Formal and informal finance for small enterprises in Ghana

INDUSTRY AND ENERGY DEPARTMENT WORKING PAPER INDUSTRY SERIES PAPER No. -1 Formal and Informal Finance for Small Enterprises in Ghana MICROFICIE COPY August 1992 Report No. :11322 Type: (MIS) Title: FORMAL AND INFOR..,L FINANCE FO: Author: Ext.: 0 Room: Dept.: AUGUST 1992 ~~~~~~~~~~~~.:n,;: --., ,,w _ M= The World Bank Industry and Energy Department, OSP  FORMAL AND INFORMAL FINANCE FOR SMALL ENTERPRISES IN GHANA Tamara J. Dugleby, Ernest Aqyeetey and William F. Steel August 1992 Industiy Development Division Industry and Energy Department, OSP  TABLE OF CONTENTS Page No EXECUTIVE SUMMARY AND RECOMMENDATIONS ......................... i L BACIKGROUND FOR THE STDY 1. A Financial Sector Reform and Programs 1. B. AnalyticalFramework .. 2 C Study Objectims . 4 n FINANCIAL LIBERAULIATION: IMPLICATIONS FOR THE FORMAL FINANCALSECrOR . 6 A Sucture of the Fonnal F ancia Sector . 7 Composition of the Bankdng Secor Complemenwuy Financdal Markets Depost Structure Lending Structure Interest Rates and Loan Prcng B. The bstitudonal Framewk ..13 Regulation and Bank Supervision Maagement andlTainig Lqg Framework C Compatibility with Maacrconomic Policy Framework .15 D. ConduSion ..16 ml FINAN4CLAL LIBERLIZ7ATION: IMPLICATIONS FOR THE INFORMAL FINANCIALSECI'R .17 A. Structure of the Ibnfrmal Fnancd Sector ..18 mme &uu system Moneylenden Savings and Loan and Purchase Fmanceompanies Deposit Structure Leding Structure Interest Rates B. Contract Enforcement ............................... . 25 C Macroeconomic Evirornent ..5.... .......................... 2 D. COncUSion .26  Table of Contents (cont.) Page No. IV. FORMAL AND INFORMAL LENDING TO SMEs ....................... 27 A. General Impact of beralization .........e........................ 27 B. SME Credit Project .......................................... 27 C Creditwortlhiness Criteria .......................... . 28 D. Cost of Funds to Banks ........................................ 29 E. Transcion Costs in Bank Lending to SMEs ....................... 29 Information Costs Processing Costs Monitoring and Loan Supervision Collection and Enforcement Costs F. Lending Risk to Bank ............. .......................... 33 Risk Reduction Measures Used by Banks Other Measures to Reduce Risk G. Capacity to Lend .................. .......................... 35 Tecnical Capacty and Training Internal Organization Manpower Utilzation and Requirements Incentive Systems IL Growth of InfDrma Fnancdal Sector Lending to SMEs . . 38 L Informal Sector Cost of Funds and Capacity to Lend ..... ............. 39 J. TanSO CtOn COts fOr lnfonnal Lenders ........................... 40 Screening Costs Loan Monitorg Costs Contract Enforcement Costs K Risk Perception In fmal Lending to SMEs ...................... 42 L Conclusions ................................................ 42 V. CONCLUSIONS AND RECOMMENDATIONS ........... .. ............. 44 A. ReducngTransactionsCosts .......... ......................... 44 Improving Information Trining in Project Analysis Processing Costs De entralization of Credit Operations Improving Bankes Ability to Work with SMEs  Table of Contens (cot.) Page No. B. Risk m4nagement . .......................................... 47 Loan Insurance Alternative Forms of Loan Security Portfolio Diversification Training for Borrowers CL Creation of More Effecdve Incentives ....... ..................... 49 D. New Financial Instruments and Institutions for SME Financing .... ..... 49 Shor-term Fmancial Products Equity or Equity Like Financial Products Rural Banks E. Support Institutions ................. ......................... SS F. Iformal Ficing ...........6..... 56 REFERENCES ... 57 4AN NEX9ES... 59 L MONETARY AND FINANC1AL DATA IL SURVEY DATA ON THE BANKING SECIrOR IIL IMPACT OF THE SME CREDIT ON THE FORMAL FINANCIAL SECTOR IV. NOTES ON INTRVIEWS WiH SEMI-FORMAL AND INFORMAL LENDERS V. BEST PRACTICES IN SIX INNOVATIVE SMALL ENTERPRISE FINANCE INSTITUTIONS  ACBNOWLEDGEMENT Tmis studywas prepared for Ghana's National Board forSmall-Scale industries (NBSSI) under the Private Small and Medhim Scale Enterprise Credit, with the cooperation of the FUSME unit in the Bank of Ghana and the Western Africa Industry and Energy Operations Dirision (Africa Region) and the Industry Development Division (Sector and Operations Policy) of the World Bank. The study is managed by Drs E. K Abaka (NBSSI) and William F. Steel (World Bank). The authors are especially grateful for the cooperation of Mke Okoto-Donkor (FUSMED) and the managers and staff of the banks, savings and loan companies, susu collectors, and other financial agents that were interviewed. Substantial inputs and comments were provided by Hemamala Hettige. The authors would also like to thank Irfan Aleem, Patrick Connolly, Carlos Cuevas, Arvind Gupta, Chad Leechor, and participants in workshops at the World Bank and NBSSI for helpful comments and suggestions, and Wilson Peiris and Vivian Cherian for word processing.  ABBREVIATIONS AD)B Agricultural Development Bank BHC Bank for Housing and Construction BOO Bank of Ghana CDIHL Consolidated Discount House Limited EMPRETEC Entrepreneurship training program en enterprises and technology of the United Nations Center for Transnational Corporations ERP Economic Recovewy Program FINSAC FLiancial Sector Adjustment Credit FUSMED Fund for Small and Medium Enterprise Development (Bank of Ghana) GCB Ghana Commercial Bank GDP Gross domestic product oVCC Ghana Veate Capital Company IFC International Finance Corporation IPC Interdszlplinalre Projekt Consult GmbH M2 Money supply (currenq and demand, savings and time deposits) MASU Mutual Assistance Susu Ld. NBSSI National Board for Small-Scale Industries NIB National lnvestment Bank NSCB National Savings and Credit Bank PAMSCAD Program of Action to Mitigate the Social Costs of Adjustment S&L Savigs and loan company SDH Securities Discount House SMEs Small- and medium-scale enterprises SSB Social Security Bank SSN1T Social Security and National Insurance Trust T-bils Treasury bills USAID United States Agency for International Development WWBO Women's World Baning (Ghana)  EXECUTIVE SUMMARY AND RECOMMENDATIONS 1. Lack of access to finance has been identified as an important constraint on the ability of small- and medium-scale enterprises (SMEs) in Ghana to fulfill their potential for dynamic growth under the Economic RecoveTy Progam (ERP). Past reasons for the neglect of SMEs by banks have included policies of direct controls over interest rates and the * .ocation of credit, the historical orientation of banks toward Import-export trade and large firms, and the lack of competition in the banking system. In tying to work with SMEs, banks also face high transaction costs and risks and have inadequate information. Informal financial agents may have better information and lower costs, but do not appear to be important sources of business finance (other than for petty trade). Tne study is aimed at assessing the current capacity of the financial system to meet the financial needs of SMEs and how this capacity might be enhanced. Baking System ii. Financial liberalization under the ERP has addressed underlying constraints on the banking system by freeing up interest rates, removing credit controls, and alowing more competitic. AIthough this has ceated the neccasaly