One of the best ways to support economic growth, especially in developing markets, is to expand access to financial services. When small businesses can obtain capital, they are better equipped to grow their businesses and hire more workers. Those workers often in turn open debit accounts, savings accounts and obtain mortgages that support their families and invest in their futures.
But what happens to the banking sector when it commits to these underserved populations? Last year, when the Overseas Private Investment Corporation (OPIC) traveled to the West Bank to explore the impact of a small-business-lending facility we support, we found that small businesses weren’t the only ones to benefit. Banks benefited, too.
A new focus for local lenders:
The West Bank, home to more than three million people and thousands of small family-owned businesses, holds many of the ingredients for a robust banking sector. The population is highly literate and highly entrepreneurial. But with total unemployment hovering around 25 percent, and much higher for certain groups such as women and youth, a large share of the population earns a living operating a small business. Unfortunately, these businesses have not always been served by the local banking sector. Instead, many have operated in the informal economy, unable to invest in their long-term growth.
Traditionally, regional banks in the region have focused mostly on a few highly capitalized corporate clients, even though about 90 percent of the businesses in the region are small businesses. To support more small-business lending, 10 years ago OPIC provided a loan guaranty to the Middle East Investment Initiative (MEII), underwriting a facility that was committed to encouraging small-business lending in the West Bank. The OPIC guaranty ensured that in cases of default, OPIC would take the loss, thereby lowering the downside risks to banks that lent to small businesses.
As the US Federal Government’s development-finance institution, OPIC invests in emerging markets around the world. Because we recognize that limited access to financial services is one of the main hurdles to economic growth and prosperity, we support many projects that encourage lending to entrepreneurs running small- and medium-size enterprises (SMEs).
In the West Bank, one of the biggest challenges facing small-business borrowers was that banks demanded collateral in the amount of 200 percent of the loan. An onerous requirement for most small businesses anywhere, this requirement was often impossible to meet in a region in which only about 30 percent of all land is registered. Land is the main source of collateral in most regions.
In response to this challenge, MEII pioneered a system of cash-flow-based lending rather than collateral-based lending to enable more small businesses to borrow. MEII took the additional step of training loan officers at the participating local banks on how to evaluate risk—a skill most local loan officers lacked.
The businesses OPIC has supported through its partnership with MEII have included a hotel that caters to tourists from around the world, a furniture-maker, souvenir shop, strawberry farm and lumber company. With the support of local-bank financing, they were all able to expand, hire more workers and buy more goods and services from other small, local businesses.
In many cases the change was incremental. A family-owned souvenir shop in Bethlehem, for example, was able to expand from a staff of three to seven. Collectively, however, this shift revitalized the local economy. To date, OPIC’s partnership with MEII has supported about 17,000 jobs. While these were the results we expected, other results were both surprising and transformational.
Approval rates rise, and default rates fall
As more small-business borrowers joined the formal economy, they began using other banking services such as checking and savings accounts, mortgages and other financial products. Everywhere we went, from the bustling city of Ramallah to smaller West Bank towns such as Bethlehem and Jericho, we encountered individuals who had become first-time banking customers. A worker in the souvenir shop in Bethlehem said that after he was hired, a better salary and exposure to a local bank via his new employer provided him sufficient resources and knowledge to obtain a mortgage for his first home. Another entrepreneur, a loan officer by day, obtained a small business loan to open a gym. Overall banking portfolios swelled as small-business borrowers accessed new financial products, often for the first time.
At the same time, this new focus on small-business lending transformed the way banks did business. When these regional banks expanded their focus to small businesses, they not only grew their base of potential clients, they developed a range of more sophisticated finance skills, from processing loans to assessing risk. As their skills increased, loan-processing times shortened. And, as these small-business borrowers began repaying their loans, the banks saw that several of the sectors that they had once deemed too risky—agriculture, tourism and women-owned businesses—were actually good credit risks.
Once banks refined their cash-flow analysis and SME loan-underwriting skills, they were able to better understand the debt capacity of individual businesses and structure loans according to cash flows. In some cases, this sophisticated analysis led them to realize that the loan was not as risky as they had initially thought, and they withdrew the guaranty request.
Between 2010 and 2014, approval rates for small-business borrowers increased from 65 to 75 percent.
Recognizing the size and strength of the small-business sector, banks committed to working more closely with small-business borrowers. Rather than immediately writing off struggling loans, they committed to work with borrowers who were at risk of defaulting. Default rates dropped largely because these better-skilled loan officers customized terms and tenors that fit individual business cycles, and better identified and responded to instances in which a potential default loomed. The net default rate for small-business borrowers supported by the MEII’s first two loan-guaranty facilities was less than two percent.
Successful lending prompts reforms
Soon regulators took notice. The local body in the West Bank responsible for regulating the financial sector saw how relieving collateral requirements brought great benefits to small businesses, tax revenues, employment and the economy. It issued a circular to local banks recognizing the MEII guaranty as an AAA-rated instrument. This allowed participating banks to offset loan-loss reserves at the same rate as if the loans were cash collateralized.
Local regulators also relaxed the collateral requirements for banks lending to SMEs and allowed banks borrowing under the MEII facilities to waive a requirement for a 1.5-percent general-reserve provision for every loan. In instances of potential default, the new regulations waived the 10-percent upfront repayment that had been required before a loan could be rescheduled. This change helped streamline loan workouts. Regulators also instituted a credit-rating system that would facilitate the risk analysis so critical to a loan officer’s underwriting process.
Ultimately, a project that had been designed to benefit a specific group of small businesses in the West Bank came full circle to return benefits to the local financial community. The growth of the banking sector was a direct result of them forging stronger partnerships with the businesses in their communities.
Small businesses are the key to creating jobs and opportunity, economic growth and stability. And as these local banks discovered, they have also catalyzed a new phase of maturity in their own industry.