Credit Risk Assessment of SMEs Essay

The equity market for small and medium enterprises is also not well developed in our country, and secondly to finance these types of companies through equity market would cost a lot to them, which would stop the development of this, one of the most important sectors of the economy. This problem doesn’t only exist in Pakistan, but in most of the developed countries like Europe, China and many more are still encountering with the same type of problems regarding the small and medium enterprises.

The Bagel’s new accords are also has much more focus on the increasing problem of Credit Risk in the financial institutions, because this always remain one of the most important reason for most of the economy break down factor since Great Depression of 1929. 1. 1. 2 Seem in Pakistan The Government of Pakistan and State Bank of Pakistan keeps encouraging the financial institutions to finance the Small and Medium Enterprises, as Hess type of industries play very important role in the economy of the country.

It is even much more important sector than the heavy industries, because the heehaw; industries need heavy investment or initial capital to settle that’s why they are very low in number. According to the Governor of State Bank of Pakistan the small and medium enterprises sector contributes almost 30% to the total GAP growth and it employees up to 78% of the non- agriculture labor force, and makes 25% of its earning through exports . Now, this major sector of the economy needs to be financed in order to grow and get settled.

Financial institutions are to play a vital role in it, but the increasing trend of defaults and infection ratio, which was 31. 4 percent in 2011 and 34. 6 percent in 201 2, is directing the banking sector towards curbing their lending practices. This therefore, shows that the small and medium enterprises are not properly scrutinized before giving loans, and defaults are increasing due to this reason. Consequently, the lending to this sector is now shrinking, which affects the reliable small and medium enterprises as well. 1. 1. Credit Rating Models Credit rating has become one Of the most focused areas Of the financial industry due to recession and down turn of many economies in 2009. Various model of credit rating has been developed earlier, but most of them doesn’t fit when small and medium enterprises come into the account; though now many of the new models have been suggested and developed, but still there is a lot of conflicts in those ideas. And, most of the models only fits in some special settings of any specific country, but yet there is no standard model for the credit rating assessment of small and medium enterprises.

KM model is one the example of such type of models, it’s stands on the Morton Option Pricing Theory, and it works on the framework that the company would go default, when the liabilities would be higher than assets. This model was a good fit for some companies only, but when it was applied to the whole Chinese small and medium enterprises it didn’t work. In this way there are a lot of different types of models and different standards of models have been created to control this issue, especially in the financial institutions, as that money, which is invested in loans, are mostly the people’s deposits.

This study would add some more angles to these type of models in specific location of Karachi. 1. Problem Statement Small and medium enterprises is one of the most profitable sector, not only for the economy but for the banks as well, because this sector needs more loans to develop and give profits to banks and other financial institutions as well. But, as discussed above that the defaults and infection ratio of small and medium enterprises has an increasing trend in the banks’ portfolio, therefore this thing is making the small and medium enterprises a risky investment for the financial institutions specially banks.

Banks also can’t completely Stop giving loans to small and medium enterprises as these are more profitable, UT the lending activities are curbing due to increasing risk factor in this sector. In short the problem is that: “Small and medium enterprises are the backbone of the economy, but treated as informal and less transparent sector in Pakistan, and it’s difficult to understand the loan criteria for them from lending practices of Financial Institutions. The defaults and infection ratio of Seem has also an increasing trend due to which financial institution are curbing their lending to Seem. 1. 3 Objective As discussed above that giving loans to small and medium enterprises are ere profitable for the banks, as well as most riskier, therefore the objectives of this research is to find out the loan policies, ways of screening any small and medium enterprises, and scales on which the loan decision is taken, and which type of small and medium enterprises don’t pay back the loans and what are the draw backs in the screening process. In short there are two major objectives for this research, which are: To find out which type (category) of Seem usually get loans.

To find out which type of Seem are more likely to default. 1. 4 Significance of Study This study would add some new angles in credit risk models for the assessment of small and medium enterprises, which would be applicable in the setting of Pakistanis banks and help banks to identify the infected enterprises of small and medium sizes, which are very much profitable as well as riskier for the bank. Though this research is conducted in the setting of Pakistan specifically Karachi, but this problem persist all over the world; even in Europe.

This study would add some more angles to the current existing researches and credit rating assessments’ methods and models in the setting of Pakistan, specifically Karachi. This study would enhance the methods of ending out the infected small and medium enterprises more efficiently. 1. 5 Justification of Study This study can be justified from the facts from Pakistan as well as from all over the world, as the this problem persists in developed countries as well.