conditions for increased SME lending, the effect so far has been limited. One reason is that, until 1992, tight monetary policies aimed at reducing inflation resulted in exceptionally high returns on government paper (Treasury and Bank of Ghana biUs and bonds), which absorbed much of the liquidity in the system and made lending to the private sector relatively unattractive. Another reason for limited SME leading is that, in the process of resucturing their portfalios and nanagement systems, banks have tended to cenutalize their decision-making, wbereas effective SME lending requires a decentralized approach. Banks are only beginning to put in pla the decentralized mangement and infomaon systems ftat would be needed. ii For financiers to become interested in and sustain lending to SMEs, it must be profitable. The most important deteminants of profitability (apart from interest rates) are the tnsacton costs involved and the risk-both of which appear to be relatively high for forma) financial institutions dealing vdth SMEs. Transaction costs are high because it is difficult and time-consuming to obtain the information needed to appraise SME loan proposals. Tis is aggravated by the centralized decision-makdng and lack of training of branch staff in workingwith SMEs Risks are high because of economic uncertainty, the high turnover rate among SMEs, and the lack of risksharing arrangements. Banks address the risk problem through stringent collateral requirements, which exclude many SMEs with good growth potential but without clear title to landed properly. iv. Another difficulty for the banks is that the short-term nature of their deposit structure reinfirees their reluctance to make long-term investment loans However, they do recognize the importance of serving their small customers to maintain their deposit base The SME Credit through the Bank of Ghana has encouraged banks to increase their efforts to finance SME clients. The tendency has been to serve the needs of exdsting, known clients more than to increase access to new, unproven borrowes  Iv - Informal Fnance v. In SME leln&g, the entrepreneues ability to manage an enterprise and to repay a loan is often more Importa than the technical feasibility of the project In this context, Informal financiers have much better InZormation and lower tansaction costs than banks because their direct day-to-fay contact with their cients enables them to assess entrepreneurs' capabilities. This Is particularly true for msu collectors, who collect savings-and hence can observe their dients' cash flow-on a daily basis. However, vu= collectors have been vety reluctant to provide credit for fear of not having sufficient funds at the end of the month to meet their obligation to return depositors' funds. Although the sUSl col:ctlon system mobilizes household savings on a wide scale and deposits a substantial share in bank it provides little intermediation between savers and borrowers. Rather, it facilitates individuals in meeting their own needs for working capital in petty uade and major consumption goods. vL SMEs make vety little use of informal finance, either as savers or borrowers. Eve if susu collectors were more willng to lend, the small amounts and the short terms they provide are unsuitable for most S/ES' needs. When they do borrow from the informal sector, it is usually from moneylenders, who can provide more substantial sums and may allow repayment over seveal months. However, moneylenders' rates tend to be too high for most reguar business activities Furthermore, the number of registered moneylenders appears to be dedining, although those in business have increasing funds available from their other economic activities, such as tading which have pspered under the ERP. vi. The most promiing informal (or semi-formal) institution for SME finance appears to be savigs and loan companies (S&Ls4 Although modeled on the 5USU collection system to mobilize deposits, they are explicitly geared toward providing crdit and they require cients to accumulate deposits over six months or more before qualifg for credit. Hence they can intermediate among their clients. Their rapid expVatson in the late 198X reflected substantial aecess demand for aedit. Unfortunately, excessive lending without adequate scrutiny, misLse of funds, poor manugement, and other diMfculties have caused most S&Ls to faiL The Bank of Ghana has stepped in to regulate them, but only two have so far qualified under the new regulations. Many of the smaller SMEs would save with sound S&Ls If they had a high probability of obtainig credit Straftag vii. To be sustainabk, cedit progms must focus on areas where information, risks, and transaction costs are lw. Hence the primary emphasis in improving the finance available to SMEs in Ghana should be on credit for working capital and expansion for existing firms with a proven track record; new Investments are harder to assess and their loger term adds to uncertainty. Survey evidence suggests that worldkg capital is the primary need for SMEs that have the potential to raise output and productivity. Many have difficulty meeting ordes (Including for export) because they cannot obtain working capital for the period necessary to produce and receive payment (about 90 days). iL For new ivestors especially in microenterprises, it makes sense to concentrate on stengthening infonnal savings mechanisms that already facilitate large numbers of Ghanaians to enter business for themsehve Credit for new SMU investments appears less critical and less likely to succeed than for  -v.w working capital, for several reasons. (a) There appears to be fairly vigorous private investment in small businesses from own saings, especally at the microenterprise level. Investing in apprenticeship and the equipment necessary to get established (or to set relatives up) In business is an Important outlet for household savings in Ghana. As a result, even semi-skilled trades such as sev ing, carpentry and vehicle repair are overcrowded, making it difficult for a new entramt to repay a loan. (b) The low ptobability that new small enterprises wil ntinue growing beyond the level of providing minimal income maintenance makes it appropriate for the entrepreneur (or relative) to bear the risk, rather than an outside institution. (c) Information costs are much lower when a business has a track record, especially when it has steadily accumulated savings with the institution considering a loan. B-PA x Banks should be able to do more in the way of providing overdrafts to help SMEs meet firm ordes At present, however, even overdrafts must be backed by fixed assets as collateral. Hence some collateral substitutes or new instuments ate needed if banks are to expand their short-term SME lending. Sinoe most successful SMEs do in fact maintain deprsits with banks, it might be feasible to introduce a fixed- tem deposit account which could serve as a basis fAz otbtaining overdrafts (preferably with some leverage). A mechanism for discounting trade bills would also help, although at present they do not meet the banking regulation requirements for secuizing loans. XiL Until one or more banks decide to move aggressively into the SME market, it is unreasonable to expect that they wi finance SMEs on a wide scale. Indeed, prudential regulations under the banking law requires them to enswe that