Financing Small and Medium Enterprises (SMEs) in Ghana: Challenges and Determinants in Accessing Bank Credit
1Joseph Kofi Nkuah, and1John Paul Tanyeh
1 School of Business and Law, University for Development Studies, WA, Ghana
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Abstract
Access to credit is crucial for the growth and survival of Small and Medium-sized Enterprises (SMEs). Thus policy makers should attempt to pursue financial sector policies to propel financial intermediaries to extend more credit to SMEs.
Access to credit still remains a challenge to SMEs especially those in developing economies and continues to dominate discussions both within business circles and at the corridor of various governments. In Ghana, for instance, a survey by the Association of Ghana Industries (AGI) for the second quarter of 2011 indicated that lack of adequate access to credit topped the factors hampering the growth of small businesses in Ghana.
The ability of SME’s to grow depends highly on their potentials to invest in restructuring, innovation etc. All of these investments need capital, and therefore access to finance. Against this background the consistently repeated complaint of SME’s about their problems regarding access to finance is a highly relevant constraint that endangers the economic growth of countries.
The general objective of this study is to examine the challenges and determinants of access to bank credit in Ghana by focusing on SMEs in the Wa Municipality.
The study employed the quantitative approach to research in which the probability sampling criteria specifically the stratified random sampling was employed to select eighty entrepreneurs from within the Wa Municipality.
The major finding for this study indicated that there exist significantly, positive relations between certain attributes of a firm and access to credits. There are also, some financial activities such as business registration, documentation/recording, business planning, asset ownership, and others that also impact heavily on SMEs access to bank credits.
Key Words: Financial Intermediaries, Access to Credit, Economic Growth, Determinants, Challenges
1.1 Background to the study
Access to credit is crucial for the growth and survival of Small and Medium-sized Enterprises (SMEs). However, access to credit still remains a challenge to SMEs especially those in developing economies and continues to dominate discussions both within business circles and at the corridor of various governments. In Ghana, for instance, a survey by the Association of Ghana Industries (AGI) for the second quarter of 2011 indicated that lack of adequate access to credit topped the factors hampering the growth of small businesses in Ghana (AGI, 2011).
Stringent requirements, coupled with bureaucratic lending procedures by formal financial institutions is the biggest obstacle to credit access by SMEs and also the reason they usually resort to informal financial institutions such as savings and loans companies, traditional money lenders, friends and relatives. Financial Repression Hypothesis and the Credit Rationing Theory captured this phenomenon as explained in (Graham 1996; and Udell 1992). They assert that policies (such as the imposition of ceilings on deposit and lending rates, directed credit policies, exchange rate controls) that lead to artificially low interest rates and high reserve requirements often result in financial market distortions. This distortion is basically in the form of fragmented financial markets where the financial needs of SMEs are crowding out from the financing activities of formal financial institutions. At the end, low risk borrowers (including SMEs) no longer have access to formal financial institutions but resort to the informal financial institutions for assistance; which most times are woefully inadequate (Graham, 1996 and Udell, 1992).
In an empirical work Fernando, Chakraborty and Mallick (2002) revealed that, “For small businesses, owner characteristics may be the most important determinant of the banks’ credit decisions. Unfortunately, most of these attributes are “soft” information, that is information that cannot be unambiguously documented by any dataset (Stein, 2000). For instance, the owner might be a skilled entrepreneur with specialized knowledge and experience in a field of enterprise. For the bank, the owner’s expertise may become the most important determinant in making a credit decision. The social embedded approach in Sociological theory predicts that bank/firm interactions overtime would lead to private networks of social relations between entrepreneurs and bank officials; again leading to higher credit limits (Uzzi, 1999).
Sharpe (1990) on the other hand, attributed the cause of financial market malfunctioning to information asymmetry which compels financial institutions to adopt non-price strategies such as credit rationing in allocating credit in imperfect markets. To them, interest rates are used as a screening device to distinguish good borrowers from the bad ones. Individuals who are willing to pay high interest rates are, on the average, worse defaulters; they are willing to borrow at high interest rates because they perceive their probability of repaying the loan to be low. Alternatively, low risk borrowers (including SMEs) who are faced with high interest rates, all other things being equal, will be expecting negative returns and thus are eliminated from the stream of potential borrowers. Therefore low risk borrowers (here again including SMEs) may not contact formal financial institutions for credit, thus minimizing their access to credit yet again.
The general objective of this study is to examine the determinants of access to bank credit in Ghana by focusing on SMEs in the Wa Municipality. Of particular interest is the need to find out the factors that distinguish successful loan applicants from unsuccessful ones.
