Abstract

This document reflects an ongoing process of arriving at a strategy for small business financing. It reflects the discussions and debates that have arisen from stakeholders, including a major workshop held in Cape Town in September 1997. It also reflects extensive research carried out in government and by parastatal agencies. The document should be seen as an initial framework for bringing the public and private sector together on how to increase SMME access to finance.

The document is submitted to provide direction to the debate, and will be workshopped with political leadership, government officials and stakeholders, including small businesses themselves, our other partners in government, commercial banks, Non-Governmental Organisations, equity financiers and other participants of the first workshop held in Cape Town.

Chapter One of the document provides an overview of the role of SMMEs in meeting the national objectives as set out in the RDP, GEAR and related Department of Trade and Industry policy documents. It assesses the obstacles to achieving these objectives, and defines the objectives of a revised strategy to increase access to finance.

Chapter Two provides an analysis of the gaps in the supply of financial services, by closely considering whether the financing needs of SMMEs are met by the provision of financial products.

Chapter Three investigates the causes of insufficient financial service provision to SMMEs, including constraints faced by formal and alternative financial institutions, equity financiers and the Johannesburg Stock Exchange, as well as structural impediments to increased investment in SMMEs.

Chapter Four concludes with an outline of the way forward and suggests a series of steps to be undertaken by each of the major suppliers and regulators of SMME credit.

FINANCIAL ACCESS FOR SMMEs

Contents

Chapter One: Overview of Finance for SMMEs 1

1.1 Introduction 
1.2 The Problem: Lack of Access to Finance 2
1.3 Current Incentive Schemes
1.4 Towards a New Strategic Framework 

Chapter Two: Gaps in the Supply of Finance to SMMEs 5

2.1 Introduction
2.2 The SMME Sector - A Market Segmentation
2.2.1 Survivalist enterprises 
2.2.2 Micro-enterprises
2.2.3 Very small enterprises
2.2.4 Small enterprises 
2.2.5 Medium enterprises
2.3 Types and Sources of Finance for SMMEs
2.3.1 Debt finance 
2.3.2 Equity finance
2.4 Conclusion

Chapter Three: Obstacles to Institutional Investment 11

3.1 Introduction
3.2 Increasing the Profitability of SMME Investments
3.2.1 Formal financial institutions
3.2.2 Alternative financial institutions
3.2.3 Equity financiers
3.2.4 The Johannesburg Stock Exchange
3.3 An Evaluation of Existing Programmes
3.3.1 The Khula Credit Guarantee scheme
3.3.2 Support for alternative financial institutions
3.3.3 Equity finance programmes
3.3.4 Other programmes
3.4 Structural Impediments to SMME Investment
3.4.1 The Banks and Mutual Banks Act 
3.4.2 Interest rates
3.4.3 Disclosure and penalties
3.5 Conclusion 

Chapter Four: Towards a New Strategic Framework 25

4.1 Introduction 2
4.2 A Strategic Framework
4.2.1 Legal and Regulatory Framework
4.2.2 Role of Government and Implementing Agencies
4.2.3 Private Sector Contributions
4.2.4 Monitoring and Evaluation
4.3 A Way Forward and Time Frames

Chapter One:

Overview of Finance for SMMEs

1.1 Introduction

Small businesses have a major role to play in the South African economy in terms of employment creation, income generation and output growth. Small, medium and microenterprises (SMMEs) account for approximately 60% of all employment in the economy and 40% of output. They are also often the vehicle by which the lowest-income people in our society gain access to economic opportunities -- at a time that distribution of income and wealth in South Africa is amongst the most unequal in the world.

In the current macroeconomic context, it is imperative that significant investment is made in SMMEs, in order to create both short- and long-term capacity for labour absorption and output growth, as well as to improve income generation and redistribution. These objectives are firmly recognised in the main development and macroeconomic strategies adopted by this government, the RDP and GEAR.

As the Reconstruction and Development Programme document set out the broad objectives in 1994,

We must improve the capacity of the financial sector to mobilise more resources and to direct these to activities set out in the RDP, from housing to small and medium-sized enterprises (1.4.23.2)... If necessary, the democratic government must provide some subsidies as a catalyst for job-creation programmes controlled by communities and/or workers, and target appropriate job creation and development programmes in the most neglected and impoverished areas of our country. Ultimately, all such projects should sustain themselves (4.3.5)... Financial institutions must assist both by funding individual programmes to meet basic needs, especially housing, and by improving their services to small-scale producers and the black communities (6.5.17).

Specifically, the RDP undertook several areas of government intervention:

The democratic government must, in consultation with financial institutions, establish prudent non-discriminatory lending criteria, especially in respect of creditworthiness and collateral; reform the laws on women and banking to ensure equality; ... require banks to give their reasons when turning down a loan application; establish community liaison boards; develop simpler forms for contracts and applications, and create an environment which reduces the risk profile of lending to small black-owned enterprises and requires banks to lend a rising share of their assets to small, black-owned enterprise. The law must also require that financial institutions disclose their loans by race and gender; their assets and liabilities by subregion and sector; their staff by race and gender; the location of their branches and defaults by neighbourhood (4.7.3)... Where anti-discrimination measures do not generate enough credit for housing, small enterprise and other RDP programmes, the government must provide appropriate kinds of financial support. The democratic government should consider reapplying the Usury Act to small loans (in addition to loans above R6 000, as presently applies), and should enforce the Act more effectively (4.7.3).

The Growth, Employment and Redistribution (GEAR) Macroeconomic Strategy also strongly supported innovative financing arrangements for SMMEs, describing those already in place:

The promotion of small, medium and micro enterprises (SMMEs) is a key element in the Government's strategy for employment creation and income generation. Due to obstacles of the past, the SMME sector is severely under-developed. A major effort will be made to operationalise and implement the policies outlined in the White Paper on small business promotion. The relevant legislation is under consideration and various programmes and institutions have been established to give effect to the strategy, including:

• the Small Business Centre attached to the Department of Trade and Industry;
• Ntsika Enterprise Promotion Agency to provide non-financial assistance;
• Khula Enterprise Finance Limited for wholesale loans;
• Khula Credit Guarantee Limited for loan guarantees;
• a pre-shipment export finance guarantee facility to expand access to working capital; and
• the Competitiveness Fund for consultancy advice on technology and marketing.

The Simplified Regional Industrial Development programme will be continued in a modified form as a grant programme tailored to the needs of small and medium-sized firms.

The need for SMMEs to play a stronger role in job and asset creation is amplified by the slow growth in employment and the restructuring of the South African economy currently underway. Integration into the world economy and the need for rapid technological advances mean that SMMEs will be more critical than in previous epochs.

1.2 The Problem: Lack of Access to Finance

Current levels of investment in SMMEs are inadequate for achieving the growth levels anticipated in GEAR. SMMEs receive approximately 2,6% of investment capital flows, through both formal and informal agents. According to the Council of South African Banks (COSAB), there are an estimated 375 000 loans on the books of two major commercial banks that can be considered micro-enterprise credit (R4 billion, averaging R11 700 per loan). Yet in the period between January 1997 and January 1998, only 633 indemnities have been granted under Khula's Credit Guarantee scheme, indicating a lack of activity in areas government has prioritised need. In order to benefit from the dynamism and labour absorption capacity of SMMEs, South Africa must substantially redirect public and private investment flows.

A key factor mitigating against increased investment in the SMME sector is the structure of the financial sector. The sector is composed of a concentrated formal banking sector targeting corporate accounts and competing with smaller niche banks and investment banks. Few second tier banking institutions exist that can absorb savings and extend credit to SMMEs. Furthermore, there is a dearth of strong alternative financial institutions providing credit to the self-employed for productive purposes.

A further concern is the risk aversion of institutional investors (particularly pension and insurance funds), who tend to focus on "safer" and larger investments which yield relatively few social and economic benefits. These investors have few social responsibility vehicles that effectively cross-subsidise from their wealthy clients to those requiring start-up support.

As a result, a large portion of the SMME sector does not have access to adequate and appropriate forms of credit and equity, or indeed to financial services more generally. In competing for the corporate market, formal financial institutions have structured their products to serve the needs of large corporates. Alternative financial institutions such as Non-Governmental Organisations (NGOs) offer a limited range of products and do not have the infrastructure to reach a significant number of SMMEs. It is estimated that NGOs currently serve only 6% of the survivalist and microenterprise sector. The net result is that there is almost no debt finance available to SMMEs in loan sizes ranging from R10 000 to R50 000, and very little between R6 000 and R100 000. Even below R6 000 and above R100 000, access remains inadequate to meet the demand.

