NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

New research from the Initiative for Smallholder Finance reveals that local bank lending to smallholder farmers – which should be a main avenue for improving their access to finance – amounts to only $9 billion. That number represents less than 3 percent of the estimated total smallholder financing demand.

This gap in finance deserves attention, as global development practitioners consider the world’s 450 million smallholder farmers a linchpin in poverty-reduction strategies. As population growth and rising incomes create unprecedented demand for food, multinational companies increasingly rely on smallholders to secure their supply of agricultural commodities. As a result, smallholders present a compelling opportunity for buyers, lenders and other actors in the agricultural value chain. However, most smallholders lack access to finance, holding them back from producing larger crop yields of higher quality to propel both economic growth and poverty alleviation.

Understanding the current size and scope of local bank lending to smallholders – and, perhaps more importantly, the constraints that banks and farmers face – can help donors, businesses, and financial institutions target their efforts and improve access to finance for smallholders worldwide.

Smallholder farmers face many constraints that are well-known in the donor community, including a lack of producer organizations and structured value chains, low financial literacy and financial management skills, and low productivity, margins and cash flow for serving loans.

Less discussed are the constraints that banks face in lending to smallholders. First, the barrier to entry is very high. Although banks surveyed in the Initiative for Smallholder Finance study reported that they can offer smallholder products profitably, doing so requires large upfront investments in staff skills, technology and back-office processes that cannot be recouped without reaching scale.

Furthermore, banks need specific agricultural expertise to assess smallholder loans and design appropriate financial products, but many banks lack or have difficulty acquiring this expertise. Given the challenges to both entering the market and excelling in it, many institutions prefer to lend elsewhere.

Thus far, donors have primarily relied on guarantee funds and technical assistance to stimulate financing for smallholders. Guarantees, however, are unable to address the fundamental need for investment capital and expertise that banks require to build distribution and back-office infrastructure for serving smallholders. As one banker in Kenya attested, “Most donors don’t do training for loan officer staff, so guarantees may just encourage irresponsible lending in the agricultural sector.”

While technical assistance is crucial to improving the smallholder finance market, the vast majority of the $1.1 billion in donor technical assistance funding goes to programs addressing demand constraints for farmers, while only 3 percent goes to addressing supply constraints that banks must face.

In order for local bank financing of smallholder farmers to expand and become a driver of economic growth and poverty alleviation, donor support must move beyond guarantee funds and demand side technical assistance toward balanced support for investment capital and technical assistance for banks – not just farmers.

For more on this new research, read the Initiative for Smallholder Finance’s full briefing document, “Local Bank Financing for Smallholder Farmers: A $9 Billion Drop in the Ocean”.

Note: This briefing is the first in a series by the Initiative for Smallholder Finance, a multi-donor effort designed to demonstrate how specific products and services can expand the reach of financing for smallholder farmers. Initiative activities include targeted market research, product development and testing, and investment facilitation in the smallholder finance market.

Subsequent briefings will break down the local lending market and explore the technical assistance landscape for smallholder farmers. Over the next year, the Initiative for Smallholder Finance will release additional research and share investment opportunities for the smallholder finance industry. NextBillion Financial Innovation will run a series of posts around these briefings.

The Initiative is implementing findings and recommendations documented in the report “Catalyzing Smallholder Agricultural Finance,” which NextBillion covered in 2012.

Dan Zook is a project manager in Dalberg’s New York office. Sara Wallace is a communications coordinator at Dalberg Global Development Advisors supporting the Initiative for Smallholder Finance.