loans are well seued, which will continue to exlude SMEs that cannot provide the necessary collateral. Although term funds are available through the SME Credit in the Bank of Ghana, the rate charged to intmediaes has been high relative to funds mobilized through deposits, and the information and procesing costs involved are also high. Banks are reluctant to pass on these costs in the form of very high interest rates, in par for fear of overburdening SME clients with ;xcessive debt xid Nevertheless, continued efforts are in order to improve their ability to serve firms at the upper end of the SME range, startng with existing costomer In particular, they need to train staff at the branch level In working with SME clients, getting to klow their business, and assessing their ability to repay in ways that go beyond simple project appraisal. This must be complemented by decentralized management and information systems that facilitate close supervion and reaction to problems at the local level Speci-l asistance in training and marketing should be made available to any bank that wishes to develop the SME market as its particular niche. Greater competition for clients by an effective SME-oriented bank would eventually force other banks to improve their services for SMs in order to retain their depositors. Xii In addition, a rik-sharing mechanism such as a well-functioning credit guarantee or loan insurance scheme would help induce banks to accept the risks involved in loans to smaller firms. Such a scheme would increase the incentive to use funds available under the SME Credit (the previous incentive of being outside credit ceilings is no longer relevant since ceiligs have been eliminated). However, it must be noted that small loan guarantee schemes elsewhere have often not performed well, especially when weak supervision by the banks has alowed repayment rates to falter and when the conditions for collecting the guarantee are unclear. Thus, it is important that banks continue to bear a share of the risk, that there is good  - vi - supervisoty capability in place (perhaps invoing other agencies to complement the banks), and that the procedures for banks to demonstrate sufficient efforts at recovery and thien to collect on the guarantee are transparent and virtually automatic. Some credit programs provide an ircentive for borrowers to repay by incorporating a fee Into their repayment schedule which is subsequently refunded If they make all payments on time. xiv. If the rural banking system is rehabilitated, it could help to epand credit to SMEs in rural areas. Based on successful eperiences elsewhere, such as Kupedes in Indonesia and Grameen Bank in Bangladesh, conditions for effective SME lending by rural banks include: locally owned and managed units with maximum direct day-to-day knowledge of their clients; incentives for staff based on the unit's profit performance; and interlinkage.v among the unit banks (or with a parent bank) that make it easy to earn a return on surplus mobilzed funds or to obtain funds to meet excess demand for credit. It is especially imporant to staff the banks with people from the local community who both know their clients personally and are trained to interact with them on a professional basis. Iormal and SemI-formal Inttutkos XV. Efforts are also needed to improve the linkages between formal and informal financial institutions. Informal financial agents would be better able to intermediate between savers and investors if they had acss to crediL The banks could benefit from the more intimate knowledge of clients that the informal agents posses. In some countries, informal agents can collect a commission by bringing creditworthy clients to the banks and guaranteeing loans to them. As a guarantor, the agent would have a strong stake in superviion to ensure repayment. Gbana's system of 5U5U collectors and groups has the potential to serve these roles either as intermediaries to lend on the basis of their access to bank credit or to facilitate direct loans from banks to their cliens xvi In principle, the S&Ls have the potential to provide the sort of finance needed by SMEs. At present, however, realizationt of this potential is restriced by the small number of active S&Ls and past bad experiences Hence it would be worthwhile to provide substantial technical support and training to the existing ones to ensure that they oper- successfully and therby provide a model to others. Over time, it would be desirable to link sucesful S&ls to each other and to banks to improve their flexibility in depositing excess funds and obtaining credit to on-lend. Support I _stons xvii Support institutions such as NBSSI, Women's World Banking (Ghana), and EMPRETEC can help SMEs improve their financial situation in two principal ways. Directly, they can help small-scale entrepreneurs improve their business and cash management procedures. Helping SMEs utilize internally- generated finance is imporat because relatively few SMEs are likely to obtain external finance. Indirectly, they can assist SMEs with applications for bank financing through better preparation of the documentation required. In addition, thy may pwvide project monitoring that complements the banks' own credit supervision and helps to avoid areas problems before they arise.  - vii- ,wlll. Special credit programs such as PAMSCAD have had some succs in helping people enter business, but (in other countiles as well as in Ghana) they have difficulty establishing sufficiently high repayment and profitability recrds to make them sustainable. Such programs are most likely to contribute to longer-term goals of financlal development when they operate on a commercial basis and Involve established financial Institutions (as agents, f not as intermediaries). ix. Ghana is likely to have more success over the long term by building up and complementing the financial and technical assistance Institutions already in place than by trying to establish a new specialized institution to serve the gpp that presently exists between the demand for finance by SMEs, the collateral and infonmation they can provide, and what financial institutions are presently able to finance under existing practices. 'here are positive signs that GhaWa's financial system is gradually establishing the conditions for more widespread finance of SMEs, through both formal and informal institutions and through linkages between them, and the long^term strategy should be to accelerate these developments.  1. BACKGROUND FOR THE STUDY 1.01 Ghana's Economic Recovety Program (ERP), launched in 1983, provided new opportunities and challenges to Its Indigenous private sector. Liberalization of markets opened up access to Imports and other resources to Ghanaian entrepreneurs, most of whom operate small- and mediumscale enterprises (SMEs) that had been largely excluded from previous systems of direct control and allocatlionL The Government has emphasized the importance of private sector investment for future growth of the economy. Despite successful economic stabilization and growth, the private sector response has fallen short of expectations. 