ImpactAlpha, October 29 – The clunky term “non-bank financial intermediaries” identifies a varied group of lenders only by what they are not.
These alternative debt funds, fintech firms, supply chain finance, lease finance and other financial intermediaries are united, though, by their shared opportunity to fill a capital gap for business in their crucial early stages, particularly in emerging markets.
Non-bank financial intermediaries may not yet have the scale that banks do, but the COVID crisis is providing an opening for them to capture a growing segment of the small business lending market – especially if banks keep their lending practices static in the face of highly dynamic conditions.
Micro, small and medium-sized enterprises, or MSMEs, contribute up to 60% of employment and 40% of GDP in many emerging economies. Regulated banks have struggled, and continue to struggle, in providing appropriate financing to such businesses. The annual financing gap for these enterprises is an estimated $330 billion across Africa, and up to $20 billion in South Africa alone.
A cohort of non-bank lenders have already developed a track record providing the types of flexible, affordable, longer-term financing that small businesses need, often pairing financing with supportive technical assistance.
What can non-bank lenders teach us about filling this gap through the COVID recovery and beyond?
Banks’ reluctance to lend
First, the problem: Banks should be frontline lenders to MSMEs in the COVID crisis and recovery. They are one of the key financing vehicles available to address the liquidity crisis that is enveloping small business. Yet systemic issues that have long hampered their ability to close the funding gap for early-stage, small and growing businesses are constraining their current efforts to support MSME business solvency.
Banks are really good at lending to established businesses that can provide tangible collateral. But what early-stage and small businesses require is flexible credit, as documented by the Collaborative for Frontier Finance’s recent survey of capital providers to MSMEs.
Multilateral banks, development financial institutions and philanthropies have all attempted to address emerging markets’ small business liquidity crisis through tools like credit guarantees. Credit guarantees aim to encourage banks to lend to businesses they perceive as “too risky” with capital to cover all or a portion of the bank’s loan if a borrower defaults. According to the World Bank, by the end of May, public credit guarantee schemes amounted to about $1.8 trillion, or 2% of global GDP, with over 50 countries setting up bank guarantee schemes.
Evidence suggests that these schemes do have an effect on lending behavior by assisting creditworthy MSMEs without adequate collateral to obtain a loan at a reasonable interest rate. Yet recent research suggests that banks’ uptake of guarantee schemes has been halting and limited.
Take, for example, the South African loan guarantee scheme that came into effect after the country went into COVID lockdown. Two-hundred billion South African rand (roughly $12 billion) was allocated for the scheme; only 16 billion , or 8%, has been drawn down. This is alarming considering that the scheme makes up 40% of South Africa’s 500 billion rand economic response package, forecast to stimulate the economy by roughly 5%. If it is not used, South Africa’s GDP is predicted to drop by 15% or more because of the pandemic’s economic impacts, instead of an estimated 10% if the scheme were fully deployed.
South Africa’s National Treasury made revisions to the scheme on July 26 because of the slow utilization rate, which increased banks’ discretion on credit assessments, extended loan period and repayment holiday, and now also includes sole proprietors. The effect of these changes has been minimal.
Similarly, in Zambia, the Bank of Zambia announced in April a 10-billion-kwacha ($500 million) Targeted Medium-Term Refinancing Facility to support MSMEs affected by COVID. The facility allows commercial banks and non-bank financial institutions to access funds from the Bank of Zambia for on-lending to businesses and households. Financial service providers that are licensed and supervised by the Bank of Zambia are eligible to participate, though these are principally local commercial banks. As of September, however, the facility has only made financing available to eight manufacturing companies.
There are other examples across the continent:
- In Kenya, the government’s $50 million MSME Credit Guarantee Scheme, issued under the 2020 budget, looks to provide a 20% credit guarantee to participating banks to support MSMEs with increased access to credit. Thirty-percent is meant to be allocated to women, youth and disabled-owned businesses. Though the government would share in banks’ non-performing loans, banks still take 80% of the loss.
