Why do Africans miss Formal Sector Investment every day?

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A successful process to raise funds for your business is the first step towards achieving success. Your business may not be able to materialize productive investment opportunities without access to easy and timely finance.

Whether it’s a start-up or an expansion, financing is a crucial step towards business success. Generally, financing is raised to fuel working capital and asset purchases.

Working capital is the amount required to manage your day-to-day business operations. This is the amount that needs to remain stuck in the business. It may be in the form of inventory, receivables, and prepaid assets. On the other hand, asset purchase is about the acquisition of the property, plant, and equipment to support the expansion and strategic capability of the business. 

It is relatively difficult for small businesses and individuals to raise finance in Africa. This article will focus on why the difficulty to get financing from formal financing institutions like banks, insurance companies, leasing companies etc.

Africa’s generally low-income economy plays a major part in this.

It’s important to note that the goal of financing companies and banks is to make money. Their business model is based on collecting interest, premiums, fees, and principal repayment. So, higher amounts of interest and premiums can be collected when the targeted country has a higher income level.

Unfortunately, African countries have some of the lowest income levels. As per a recent report from the World Bank, more than half of sub-Saharan countries have a poverty rate of more than 35% (world bank). And a more alarming situation is that there has been a 3% rise in poverty in recent years mostly due to the Coronavirus pandemic (UN). Furthermore, it is projected that 6% of the entire world’s population in 2030 will still be living in extreme poverty if current trends continue (UNSTATS). So it becomes difficult for the banks and other financing companies to collect timely repayment for the interest and principal. 

Another picture to analyse is that banks approve a loan for the business on the basis of financial feasibility and financial sustainability. It is difficult to prove financial feasibility/sustainability due to lower buying power in African countries. So, there are few instances when financing is approved for the Africans. 

Financial feasibility is focused on the economic viability of the project. It helps understand the related cost, expenses, and revenue specific to the project. If expected revenue is higher than the total cost, the project is financially viable. However, it’s important to note that feasibility involves operational aspects like managerial competence, operational capacity, and other aspects.

Financial sustainability means the business is able to sell the products/services at a price that covers expenses and leads to profitability. In other words, if the business is not able to generate sufficient return for the stakeholders, it will not be able to survive in the long term.

Most businesses do not know how to present their proposals in this manner to analysts in the formal financial markets i.e. clearly articulating the financial feasibility and sustainability of their projects in a format that can be easily be assessed. 

The Business Plan/Proposal is your story of why you need the capital and that should clearly spell out how the investor stands to benefit and how their funds will be safeguarded with clear structures on how every single aspect is going to be handled. Identify all the risks in your business and how to mitigate them and you will have the attention and interest of the investor/lender.

In Africa, many households complain that they do not get financing while many banks complain they are not able to find creditworthy customers. Hence, one prime reason for limited banking activity seems to be the lower-income economy of an African region.

The irony is that greater financing efforts by the formal financial institutions to these same low-income households will help to foster the economic development of the country, of the continent. For instance, financing made available by the banks can be used to efficiently run business operations leading to enhanced production, exports, revenue, and increase of a country’s GDP. So banks have massive potential to enhance economic activity. However, their personal interest is at stake here in such situations as they may not be able to collect their funds. To chip in on insurance companies, they also depend on the premium collected from policyholders. Hence, they also consider businesses’ ability to pay a premium on a timely basis. (VOXEU)

Further, businesses operating in a low-income generating economy may not be able to cover the financing cost, as their revenue may not be sufficient to cover the operational expenses. And in the instance where they have a good case, articulating this to the formal financial sector can be a barrier to accessing financing.

An interesting side of the business model of the bank should be looked at. Understand that banks raise cash through deposits, amongst other ways. The cash is deposited in the banks via current accounts and savings accounts. On the current account, the bank does not need to pay interest. However, banks need to pay interest on the savings accounts.

Generally, that cash is disbursed as a loan at a higher interest cost than the interest payable on the savings accounts collectively. The difference of interest payable on the savings accounts and interest receivable on loans is income for the bank.

That said, banks are usually reluctant to disburse loans into a low-income economy because of fear of bad debts. So, they prefer to invest deposits in the Government and other stable cash-generating securities with a low risk of default. Alternatively, the bank can also invest in foreign securities. It helps them in managing risk on the investments portfolio and balancing their income/expenses with higher confidence.

This creates a low negative impact on banks’ profitability even if they are not able to locate enough creditworthy borrowers. Hence, the banks can extend utilising this simple business model and enjoy profitability.

Shortage of information from and about borrowers poses another great problem, as earlier stated; but let me dive in further. Sometimes, the business idea is strong, managing personnel is competent, and the market is attractive as well. The problem then seems to be that the business idea is not pitched in an effective manner leading to an understanding gap between primary lenders like banks and small businesses/households. 

Correspondingly, when a bank does not know or understand you, it becomes difficult for banks and other financial institutions to trace the credibility of the loan applicant. Many times, a bank will tell you to bank with them for a while before they consider you application. It’s for good reason; sometimes the intention of the loan applicant might be to deliberately default on the loan. From a bank’s perspective, when it’s difficult to assess the intention of an applicant there exists a real risk of moral hazard (intentional act to default on the loan) (IDEAS).