1.02 Small entrepreneurs in Ghana face a variety of obstacles, including competition from imports and large industries, Inadequate infrastructure and business services, a difficult regulatory environment, and a conservative financial system that has traditiona1ly concentrated its resources on short-term commercial finance. Lack of access to finance has been identified as a primary constraint on the ability of SMEs to adapt and grow. The Government has liberalized financial policies and taken steps to improve the financial system, but its capacity to reach smaller firms remains limited. This study was undertaken to investigate the flnancial system's capacity to meet the needs of SMEs and to suggest ways of hastening the process of financial development in ways that would facilitate growth of an efficient, dynamic prvate sector. It examines informal as well as formal sources of finance. A. Firnial Sector Reforms and Programs 1.03 To crate market conditions more conducive to efficient credit allocaton and Iased intermediation, the Government of Ghana has undertaken a program of financial policy reform. As part of the structal adjustment program, deposit and lending rates were gradually liberalized in the mid-1980s, leaving banks free to set their own rate stuctutes according to market signals and the costs of doing business. Sectoral credit ceilings were lifted during 1987 through 1989 and replaced with a global ceiling for each bank b3sed upon prior year increases in lending actvity. Global credit ceilings were in turn removed late in 1991 and replaced with benchmark indicators provided to banks as a guide to the appropriate rate of credit expansion. These policies were complemented by measures in 1990 to strengthen the regulatory framework and bank supervision. Ghana is among the countries that have received a World Bank Fnancial Sector Adjustment Credit (FINSAC), designed to assist balane. sheet restructuring of existing financial institutions and generate fiacl deepenng and inacased leves of intermediatioiL 1.04 In order to build the institutional capacity of lending institutions to meet financing requirements of emerging market economies, the World Bank has extended lines of credit for SMER. Such credits have been made available both through development finance institutions and through apex lines of credit to commercial banks. By giving greater access to term financing for viable SMEs and stimulating V This report focuses on enterprises that are sufficiently large and formal to operate bank accounts and be possible recipients of bank credit. The issue of financing self-employment and microenterprises (roughly defined as having fewer than four workers) is discussed in the contea of informal finance, but not treated at leugth because such activities are generally self-financed unless successful enough to have grown to the SME range.  -2 - increased financial intermediation, these projects have attempted to encourage growth of locally-owned enterprises and to stimulate employment in relatively labor-intensive activities. The SME Credit in Ghana has attempted to increase the aedit available to SMEs through commercial and development banks since 1990. Special funding for small-scale entrepreneurs has also been made available through the Program of Action to Mitigate the Sodal Costs of Adjustment (PAMSCAD), which uses the banking system as a" agent to process the disbursements. 1m The central hypothesis for this study is that restrcturing and liberalization of the financial sector should create suitable conditions for increased SME lending. Nevertheless, experience with SME credits and FINSACs in other African countries has been varied and, on the whole, disappointing. Available research on SME credits in Africa (Webster 1991) indicates that: * disbursements have generally fallen short of desired levels; * credits have gone disproportionately to medium-scale enterprises, rather than smaller ones; * there is little evidence of increased domestic resource mobilization and term transformation on the part of particpating finanhcl institutions; and e little financial deepening has taken place, in the form of substai.Jal increases in debt and equity financing accessible to viable SMEs and emergence of new financial instruments and institutions that meet their financial needs. B. Analytical Framework N 1.06 Fiancial deepenig (as measured by various monetary and credit aggregates relative to income) is an important characteristic of the growth process (Getler and Rose 1991). Increased financial intermediation promotes growth by bridging the gap between potential savers and would-be investors; economic growth in turn stimulates the development of financial institutions (Gurley and Shaw 1967). Nevertheless, a study of eleven Arican countries did not find the expected relationship between financial intermediation and the rate of economic development (Bhatia and Khatkate 1975). Important issues for the present study are the adequacy of finandal policy reforms and the importance of other conditions for the ability of the financial sector to play its potential role in growth, particularly of the indigenous private sector. L07 iUke many other African countries, Ghana's past financial policies were aimed at directing subsidized credit to preferred sectors and keeping the cost of deficit finance low. The result was what McKinnon (1973) and Shaw (1973) charactrzed as iancial repression," shifting the allocation of investible funds from the market to the government. They argued that holding interest rates below the rate of inllation reduces savings and, consequently, investment and growth. Further, when financial institutions have to ration credit by means other than the interest rate, they tend to favor large borrowers with substantial security and reputation and exclude SMEs and new investos Low interest rates and directed credit policies have been found to retard domestic savings mobilization and financial development without necessarily producing the 2/ This section is based on Hettige (1992).  -3- desired impact on resource allocation (Fry 1989, World Bank 1989). Lack of competition provides no incentive to develop new instruments that might be better suited to small-scale savers and borrowers. Financial repession also is likely to increase the volume of transactions In informal flnancial markets, which serve the needs of those who lack access to formal financial Institutions and which have the advantages of knowing individual clients well and avoiding interest rate restrictions. 1.08 In the context of financial repression, liberalization of financial policies is expected to enable the market to allocate funds more optimally among borrowers, thus promoting economic growth. Countries in which positive real interest rates have been associated with rapid financia! and economic growth include Japan, Korea, Taiwan and Singapore (McKinnon 1989). Nevertheless, these countries do not represent full financial liberalization, since they have also maintained controls over financial markets and provided subsidized credit to priority sectors. Furthermore, it has not been empirically established that higher interest rates necessarily raise aggregate savings, although they are likely to at least shift savings from non-financial and informal forms to formal financial markets (Fry 1989, Hoist 1989). 