In the past five years, a number of private equity funds have been established. Fund managers have focused on larger investments (greater than R5 million) and have targeted expanding businesses and management buy-outs. However, most SMMEs require initial capital investments of well below R5 million. Equity and loan finance for new enterprises has been almost exclusively been targeted at franchises. Furthermore, the Johannesburg Stock Exchange has not been effective in providing access to capital for SMMEs despite the establishment of alternative investment markets in the 1980s.

An overarching concern is that previously disadvantaged individuals do not have adequate access to formal financial institutions and, therefore, are forced to seek relatively expensive (and often inadequate) amounts of credit from alternative financial intermediaries, sometimes illegally. Several reasons account for the lack of access in addition to the factors outlined above. These include lack of collateral, bad or no credit histories, an exaggerated risk perception of previously disadvantaged borrowers, discrimination on the basis of gender and race, and inability to afford the current high levels of interest rates.

1.3 Current Programmes

In recognition that access to capital was a key constraint to development of SMMEs, the Department of Trade and Industry put in place a set of incentives designed to leverage greater private and non-governmental sector investment in SMMEs. Notably, two new institutions, Khula Enterprise Finance Limited and Ntsika Enterprise Promotion Agency, were established in 1996 to create increased delivery capacity to SMMEs. They provide support infrastructure and absorb a portion of the risk and cost of private investment in SMMEs.

The strategy adopted was long term and sought to provide the private sector with the opportunity to learn how to make SMME investments in a profitable manner. While the new institutions have made significant strides in the implementation of the strategy, the perception that SMME investment is not an economically viable investment, still largely prevails.

In view of the macroeconomic objectives and the persisting perceptions of the private sector, it is, therefore, necessary to review the current incentive structure and implementation approach. A broader policy framework that begins to address the structural impediments to increased SMME investments must be developed to supplement and support revised incentives and subsidies. This document is a step in that process, and is meant to assist political leaders, government officials, SMME finance practitioners and SMMEs themselves in establishing a consensus on creative financing strategies.

1.4 Towards a Comprehensive Strategy for Small Business Financing

There are four objectives associated with access to affordable finance for SMMEs:

to significantly increase the level of commercial and NGO lending (and financial services) to SMMEs at interest rates (and fees) not inflated by unreasonable risk perceptions; to improve the outreach and efficiency of both conventional and alternative financial institutions, especially in unserved rural areas; to stimulate the provision of start-up and small-scale equity products for SMMEs; and to expand the number of SMEs listed on the Johannesburg Stock Exchange.

A comprehensive and integrated policy framework and implementation approach should address these objectives.

Chapter Two:

Gaps in the Supply of Finance to SMMEs

2.1 Introduction

In order to assess the gaps in the supply of finance to SMMEs, it is necessary to consider the financing needs of different segments of the market, according to the following size categories: Survivalist, Micro-, Very Small Enterprises, Small and Medium. Following this, the two main types of finance for SMMEs -- debt and equity -- can be examined.

2.2 The SMME Sector - A Market Segmentation

The National Small Business Act classifies SMMEs according to five size categories, ranging from Survivalist to Medium-Sized. Each has particular financing requirements.

2.2.1 Survivalist enterprises

Survivalist enterprises are enterprises with no paid employees and minimal asset value. The enterprises generate income below the minimum income standard or the poverty line, and their main aim is to provide minimal subsistence means for the unemployed and their families. Most entrepreneurs in this category are involved in hawking, vending, subsistence farming, etc. In the National Small Business Act, the survivalist sector is considered to be part of the micro-enterprise sector.

It is estimated that the survivalist sector constitutes 23,3% of all enterprises recorded in South Africa and contributes approximately 3,0% of total employment. This category has great potential for the absorption of unskilled labour, as has been confirmed by the correlation between the unemployment rate and the amount of self-employment in unregistered, mainly survivalist, enterprises that prevails in informal settlements and rural areas. The largest number of South Africa's survivalist enterprises are located in KwaZulu-Natal, Gauteng, the Eastern Cape, and the Northern Province (23%, 21%, 17% and 11% respectively).

The main sources of finance for the survivalist sector are family and friends, informal money lenders, NGOs, and credits obtained from suppliers. Most survivalist enterprises have never had access to formal financial institutions. The greatest need faced by enterprises operating in the survivalist sector is for working capital to purchase supplies and inputs, often for periods of less than a week. Very little capital accumulation takes place in these enterprises, as most income is consumed by the family. As a result, survivalist enterprises have continual borrowing needs and run the risk of an excessive dependence upon sources of capital outside the business.

Entrepreneurs operating in the survivalist sectors generally have very little or no collateral. Alternative lending approaches, such as group lending, are sometimes successful in overcoming the collateral constraints faced by the sector, but the character of the programme is important.

2.2.2 Micro-enterprises

Micro-enterprises have a turnover below the VAT registration limit (presently R150 000 per annum) and have less than 5 paid employees. These enterprises tend to lack formality in terms of registration for tax-purposes, labour legislation, business premises and accounting procedures. Examples of microenterprises are spaza shops, mini taxis, and household industry. Micro enterprises without employees constitute approximately 31,0% of all enterprises and are estimated to contribute 3,9% of total private sector employment, while micro enterprises with 1-4 employees constitute approximately 16,4% of all enterprises and contribute about 6,8% of employment. The largest numbers of microenterprises are located in Gauteng, KwaZulu-Natal, the Western Cape and Eastern Cape (34%, 18%, 14% and 10% respectively).

Micro entrepreneurs are more likely to have had access to formal financial institutions than survivalist enterprises, but often for purposes other than their business, since such businesses are usually too small to interest commercial lenders. Common sources of enterprise finance include family and friends, money lenders, and NGOs.

The financing needs of microenterprises are more complex than for survivalist enterprises. Generally, microenterprises require small fixed asset loans for equipment, such as sewing machines, deep freezes, etc., as well as working capital for supplies and material inputs. Loan requirements are for longer periods, ranging from 3 months to 3 years (longer periods are required for mini-taxis), and for larger amounts, ranging from R2 000 to R30 000. While some microenterprises may have access to collateral, such as a house, they are generally unwilling to risk their property. Furthermore, few micro entrepreneurs have the type of collateral required by formal financial institutions. These entrepreneurs are most likely to benefit from a revision of regulation around collateral.

2.2.3 Very small enterprises

Very small enterprises employ fewer than 10 paid employees -- but in the mining, electricity and manufacturing and construction sectors, fewer than 20. They operate on the formal market and usually have access to modern technology. The smallest of these enterprises are self-employed owners with no employees, such as artisans and professionals. Very small enterprises make up an estimated 19,7% of all enterprises recorded and account for 13,3% of employment. The largest concentrations of very small enterprises are found in Gauteng (42%), the Western Cape (16%) and KwaZulu-Natal (15%).

Very small enterprises sometimes have access to formal financial institutions, and are often considered to be formal microenterprises by institutions such as commercial banks. Very small enterprises could benefit from a combination of debt and equity, but their equity requirements are generally too small for equity financiers. The only equity in the business is, therefore, generally the owner's own contribution. Often, very small enterprises are established as a result of an entrepreneur's retrenchment package from previous employment.

The debt financing needs of very small enterprises are usually for fixed assets investment, capital outlay for enterprise establishment such as office equipment etc., and working capital, especially bridging finance or revolving credit facilities. Leasing finance is, therefore, important for very small enterprises. Factoring could potentially be a source of capital for this sector, but is not generally available due to the small number of debtors. Very small enterprises may have established relationships with their suppliers, but generally do not buy in adequate volumes to obtain credit. The average credit requirements of very small enterprises range from R10 000 to R200 000.

Very small enterprises are often constrained by collateral requirements imposed by formal financial institutions. While the entrepreneurs may have some life insurance policies or pension funds and are often home owners, they usually are overly leveraged. Most business failures occur in this sector.

