A new survey of 1,800 banks conducted by the Initiative for Smallholder Finance reveals that the total amount of debt financing supplied by local banks to smallholder farmers in the developing world is approximately $9 billion. This is a small figure compared with the total demand for smallholder financing, which is $300 billion excluding China and $450 billion globally.
The gap is huge. Only 16 percent of surveyed banks provide smallholder farmer financing. Where formal financing is available, 80 percent of the existing supply comes from public institutions—state and agricultural development banks that were originally established by local governments and later fully or partially privatized.
Barriers to Entry
Without question, demand-side barriers have played a role in preventing growth in the smallholder finance market. These are large and familiar challenges: lack of producer organizations and structured value chains for smallholders; low financial literacy and financial management skills among farmers; and low productivity, margins, and cash flow for servicing loans.
Assessing smallholder loans and designing appropriate financial products requires specific agricultural expertise that many banks lack or have difficulty acquiring. While banks report that the margins and average risk for smallholder lending is similar to the rest of their lending portfolios, the risk distribution is skewed toward occasional negative spikes that can undermine profits in down years.
The lack of reliable insurance or reinsurance products for smallholders further contributes to banks’ discomfort with lending. Another significant barrier to standard lending practices is the absence of land titles (for collateralization) and credit bureaus (for customer assessment). It’s little wonder, then, that most local banks are not taking the initiative to lend to smallholders.
Photo Credit: Erkan Kalenderli
Understanding Client Needs
The few banks that have managed to overcome these barriers have done so through a mix of product, distribution, and collateral customization—all of which begin with a fundamental understanding of what smallholder clients want and need.
To improve farmers’ ability to pay on time, for example, some banks have collaborated with local agriculture experts to design loans with flexible repayment terms that are linked to actual crop cycles. And to manage risk effectively, the most innovative banks have developed intimate knowledge of value chains and buyer relationships in order to gauge future cash flows and improve the credit assessments of smallholders.
Once the loans are made, banks have adopted mobile technology and roaming agents to distribute financing to rural customers where they live and work, collecting information while reducing transaction costs. Where they are well organized, farmer organizations can also serve as a central point for loan distribution and collection.
And when it comes to overcoming the lack of collateral, banks have relied on group lending, warehouse receipts, or equipment leasing to offer financing to farmers without traditional hard assets as collateral.
There is an opportunity for banks to learn from one another to improve their smallholder practices. Only a subset of banks use the practices listed above, and few, if any, use all of them. Donor support must move beyond the limited focus on guarantee funds and demand side technical assistance for farmers and focus on helping local banks better structure their interventions to meet the demands of smallholders.
Banks that recognize the unique characteristics of farmers as customers and can adapt their businesses using financial and skill-based support from donors will be best positioned for success in the smallholder market. It is no small feat, but if local banks can increase their capacity to serve smallholders, they will be supporting over two billion of the world’s poorest people who depend on agriculture for their livelihood.
The challenge sets up our sector for exploration of further questions, including: What kind of technical assistance to banks will most dramatically improve their smallholder services? How can public and commercial investors best allocate capital to the banks and financial institutions that have the capabilities to grow and innovate to serve smallholders? What forms of technical assistance to smallholders most effectively improve their skills, inputs, and access to markets? And finally, what steps can sector players take to measure the impact of bank and donor efforts to support smallholders?
Dan Zook is a Project Manager at Dalberg Global Development Advisors, a strategic advisory firm that works to raise living standards in developing countries and address global challenges.
This blog post is part of a series on understanding demand for smallholder financing, which brings together a range of perspectives on farming households' array of financial services needs. Read the entire series here.