Financial Sector And Sme Development In Ghana Economics Essay
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The theoretical background of this paper is the Agency Theory . The assumption made is that information asymmetry exists at all stages of the banking services supply chain and that actors are rational utility maximizes. Financial institutions have traditionally focused on micro and large multi corporate businesses due to the high risks and high transactional costs involved when dealing with SMEs. A gap is created due to the neglect; this is what the IFC and others refer to as the SME Financial Gap . The concept SME financial gap generally refers to the
Ghana is one of the three strongest economic policy performers among low-income African countries with a stable political climate to do business. Ghana still relies heavily on international financial and technical assistance. Gold, cocoa and timber are the major sources of foreign exchange. The introduction of Ghana¿½s Economic Recovery Program (ERP) in 1983 to recover the initially very weak private sector participation did improve consistently but although still levels were modest during 1987-91.
Over the past years, Ghana has witnessed dynamic changes in its financial sector. There are 26 major banks currently operating in the country as at 2008. Banks serve a prominent role as corporate entities that provide investment capital in the economy to support employment opportunities, human resources development and contribute towards national and community development programmes. They primarily furnish loans to individuals and companies to finance various projects, which lead to economic, and private sector development.
1.2 Purpose of Study
The paper seeks to identify the cause of the problem which hinders SMEs from gaining access to financial products and services in Ghana; then describes the huge opportunities being lost due to lack of financing for SME development and what economic contributing factors it impacts on the country.
Data on SMEs in Ghana is not easily available but there have been numerous researches on the development and progress of financing SMEs in Ghana by international organisations and other research experts. Secondary data from such findings will be employed to analyse financing and its effects on SME development in Ghana.
2 Literature Review
Chapter 2 provides an overview of existing literature on SME financing including common definitions of the SME sector, their economic importance and various problems that result in the limited access to finance.
2.1 Importance of SMEs
SMEs contribute significantly to employment and GDP making it an important area of development in emerging markets. Most countries have the most jobs generated from SMEs.
The definition of SMEs defers from country to country, there is no single uniformly acceptable definition of an SME. According to the World Bank Group, the definition of SME includes three sub-categories:
? Micro-enterprise: up to 10 employees; total assets/total annual sales of up to US$100,000; turnover must be in excess of US$400,000, and tangible assets in excess of US$200,000;
? Small enterprise: between 10 and 50 employees; total assets/total annual sales between US$100,000 and US$3 million;
? Medium-sized enterprise: between 50 and 300 employees, total assets/total annual sales between US$3 million and US$15 million.
2.2 Constraints to SME Access to Financing
Constrained SME development and competitiveness is mostly due to access to finance rather than the cost of finance. In addition, because of location or sectoral specialization, many firms within the SME sector are growing beyond the size that informal sources of finance can support and institutional credit is the only feasible option for upward movement to them
The absence of proper financial accounting among many small and even medium-scale firms may be due to various reasons, ranging from the reluctance to reveal critical information to competitors to non-transparent practices to minimize the tax burden. Nevertheless, it precludes the establishment of long-term bank-client relationships, which are part of the reputation collateral. The availability of good information on enterprise finance and governance structure is a prerequisite for the preparation of a bankable business plan, which, can be used as a partial substitute for fixed-asset collaterals on the financial supply side. Shortcomings in information disclosure can therefore be viewed as evidence of management weaknesses and financial indiscipline by institutional analysts and loan appraisers.
A good business plan is of critical importance for new, young or small firms because of their typical lack of real-asset collateral, equity capital and credit track record.
