Submission to the Portfolio Committee for Trade and Industry
on
The role of banks in financing SMME (Small, Medium & Micro
Enterprise)

1. Introduction

Three sets of high-level forces bear on bank financing of SMME -

• The imperatives which dictate that the South African economy must be substantially transformed, the distribution of income equalised, and large numbers of people integrated into the mainstream of South African life;
• The soundness of the South African financial sector must be maintained; and
• The practical difficulties in lending to start-up businesses with a debatable business proposition, no risk capital or collateral, and limited management resources.

The banking industry understands the imperatives well. And for that reason there is a high level of commitment to finding solutions.

The first two sets of forces are given, but the practical difficulties of lending to SMME vary significantly between the S, the M, and the M, enterprises. The reality is that lending to Medium and Small enterprises is profitable, and established medium and small enterprises do not, by and large, have difficulty in accessing bank finance (although start-up ones might).

But the costs of making loans to micro enterprises are enormous compared to the amount of the loan, and it is almost impossible for micro-entrepreneurs to cover those costs. Lending to very small enterprises is not much different.

This paper attempts to analyse the different forces and practicalities, and to suggest some principles on which we might begin to address them.

1. The domestic socio-economic context of this discussion

During the nineteenth century, when the economic structure of the country was in the melting pot, South Africa was rich in minerals and unskilled labour. This "natural" advantage led to the development of an economy that was dependent on unskilled labour for the extraction of minerals and the export of primary products. The export of those commodities paid for imported capital equipment and manufactured goods.

The consequence of a relatively high exchange rate and the failure to develop human skills was that the growth of our local manufacturing industry was severely inhibited. This situation changed after 1945 when import substitution was encouraged behind high tariff barriers in order to protect the fledgling domestic industries.

Virtually every sector of the economy was, as a consequence, very concentrated, and the financial services sector was no exception. As a legacy from the past we have four major banking groups which today account for over 80% of the total assets of the industry and over 90% of the total branch and other networks.

In the late 1960s it became clear that wealth creation does not lie in mineral extraction and import substitution, but in outwardly oriented manufactures and services, and more particularly in the development and effective application of the education and skills of the human resources of the nation. Unfortunately, by that stage, South Africa was destined to spend the next 20 years isolated from the world, and fighting its own peculiar set of battles.

2. The Apartheid constraints

• The Land Act of 1913 and the Group Areas Act of 1960 effectively prohibited blacks from owning immovable property anywhere in South Africa. The ownership of immovable property is, undeniably, the primary mechanism for the accumulation of capital, and blacks in South Africa did not have that opportunity until the 1980s.
• The Group Areas Act of 1960 also prohibited blacks from rising to the level of supervisor or above anywhere in the so-called white areas until the mid 1980s. So blacks had very limited opportunities to develop their management skills.
• The Bantu Urban Areas Act of 1961 and regulations prohibited any black person from trading anywhere other than from a limited number of trading sites (and subject to stringent conditions) in the black townships. This meant very limited opportunities for the development of entrepreneurial skills.

1. The imperative for a new socio-economic model

Consequently, when the new democratic government took power in 1994, it also took over an economy that had brought on 30% unemployment and a continuous deterioration in GDP per capita over the previous 10 years. The economy was not remotely equipped -

• to underpin the initiatives of the Government to stimulate economic growth and bring about a more equal distribution of incomes which will be necessary to satisfy expectations; or
• to redress the imbalances of the past.

In fact, the formal sector continues to shed jobs in significant numbers rather than creating them.

It is not a question of whether the economy needs to be re-structured. It is a question of how and how fast. In future it will be the nimble small and medium sized enterprises producing goods and services for the domestic and export markets which create new jobs. It will not be the old, large, bureaucratic, primary producers.

Failure to create opportunities for the previously disadvantaged to fulfil their potential, and to some degree their expectations, is likely to result in anger and frustration. That would make it almost impossible to establish the peaceful and prosperous environment necessary to build a successful new South Africa.

It is essential, therefore, that we stimulate the development of

• medium and small businesses which are likely to be the "job" creators of the future, and
• very small and micro businesses which tend to provide subsistence-level self-employment opportunities.

1. The international or "global" context of this discussion

1. The "globalisation" of financial markets

Over the last 20 years "globalisation" of world commerce and of the financial markets in particular has accelerated remarkably, facilitated by modern technology.

Money is really no more than an item of information that someone owes another a given amount. Interest is the price that is paid for the use of someone else's money. Since computers can transmit information of this nature very easily and swiftly anywhere in the world, the market for money has been "internationalised". In the sense that money can flow and the price adjust very freely to balance the supply with the demand, the international market for money is probably the most perfect market in the world. Because it is international it is impossible to argue with.

Those international markets, and their view of what is happening in South Africa, directly influence the interest what we have to pay on our loans, and on the exchange rate of our currency. That puts us, effectively, in competition for finance with the Government of the USA, with the biggest bank in the world in Tokyo, and with the Shell Corporation wanting money to build a new oil refinery in Saudi Arabia.

It is probably needless to say that in this highly integrated market it is the market forces and not the decisions of Governments that determine the flow of capital and investment around the world.

2. The world financial markets are highly integrated

What has become increasingly apparent in the international market is that a banking failure anywhere can result in a banking crisis almost anywhere else. This is because the market is so integrated that an institution failing in one part of the globe can bring a whole string of others down with it. And of course, since banks throughout the world are dependent on trust to remain in business, there is a high level of systemic risk once there is a bank failure. This was very evident during the banking crises in Asia in 1998 which came precipitously close to derailing the world banking system. The three major failings in the Asian banking system were that:

• Banks were inadequately capitalised for the risks that they were carrying;
• There was inadequate and weak supervision; and
• Governments interfered in bank decision making, with the result that the banks were not accountable to the market place, but to the governments.