2.2.4 Small enterprises

Small enterprises have fewer than 50 paid employees and are more established, with more complex business practices. Usually, the owner does not manage the enterprise directly, and a secondary co-ordinating mechanism has been put in place. Growth from a small to a medium-sized enterprise requires an accumulation of resources as well as a set of appropriate incentives for enterprise expansion. Small enterprises constitute an estimated 7,6% of all enterprises and contribute 19,9% of employment. Almost 50% of small enterprises are located in Gauteng (46%). A further 16% and 12% are located in KwaZulu-Natal and the Western Cape, respectively.

Small enterprises are more established than very small enterprises and have greater capital needs, especially for equipment and working capital. They rely more upon leasing finance and factoring. However, long-term outlays for machinery and equipment are often required, as are overdraft facilities and suppliers credits for working capital. Businesses in this sector also require equity injections, but as with very small enterprises, the equity amounts required are often too small for equity financiers to consider (below R5 million). Loan finance requirements of small enterprises range from R20 000 to R5 million.

Entrepreneurs in the small enterprise sector often have some form of collateral that would be acceptable to formal financial institutions, but it is usually not sufficient to meet their requirements. Collateral thus remains a constraint.

2.2.5 Medium enterprises

Medium-sized enterprises are enterprises with up to 100 paid employees -- although in the mining, electricity and manufacturing sectors, up to 200. Although usually still controlled by an owner/manager, the ownership and management structure is more complex. Often the decentralisation of power to an additional management layer and a greater division of labour are the main differences between small and medium-sized enterprises. A more complete separation of ownership and management is often the natural barrier between medium and large enterprises. Medium-sized enterprises make up 1,4% of enterprises recorded and account for approximately 13,8% of employment. Medium-sized enterprises are concentrated in the metropolitan areas of Gauteng, KwaZulu-Natal and the Western Cape.

Medium-sized firms generally have established relationships with their bankers, and those with growth potential are also targeted by equity financiers. A range of institutions serve their financing needs. Medium-sized enterprises are also more likely to seek a listing on the stock exchange.

2.3 Types and Sources of Finance for SMMEs

The market segmentation of SMMEs provides the basis upon which to assess the adequacy of financial service provision, both in terms of the products available, as well as the geographic spread of service providers.

The formal financial sector -- namely, commercial and merchant banks, factoring houses, leasing finance companies and equity financiers -- serves mainly the small and medium enterprises. Some smaller banks, as well as some local branches of large commercial banks, also occasionally serve very small enterprises. Parastatals that retail finance have similarly focused largely on small and medium-sized companies. Thus the survivalist and micro enterprise sectors are largely reached only by NGOs and family-based financing. This is true of both debt and equity finance.

2.3.1 Debt finance

Although data on the day to day activities of bank branches is not available, research has revealed that commercial banks tend to make finance available to small and medium-sized enterprises in ranges from R50 000 to R1 000 000 or more. Most banks provide working capital, leasing finance, and start-up capital, mainly for franchises. Three of the five largest banks provide bridging or contract finance. The average investment range for asset-based financing for SMMEs is between R50 000 and R600 000. Some merchant banks and finance houses also provide asset based finance in ranges between R100 000 and R1 000 000 or more.

NGOs tend to focus on the survivalist and microenterprise sectors. Two types of institutions can be distinguished: those that provide loan finance up to R6 000, often applying a group based lending methodology, and those providing larger individual loan amounts, but in most cases no larger than R50 000. Very few institutions serve the very small enterprise sector or those larger microenterprises that have employees.

While commercial banks have the most extensive branch network, outreach even to small and medium sized firms remains limited. Furthermore, microenterprises, both formal and less formal, and very small enterprises have little, if any access to formal financial institutions. As most previously disadvantaged entrepreneurs operate in these sectors, it means that they do not have access to formal financial institutions and thus have to rely on alternative financial institutions such as NGOs for access to capital. The main constraint here is that NGOs have very little infrastructure and hence outreach is sporadic. Studies suggest that NGOs reach approximately 15% of the potential market in the survivalist and microenterprise sectors, and indeed Khula estimates that the 21 NGO clients on their books together have fewer than 60 000 clients (more than half of which are attributable to two NGOs).

The table below illustrates the regional spread of infrastructure as well as borrowers of NGO clients of Khula's, as well as the utilisation of the Khula Credit Guarantee Scheme. Although the table is incomplete in that it does not include a number of NGOs, nor Provincial Development Corporations and other parastatals, it does provide an overview. As is clear, very few institutions serve microenterprises with 1 to 4 employees and very small enterprises. Furthermore, few NGOs serve survivalist and microenterprises in the Free State, the North West and the Northern Cape. Finally, the level of utilisation of the Credit Guarantee Scheme is placed in perspective when one considers the number of bank branches and the percentage of small and medium sized enterprises served through the scheme.

2.3.2 Equity finance

Private Equity funds, commercial and merchant banks target small and medium-sized enterprises. Standard investments range from R2 million to approximately R20 million, although some make investments available for as little as R200 000. This means that essentially, these institutions invest mainly in medium-sized enterprises, as the investment requirements of small and very small enterprises are much smaller. Furthermore, very little start up or early stage capital is made available, with the overwhelming focus being on franchises.

Leading equity funds include those set up by merchant banks and investment companies (which generally require higher than 30% return on investment), the World Bank's International Finance Corporation (20% in US$s), and the Industrial Development Corporation and Small Business Development Corporation (both 15%). Another source of equity finance for medium-sized enterprises is through the Johannesburg Stock Exchange, which created a Development Capital Market (DCM) in 1984 and a Venture Capital Market (VCM) in 1989. The aim of the DCM was to provide growing companies with an opportunity to raise capital by listing on the stock market. Similarly, the VCM was established to assist new ventures in raising capital. The level of activity in these markets has been very low, with a total of 15 companies being listed in the two markets. The market capitalisation of the 15 companies amounts to roughly 0,02% of the total market capitalisation of the market.

2.4 Conclusion

The smaller end of the enterprise spectrum, ranging from survivalist, micro and very small enterprises have very little access to capital, from either alternative financial institutions or the formal financial sector. This is a critical issue in the South African context, as most previously disadvantaged entrepreneurs operate in these sectors, thus perpetuating a situation of unequal racial and gender access to finance. Yet these sectors have the greatest potential for labour absorption in the short run.

Given the potential of existing formal financial institutions to utilise and expand their infrastructure and outreach to SMMEs, in relation to the alternative institutions, it is critical that formal sector financiers adopt more innovative approaches and partnerships.

However, it must also be recognized that for various reasons associated with the administrative costs of banking and limited entrepreneurial sophistication, most formal financial institutions are unlikely to be successful at serving the full needs of survivalist and small microenterprises. For this reason, it is necessary to accelerate the expansion of alternative financial institutions to address these sectors.

While equity funds have been seen as a way to stimulate the growth and development of small and medium-sized enterprises, particularly owned by the previously disadvantaged, the preferred investment ranges are too high to significantly reach these enterprise sectors.

A related issue to access is cost of credit. Although the Usury Act provides protection to borrowers of more than R6 000 in the form of a 32% interest ceiling, many informal lenders have found means of operating outside the Act. Likewise, equity investors -- particularly venture capitalists -- often demand substantial rates of return which drain resources otherwise available for reinvestment.

Chapter Three:

Obstacles to Institutional Investment

3.1 Introduction

From the preceding chapter, it is clear that the key challenges are:

1) encouraging formal financial institutions to make finance and indeed financial services more generally available to larger micro and to very small enterprises;
2) encouraging the growth of alternative financial institutions providing finance to survivalist and micro enterprises, especially in informal settlements and in rural areas; and
3) encouraging greater availability of equity finance for smaller firms.

Two overarching strategies are proposed:

1) increase the perceived profitability of SMME investments;
2) improve the structure, regulatory framework and financing terms of the financial system

This chapter seeks to explore these issues in greater detail in order to provide a basis for sound policy decisions.

3.2 Increasing the Profitability of SMME Investments

3.2.1 Formal financial institutions

One of the key factors constraining investment by formal financial institutions in the SMME sector is the perception that these investments are not profitable. The profitability of any investment hinges on the difference between the costs of making the investment (input costs, such as overhead and administrative expenses, the cost of capital, as well the cost of default) and the returns it yields. Formal financial institutions perceive SMME investment to be both costly and risky, which in itself should not be a constraint provided that pricing allows for cost-recovery and risk.

