SOUTH AFRICAN RESERVE BANK

BANK SUPERVISION DEPARTMENT

THE ROLE OF BANKS IN FINANCING SMALL, MEDIUM AND MICRO ENTERPRISES ("SMMEs")

SECTION A: SHORT TERM SCENARIO

  1. INTRODUCTION
  2. It is evident that different financial service providers will require supervisory approaches that differ in focus and intensity according to the role of these players in the market and the manner in which they are funded.

    The fact that a bank (as principal) "guarantees" the capital and interest payments to depositors necessitates a certain supervisory and regulatory intensity. In the case of agency business, such as money broking and portfolio management, the risk is not assumed by the agent, but "transferred" to the investor. Consequently, there is a corresponding difference in the manner in which the agent is supervised. Of fundamental importance in this context is the sophistication of investors and depositors, particularly as regards their ability to distinguish between the risk implications when dealings with agents or principals (banks).

    Without an effective banking system to encourage, collect and deploy society’s savings in a fair and efficient manner into productive investment, there would be little hope for any economy to mobilise the resources necessary for economic growth, financial stability and development. Banks are at the core of the financial system in both developed and emerging countries. In fact, banks play an even more important role in financing economic activity in emerging and developing countries than they do in developed countries. Banks borrow by giving certainty to savers that their deposits are liquid and secure.

    The need for finance is universal. Every individual, enterprise, organisation, or government requires working capital and finance, even if it is self-finance to smooth out income and expenditure flows and to provide the basis for capacity investment. Finance is central to the development of any economy. The financial sector is the primary mechanism for transforming and transferring the savings of an economy into its investment. The operation of an efficient financial system is dependent on effective financial regulation. Finance involves an unavoidable time sequencing, which creates risk.

  3. THE BANKS ACT AND DEPOSIT-TAKING
  4. The Banks Act, 1990 (Act No. 94 of 1990), changed the focus of banking legislation in South Africa to a large extent. The Banks Act focuses on prudential regulation and risk management, since banking is a business of identifying, measuring and managing risk. The Banks Act also complies with the requirements of the Basel Committee on Banking Supervision with regard to capital adequacy and effective banking supervision.

    The approach of the Banks Act is functional, not institutional. It addresses the function of deposit-taking, rather than the institutions accepting deposits. The Banks Act also introduced a prohibition on the taking of deposits from the general public by an institution not registered as a bank.

    Since the central theme of the Banks Act is to address the functions of accepting and investing deposits, rather than the specific institutions that accept and employ such deposits, a wide meaning has been given to the term deposit. "The business of a bank", as defined in the Banks Act, describes the distinctive feature of the business of institutions regulated in terms of the Banks Act and incorporates two distinct functions, namely, that of accepting deposits as a regular feature of the business in question, and that of acting as a financial intermediary in the investment of funds accepted by way of deposit.

    The Bank Supervision Department (BSD), within the South African Reserve Bank (SARB), is responsible for the regulation and supervision of banks in South Africa. Because banks lend out the money that they receive from depositors, prudential regulation and supervision must be in place to protect these depositors. In its process of supervising banks, the BSD adheres to international best practices. One of these best practices is to maintain sound credit standards. In this regard Mr William McDonough, President of the Federal Reserve Bank of New York, has the following to say:

    "… one of my major concerns going forward is the quality of bank lending. Banks are now at a critical phase in the credit cycle. After years of high quarterly profits, low delinquency rates and comfortable capital ratios, it is easy to forget the fundamentals of sound lending.

    The most important of the fundamentals is maintaining rigorous credit standards, especially in an environment of increased competition for new and existing customers. Experience teaches us that the worst loans are often made in the best of times.

    In circumstances this favourable, loan officers must make doubly certain that there is every reason to believe that the loans they make are collectible.

    From a supervisory perspective, I believe it is time for us to exercise an extra measure of caution. We must ensure that banks’ lending decisions continue to reflect a disciplined approach, one that matches a clearly defined risk appetite, and a well understood risk capacity, with a real sense of the returns that are necessary to cover that risk. I see such a supervisory approach as increasingly essential to counterbalance the pressure of the fiercely competitive markets in which banks are operating.

    Maintaining sound credit standards is one of several significant challenges banks currently face. Another challenge is to maintain pricing that appropriately reflects risk amid fierce competition, from other banks and non-bank financial institutions."

    If a country such as America, which has completed its 37th consecutive quarter of expansion, attaches such a high priority to maintaining sound credit standards for banks under favourable economic conditions, what should we do in South Africa? To create new legislation to force banks in South Africa to direct some of their lending to certain agents in the economy, such as SMMEs, is surely not sending the right signal to investors, locally and internationally.