Basel second accords has also focused on this part of the financial institutions. In Pakistan this study is important, because of the very much high relationship of economy and small and medium enterprises. On, the other hand, the default rates and increasing trend of default rates are also increasing which is restricting the development of this sector and affecting he economy of Pakistan. The increasing trend of infection ratio, which is discussed above, also shows why this study is important.

According to the Governor of State Bank of Pakistan the small and medium enterprises sector contributes almost 30% to the total GAP growth and it employees up to 78% of the non-agriculture labor force, and makes 25% of its earning through exports, but such profitable sector’s financing is curbing due to some bad fishes or unexpected Storms, which can been seen from this data: defaults and infection ratio of small and medium enterprises remained 31. 4 percent in 01 1, while it was 34. 6 percent in 2012 1. Scope of Study The information in this research would be taken from the Pakistanis big five banks, which are the five pillars of Pakistan banking industry; which are Habit Bank Limited, United Bank Limited, Muslim Commercial Bank, Allied Bank emitted and National Bank Limited (HUMAN). The data of small and medium enterprises would be Karachi based, and the industry on which this research would base will probably be textile industry of small and medium sizes. The source of information would be the interview;v’; from the managers of loan department of these banks.

Information would also be gathered from the document analysis of the policies regarding lending small and medium enterprises, the ways of screening out these types of firms and criteria for loan decisions, of these big five banks. The information would also be extracted from the empirical data of these banks (if possible), which will show exactly which type of small and medium enterprises were given loan, which type of small and medium enterprises pay back late and how much late payment problems are faced by these banks.

On the other hand these Seem would be analyzed in terms of various different factors from the empirical ATA, which would show why some small and medium enterprises become unable to payback, and weather those factors are included in the screening of Seem or not. In short the sources of gathering information for the research would be: Most important source would be the Interviews from the field related person of big five banks . Document analysis, of the policies and criteria on which the small and medium enterprises are given, of big five banks.

The data of small and medium enterprises would be Karachi based. The industry on which the research would base would be textile industry of mall and medium enterprises (industry may change, depends on the availability of the data). 1. 7 Limitations The focus of this research would be on any of the only one industry of small and medium enterprises sector, which would probably be the textile industry. The confirmation of the industry depends on the availability of the data. The data wouldn’t represent any other city of Pakistan except Karachi.

The data would not be taken from the any foreign bank or any other banks except the United Bank Limited, National Bank Limited, Allied Bank Limited, Muslim Commercial Bank Limited and Habit Bank Limited. The number of interviews would be limited from ID to 15 due to lesser number of target population, and limited resources to reach to them. The time limitation is also there, as the time would be very scarce in order to interview the bank personnel along with the studies and bad condition of law and order would also become a hurdle in order to reach the respondents.

In short, the major limitations of this study would be: This research would not include any small medium enterprises in its data, which are located outside of the Karachi. The data would only be collected regarding the textile industry Of small and medium enterprises sectors. The data would only be collected from the big five banks. The number of respondents for interview would not be more than 10 to 15 due to limited target population (Banks’ personnel related to loan department). The time and law and order situation would be a great hurdle in reaching to the respondents. . 8 Basic Assumptions The basic assumptions of this study are: The textile sector of small and medium enterprises usually defaults more as compare to other sectors. Financial Institutions are the major source of financing the small and medium enterprises. The equity financing for small ND medium enterprises is negligible in Pakistan, and secondly it’s very costly for small companies to make economies of scale. The unregistered Seem are more likely to default. The Seem, which have lesser firm value ratio would have greater default risk.

The older the industry and competition, the more would be risk to default. The worst the economy the more would be the risk to default. The worst the performance of the company, the more would be the risk to default. The more the defaults the lesser the loans the Acme’s would get. 1. 9 Key Terms Some of the most important key terms for this report are: 1. . 1 Small and Medium Enterprises The small and medium enterprises has many definitions; and almost every country has its own definition of small and medium enterprises; even in Pakistan there remained many conflicts in defining small and medium enterprises.

According to act of 2005 of the Small and Medium Enterprises Development Authority of Pakistan, small enterprise is the one, which employs 10 to 35 employees and total assets (excluding Plant and Equipment) should be equal from 2 million to 20 million Pakistani Rupees; while the medium enterprise is the one, which employs 36 to 99 employees and the total range of assets (excluding Plant and Equipment) should be from 20 million to 40 million Pakistani Rupees.

