Many SMEs in emerging markets often rely on informal sources of capital, such as borrowing from relatives, to meet finance needs. However, when a small or medium enterprise does access formal channels, it typically looks to a bank as its primary source of financial services. Banks have begun to turn their attention toward this untapped market and their service of SMEs is a major factor in increasing SME access to finance.
Although, numerous issues surface when it comes to SME lending, banks, by employing a range of measures, such as risk adjusted pricing, credit scoring models, and SME-tailored non-lending products are developing ways to mitigate risks, lower costs, and increase the overall benefit accrued from SME banking. Question 1: Why Banks should lend to SMEs? SME banking is an industry in transition. From a market that was considered too difficult to serve, it has now become a strategic target of banks worldwide.The “missing middle,” describing the gap in financial services provided to SMEs, is shrinking. SME banking appears to be growing the fastest in emerging markets (low- and middle-income countries) where this gap has been the widest. More and more emerging market banks are developing strategies and creating SME units. IFC’s committed portfolio of investments in SME financial institutions has grown dramatically over the last five years — by 271 percent — totaling $6. 1 billion as of end of FY09.
The SME market has been perceived in the past by banks as risky, costly, and difficult to serve.However, mounting evidence suggests that banks are finding effective solutions to challenges such as determining credit risk and lowering operating costs, and are profitably serving the SME sector. For these banks, unmet SME demand for financial services has become an indicator of opportunity to expand their market share and increase profit. Following are the important reasons why banks look forward lending to SMEs: * Competition in other markets is one reason cited for commercial banks moving “downstream” to serve SMEs.
Many of the banks are targeting this sector. A number of tools are being used to increase banks’ focus on the sector including undertaking and publishing market research, a shift toward more emphasis on relationship management and greater use of performance measures at relationship manager level aimed at growing the SME loan book. * Governments around the world now recognize the importance of the SME sector and have worked to support its access to finance, sometimes by addressing legal and regulatory barriers or building credit infrastructure.Considering the growth potential of Indian SMEs, the Government of India has asked public sector banks to achieve a minimum 20 per cent year-on-year growth in the funding of SMEs that will lead to double the flow of credit to the sector from `67,000 crores in 2004-2005 to `1, 35,000 crores by 2009-2010. * Banks are unlocking some of the potential in the market is that they are reporting higher returns on assets from their SME operations.
For example, leading banks reported ROAs of 3–6 percent for their SME operations compared with 1–3 percent bank-wide. There is a renewed focus by banks on the SME market.This involves packaging different banking services into a combined service offering, providing more economic and business related information to their SME customers and renewed emphasis on relationship management. Banks are ‘defending’ existing client relationships.
This includes more regular reviews of facilities and pricing reductions to match competitive offers. Key to the growth of SME banking may be that banks are starting to understand the particular needs and preferences of SMEs, and are developing tailored approaches to overcome the historical challenges of high credit risk and cost to serve.Also, contrary to common perception, the SME market is served by a wide spectrum of banks, not just smaller banks with relationship-based models.
Today, despite the significant challenges posed by the current (2009) global economic crisis, and the uncertainty ahead, many banks seem to be holding fast to their strong commitment to the SME sector, especially in emerging markets. While the full impact of the crisis is not yet apparent, banks maintaining their focus on SMEs often cite a strong belief in the importance of the SME sector to the national economy as a whole. Question 2: Discuss the empirical studies on products for lending to SME.SMEs are particularly in need of bank services because they lack the cash flow to make large investments, they cannot access capital markets as large firms can, and they often lack qualified staff to perform financial functions. Although there have been numerous schemes and programs in different economic environments, there are a number of distinctive recurring approaches to SME finance. * Collateral based lending offered by traditional banks and finance companies is usually made up of a combination of asset-based finance, contribution based finance, and factoring based finance, using reliable debtors or contracts.
Information based lending usually incorporates financial statement lending, credit scoring, and relationship lending. * Viability based financing is especially associated with venture capital. Collateral based lending: This can be further exposited through the following lending technologies: financial statement lending, small business credit scoring, asset-based lending, factoring, and trade credit. 1. Financial statement lending involves underwriting loans based on the strength of a borrower’s financial statements.There are two requirements for this technology. First, the borrower must have informative financial statements (e.
g. , audited statements prepared by reputable accounting firms according to widely accepted accounting standards such as GAAP). Second, the borrower must have a strong financial condition as reflected in the financial ratios calculated from these statements. The loan contract that arises out of the analysis of these financial statements may reflect a variety of different contracting elements including collateral, personal guarantees and/or covenants.However, under financial statement lending, the lender will view the expected future cash flow of the company as the primary source of repayment.
2. Small business credit scoring is a transactions lending technology based on hard information about the SME and its owner. The information on the owner is primarily personal consumer data (e. g. , personal income, debt, financial assets, and home ownership) obtained from consumer credit bureaus. This is combined with data on the SME collected by the financial institution and in some cases from commercial credit bureaus.