1.09 The recent literature concludes that financial liberalization may not be sufficient to stimulate growth unless efficient financial markets and institutions are in place, and it may even have perverse effects under unstable macroeconomic conditions and shallow financial markets (Collier and Mayer 1990, Getler and Rose 1991). Even in an unregulated lending market, credit rationing may occur when the diffculty of obtaining adequate Information about the viability of the project to be financed and the ability and willingness of borrowers to repay adversely affects lenders perception of the risk involved (Stiglitz and Weiss 1981). Because very high interest rates may attract only high-return high-risk borrowers, bank may be reluctant to age the rates necessary to cver these risks and the high transaction costs of lending to small borrowers. Bancs may also shy away from term lending in low-income countries that are sensitive to external shocks such as political change, adverse weather conditions, and falling terms of trade, in the absence of well-developed financial mechanisms to hedge and to pool risks. 1.10 Under these conditions, the access of SMEs to formal finance may benefit littie from financial iberalization unless measures are also taken to reduce the transaction costs involved in obtaining information on projecss and borrowers and in negotiating, monitoring and enforcing loan contracts. For example, a well- functioning legal system for contract enfor-ement is needed if banks are to move away from insisting on clear title to landed property as collateral-a condition that excludes most SMEs Issues for this study include the cost and risk perceptions of formal lenders toward SMEs and whether informal lenders play a special role by virtue of their relatively detailed information and low transaction costs in dealing with individual clients on a small scale. 1.11 Institutional development of the fonnal financial system is another likely precondition for fnancial lberalization to significantly increase the access of SMUs Bank naanagement is an important area of institutional development. The tendency of African banking systems to centralize decisions and to focus on urban areas has been reinforced by weak competition, lack of trained staff, poor communications, and the absence of computerized management infomation sytems. An issue for this study is whether liberliation, including increased competition, has been sufficient to stimulate increased decentralization of banldng networks and accountability and hence to improve access of SMEs and rural clients.  .4 - 1.12 The development of oey and capital markeS is also important for banks to undertake more investment lending, based on mobilization of long-term savings through new instruments and maturity transformation of short-term liabilities. In most developed countries well-functioning money and capital markets enable authorities to sell government bonds and other securities without directly crowding out private sector borrowing from the banking system. To function well, banking systems also need adequate regulation, supervision, and mechanisms to guard against excessive withdrawal of deposits. An issue for this study is the extent to which the development of money and capital markets under financial liberalization in Ghana has increased the flow of funds available to private investors, especially SMEs. C Study Objectves 1.13 This study was undertaken to investigate concerns on the part of the Government of Ghana and the World Bank about the extent of *bankable demand for credit among SMEs, the capabilities of financial institutions to respond to such demand, and the degree of financial deepening that is taking place. The specific objectives of this study are to: * assess the bankable demand for financing among Ghana's SMEs; iLe., demand for credit or equity financing among viable, creditworthy expansions or start ups; * analyze lending capacity, degree of interest and constraints to extension of formal bank credit to viable SMEs, and how these have been influenced by financial policy reforms; * suggest effectiv mechanisms for managing risks and reducing transaction costs, thus bridging the gap between conservative lending practices and improved knowledge of the characteristics of viable SMEs as potential borrowers; 3 identifi, ways to acoelerate the process of financial deepening in Ghana by strengthening intermediate fiancial instruments and semi-formal institutions which could effectively meet the demand for finance among Ghana's dynamic SiEs, and * develop a famnework for improving the capability to structure, monitor and evaluate SME projects for lending. L14 To acoomplish these objectives, the study was structured to focus both on the supply side, or the availability and terms of financing through formal, semi-formal and informal financial institutions, and the demand side, or bankable demand among Ghanaian SML The demand side is to be discussed in more detail in a separate paper based on firm intervews Thi report analyzes the supply side, based on interviews held with both formal financial institutions (banks and finance companies) and semi-formal and informal institutions (non-bank intermediaries, savings collectors and moneylenders). Also discussed is the need and potential for generating new financial instruments, including venture capital, mutual investment funds and  - 5 v others, which was explored through interviews held with investment banks, finance companies and SMEs as investors in their own expansions.Y 1.15 The repon is organized into five sections. Sections II and III review the effects of liberalization on the formal and informal financial sectors, respectively. Section IV focuses on the implications for lending to SMEs Section V presents conclusions and recommendations. To strengthen toe empirical results and derive useful tools for SME assessment and reduction of risk, Annex V develops a best practice framework based on in- views with non-bank financial intermediaries serving the debt and equity financing needs of SMks in Haiti, Jamaica, Senegal, Cote d'Ivoire, Mali and Botswana. Relevant findings are integrated into the discussion of new financial instruments in Section V.  -6- IL FINANCIAL LIBERALIZATION: IMPLICATIONS FOR THE FORMAL FINANCIAL SECrOR 2.01 Financdal liberalization has been pursued in Ghana since 1983 as part of a wider formal financial sector reform program. Reform within the sector was necessitated by difficulties in mobilizing domestic financial resources and supporting investment. These difficulties included the inability to finance investment at a time when the commercial banking system held exoess reserves; the holding of many non- performing loans by the banks; the relatively high costs of operations of banks; and the absence of a well- functioning capital market. 2.0 Under a repressive financial regime, interest rate controls are imposed in order to keep borowing costs low to investors (and to the government). Ceilings on deposit rates are thought to produce the same effect, since banks that obtain their funds cheaply will be able to lend them cheaply. Nominal lending rates in Ghana had remained below 19%16 for at least five years preceding the ERP in 1983, and deposit rates varied only slightly despite high inflation (Annex Table 11). 