1. The tightening of banking regulations

Following the crisis, the international banking community has considerably tightened up the conditions on which a bank can participate in the international banking system by insisting on –

• Higher levels of capitalisation, particularly in developing countries such as ours where the risks are higher;
• More intense and on-site supervision; and
• Absolute market accountability. This means that the international community will not tolerate any governmental interference unless the Government in question guarantees the loans that it insists the local bank should make.

1. The requirements of the South African Bank Regulator.

South Africa is a very open economy and depends on the export and import of goods and services. The conduct of that trade, and the payment and receipting of the proceeds, are heavily dependent on having banks which are part of the international banking system.

We are also heavily dependent on foreign investment because -

• our existing productive infrastructure is out of date and deteriorating, and in many instances needs replacement; and
• we desperately need to grow; but to do so we need to increase our productive infrastructure.

The financial resources necessary to replace and improve that productive infrastructure cannot come

• from the Government, since it is still a dissaver; or
• from private citizens since they are saving less than 1% of their disposable income; or
• from the nation as a whole, since we are saving less than 15% of GDP.

The only real saving that is taking place is in the corporate sector.

That makes us heavily dependent on foreign investment and the international capital markets to finance the replacement and improvement of infrastructure. We will only get that investment if the right environment exists in South Africa for foreign investors to commit their capital. A sound and stable financial system is an indispensable component of that environment.

For that reason, the Regulator has no alternative but to ensure that

• the banks meet the international standards of minimum capital adequacy for a developing country such as ours;
• banks maintain international standards of best practice in relation to the conduct of their business; and
• the Government does not interfere in banks' decisions unless it guarantees the loans that it insists the banks make.

The first two imperatives significantly push up the costs of banking and force the banks to achieve a higher level of profitability. The Registrar has signalled his intention to increase the minimum capital requirement for banks from 8% to 10% to comply with the new Basel Principles. That means that where a bank had R80 million of capital and was making R16 million (i.e. 20%) profit and it is now required to hold R100 million of capital, it will have to make R20 million (i.e. 20%) profit to give the shareholders the same return on their investment.

Reserve Bank Deputy Governor Gill Marcus recently noted that

"One of South Africa's strengths, compared with other emerging markets, is its sound and well-regulated financial system. That gives foreign counterparties confidence in dealing with SA banks and contributes to SA's investment grade ratings by international agencies."

1. The profitability pressures on retail banks in SA

Apart from the regulatory pressures on our banks, we are also dependent on the four major banks for the nation-wide provision of banking services. According to an independent study done by accounting firm KPMG for the Registrar of Banks –

"Taking into account the full cost of capital utilised, the calculated loss for 'commercial banking activities' of the four major banks was R181 million in 1997."

An analysis of the profitability of the 4 major banks in South Africa is contained in Appendix 1. That analysis is based on the analysis presented to the Portfolio Committee last year, and has been updated with the latest data.

But the lesson remains the same -

Far from being too profitable, the four major banks' retail banking activities are not profitable enough to yield a satisfactory return on their shareholders' capital. They are therefore under considerable pressure to increase that level of profit, or to curtail their retail banking operations.

If pressure is put onto banks to do business which is likely to further undermine the business logic of providing a satisfactory return on investment to their shareholders, then they are likely to respond by contracting out of the markets in question even more rapidly than they are already doing.

Moreover there is no basis for distinguishing between banks, all of which trade under the same banking licence, and are subject to the same capital, liquid asset, cash reserve and other regulatory requirements.

At our peril do we, as a nation, fail to maintain international standards of best practice in our banking industry. If we do, the collapse of our economy might be even more dramatic and sudden than if we fail to bring people into the mainstream.

2. Seeking the "knife-edge" between maintaining sound banking practice and international standards on the one hand, and adopting an affirmative approach to the financing of SMME on the other.

The Minister of Trade and Industry has accused the banks of not doing enough to finance SMME's, and of being excessively cautious and "risk averse". There is no debate about the need to stimulate the development of Medium, Small and Micro Enterprises, but his statements must be tested -

• first against the facts (and the banks will give evidence of those);
• secondly against the practicality of banks lending to some categories of SMME; and
• thirdly against the international regulatory pressures.

The imperatives for bringing large numbers of people into the mainstream of the economy on the one hand, and of maintaining sound banking practices and of measuring up to international standards of capital adequacy and supervision on the other hand, are contradictory and cannot be ignored or wished away.

Somewhere between the two there must be a knife-edge, which we, as a nation, must find. It is also undeniable that "the banks" can, and must, do more to place themselves on that knife-edge.

But no-one has defined the "knife-edge", and the Government departments responsible for reconciling the conflicting forces have, to the best of our knowledge, not talked to each other about how they might do so. In defining the knife-edge we need to sort out which financial institutions, which new businesses in which sectors, what and how the Government and other sectors and institutions can contribute, within what framework, with what guarantees and so on.

This is an issue which we raised with the Government and with the Minister of Trade and Industry over a year ago. We fully understand the difficulties of defining the knife-edge, but it has to be done and the banking industry is committed to playing a constructive role in the process. The individual banks will detail how they are attempting to get onto the knife-edge in their own different ways, and what difficulties they are experiencing in doing so.

