinance institutions used to provide group lending services that allowed lenders to replace physical collateral with social collateral. Unfortunately, these services are beginning to be phased out, particularly due to the growing popularity of financial technology (fintech) services that allow people to access microfinance products via their mobile devices.
We've also seen a surge in the number of digital lending and fintech companies focused on increasing the accessibility of credit services to Africans, which they brand as financial inclusion. However, there’s a lot of debate about the viability of these services and whether they actually fulfill their promises.
Have digital lending platforms shifted the needle in any way? Have they contributed to decreasing the credit gap that exists for African SMEs? I've got plenty more to say on this, but I'll save it for Part 2. Stay tuned to get my take on these questions!
References:
Looks like we have a chicken (lack of MSMEs access to credits) and egg (poor Fin Infra to give MSMEs access to credits) problem in our hands. I am keen to read the follow up article on this to see what the most practical solutions look like.