#79 - Why Scaling Mid-Market Commercial Lending is so Hard in Africa

The role of collateral gridlock in gumming up commercial lending and why it's a massive brake on growth for SME focused Fintechs

Illustrated by Mary Mogoi

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Introduction

Recently the Central Bank of Kenya lowered their base rate, the Central Bank Rate (CBR) to 10% from 10.75%, this marked a continuation of a steady decline in the CBR from a high of 13% mid last year. As always happens, borrowers started complaining that the Central Bank Rate keeps decreasing while the rate at which they borrow from banks barely moves. To be fair, a number of banks reduced their base rates. Nonetheless, this is a regular occurrence in Kenya’s financial system. Banks often respond by arguing about how it takes long for their deposit rates to go down and they can only reduce rates for borrowers once they have lowered the rates on their deposits. In effect, they simply ignore the Central Bank and move on with their lives as if nothing happened. In response, Members of Parliament often summon the Central Bank Governor to grill him about why rates remain stubbornly high despite the Central Bank Rate cuts. In turn, the Central Bank Governor always summons bankers to read the riot act. This time round, the big idea is called “Risk-Based Pricing”. In essence, banks should build models that enable them to clearly map out their clients from a risk perspective and in-turn give rates that are commensurate with the level of risk. The CBK governor wants banks to implement risk-based pricing so that borrowing rates can go lower. This is the idea that banks build models so that they can offer tailored interest rates based on a client's risk profile.

Unfortunately, it’s a lot of smoke and mirrors. If you ask 10 people what Risk-Based Pricing is in the context of Kenya specifically but largely across the continent, you will get 100 different answers. This people to answer ratio is usually a great BS detector specifically if it's not something new. It’s ok to get 10 answers per question if you were asking about Bitcoin in 2011 but not for something that is meant to be well-known. There’s a deeper issue at play that the Central Bank should pay more attention to.

In my former iteration as an economist, I wrote extensively about this issue. In fact, my Masters Dissertation was about monetary policy transmission mechanisms i.e. how do changes in the Central Bank Rate affect the rate borrowers get when taking a loan. Back then I used to make academic arguments about how the Central Bank should make tweaks to how it communicates its rates or which specific rate to target when trying to affect rates in the market. Many years later, I realised why I got jaded with the entire field of economics and left it completely. Years of economic modelling made me realise the textbook channel fails because the market itself is structurally uncompetitive, a fact I later witnessed first‑hand in banking.

Working in the real world of banking and fintech has shown me that fundamentally, the reason why rate changes by the Central Bank are not quickly transmitted into the real economy is down to broken credit markets. Most African countries don’t have competitive credit markets in the sense that borrowers don’t have real choices when it comes to accessing credit and in fact most are stuck with their existing lender. When rates change, there’s simply no incentivising mechanism that would make banks want to reduce their rates quickly.

I stopped being an economist and moved on to the real world. The key insight was that in Africa, there’s no Ceteris Paribus. In fact, as Keynes said, in the long-run we’re all dead. As economists would call them, the economy is filled with endogenous (internal) and exogenous (external) shocks.

Going back to the issue of credit markets in Africa. The lack of competitiveness and thus a failure to transmit monetary policy is an issue that happens in most countries across the continent. Apart from South Africa, studies consistently show this disconnect between policy rates and the rates at which borrowers can access loans.

There are a few culprits; one is open-data which should enable easier information sharing. However, I always argue that data doesn’t necessarily need to be open for it to help you. I own my data as a bank customer, I can download my statements whenever I want and share them with whoever I want. Open data makes things easier but it facilitates a process that has always existed, so it can’t be the main culprit to robust credit markets. One of the main culprits is the idea of collateral grid-lock particularly for SMEs and mid-market corporates in the continent. Think specifically about businesses making US$ 500k to US$ 50m in Africa.

This article will introduce the idea of collateral grid-lock, explain how it works, highlight why it should matter for any Neobank or growing digital lender, explain what needs to be done to make things work and give global examples of how reducing collateral grid-lock can power both lending and economic growth. It will also show the link between this collateral gridlock and the lack of competitiveness in the credit markets.

The article is geared towards lending to the Missing Middle of Enterprises in Africa. These are enterprises that are too big for micro-lending or some of these impact SME funds and are too small to be a large corporate. Often, these are businesses earning anywhere between US$ 500k a year to US$ 50m. We’ll also explain why this matters.