• the capital amount of the loan must be repaid. Effectively 92% of all funds that are lent out by the banks ultimately belong to the depositors and 8% to the shareholders;
• the loan must generate sufficient revenue to pay the interest which has to be paid by the bank to its depositors;
• in addition, the loan must generate sufficient revenue to pay the costs of granting, administering and recovering the loan, mentoring the borrower and covering any losses that might be incurred; and
• in addition to that, the loan must generate sufficient revenue to provide the shareholders with a satisfactory market-related return on their investment.

It is not sufficient simply to have "collateral security" for the loan. That merely addresses the first of the abovementioned fundamental requirements, namely that the bank will get the capital amount back. If the other three fundamental requirements are to be met -

• the business must be viable and sound, and
• the loan must be sustainable.

1. It is not necessary to have a banking licence to make a loan. The Banks Act only regulates institutions that take deposits from the public. Any person or institution may make a loan, and need not adhere to the same requirements as are set out in sub-paragraph 9.1 – although it is significant that well-managed ones invariably do.

1. A Viable business

1. At the most basic level of analysis, a viable business is one which has -

• entrepreneurial energy;
• the managerial skills necessary to manage the business and the resources successfully;
• a market which is willing and able to pay a profitable price for its product; and
• adequate risk and loan capital in the appropriate ratios.

1. The need for "entrepreneurial energy"

Most white South Africans have grown up and lived in an environment where the norm is a lifetime "job" with a big corporation or state department. Americans who come to this country remark time and again on the lack of entrepreneurial energy – the energy to move out of the protective environment of the big employer and take risks. Risk-taking is part of the way of life in the USA and most other high-performing nations, particularly in Asia. This should not be read as a commentary on the entrepreneurial energy of South Africans (who are unemployed) to subsist in the micro-sector.

The lack of entrepreneurial energy in South Africa is worrying, and there is no quick and easy answer to the problem. Clearly there is a desperate need for some sort of business education for young people.

One of the banking sector’s practical experiences of this phenomenon was the paucity of applications for Sizanani loans - even though the originating, mentoring and risk capital needs are effectively addressed through the grant funding of that organisation. Sizanani is a joint bank initiative under the auspices of the Banking Council which has been grant-funded by the banks and other donor agencies. Sizanani grants loans to very small businesses, arranges and carries the costs of mentoring for two years, and guarantees the loan which is then held on the books of the bank which introduced the application to Sizanani in the first place. A description of Sizanani is contained in Appendix 3.

2. Managerial skills

The only way to address this shortcoming is to mentor the entrepreneur on the job.

As will be seen from the calculations in Tables 5, this is costly, and in most instances cannot be borne by the very small business which has just started up and struggled to put up the necessary risk capital in the first place.

3. A market that is willing and able to pay a price for the goods or services that will yield the entrepreneur a profit

Not many very small businesses attempt to break into international markets, and so they are likely to be dependent on the domestic markets. Obviously those markets are weakened by the fact that the economy is growing so slowly, with over 30% of the population unemployed. Specific initiatives such as the Preferential Procurement Policy Framework Act are therefore important.

The irony is that we are all trying to assist in the establishment of sustainable businesses. If the preferential procurement contract is only for one year, it is rather like an addictive stimulant, which, when withdrawn, results in the addict collapsing into a weaker condition than if the stimulant had never been given. And yet that is precisely the form of many of the contracts awarded in terms of the Act. Banks have no option but to take the term of the procurement contract into consideration when considering a loan to a business which is relying heavily on that contract to establish its viability.

4. Adequate risk and loan capital in the appropriate ratios

When the bank insists on the entrepreneur having his or her own appropriate level of capital in the business, it is because that is necessary for the viability of the business. There are three basic categories of funding required by a business -

• The "owners", "founding", "venture" or "risk" capital (which we will continue to call "founding capital"). This is used to get the business off the ground, meet any unforeseen contingencies and provide the base on which the business can be "geared up" with asset-backed long-term loans and working capital. It ensures an acceptable level of financial resistance to business fluctuations. If the business is funded solely with loan capital on which interest has to be paid every month, it leaves no cushion if the cash flow of the business does not precisely match the interest payable on the loan.
• It is also essential from a business point of view that the owner of the business has something at stake. An individual will put more energy into something if he or she stands to lose something if it is not a success;
• Asset-backed long-term loans. This is used to acquire the fixed assets that the business needs. Banks and other financiers will almost invariably insist that the business uses some of its founding capital to pay a portion of the cost of the fixed assets; and
• Working capital, which is used to buy raw materials, pay wages, salaries and interest and finance the debtors of the business.

So the typical balance sheet of a highly geared business in South Africa might look something like this -

In the classical model of a new business, R500,000 (or 50%) capital would be required.

A major challenge to every enterprise is to manage the cash flow to meet the financial obligations of the venture. Failure to do that results in financial collapse. The bank requirement that there is adequate founding capital has little to do with needing "collateral security". It is only if the business goes insolvent that the preference of the creditors over the shareholders becomes an issue, and insolvency of the business is not what the bank is interested in. If the business goes insolvent, the bank and the shareholders have already lost, and the only thing in question is how much they will lose relative to each other.

One of the major difficulties we face is that black people in South Africa were historically deprived of the ability to accumulate capital through the ownership of immovable property. Very few of the black entrepreneurs coming forward therefore have the necessary founding capital and there are no institutions providing "venture" capital at the micro- or very small levels.

1. The Cruikshank Report

Recently the Cruikshank Report on competition in the UK banking system, and specifically the provision of banking services to the SME market, was released in the UK. In the Report the most common sources of founding capital for new small businesses in that country were identified as being –

"Family, friends, savings, Equity in residential property, Trade credit"

Table 6.1 page 169.

