Section 2:
Recent Lessons from international Best Practice in Small Enterprise Finance


• 2.1 CHANGING PARADIGMS OF DEVELOPMENT FINANCE
• 2.2 Principles of Successful Small Enterprise Finance Institutions

Section 2:
Recent Lessons from international Best Practice in Small Enterprise Finance

In order to assess Namibia’s financial services to small enterprises, we need to understand the international discussion on this subject. In recent years a major shift in thinking about financing small enterprises in developing countries has taken place, based on accumulated experience in many countries. There are common strands in this thinking and major lessons have been learned. These lessons provide the background for our evaluation of the credit system in Namibia. We can evaluate the current system of credit provision to small enterprises in this country by comparing it with the "best practice" in other countries.

This short section of the booklet summarises this theoretical background. The bibliography at the end of the booklet provides references for further reading, and includes documentation containing very practical advice which service providers can use in a "hands-on" manner – making use of the relevant findings and lessons. The first subsection below summarises the evolution of approaches to finance in development in general, which has implications for the thinking on financing small enterprises. This summary is followed by a discussion of the principles underlying successful small enterprise finance.

2.1 CHANGING PARADIGMS OF DEVELOPMENT FINANCE

The dominant thinking about the importance and role of finance in development has changed significantly over the last 40 years (Krahnen & Schmidt, 1994). Broadly speaking we can distinguish four phases in the mainstream thinking, each of which emphasises different elements.

At the birth time of development economics in the 1950s, development was equated with growth, which in turn was largely regarded as a process of capital accumu-lation. According to this model, growth of capital is seen as the result of saving, that is, of foregone consumption out of current income. Poverty perpetuates itself because incomes are too low to enable saving, which would be necessary to invest and increase income. Development capital comes in to close the savings gap. Although there is obviously some merit to this view, it is certainly much too narrow and simplistic: a number of other factors determine the success of development interventions of this sort; such capital is not a simple function of the amount of savings. Furthermore, this view emphasises finance in the sense of capital and ignores the crucial aspect of the financial system. It simply assumes the existence of proper mechanisms that transform savings into investment capital. This is an improper assumption in developing countries especially. In fact, it is reasonable to suggest that an "institution gap" is one of the key features these countries have in common.

This mechanistic view of development was questioned in the 1970s. It was realised that the infusion of foreign capital into large development projects had seldom resulted in a significant growth and "trickle down" of positive effects into the traditional economy. Instead, dualism, poverty, unemployment and rural-urban migration were enforced. As a result, economists shifted their attention from the economy in its entirety to target groups, aiming at poverty alleviation, employment creation and income generation rather than growth. However, the basic perception of "finance" remained the same: provision of capital to those who would be able to use it optimally. Credit was perceived as the critical bottleneck to the development of small-scale farmers and small business. Because existing banks were found to be unwilling as well as unsuited for use as institutions for channeling credit to disadvantaged groups, specialised development banks were set up. These provided generally subsidised credit and did not operate on a commercial basis. Efficiency and effectiveness were not high on their agenda, due to the conviction that their target groups were too poor and too risky for these criteria to be applied.

The failure of this subsidised target-group credit provision led to a process of rethinking on finance. The third view strongly attacks the financial repression on which the two preceding views are based. The third view instead emphasises the strategy of liberalising and strengthening the financial system, such emphasis being based on the premise that a functioning financial system which is not constrained by unnecessary regulation will be able to mobilise large volumes of savings, to transform these savings into investible funds, and to allocate these funds to socially valuable projects. Emphasising the importance of the quantity and quality of financial inter-mediation for development and its determination by economic policy, a policy of drastic deregulation was recommended. It was demonstrated that on the one hand, low interest rates made people save less, which led to less rather than more investment as hoped for, and on the other hand, the subsidisation of capital made borrowing attractive also for projects which had not been profitable at market interest rates. Credits had to be rationed, and were frequently allocated according to non-economic criteria, leading to a lower average productivity rate. It was largely those with the best political connections who benefited, rather than those most in need. Thus, the quality of investment was also negatively affected. Furthermore, it was not only savings, investment, growth and distribution that were negatively affected, but also the financial institutions themselves.