According to the proposal of 2007 of Small and Medium Enterprises Development Authority of Pakistan the Small and Medium Enterprises are one having up to 250 employees and paid up capital up to 25 million or annual sales of 250 million. 1. 9. 2 Credit Risk It’s a type of risk associated specially with the financial institutions, in which a borrower would fail or default to pay either the amount of principal or cost of loan and breach the contract with the lender (financial institutions). 1 . 9. 3

Financial Institutions Financial institution is the organization, which provide financing to its members or any of the needy person and earn interest payment from those loans or financing amount. In Pakistan banks has the majority share for this sector. 1. 9. 4 Default Default is the ability or probability of the borrower to fail in order to pay back either the principle amount or interest payment to the lender or financial institution. 1. 9. 5 Infection Ratio Infection ratio shows the percentage of the total defaults or non performing loans from the total amount of loans made or given to the borrowers. . 9. 6 Credit Rating Credit Rating is type off scale, on which worthiness of giving or lending credit to every borrower, whether any entity or individual, is evaluated. The credit rating scale’s standards are set by most of the credit rating agencies, which evaluate each borrower (Individual, Organization, Government or Corporation) with the criteria set by those agencies. Mostly, credit history of any borrower becomes the base of credit rating any borrower receives; if it has no any credit history than other factors such as source of income, amount of income, reliability of income in future etc. Re kept into the inconsideration. 2 LITERATURE REVIEW 1. 10 Introduction Seem (Small and Medium Enterprises) are highly bank dependable firms across the globes that have less public disclosure and more information asymmetry (Kind & Arrogance, 201 1 These are the sectors that remain ignorant from availing credit from financial institution, especially during distress (Kind & Arrogance, 2011). Banks, the financial intermediaries, are reluctant to extend loans to Small and Medium Enterprises because of their low disclosure to public and low management of their financial statements. 1. 10. 1 Interest Rate a Tool to Curb Credit

Besides, the interest rate (Cost of Borrowing) for Small and Medium Enterprises compared to large firms show discrimination from the lending institutions (Kind & Arrogance, 2011 Banks possess superior Finance Risk Management capabilities, to them credit risk, that is, risk on the borrowers side for non-payment of debt is central to the intermediation (Kind & Arrogance, 201 1). Thus, this credit risk is directly the one that influences the bank’s profitability, increasing in value reduction of receivables and perhaps failing in upgrading the economic system (Kind & Arrogance, 2011).

Therefore, Banks undergo complex, credit rating to screen out defaults from non-defaults. The credit rating by Banks is biased for Small and Medium Enterprises in terms of several variables that affect the credit worthiness of the applicant. These may include; Firm size, Working Capital, Financial statements, Trade credit terms, previous lending history, Credit policy and Credit rating (Y. Paul & Boded, 2011). Banks evaluate applicants credit worthiness on the basis of two criterion; repayment or ability-to-pay model and asset based lending or collateral based lending (Matins Gamma & Amoral

Gerald, 2012) and (Kind & Arrogance, 2011). 1. 10. 2 Pegging Interest Rate to Rockiness of Investment Project In order to avoid, or mitigate credit risk associated with Small and Medium Enterprises banks employ several risk mitigating techniques in order to prevent themselves from taking excessive risk, e. G. Credit pricing (Kind & Arrogance, 201 1). Banks peg the interest rate directly to rockiness of the investment project (Kind & Arrogance, 201 1), reflecting a positive relation in a sense, that as the rockiness of the project increases the cost of borrowing associated increases too.

There are four strategies to lower the risk associated with an investment project; reducing risk, coping with risk, risk transfer and risk retain (Kind & Arrogance, 2011 1. AD. 3 credit Rationing; Good or Bad Credit rationing is barrier for Small and Medium Enterprises to develop, argues (Kind & Arrogance, 2011). Credit rationing is process of either aborting or reducing the supply of credit in order to avoid risk. Moreover, in financial distress, where almost every sector has to face credit cutbacks, argues (Y. Paul & Boded, 201 1), that Small and Medium Enterprises have to ace more severe ignorance from the lending institutions.