3.Under asset-based lending, the financial intermediary looks to 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. The pledging of collateral by itself, however, does not distinguish asset-based lending from any of the other lending technologies. Under asset-based lending, the extension of credit is primarily based on the value of specific borrower assets rather than the overall creditworthiness of the borrower.
. Factoring involves the purchase of accounts receivable by a “lender” known as a factor. Like asset-based lending underwriting focuses on the value of an underlying asset rather than the overall value/risk of the firm.
In some sense it is a cousin of asset-based lending. However, there are three important distinctions. First, factoring only involves the financing of accounts receivable unlike asset-based lending which, in addition to accounts receivable, involves financing inventory and equipment. So factoring is more focused.Second, under factoring the underlying asset, accounts receivable, is sold to the “lender” (i. e.
, the factor). Thus, title to the asset passes from the borrower to the lender. The third distinguishing feature of factoring is that factoring is essentially a bundle of three financial services: a financing component, a credit component and a collections component. 5. Trade Credit lending: Many of the procedures and processes associated with the other lending technologies appear to be utilized in underwriting trade credit.For example, credit scoring and similar quantitative techniques have long been a part of the underwriting process used by credit managers. For larger accounts, financial statements are analyzed as part of the underwriting process. However, soft information and mutual trust play a role in some trade credit underwriting similar to relationship lending.
Information/Relationship lending: The primary information used by lenders is based on “soft” information about the relationship between the lender and the borrower.The length of the relationship between a bank and its SME customers is also an important factor in reducing information asymmetry, as an established relationship helps to create economies of scale in information production. A relationship between a SME and a bank of considerable duration allows the bank to build up a good picture of the SME, the industry within which it operates and the caliber of the people running the business. The closer the relationship, the better are the signals received by the bank regarding managerial attributes and business prospects.Under relationship lending, the lender acquires proprietary information about the borrower and the business over time with respect to the provision of loans (Petersen and Rajan 1994, Berger and Udell 1995) and the provision of other products (Nakamura 1993, Cole 1998, Mester, Nakamura, and Renault 1998, Degryse and van Cayseele 2000). Relationship lenders collect information beyond that which is available on the firm’s financial statements and information that is readily available to the public.
This includes information on the entrepreneur’s local community/business environment and the entrepreneur and the SME’s interaction with that environment. Viability based lending: Thus, the last approach has been to broaden the viability based approach. Since the viability based approach is concerned with the business itself, the aim has been to provide better general business development assistance to reduce risk and increase returns. This often entails a detailed review and assistance with the business plan.
A common aim or feature of the viability based approach is the provision of appropriate finance that is tailored to the cash flows of the SME. Although the returns generated by this approach in less developed countries may not be attractive to venture capitalists, they can be significantly better than conventional collateral based lending – whilst at the same time being less risky than the typical venture capitalist business. Thus, a new, distinct asset class, offering a new avenue for diversification, is available to investors.With higher profitability than traditional SME finance and lower risk than traditional venture capital, this sector has been named the “growth finance sector”. Question 3: Present the empirical information on SME loans versus Corporate loans. Corporate Lending: Corporate loans are available to the existing businesses / industrial houses in Indian Rupees or in foreign currency. Corporate loans are obtained to generate funds or working capital which has specific business objective.
Corporate Loans are sanctioned to those applicants who establish their usiness existence for at least 5 years out of which last 2 years with profit coupled with strong credit rating and proven track of successful business transactions. The repayment status with other lenders or financiers, strong working capital management etc. is the other factor considered by the lending institutions while sanctioning the loans. With quite competitive rate of interest Corporate Loan is one of the well accepted way to raise the business finance for a period of 5- 5. 5 years. Following are the products offered under corporate financing: 1.
Working capital financing: Funding provided for financing of particular working capital needs that can take a number of different forms. Two main categories are short-term loans and overdrafts. * Short-Term Loans: Short-term loans can be provided with typical tenors of 3, 6, 9, or 12 months. Available types comprise, among others, receivables financing, VAT pre-financing, pre-export contract financing, financing of inventory or raw-material purchases. Receivables financing, both export and domestic, represent the most common type of working capital loan.Structures can be tailor-made to client requirements, with security ranging from support to full assignment. * Overdraft Facilities: Overdraft represents a fully flexible form of financing, where drawings need not be pre-advised and which allows the customer to draw funds against its current account up to a specified limit.
2. Trade Credit Products: Letters of Credit: Export and import Letters of Credit are widely used in the international trade as a means of payment. Citibank has the capability for opening, advising, negotiating and confirming of all types of letters of credit on a global basis.Letters of Guarantee: Many specific types of guarantees are offered to our clients such as individual and global customs guarantees, bid, performance and money retention bonds, payment guarantees, and advance payment guarantees, etc.
