Archives for category: SME finance

Uhuru and Ruto wrote in the Jubilee Manifesto that they plan to establish a development Bank to “prop up the private players”. Although nobody is talking about it, and although we have no idea if that will happen anytime soon, this could be a huge deal for the future of Kenya. What is a development bank? And is it a good or a bad idea for Kenya?

A traditional definition of a development bank is one which is a national or regional financial institution designed to provide medium-and long-term capital for productive investment, often accompanied by technical assistance, in less-developed areas. Development banks fill a gap left by undeveloped capital markets and the reluctance of commercial banks to offer long-term financing. [full “primer on development banking” here]

We have to keep in mind is that UhuRuto provided no details about how a development bank fits into their grand scheme for economic development in Kenya. For example, we don’t know if the objective is to promote small businesses (like the informal sector or SMEs), whether they want to finance large infrastructural projects, agriculture or large manufacturing industries.  However, the sure thing is that whenever the plan is to increase the government role in the economy, you attract both huge praise and criticism:  that’s the difference between the “industrial policy view” and the “political view”

According to the industrial policy view, development banks do more than just lending to build large infrastructure projects. They also lend to companies that would not undertake projects if it was not for the availability of long-term, subsidized funding of a development bank. Furthermore, development banks may provide firms with capital conditional on operational improvements and performance targets. In such circumstances, we would expect to see the firms who borrow from development banks increasing capital investments and overall profitability after they get a loan.

According to the political view, on the other hand, lending by development banks leads to misallocation of credit for two reasons. First, development banks tend to bailout companies that would otherwise fail (this is the soft-budget constraint hypothesis, e.g. Kornai, 1979). Second, the rent-seeking hypothesis argues that politicians create and maintain state-owned banks not to channel funds to socially efficient uses, but rather to maximize their personal objectives or engage in patronage deals with politically-connected industrialists.

So, whether a development bank is a good idea or not for Kenya entirely depends on your opinion on the current political class: will they be committed-to-development or good-old rent-seekers? For now I want to keep on the optimist side.


This 2008 paper by GMU’s Peter Boettke, Chris Coyne and Peter Leeson (pdf) is one of my all-time favorite studies on institutions, path dependence and economic development. If you think that the title of the paper is catchy, wait and read the full abstract:

Research examining the importance of path dependence and culture for institutions and development tells us that “history matters,” but not how history matters. To provide this missing “how,” we provide a framework for understanding institutional “stickiness” based on the regression theorem. The regression theorem maintains that the stickiness, and therefore likely success, of any proposed institutional change is a function of that institution’s status in relationship to indigenous agents in the previous time period. This framework for analyzing institutional stickiness creates the core of what we call the New Development Economics. Historical cases of postwar reconstruction and transition efforts provide evidence for our claim.

The authors divide institutions in three types: foreign-introduced exogenous institutions (FEX), indigenously introduced exogenous institutions (IEX) and indigenously introduced endogenous institutions (IEN). The core argument is that institutions tend to “stick” when they are built upon the “mẻtis” of a society.

 A concept passed down from the ancient Greeks, mẻtis is characterized by local knowledge resulting from practical experience. It includes skills, culture, norms, and conventions, which are shaped by the experiences of the individual. This concept applies to both interactions between people (e.g., interpreting the gestures and actions of others) and the physical environment (e.g., learning to ride a bike). The components of mẻtis cannot be written down neatly as a systematic set of instructions. Instead, knowledge regarding mẻtis is gained only through experience and practice. (…) In fact, mẻtis can be thought of as the glue that gives institutions their stickiness.

I often try to think about how this “mẻtis” looks like in real life, especially in the realm of small enterprise finance. If I think about the Kenyan context, my best guess is that the culture of “chamas” (i.e. self-help groups) is part of the mẻtis and that any new financial, welfare or regulatory institution has a much higher chance of “sticking” if it is built upon them. Kenyan banks understood this many years before me, and they introduced new financial products specifically designed for self-help groups (so-called chama accounts). As far as I know, these accounts have been a big success.

The role of chama groups in the Kenyan society and economy is an intriguing topic, which deserves way more attention. I’ve written about it before here and here. New posts are in the pipeline.

It is always boring to talk about definitions, but when it comes to SMEs (small and medium enterprises), the matter is extremely urgent. I’ve read between 1 billion and 1 trillion papers on SME finance over the last few months, and I’ve come to the conclusion that SMEs are a place in the heart of the people (imagine the hard-working entrepreneur paying taxes and tuition fees), rather than any identifiable component of the private sector. The term SME is used by politicians to gain consensus, by non-governmental organizations to attract donor funding and by academics to publish papers. The problem is that there is absolutely no agreement about what we are talking about. Just imagine an evil corporate multinational exploiting workers and the environment. Now think the opposite: there we go, that’s a SME.