    One of the major problems during the 1997-1998 Asian financial crisis was the poor credit-risk management of banks in the region. Credit-risk management entails, inter alia, knowledge of the customer’s business and of the risks associated with directed loan activity, and issues of guarantees and collateral.

  5. ROLE OF THE BSD IN THE PROCESS OF SOCIAL UPLIFTMENT

The BSD is well aware of the difficulties experienced by people in the unbanked sectors or people that have little access to formal banking services. The BSD has already taken a number of steps in order to address these sectors’ needs for access to loans:

In recent years, South Africa has seen enormous growth in the microlending industry. Since most of the players in that market evidently provide access to financial services to a portion of the market that has little access to formal financial services, it became clear that a suitable and effective regulatory framework was needed in order to regulate the microlending industry in this country.

Consequently, for purposes of identifying a suitable regulatory framework, the BSD held discussions with interested market players involved in the microfinance industry. These parties included, inter alia, officials of the Alliance of Microenterprise Development Practitioners, the Microlenders Association, the National Housing Finance Corporation, the Land Bank, Khula Enterprise Finance and the Department of Trade and Industry.

From the outset, the BSD’s view on regulating the microlending industry was that the process should include the following steps:

Because of the nature of the microfinance industry, it became clear that the most suitable framework for the regulation of microlenders would be one based on the principles of self-regulation. The regulatory framework that was developed involves, inter alia, the following:

The board of the MFRC has equal and balanced representation of consumers and the moneylending industry, and has the capacity and mechanisms in place to manage effectively its business as regulatory institution. In terms of the framework, designated officials of the parties previously mentioned, as well as an official of the BSD, were appointed as directors of the board of the MFRC. Microlenders are required to become affiliated to (register with) the MFRC in order to enable them lawfully to conduct their business. The intention is that this will eventually include the taking of wholesale deposits. A suitable exemption from the provisions of the Banks Act will, however be required in this regard. It is therefore envisaged that:

The main objective of the MFRC is to promote the common interests of microfinance members advancing small loans through compliance with the regulations and rules of the MFRC. The MFRC has also made rules with which lenders wishing to register with the MFRC have to comply. To date, the MFRC has received applications from 1 304 legal entities, totaling 5 379 business premises. The Accreditation Committee of the MFRC has registered 829 legal entities and 3 834 business premises, and a total of 16 legal entities and 21 business premises have been registered provisionally.

A village financial service co-operative (FSC) is a special vehicle regulated under the Banks Act. In terms of an exemption notice published in the Government Gazette on 10 March 1998 and expiring on 31 December 2000, the activities of an FSC do not fall within the meaning of "the business of a bank"

The exemption notice provides for a legally enforceable business arrangement between a bank and a village FSC, in terms of which:

A village FSC is a closed cooperative, which means that it is a cooperative that does not conclude transactions with persons who are not members thereof. An FSC, on the other hand, is a trading cooperative incorporated in terms of the Cooperatives Act, 1968. In terms of the Banks Act exemption notice, a village FSC is confined to a geographical area, as defined in the statute of the village FSC concerned, and has a business arrangement with a bank. Thus, a village FSC is a closed cooperative, the members of which are also members of a community within a defined geographical area not serviced by banks, and which cooperative:

"(a) with the objective of providing banking-related financial services to its members

    1. accepts funds from such members against the issue of shares;
    2. accepts deposits from members;
    3. advances loans to members; and or
    4. provides for members to share in profits of the cooperative and to nominate management;

  1. has entered into, and maintains, a business arrangement with a linked bank; and
  2. subject to the prior written consent of the Registrar of Banks, has been incorporated as a cooperative."

The Registrar of Banks has appointed FinaSol and the Financial Services Association (FSA) as self-regulatory bodies for village FSCs. FinaSol is predominantly active in the KwaZulu/Natal region, whereas the FSA is more active in the North West and Northern provinces of South Africa.

  1. ALTERNATIVE METHOD TO FINANCE SMMEs

I do not believe that it is necessary to promulgate new legislation to force banks to lend to SMMEs. In our opinion the commercial banks in South Africa would have to decide, based on sound business and risk-management practices, whether to cater for the special needs of SMMEs.

Banks catering for SMMEs could provide the service on lines similar to village banks or village FSCs. The exemption whereby the village FSCs are exempted from compliance with the provisions of the Banks Act could be easily adapted to suit a type of a "SMME cooperative" framework. Banks may also extend a broader range of financial services to their clients. Village FSCs, for example, are already extending other financial services, such as insurance policies, burial schemes and financial advice, to their members.