2.03 The financial reform package addressed issues of credit allocation, the efficiency of banking operations, the Bank of Ghana's supervision of the commercial banks, and development of capital markets Sectoral credit ceilings, which had proven ineffective in channeling credit to priority sectors, were gradually phased out after 1987, with the agricultural credit target removed in November 1990. Global ceilings were retained for each bank until late 19910 At the same time, interest rates were permitted to rise to align them with inflation rates and achieve positive real rates. Nominal lending rates of commercial banks rose to 30% in 1991, and the real lending rate of -104% in 1983 first became positive in 1985 (11%), then remained only margnally negative until 1989 when positive rates were again achieved. Since the end of 1991, when the annual inflation rate fell to 14%, the central bank has reduced its rate and encouraged commercial banks to reduce their lending rates to an average of 19%, although most banks remained above the latter rate as of FebruaTy, 1992. 2.04 While positive real rates have been achieved, it is only gradually becoming evident how this has affected the structure of the formal and informal sectorm Views diverge on the likely impact of liberalizing interest rates. Proponents of financial liberalization argue that it is likely to stimulate institutional development and to encourage individual borrowers and savers to switch from the informal sector to the formal sector and from iflation hedges to monetary assets Eventualy, the range of financial instruments available would increase, and the overall result would be to transform a narrow, inefficient, and fragmented financial system into a lrger, more complete and more efficient financial system. In other words, the fomal and informal financial sectors are considered to be substitutes. In a country with underdeveloped financial institutions and instruments, such as Ghana, the willingness of savers to hold money in the form of bank deposits would therefore be crucial to the savings-investment intermediation process. In ali this, the real rate of interest is regarded as the crucial determinant of the willingness of savers to hold money in the form of bank deposits. 41 As of 1992, the Bank of Ghana still exerted indirect restraints on credit expansion through benchmark indicators intended as guidelines and through weekly reporting requirements.  2.05 Monetary policy has affected the availability of loan funds to the private sector through the banking system. lhe government has used Treasury bills (under one year) and notes (one to two years) and Bank of Ghana (BOG) biUs and bonds (one to five years) as a means of absorbing excess liquidity in the banking system and restraining the growth of the money supply in an effort to bring inflation down. By mid- 1991 the rates on these instruments had risen as high as 34%, higher than the lending rate to the private sector. Tbe result was a crowding out of funds available to private sector borrowers, particularly new SME clients, as discussed in Section IV. By early 1992, however, the month-to-month annual infation rate had fallen to 10% and the yield on T.bills was reduced to 16% to 18%. It is too early to obtain more than a preliminaiy indication of how the latter change will affect lending rates and the availability of funds. 2.06 This section first reviews the structure of Ghanas formal financial system. It then anabzes ways in which liberalization has affected banking practices and performance. A. Structure of the Formal Financial Sector Composition of the Bankdng Sector 2.07 The entral bank of Ghana (BG) supervises the opertions of all other banks, monitors the application of monetary policy and overal credit ceilings, and registers new financial institutions. The formal banking sector is comprised of twelve other banks, which for the most part engage In low-risk, short-term lending to existing customers in the private and public sector These banks include eight Government.owned institutions: Ghana Commercial Bank (GCB), Merchant Bank (Ghana) Ltd, National Investment Bank (NIB), the Bank for Housing and Construction (BHC), National Savings and Credit Bank (NSCB), Agricultural Development Bank (ADB), Social Secuity Bank (SSB), and Ghana Co-operative Bank. In addition, there are two majority privately-owned banks, Barclays Bank of Ghana Ltd. and Standard Chartered Ltd. Following a 1976 Govenment-mandated sale of stock by public limited companies, these commercial banks now have some Government saeholdings (about 40% and 25, respecmvly). 2.08 The largest of the commercial banks operating in Ghana is Ghana Commercial Bank (GCB), the first indigenous bank, established in 1953. It was created by the Government to offset the lending policies of foreign banks, who favored well-established foreign firms in awarding loans and advances. Although it is a commercial bank, GCB also does some development lending in the form of medium-term project loans for business expansion under SME credits and donor-prov;ded agricultural funds. Along with two expatriate- owned banks (Barclays Bank and Standard Chartered Ltd.), GCB plays an important role in meeting the financial needs of major corporations and large scale exportes These banks share portions of this market with Merchant Bank (Ghana) Ltd. and, more recently, ECOBANK Ltd. 2.09 Merchant Bank (Ghana) Ltd, opened in 197, provides or arranges business services including trade finance, supplier and other documentaiycredits, bill discounting and acceptances, export finance,working capital finance and project finance It is jointly owned by the Government of Ghana (30%), National Investment Bank (25%), State Insurance Corporation (15%) and Grindlays Bank (30%). Through its subsidiary, Merbank Investment Holdings, the group manages funds for institutional and individual clients. Merbank Stockbrokers Ltd. is a brokerage and stock advisors service, and a lcensed member of the Ghana Stock Exchange.  -8- 2.10 The Social Security Bank (SSB), opened in 1977, Is wholly owned by the Social Security and National Insurance Trust (SSNIT). The bank is administered by the Trust and operates like any other commercial bank, with some emphasis on consumer lending facilities for workersm Due to its substantial deposit base among working people, SSB has overtaken the two expatriate banks in terms of branch network, assets, deposits and loans. GCB, Barclays, Standard Chartered and SSB together control over 90% of the assets in the commercial banking sector. 2.11 Several specialized banks provide banking services in speciflc sectors of the economy. ADB caters to the credit needs of agriculture and related activities; NIB serves the needs of industry, BHC provides deposit and lending facilities for housing, construction, and other service-oriented sectors. While these banks were established as development finance institutions, under liberalization and the new Banking Law (1989) they have introduced commercial banking services and operate on a commercial basis. At NIB, lending is supported by intensive technical review and close loan supervision, carried out by bankers in specialized lending units (agriculture, mining, manufacturing, processing). BHC has the capacity to work with the technical requirements of housing and construction. 212 Two small Government-owned banks complement activities of others in the market. National Savings and Credit Bank (NSCB), known until 1972 as the Post Office Savings Bank, was re-established by Goverment in that year to play a more effective role in mobilizing savings country-wide and was given authority to lend. 