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Informal money lenders pose more risks than opportunities

Kenya’s financial sector is arguably one of the most advanced in Africa. The East African economic heavyweight has made commendable strides in recent years with regard to financial inclusion, and more people can now access basic banking services.
“Kenya has real reason to cele-brate as regards financial inclusion. To date Kenya has the third highest rating in Africa in financial inclusion after Mauritius and South Africa,” says Central Bank of Kenya (CBK) Deputy Governor, Sheila M’Mbijiwe. “We have 75 per cent financial inclu-sion, which means that 90 per cent of Kenyans are within three kilome-ters of a financial access point,” adds Ms. M’Mbijiwe.
There is unanimous consen-sus that one of the key drivers of financial inclusion in Kenya is the increased penetration of mobile phones. Mobile phones have rev-olutionized the game, acting as a financial access point for millions of Kenyans who would have otherwise been sidelined by the less pervasive brick and mortar bank networks.
Platforms such as Safaricom’s M-Pesa have provided crucial link-ages between banks and customers, allowing for deposits, balance enqui-ry and withdrawal, among other banking services, between its close to 20 million subscribers and a host of Kenyan banks. M-Pesa has been uniquely instrumental in bringing banking services closer to people.
Bringing services closer to peo-ple is one thing; enabling people to actually benefit from these services is another. Although Kenya’s increased financial inclusion has allowed the vast majority of Kenyans to access basic services such as deposits and savings, especially through mobile phones, it has not been nearly as successful in increasing the number of small and medium sized enterpris-es (SMEs) that can successfully get loans from banks.
SMEs and low income individu-als still find it difficult to get loans from banks. They are still not truly included, despite the dominant nar-rative depicting Kenya as a hub of financial inclusion. This represents an inequality in financial inclusion, which seems to have favored urban-ites and bigger businesses at the exclusion of rural folk, low income earners, women and small business-es.
“We need to look at the equi-ty at which financial inclusion has occurred. In the urban areas, it is more successful than the rural areas and also women have far less access compared to men,” says CBK’s Ms. M’Mbijiwe.
The reason why it has hard for SMEs, low income earners, women, rural folk and other vulnerable groups to get loans from banks is not so much a matter of actual physical access, which has actually been eased by branch expansion and mobile platforms, but a matter of terms and conditions.
The terms that banks demand for loans are simply untenable for most SMEs and low income earners, lead-ing to their classification as “risky borrowers” and consequently attract-ing usurious interest rates or outright rejection of loan applications.
Demands for security such as land from SMEs and low income earners, for instance, are out of touch with the facts on the ground. Only around 6 percent of Kenyans have title deeds. Moreover, some low income earners and SMEs have assets such as land which is customarily held, locking them out due to the difficulties of legally proving ownership of custom-arily held land.
Filling a gap
The exclusion of SMEs, low income earners, women, youth and basically the entire informal sector from the banking system means that there is a lot of unmet demand for credit in Kenya. To get an idea of just how big this unmet demand is, it is instructive to appreciate the fact that the informal sector accounts for close to 90 per cent of the Kenyan economy.
Because the demand for credit in the informal sector is not being met by banks, someone else is filling the gap. There is no such thing as a vacuum in business, much less when the demand for a service is as colossal as SMEs’ demand for credit. Informal money lenders are moving in to cash on desperate borrowers, particularly those who don’t measure up to banks’ terms and conditions.
Informal lenders are in fact using the same technological channels like banks in order to reach borrowers more efficiently. They are using the Internet and mobile phone apps that can run on any android phone.
Some of the unconventional lenders that have resorted to mobile applications include: including Mkopo Rahisi, Saida, Branch, Get Cash, Cash Now, and Pesa Direct, which can all run on any android smartphone. On some of these plat-forms, you can get a sh50,000 loan through your phone—a sizeable amount for an SME or low income earner looking to restock their shop, pay school fees or make some basic purchases.
“Branch is a bank in your pock-et, there for you at all times. Our first service is credit. We use tech-nology to dramatically reduce the cost of delivering financial services in emerging markets. Join our team and help us disrupt financial ser-vices around the globe,” says online loans provider Branch on its web-site, showing just how “digital” infor-mal lenders have become.
The numerous unconventional lenders using technology to reach a wider range of borrowers are capitalizing on the drawbacks of the formal banking system. The loan approval process in banks is long, sometimes longer for SMEs and low income earners who have to be subjected to lengthier and more intense scrutiny before approval or, as is often the case, rejection.
The online informal lenders, however, offer instant credit. They advertise that they can process your loan request within minutes of appli-cation. This has reeled in many SMEs and low income borrowers, who do not want to spend time applying for a loan in a bank only to end up unsuccessful.
The phenomena of informal lenders resorting to technological channels to reach borrowers is, in the final instance, a representation of just how huge demand is for cred-it in the informal sector. In the infor-mal settlements of Nairobi, which make up a staggering 60 per cent of the city’s population, there are countless pawnbrokers and money lenders who capitalize on demand for credit from vegetable sellers, electronic dealers and other small businesses.