In establishing branches in several rural and urban areas, the SMME cooperative bank can fill a niche market, similar to that of the community bank concept in America.

The concept of a cooperative is not new and, therefore, need not to be researched afresh. The most distinctive characteristic of a cooperative is that it is controlled and managed by its members. Another advantage of a cooperative is that it encourages savings. The current trend worldwide is to mobilise the savings of poor people and to reinvest the money in their own community. Thereby, the spiral of debt can be broken. We should not encourage the notion that people have the right to credit.

SECTION B: MEDIUM TO LONG TERM SCENARIO

  1. INTRODUCTION

In a relatively poor country like South Africa, with more than half the population living below the subsistence level, and where 18 per cent of the total population produces all output (GDP), the importance of entrepreneurship among the broad spectrum of the population is self-evident. To develop the Small, Medium and Micro Enterprises (or SMME’s) entrepreneurship, managerial and technical know-how, as well as finance is of crucial importance. In fact, given the extreme skewed income distribution and major unemployment in the country the development of SMME’s may have significant social benefits well in excess of the direct economic costs thereof.

At the same time it has to be noted that the South African economy has become a consumer economy with nearly 85 per cent of its total production spent on private and government consumption expenditure. Accordingly savings and thus available capital resources, come at a premium. The mirror image of this low savings structure, is the low level of net investments, which in turn places severe limitations on the freedom of government and its fiscal policy. Because South Africa is still heavily dependent on foreign savings (i.e. capital inflows), the scarce capital resources are distributed on a strict profitability basis. Investment projects that have a potential high return on capital are more likely to obtain credit than lower yielding enterprises. As the economic return on SMME’s may be too low or too risky for investors, the available capital resources to finance this socially important economic segment may be limited as well. To cope with this socio-economic dilemma requires a critical look at all funding alternatives: i.e. bank finance, foreign donor finance, as well as funding through the securities markets.

This note will shortly sketch various alternative funding routes to finance SMME’s. Each of these methods has its own advantages and disadvantages. A successful government policy should aim at maintaining a reasonable balance and spread of these funding risks.

2. THE ADVANTAGES AND DISADVANTAGES OF FINANCING SMME’S BY MEANS OF BANK LOANS

2.1 The advantages

Banks are there to accept deposits of the general public and invest these savings of the nation in profitable businesses. If banks would consider SMME’s attractive investment opportunities the financing problem would in principle be solved. However, in practice banks avoid lending to SMME’s because they consider the returns of this industry unattractive and too risky. As private enterprises, banks also have no, or at least little, ability to consider the social benefits of SMME’s as their investment evaluation is limited to economic criteria.

Government usually does the trade-off between social benefit and economic costs. If the social benefit is considered sufficiently attractive, the government can use its sovereign powers to simply force the banks to lend a predetermined percentage of their advances to SMME’s. The elegance of these solutions is its (apparent) simplicity.

2.2. The disadvantages

The use of the stick rather than the carrot has a number of consequences. The following issues have to be considered in this respect:

Weighing the pro’s and con’s of bank lending to SMME’s, seems to indicate that the government should not expect too much success by trying to force a policy on the banks they do not desire. What was intended to be a shot in the arm, may well become a shot in the foot. The indirect costs of the "stick method" could be significantly higher than perhaps initially anticipated. Moreover, the financial muscle of the international financial community dwarves the financial strength of South Africa: the state is simply too much indebted to dictate anything to the global capital markets. Considering the inherent weaknesses of the "stick method", more success may be obtained by increasing the competitive forces in the market place. It is here that the securities markets come to the forth as they are the natural competitors of banks.

  1. THE ADVANTAGES AND DISADVANTAGES OF FINANCING SMME’S BY MEANS OF INVESTMENTS THROUGH THE SECURITIES MARKETS
    1. The advantages

Financing SMME’s through the securities markets (i.e. direct financing), rather than through financial intermediaries (i.e. indirect financing), is quite similar to the equivalent of investing one’s savings in a bank deposit account or alternatively in a money-market fund. By investing in a deposit account one eliminates market risk at the cost of a lower return. While a money-market fund pays more than a bank deposit, the investor has to accept the risk that the price of investments are subject to change. Likewise a collective investment scheme can be created in the securities markets that accepts investments from the broad public and channels these proceeds into SMME’s of various investment qualities.

