The involvement of Kenyan banks in the SME segment has grown remarkably over the last few years and most banks intend to continue expanding their SME portfolio in the near future. The segment has also received growing interest from policymakers and donors, recognising the pivotal role that SMEs play in economic development, investment and employment creation. Many SMEs, however, continue to lack appropriate financial services and have to rely on lending technologies that are expensive and often unsuited to their needs.

Banks often lack crucial information to inform their product development and expansion strategies due to a lack of systematic data collection and a common definition of the SME finance market. This also affects the work of the Government, regulatory authorities, and credit bureaus, as it makes it difficult to identify the key developments, challenges, and opportunities in the market.

FinAccess Business is a research project conducted jointly by FSD-Kenya, the World Bank, and the Central Bank of Kenya (CBK) to improve understanding of the SME market on both the supply and demand sides. Demand-side data continues to be limited due to the lack of a representative list of active business establishments in Kenya, which makes it difficult to track the size of the market as well as the evolving characteristics of the business population and their need for financial services. This is a major gap in the analysis of the Kenyan SME finance market, which will be analysed in a forthcoming, indepth report. The present report provides instead a comprehensive view of the supply-side of SME finance and its evolution between 2009 and 2013.

In addition to quantifying the size of the supply-side market and its growth rate, it shows the exposure of different types of banks in the segment, the portfolio of services most used by SMEs, and the quality of assets. The report also discusses the regulatory framework for SME finance, the drivers and obstacles of banks’ involvement with SMEs, and their specific business models.

The study shows that the total SME lending portfolio in December 2013 was estimated to be KSh332 billion, representing 23.4 per cent of the banks’ total loan portfolio. The SME portfolio grew fast in absolute values but also as a percentage of total lending: in 2009 and 2011 the total SME portfolio was estimated to be KSh133 and KSh225 billion, respectively, representing 19.5 and 20.9 per cent of total lending. These figures show that in the context of the general growth of the financial sector, SME financing is growing at a relatively fast rate, and is thereby representing a growing share of the commercial banks’ portfolios.

Based on the findings of the study, the banks’ business models in the SME finance market can be divided into three main types: the corporate-oriented business model (CBM), the supply-chain oriented business model (SBM) and the micro-enterprise oriented business model (MBM). Although banks may diversify between these categories, resulting in some overlap between the three categories, banks tend to differ in terms of lending technologies, customer acquisition strategies, and risk management mechanisms. Risk management strategies vary widely across banks and may be based on ‘hard information’, ‘soft information’, or a combination of the two. Hard information may consist of financial ratios calculated from certified audited statements and data assembled by credit bureaus. Soft information consists of non-financial information about the firm or entrepreneur, such as the sources of revenue or the borrower’s historical relationship with the bank.

While there have been positive developments over the last few years, there is still considerable room for product innovation in the SME finance space. A large number of SMEs continues to use overdrafts to finance their working capital needs, although banks have introduced several trade finance and asset finance products designed for the SME market. The development of other important SME finance products, such as factoring and financial leasing, has made some progress over the last few years but is still very limited. Developing such products is expected to lower transaction as well as borrowing costs for SMEs and reduce reliance on collateral by drawing on a more diverse set of information. The main constraint to financial leasing appears to be the ambiguous treatment of leasing in the Hire Purchase Act as well as the application of VAT. Potential constraints to the development of factoring, such as the recourse mechanism and the impact of stamp duties, need to be explored as well. In addition, it would be useful to study in more detail the potential and feasibility of an electronic reverse factoring platform similar to the one operated by Nafin in Mexico or factoring schemes as used in Paraguay or Peru. This could lower transaction and borrowing costs further and introduce more competition into that market segment while also increasing transparency.

The cost of credit for SMEs remains high due to a number of factors, including the limited use and sharing of positive information about borrowers, inefficiencies in the collateral registration process, the cost of the judicial process, and high overhead costs. The move towards positive information sharing by banks should go some way towards addressing these problems, but positive information sharing from all credit providers including payment service providers and utilities companies among others, would add great value to the information already present in the credit bureaus and should be prioritised going forward, provided that data quality can be ensured.

The collateral registry could be made more efficient in terms of the speed and the range of items accepted as collateral. Resolving the legal and regulatory challenges, especially regarding the contractual environment, will require significant reforms over a period of several years. Supporting the alternative dispute resolution system established by the Kenya Bankers Association (KBA) and the Association of Kenya Credit Providers (AKCP) would be a promising approach. Such a system would ensure that the majority of disputes are mediated and resolved prior to entering the judicial system, therefore avoiding lengthy judicial procedures.

While the Government sees its role in supporting SMEs primarily as market enabling and has largely avoided direct interventions in the SME finance space, several donors are active in supporting banks through credit lines or partial credit guarantees, often coupled with technical assistance. Given that the market for SME finance is relatively vibrant, the question is what gap donors are filling. Inevitably there is bound to be overlap in the donors’ involvement. Closer donor coordination could therefore be quite important in ensuring that resources are allocated effectively and are market enabling, and that they do not create an uneven playing field for market players. The government could play a stronger role in keeping track of the various donor initiatives to encourage transparency and a sharing of best practices across initiatives.