I hope I’m not going too far with my rant here, but lately I’ve started to think that the term “SME” is used in policy-making circles in the exact same way the term “Africa” is used among do-gooders in the aid community: it tells us no detail about the topic of the conversation, but it surely hits a soft spot. Who would say anything against SMEs? Who would say anything against Africa? Let me quote my favourite line in Binyavanga Wainaina’s classic essay: “Never, ever say anything negative about an elephant or a gorilla”. In some odd way, I feel we are all talking about the same problem here.

Now I’ll stop the rant and try to get closer to the core of the problem. I’ve had many meetings over the last few months with government institutions, banks, research organizations, NGOs, and academics about the potential of expanding SME finance in Kenya and Africa at large. As soon as the term SME is brought to the table, you see confusion in the eyes of the people: what are we talking about? Are we talking about the informal sector? Are we talking about formal businesses? Which ones exactly? This discussion usually lasts until the end of the meeting.

The confusion is very easy to spot online. I just googled “SME + Africa” in the news section and that’s what I got: Source: “The Star” (a Kenyan newspaper). Title: Kenya: SME Authority to Be Set Up”. First line: “OPERATIONS of micro and small and enterprises will soon be coordinated by …” You probably notice that the “M” of SME does not mean “medium”; in this case it is used as “micro”. The entire definition of SME is therefore shifted down a notch. You’ll see similar confusion in many other venues, for example bankers all over Africa define SMEs by the size of the loans instead of the size of the businesses. That definition tells us nothing about the actual characteristics of the enterprises using financial services and a whole lot of crucial knowledge is wasted for no good reason.

So, I use this blog to make an appeal to the development community through the web: let’s find a common definition for SMEs. This would allow banks, governments and researchers to collect data in a more meaningful way making it comparable across sectors and across countries. This would be in EVERYBODY’S interest and our understanding of the private sector would increase enormously. Personally, my impression is that the term SME should be refined in a complex economy like Kenya – more precision is necessary especially for the lower end of the market. I’d like to see, for example, small enterprises divided in “lower end” and “upper end”. Medium enterprises divided between “lower middle” and “mid-corporate”. Of course there would be plenty of space also for micro-enterprises, which should also be divided between lower and upper ends (survival and growth oriented), or something like that.

Having a common understanding of SMEs nowadays has become more important than ever. Now that “job creation” and “industrialization” are slowly reappearing in the development agenda, we need to come up with good definitions before it’s too late, or we will end up wasting entire meetings not knowing what we are talking about.

We shouldn’t  trust the entrepreneurs too much, says Jacques Morisset

Allow me to illustrate. According to the entrepreneurs operating In Tanzania, electricity is their major constraint (85 per cent) followed by access to finance (52 per cent), taxes (37 per cent), and administrative red tape (25 per cent).Surprisingly, labor and transports costs are only at the bottom of their concerns (less than 10 per cent). According to this ranking, the priority should be therefore given to reducing electricity costs, increasing access to finance and reducing taxation.

A closer look at the firms’ financial balance sheets provides a different picture. In reality, electricity counts for a marginal share of firms’ operating costs in Tanzania (see Figure). For example, it is equivalent to only 3 per cent for a standard firm operating in the apparel sector. In other words, a decline, say, of 50 per cent in electricity prices would only reduce its costs by 1.5 per cent – hardly a high number for such a big effort. By contrast, transport and labor costs are equivalent to 41 per cent and 38 per cent of its total operating costs. This means that reducing transport costs by only 4 per cent would achieve the same gains for the enterprise than cutting by half its energy costs.


I have just one remark. My impression is that the problem with electricity is not much the costs but the frequent power cuts –a huge problem in Tanzania, and also in Kenya – which can disrupt production and provoke considerable losses to the income of the firms.

Having said that, I agree on the idea that policymakers should take the results of these surveys with a grain of salt. In my experience with firms’ surveys I noticed a number of recurrent problems with the instrument I was using. First, entrepreneurs have a tendency to give more weight to their “most recent” problem rather than the “most important” ones they face over the course of the year. Second, both the (i) sequencing of the questions and the (ii) overall topic of the questionnaire has an effect on the answers. If you are dealing with access to finance in a questionnaire, and you have talked about loans and credit for the 30 minutes preceding the your “main obstacle” question, the chances that the entrepreneur will indicate “access to credit” as their main obstacle are very high. If your questionnaire deals with electricity, the dynamic will be the same. Finally, and this is more of a general critique, I believe that both researchers and policymakers should understand better the difference between perceived and actual constraints in an economy. Policymakers should listen to their entrepreneurs (and to the surveys) in order to identify the underlying causes of slow growth in certain parts of the economy. But in most cases the dynamic is different: usually a team of experts is hired to identify these “main problems”, and then survey questionnaires are used to confirm these pre-formatted ideas.

