Written by James Makau
February 27, 2008: The destruction of small businesses in last month’s post- election violence has exposed the soft underbelly of micro finance institutions’ lending strategies, highlighting the need for improved credit risk assessment.
Small businesses, which give a lifeline to many Kenyans outside formal employment, have been the hardest hit with the knock on effect hitting the principal lenders.
Micro-finance institutions loan books are likely to face severe tests in the coming months as the reality of huge defaults and massive write-offs sinks.
“The concentration of lending in most MFIs loan books to specific sectors and locations has exposed them to the possibility of massive write downs,” says Mr Ken Kaniu, the investment analyst at Stanbic Investment Management Services.
MFIs revealed last month that they may have lost between Sh3.75 billion and Sh10 billion, or 15 to 40 per cent of the value of loan repayments estimated at Sh25 billion which have become doubtful.
The exposure is further fuelled by the fact that most MFIs lend locally and some had taken the deeds of physical business premises and land as collateral.
“Focus must shift from collateral-based lending to looking at the viability of the business and the character of the entrepreneur,” says Mr Sam Omukoko, the managing director of Metropol East Africa Ltd.
He says the rating of Small and Medium Enterprises (SMEs) based on parameters such as the character of the borrower and the viability of the business would allow the creation of credit insurance policies, which would move to hedge lenders from credit risk defaults.
“SMEs will be able to access cash not on the collateral they have but on their ability to run a business well enough to meet their obligations.
MFIs are then able to lend to small businesses with the assurance they will get their money in case of any eventuality,” says Mr Omukoko.
A similar model can be drawn from an export credit insurance partnership between the African Trade Insurance Agency (ATI) and NIC Bank in 2005. The facility offered by NIC Bank to ATI was aimed at protecting against financial risk and had the significant advantage in that the agency was no longer required to provide any additional securities such as land or property.
This freed up exporters borrowing capacity allowing them to grow their business.
Unlike banks, MFI’s are not deposit-takers, which limits their capacity to use interest rates to cushion themselves. Since banks are both deposit-takers and lenders, they can choose to raise the interest rates on lending, while lowering interest on deposits.
Although lending institutions have tried to employ the Know Your Customer (KYC) concept prior to lending, they still lack enough information on potential borrowers, limiting their ability to assess default risk.
Rather than focus on the SMEs as a whole, an SME credit tool formulated by Metropol East Africa late last year will score the credit risk of the principals or owners of a start up. “An SME start up is owner-driven. So vetting the person who holds the cheque book rather than the SME itself, gives a more accurate picture of the credit risk,” says Mr Omukoko.
Available statistics estimate that less than five per cent of SMs startups in the country have access to credit.
Largely linked to the low penetration of banking services in the country, lending to startups and individuals has also been slowed down by the tedious processes of sifting through loan applications and the lack of data for lenders to vet potential borrowers.
The high mortality rate of SMEs — estimated at three years — and the high transaction costs involved in lending to startups have also played a part in the failure of banks to lend to this segment.