It is widely recognized that SMME investments are more labour intensive for financial institutions given the investigations required. They thus tend to be more costly than corporate accounts. Banks estimate that training and support constitutes a major portion (approximately 34%) of the total cost to banks of making loans to small businesses.

Yet the cost of lending must be seen in the context of a commercial banking sector that is already considered inefficient. The ratio of overheads as a percentage of total income is 65% or more for most major local banks, against an international benchmark of 50%. Despite a significant spread on interest margins (far higher than international norms), South African banks still struggle to cover administrative expenses from interest income. Nevertheless, South African banks remain highly profitable by international comparison, largely due to fee income and retail banking fees.

Given the internal restructuring of most major banks, it is thus unlikely that banks will make significant inroads into the SMME market, especially for the smaller loan amounts (between R10 000 and R50 000) required by formal microenterprises and very small enterprises, unless there is a means of reducing or, in the short run, of sharing the cost of extending smaller loans through cross-subsidising such loans from larger corporate accounts (a common practice for many public utilities such as telephones, electricity and water).

The risk of default is also often cited as a reason why formal financial institutions are not particularly interested in the SMME sector. Traditionally, banks insure themselves against the risk of non-payment by obtaining insurance against disability or death, by applying screening mechanisms, such as credit checks and business plans, and by imposing collateral requirements.

Application for loans from banks by SMMEs are usually rejected on the basis of credit checks, the business plan, or due to insufficient collateral. These factors also most commonly apply to previously disadvantaged entrepreneurs.

A large number of previously disadvantaged entrepreneurs have bad credit records registered with the Credit Bureaux. This is largely a historic situation, resulting from collective political action, such as rent boycotts and violence in townships which made living in many areas unsafe (hence leading to arrears on mortgage bonds). At present, there is no effective mechanism for credit rehabilitation. Moreover, since full client credit information is not often shared between banks and other credit institutions (e.g. retailers), bankers cannot assess the true level of indebtedness of potential borrowers and thus the level of risk in extending further credit. Credit records are, as a result, not a very effective mechanism for verifying credit histories. While credit checks are still performed by banks in evaluating loan applications, it is increasingly recognized by banks that a bad credit record in itself is not sufficient cause to reject an application.

Often, applications are also rejected because the style and presentation of the business plan is not clear and does not provide all the required information. However, as bankers have little experience and training in SMME lending, business plans are also rejected because of their own lack of understanding of the sector and their inability to accurately assess the level of risk.

The risk of business failure is high amongst SMMEs. International research reveals that the major causes for business decline and/or failure are internal factors -- especially lack of financial control, poor cash flow management, high gearing levels, inadequate management competence, poor production planning and control and insufficient marketing -- rather than external factors such as economic and competitive changes. Unless there is experience and understanding of the SMME sector, the warning signals associated with business decline will go undetected. Due to a general lack of understanding of SMMEs, bankers thus tend to rely on collateral rather than on the potential profitability of the businesses and its ability to repay the loan.

The substantial amounts and type of collateral required by banks prevent many previously disadvantaged entrepreneurs from gaining access to formal financial institutions. As the legal and regulatory framework governing financial contracts and collateralisation makes it costly to register collateral, banks have a strong preference for life insurance policies, financial assets, mortgages and personal guarantees. Types of collateral that are more easily accessible -- such as chattel mortgage, pawned movable personal assets and assignment of claims against third parties -- are less preferred because of the costs, limited marketability and appropriability.

The amount of collateral required by formal financial institutions is often exaggerated for SMMEs, due to flawed risk perceptions on the part of lenders. Due to past experience in certain areas of lending (notably late 1980s township housing lending), as well as a lack of understanding of the emerging markets, formal financial institutions overstate the likelihood of default of particular classes of borrowers and impose unrealistically high collateral requirements, which has effectively resulted in credit rationing.

An argument can be made that banks apply strict collateral requirements, because the interest rate ceiling imposed on loans up to R500 000 through the Usury Act makes it impossible for banks to charge an extra risk premium to uncollateralised clients. However, this argument presupposes that, firstly, banks have the correct risk perception of SMMEs, and, secondly, that banks would charge the risk premium if the Usury Act permitted them to do so. Bank representatives have stated that, politically, it would be difficult for them to charge higher interest rates than are currently imposed, especially as real interest rates in South Africa are very high by international standards.

3.2.2 Alternative financial institutions

The exemption of money lending transactions under R6 000 from the requirements of the Usury Act has resulted in the proliferation of institutions providing small amounts of short-term credit, largely to previously disadvantaged borrowers. But most of this lending has been for consumption purposes, as well as for small housing loans, and has been targeted at employed individuals. If there is so clearly a market for short term credits, why has a similar proliferation of institutions targeting the self-employed not been recorded?

One reason is that South Africa has not, unfortunately, generated large-scale success stories to inspire confidence in microenterprise lending. Internationally, in countries such as Bolivia, Bangladesh and Indonesia, the stimulation of the microlending sector occurred largely as a result of one institution achieving significant success. Employer-based micro lenders have found cost-effective and relatively secure ways to make small loans, accompanied by the fact that some charge extremely high interest rates. The demonstration effect of a few NGO programmes has led to increased private sector interest in the sector.

Microenterprise lending, on the other hand, has had few South African champions. This is largely due to the fact that, with the exception of one or two institutions, no NGOs have reached sustainability or been able to expand significantly without experiencing bad debt problems. While the past two years has seen an increasing number of new institutions starting up, these institutions tend to be small and localised, with limited outreach.

Several factors contribute to the lack of sustainable institutions in the South African context, including lack of capacity, and overhead and administrative expense. NGO practitioners regularly complain about the lack of staff training, information, and access to technology that would make their programmes more effective.

The overhead expenses of South African NGOs as percentage of total income are on average 40-50%, as opposed to international standards of 20%. The high costs of NGOs are partly due to inefficiencies within organisations, but also partly a reflection of the high cost of skilled professionals on the South Africa labour market. The table below illustrates that in South Africa, the average base salary of loan officers tends to be significantly higher than international standards, especially when compared to the average loan size.

Country Average Loan Size GDP Per Capita Annual Loan Officer Salary

Bolivia $500 $665 $4 000
Dominican Rep. $1 354 $945 $4 620
South Africa $225 $2 764 $6 800
Egypt $730 $700 $528
Philippines $700 $734 $1 920

Source: Calmeadow Foundation, 1995

Some South African NGOs apply the group lending methodology to reduce the cost of making small loans, as well as to substitute for collateral in tight communities. However, one of the problems experienced in much of South Africa is the low geographical density of enterprises, especially in rural areas, which raises the costs of verification and follow-up. While group lending has great potential, its greatest successes are with smaller loan amounts. As the loan sizes become larger, typically group cohesion suffers. Thus group lending is most appropriately applied to survivalist and microenterprises.

Larger microenterprises and very small enterprises, on the other hand, are most appropriately served through individual loans and more differentiated loan products. In South Africa, NGOs providing individual loans have suffered repayment rates below those of group lending programmes. No single individual loan methodology has emerged as highly successful in South Africa. As a result, some NGOs have tended to shift towards traditional, collateral-based lending.

While the average loan size of individual loans is larger than for group loans and thus the cost per loan may be lower, the risk of loan default is often higher. Furthermore, as individual loans are larger, more security is generally required.

A general problem is the high cost of establishing infrastructure. Unlike the formal banking sector, NGOs do not have established, wide-ranging branch networks. A large initial capital outlay is required to establish new infrastructure in unserved areas.

Innovative partnerships between banks and alternative finance institutions to share infrastructure, both physical and technological, should thus be encouraged, especially in provinces where alternative finance institutions are underrepresented, notably in the Western Cape, Eastern Cape, North West, Free State and Northern Cape.

3.2.3. Equity financiers

Because SMMEs are often undercapitalised, the enterprises are particularly vulnerable to economic fluctuations and interest rate changes. Adequate and appropriate equity investment in smaller enterprises in particular is therefore critical for the health of the sector and for its ability to sustain itself during periods of economic fluctuation. However, most equity investments are made in medium-sized and large enterprises, and for management buy-outs of existing large enterprises.