The micro-economic implications of this third view are as follows:

• There is a demand, not just a need, for financial services among the poor.
• People do not need subsidised credit, but rather access to fairly priced credit. In other words, their problem is gaining access to credit, rather than the cost of credit.
• The demand for deposit facilities with low transaction costs is even higher than that for credit, and for this reason an appropriate savings mobilisation system can mobilise sufficient savings to cover local investment needs.
• Banks which have to mobilise their own savings will do their best to ensure proper lending practice.
• If a favourable legal and economic environment exists, a proper financial intermediary targeted at the majority of the population is feasible.

This view can be regarded as basically correct. However, the empirical evidence supporting this radical view on liberalisation is as yet limited. There is also not enough theoretical underpinning for this view. The implicit model on which the view of radical liberalisation is based looks at financial institutions as monolithic, profit-maximizing firms. Furthermore, financial markets are seen as functioning in the same way as any other markets. These two assumptions, however, are too crude.

The fourth view on the role of finance in development is based on recent insights into the theory of organisation, finance and markets, known as "new theoretical institutionalism". This view emphasises the idea that economic development is more dependent on "good institutions" than on anything else. It rejects the claim of the third view that a financial system which is not repressed functions optimally by itself. Rather, the issue is how institutions function, based on the information they have and the incentives to which its agents are subject. Information is not available at no cost and neither is it evenly distributed, as is implicitly assumed by the third view. Thus, an intervention should aim at improving the way that institutions function, and at improving the incentive system. The basis for such aims should be an analysis of the current functioning of the market as well as the institutions.

The table on the following page summarises the four views discussed above.

2.2 Principles of Successful Small Enterprise Finance Institutions

Any thinking on SME finance should commence with a reflection on why such consideration is necessary, or in other words, why SMEs experience problems in gaining access to credit from the formal banking system.


TABLE 2:
CHANGING PERCEPTIONS OF THE ROLE OF FINANCE IN DEVELOPMENT AND THEIR IMPLICATIONS

The following elements are relevant (Levitsky, 1993: 6-7):

• SME lending is perceived as risky.
• This perception has a real basis, as the mortality rate of SMEs is in fact high.
• There is also a reluctance on the part of SMEs to borrow from formal banks due to administrative and costly formalities.
• Banks maintain an institutional bias towards lending to the large corporate sector due to close links.
• The administrative costs of SME lending are high.
• SMEs are either unable or unwilling to present the full accounting records demanded by banks.
• SMEs are usually unable to provide collateral and security.

These are real and not just perceived obstacles, which have to be taken into account in designing programmes to provide financial services to SMEs.

The general evolution of our understanding of the role of finance in development has had profound implications for the practice of providing finance for small enterprises. The most recent approach to small- and micro-enterprise financing is based on the fourth view described in the previous subsection. However, most existing finance programmes are still based on the second view, or otherwise they are undergoing the process of evolving towards the new view and practice. This is especially true for African countries (World Bank, 1997).

The traditional practice of small enterprise finance:

• operated with a high rate of subsidy;
• made high losses due to low repayment rates;
• reached only a few; and
• as a rule, reached neither those most in need nor those who would make the most economical use of it.

By contrast, successful programmes (Christen et al., 1994; Rhyne & Otero, 1994) following the new approach:

• reach out to a large number of clients;
• reach especially the very small or micro enterprises which have no access to formal banks;
• are financially viable, i.e. they operate at a level of profitability that allows for sustained service delivery with minimal dependence on donor funds;
• are in many (but not all) cases fully self-sufficient, i.e. they generate positive returns on capital;
• depend largely on the local financial market;
• provide savings mobilisation services;
• adopt a market perspective in considering the preferences of the client group;
• specialise in providing only financial services;
• focus on measures to increase access to financial services, rather than on their "impact" on measurable enterprise growth;
• use innovative techniques to slash administrative costs as well as to motivate repayment (e.g. group guarantees, pressure from social networks, promising repeat loans in increasing amounts, savings requirements).

