Smallholder farms require capital to operate and grow.  The most common capital requirement for Asian farms is to cover the cost of inputs such as fertilizers and crop protection products. Although traditional, localized lending models currently dominate the market, digital platforms may enhance loan repayment rates and opportunities for formal lenders.

 

Today, farmers are presented with two main sources of finance to cover these costs: the retailer who sells them the product, or the trader who will buy their crop at the end of the season.  These “village level” funding options are usually expensive, often charging 10% interest per month.

 

These high interest rates reflect both a high level of inherent risk, but also the reality that village-level lenders have a number of advantages over formal lenders:

• It is cheaper for them to acquire lenders.  Banks struggle to sell smallholder loan products because the customers are expensive to reach.

• They have insights the banks don’t on each farmer’s credit worthiness.

• They don’t need to comply with the same Know Your Customer (KYC)[1] requirements as a bank; and

• They ask the farmer for less paperwork.

 

Due to the advantages to both farmers and village-level lenders, the smallholder farmer segment has remained hard to reach for formal lenders.  This leaves farmers with few options and drives high interest rates. Formalizing loans to farmers could offer compelling, desirable returns to lenders and lower interest rates for farmers.

 

A range of digital solutions are emerging which solve one or more of these challenges. Digital lending solutions can help address all four limitations, which are: lowering the cost of acquisition, helping to gather data on the farms, reducing the cost of the KYC process, and reducing paperwork required.

 

At the forefront of this digital transformation are the Peer to Peer (P2P) lending platforms. P2P platforms emerged as a means of allowing urban professionals (often in capital cities) to tap into the high interest rate market for loans to farmers in rural areas.  The motivations of urban lenders vary from seeking a higher return than other assets, to a philanthropic motivation to help farmers succeed.  Investments are typically small - a few hundred dollars per farmer - but lenders often provide loans to dozens of farmers.

 

Loans are typically made at the start of the cropping season and repaid a few months later.  Short cycle crops that generate strong returns are ideal; including chili, vegetables and corn.

 

P2P lending is growing quite quickly, with leading solutions in both the Philippines and Indonesia seeing double digit growth annually.

 

[1] Know your customer is the process of a business verifying the identity of its clients and assessing their suitability, along with the potential risks of illegal intentions towards the business relationship.

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However, the pool of potential lenders in a P2P model is limited compared to the size of the market for loans.  As a result, P2P lending platforms are changing over time, packaging up larger portfolios of loans from their platform to be securitized at scale by financial institutions. It is at this point that digital lending to smallholders is likely to expand much more rapidly.  However, for now, the P2P model allows the platforms to continue to improve their acquisition processes and credit scoring algorithms. Once developed, these two capabilities (low cost acquisition and sound scoring model) will unlock portfolio investments, and much faster growth.

 

The P2P lending model is quite simple. The platform matches a farmer with a lender and charges the farmer a higher rate than it pays to the lender. On a loan size of $1,000 (over three months) a platform can earn $60 based on a 5% interest rate markup. The platform normally carries the cost of non-performing loans, so accurate scoring is critical to ensuring this margin is not lost to bad loan decisions. Most platforms provide the loans as vouchers for inputs, rather than cash, which improves repayment rates.

 

While P2P lending is growing quickly, in order to reach scale and move from a peer lender to a portfolio securitization model, two key challenges need to be addressed:

• The regulatory environment for P2P is uncertain, and the unscrupulous practices of one or two lenders could put the whole industry in jeopardy.

• Pricing the loans, and correctly setting rates remains a challenge for platforms; it can take years to gather enough data to price accurately.

 

Of the six models covered in this series, P2P stands out for its strong underlying profitability because smallholder farmers are valuable lending customers.  While the other models in the series rely on data sales or subscriptions, which typically net only a few dollars per season per farmer, this model generates the highest lifetime value from each farmer client.

 

Digital lending is likely to grow quickly, opening a new market for financial institutions and reducing loan costs for farmers.  The diagram below highlights the key competitive pressures on P2P lenders.

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