Opinion: An innovative way to loan to underserved clients

Africa has the fastest number of growing retail banks globally. The continent yields nearly twice the return on equity compared to other developed markets. The sector is primed for growth and expected to achieve an 8.5 percent growth rate for retail and wholesale products by 2022, 13 percent of which is expected to come from the mass-market segment, which is currently the fastest growing segment regionally.

Despite this growth rate and potential, only 32.8 percent of Africa’s population uses financial products and services, and over 800 million Africans remain unbanked. The African Development Bank states that 80 percent of the population does not use formal or semi-formal financial services and half of them are living on less than $2 a day.

Most banks worry about lending to populations experiencing poverty, citing high credit default risk, unpredictable income flows, limited collateral, and high cost-to-serve as the main reasons for not targeting most of Africa’s population.

While most banks shy away from the people belonging to the so-called “bottom of the pyramid,” some have started developing innovations in products and distribution models to profitably serve these segments.

One product innovation is deploying “closed lending cycles” to overcome high transaction costs and the need for granular distribution models to serve a large number of relatively small customers. In this model, first-time credit clients give banks permission to internally reconcile their loan repayments regularly, based on a specific declared income stream received over the loan term.

This model has been explored mostly with smallholder farmers, who account for nearly 70 percent of Africa’s population and represent the largest productive sector accounting for employment of Africa’s low-income population.

Financial service providers in the agriculture sector are recognizing the powerful role agribusinesses can play at the end of the value chain as guarantors of revenue for banks, when they lend to rural smallholder farmers. Closed lending structures are effective in safeguarding banks against the inability of farmers to pay back their loans. They can also be used for alternative expenditures that do not increase farmer productivity. For the bank, this model lowers transaction costs.

In such arrangements, a bank agrees to offer an asset loan as input credit or asset financing to a smallholder farmer. A preplanting contract will serve as proof of access to a market channel for their produce. At harvest, farmers sell their crops to the off-taker, who pays them through the bank’s payment channel. The outstanding bank loan is settled internally, with the remaining cash sale revenue sent to the farmer’s account.

While closed lending cycles are effective in streamlining operational inefficiencies of accessing or lending to the bottom of the pyramid, they are limited in their ability to mitigate the underlying credit risk. By relying on agribusinesses to market their bank products to smallholder farmers, the need for debt recovery reduces. The need for collateral, however, is unavoidable. Smallholder farmers typically access products based on trust.

Service providers are even going further by establishing corporate relationships with these off-takers, so they can cross-sell other products and bank the whole value chain. This enables them to offset the initial high cost-to-serve for first time mass-market clients with additional products and services.

Banks tend to negotiate discounted input prices for farmers, which is a strong incentive for them to take out loans, as long as the value of the discount is not eroded by interest repayments on the loan — banks must be careful to not overpromise and underdeliver to this segment.

In 2016, the World Food Programme developed a digital product called Patient Procurement Platform, a first attempt at a closed lending cycle. WFP provided access to market and financial services for smallholder farmers in Rwanda, Tanzania, and Zambia.

Farmers on PPP received access to input credit from a consortium of banks, including the International Finance Corporation. This is paid back by off-takers on the platform and reconciled internally by the banks before farmers get their sales profits.

The off-takers pay the bank for yields delivered and the bank would internally reconcile the groups’ input finance loans and transfer the remaining amount into the unions’ account for disbursement. Such arrangements do lower the overheads of assessing individual customers for banks, however, banks should target structured value chains with regular payments to offset the increased risk of group lending.

Most banks will only have the client’s transaction history at the bank to understand the customer’s behavior and credit risk. At the same time, they need to adjust their payment terms to allow for the irregular flows of capital for this market segment.

Banks will need to carefully manage risks, such as side-selling of harvest. Widespread side-selling could break down the entire system. There is also a need to hedge for macro-level risks, such as changing weather patterns that can affect crop yields. Bundling loans with some form of insurance product can cover the customer in case their asset cannot yield the required returns.  

Closed lending provides a unique opportunity to bring innovative financial products to developing markets. They are effective in lowering transaction costs and improving customer loyalty.

Banks, most likely, already have access to the right type of downstream corporate clients to effectively build such lending cycles in the energy sector and agrisector. And while this is not a silver bullet, this may be the next big break for a cost-effective and more reliable way to lend to the 2 billion at the bottom of the pyramid.