To improve the availability of risk capital in the UK, where there has been ample opportunity for capital accumulation over the years, Cruikshank has recommended that

"The Government should progressively switch financial support from the Small Firms Loan Guarantee Fund towards a greatly enlarged venture capital fund programme. This should be put on a permanent financial footing." (Para 6.45)

"The government should examine all its current and proposed policy interventions that are inappropriately focused on debt ……with a view to redirecting the resources to equity support for SME's."

Para 6.46

2. The need for venture capital

Khula has already made a move in this direction by establishing NEWCape Equity Fund. That fund is intended to provide venture capital of between R250,000 and R2 million, so it will not address the problems of access to venture capital for very small businesses.

The Small Business Development Corporation (SBDC) was originally intended to provide venture type capital in the very small business market, but it found over a period of time that it was not able to do that on a sustainable basis. So as Business Partners it now only capitalises the small and medium enterprises.

The Industrial Development Corporation, on the other hand, was never intended to address anything other than the need for venture capital in the corporate market, and has certainly never considered entering the very small business market.

The mere fact that none of the governmental agencies have been able to address the need for venture capital in the very small business market is no justification for dispensing with the business need for founding capital, and insisting that banks replace that with loan capital. To do so is to miss the point of why it is necessary for a business, and particularly a start-up one, to have adequate founding capital and the commitment of the entrepreneur.

This calculation only includes the cost of providing a mentor for the R30,000 very small business loan in Table 4. The R1 million small business loan applicant probably doesn't need it, and the R500 micro business loan applicant can't afford it. It is probably also true that the micro business is not complex enough to justify the mentoring.

But there is a further problem. Retail banking itself is becoming less and less profitable, forcing the banks to either

• reduce and scale down their branch networks;
• use electronics and ATMs; or
• change the functionality in the branches to one of a transaction and sales centre, but not a relationship or advisory centre.

Whichever strategy a retail bank adopts to contain the costs, it is no longer able to interface with, or mentor, the small entrepreneur at the local level. An analysis of this problem and some suggestions as to how it might be addressed are contained in Appendix 1.

1. Cost of liquid assets, cash reserves etc. required by the Reserve Bank

Banks have to hold 2.5% of their assets in non-interest bearing deposits with the Reserve Bank, and 5% of their liabilities to the public in low-interest bearing Government bonds. The opportunity cost of holding those deposits and bonds is about 0.4%.

2. Loss provision

There is regrettably always a risk factor in lending, and some loans don't get repaid. So a provision for that eventuality has to be built into the cost of the loan, rather like an insurance policy where everyone pays so that the ones who suffer the loss are covered. The risk factors that we have built in are based on the experience of the banks on the different types of loan, and the loss rate is calculated after recoveries on collateral security have been taken into account.

The analysis of the Banking Council corresponds with that of a Harvard Institute for International Development study into Commercial Bank Behaviour in Micro and Small Enterprise Finance (the Commercial Bank Behaviour Study, 1997). That study of 220 banks in 78 countries found that

HIID Development Discussion Paper No 471

1. Viability of the different categories of loan

1. Loans to going concerns which are appropriately capitalised

If the applicant for a loan is a going concern which is appropriately capitalised, three crucial factors are materially different from those of a start-up business -

• Because the business is a going concern, it is much easier to assess the viability of the business and the sustainability of the loan;
• No mentoring is necessary; and
• The funding of the business is stable, and on the basis of experience the losses of the banks are materially lower.

The consequence is that banks do a considerable amount of business advancing loans to small and medium enterprises which are going concerns. Some of them also make loans to very small businesses and even micro-enterprises falling into this category.

1. Start-up Micro-business loans

From the analysis in Table 5, it is evident that the rate of interest that would have to be paid by the R500 start-up micro-loan applicant to cover the costs of the bank is totally unacceptable. The loan itself is not sustainable, regardless of whether collateral security is available, which it almost invariably isn't. For this reason, start-up micro-businesses cannot afford to take loans from banks, and they do not do so anywhere in the world, unless the banks are heavily subsidised. Numerous international studies have found that subsistence-level micro-businesses must be funded by agencies which themselves are sustained by grant aid, and not by the commercial banks.

This is not to say that the banks do not have a role to play. It is only to say that it is most unlikely that the banks can, or ever will be, lenders on any significant scale to micro-businesses. However banks do have the network capability to handle transactions, and they are able to make loans to well-founded and secure NGOs. So it might be appropriate for banks to -

• gear up well-founded and well-run NGOs which are involved in providing finance to micro-businesses; and
• provide the transaction handling services to get the money into the hands of the micro-entrepreneurs and for them to make repayments to the NGOs.

1. Very small start-up business loans

0. Looking at the calculation in Table 4 for the R30,000 very small start-up business applicant, the loan cannot be regarded as sustainable. It is not realistic to suggest that a bank should be willing to grant a marginally sustainable loan to a start-up business -

• which has not proved itself to be a viable business; and
• without any collateral security.

1. It is noticeable that, in line with the findings of the Commercial Bank Behaviour Study, the factors which make the loan unprofitable are:

• the costs of granting and administering the loan;
• the mentoring costs; and
• to a lesser degree the level of bad debts on this category of loan.

1. For these reasons the banks have established Sizanani and Sizabantu, and grant-funded those two organisations. The joint bank project is described in Appendix 3.
2. Without this type of grant-funded support, loans between R10,000 and R50,000 are not sustainable by very small businesses. The Khula Loan Guarantee Scheme only covers a small range of the total problems involved in lending to very small businesses.

