Bank Financing to SMEs in East Africa

Feb 24, 2012
Small and medium enterprises (SMEs) play a major role in economic development in Africa. Studies indicate that SMEs contribute on average about three-quarters of total employment in manufacturing, when the informal sector is included. A number of factors affect the growth of African SMEs, including the business environment and the quality of the labour force. However, a crucial element in the development of the SME segment is access to finance, particularly to bank financing, given the relative importance of the banking sector across the continent.
African SMEs are more financially constrained than in any other developing region. Only 20 percent of SMEs in Sub-Saharan Africa have a line of credit from a financial institution compared, for example, with 44 percent in Latin America and Caribbean, and only 9 percent of their investments are funded by banks versus 23 percent in Eastern Europe and Central Asia. It is, therefore, not surprising that the international development community has listed access to finance for SMEs as an important policy priority for Africa.
In spite of the importance of the topic, relatively little research exists on SME financing from a supply-side perspective. This is compounded by the fact that comprehensive data on SME finance is still to be more consistently collected and monitored over time. Nonetheless, existing studies conducted in other developing economies show that, contrary to the conventional perception that financial institutions are not interested in dealing with SMEs, banks consider the SME segment as strategically important. Yet institutional constraints remain and the market is far from being saturated.
In a recent paper co-authored with Victor Chando and Sofiane Sekioua, we shed light on current trends and practices in bank financing of SMEs in four East African countries, namely Kenya, Tanzania, Uganda and Zambia. In particular, the paper forms part of a broader African Development Bank regional project on the topic, whose objective is to identify best practices in SME lending as well as constraints that impede growth in the SME finance market so as to draw relevant policy implications.
We find that the SME segment is a strategic priority for the banks in the region. SMEs are considered a profitable business prospect and provide an important opportunity for cross-selling. Banks consider that the SME lending market is large, not saturated and with a very positive outlook. A number of obstacles are, however, constraining further banks’ engagement with the SME segment, including SME-related factors such as the lack of adequate information and collateral as well as their largely family-owned structures. Macroeconomic factors, business regulation, the legal and contractual environment, the lack of a more proactive government attitude towards the segment, some areas of prudential regulation and some bank-specific factors are also perceived to negatively affect the SME lending market in East Africa. Nonetheless, banks have adapted to their environment and developed mechanisms to cope with it through innovation and differentiation. Most banks have dedicated units serving SMEs, to which they offer largely standardized products though the degree of personalization is growing. And albeit advanced transaction technologies based on scoring and risk-rating systems remain relatively underdeveloped, banks are gradually automating their risk management frameworks to achieve efficiency gains.
On the whole, our findings are broadly akin to those of similar studies in other geographical contexts, suggesting that banks in the region have enthusiastically embraced the SME segment and are making substantial investments to develop their relationship with SME clients. This holds good promise to contributing to close the “SME financing gap” which characterizes Sub-Saharan Africa, including East Africa, compared to other developing regions. It is, therefore, important that this trend is supported and encouraged by removing those institutional and policy obstacles that constrain SME lending.
A necessary condition for the sustainable growth of the SME lending market in East Africa is the presence of a stable macroeconomic environment and a predictable policy regime. The findings of the paper suggest that banks in the region are pursuing the SME segment because of its attractiveness, despite important constraints. In order to ensure that this trend continues uninterrupted, strong macroeconomic performance and a stable and consistent fiscal and monetary framework have been identified as important considerations. It is also important that countries in the region continue their efforts to modernize their financial systems, including the prudential regulatory framework, enhancing competition and innovation so as to give rise to alternative financing providers and financial solutions to better serve the SME segment.
Reforming the legal and regulatory environment might contribute to increase banks’ involvement with SMEs. A first area of intervention might be the legal framework for creditor rights and for secured lending. Efficiency of the courts and issues surrounding the definition of collateral have been listed as important constraints to the development of the SME lending market. Targeted interventions on the relevant legislation might contribute to speed up enforcement procedures and improve the efficiency of the judiciary. For SMEs, what constitutes acceptable collateral is also an important issue. Reforming the legal framework for secured lending and reviewing the regulatory treatment of collateral would facilitate SMEs to pledge a wider share of their assets as a guarantee for their borrowings. Finally, governments might explore the possibility of introducing a simplified company registration process, which takes into consideration the peculiarities of SMEs compared to larger companies.
There is also room for optimizing the role of the governments in the region. Current government programs in the SME space are perceived as generally insufficient in supporting the growth of the market. This might be due to the lack of consistency. Governments might therefore consider introducing a dedicated and organic SME policy to boost this segment. A first start should be the adoption of a uniform definition of SME. Most of the banks in East Africa use loan size and turnover as criteria to define SMEs. The adoption of such criteria and their formalization into relevant legislation might ease the attainment of policy objectives. A second area of intervention might include an optimization of current financing support mechanisms, including national and regional development finance institutions, by focusing on additionality and on developing new instruments. In this respect, an assessment of their mandate and their development effectiveness would help fine tune a policy review in this area.
Finally, a better understanding of the SME segment and the implementation of measures aimed at addressing some of their intrinsic weaknesses should be a further policy priority. Given the crucial importance attributed by banks to SME-specific constraints, priority might be given for example to the collection of statistics and data on their characteristics in order to better understand the demand-side perspective, which is equally important in the development of the SME lending market. Measures in this domain might include the scaling up of capacity building programs and the introduction of incentives for SMEs to formalize.

Pietro Calice is a Principal Investment Officer within the Private Sector Department, Financial Institutions Division, at the African Development Bank (AfDB). In his capacity, Pietro focuses on financial stability and financial inclusion, with a particular emphasis on the intersection between the two dimensions. He covers the financial sector through an appropriate mix of knowledge development and dissemination, selected transactions and policy dialogue. In particular, he has written expensively on the Basel capital accord and its effects on developing economies as well as on access to finance for SMEs. He has designed and implemented innovative financial inclusion initiatives, including the African Guarantee Fund for SMEs. Prior to joining the AfDB, Pietro worked at ratingagencies and investment banks as a credit research analyst.

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