In part, the bias towards larger equity investment is due to the costs associated with gaining the required rate of return from SMMEs. Equity investments require a significant amount of preparatory work and due diligence prior to investment. More hand holding is also required to protect the investment. These sunk costs can only be recovered if the investment size is sufficiently large or if the returns are sufficiently high.

The rate of return is also related to the relative security of investment required by institutional investors. Investments in SMMEs are seen as particularly risky, and start-up enterprises even more so, and thus concurrently high returns are required. As a result, institutional investors -- particularly the large pension funds and insurance companies -- have not been particularly enthusiastic about the SMME market. It may be necessary to establish alternative sources of investment capital that require lower returns than institutional investors. In Britain and the United States, government played a large role initially in providing investment capital to stimulate investment in smaller enterprises and in start- up and early stage investments. Internationally, tax incentives have also been effective in stimulating SMME investments by institutional investors.

3.2.4 The Johannesburg Stock Exchange

Another potential source of equity finance, mainly for small and medium-sized growth companies, is the Johannesburg Stock Exchange (JSE). However, the level of activity in the Development Capital Market (DCM) and the Venture Capital Market (VCM) of the JSE has been low. The JSE has attributed this to the fact that the large institutions generally only invest in corporations, and smaller investors equate the DCM/VCM market with unmanageable risk. Both turnover and price-earnings ratios are generally low. Moreover, credible directors are not prepared to risk their reputations by serving on the boards of DCM/VCM listed companies, and likewise corporate advisors are reluctant to become involved in DCM/VCM listings. The JSE fears that failures on the DCM and VCM will taint the Main Board, while entrepreneurs are generally unaware of the DCM and VCM and of the benefits of listing.

International experience has shown that two-tier stock exchange systems with differentiated listing requirements are sometimes successful in increasing access to equity for small firms. However, differentiated listing requirements in themselves are not sufficient to attract investors. On both the NASDAQ and the Alternative Investment Market of the London Stock Exchange, the marketing of small businesses has been a vital element in attracting attention from both investors and companies. Furthermore, a set of incentives and social responsibility guidelines may need to be introduced to encourage both brokers and investors to become involved in the alternative market.

3.3 An Evaluation of Existing Programmes

The key constraints faced by formal financial institutions -- both debt and equity financiers -- in making SMME investments can be summarised in two categories.

Factors relating to debt and equity -- These factors include high overhead costs in general; the administrative cost of extending small loans to SMMEs; the high risk of business failure; an exaggerated risk perception of SMMEs on the part of bankers and institutional investors; and returns on SMME investments that are considered low relative to the risk and cost of making the investment.

Factors relating to debt -- These factors include an inability to accurately assess the level of risk inherent in an SMME transaction; the lack of collateral of SMMEs, especially previously disadvantaged entrepreneurs; and the cost of registering and realising collateral.

For alternative financial institutions, there are similar constraints.

Factors common to group and individual lending -- These factors include the cost of extending loans to SMMEs; returns on SMME investments that are considered low relative to the risk and cost of making the investment; and the cost of establishing new infrastructure.

Factors relating to individual lending -- These factors include the cost of registering and realising collateral; and the risk of business failure.

In recognition of these constraints, Khula Enterprise Finance Limited and Ntsika Enterprise Promotion Agency were established in 1996. The institutions' mandates were to establish programmes that would absorb a portion of the risk and cost of making SMME investments, as well as increase the delivery capacity of alternative financial institutions. The overall aim was to provide private and non-governmental institutions with an opportunity to learn how to make these investments profitably. While significant strides have been made by the implementing agencies in meeting their mandates, more rapid progress is required, especially with respect to appropriate non-financial service provision.

3.3.1 The Khula Credit Guarantee scheme

In recognition that collateral constitutes a serious constraint for SMMEs, particularly for previously disadvantaged entrepreneurs, Khula established Credit Guarantee Schemes. The original scheme was transferred to Khula from the Small Business Development Corporation (SBDC). Khula substantially revised the scheme, with the result that the percentage of guarantees issued to previously disadvantaged entrepreneurs has risen from 25% to 50%; 633 guarantees were issued within the first year of operation (as opposed to about 1470 under the SBDC over a four year period). Nevertheless, the level of utilisation remains far below expectation.

Three reasons have been given for the low level of utilisation. Firstly, the guarantee schemes were operating through the small business units at the banks rather than through the branch structures. Secondly, high bank transactions costs were not significantly reduced by Ntsika's non-financial support services. Thirdly, Ntsika's programmes did not adequately address the risk of business failure.

In response, Khula has decided to significantly revise the Credit Guarantee Scheme. From 1 March 1998, Khula has increased the maximum loan amount to R1 million and the maximum guarantee to 80%. Collateral requirements for the unguaranteed portion were revised to include a personal guarantee based on a certified statement of net worth, which has reduced the cost of registering collateral.

A more fundamental restructuring of the Guarantee Scheme is envisaged. Business development officers will be employed at a local level to receive, review and appraise business plans from entrepreneurs. Once the officer is satisfied with the viability of the proposal, these proposals will be forwarded to Khula. Should Khula be satisfied with the proposals, a guarantee will be awarded. The business development officer will then offer the proposal to local bank branches for approval. Every successful applicant will be assigned to a mentor, who can be called upon either by the bank directly in the case of arrears or by the client for business support. Two categories of mentors will be established, those with general business skills, and those with specialist knowledge.

Khula envisages that this scheme may be financially more viable than the existing scheme, as some banks have expressed a willingness to pay an administration fee for the acceptance of pre-guaranteed proposals. Two issues are critical to the success of the scheme: firstly, banks have to support the revised scheme; and secondly, while the scheme may be self-sustaining in the long run, it will require significant initial capitalisation.

The revised Credit Guarantee Scheme should go a long way to increasing access to finance from banks for SMMEs. However, there remain questions over whether the government should be responsible for subsidising private sector investment, on the "supply side," for an extended period of time.

Furthermore, it is impossible for all bank lending to SMMEs to go through the guarantee scheme. It order to evaluate the success of the scheme and to monitor changes in the banking culture, it is critical that bank lending to SMMEs is disclosed. New legislation that would encourage disclosure of all community lending by banks is now being considered.

While Khula envisages that it will provide training to bankers on alternative lending methods, it is important that such training be internalised in banks or through COSAB. However, it may be necessary for government to make the initial investments.

3.3.2 Support for alternative financial institutions

A critical issue for Khula has been inadequate infrastructure on the part of alternative financial institutions extending microenterprise loans. The programmes put in place have seen success in stimulating the establishment of new institutions in areas that were not previously served. To date, Khula has extended support to 21 retail financial intermediaries, of which 8 are new institutions. It must be noted that any strategy entailing new infrastructure is by necessity a long term process, and it is too early to judge the success of the programme.

However, questions can be raised over the wisdom of supporting a large number of individual institutions, as loan methodologies differ, and a range of different weaknesses may emerge which are difficult to address systematically. Instead, a model for successful large scale delivery must be developed.

In addition, the future of Provincial Development Corporations (PDCs) and their existing infrastructure urgently needs to be reviewed in the context of provincial economic development plans. While there has been variation in the performance and financial strength of PDCs, the institutions have tended to be inefficient, with weak SMME loan portfolios. Several PDCs have undergone severe financial crises since 1994 and some have attempted restructuring. In some cases, the financial crises were exacerbated by provincial authorities' attempts to channel subsidised credit through these institutions. Given the lack of existing infrastructure, it is thus critical that relevant authorities, both at a national and provincial level, revisit once more the mandates of PDCs and consider the role that they could play in providing appropriate and sustainable support to SMMEs.

Furthermore, savings and lending vehicles for low income communities, such as municipal banks (as exist, successfully, in Peru), could also be investigated, and if they apply in the South African context, be encouraged.

Finally, the ability of alternative financial institutions to grow and prosper requires an added degree of regulatory credibility, which could emerge in the initial stages through the establishment of an ombuds function to handle complaints and help arbitrate disputes.

3.3.3 Equity finance programmes

An integrated programme to stimulate equity investment in SMMEs has not yet emerged. Khula has developed an equity programme that seeks to leverage private sector investment through provincial programmes. While the concept of provincial equity funds has merit, the emphasis has been on larger scale investments from R2 to 5 million upwards. Thus the programme in its current conception does not address the market gap for small-scale and start-up investment capital.