Looking at developed countries like the United States and the United Kingdom, the financial credibility of an individual can be traced relatively easily in terms of timely repayment and other aspects. So it’s easy for banks and financial institutions to assess the creditworthiness of an applicant. 

On the other hand, in Africa, there is no strong mechanism to trace financial credibility. Hence, it can be difficult for financial institutions to bypass moral hazards and approve financing, leading these banks to invest sizeable amounts in foreign assets. These are money that is withdrawn from the economic system instead of being used to enhance the local industry.  

Generally, there is also a lack of information on the financing type that suits a particular project. Most business owners consider financing to be simply “loans” because that is what is commonly known. However, depending on your business model, different types of financing may be better suited for you. Businesses can raise capital in 3 main ways; by borrowing (debt financing), by equity capital or through the profits from operations. (Investopedia)

Debt financing or debt capital is when a company borrows money and agrees to pay it back at a later date to the lender with an interest. Debt capital is usually in the form of loans or corporate bond issuance. With corporate bonds, an investor buys the bond, effectively lending money to the business for a period of time (maturity) in exchange for regular interest payments from the business (issuer). Once the bond matures, the original amount given to the company (face value) is paid back. Loans are usually taken from financial institutions such as banks which also charge interest and require the lender to make regular payments (usually monthly) irrespective of the performance of the company. 

Equity capital is simply funding for the company in exchange for a stake in the company, usually in the form of stock or shares. With equity financing, the money isn’t paid back and the company doesn’t have to pay interest. The catch is that some control of the company is ceded and all future profits that are made, will be shared with the investors in an already agreed manner. Therefore, there isn’t a lot of pressure on the company to make profits as compared to financing with debt capital. Hence this kind of capital can be raised even if the company isn’t making money yet. The investors make money when the company value appreciates or dividends are paid or both.

Profits from operations is usually the preferred means of financing growth in a company. However, sometimes when the expansion is huge, it is simply not sufficient and outside funding has to be sought.

Businesses, therefore, need to analyse their situations and decide what option works best for them.

SO, WHAT CAN BE DONE TO ENHANCE FINANCING FEASIBILITY FOR THE AFRICANS?  

There is a need to install a credibility tracking system in terms of personal finance management – a working credit bureau. It requires setting certain mechanisms that track the payments and money behaviour of the individuals. For instance, data can be collected from utility companies, banks, financial institutions, financing companies, and other organizations. The person with proven financing credibility should be given a higher score and vice versa. Although it may be challenging, it is highly feasible in the long run.

There is also the need to enhance banking regulations in terms of an enforceable contract. Enforceable contracts can help to enhance the quality of banking operations. It sets a certain threshold for the operational regulations on lenders and borrowers.

Strong regulations in areas of loan approval and recovery can lead to optimized processes, low default risk, and low risk of adverse selection. Banks can then more confidently lend. 

Just my two cents.

We should as well promote healthy economic activities in the economy. There are various ways to promote economic activities and financial stability in the country. For instance, Africa can work to promote diversification in terms of business operations, replace imports with viable local production alternatives, increase exports, increase financial literacy, advance initiatives that boost entrepreneurship and take steps towards the transition to sustainable energy. 

I will admit: it is and has been difficult to formulate a single strategy to respond to all these issues. However, general growth in the economy can lead to better financial operations and increased banking activity in the country.

In conclusion, financing is the first step to fuel expansion and working capital management. Without quick and easy financing, it can be difficult for entrepreneurs and small businesses to execute a business idea and ensure economic viability.

In Africa, it’s difficult to raise financing from the formal sector because of a low-income economy, some banking regulations, a lack of knowledge on the kinds of financing available and suitable for one’s needs and a shortage of information available to banks for loan approval. 

Loan approval from the bank and other financing companies is based on two factors. These factors include moral hazards (intentional act to default by individuals/businesses) and adverse selection (not being able to properly assess the financial feasibility of the projects). These factors seem to contribute to a higher default rate for loans in Africa. Hence, banks prefer to invest deposits in Government-backed/foreign assets. 

If the banks invest in foreign assets, they earn a return on the investment. However, cash is pushed out of the economy. We prefer it not so.

Different steps can be taken to enhance overall banking processes. These include setting a robust structure for a working credit bureau, promoting healthy economic activities in the country, and ensuring the implication of the regulations on a complete process of banking that results in more funding.  

The system of credit bureau traces and collects payment-related information from different places and helps build a trend showing the payment habits of a specific person. It helps banks and other financing companies in understanding an individual’s financial credibility. So, these steps can help to bridge the gap.

 

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References

IDEAS. (n.d.). https://ideas.repec.org/p/lec/leecon/11-19.html 

INVESTOPEDIA (n.d.) https://www.investopedia.com/ask/answers/03/062003.asp 

INVESTOPEDIA (n.d.) https://www.investopedia.com/ask/answers/032515/what-are-different-ways-corporations-can-raise-capital.asp 

  1. (n.d.). https://news.un.org/en/story/2022/01/1110192

UNSTATS (nd) https://unstats.un.org/sdgs/report/2019/goal-01/ 

VOXEU. (n.d.). https://voxeu.org/article/why-do-african-banks-lend-so-little 

World bank. (n.d.). https://blogs.worldbank.org/opendata/african-countries-show-mixed-progress-towards-poverty-reduction-and-half-them-have-extreme

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