Structured Trade Financing: Citibank has a long-standing expertise in structuring and negotiating trade financing, utilizing available facilities by not only EGAP, but also other export credit agencies like EXIM, HERMES, COFACE, ECGD, SACE, etc. . Leasing: Leasing financing may be advantageous for many companies instead of purchase of certain tangible assets. Depending on structure, leasing may provide cash flow as well as amortization of fixed assets benefits to the customer. Leasing reduces the effective costs of financing, improves cash flow by providing the tax deferral during the lease term, gains access to medium term financing, allows off-balance sheet financing and improves return on assets.Financial Lease: Financial lease is a rental contract with the right to purchase the leased asset upon its termination. Operating Lease: Operating lease is a rental contract with the option to return the leased to the lessor upon its termination. Capital Lease: A lease transaction (for financing of movable assets) as per International Accounting Standards (IAS) is classified as a capital lease when it meets at least one of the following criteria.
When it meets none it can be accounted for as an operating lease: * The lease transfers ownership of the leased property to the lessee at the end of the lease term * The lease contains a bargain purchase option determined at the inception of the lease * The lease term covers at least 75% of the remaining economic life of the leased property * The present value of all minimum lease payments equals or exceeds 90% of the estimated fair value of the leased property at the inception of the leased . Additional corporate financing products: * Structured Products: acquisition finance, pre-IPO investment, IPO finance, promoter funding, etc. * Takeover of accounts from Banks / Financial Institutions / NBFCs * Financing promoters contribution (private equity participation)/subscription to convertible warrants * Purchase of Standard Assets and NPAs SME Lending: A bank’s product and service offering includes, but is not limited to, lending, deposit, and transactional products.The breadth of the offering is important because it impacts a bank’s SME market share by drawing in new clients or securing more business from existing clients. The design of products and services also impacts the profitability of serving the SME market. Lastly, effective product development can influence the size of the addressable market itself by enabling banks to reach clients that would otherwise be uninterested or unable to meet requirements for service.There are three main challenges in developing a product and service offering geared toward the SME client: The first challenge is to develop a set of products that are bundled in a compelling way that persuades the SME client, who may bank with multiple institutions, to bring all their business to one institution. Products and packages that increase “share of wallet” and meet a range of customer needs help banks establish a portfolio of high-value, loyal clients.
The second challenge is to ensure overall profitability across the offering, recognizing that SME-specific data is difficult to gather, particularly at the product level.This challenge is also complicated by the fact that the role of one product in securing the rest of an SME’s banking business may be uncertain. Furthermore, while revenues from a particular product may be easy to observe, the costs to provide it may be difficult to disaggregate.
A third challenge in developing a product and service offering is to strike the right balance between increasing one’s offering to appeal to a broader market and recognizing one’s limitations in the bank’s capabilities.This is particularly true with lending products, where new product designs have the potential to make financing available to SMEs, for example, that cannot provide collateral in traditional forms. New means to secure lending, or new ways to provide unsecured loans, can increase market size by tapping into the vast unmet demand of SMEs lacking collateral and by fostering the growth of SME clients. The key issues faced by the banks while lending SMEs are: Inconsistency in the Information: Accurate information about the borrower is a critical input for decision-making by banks in the lending process.Where information asymmetry (a situation where business owners or managers know more about the prospects for, and risks facing their business than their lenders) exists, lenders may respond by increasing lending margins to levels in excess of that which the inherent risks would require.
No single yardstick for assessment risks: This refers to a situation where the risk grading system at banks does not have the requisite capability to discriminate between good and bad risks. The consequence is tightening of credit terms, or an increase in prices, or both.From the borrower’s perspective, this leads to an outcome where the bank is over-pricing good risks and under-pricing bad risks. Pecking Order Theory: Pecking order theory flows from the above two issues, which makes SME lending highly difficult for banks.
Under this hypothesis, SMEs, which face a cost of lending that is above the true risk-adjusted cost, will have incentives to seek out alternative sources of funding. Evidence suggests that in such situations SMEs prefer to utilize retained earnings instead of raising loans from banks.Moral Hazard: Even when loans are made to SMEs, it may so happen that the owners of these SMEs take higher risks than they otherwise would without lending support from the banks. One reason for this situation is that the owner of the firm benefits fully from any additional returns but does not suffer disproportionately if the firm is liquidated.
This moral hazard problem may result in SME lending turning bad in a short period of time, a situation that banks would like to avoid. Switching Costs: SMEs may find it harder to switch banks, when countered with any issue.It is a known fact that the smaller the business, the more significant the switching costs are likely to be and, therefore, it is less likely that the benefits of switching outweigh the costs involved. This situation results in SME lending becoming a sellers-market, which may not be attractive to SME borrowers.
Approaches to improve Banks ; SMEs relationship in lending: Developing an effective product offering may begin with understanding the scope of products and services banks can offer SMEs.While lending is a central offering in SME banking, the ways in which banks can meet SME needs extend far beyond lending. Figure 1 illustrates some of the bank products and services used by SMEs. Although this data is specific to Latin America, it provides an overview of products that is largely relevant across regions worldwide.
It shows that SMEs use a current account more than anything else, that many rely on banks for payment and other transactional services, and that financing itself can come in many forms besides standard loans.