Banks can de-risk lending to SMEs

Phillip Niwamanya, the sector head oil and gas & value chain banking at Absa Bank.

What you need to know:

  • Banks are willing and ready to extend credit to SMEs, but this must be done responsibly.

SMEs are the life blood of Uganda’ economy. According to the Uganda Bureau of Statistics, there are an estimated 1,500,000 Micro Small and Medium Enterprises in Uganda which employ around 2.5 million people in Uganda's workforce. They make up 95 percent of the total enterprise population in Uganda and contribute 85 percent of Uganda's GDP.

However, about half of formal SMEs fail to access credit primarily because they lack collateral. Additionally, poor record keeping, poor working capital management practices, poor credit history, and the lack of information about available financing solutions also contribute to the inability of most SMEs to access funding from supervised financial institutions.

Many SMEs and businesses generally believe that the only way to access credit from a financial institution is if you have a piece of land or building that can be used as collateral for a loan.

And because the lack of collateral is one of the biggest hindrances to SMEs acquiring financing, many end up not living to their full potential even though they are the biggest drivers of Uganda's economic growth.

Banks are willing and ready to extend credit to SMEs, but this must be done responsibly, given the bank's duty of care to the public that entrusts it with its deposits and to protect shareholders' capital.

With this in mind, several financing models are available to SMEs outside of traditional borrowing through the collateral model – which still minimises the risk to the bank while also applying innovation to overcome the barriers to SME financing.

One such model is value chain financing – a nontraditional financing model aiming to lower the risk of lending to SMEs (specifically suppliers and distributors) that are part of an extensive and credible corporate ecosystem. This solution is founded on a close-loop deal structure (contract financing) aimed at mitigating performance and payment risks.

In partnership with corporates, banks can de-risk lending into the SME sector and use a forward looking cash flow based lending model to unlock unsecured lending to SMEs. This lending is conducted on the strength of confirmed contracts between the SME (borrower) and corporate (anchor) where the bank is able to leverage on the cash-flows from the contract proceeds for debt repayment.

Government and large corporates have a role in making this financing form accessible to many SMEs within their value chains. Entering into a partnership with a Bank can enable SMEs in their supply and distribution chains secure funding without the need for collateral. It may also result in negotiated rates for all SMEs within its value chain.

The partnership between the bank and the corporate does not make the corporate a guarantor for the SME but spells out the responsibilities of the corporate and the financial institution in the financing arrangement.

To qualify for this form of financing, SMEs should keep good financial records that demonstrate the financial health of their businesses for at least three years, have formal contracts with corporate companies, and ensure that their performance targets with these companies are well documented, strive to adhere to the financial and non-financial covenants included in their agreements with financial institutions, maintain a clean credit history by ensuring that they meet their financial obligations with any financial institution and SME directors should also strive to maintain a clean credit history.

Prioritising this and other innovative financial instruments will help support the growth of Uganda's indigenous private sector, increase exports, create jobs, and improve local content as outlined in the government's National Development Plan III and the 'Buy Uganda Build Uganda' agenda.

For this to happen, however, there is a need for all the players involved to innovate towards overcoming the unique challenges that lower SMEs' chances of accessing credit and taking advantage of all the opportunities available in the market to help them grow their businesses.

The author is the sector head oil and gas & value chain banking at Absa Bank.