Positioning Local Banks for Success in Smallholder Finance
New research from the Initiative for Smallholder Finance reveals that approximately 290 banks in the developing world provide a total of $9 billion in local funding to smallholders – a lending rate that fails to meet 97 percent of smallholder demand for financing. Because they lack financing, smallholders cannot produce the volume of crops necessary to sustain their livelihoods or improve country economies. To support smallholders effectively, banks must be able to lend at affordable rates, offer products specifically designed for farmers, and improve accessibility of financial institutions to farmers.
Keys to Financing Smallholders Effectively
To help banks and financial institutions offer smallholders broader access to financing, public and commercial investors must allocate more capital so lenders can develop a wider array of smallholder-focused products and services. The Initiative for Smallholder Finance has identified five key capabilities that financial institutions must possess to succeed in smallholder financing:
- Flexible Products: Cash flow can be very unpredictable for farmers, especially when they receive most of their money during the harvest season. Smallholder farmer-focused products require flexible payment arrangements aligned with crop cycles, rather than monthly repayment schedules.
- Innovative Distribution: Banks can keep costs low by relying on a combination of new distribution channels such as producer groups, value chain relationships and mobile technology.
- Alternative Collateral: Group lending, warehouse receipts, and equipment leasing allow banks to offer financing to smallholder farmers who might not have traditional hard assets as collateral.
- Risk Mitigation: By better understanding value chains and buyer relationships, lenders can evaluate smallholders’ future cash flows and improve credit assessments. Additionally, banks can mitigate risk by spreading their risk across multiple crops, regions or non-agricultural sectors.
- Partnerships: Successful smallholder lenders partner with institutions that can give additional agricultural training and support to smallholder farmers. Institutions may include government extension programs, NGOs, producer organizations or technical assistance providers.
The Three Types of Local Lending Institutions Serving Smallholders
There are three types of lenders that can be attractive to investors looking to boost smallholder farmer financing and the growth of new financial products. These include:
- Public Policy Lenders: These are either fully or partially privatized state and agricultural development banks. They currently serve as the cornerstone of smallholder lending, but they are not positioned to drive future financing growth. While they offer effective agricultural finance products and boast a large branch footprint, as well as collateral and risk management experience, they are slow to innovate because they depend on governmental funding. Public policy lenders present a risky investment because of their dependency on policies or political priorities. In some cases, investors may be able to support public policy lenders via specific products or customer niches, or when a public policy lender transitions to become a commercially driven bank.
- Niche Poverty Banks: This category of lenders, which includes microfinance banks, is particularly prevalent in Asia. Niche poverty banks use group lending tactics that allow them to service poor customers who do not have traditional collateral. While niche poverty banks are comfortable working with NGOs and other organizations that help the poor, they often have restrictive payment terms that make their products inaccessible for smallholders without steady cash flow. However, some niche poverty banks are looking into developing new, more smallholder-favorable products.
- Diversified Branch Banks: These are commercial banks with a large branch footprint and greater access to capital than niche poverty banks. Unfortunately, their off-the-shelf products rarely fit agriculture cash flows and often require hard assets as collateral, which limits their accessibility to smallholders. Working with NGOs and agricultural extension programs may help diversified branch banks reach more smallholder farmers. Moreover, some diversified branch banks have begun to mimic the group lending approaches of niche poverty banks. In the future, the two types of financial institutions may merge to offer a wider range of resources.
The smallholder banking market presents interesting opportunities for investors to come forward and help grow the market, regardless of whether they have $1 million or $100 million to invest. Niche poverty lenders – particularly those that have or can obtain agriculture sector expertise – present the most attractive investment opportunity among these types of banks. Regardless of their approach, investors directing capital towards smallholder finance should couple that capital with technical assistance—either by delivering it themselves or partnering with a third party provider—to strengthen the agricultural financing capabilities of the bank.
Read the full briefing document, “A Roadmap for Growth: Positioning Local Banks for Success in Smallholder Finance” (PDF).
Dan Zook is a project leader in Dalberg’s New York office. He leads cross-functional teams in projects around the world with major donor agencies, financial institutions, and corporations in areas of strategy, operational effectiveness and social impact.