- In Ghana, a $100 million Coronavirus Alleviation Programme business support scheme was intended to support MSMEs negatively impacted by the pandemic. To date, Ghana’s program is only disbursing amounts of around $1,000, which is highly insufficient to meet the need of enterprises.
- In Senegal, even with the support of the government program, local banks are not re-extending existing bank lines.
Why are these guarantee schemes falling short of their intended impact on MSME financing? Because the schemes’ constructs call for banks to apply the same risk and transaction structures that they would have applied pre-COVID—modelling that is no longer relevant in the current MSME economic environment.
Recently, Shell Foundation supported a study and assessment of how non-bank financial intermediaries are operating in South Africa and across the continent. The study provides an informative framework to alternative approaches that address the urgent funding needs of MSMEs, and offers a template for longer-term solutions.
Non-bank lending solutions
In contrast to traditional banks, non-bank MSME lender platforms are often better situated to provide MSME financing in a number of ways, depending on their specific investment theses, operational models and portfolio development.
First, many non-bank financial intermediaries are situated in the communities they serve, which gives them first-hand knowledge of pipeline opportunities, entrepreneur capacity constraints and a realistic view of economic shocks’ effects on. For example, Phakamani Impact Capital is highly decentralized, placing key staff in regional hubs located in the mining towns they serve. These individuals support local MSMEs through the provision of capital and through centralised sourcing and business development courses.
Second, small-business-focused fund managers have demonstrated that they understand and can manage the perceived versus actual risks of early-stage investment. Many have built systems to be able to provide affordable capital to MSMEs despite these risks, which increases the chances of business survival.
Some have been able to develop this track record by attracting low-cost corporate investment, such as commitments South African corporations make to small business lenders and financial intermediaries under the Broad-based Black Economic Empowerment legislation, which is designed to redistribute wealth post-apartheid. Nevertheless, default rates are often sufficiently low to warrant further blended and commercial investment.
Inyosi Empowerment Fund, for example, has found that if loans extended to entrepreneurs are reasonably priced, those businesses will be better able repay interest and principle. Thus, offering businesses loans at tailored, affordable rates is one of the keys to their survival and growth.
Third, non-bank MSME lenders and fund managers have the flexibility to tailor financial instruments to support businesses’ working and growth capital needs. Such instruments include term loans, revolving working capital facilities, or one of a growing number of hybrid tools, including preference shares and revenue-based financing. The balance between standard and bespoke approaches are determined by the fund manager, based on a business’s distinct need and are optimised to reduce cost.
For example, ASISA Enterprise Supplier and Development Fund uses hybrid investment terms to capture upside while delaying equity valuations in a growing percentage of high growth deals that come across their desk. In some cases, these deals are supported through the use of performance covenants related to liquidity, and partial credit guarantees.
Finally, non-bank financial intermediaries are often more tech savvy than traditional lending institutions. Rapid digitization of back and middle office functions create efficiencies in loan administration; an exponential increase in the availability of digital data enables alternative underwriting methodologies.
For example, Lulalend leverages technology and a proprietary algorithm to evaluate applicants using electronic data, decisions are largely automated, and funding can be supplied within 24 hours. It does this by analyzing a potential borrower’s cash flows through point-of sale merchant account transactions, online market payment data, mobile wallet transactions, digitized supply chain data and tax invoices. This saves significant time and costs compared to manually underwriting loans based on financial statements.
Strengthening the MSME lending environment
Non-bank lenders, funds and financial intermediaries do not yet have the scale that banks do. But if banks are going to continue to lend according to current practice, then a new lending segment needs to be developed to fill the lifecycle funding gap in for early-stage and MSME businesses. In South Africa alone, roughly 33,000 businesses do not meet the lending requirements of the country’s COVID bank guarantee scheme. Non-bank lenders are therefore crucial to increasing access to business finance for MSMES in emerging market economies, today and long-term.
We offer five recommendations for circumventing existing systemic constraints to MSME lending and accelerating the capacity of non-bank financial intermediaries, which is urgently needed to alleviate the impacts of the COVID crisis.