According to Hallberg 2001, complex legal and regulatory environment has often combined with opaque discretion to raise significantly the transaction costs on SMEs because of their limited size and resources. He further says that slow progress in the development of sustainable financial schemes, the structural diversification of financial institutions and the emergence of a ¿½non-repayment culture¿½ among enterprises, especially if the resources concerned are regarded as part and parcel of poverty reduction efforts from the public sector
SMEs have to pay a higher rate of interest and comply to more restrictive requirements on institutional credit obtained by them, compared to those imposed on their large-scale counterparts. For example, the interest premium in 33 completed World Bank projects on SME financing (mentioned earlier) averaged 4.9 points for small enterprises and 4.4 points in the case of medium-scale firms. In absolute terms, the rates on SME loans are as high as 24-33 per cent, reflecting in part the larger inducement for financial institutions to participate in SME lending
Persistent constraints on SMEs financing, and the restrictive terms and conditions on approved loans, are virtually a universal and significant problem among developing countries. In China, for example, commercial banks can vary the interest rate on one-year term loans (which stood at 5.31 per cent in February 2002) up to plus or minus 10 per cent for SOEs. The percentage variation can be up to 30 per cent for SMEs and 50 per cent for rural cooperatives. However, many banks still see the returns as inadequate to compensate them for the risks and costs incurred in lending to private firms. Most financial institutions have not been able to operate profitably with SMEs as their sole or major debt clientele, despite the interest premium based on higher risk and transaction cost. Even in developed countries such as the United States, small-business loans are regarded as opaque assets, constituting thus the main component of credit risk
Collateral requirements by commercial banks in developing countries have been a contentious issue in SME financing. However, 92 per cent of all small-business debt to financial institutions in the United States are secured.
Many SMEs avoid using commercial banks for payroll management and other day-today working accounts (of incoming and outgoing transactions), thus precluding the formation and cementing of bank-client relationships which are an integral part of the so-called reputation collateral on the SME side. Thus, most commercial banks and DFIs do not have sufficient information on, among other things, the likely cash flows in business performance (and hence the capacity for loan repayments internal to the enterprises under consideration) plus the credit histories of the concerned SME entrepreneurs themselves, including their personal characters and business commitment. As a result, the paperwork and documentation required by banks can often take 24 workdays to complete, compared to the 14-day gestation time on credit applications from large firms and less than two weeks in micro lending. For example, only 10 per cent of start-up firms in Ghana can obtain bank loans but medium-sized enterprises and older firms (presumably with a good credit history and hence relationships with banks) are provided with start-up credit three times more often than their smaller counterparts.
2.3 Agency Theory
Agency theory assumes that social life is a series of contracts. The theoretical background of this paper is based on the principal agency theory. The assumption made is that information asymmetry exists at all stages of contracts between banks (agents) and SMEs (principal). Assuming that both are rational utility maximizes and are likely to have different goals. Charles Perrow states that ¿½agency theory assumes that social life is a series of contracts. Conventionally, one member, the 'buyer' of goods or services is designated the 'principal,' and the other, who provides the goods or service is the 'agent'¿½hence the term 'agency theory.' The principal-agent relationship is governed by a contract specifying what the agent should do and what the principal must do in return¿½.
The principal-agent model has two different key elements which exist in both the agents and principals namely goal conflict and information asymmetry; these elements bring meaning to the theory in its context. To illustrate this relationship further, an example given by Evans, 1980, refers to the market for professional services in economics, between a patient (principal) and a physician (agent); the assumption is that both are rational utility maximizes. The patient would want a good treatment at the lowest charge possible. On the other hand, the physician also wants to maximize his income, in that case he may be tempted to provide more medical services than necessary or set a higher price than the normal rates. Clearly, the patient is at a disadvantage in this exchange because there is no way of evaluating the physician¿½s services. Both parties have hidden information that the other does not know. This situation shows that information asymmetry exists with the physician being on the advantageous sided. Relating this example to banks and SMEs a similar situation can be seen. Banks are revenue generating institutions and offer financial services and products. SMEs on the other hand need these financial services to strive their business
Due to the existence of goal conflict between agents (banks) and principals (SMEs), agents have a distinct motive to move to other market segments thus neglecting the SME market segment (see figure 1). Although agents may face similar challenges in other market segments (large multinational and corporate large businesses); the incentive to shift to these markets is that marginal returns are high and on the microfinance level, there is lower risks in giving loans . According to the IFC, a study on emerging markets revealed that as corporate banking margins continue to shrink and increasing fiscal restraint lowers yields on government borrowings, banks have begun to assess the opportunities offered by SMEs. Providing banking services to this underserved SME market segment can increase their access to financial services and generate more employment opportunities and income.