1. Small and Medium businesses

Most medium and small businesses were originally established with the necessary risk capital, and have proved that they have the capital, a market and the necessary managerial skills to make the business viable. So, apart from the requirements of a sustainable loan and a viable business, it is hardly surprising that the business frequently also has the necessary collateral security. In fact their difficulties seldom have anything to do with access to loan finance, and very much to do with cost of finance, red tape, access to markets, unfavourable tax comparisons, labour inflexibility and so on.

All of the major banks regard these two segments as extremely important contributors to their overall profits, and have very substantial books of these loans. This is in line with the findings of the Commercial Bank Behaviour Study that

"The main conclusions … are that banks world-wide are major sources of both micro enterprise and small business finance. These banks are in this business mainly for commercial reasons and not because of government requirement or policies. When banks do not make such loans it is mainly due to financial and organisational barriers rather than social and cultural problems."

(Ibid P31)

It should be borne in mind when reading this quote that:

• "Micro enterprise loans" imply loans of R70,000 and less, and "small business loans" are loans of R70,000 to R700,000 ($100000); and
• In other countries they do not have our problems of a lack of risk capital and the need for mentoring. It is those problems that make bank loans unsustainable for "very small" businesses. (See paragraphs 13.2.2 and 13.2.3).

1. Empowerment loans

Empowerment loans are granted to enable the previously disadvantaged to take over existing businesses. That enables the bank to evaluate the viability of the business on its previous track record. It is then usually able to take the shareholders' interest in the company itself as security for the empowerment loan.

This is obviously radically different to evaluating a start-up business, where there is no experiential basis on which to evaluate its viability.

1. Banks’ key interests are a sustainable loan and a viable business. Collateral is only required in case all else fails.

The analysis by the Banking Council in Paragraphs 9, 10 and 11 verifies the findings of the Commercial Bank Behaviour Study that the disincentives for making Micro and Small loans are:

• higher administration costs in 40% of the cases;
• lack of network and personnel to serve the market in 32% of the cases;
• interest rate controls in 29% of the cases;
• risky borrowers in 17% of the cases; and
• lack of interest in micro enterprises and other reasons in only 12% of the cases.

In the Commercial Bank Behaviour Study Report it is noted that

(Ibid, P7)

(Ibid P21)

The bank is looking for a client who is going to survive and prosper, and hopefully become a more profitable and bigger client in the future. It has no interest in a business client that is not going to survive. It is very seldom that a bank will make any profit at all out of a client that fails, even if there is collateral security or a guarantee.

By the time the client has gone into liquidation, or judgement has been taken and the collateral security realised, the costs of recovery grossly exceed the net interest revenue earned. Long before that time, the business logic for the bank has shifted from

"What profit can we make out of this loan?"

to

"How can we limit the amount of the loss that we are going to make on this loan?"

1. Definitions and Statistics

One of the difficulties that we have in even talking about the problems, let alone resolving them, results from a failure

• to agree what we mean by the terms Small, Medium and Micro Enterprises,
• as a consequence of that, to identify the different needs of the different categories of SMME,
• and as a further consequence of that, to collect data on the different categories of SMME.

While the National Small Business Act 102 of 1996 contains a definition of micro, very small, small and medium enterprises, it is complicated by the differences between sectors, and is not widely accepted and implemented as the norm.

1. Other issues

Attached as Appendix 2 is an analysis, from the banking industry's perspective, of the role of Khula and Ntsika, and a commentary on Community Reinvestment type legislation, and how it should be formulated and applied in South Africa.

2. Conclusion

It will be quite apparent that if -

• we are not to erode the confidence of the international community in our financial sector;
• nor fail to bring large numbers of our people into the mainstream of our economy and society,

we will have to define the elusive "knife-edge" between the two.

But banks will not be able to do so on their own. Policies and strategies need to be established at the national level, and there has to be reconciliation between the different arms of Government as to where the balance lies.

In our view it is also very clear that no single sector is going to be able to do this on its own. The Public, Private and NGO sectors must work very closely together, each one doing what it is good at and assisting the other sectors in the most appropriate way.

6^th June, 2000

1. A Financial Analysis of Retail Banking

South African banks are involved in a multitude of activities. The most visible of these is the one in which they interface with the public, taking deposits, granting loans and handling transactions. In banking terms this is referred to as "retail banking". By contrast, 'investment and merchant banking' entails giving advice, making investments for the bank and its clients, and trading for the bank's own account. Some of these activities cannot be undertaken without a banking licence, while others can. Moreover, some banks, particularly the 'big four' (ABSA, First National, Standard and Nedcor), engage in all areas of banking and related business, while others focus on specific aspects.

Retail banking is under considerable pressure at present, especially as far as the Big Four are concerned. Because of their extensive interface with the public, they are exposed to constant criticism regarding their relations with their clients, and to persistent demands that they extend banking services to low-income South Africans. However, they earn a significantly lower return on equity (ROE) in this segment of their business than they do in their investment and merchant banking activities, and their overall ROEs are at best 'satisfactory'.

The following diagram is based on the statistics of the Registrar of Banks for the year ended 31 December 1999. It shows the total costs, income and profit of all the banks and includes figures for both retail and investment and merchant banking activities.

The minimum return expected by shareholders can be estimated by using the Capital Asset Pricing Model (CAPM) which specifies the relationship between risk and required rates of return on assets when they are held in well-diversified portfolios. The calculated return is the minimum return required to persuade investors to purchase the share, or to hold it. The return expected by shareholders equals the 'risk-free' return on their capital plus the 'risk premium'.

The 'risk-free' return can be regarded as an imputed cost of capital, and is the minimum (but not necessarily satisfactory) return that an investor would seek without incurring risk on the actual money that is invested. For example, in the past year investors could have invested their money 'risk-free' in RSA 150 bonds at a return of approximately 14% if held to maturity.