1. Reallocate government credit enhancements. If bank guarantee programs continue to languish in government bank accounts, then a portion could be reallocated for distribution through functional non-bank institutions. In South Africa, wholesale investors such as DBSA, IDC and PIC have systems to distribute capital and support to non-bank lenders for rapid deployment to MSMEs.
The Project Development Partnership Fund, for example, has recently undertaken due diligence on a cohort of early stage funds with a focus on job creation, inclusive growth and transformation alongside financial viability. This cohort is likely to include not only venture capital funds supporting high growth, predominantly tech-focussed enterprises, but also funds supporting bread-and-butter industries.
Across sub-Saharan Africa, there is an emerging class of non-bank MSME lenders who are similarly positioned to leverage government guarantee programs and help meet the capital needs of small businesses. Nairobi-based Lendable, for example, provides competitive pricing and flexible structuring for businesses, enabling them to monetize their accounts receivables, which frees up their balance so they can re-allocate resources to continue to grow.
2. Expand banks’ data applications. Banks can replicate fintech companies’ tools and expertise to supplant traditional credit assessments with more advanced methodologies and speed up loan deployment processes. The availability of real-time data would also allow banks with better systems to tune their lending algorithms to optimize lending practices in ways that increase their risk appetite while protecting taxpayers’ money (in the case of government guarantee schemes.)
3. Reallocate funds from Emergency Relief Programs to non-bank financial institutions. In response to COVID, both governments and philanthropies have established emergency financing funds to support MSME businesses during the crisis. At the moment, these capital pools principally work through regulated banks to deploy the funds to small businesses. South Africa-based Sukuma Relief Programme is an example of how these funds could also leverage the capabilities of non-bank lenders. Sukuma has extended loans of up to 1 million rand, paired with non-repayable grants of 25,000 rand and repayment holidays. This fund has close ties with Business Partners, who have a strong track record of providing small ticket asset-based finance to support MSMEs. These capabilities could be harnessed to distribute unspent emergency funding.
Similarly, in Zambia, the government is considering a pilot within its Targeted Medium-Term Refinancing Facility that would enable non-bank financial intermediaries to participate alongside banks. The government is looking to partner with intermediaries supporting the agriculture sector in particular, since many Zambians depend on agriculture for their livelihoods.
4. Challenge MSME risk perception. A major challenge for MSME owners in securing financing is the perceived risk associated with their business. This risk perception is the reason most African banks seek collateral or charge exorbitant rates on MSME loans, if they loan to MSMEs at all. Financial intermediaries like Teranga Capital in Senegal, iungo capital in Uganda and XSML in the Democratic Republic of the Congo are debunking long-held risk assumptions and are succeeding at offering capital to businesses banks have rejected or ignored.
Governments would benefit to support such financiers, because by working with these MSME lenders, governments could test (and confirm) the viability of alternative MSME financing theses and portfolio management approaches in order to expand capital to the types of businesses driving their local economies and job creation. Governments could also help non-bank lenders grow their pipelines by asking banks to share information on businesses that did not meet banks’ lending requirements.
5. Support an increase in available wholesale capital for non-banks. Across sub-Saharan Africa, there are opportunities to tap local pension funds and other sources of domestic institutional capital to support MSME financing. For example, in South Africa, corporations could increase concessionary capital allocations under the Broad-based Black Economic Empowerment rules into high-performing non-bank MSME lenders. Impact Investing South Africa and Tshikululu Social Investments are currently developing an institutional capital program through development of de-risked local financial intermediary vehicles.
These are just a sampling of the alternative pathways to expand much-needed capital for MSMEs across Africa. COVID has put a bright spotlight on the scale of the MSME financing problem in Africa, exposing a persistent systemic challenge for both businesses and local economies that rely on entrepreneurs for prosperity and jobs.
For more information on this article, see work undertaken by Susan de Witt of the University of Cape Town’s Bertha Centre and Drew von Glahn of the Collaborative for Frontier Finance, with support from Shell Foundation.