Therefore, they turn towards trade credit as an alternative source of credit. This further, increase the credit risk associated to customers of Small and Medium Enterprises, as in case of default, there will be cut back in receivable and ultimately profits (Y. Paul & Boded, 2011). Another important reason for why banks cut back credit for Small and Medium Enterprises is to fulfill the requirement posed by Basel Committee of Banking Supervision. It requires banks to align their capital requirements with the risk profiles of the extended moans (Matins Gamma & Amoral Gerald, 2012).

This then prevents banking to base their judgment for Small and Medium Enterprises on soft information and more on collateral based rating (Kind & Arrogance, 2011). This makes the large firms more worthy for the credit, as in case of default, the value of the collateral pledged when sold off, will bring in alignment their capital requirements of BASEL II framework (Matins Gamma & Amoral Gerald, 2012). 1 . 10. 4 Banks Gross Bad Debts Relation with Small and Medium Enterprises According to (Chine, Wang, & Dash Www b, 201 0) study, 63. 3% of the bank’s Ross bad loans are caused by Small and Medium Enterprises. Moreover, these bad debts bring in with them high operational costs and back-end activities costs to the lending institutions, which include chasing, extracting funds, transportation costs etc. (Chine, Wang, & Dash Www b, 201 0) (Y. Paul & Boded, 201 1). In most of the economies there are only a few good Small and Medium Enterprises that are credit worthy; Industrial and Commercial Bank of China (CUBIC China) in 2001 statistically showed, there are only 16. 31% of Small and Medium Enterprises in grade A or higher, but 83. 9% of Small and Medium Enterprises in grade EBB or lower by contrast (Chine, Wang, & Dash Www b, 2010). 1 . 10. 5 Interest Rate and Asymmetric Information Small and Medium Enterprises are an important sector of the economy, for both developing and under developing countries, yet they face a lot of hardships in getting loans. This however, is not the banks fault only but there are basis of this discrimination too. Briefly, Small and Medium Enterprises too are responsible for this curb in lending by the financial institutions (Y. Paul & Boded, 2011) (Matins Gamma & Amoral Gerald, 2012). Small and Medium

Enterprises, specifically the one that face hardship in getting credit are the ones, which have bad credit rating policies, implicit or no late payment policies, no record for their financial statements and no insurance for their extended trade credit (Y. Paul & Boded, 2011). Therefore for them, banks increase their interest rates in order to compensate defaults, but this causes banks to engage in adverse selection and moral hazard issues. The more the interest rate, there is probability for risky borrowers to me in and get credit rather less risky ones; lemon’s effect, argues (Kind & Arrogance, 201 1) . 1. 11

Historical Research Stilling and Weiss in 1 981 were the first to give justification on credit rationing process and argued that in equilibrium a loan market may be characterized by credit rationing. Gosh et al in 2000 pointed out the credit quantity constraints at micro and macro level; denied access to credit completely and limiting the loan size below borrowers’ request respectively. Moreover, Toxic & hashing in 2009 argued, that credit rationing is supply and demand driven, in a sense that due to lack of motivation it is possible that Small and Medium Enterprises themselves hesitate to apply for credit, following in their minds ejection.

Moreover, toxic and Hashing argued, that borrowers, ones who are rejected and those who are discouraged are included in credit constrained borrowers (Kind & Arrogance, 2011). 1. 1 1. 1 Optimal Distribution of Credit to Maximize Expected Return Banks are proactive in their measurement of credit risk as it brings interest income. They prefer their credit distribution to be optimal so that they can earn high expected return on their investment.

Therefore, if the expected return on a loan is low, it is evident that the risk associated with the investment is high and thus there are a few potential borrowers. In order to maximize their profitability through interest income in the form of expected return, banks charge a higher interest rate. This increases adverse selection issues as stated earlier and moral hazards in the form of defaults later as rising interest will also prevent the potential borrowers to apply for loan. Therefore, as argued by (Kind & Arrogance, 201 1), loan supply is a function of loan interest rates. . 11. 2 Credit During Recession and Boom However, banks grant Small and Medium Enterprises only short term loans and in financial distress they even cut the short term loans for the, and the indention is vice versa in booming conditions (Kind & Arrogance, 201 1) (Matins Gamma & Amoral Gerald, 2012) (Y. Paul & Boded, 201 1) . Further, in recessionary times, there is crunch in lending for Small and Medium Enterprises through two ways; increase in cost of borrowing discouraging them to apply for loan and cut in loan supply in severer situation.