The 'risk premium' is the 'profit' that the shareholders actually receive over and above the risk-free return. For 1999 that amounted to R0.6 billion, which equals to 1.4% of first-tier capital and reserves. This 'risk premium' is the return for taking risk that they would not have taken if they had invested their money in RSA stocks. According to a recent study by KPMG, the estimated benchmark of the risk premium for the banking industry in South Africa should be between 4% and 6%.

The aggregate pre-tax net profit of all the banks for 1999 (without imputing the cost of capital) was R9.5 billion (1998: R9.2 billion). Tax on the 1999 income amounted to R2.4 billion (1998: R2.5bn) and the aggregate after-tax profit was therefore R7.1 billion (1998: R6.7bn) - the aggregate of the imputed cost of capital and the risk premium.

By international standards, South African banks are relatively cost efficient, and they are constantly improving.

• GDP per capita is relatively low with the result that the average balance and net interest income per account is low.
• Volumes are inadequate to justify the infrastructure needed to deliver the services and there is also a high level of cheque fraud.
• The inflation rate is relatively high and costs have increased rapidly.
• The exchange rate has deteriorated markedly over the last few years and that has resulted in huge increases in the cost of computer equipment (which the banks use extensively).
• The responsibility for paying wages has been passed from the employers to the banks. The banks have therefore had to increase their infrastructure to cope with the peaks at the end of each week and month. The rest of the time the infrastructure is under-utilised, and the volumes in many branches at off-peak times are totally inadequate to justify the investment in infrastructure.
• The costs of moving and storing cash have escalated rapidly, in line with the rising levels of crime.
• Telecommunications costs have escalated rapidly and in addition the banks have to run permanent backup lines and take other costly precautions in order to ensure that they can provide services at the week-end and month-end peak times. One of the major banks calculates that its telecommunications costs are 40% higher than necessary because of this factor alone. The banks are also compelled to use a single telecommunications provider (Telkom), and so have to use technology that is compatible with that of Telkom, even though more appropriate technology is available.
• Fraud and robberies cost the banks R1 billion per annum in 1999 (1998: R800 million per annum)
• Banks lost R47.8 million on cheque fraud alone – figures for 2 major banks + 7 smaller banks; (1998: R55.1 million)
• 3 200 000 cheques were returned to drawer; and (1998: 3 200 000)
• 173 000 cheques were lost, a high percentage of them stolen. (1998: 173 000)

These costs impact particularly harshly on retail banks, and the following Operating Cost Ratios of Standard Bank for its various divisions are indicative of the differences in operating costs of the different banking operations.

Although all the major banks have been under considerable pressure to reduce costs in order to maintain profitability and are trying to reduce staff or contain staff numbers in order to come into line with international cost ratios, the total number of branches has not contracted excessively. But rationalisation and mergers within the industry have started. The contraction is an international phenomenon; recently Barclays closed 171 branches in the UK on a single "sad day". It is unlikely to be significantly different in South Africa.

The consequence of this state of affairs in South Africa is that although the nominal ROEs of the US, Australian and Canadian banks are lower and the UK banks' very close to ours, their interest rate levels on government bonds are very much lower than rates in South Africa. Comparisons with interest rates on government bonds (the 'risk-free' rate) in the various countries consequently reveal that South African banks yield a much lower risk-taker's return, even though their ROEs are nominally higher.

• are able to build relationships with communities and the individuals that they serve and understand their needs and the dynamics that they have to contend with;
• have a basis for making sound credit judgements because of their local knowledge;
• are able to deliver appropriate and affordable services at the local level.

The branch networks that the majors have today are inappropriate to what is needed to support very small businesses at the local level. As a consequence of the international pressures, they are much more inclined to contract those networks than to expand them, or make them more relationship oriented.

Apart from the fact that they are subject to the pressure of measuring up to international standards, other factors which give rise to this lack of community-based banks, include the following facts:-

• The history of the development of our banking industry;
• We have only one standard of banking licence (and that is the international standard one);
• We do not have a securitised market for bank loans, and so the institution originating the loan has to keep and fund it and has no option of selling it; and
• We do not have depositor insurance (although it is questionable whether this alone would change the situation in the light of the strength of the big brand names in the minds of the public).

Interestingly, the Commercial Bank Behaviour Study found that –

In our view this is not surprising, as the large banks are concentrating on their existing profitable markets where they are encountering vigorous competition from new niche and foreign banks. It is not worth a new small bank's energy to compete in the high-value markets where competition is so intense, and so they logically focus on the lower value markets.

In the light of this analysis and concerns in the banking industry about the development of our financial markets and the structure and philosophy of market conduct regulation, the Banking Council put together a Position Paper for the consideration of the Policy Board on Financial Services and Regulation. The following is an extract from that Position Paper on the subject of "banking for the poor".

1. The role of the Government Agencies

1. The Department of Trade and Industry has commissioned an international consulting firm, Carana Corporation, to report on the efficacy of the National Strategy for the Development and Promotion of Small Business and the institutions that were created in terms of that strategy. For that reason we do not believe it would be appropriate for us to comment at any length on the strategy or the institutions. We hope that the Department will release the report in the near future.

We will, however, comment on the roles of Khula and Ntsika insofar as they impact on the activities of the banks.

2. Khula

From the banks' perspective, the only strategy available to Khula to facilitate more bank lending was, until very recently, its Loan Guarantee program.