THEORITICAL ISSUES
2.1.1 Small and Medium-sized Enterprises (SMEs)
SMEs are businesses that are privately owned and operated, with small number of personnel, and a relatively low volume of sales. Small businesses are normally privately owned corporations, partnerships, or sole proprietorships. There is no universally accepted definition of a small and medium-sized business. The legal definition of "small" is country specific, ranging from fewer than 15 employees under the Australian Fair Work Act 2009, to fewer than 500 employees in U.S, which qualifies a business for the small business Administration Programme. The European commission (2003) defines SMEs as enterprises which employ fewer than 250 persons and/or have an annual turnover not exceeding EUR 50 million, and/or an annual balance sheet total not exceeding EUR 43 million. Thus, the definition of SME varies and is dependent upon whose point of view (Taylor and Adair 1994).
In Ghana, the most commonly used definition of SMEs is the number of employees of the enterprise. In applying this definition, however, there is some controversy in respect of the arbitrariness and cut off points used by the various official records (Dalitso and Quartey, 2000). The Ghana Statistical Service (GSS) defines small businesses as enterprises that employ less than 10 persons while those that employ more than 10 people are classified as Medium and Large-Sized Enterprises. Alternately, the National Board for Small Scale Industries (NBSSI) in Ghana utilized both the ‘fixed asset and number of employees’ criteria to define SMEs. According to the NBSSI, enterprises with not more than 9 workers, has plant and machinery (excluding land, buildings and vehicles) and not exceeding 10 million Cedis (US$ 9506, using 1994 exchange rate) are considered as Small Scale Enterprises.
For the purposes of this study, the operational definition of SMEs by Osei et al. (1993) is adopted. Osei et al. (1993) used employment criteria in defining SMEs. In their definition, SMEs were classified into four main categories; micro enterprises are those that employ less than 6 people; (ii) very small enterprises constitute those employing 6-9 workers; small enterprises are business units that employ between 10 and 29 employees while medium sized enterprises are those that employ between 29 to 50 people. This study therefore defines SMEs as enterprises that employ not more than 50 people. The choice of this definition is justified on the grounds that it is a fair representation of the employment level of SMEs in Ghana and will ensure that adequate numbers of enterprises are included in the study.
Per the definitions given above, the following are some of the informal sector organizations in Ghana as iterated by Yankson (1992): They include Ghana Private Road Transport Union (GPRTU), Ghana National Chemical Sellers Association, Ghana National Tailors and Dressmakers Association, National Drinking Bar Operators Association, Chop Bar Keepers and Cooked Food Sellers Association, Hair Dressers Association of Ghana, Susu Collectors Association, Blacksmiths and metal workers union, amongst many.
Access to Finance
Access to credit (also referred to as financial inclusion) refers to the absence of both price and non-price barriers in the use of financial services. In the literature, there are many supporting and also skeptical arguments about SMEs access to credit. Lending to small businesses has traditionally been a time consuming and costly proposition for banks and other financial intermediaries. Small firms lack proper accounting procedures and owners frequently mix their business and personal finances, so their financial statements are often unreliable. For the purpose of this study, loan applicants whose loans were approved by commercial banks are considered as having access to credit and those whose loan application were rejected are said not to have access to credit.
Inefficiencies in Financial Markets
Small businesses traditionally may not contact formal financial institutions for credit because of stringent lending requirements. Rather, they will contact informal financial institutions such as Savings and Loan Companies, traditional money lenders, friends and relatives for credit. This reduces their access to credit (both price and non-price) for their expansion and growth.
The Credit Rationing Theory and Access to Finance
The credit rationing theory, propounded by Stiglitz and Weiss (1981), provides a framework for analyzing financial market inefficiencies. According to the theory, information asymmetry is the main cause of financial market malfunctioning in developing countries. This is the case as banks that advance loans to economic agents are not only interested in the interest they receive on loans, but also the risks of such loans. Again, the interest banks charges on loans have the tendency of affecting the risks of a pool of loans by either sorting potential borrowers (the adverse selection effect) or affecting the behavior of borrowers (the moral hazard problem). The end result of these two decisive problems are that banks have to resort to various screening means to identify potential borrowers who are more likely to pay back their loans; since the expected return on such loans depends crucially on the probability of repayment. One screening device identified by Stiglitz and Weiss (1981) is the interest rate that an individual is willing to pay. This is because, given the efficient financial markets hypothesis, individuals who are willing to pay high interest rates may on the average not pay back the loans collected and banks may not be interested in giving loans to such borrowers. On the other hand, low risk borrowers, faced with high interest rates, all other things being equal will be expecting negative returns and thus are eliminated from the stream of potential borrowers. Overall, in a world with perfect and costless information, banks could stipulate precisely all actions by borrowers but may not be able to control them. The terms of loan contract are thus designed (by banks) in a manner that induces borrowers to take actions in the interest of banks, and that also attracts low risk borrowers. For both reasons, the expected returns of banks increase less rapidly than the interest rate and beyond a certain point, actually declines. The moral hazard problem, on the other hand, is that a risk-neutral firm will prefer projects with low probability of bankruptcy and hence make lower expected returns.