'Jp to the current restructuring as part of FINSAC, NSCB managed a portfolio of small loans, predominantty short-term credits to consumers and small trading businesses. The Ghana Co-operative Bank is a development finance institution that began operations in 1975, but its operating history goes back to the 1930X It provides prinantly short-term credit facilities to customers, including smaUholder agriculturalists and small retail and trading activities. 2.13 To help mobilie resources and extend credit locally, 122 rural banks were established as unit banks over a period of 16 years. The initial capital for these was contrbuted by BOG, while management and ownership were given to the local communities. Despite their large network, they did not contribute effectively to Increased deposits or lending Their total assets accounted for about 5 percent of the total assets of the banking system Many of them became financially weak and are being closed or restructured under the bank restructuring program adopted as part of the Rural Finance ProjecL 2.14 Competition in banking has increased in the context of financial sector liberalization and economic restructuring. Two private merchant banks, ECOBANK Ltd. and Continental Acceptance Ld, were established in 1990. Ihese banks are predominantly foreign-owned and represent the only new bank approvals since 197& Merchant banking can be distinguished from commeral banking by its emphasis on a full array of senrices meeting the trade and inestment needs of larger commercial customes During nearly two years of operation in Ghana, ECOBANK has provided trade and expansion financing primarily to the top end of the business market, as well as investment management services to local investors and foreign exchange operations for regional traders. It is seeking to make long-term project finance available on a selective basis to medium-scale industries that are highly profitable and uniquely positioned In the domestic or export markets. Continental Acceptances Ltd. specializes in purchase and placement of commercial paper and other securities issued by large-sca companies.  -9- 2.15 WIth their aggressive marketing and efforts to adapt financial products to customers needs, ECOBANK and Continental Acceptances are generating increasing competition for the commercial banks, as well as for MTrchant Bank In addition, Meridien Bank has been licensed to operate since 1990 and is in the prooes of establising operations, while Citibank is expected to be licensed soon. There is some evidence that borrowers are beginning to -shop" the banks. While the tendency is to make the first loan applicatic-, with their deposit institution, a number of SMEs expressed willingness to switch banks, if better terms with less red tape could be secured at another institution. Management of larger banks interviewed Indicated that as much as 50% of their savings base represents customers who deposit In multiple banks. 2.16 'he pre-existing banks continue to concentrate mainly on commercial banking activites in general or in their specific areas of expertise. GCB has not opened a new branch since 1985 and dosed 7 branches in 1990 under the bank restructuring program. Ghanaian banks have for the most part reassessed profitability and eliminated or consolidated branches to increase returns, rather than expanded branch networks. 2.17 Besides becoming more commercial, the formerly specialized banks have diversified their portfolios by making selective loans in other sectors. While this diversification has followed the lifting of sectoral ceilings, it seems to have been undertaken more in response to restructuring pressures to spread risks and improve the performnance of bank portfolios. These banks still concentrate on the areas they know best. For example, BHC continues to emphasize loans to service sectors with which it is most famfliar, while at the same time processing a range of applications for small industry expansion under the SME Credit. Likewise, ADB is submitting loans for small industry witbin a market that is new for the bank (SMEs and longer term lending), while still lending largely to agriculture-related activities. Complementary Fnancia Markets 2.18 Ghana's financial market is seved by several non-banking institutions. These include the Ghana Stock Exchange, several insurance companies, SSNIT, Consolidated Discount House Limited (CDHL), Securities Discount House (SDH), and a building society. These institutions are not regulated by banking law. The capital market In Ghana is still at a preliminary stage and is not able to mobilize significant amounts of long-term resoures The recently reorganized Ghana Stock Exchange began trading in November 1990, handling active trading for some 25 to 30 listed companies. The listed companies are primarily Ghana's public limited companies Despite the substantial volume of trading initially, its trading volume dropped as a result of rapid increases in the yields of short- and medium-term paper issued by the BOG and the Government. 2.19 The two discount houses were established in 1987 and 1990, respectively, to promote the development of a money market. CDHL acts as an intermediary for short-term assets to enable banks to better manage their liquidity positions. It deals in Treasury Bills, short-term Government securities, bankers acceptances, commodity bills, negotiable short-term Certificates of Deposit, and commercial paper. It is essentially a short-term financing institution, and is required to hold at least 70% of its assets in short-term paper. It is also allowed to accept short-term deposits from financial institutions. SDH was set up in June 1991, with assistance from the Intmrnational Fnance Corporation (IFC to provide a secondary market for commercial paper issued by larger public and private companies.  - 10. 2.20 The insurance market consists of about 20 Insurance companies (both life and non-life insurance) and SSNIT, which deals with social security. The latter accepts contributions from both employers and employees. Until 1986, it was required to invest In special government stocks, but it is now free to choose the composition of its assets. As a result of the high yields offered In 1991, it shifted a substantial part of its portfolio to short-term bills. 2.21 At the present time, no venture capital or equity financing institutions are active in Ghana. However, two venture capital facilities are being structured to enter the market In 1992. ECOBANK, with IFC participation, is in the process of capitalizing an $18 million regional venture capital fund that will invest directly in high-return manufacturing and mining industries in Ghana and several surrounding markets (about five investments a year). The fund is expected to serve the top of the market in terns of profitability and market position, and will also provide restructuring and management technical assistance. Continental Acceptances Limited, in collaboration with the Commonwealth Development Corporation and with support from USAID, is about to launch the Ghana Venture Capital Company (GVCC) to invest directly in Ghanaian SMEs (up to five investments a year). GVCCs management will actively supervise investments through strategic planning and management assistance to each invested company. Deposit Structur 2.22 The liability structures of Ghanaian banks are predominantly short term. Before 1983 roughly two-thirds of the aggregate deposit base was in demand deposits, which generally do not earn interest unless they are vely large accounts (Annex Tables Ll and 1.3). In 1991 demand deposits still accounted for 57% of the deposit base, with most of the rest in savings accounts earning 20% or less. Besides time deposits of different terms, several banks also began offerig Bearer's Certificates for 91 days to a year at rates ranging from 23% to 26% during 1991 (while T-bill rates were in the range of 30% to 34%). 