Indeed, to finance SMME’s one does not need financial intermediaries at all; one can also approach the ultimate lender directly. Anyhow, the supply of credit is no essential part of banking. Many institutions (both financial and non-financial) grant credit. Accordingly the need for funds for SMME’s can in principle be supplied through the securities markets on a competitive basis vis-a-vis the banks. The advantages of this type of funding are the following:

3.2 The disadvantages

Financing SMME’s partially through the securities markets will have the natural setbacks of any instrument traded in these markets, such as:

However, all these disadvantages are not of a principle nature. In practice the authorities can address them. For instance, it is crucial that the authorities or the financial exchanges make sufficient information available to the press. Ultimately the link between the financial markets and consumers is the financial press. The press is a critical role player in any financial system and has to be educated and supplied with relevant and updated information about market conditions, investment patterns, and the relative importance of the various investors and borrowers. Questions like "who is really supporting SMME’s?" and "how are these investment funds really used?" are not only of interest to pressure groups and politicians, but also to market participants in a broader sense. Disclosure is a powerful instrument, provided it used properly: i.e. no information overflow, but the disclosure of selective information, which is the key to success.

  1. EXISTING HURDLES AND HOW THEY MAY BE OVERCOME

In the early 1990’s a significant number of retail investors were being ripped of their life savings by companies such as Masterbond and Supreme, that engaged in shaky and shady debenture issues. At the time the Financial Services Board (FSB) had great difficulty stopping these totally undesirable business practices and the SA Reserve Bank had to help out: it did so by broadening the definition of "deposit taking" in terms of the Banks Act. In fact the definition of a deposit became so wide that it includes the raising of loans and effectively eliminated the commercial paper market in South Africa for retail investors.

The de facto involvement of the central bank in the securities markets was seen as a short-term solution at the time. The long-term solution to the problem entailed a major rewrite of the Companies Act (particularly the part dealing with corporate governance and debenture issues), the streamlining of the legislation on collective investment schemes, and the initiation of new legislation in the area of investment services in general. However, nearly a decade later no better legislation has been put on the statue books to address these underlying issues. The revision of the Companies Act is still dragging on; while the FSB is also still involved in the finishing touches to the proposed Collective Investments Scheme Bill and the Investment Services Bill. However, unless these three Acts are passed by Parliament it will be difficult to relax the definition of a deposit in terms of the Banks Act. Investors in general, and the SMME’s in particular, are paying a hefty price for this regulatory delay.

To appreciate more fully the current restrictions of the Banks Act, it has to be noted that commercial paper may only be issued by a listed company with net assets exceeding R 100 million to obtain operating capital. In addition commercial paper has to be issued in denominations of R1 million or more, unless:

Moreover, only the following persons may be ultimate borrowers of the money obtained from the general public against the issue of commercial paper:

These restrictions make it currently impossible to use the securities markets as a competitive alternative force for SMME’s finance. In addition, South Africa’s securitisation legislation is written very much from a banking point of view, implying that it is unfriendly to non-bank financial institutions. To propel SMME’s financing through the securities markets forward, securitisation may be a key concept in future. But without any form of competition between the securities markets and the banks, the odds are against the regulators and the interests of the investing public (at least those who would be willing to contribute to the direct financing of SMME’s).

The possible solution to these problems seems a redefinition of deposit-taking in terms of the Banks Act. However, such a step can only be considered after the Department of Trade and Industry has enacted a new Companies Act and after the FSB has completed its work on the above mentioned two bills. It is unclear to both taxpayers and the investing public why the drafting of urgent required legislation must take close to a decade. The opportunity costs of delaying the enacting of these bills will particularly be felt by the SMME’s in years to come.

As so often state failure has the potential to be more damaging to the economy than market failure (e.g. monopolies). Government has to address both state and market failures. In fact, state failure may reinforce market failure, for instance if inertia on part of the public sector entrenches uncompetitive conditions in the economy. The authorities have to consider the inherent costs of state failure and adjust their official policies in the light thereof. Ultimately the successful funding of SMME’s is crucially dependent on stiff competition between the securities markets and financial institutions, the stipulation of detailed disclosure requirements, and a critical role for the financial press in the overall regulatory regime. In all these three area’s the government can, and must, play a key role.

CONCLUSION

We have argued that an effective banking system can contribute to economic growth and development. Therefore, we should not promulgate legislation in South Africa that can inhibit the effectiveness of the banking system. We have also argued that South Africa has a low savings ratio and that we therefore need foreign capital. An effective banking system will clearly enhance our country’s ability to draw capital to South Africa.

We should also take care that the proposed social responsibility and disclosure legislation does not result in banks in South Africa being forced to deviate from sound lending practices.

We believe that alternative methods to fund SMME should be researched further. In this research, other market players, such as non-bank financial institutions, should be drawn into the process. The modalities of such a process can be decided between Government, the central bank, business, labour and other players, such as large non-bank financial institutions.

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