2.4 The SME Finance Gap
The SME finance gap depicts the severely constrained access to financial services and products in many developing countries. The SME banking market consists of firms whose financial requirements are too large for microfinance, but are too small to be effectively served by corporate banking models.
Figure 1. The finance SME gap
In addition, information asymmetry creates an unbalanced information flow and this imperfect information influences economic decision-making on both sides. Three other problems can be drawn from the interrelationship between the agent and the principal, which addresses the outcome of information asymmetry (see diagram 1)
Diagram 1: Principal-Agent relationship
Source: self-prepared; adapted from various literature
Theoretically, in assuming perfect competition, the agent and the principal will act for their own interest but at the same time be conscious of the basis for which the other is operating. This will then result in a beneficial exchange for both parties and contracts can be made. Even in a case where there are relatively similar goals, conflict may exist over the exact means to use with an agent's desire to obtain slack resources that provide the incentive and the information asymmetry that provides the opportunity to shirk
3 SME Financing in Ghana
Chapter 3 give the definition of SME in Ghana, a brief description of the financial system in and assesses the problem of SME finance gap and the principal-agent problem; then it goes further to describe the SME banking services and products available in Ghana.
3.1 Definition of SME in Ghana
for instance in the case of Ghana SME has no common definition. The NBSSI refers to small enterprises as businesses that have about 6-29 employees or with a fixed asset (excluding land and building) not exceeding ¿½780 million ($54,948) ; and a medium enterprise is one that employs between 30-99 employees or with fixed assets not more than ¿½2.5 billion ($176,118). In addition, the Ghana Statistical Service has its own definition, which recognises small enterprises as those with below 10 employees and a medium enterprise as those businesses that employ above 10 employees. The Empretec Ghana foundation , regards all businesses managed by its owner as an SME.
3.2 The Ghanaian Financial System in Brief
Over the past years, Ghana has witnessed dynamic changes in its financial sector. The number of banks has increased from 9 in 1989 to 21 at May 2006 (www.bog.gov.gh). These banks serve a prominent role as corporate entities that provide investment capital in the economy to support employment opportunities, human resources development and contribute towards national and community development programmes (Aryeetey, E. & Gockel, F. 1990). They primarily furnish loans to individuals and companies to finance various projects, which lead to economic, and private sector development.
The Africa competitiveness report for 2009 indicates that access to finance is the most problematic factor for doing business in Ghana as shown in figure 2. From a list of 15 factors, respondents were asked to select the five most problematic for doing business in their country and to rank them between 1 (most problematic) and 5. The bars in the figure show the responses weighted according to their rankings.
Figure 2. The most problematic factors for doing business
Source: The Africa Competitiveness Report 2009: Ghana p. 198
A survey conducted by Bank of Ghana in 2005 on credit to SMEs found that: ¿½the share of SMEs in total exposure of banks has increased from 0.95 percent of GDP in 2001 to 1.54 percent of GDP by 2004; whereas total credit to the private sector increased from 11.8 percent to 13.05 percent of GDP over the same period. This is an indication that these enterprises are sharing in the general growth in lending. The swings in lending in favour of SMEs are more pronounced in commerce, less so for agriculture, services and manufacturing, and weakest for the transport and other sectors.¿½ This sign shows positive improved access to financial credit and the participation of SMEs in bank loans.
3.3 The Principle-Agent Problem
The principle-agent relation as already explained in chapter 2 addresses the problem with financial access to SMEs in Ghana. Financial institutions focus less on the SME segment in Ghana due to various factors, more importantly factors that conflict with their policies. SMEs are not able to provide collaterals demanded by banks to make contracts for loan. Banks incur higher cost in serving smaller transactions. Financial institutions make higher margins from serving large businesses. Collaterals and credit ratings are essential elements of the financial infrastructure necessary for SMEs to effectively acquire financing.
