Sanderson Abel
Lack of access to finance is often rated as the most serious constraint to informal businesses, preventing them from expanding their production and productivity. This relates to both informal small and medium enterprises, as well as smallholder farmers who often cite cash flow as their major problem. Lack of official status or collateral, low levels of literacy and inconvenient location of banks are among the main factors impeding businesses in the informal sector from accessing finance.Given their heterogeneity, informal sector includes a wide range of businesses, which differ in their dynamism, technical advancement and risk attitude.
Many are relatively stable in their technology, market and scale, while others are more technically advanced, filling crucial product or service niches.
This makes their financing of great interest.
What are the potential sources of funding for informal sector?
Informal sector players should understand that while banks have a comparative advantage in credit information processing and intermediation, they must continue to play an important role in funding the informal sector segment, a more diversified mix of funding options than those currently available would represent a more sustainable long-run in the country’s financing environment.
At the national level, a range of policy actions have to be put in place, which aim to create a more diversified set of viable funding options. It is then imperative that the informal sector critically evaluates these various financing mechanisms before settling on what they think will best suit their business models.
Before any informal sector player decides to approach a bank, it is important to develop a checklist of potential sources of financing.
It is always important that they continuously evaluate to check on the proportion of their working capital and new fixed investment that has been financed from some of the following sources during their subsistence, bearing in mind that financing innovation and small businesses requires a funding system that sustains entrepreneurship and drives job creation
The potential sources of financing would include:
Internal funds/retained earnings
Borrowing from local private commercial banks
Borrowing from state-owned banks
Loans from family/friends
Money lenders or other informal sources (other than family/friends)
Trade credit from suppliers
Trade credit from customers
Leasing arrangement
Non-bank financial institutions
Non-Governmental Organisations
Venture capital is also an important part of such a framework
Is diversification away
from banks good?
Diversification away from reliance on bank funding is desirable, it is important that policymakers mitigate the risk that firms are merely turning to other under-developed and costly forms of financing due to inability to access bank credit.
Policy must aim simultaneously to stimulate the flow of bank credit and to create well developed markets for a range of alternative financing sources to complement the role of banks in financing the informal segment.
There is need for increased coordination among various and often disconnected stakeholders interested in sustainable informal sector financing.
Institutions whose objectives are to stimulate and promote private capital for poverty alleviation and promotion of sustainable development could be used as platforms for a coordinated mechanism for various stakeholders including investors from public, private and philanthropic institutions, active in informal sector financing and seeking synergies with players from complementary sectors.
Against all odds, the existence of marked informational asymmetries between small businesses and lenders, or outside investors; the intrinsic higher risk associated with small-scale activities and the existence of sizeable transactions costs in handling informal sector financing are some of the inherent challenges faced by institutions that have an appetite to finance informal sector.
It is therefore important that policy frameworks governing the operations of the informal sector should be able to proffer potential solutions so that these factors cease to be the scaring for those with the appetite to finance this group of entrepreneurs.
It has been observed that the majority of the players once they find business opportunities, apply for loans from banks. And they ask banks to offer loans as soon as possible in order to organise materials and realise transactions in time.
However, commercial banks have to follow strict procedures and operational standards before issuing loans.
This is the standard procedure everywhere, which sometimes could not satisfy their needs for financing though necessary from a banks point of view.
It is in light of this urgency that the informal sector players should resort to other sources of financing so that they don’t jeopardise their business deals.
Although bank loans will certainly remain the dominant source of financing for economic activities, long-term investments are better financed by equity capital.
In particular, share capital is preferable to foster innovation and growth in businesses with uncertain results and pronounced information asymmetries.
While banks can count on guarantees and long-term relationships with firms to reduce the information asymmetries, equity capital enables investors to benefit in full from the returns to successful innovation.
Sanderson Abel is an economist. He writes in his capacity as senior economist for the Bankers Association of Zimbabwe. For your valuable feedback and comments related to this article, he can be contacted on abel@baz.org.zw or on numbers 04-744686 and 0772463008