I’ve been asked about a zillion times what is the difference between savings and credit cooperatives (SACCOs), microfinance institutions (MFIs) and commercial banks. I’ve never had time to reply properly but now I came across this table from the World Council of Credit Unions (see below) that summarizes the differences in very simple terms. If there are other issues not included in the table (I’m sure there are tons), please write them down in the comment section.

Credit Unions

Commercial Banks

Other Microfinance Institutions (MFIs)


Not-for-profit, member-owned financial cooperatives funded largely by voluntary member deposits For-profit institutions owned by stockholders Institutions typically funded by external loans, grants and/or investors


Members share a common bond, such as where they live, work or worship. Service to the poor is blended with service to a broader spectrum of the population, which allows credit unions to offer competitive rates and fees. Typically serve middle-to-high income clients. No restrictions on clientele. Target low-income members/clients, mostly women, who belong to the same community.


Credit union members elect a volunteer board of directors from their membership. Members each have one vote in board elections, regardless of their amount of savings or shares in the credit union. Stockholders vote for a paid board of directors who may not be from the community or use the bank’s services. Votes are weighted based on the amount of stock owned. Institutions are run by an appointed board of directors or salaried staff.


Net income is applied to lower interest on loans, higher interest on savings or new product and service development. Stockholders receive a pro-rata share of profits. Net income builds reserves or is divided among investors.

Products & Services

Full range of financial services, primarily savings, credit, remittances and insurance. Full range of financial services, including investment opportunities. Focus on microcredit. Some MFIs offer savings products and remittance services.

Service Delivery

Main office, shared branching, ATMs, POS devices, PDAs, cell phones, Internet Main office, shared branching, ATMs, POS devices, PDAs, cell phones, Internet Regular visits to the community group

Thorsten Beck, one of the world’s major experts in SME finance, argues that the “size” of the SME sector in an economy does not really matter for economic development. What counts is its dynamism:

Policy efforts targeted at SMEs have often been justified with arguments that (1) SMEs are an engine of innovation and growth and (2) they help reduce poverty because they are labor-intensive and thus stimulate job growth, but (3) they are constrained by institutional and market failures. Cross-country, country-level, and microeconomic studies, however, do not support these claims. One study shows that, although faster-growing economies have a higher share of SME employment in their manufacturing sectors, it is not the size of this segment that drives growth.

… The empirical evidence thus points to the entry of new firms—which are mostly small at entry—and the possibilities for successful SMEs to grow as decisive. It is not the size of the SME segment but their dynamism that helps economic development. Recognizing dynamism rather than size of the SME sector as the source of economic development identifies another important distinction that analysts should make among the firm population: informal microenterprises, the establishment of which is often the result of a lack of alternative economic opportunities, and small formal enterprises, some of which might have high growth potential.

I do not entirely agree on the last point. Although it is true that many businesses operate for survival, my experience in Kenya is that the distinction between “informal microenterprise” and “small formal enterprise” is just not clear in the real economy.

I see this blurry boundary as a sign that dynamism can occur at an extremely small scale, namely the “micro-to-small” (MSE) segment. If we go to an even smaller scale, the “graduation” of some businesses from “self-employment” to “micro-enterprise” is also very interesting. In other words, whenever a business is growth-oriented, no matter how “micro” it is, should get more attention

More (from Thorsten Beck’s paper) here

I’ve been reading an interesting World Bank report on finance for small and medium enterprises (SMEs) in South Africa (the only link I found online is here). There is an interesting passage on how the Black Economic Empowerment (BEE) program has (not) changed the bank’s behavior towards SMEs:

In contrast to the economic drivers, political economy considerations appeared to play only a marginal role in determining bank strategies toward the small enterprise sector. For example, most banks said that in the absence of the Financial Sector Charter (FSC), under which the banking industry agreed to lend R5bn to Black- and women-owned SMEs between 2003 and 2008, their lending to SMEs would stay the same.

Their response does not suggest that banks were unaware of the developmental importance of small enterprises in South Africa but, rather, that the market-based incentives shaping bank strategies were comparatively stronger. Banks generally were well attuned to the opportunities generated by the structural changes taking place in the country’s economy and responded accordingly—but in a commercial way rather than out of any sort of societal or political obligation. This commercial orientation is borne out by the fact that banks’ utilization of the Khula guarantee scheme was very low. In most cases, less than 5 percent of their total small enterprise loan book was covered by a Khula indemnity. It could be surmised that if the banks felt the political pressure to lend more to small enterprises, they would have made more active use of the Khula indemnity scheme, even if they had felt it needed reform and did not operate efficiently. As mentioned above, the banking industry generally was happy to go along with government calls for them to adopt a more lenient stance toward small businesses that were struggling during the downturn. The banks did react more leniently, not because they wanted to please the government but because it made business sense for them to do so.