Ntsika has not yet established non-financial support programmes to reduce the cost of making equity investments in SMMEs. Donor-funded programmes, such as the EASY initiative funded by US AID, have instead sought to fill the gap. These programmes assist entrepreneurs with structuring proposals, the performance of initial due diligence, and the identification of potential funders. However, these programmes do not have the funding required to reach significant scale.

Furthermore, the risk of business failure and the scarcity of potentially profitable business opportunities present real constraints to equity financiers. Targeted support and training for SMMEs must be developed, to both increase the profitability of existing companies and to reduce the risk of business failure for new enterprises.

Finally, the risk perception of institutional investors must be addressed. While successes in the SMME sector would probably have the most significant effect in the long run, in order to stimulate private sector funds in the short run a set of clearly defined tax incentives could be investigated. Social responsibility guidelines could also be considered.

The SBDC is another institution that holds significant government funds. The SBDC's mandate has been revised and its core business is now equity financing. Its target market is small and medium sized enterprises that require capital between R50 000 and R3 million. It has thus positioned itself to provide support in an area where a market gap exists. Should the SBDC be successful in providing equity investments in these ranges, it could stimulate the market for small-scale equity investments. However, currently, most SBDC transactions are loans that use an equity stake to increase returns and to substitute for collateral. While the approach is innovative, it is not fulfilling the mandate of the institution. Furthermore, the borrower profile of the SBDC is changing only marginally. However, targets have been put in place to achieve a transformation of the SBDC over a five year period. These figures should be made public, so that the SBDC is held publicly accountable.

3.3.4 Other programmes

The IDC is currently reorienting its loan programmes to include an increased emphasis on small and medium sized enterprises (SMEs) in the manufacturing sector and has recently announced a cut in interest rates for small and medium-sized manufacturing enterprises. With its experience in industrial financing and the provision of subsidised credit, as well as its significant capital base, the IDC is in many respects an ideal institution for channelling subsidies to SMEs. However, the IDC defines SMEs as enterprises with assets below R60 million. In terms of the National Small Business Act, the enterprises with assets up to R18 million are defined as medium-sized. Thus, effectively, the IDC is still targeting large enterprises. The IDC should thus be encouraged to consider smaller enterprises than are currently served.

The Department of Trade and Industry also offers a host of other programmes and incentive schemes. One programme specifically tailored to small and medium sized manufacturing concerns is the Small Medium Manufacturing Development Programme (SMMDP), designed to encourage investment by SMEs. The programme essentially offers a rebate on a portion of the investment incurred over a period. While there has been great interest in the programme, previously disadvantaged entrepreneurs in particular have had difficulty in accessing it, as they have largely been unable to obtain the finance for the initial investment. There is thus a need for greater cooperation between Ntsika, Khula, the IDC and commercial banks with the SMMDP programme, so that an integrated support package can be developed.

3.4 Structural Impediments to SMME Investment

While incentives have been put in place to stimulate SMME investment, their success will be limited by the structure of the financial system. Due to limited competition at all but the highest end of the market, there is little incentive for banks to explore new markets and products. Yet due to increased competition between institutions for high-income consumers and corporate accounts, banks do not have in place the kinds of cross-subsidisation systems that might solve the problem of limited SMME access to financial services infrastructure.

The financial sector is composed of a highly concentrated formal banking sector targeting corporate accounts and competing with smaller niche banks and investment banks. South African banks are considered profitable by international standards, despite inefficiencies resulting from the lack of domestic and foreign competition. Approximately 85% of all bank assets are held by four banks.

There are few second tier banking institutions that can absorb savings and extend credit. While credit unions have the potential to grow into a secondary banking tier, the sector is undergoing a transition. Furthermore, as credit unions target the employed rather than the self-employed, they have little applicability to SMMEs. Another savings vehicle, the Post Office Savings Bank, offers (relatively unsophisticated) savings services but little in the way of credit. Finally, there is a dearth of strong alternative financial institutions providing credit to the self-employed for productive purposes.

Government needs to help stimulate a greater diversity of financial institutions, especially alternative financial institutions that serve as vehicles for savings and loans to low and middle income individuals, as well as the self-employed.

The White Paper on National Strategy for the Development and promotion of Small Business in South Africa makes reference to the need for a legislative review or a Small Business Finance Act with the following purpose:

A new act, or the addition of relevant clauses to existing legislation, could address a number of fundamental issues regarding the access to finance by SMMEs. This could include steps to encourage existing financial institutions to become more active in the SMME-market segments, the facilitation of deposit-taking by lender-NGOs, the recognition of certain non-conventional collateral types and the widening of scope for more specialised lending and investment institutions focusing primarily on SMME needs. (p.26, paragraph 4.1.3)

In this context, legislative review is proposed.

The current legislative framework makes provision for a two tier banking system. Two pieces of key legislation govern the system: the Banks Act, and the Mutual Banks Act.

3.4.1 The Banks Act and the Mutual Banks Act

The need for firm financial regulation is rarely contested, especially in light of the recent spate of domestic financial system crises from Mexico to South Korea, and many places in between. As expressed recently by Joseph Stiglitz, World Bank Chief Economist, ......" I have sometimes likened the financial system to the "brain" of the economy. It plays an important role in collecting and aggravating savings from agents who have excess resources today. These resources are allocated to others - like entrepreneurs and home builders - who can make productive use of those resources... The most important lesson of the theory and observation of financial markets is the pervasiveness of market failure... "

In successful financial markets, regulations serve four purposes: maintaining safety and soundness (prudential regulation), promoting competition, protecting consumers, and ensuring that undeserved groups have some access to capital.

In many cases, the pursuit of social objectives - like ensuring a supply of funds to minorities and poor communities, as under the United States' Community Reinvestment Act - or ensuring a supply of funds for mortgages, the essential mission of the government created Federal National Mortgage Association - or ensuring a supply of funds for small businesses, the central objective in the United States of the Small Business Administration - can, if done well, reinforce economic objectives. ("More instruments and broader goals: Moving toward the Post-Washington Consensus", 1998 WIDER Annual Lecture, Helsinki, Finland)

The main object of the Banks Act (1990) is to create a framework for the regulation and supervision of institutions accepting deposits from the general public, in order to safeguard the investments of depositors and to protect the integrity of the banking system. The Act was passed at a time when many institutions were failing, and as large mergers and acquisitions (in one case supported with a huge Reserve Bank loan at highly subsidised rates) reduced competition the banking sector dramatically.

The banking environment, which is characterised by deregulation and greater risk for those institutions already well established, creates high barriers to entry. Along with conditions in the market, the regulatory environment has generated a few powerful banking groups which dominate the industry. Criticism of the Banks Act and the prospects of a new Community Bank led to the promulgation of the Mutual Banks Act (1993).

In order to register as a bank or a mutual bank under the Acts, an entity needs to comply with certain statutory requirements, both in relation to the application for registration, its ongoing operations and prudential requirements. Generally, it would be obliged to:

1) meet certain capital adequacy requirements, which entail maintaining issued primary and secondary share capital as well as primary and secondary unimpaired reserve funds in an amount of at least R10 million in the case of a Mutual Bank and R50 million or up to 8% of its risk exposure in the case of a commercial bank;
2) maintain a minimum reserve balance in an account with the Reserve Bank to an amount equal to 1% and 3% of its liabilities to the public;
3) hold liquid assets of not less than 5% of its total liabilities;
4) carry on its operations subject to certain restrictions e.g. it may not be exposed to any individual person in excess of certain percentages without making specific reports to the Registrar; and
5) give monthly and quarterly returns showing its various risk exposures and the manner in which it is complying with the above mentioned capital adequacy and liquid asset requirements.

The Banks Act introduced a general prohibition on the taking of deposits from the general public unless an institution is registered as a bank. Taking deposits as security for the completion of a contract is exempted under the Act. Similarly, taking deposits against the issue of commercial paper is exempted (however, such funds may not be used for lending). Only stokvels and credit unions with capital of less that R10 million have been exempted from requirements of the Act.