From the analysis in this paper, it is clear that no matter what guarantees are issued, commercial loans to micro-enterprises cannot be made viable. Collateral security, which is all that is offered in terms of the Khula Loan Guarantee program, is the least of the problems.

The fact that this was the only strategy put in place to facilitate more bank lending was attributable to the way that Khula was funded, and not to the management decision of its executive. Khula was provided with an "endowment" fund, and the first duty of the executive of Khula was to protect that "endowment" fund.

That effectively forced Khula to be even more risk averse than a bank would be given that Khula could not afford to lose any of its endowment funding.

Effectively Khula guarantees 80% of the loan amount in the event of default (until recently 60%) and the bank has to bear the first 20% of the loss on default (until recently 40%). This leaves the bank with the problems of -

• The profitability of the loan;
• The viability of the business; and
• The first loss of the capital amount of the loan.

So, in practice and on an extensive scale, banks have granted profitable loans to viable businesses without Khula guarantees. In those cases Khula offered the bank nothing additional apart from the additional cost to the client for a guarantee that was not needed.

After discussions with Khula's executive, Khula has introduced its "Equity Fund" program and the first of the funds (in the North, East and West Cape) was launched a few weeks ago. In this respect, Khula is, in its analysis of the problems, ahead of the British. It has effectively started implementing the recommendations of the Cruickshank Report at about the same time as the recommendations were actually made in the UK, let alone implemented.

It is significant that the program is aimed at businesses needing between R250,000 and R2 million of venture capital. So this initiative is also aimed at businesses which fall outside the category of "very small" and way outside "Micro".

1. Ntsika

From the Banking Council's analysis, it is clear that the viability of the business is crucial to the profitability of the loan. That viability is dependent on the quality of the management and on a variety of other support services (for which Ntsika is largely responsible). Because of the negative impact that apartheid had on the development of black management skills, those skills will, in future, depend on first class mentoring.

So, for credit schemes to be effective and have impact, there must be access to –

• suitable Business Development Services (providing mentoring); and
• institutional support services (providing the other support services).

Bank SMME development strategies rely on the mentoring role of professional and fee-charging BDS providers. For success, it is important that there is rigorous quality control of the mentoring provided. Entrepreneurs will also have to be educated to regard payment for such services as a necessary financial expense of their businesses.

The institutional support services should be provided in a co-ordinated and efficient way at the local level where they are accessible to the entrepreneur.

We therefore believe that the Government should ensure (through Ntsika) -

• Decentralisation of SME support institutions;
• Effective monitoring by the government and donors;
• More focused assistance to entrepreneurs;
• More focus on technological transfer to SMEs; and
• Greater co-operation between BDS providers and SME support institutions.

1. Community Re-investment Legislation ("CRA")

As regards Government interference and compulsion, there is frequent misunderstanding about the so-called "Community Re-investment" legislation.

The universal model for this type of legislation is the USA where the model has been honed over a period of 30 years. From research and discussions, it seems that the legislation is now producing good results, and the banks are increasingly complimentary about the legislation and how it is applied.

There are 3 separate pieces of legislation –

• A prohibition against discrimination in lending. If it does occur it constitutes a criminal offence, and is punishable as such. This legislation is substantially replicated in South Africa in the Promotion of Equality and Prevention of Unfair Discrimination Act;
• Disclosure in lending legislation, which provides the necessary information to establish whether discrimination might be occurring. This legislation will be replicated in South Africa in the Home Loan and Mortgage Disclosure Act; and
• Community Re-investment legislation, which is unrelated to the first two pieces of legislation. This act has not yet been replicated in South Africa.

There are two founding principles of the Community Re-investment Act (CRA) namely –

• Everything must be done in accord with the principles of sound banking practice. In fact the principle is translated into the policy that CRA activity should be profitable for a bank.
• There is no compulsion. The only sanction in the act is that when a bank applies to the regulator to exercise its discretion in the bank's favour (such as permission to merge or open a branch) the bank's performance in terms of the CRA is taken into account. Of the 20,000 odd occasions on which such discretion has been exercised, there is not one example of it being exercised against the bank on the grounds of inadequate performance in terms of the CRA.

The Commercial Bank Behaviour Study found that banks make micro and small enterprise loans around the world -

• Firstly because of the profitability of the loans;
• Secondly because of intensity of competition in the large and medium enterprise markets;
• Only thirdly because of regulations imposed by Governments; and
• Lastly because of some sense of social responsibility.

It is reported that

"The findings indicate that, banks, as regulated and commercially sustainable institutions, are more likely to respond to profitability and market conditions than to indirect objectives of poverty alleviation or other socially oriented objectives." (ibid P 5)

1. Background

1. The inherent lack of an entrepreneurial culture in South Africa, the failure to develop human resources and the exclusion of the majority of South Africans from the formal economy has resulted in a number of entrepreneurs who have:

• no own capital to start businesses;
• undeveloped management skills to run their own business;
• not had the opportunity to develop their entrepreneurial skills; and
• no collateral security

1. In the light of this, it became clear to the banks that an intervention was necessary to address two identified gaps, namely:

• Finance Gap

Banks do not grant loans of less than R50,000 to start-up businesses because of the high transaction costs and the marginal viability of the loan. On the other hand, Retail Finance Institutions and Non Government Organisations’ cost structures seldom permit them to provide loans in excess of R10,000. So there is a need for loans between R10,000 and R50,000 to start-up small businesses.

• Synergy between financial and non-financial support

The key to an investment in an enterprise lies in the viability of the business and the quality of the entrepreneur. So there is a need to develop a synergy between financial and non-financial support, in order to assist entrepreneurs to convert their business idea into a technically and financially viable business proposal and to assist the entrepreneur in running the business in the initial stages. An intervention was required to ensure that there were sufficient, well presented proposals for funding that were in a bankable form in the R10,000 to R50,000 category.