As mentioned above, some programmes manage to become fully profitable, but the debate continues as to whether this is feasible for most institutions. When it comes to micro enterprises and rural areas in particular, there are limits to full profitability. Institutional performance can be analysed in terms of four levels of self-sufficiency which institutions can attain (Rhyne & Otero, 1994). The lowest level pertains to traditional, highly subsidised programmes. Grants or soft loans cover operating expenses and establish a revolving loan fund, but the fund erodes through delinquency and inflation. There is a continuous need for grants.

At the second level programmes raise funds by borrowing on terms near, but still below, the market rate. Interest income covers the cost of funds and part of the operating cost, but grants are still needed.

At level three most subsidising is eliminated, but a dependence on some subsidy persists. The programmes operating at this level are generally not required to move further, as donors are satisfied with such a degree of performance. The Grameen Bank programme is perhaps the most prominent example in this category.

At the fourth and final level, programmes are self-sufficient, that is, they are fully financed from the savings of their clients and from funds raised at commercial rates from formal financial institutions. Fees and interest cover the real cost of funds, including loan loss reserves (for many, programme losses amount to less than 3% of principal).

While the fourth level is of course the most desirable to attain, programmes should be judged less by their current level of operation than by the progress they are making towards a higher performance level. In Namibia, the experience on this count is very encouraging. During the field work for the first study in 1995, it was found that the "new approach" to finance service provision, which emphasises sustainability and outreach, was largely unknown to Namibian service providers and met with a lot of skepticism. By contrast, just over two years later, these concepts had become widely accepted and institutions are now on their way to restructuring their operations accordingly.

Providing increases in finance to small and micro enterprises can be effected within different institutional structures. Three promising avenues have been identified (Rhyne & Otero, 1994):

• Linking non-governmental programmes to sources of finance (especially relevant when there are obstacles to finance through deposits).
• Transforming programmes into specialised financial institutions.
• Specialised operations within financial institutions.

The importance of including savings elements in the financial services package is increasingly being recognised. This can be done either through a joint credit and savings scheme in which a loan is conditional upon savings, or through separate savings and credit schemes, each with its own clients. The importance of savings lies in the following areas:

• There is a demand for savings facilities not only among SME entrepreneurs, but among the population at large. Contrary to popular belief, the poor also save. Because the demand for savings facilities is not met, savings are held in non-financial forms (e.g. cattle, precious metals), and this is sub-optimal from the point of view of both the savers and the national economy.
• Where credit is linked to a savings requirement, there is a greater commit-ment to using the credit for income generation.
• The savings linkage also diminishes the inclination to invest the borrowed resources in risky business ventures.
• There is evidence of a direct relationship between savings and higher loan repayments.
• Savings render financial institutions independent and require the discipline that only voluntary deposits can provide (additional information on potential borrowers, relationships that bind intermediary and client, the borrowers’ knowledge that loans come from neighbours’ savings rather than anonymous institutions).

One insight of the "new view" on SME finance is that financial services should be separated from non-financial services. If both kinds of services are provided by the same institution, it is not advisable that the same personnel who advise the entrepreneurs decide on the credit to be provided. Service providers following the "minimalist approach" – they do not provide any other service and do not concern themselves about the use of the credit provided – are very successful. However, this approach does not point to an absence of need for non-financial services. On the contrary, it is increasingly recognised that the financial constraint of a borrower must not be seen and addressed in isolation (see Finance Policy). Although few entrepreneurs would reject the offer of financial assistance, their perceived need for credit often emanates from deeper problems, and often masks other problems, or otherwise it relates to other issues. For example, entrepreneurs may not approach financial institutions because they are not informed about the services offered, or an application for credit is rejected because the institution does not have enough information about the entrepreneur and business, or the entrepreneur does not keep records due to a limited ability to present the necessary data. Also, although one may discern a solution to every problem in accessing capital, this may not be a sustainable solution. For example, there may not be enough demand for the entrepreneur’s products or services because of limited purchasing power, or the business idea may not be feasible for other reasons. In such cases the solution to the entrepreneur’s problems does not lie in the provision of finance but in other areas, or in a combination of finance and one or more other areas. For financial assistance to make sense, it has to be ensured that appropriate use can be made of the capital through the provision of other services, such as training and business advice.