Collateral Gridlock & Implications

What it is;

When a local corporation or SME is taking a loan in Africa, it has to jump through a few hoops to get the loan. Once it’s gotten the loan, the loan offer almost always insists on this thing called an all-asset debenture that is exclusive to the lender.

Let me explain what this means. In addition to physical property such as land and buildings, banks insist on this all-asset debenture which is also called a blanket charge. What this means is that in the event of a default, the bank has a first right to all your existing and future assets. These are assets such as inventory/stock, receivables, cash in your bank and other assets such as vehicles and machinery. Everything your company owns now and in the future becomes the bank's property when you default. This is called a floating charge, the best way to think about it is a floating arm that hovers over the business, when you default that arm swoops down and grabs everything the company owns. This act of swooping down to grab everything in legalese is referred to as a floating charge becoming a fixed charge. The diagram below makes it easier to understand;

On the left is a floating charge, the business can continue as normal, when it defaults, the charge becomes fixed and the bank can take possession of the assets.

Let me put this in more practical terms. Assume the following for a fictional company called Kampala Glass Ltd - We breakdown its financial situation below;

Kampala Glass Mart;

Kampala Glass is a fictional company that manufactures glass products and sells them to retail outlets who pay after 60 days. It has a manufacturing plant at the outskirts of Kampala as you drive towards Entebbe. Its books look like this;

1. Total Revenue = US$ 5m;

2. Net Revenue = US$ 1m;

3. Value of Fixed Assets - Factory and Land = US$ 2.5;

4. Value of Current Assets (Receivables, Cash and Inventory) = US$2.5 which is further broken down as;

   1. Receivables = US$1m;

   2. Cash = US$ 500k;

   3. Inventory = US$1m;

5. Size of Loan - US$ 2m broken down as;

   1. US$1m Long-term Loan that was taken to finance the factory;

   2. US$ 1m working capital loan that is meant to finance both inventory and receivables;

For Kampala Glass, its bank has taken both its property (Land and Factory) as collateral as well as a blanket charge (all asset debenture) over all its current and future assets. This means that as the business continues to grow and generate more cash with that cash being invested into inventory, the bank has a right over all those assets. Before we discuss the implications, it is useful to understand why banks do it.

Why do Banks do This

There are a number of factors that make banks do this. It’s a mix of on-ground realities and embedded culture. Lending in Africa is difficult, you not only have to deal with weak laws and contract enforcement mechanisms, you also have to deal with clients who sometimes have no intention to pay. The key issues are;

1. Information Asymmetry - It’s said that every business in Africa has three sets of books, one for the tax authority geared at minimising the tax bill. One for the bank, aimed at impressing it with a view to larger loan limits and an internal one that tells the reality. In the light of this information asymmetry, the logical thing to do is to say that “I don’t care what your books say, everything you own is mine in the event of default”;

2. Weak Contract Enforcement - In Africa, one of the biggest issues is document fraud. This involves companies presenting fake or misleading documents to obtain something. In the case of banking, this involves sometimes presenting a fake supplier invoice when making payments so as to divert funds. In such a scenario it makes sense to take a “blanket charge”;

3. Visibility and Valuation of Assets - Difficulty in valuing these current assets (also referred to as movable assets) - Banks just don’t have the infrastructure to identify and value these assets on a consistent basis. They also have zero to no visibility on these assets so it makes sense throwing a blanket over them;

4. Internal reasons - Part of the embedded culture. Some of these reasons are;

   1. It’s administratively easier and the bank’s legal teams are trained on doing all asset debentures - An expertise issue;

   2. The credit committees and credit policies are built around all-asset debentures for such loans - there’s no customisation or bespoke banking. A blanket charge is a blanket policy;

   3. They’re viewed as offering the most protection in the event of a default against other creditors. Sub‑ordination would expose the first lender to dilution risk and breaches internal credit‑policy caps; hence blanket charges become a rational but anti‑competitive equilibrium;

It makes sense for banks to be cautious. This policy in essence doesn’t emanate from an innate callousness, it’s built from years of dealing with the worst that lending in Africa can throw at you. I always say the most jaded people in the world are credit recovery heads who have had over 20 years experience. They’ve seen the worst of humanity.