Most entrepreneurs running small businesses in Ghana are unlikely to disclose their business financial status due to probably fear of exposing themselves as they may be evading taxes. This has been a major problem when banks request to see the financial viability of a business, which is requirement in getting a loan or financial credit. The tax institution in Ghana has been very reluctant in enforcing tax policies in the past but until recent times that has changed; the government has taken steps to rectify this problem. Ineffective institutional policies play a part in decision of banks in giving loans. If the institutions are effective the banks can trust to release loans for small business to expand their businesses.
3.4 The SME Finance Gap
One of the main objectives of this paper is to assess the nature, extent and origin of the SME financial gap. Estimation shows that in 1999/2000 the Ghanaian informal economy contributed 38.4 percent of GNP as against 42 percent average of 23 African countries.
SMEs must be seen as a major player in job creation and generating income for low-income people. In effect, this contributes positively to economic growth, social stability, which helps build a vibrant private sector.
However, this segment of banking is gradually shrinking due to the entrants of new private banks in Ghana. As a result, competition for products services has set in. Figure 2 shows data of the financial system from 2004-2008. The major banks are made up of mostly foreign banks with Nigeriaian banks dominating the market segment.
The government has been able to identify the informal private sector and has introduced sponsored business support services such as the National Board for Small Scale Industries (NBSSI). Their objectives include:
¿½ To contribute to the creation of an enabling environment for the development of small-scale enterprises.
¿½ To contribute to the development of an entrepreneurial culture in Ghana.
¿½ To facilitate access to credit for small enterprises.
¿½ To provide non-financial support for sustainable small-scale enterprise development.
¿½ To facilitate the growth of enterprise sector associations.
3.5 SME Banking
There is good news for SMEs in Ghana, there has been a sudden twist from the traditional focus of banking institutions in serving larger businesses to SMEs; SME banking has emerged strongly in the Ghanaian-banking sector and more attention is being directed at that SME market segment. The Ghanaian Chronicle on July 10th, 2006, reports that ¿½¿½Commercial and Universal Banks in Ghana are shifting from one of their traditional source of income, investing in government treasury bills but have taken the finance of Small and Medium scale Enterprises ¿½¿½. This is the exact situation that the IFC describes in the previous chapter. The shift is as a result of banks trying to maximize their revenues in a keenly competed market. With the number of banks operating in Ghana it is rightfully noted that the banking market is getting saturated. The Chronicle further states that almost all the major banks in the country have established SME banking departments specially structured to meet the banking needs of SMEs. Competition has played a key role in pushing banks to enter this neglected area. Even with revenue maximization as their goal still the banks are careful with their selection process for loans and credits. Information asymmetry still remains a bigger obstacle between banks and SMEs in Ghana and can be attributed mainly to poor accounting practices and record keeping. But the positive aspect lies in the opportunity that at least some attention has been focused on SMEs which forms the basis of improving their credibility to be able to gain access to loans.
This new era of banking has come not as a matter of banks addressing the challenges SMEs face with access to finance but rather they have been forced to move into SME market segment due to competition in financial products and services from new banks. As the number of banks in the country keeps increasing so does the banking marginal market share dwindle: forcing banks to relook at what the SME market segment has to offer. Figure 3 shows the growth of the number of banks from 2004 to 2008.
Figure 3: Growth of the Banking and Non-Banking Financial System
BANKS 2004 2005 2006 2007 2008
Major Banks 20 21 24 24 26
Branches 360 392 450 595 640
Rural Banks 119 121 125 127 129
Agencies - - - - 486
Non- Banks - - 36 41 45
Source: Bank of Ghana Annual Report 2008
The onus is on the government to ensure that financial policies are directed at ensuring a vibrant economy to foster the development of SMEs. The emergence of SME banking should serve as an economic break through and possibly address the importance of credit information that SMEs lack which has considerably hampered banks in rating financing proposals. Furthermore, regular surveys of rates of SME financing for evaluation purposes is another way for banks to fully assess their involvement in SME development and identify the niche in satisfying this market segment as competition gets keen.
DFIs- development financial institutions
SOEs- State-owned enterprises
IFC- international finance corporation
NBSSI-National Board for Small Scale Industries
UNCTAD- United Nations Conference on Trade and Development
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