1. In response to these identified needs, the Banking Council, ABSA, FBC, FNB Nedcor, and Standard Bank set up a joint venture. The banks, together with the Kellogg Foundation grant funded the joint venture to cover the costs of originating the loans, mentor the entrepreneur, and to guarantee the loans, given the high risks inherent in this sector of the market. Two companies were formed, Sizanani Advisory Services and Sizabantu Guarantee Company.
2. Sizanani carries the costs of originating the loans and of mentoring the entrepreneur.

Sizabantu provides a guarantee against default, partly support by a Khula Portfolio Indemnity.

1. Sizanani Advisory Services

1. Sizanani assists the emergent entrepreneurs in the planning of the business and applying for the necessary finance. It also provides an "aftercare service" to assist the owners to manage the business as planned and to address problems that were not foreseen in the planning and implementation stages.
2. Criteria for assistance

Applicants must meet the following criteria before they may apply for assistance:

• They must require a bank loan for enterprise purposes, between R10,000 to R50,000.
• They must be able to prove that they have at least 10% of the amount applied for available in cash. The banks will only provide 90% of the financial needs of the business.
• They must have some experience in the type of business they wish to start.
• They must manage the business on a full-time basis.
• The business must be a very small business.
• They must trade from a fixed address.

Applicants are not required to provide security, but if security acceptable to the bank is available, it WILL be taken.

1. Under no circumstances will replacement finance be provided.

1. Mentorship

1. Sizanani initially "employed" retired business people as mentors. They were remunerated on an hourly basis for the support provided to the applicants.
2. This strategy proved to be both ineffective and costly. Some of the mentors leaned heavily towards the development of applicants who stood no chance of managing a business successfully and/or qualify for finance under the scheme. Furthermore the mentors encountered difficulties in presenting acceptable proposals to the participating banks. Some of the businesses which were financed in this way are already experiencing problems.
3. As a response to these problems Sizanani then outsourced the mentorship function to Business Skills South Africa Foundation (BSSA), an initiative of PriceWaterhouse Coopers, that has extensive experience in the training and accreditation of business consultants/mentors.
4. There are presently 101 Experienced Mentors accredited by BSSA with the following spread:

PROVINCE NO. OF MENTORS

Gauteng 37

Western Cape 18

Eastern Cape 7

KwaZulu Natal 12

Free State 4

Mpumalanga 8

Northern Province 6

North West 8

Northern Cape 1

There are a further 150 Associate Mentors and Community Mentors who can and will be working with the Experienced Mentors to assist entrepreneurs.

5. In response to the dearth of good investment proposals, Sizanani embarked on a major communication, advertising and advocacy campaign to attract potential applicants. To date, over 1000 respondents have responded and the number is growing daily. The respondents are assigned to mentors who then take over the assessment and assistance process.

2. Development channel

1. Applicants meeting the basic entry criteria, but who may not qualify for financing for one or other reason are not totally rejected. Although the scheme is not tailored to provide all non-financial support to potential clients, it has a developmental responsibility to direct respondents to another service provider that can train the potential client. In pursuance of this objective, entrepreneurs whose applications are deemed by the mentors to be unsuccessful are provided with written reports setting out the reasons why they cannot be assisted.
2. If the reason for their unsuccessful application is a developmental need, then they are moved into a "development channel" through which they will be referred to non-financial support service providers that have been accredited by Ntsika Enterprise Promotion Agency. On completion of their course or training those entrepreneurs can re enter the "business plan channel" without having to pay the registration fee again. This process ensures that those who are serious about setting up in business are not lost in the system.
3. BSSA are paid for services rendered by the mentors at a fixed fee at the following stages:

Client registration fee R 100

Viability assessment fee R 250

Business Plan support fee R2,250

Aftercare up to 24 months R6, 750-00 (to which client contributes R1, 200-00)

3. Response of clients

To date, 279 applications for loans totalling R9, 238,617 have been "registered".

Twenty-four (24) applicants withdrew their applications, and a further six (6) were closed because the applicants did not respond to information called for.

Forty four (44) were rejected.

Thirty-three (33) loans were approved totalling R 1,172,429 and the others are still under investigation.

Some of the outstanding applications will probably be closed because the applicants have not provided the necessary information for the mentors to complete the viability studies.

4. Difficulties encountered

• Lack of entrepreneurial culture.
• LBSC’s not able to generate successful applications.
• Inability of applicants to provide 10% owns contribution.
• Modular business training not freely available.
• Suitably qualified persons not available in all areas for accreditation as mentors.
• Many mentors need to be further trained to operate successfully.
• Mentorship is very costly – This can only be done through grant funding.

1. Lessons learnt

• It is still our experience that the applicants registered by the scheme stood very little chance of raising finance in terms of the normal lending criteria of banks.
• Retired executives are not proving to be a successful as mentors.
• Limited and carefully targeted branches of banks should receive loans for the scheme.
• A development channel is necessary because of the skills shortage and training requirements in this environment.
• The mentorship methodology is suitable to all SMEs and will increase their chances to raise bank finance.

1. Future plans

• Increase number/spread of accredited mentors.
• Ntsika to introduce service providers that can provide purposeful training.
• The methodology will be expanded to all SMEs.
• Donor funding will be raised in order to continue free mentoring service to Very Small Enterprises.
• Agreement with Khula to subsidise the cost of mentorship services for other SMEs.
• Acceptance of payment for non-financial support as part of "own contribution" by entrepreneurs.