The Mutual Banks Act sets out to create a regulatory framework for mutual membership in a banking organisation with above R10 million in capital. The primary feature distinguishing mutual banks from existing equity banks lies in the corporate constitution, in that its members invest in shares permissible for mutual banks. The Act was intended to promote the creation of a second tier of banking. However, its capital and reporting requirements are generally regarded as being so stringent and inflexible -- in part because of the special purpose institution for which the Act was intended -- that an innovative second tier has not emerged.

According to a regulatory panel established jointly by Khula Enterprise Finance Limited (Khula) and the National Housing Finance Corporation (NHFC), both the Banks Act and the Mutual Banks Act are too restrictive to encourage the registration and regulation of alternative lending institutions. Under both Acts, institutions are regulated by the Registrar of Banks, an inhibiting factor given the type of lending approaches and the collateral accepted, as well as the cost of complying with the reporting requirements. Furthermore, as the Registrar must be satisfied with the directors and senior management, it may imply hiring more highly paid staff which in turn may affect the viability of the institutions. The Act's minimum capital of R10 million is perceived by many NGO practitioners as being excessive, and the Act's liquidity requirements would sterilize too great a proportion of loanable funds. Finally, the form of ownership imposed by the Mutual Banks Act is restrictive and does not allow for stock ownership.

In order to create an enabling environment for a second tier of banking, it is necessary to review the Mutual Banks Act. Furthermore, it may prove necessary to consider a form of deposit insurance for special purpose institutions so as to assure public confidence at a time when many informal (and new, formal) financial institutions have struggled to survive. Introducing a system of deposit insurance would protect depositors, especially in smaller banks and savings and loan institutions. Currently, the banking sector is so highly concentrated that banks can insure themselves, and their cross-ownership with major conglomerates and insurance companies provides an additional measure of security. The Reserve Bank's doctrine that some banks are "too big to fail" also provides a corresponding deposit insurance to many depositors in the large institutions, which is not yet matched by support to smaller financiers.

3.4.2 Interest rates

One of the main factors inhibiting greater SMME activity in the financial sector is the level of interest rate required to make lending profitable. There are two ways to consider the problem. Firstly, most of the subsidies directed to SMMEs for financing have gone to suppliers in one form or another (either through operating subsidies to NGOs or in the form of guarantees on lenders' funds). Very few subsidies find their way, directly and transparently, to borrowers. Yet if increased SMME activity is desired in targeted sectors and if interest rates hamper SMME development in these sectors, there should be greater scope for government and agencies at all tiers (local, provincial and national) to shift subsidies towards select borrowers if this is transparent, economically and socially justifiable and does not lead to open-ended obligations. Secondly, the Usury Act has been raised as an inhibiting factor, and should be revisited, in the context of an appropriate mix of regulation and deregulation of the financial system.

In general, interest rates are, at present, at their highest real (after-inflation) levels in South Africa's history. Complaints about the unaffordability of credit are thus not limited to SMMEs. So far, most of government's various programmes have been aimed at changing the behaviour of suppliers of credit, with financial subsidies rarely reaching credit beneficiaries directly. However, subsidies in the form of non-financial support have been an integral component of the National Small Business Strategy and large numbers of SMMEs have benefited from these programmes. Targeted subsidies as part of an integrated support package for SMMEs could therefore be considered in the context of regional (provincial or local) economic development through appropriate government agencies such as the Industrial Development Corporation (IDC).

Below-market lending for selected beneficiaries may be justified if targeted enterprises (and their local economies) benefit from having a larger source of funds available to reinvest as a result. But this raises the issue of the maximum rate permissible for SMMEs. Here again, there is a rationale for government intervention to prevent debt burdens from becoming extremely onerous. That was historically the purpose of the Usury Act.

While interest rate deregulation -- in the form of a larger Usury Act exemption than the present R6 000 -- and changes to banking legislation could together increase the numbers of creditors willing to become active in SMME markets, international experience cautions against summarily lifting interest rate ceilings. In order to prudently liberalise interest rates, the following four conditions should prevail:
1) high levels of macroeconomic stability;
2) high levels of bank solvency;
3) high levels of competition and low barriers to entry in the financial sector; and
4) strong and capable supervisory institutions, and ability to intervene in the case of bank failure.

With the development of the financial sector and increased competition both for credit extension and for deposits, a substantial deterioration in loan assessment and therefore portfolio quality could result. It is therefore critical that a strong regulatory and supervisory structure for deposit-taking institutions is in place.

Furthermore, a system of deposit insurance would have to be considered, should the financial sector begin to open up to more institutions of varying sizes. If the market is not contestable, it will not change the behaviour of major banks and the current lack of price competition would prevail.

Financial sector liberalisation could have significant benefits, if properly phased. However, it should be a gradual and closely monitored and controlled process, and usually best occurs towards the end, not the beginning, of economic restructuring and reform. What is suggested in the short-term is not deregulation, but rather a process of reviewing the regulatory framework gradually to allow for increased competition. Ultimately this may permit a gradual raising of the Usury Act exemption, in the context of a general rewrite of the Act.

3.4.3 Disclosure and penalties

In order to ensure that there are penalties in place should banks and institutional investors not significantly increase the volume of investment in SMME, a variety of measures including new legislation modelled on the US Community Investment Act (CRA) could be introduced. The main objectives of such measures would be increasing the disclosure of who lends and to whom (in general terms while assuring client confidentiality), improving the monitoring of SMME financing, assessing penalties for non-performance and discriminatory behaviour and outcomes, and establishing a customer-driven complaints process.

In the United States, the CRA is applied to deposit-taking institutions that are formally chartered to do banking business (and hence that have access to the national deposit insurance system). Federal and state regulators investigate the CRA records of banks and accord performance ratings during banking examinations. The penalty for a bad CRA rating is that regulators decline permission for mergers and acquisitions, the opening of new branches, and other regulated business activities. As a result, communities have used the process to more coherently voice their objections to bank business practices, and to negotiate reinvestment commitments from banks. Similarly, by being chartered and falling under the protective arm of the Reserve Bank and the financial registrars, South Africa's financial institutions have an obligation to increase their efforts to meet the banking (lending and deposit) needs of their entire communities. Failure to do so in a systematic way should be the basis for penalties.

However, in applying CRA type legislation in South Africa, it will be necessary to take a broader view than is currently the case in the US. The insurance industry and pension funds, for example, should also be included amongst those having responsibility for expanding their financial services, as they draw on domestic savings. Limited-purpose financial institutions attempting to serve only high-income market niches should not be exempt from the social responsibility of channelling investment funds more productively, and without discrimination based on size of potential borrower.

In addition to new CRA legislation, the outcome of consultations around the new Monopolies Act should be closely monitored, and the small business sector could consider proposing the inclusion of a clause that sets out developmental criteria to be taken into account when considering mergers or acquisitions.

Furthermore, disclosure is critical. The SA Reserve Bank and the Financial Services Board could be tasked with publishing data on financial sector investment in small business, housing and education. These data could serve to inform decision making in a range of areas associated with approval of mergers and acquisitions, and with the investment of public funds.

Finally, the banks could also be required to periodically publish information about the availability of bank infrastructure, to address the community access consequences of branches that have closed, are to be closed or that will provide limited service, and to provide plans about increasing their infrastructure and marketing to reach areas not presently served by the banking system.

3.5 Conclusion

While programmes currently in place address some of the obstacles to institutional investment in SMMEs, there are certainly areas in which dramatic improvement is required, notably around the provision of non-financial support tailored to the needs of formal financial intermediaries and equity financing. A model for large-scale service delivery to micro-enterprises should be developed from the various small-scale programmes presently underway. A need to increase the scale of the programmes has also emerged, notably around the Credit Guarantee Scheme. And means of addressing the responsibilities of banks to meet the needs of their entire communities, such as legislation, should be pursued.

The revised and expanded programmes, however, only begin to provide the incentives for greater private sector involvement, and the penalties associated with failing to meet a more comprehensive cross-section of community needs. A broader policy framework that begins to address the structural impediments to increased SMME investments must be developed to supplement and support the revised incentives and subsidies that flow to the private sector through Khula and Ntsika. The policy framework should allow for an opening up of the financial sector to enable the development of a greater diversity of institutions. In addition to reducing barriers to entry, however, a more explicit set of regulatory "incentives" should be developed to overcome the resistance of institutional investors and formal financial institutions to recognize the potential profitability of SMMEs.