2.23 About 50% of the deposits are held by GCB, which has the largest branch network. By comparison, Merchant Bank (Ghana) Ltd. holds about 7% of the deposit base. Despite their large network, the Rural Banks hold only about 3% of deposits. 2.24 The growth of deposits has been restrained by four principal factors: * lingering lack of confidence stemming from the freeing and investigation of many bank accunts in 1981-V4 * the time invohved in making bank transactions; * the persistent high rate of inflation; and e attractive yields on government paper as an alternative. The latter two conditions have changed significantly in the last year as the inflation rate and T-bill rates have fallen, and deposits are reported to have grown substantially as a result. Whereas bankers previously estimated that as much as 45% of the national savings base was held outside the banking system, by early 1992 estimates  - 11. were closer to 25%. They believe that deposits will continue to grow even without additional measures such as deposit insurance. 2.25 Depositors' interest in time deposits has heightened with the drop in rates on government paper. Commercial banks are now exploring deposit instruments that would attract langer-term deposits. For example, one bank is developing a high-rate fixed-deposit instrument that would allow business customers withdrawal privileges to meet cash flow needs. Nevertheless, most banks remain wary of locking themselves into high interest rates beyond a year as long as economic growth remains weak. Tley are now paying from 3% to 5%Y on demand deposits above C 10 million, perhaps to retard the shift into longer-term accounts. 2.26 With liberalization and the gradual movement toward privatization of banks, Ghanaian financial institutions report for the most put not having lost but gained customers. This appears to be due to increased bank competition for priate sector business, as a means to diversify risks and increase income- earning assets under restructuring. One bank is reportedly phasing out its development lending operation and offering large commercial customers lending rates of up to 3% below those for smaller customers on short- term credits (26% vs 29%), to capture more of the corporate narket. ILading Structure 2.27 Lending by the private commercial banks and the majority of the Govenmment-oned banks has tended to reflect the short-term nature of their deposit base. Except for the development fnance institutions, banks' ponf olios are dominated by short-term credits to existing commercial customers (overdrafts, worldng capital, documentary and trade credits). These are interspersed with some expansion loans to established medium-to-large-scale customers. 228 Lending to the private sector has been constrained both directly by the cedit absorbed by state enterprlses and indirectly by Government borrowing from the banking system. Although the state enterprise sector is in the process of being restructured and banks are no longer obligated to lend to them, they remain important clients of the banks and continue to absorb a substantial share of the credit available. Perhaps more significant in recent years bave been the high rates on government paper associated with efforts to absorb excess liquidity. From 1984 to 1988 total loans and advances of the commercial banking system had grown much more rapidly than its holdings of central govermment domestic debt (Annex Tables L4 and 1.5). With the rediscount rate on T-bilUs rising from 19.9% in 1989 to 27.3% in 1990 and 32.0% by mid-1991, this trend was reversed (Annex Tables Li and L2). 2.29 With the lowering of rates on gvernment paper by the end of 1991, it was expected that term lending would become a more attractive Investment for banks No clear increase materialized early in 1992, however, in part because of the uncertainty surrounding the upcoming elections and in part because banks do not see an adequate supply of viable projects. SME lending remains quite selective, concentrating on existing customers seeking working capital or credit for expansion, although bar.ks do appear to be accepting loan applications from existing clients that have not previously borrowed (but not from new clients). With deposits apparently increasing faster than loans, there is some possibility that a situation of excess liquidity will re- emerge if banks remain reluctant to expand SME and term lending. 2.30 Ibe majority of banks reported that global and secto- -l lending ceilings in force before 1989 constrain.-4 their lending to SMEs. With those ceilings lifted and interest rates freed, five banks of the nine  -12- interviewed reported that SME lending had increased by about 10 to 209%o. Nevertheless, the share of indigenous manufacturing sole proprietorships in total bank lending to the private sector, which may be used as a proxy for the SME credit share, dropped from 1.6% in 1987 to 1.1% in 1990. On average no more than about 15% of banks' loan portfolio is made up of credits to SMEs.O Interest Rates and Lean Pridig 2.31 Following the gradual relaxation of lending and deposit rate controls since 1987 and full liberalization In 1989, banks are free to set their own rate structures. The anticipated effect of rate liberalization was that savin{s and lending rates would rise to very high levels initially and then fall in response to increased competition and lowered inflation. Nevertheless, bank lending and deposit rates remained high through 1991, sustained by the exceptionally high yields on Treasury and BOO monetary instruments with the objective of further lowering the Inflation rate. 2.32 Lending rates have responded to movements in the T-bill rate, but with some lag. The minimum rate charged to domestic producers rose by only 1.5 to 3.5 percentage points between December 1990 and June 1991, although the maxmum rate matched the jump of nearly 5 percentage points in the T-bill redicount rate (Tabl' 2.1). When the rediscount rate fell by 14 percentage points, the minimum lending rates fell by only 7 to 9 percentage points and the maximum rates had fallen only slightly by February 1992. Thus lending rates in early 1992 were high relative to both the T-bill rate and the rate of inflation. Table 2.1: Bank Lending Rates by Subsector, 1990-92 (percent per annum) Subsector Dec. 1990 June 1991 Feb. 1992 Agriculture 22.5-29.5 23.0-35.0 16.0-35.0 Export trade 20.0-30.25 25.0-35.0 1&0-33.25 Manufacturing 22.5-3025 26.0-35.0 17.0-33.0 Construction 26.0-29.5 28.0-35.0 20.0-28.0 Treasury bitl rediscount 27.3 32.0 l8o Source: Annex Table LZ 2.33 Both commercial and development banks maintain t.at they set lending rate structures prmarily according to market competition and the average cost of funds, with transaction costs mentioned as