This then promotes increased degree of contraction in the economy (Matins Gamma & Amoral Gerald, 2012). 1. 11. 3 Firm Size and Credit Worth are History Why large firms even get credit in financial distress and they also get a chance o negotiate on the interest rate, can be answered through Small and Medium Enterprises comparison with that of large firms. Firm size is not an issue now days which is hard information about the firm but rather soft information plays a pivotal role in assessing credit worth of an SEEM or any firm (Kind & Arrogance, 201 1).

This mainly focuses on the bank-customer relationships, customer-supplier relationship, past lending history and payment modes; in brief the reputation of the firm itself speaks for the credit worthiness of a firm. 1. 12 Current Prospects Early Keynesian economists’ state credit rationing for Small and Medium Enterprises is a market failure in itself, as there are no competitive forces prevalent in the market place to align back the forces of supply and demand together.

However, there is a completely different opinion Of post Keynesian economists (Kind & Arrogance, 201 1 Post Keynesian economists approach to credit rationing; time and expectations play a major role rather information asymmetry and interest rates, is similar to the contemporary theories of financial intermediation; risks and future predictability rather information asymmetry or transactional costs associated with lending practices. (Chine, nag & Dash www b, 201 0) (Kind & Receiver?% 201 1). Small and Medium Enterprises though an important sector of the economy, yet are considered an opaque one by the lending institutions (Y.

Paul & Boded, 201 1) (Kind & Arrogance, 201 1). Small and Medium Enterprises are more rationed when it comes to firm size. There is appositive correlation between the firm size and its behavioral characteristics and most of the Acme’s face financial constraints due to their small size (Kind & Arrogance, 2011). 1. 121 Rationing of Long Term Credit for Small and Medium Enterprises It is also observed that small ankhs are more proactive in lending to local Small and Medium Enterprises as compared to large banks, who lend to larger Small and Medium Enterprises; one with good financial ratios.

Moreover, Small and Medium Enterprises are more rationed or curbed for Long term debt as it is associated with more risks than short term debt; usually with a maturity within one year. (Kind & Arrogance, 201 1). Therefore, the evidence suggests that Small and Medium Enterprises are not given loan or they themselves don’t apply for one due to one the following reasons; Higher interest rates (cost of borrowing), collateral acquirement that fulfill capital requirements of the BASEL II framework, and completely no access to long term debt (Kind & Arrogance, 201 1 ) (Matins Gamma & Amoral Gerald, 2012). . 12. 2 Revision in Trade Credit Terms Of Payment However, there is still a chance for Small and Medium Enterprises to get to the list of the credit worthy applicants of banks. This effort needs to be done on the part of Bank in order to assess the credit worthiness of Small and Medium Enterprises. Banks can look into the trade credit terms of Small and Medium Enterprises with their suppliers and get readily accessible information about the performance of their business. 1. 12. Risk and Benefits Associated with Trade Credit Trade credit is one that is given by the Small and Medium Enterprises to their suppliers; it means to buy out goods and services and pay on a later date. This can reflect to what extent the SEEM is active in getting their receivables, through their receipts and policies for trade credit (Kind & Arrogance, 201 1). However, there is counter argument for this, and a research study by (Y. Paul & Boded, 201 1) indicates that risks increases as Small and Medium Enterprises engage in trade credit. 1. 12.

Increase in Receivables due to Trade Credit This is given justification by the idea, that Small and Medium Enterprises don’t have a good credit rating system or they don’t bother to know much about their customer’s credit worthiness. And therefore, due to asymmetric information, this can bring a hole in their receivables if the customer defaults (Y. Paul & Boded, 201 1). Further, worsening the situation would be when these defaults increase and hence the Small and Medium Enterprises would get bankrupt. 1. 12. 5 Seem Contribution to Economy Small and Medium Enterprises are in important sector for the up gradation of verbal economy.

This sector employees a huge number of people, reducing inflation, curbing poverty, recovery on lower costs after economic shocks and is responsible for catering the domestic needs for any state. A big question is raised an answered by research study of (Kind & Arrogance, 201 1), which show skeptical views from various researchers. According to Clapper et al. In 2002 a cross country survey conducted revealed that Small and Medium Enterprises were not a cause for poverty reduction or higher GAP rather were the businesses of all size, competition and sound business environment did Kind & Arrogance, 2011).