Chapter Four:

Towards a New Policy Framework

4.1 Introduction

The framework for the development and implementation of a small business financing strategy recognizes that in order to achieve our macroeconomic and developmental objectives, significant state resources must be dedicated to the revision and expansion of incentive schemes. However, it also recognizes that the private sector should play a significant role in resource mobilisation and in directing investment flows towards SMMEs. In this regard, the strategic framework must include both incentives as well as penalties. A new framework must, therefore, encompass the following:

1) a regulatory framework that ensures optimal allocation of investment funds, by
a) ensuring a high level of efficiency in the provision of investment capital;
b) maintaining the stability of the financial system;
c) securing an investment climate that will attract foreign investment;
d) reducing barriers to entry;
e) protecting the interests of all parties availing themselves of financial services; and
f) facilitating the inclusion of all sections of the population in economic activity.

2) the expansion of an integrated system of government incentives that leverages capital into areas where there is a lack of investment caused by market failure or other reasons.

3) public-private partnerships based on the principles of cost- and risk-sharing.

4) clarification of the respective roles of national, provincial and local government.

4.2 A Strategic Framework

In order to develop a comprehensive and integrated strategy, the following activities, roles and responsibilities are envisaged:

4.2.1 Legal and regulatory framework

1) A review of the Banks Act, the Mutual Banks Act and the Usury Act should seek to open up the formal financial system and reduce barriers to entry, but maintain the integrity of the financial sector. The focus will first be on establishing a sound system of regulation that encompasses the needs of all South African banking customers, redrafting the existing legislation and revising the Usury Act. Consultation with other government departments on legislation will proceed with the Departments of Finance, Housing, and Agriculture, the Land Bank, the National Housing Finance Corporation, Khula and the South African Reserve Bank.
2) A review of the Pension Funds Act, the Insurance Act, Securities Act, Financial Markets Act and Stock Exchange Act will seek to allow investors greater freedom in investing funds at their disposal, while maintaining a level of protection for different classes of investors.
3) A review of financial contracts and collateral laws will seek to facilitate the registration and realisation of collateral.
4) New CRA-type legislation will require disclosure of lending and investment patterns, penalise lack of investment by large institutional investors and the formal financial sector in socially and economically productive areas, and make discrimination in any form of credit extension illegal. This legislation will be considered alongside similar initiatives of the Departments of Housing and Finance and the South African Reserve Bank.

These issues will be considered under the National Small Business Regulatory Review process that is already in motion.

4.2.2 The Role of government and implementing agencies

National
1) The Khula Credit Guarantee Scheme will be revised and expanded significantly to facilitate greater access to finance for entrepreneurs.
2) There will be more non-financial support services, better tailored to the needs of financial intermediaries, so as to facilitate greater access to debt and equity finance for entrepreneurs.
3) A wholesale equity programme will leverage capital for smaller, early stage and start up equity investments.
4) Possible tax incentives for institutional investors will be investigated, to enhance investment in SMMEs through the JSE and equity funds.
5) A model of large-scale delivery of SMME financial services, especially for rural areas, will be established.
6) There will be an investigation into a process for credit rehabilitation for borrowers with bad credit records listed with Credit Bureaux in association with the Department of Justice. Discussions around credit rehabilitation are already underway in the National Consumer Credit Forum.
7) Regional business incubation programmes will provide an integrated support package of finance, targeted subsidies, training, counselling, marketing assistance, business premises and technology assistance. The possible role of the IDC in the development of such programmes is to be investigated.
8) Specialised capacity building support (training, workshops, conferences) will be provided based on local and international best practice in areas such as individual lending methodologies for alternative and formal financial institutions and small scale and start up equity investments for equity financiers.
9) There will be a review of the impact of interest rates on SMMEs, and their contribution to business failure.

Provincial
1) There will be a review of the mandates of Provincial Development Corporations, particularly with respect to their pricing policies, the SMME and industry sectors targeted, the range of products and their suitability for the local context and provincial development strategies.
2) The role of the SBDC in the respective provinces will be assessed, and regional management will be approached regarding the SBDC's fulfilment of targets.
3) There will be an assessment of geographical areas in each province where there is a lack of SMME service delivery infrastructure as a basis to engage with Khula and Ntsika.
4) Closer relationships with regional bank officials will be established, and provincial accounts placed with banks demonstrating the greatest commitment to SMME sector.

Local
1) The Peruvian model of municipal banks will be considered as a means of better serving low and middle income groups and the self-employed.
2) Information about bank services at the local level will be gathered by means of guidelines and survey questionnaire.
3) Relationships with local bank officials will be established, and municipal accounts placed with banks demonstrating the greatest commitment to the SMME sector.
4) Local SMMEs will be supported through the provision of advisory and information services.

4.2.3 Private sector contributions

Commercial banks
1) Each financial institution should adopt targets for using the Khula Credit Guarantee Facility.
2) Each institution should introduce a training scheme for staff on SMME lending.
3) Each institution should make financial contributions to non-financial support services such as mentoring and counselling.
4) Each institution should clearly publicize its strategy for expanding financial services to unserved areas and should make full information available about services at branches.
5) Each institution should establish a strategy on how its infrastructure can be shared by alternative financial institutions.
6) Each institution should disclose information on lending to SMMEs, according to race, gender, geography, loan size and purpose.

Alternative financial institutions
1) Alternative financial institutions should adopt Khula industry standards.
2) Alternative institutions should enhance their efficiency and should lend at reasonable interest rate levels, within the constraints dictated by sustainability.
3) There should be research into, and publication of, successful individual loan methodologies, through microlender associations.
4) A comprehensive data base should be established describing institutions serving the SMME sector and publish information about products, terms and conditions.
5) There should be comprehensive disclosure of information on SMME lending.
6) The alternative financial institutions should help establish their own ombuds function to investigate and mediate disputes.
7) Alternative financial institutions should consider innovative ways of sharing infrastructure and achieving economies of scale.

Equity financiers
1) The major equity financiers, including the JSE and large institutional investors, should improve, and develop new, specialised equity funds for small-scale equity investments.
2) The Venture Capital Association should be revitalised, and should publish literature on equity products for SMMEs.
3) The equity financiers should initiate an education campaign on how SMMEs can raise capital.
4) The equity financiers should disclose information on SMME investments.
5) The equity financiers should look into the establishment of new JSE vehicles listing SMEs.

4.2.4 Monitoring and evaluation

1) An annual report on small business financing should be jointly produced by the Reserve Bank of South Africa, the Financial Services Board and Ntsika Enterprise Promotion Agency.
2) An annual round table discussion should commence between the Minister of Trade and Industry, the formal financial sector, institutional investors, NGO financiers and representatives of SMME borrowers.
3) Local and provincial government should provide ongoing reviews of the implementation of the policy in their respective areas.
4) Private sector investment in socially and economically productive sectors should be monitored by the Department of Trade and Industry.
5) Performance reviews of Khula, Ntsika and the SBDC should occur and be made public.
6) There should be progress reports to MINMEC, Parliament and stakeholders.

4.3 A Way Forward and Times Frames

This document has been submitted to MINMEC. Over the next two months, the focus will be on the development of a Plan of Action in association with SMMEs, NGOs and financial institutions.

A stakeholder workshop will be held on 28 April 1998 to discuss and obtain inputs on the document. Stakeholders will be expected to propose resource and other in kind contributions and a tentative time frame for implementation. In order to provide stakeholders with an opportunity to discuss commitments and time frames with their respective constituencies, a second workshop will be held at the end of May to confirm contributions and commitments as well as time frames. It is intended that a Small Business Financing Accord will be concluded at the second workshop.

The Department of Trade and Industry wishes to express its gratitude to a range of stakeholders who have made valuable contributions to the formulation of this document.

The Department would particularly like to extend its thanks to the Portfolio Committee on Trade and Industry for its insights, support and active participation, as well as to all the participants at the Cape Town workshop, who together helped shaped the contents of the this document.

Furthermore, the Department wishes to thank the Southern Africa Labour and Development Research Unit at the University of Cape Town for its assistance in the organisation and hosting of the Cape Town workshop, as well as for the preparation of a workshop report.

Finally, the Department would like to thank Khula Enterprise Finance Limited, Ntsika Enterprise Promotion Agency and the National Small Business Council for their inputs and contributions to the process, as well as a number of individuals who provided comments on the initial draft.