Stiglitz and Weiss (1981), further argued that the problem of adverse selection and credit rationing can again occur if banks require collateral for loans. They argue that since low-risk borrowers (borrowers who face a lower rate of return if a project returns its highest outcome) expect a lower rate of return if the rate of inflation is high, they are on the average less wealthy than high-risk borrowers (after some time period) and even, are unable to provide more collateral for extra loans (as they may not have the necessary collateral). Thus, as the collateral requirements for loans by banks increase, the same adverse selection problem, as observed in the case for high interest rates, takes place. Altogether, low risk borrowers (which likely include SMEs) are eliminated from the stream of potential borrowers and banks may not be interested in granting loans to them.
The most important conclusion from Stiglitz and Weiss (1981) argument is that information asymmetry in the form of adverse selection and moral hazard is the source of market inefficiency in developing countries and this leads to low risk borrowers such as SMEs being sidelined or even excluded from the stream of potential borrowers.
2.3 Entrepreneurial Characteristics and Access to finance
The characteristics of owners of small and medium-scaled enterprises cannot be easily separated from their business. This is because most SMEs are mainly made of sole proprietorship and partnership form of business where ownership is inseparable from control. Even in the case of limited liability companies where there exists a separate legal entity, ownership can rarely be separated from control. A number of studies on entrepreneurial characteristics and SMEs access to credit focus on factors such as the managerial competence, level of education, experience, age and gender of SMEs owners.
Schmitz (1982) asserted that small scale producers in developing countries fail to expand primarily because they lack managerial ability, and that the issue of managerial competency is one of the criteria used by banks in taking their lending decisions.
Access to Finance and SME Development
Steel and Webster (1991) observed that despite the wide-ranging financial reforms instituted in various regions, SMEs face a variety of constraints due to the difficulty of absorbing large fixed costs, the absence of economies of scale and scope in key factors of production, and the higher unit costs of providing services to smaller firms. Below is a set of constraints identified within SME development.
Access to finance remained a dominant constraint to small scale enterprises. Credit constraints pertaining to working capital and raw materials are cited by respondents in a survey conducted by Parker and others (1995). Aryeetey et al (1994) reported that 38% of the SMEs surveyed in Ghana mention credit as a constraint; in the case of Malawi, it accounted for 17.5% of the total sample (Daniels and Ngwira, 1993). This stems from the fact that SMEs have limited access to capital markets, locally and internationally, in part because of the perception of higher risk, informational barriers, and the higher costs of intermediation for smaller firms. As a result, SMEs often cannot obtain long-term finance in the form of debt and equity.
To Antwi-Asare and Addison (2000) the Financial Institutions Structural Adjustment Programme (FINSAP) generally addressed the structural and institutional weaknesses of the financial sector in Ghana. They held the view that a strong and competitive financial sector could make significant contributions towards increasing access to finance by businesses. It is right to suggest that the financial sector liberalization was to provide access to funding for SME’s. Most studies consider the access problem as a creation of the financial institutions through their lending policies. For instance, Tagoe, et al (2005) indicated that the type of financial institutions and its credit policy will determine the access problem. Where required security does not fit the needs of target group, potential borrowers will not apply for credit even where it exists and when they do, they will be denied access.
According to Abor and Quartey (2010) financial intermediaries that uses the asset-based lending techniques looks at the underlying assets of the firm (which are taken as collateral) as the primary source of repayment. For working capital financing, banks use short-term assets, such as accounts receivable and inventory. For long-term financing, they use equipment. He noted that the pledging of collateral by itself does not distinguish asset-based lending from any of the other lending technologies. Collateralization with accounts receivable, inventory and/or equipment is often associated, for example, with financial statement lending, relationship lending, and credit scoring where collateral is used as a secondary source of repayment. Ideally, small businesses should have well-established systems for gathering information and forecasting, and also addressing several constraints to minimize the access to credit problem.