Much as informal money lenders fill a gap in the market and help small businesses survive another day in business, they also present a lot of risks to the economy, especially because there is no proper regula-tion, much less information about how they do their business.
As just mentioned informal lend-ers provide very little information to the general public. Their dealings are structured opaquely. This means that there are instances where even the borrower is not aware of how much exactly they are paying in interest for the money they borrowed.
Most lenders will only give you the amount to be paid back monthly, without actually quoting a rate of interest. However, when the total amount of monthly payouts are cal-culated in light of the amount bor-rowed, the interest rates are revealed to be notably higher than what for-mal lenders offer.
“They (informal lenders) do not give you a rate or if they do they give you a monthly or weekly fee but when calculated annually, you are ending up paying so much,” says Wilfred Onono, Managing Consultant at the Interest Rate Advisory Centre (IRAC), a finan-cial consultancy. Onono adds that some informal lenders are charging interest of up to 33 per cent, almost double what banks charge and just shy of triple the CBK’s 11.5 per cent benchmark lending rate.
These high interest rates impede the growth of SMEs and small income earners. This is because even if these SMEs do make profits, some-thing that is never certain in busi-ness, the loan repayment is so high that the net profits are never enough to finance a serious expansion plan. Rather than lift small businesses out of survival mode, loan sharks push small businesses to the brink of total annihilation.
Indeed, an interest rate as high as 33 per cent is simply impractical by any measure. A rate of 33 per cent basically means that for every Sh100 of debt, you need to make at least Sh133 to earn profit from the debt—and this without factoring other operations costs and the loss of value of money over time (infla-tion). A rate of 33 per cent leaves a business with only two options; enter into a very lucrative sector (that gives at least 40 per cent return in order to cover loan, inflation and other expenses and still make profit) or go out of business.
“You need to be doing a very lucrative business to pay up so much and in business you have to default sometimes,” observes IRAC’s Onono. But what lucrative business in the world gives a consistent return of at least 40 per cent? Certainly none that is legal or ethical. This means that most SMEs and small business-es who borrow from informal lenders end up closing shop or, worse, resort-ing to unethical and often illegal practices.
Ethics in business is currently a hot button topic in Kenya and this is a time when stakeholders should be rigorously working to reduce occa-sions that promote unethical busi-ness practices. A businessman who has to consistently make a return of at least 40 per cent in order to stay afloat will very likely overprice, fail to pay suppliers, evade taxes or resort to other unethical practices. To solve this, some sort of regulation needs to creep into the informal lending space in order tame interest rates.
Loan sharks are also not the most ethical lenders you will find. Very often, intimidation and threats, rather than law courts and arbitra-tion, are their weapons of choice for defaulters. They basically Special Feature
propagate a climate of terror for defaulters. IRAC’s Onono notes that most of the shylocks can charge defaulters rates as high as 60 per-cent—quite literally a pound of flesh, as the saying goes.
Of course, most borrowers who turn to informal lenders never read and understand the fine print due to their own desperation and, quite commonly, contracts that are inten-tionally ambiguous. Onono, howev-er, argues that consumers have the power to fight back against loan sharks who structure contracts ques-tionably by relying on Consumer Protection Act and the Land Act.
“According to the consumer protection law, any ambiguity in a lending contract will be interpreted to the benefit of the consumer. So if your lender did not disclose the interest, you can pay at the current market rate,” he says. Still, the extent to which such consumer protection laws can be applied and enforced in the informal money lending market is highly debatable. Some of the deals are struck in quasi-black mar-ket settings where law enforcement cannot be appropriately applied. This creates a vacuum that is nearly always filled by mafia-style organiza-tions whose style of enforcement and justice not only oppresses the weak, but is also flagrantly disregards eth-ical or human right considerations.
There is therefore a need to really rethink the current banking model and find ways of bringing real inclusion for SMEs and informal businesses, especially in the area of access to reasonably priced loans. For now, the only alternative to infor-mal money lenders are SACCOs, which have always given cheap loans to members.
The banking sector’s under-standing of innovation also needs to expand. Innovation is not just about sophisticated gadgets such as mobile phones, but primarily about real practical solutions that are responsive to the real needs and situations of people.
Banks and microfinance insti-tutions therefore need to find ways of overcoming some of the obstacles that SMEs and low income borrow-ers face when seeking loans. This can be done, for instance, by expanding the criteria of assets accepted as col-lateral to include assets such as live-stock and certain household goods of great value or necessity.
Despite the prevailing narra-tive of high levels of innovation and entrepreneurship in Kenya, the World Bank, in its recently released Country Economic Memorandum, reveals that innovation levels in Kenya are still low in comparison to global standards. introduced products that were actu-ally new to the domestic market, the World Bank study shows. Also, only one out of four firms carried out any kind of in-house research and development (R&D), a key factor for achieving breakthrough innova-tions anywhere. The share of firms spending on R&D in Kenya is 40 per cent lower than in Ghana or Egypt, and less than 50 per cent of that in South Africa.
This means that there is often no real understanding that is grounded in solid, scientific research about the needs and profiles of customers, possibly explaining why the informal sector, despite its huge size, has been largely neglected by formal banks and consequently left to the mercy of shylocks.