Dan Zook: A Roadmap for Growth: Positioning Local Banks for Success in Smallholder Finance

 

By Dan Zook, Dalberg Global Development Advisors

 

Current local bank lending to smallholder farmers meets only 3% of the global demand, but the sector presents enormous opportunities for growth, innovation, and investment. Expansion of this lending market would support the livelihoods of two billion of the world’s rural poor.

 

In the first briefing document in this series, the Initiative for Smallholder Finance found that donors can best improve smallholder access to finance by providing local banks with a combination of investment capital and technical assistance. New research from the second briefing document in the series identifies five key characteristics of local lending institutions that—if supported by public and commercial capital—have the potential to expand the smallholder financing market significantly. This briefing also assesses the investment appeal of three types of lending institutions: public policy lenders, niche poverty banks, and diversified bank branches.

 

Expanding smallholder finance requires investing in banks that can grow and innovate

 

The study analyzed numerous characteristics of lending institutions and found five common capabilities of banks that have demonstrated growth in smallholder financing.

 

1) Flexible Products: Banks need to design products with flexible payment schedules aligned with harvest cycles.

 

2) Innovative Distribution: Banks can distribute funds via producer groups, value chain relationships, and mobile technology to keep costs low when serving smallholders in rural areas.

 

3) Alternative Collateral: As smallholders often cannot offer hard collateral to lenders, banks using group lending, warehouse receipts, and equipment leasing can help farmers maneuver around traditional loan requirements.

 

4) Risk Mitigation: Knowledge of agriculture value chains and assessments of buyer relationships help bankers evaluate future cash flows and improve credit assessments of smallholders.

 

5) Partnerships: Banks are more effective when they work in conjunction with institutions such as government extension programs, NGOs, and producer organizations, that can provide external support to farmers.

 

Three types of local lending institutions serving smallholders

 

The banks we identified in our survey can be grouped into three archetypes with differing degrees of attractiveness to investors.

 

Public policy lenders are state and agricultural development banks that local governments originally established but later fully or partially privatized. They currently account for about 80% of smallholder financing, but are unlikely to drive future growth in supply. Although they offer products and services tailored to the agricultural sector, their general dependency on government funding stymies innovation, and their vulnerability to shifts in the political landscape can make these institutions a risky investment. Government ties can also place restrictive regulations on external investments. The most appealing investments among public policy lenders are those converting to more commercially driven models.

 

Niche poverty banks include microfinance (MFI) banks and banks focused on lending to the poor that have moved into customer segments adjacent to their urban lending base (typically including poor farmers). Though they currently represent only about 10% of smallholder lending, niche poverty banks are positioned for growth in this market—particularly those that already possess agricultural expertise. Most of these banks use methods such as alternative collateral and group lending to meet the unique needs of farmers, and some are creating products tailored to clients with harvest-based cash flows. A common challenge for these banks is that they face high distribution costs because of their limited footprint. Many niche poverty banks are too small to take on capital from a commercial investor, but they might be an appealing investment for impact investors or other investors who can wait for a longer return. These banks would require a combination of capital and technical expertise in agricultural products to reach their full growth potential.

 

Diversified branch banks are commercial banks that have come “down market” to offer products to smallholders. They conduct over 10% of the total lending to smallholder farmers, yet smallholder customers represent only a fraction of the banks’ total portfolios. Though diversified branch banks’ extensive branch footprints and risk management expertise position them well to serve smallholders, their off-the-shelf products rarely fit agriculture cash flows and often require hard assets as collateral, which limits their accessibility to smallholders. Some diversified branch banks have begun to use niche poverty lending practices, however, which suggests that there may be potential for mergers or partnerships between the two types.

 

Investors can grow the smallholder market

 

The current supply of loans to smallholder farmers leaves 97% of the demand untouched. There are ample opportunities for investors and innovators to grow the market for smallholder farmer finance. Among the three types of lenders, niche poverty lenders with agricultural expertise represent the most promising investment opportunity, though investors might find case-by-case opportunities to support public policy lenders that are transitioning to a more commercial approach. As stand-alone institutions, diversified branch banks are not as profitable investments in smallholder finance. However, they may offer stronger investment opportunities through partnerships or mergers. Finally, any investment across these institutions should be accompanied by technical assistance to strengthen the agricultural financing capabilities of the bank in order to effectively grow the smallholder agricultural sector.

 

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