What are the Implications?

Going back to the case of Kampala Glass Limited, let’s imagine a year later, the situation looks like this;

1. Total Revenue has grown to US$ 7m;

2. Net Revenue = US$ 1.5m;

3. Value of Fixed Assets = 2.5m;

4. Value of Current Assets = 4.5m;

   1. Receivables = US$2m;

   2. Cash = US$ 500k;

   3. Inventory = US$ US$2m;

At this point, the business probably needs more working capital to support the receivables and the inventory. Kampala Glass approaches its bank with a view of extending this loan to US$ 3m. Nonetheless, the value of the Fixed Assets hasn’t grown and it remains at US$ 2.5m. The bank is hesitant to extend this because their policies state that the collateral should exceed the loan value by at least 25%. Kampala Glass still needs to grow, the business won’t wait for the bank.

In the 2000s and 2010s, banks found a way around this by simply revaluing the land that the factory sits on and they’d magically increase their collateral. I think this was a key driver of the property boom across the continent. However, in most countries, this game is over as banks are sitting on property inventory that they can’t shift.

In this regard, the CEO of Kampala Glass reaches out to a few financiers who are happy to set up a loan based on the value of current assets worth US$ 4.5m. These new lenders believe that they’ve seen enough businesses like Kampala Glass so as to understand the risks and how to manage the loan. They’ve not only built solid credit scoring models, they also have strong monitoring capabilities using new fangled tools like IoT. Moreover, they’re not set up to take land and buildings as collateral.

They are happy to offer Kampala Glass a US$ 4m working capital security secured by just the receivables and the inventory. Nonetheless, this path is blocked. Kampala Glass’ bank has a blanket charge so no new lender can come in and claim anything. The existing charge covers all existing and future assets. Moreover, the credit sanctioner will not allow this charge to be shared or subordinated to anyone else. Kampala Glass is stuck. In essence, they have dead capital in the business. In their case, US$ 4.5m worth of dead capital that can’t be unlocked.

This story reverberates across the continent. For both large and small institutions. What stymies Kampala Glass also scales to thousands of mid‑market firms – and collectively distorts the entire credit market. The focus on mid-market firms, defined as companies earning between US$ 1m and US$ 50m a year is apt. This mechanism is not the same for all companies.

Large corporations such as Safaricom, MTN, Dangote, Seplats and others have a velvet touch banking experience. Most of their loans are unsecured and where necessary, banks are happy to include other lenders in their debentures given that the corporates have strong negotiating power. For individuals and local businesses, there’s simply no incentive. I have you locked in to these rates, you simply can’t up and leave. In other markets, this pricing mismatch would be competed away. In the continent, it’s impossible for this to happen. The transmission is broken due to legal mechanisms that create lock-in.

To be fair, there’s lots of more nuance, but this is an issue. It may be useful to break down why this matters to Fintechs.

Why it Matters

A number of lending-focused Fintechs are building with a view of supporting micro-entrepreneurs and consumers. Plenty of progress has been made in this regard from the M-Shwari’s to the Fairmoney’s, Branch, Tala and Fido in Ghana. Nonetheless, there are two paths these businesses can take.

1. For consumer lenders, these digital models are seeing 40%+ default rates. The sustainability of these models in the face of new entrants is up to question. A number of these players are moving to more traditional models of financing such as car loans (Umba) or payroll based financing. This will reduce the default rates but I still think that lending in Africa has to be primarily productive and a number of these loans are going towards sustenance and consumption, leading to further questions about sustainability;

2. For SME finance, most players will grow as their clients will grow. Right now, a number of players in the digital space are targeting Micro SMEs with unsecured loans to fund trading. However, a number of things will happen or are happening;

   1. Your best customers will graduate to banks;

   2. Scale will be limited due to ticket sizes necessitating you to go upstream towards larger more established SMEs;

   3. As you scale, you will need to attract borrowers from banks who have already been “vetted by existing banks”

   4. Niche players will need to do more inventory and receivables financing to secure themselves and mitigate risk. This securitisation will also matter downstream from a fund raising perspective as it enables you to leverage these assets for wholesale funding. Much in the way Moove securitises its receivables.

Simply, growth requires legal sophistication and the ability to carve out security from SMEs.

How to Fix the Problem

At core is to create a system that has the following characteristics based on the situation we described;