The Hindu Business Line : Banks must re-invent SME financing

Small and medium enterprises are the engines of growth in an economy. But as the sector is characterised by information asymmetries and high processing costs, banks are reluctant to lend to SMEs. With the Government soon to put in place a rating mechanism for SMEs, however, and armed with better risk information, banks can now use technology for effective credit delivery, says P. P. Pathrose.

SMALL and medium enterprises (SMEs) play a catalytic role in the development of any country. They are the engines of growth in developing and transition economies. In India they account for a significant proportion of manufacturing, exports and employment, and are major contributors to GDP.

The Government of India recently unveiled a policy package aimed at stepping up credit flows to the small and medium sector. For the first time, it clearly defines medium enterprises, proposes a one-time settlement (OTS) scheme for non-performing assets of banks and a Corporate Debt Restructuring (CDR) mechanism for the SME sector on the lines of what is now in force for larger companies.

The Government has asked public sector banks to achieve a minimum 20 per cent year-on-year growth in the funding of SMEs, leading to a doubling of credit to the sector from Rs 67,000 crore in 2004-2005 to Rs 1,35,000 crore by 2009-2010. A small-scale unit is defined as one having original investment in plant and machinery not exceeding Rs 1 crore. While recognising the need for larger investment in some of the more important segments of SSI, the Government has enhanced this to Rs 5 crore for specified industries.

The Government felt that a separate category of medium enterprises (MEs) needs to be recognised and, accordingly, the new policy package clearly defines the medium enterprises as those units having investment in plant and machinery above the small-scale industry limit and up to Rs 10 crore, as recommended by the Working Group on Flow of Credit to the SSI sector, headed by Mr A. S. Ganguly.

The Working Group had observed that the earlier definition of SSI, based on investment in plant and machinery, excludes the rapidly-growing service sector. In the past decade, the services sector contributed almost half the country's GDP. The Working Group strongly recommended the adoption of turnover as a measure for defining the SME sector.

Inadequate financing

The future of SMEs is of major policy concern given their strategic importance in reshaping the industrial sector. The biggest problem the SMEs face is the non-availability of adequate financing facilities. As the sector is characterised by information asymmetries and high processing costs, often exceeding the returns, banks are generally reluctant to extend credit to the SMEs.

For a sector that contributes about 40 per cent of industrial production, the SMEs lack government backing and the right infrastructure and inputs. With the advent of rapid globalisation and theWTO commitments, the SME sector, more than the larger business ventures, faces new challenges and threats. The opening up of national economies, the removal of trade barriers, the constant arrival of new products, and the introduction of ever new processes of production and service provision, have transformed the business operations of SMEs.

The growing incidence of sickness is yet another area of concern. Prolonged sickness leads to the closure of units and unemployment.

Wary of funding SMEs

Banks, like other businesses, concentrate on creating value under a controlled risk milieu. When a business applies for a loan, a bank focuses on the risks involved and the methods to mitigate those risks. The banks are reluctant to lend to the SMEs for a number of reasons, including the following:

The information asymmetry that arises from small businesses' lack of financial information and standardised financial statements, in addition to the bank's limited knowledge about the borrower company.

The high risks involved in lending to the SMEs as a result of limited assets that can be used as collateral, high failure rates, low capitalisation and vulnerability to market risks.

As small businesses cannot offer adequate collateral, the banks are unable to determine whether the borrower possesses the technical, managerial and marketing skills to generate adequate cash flows and service the loan. The process of financial intermediation, therefore, breaks down for the SME borrowers.

Win-win situation for banks

Recognising the vast potential of the SME sector, banks have positively responded by providing adequate credit to the small and medium units. Bank credit to SSIs has increased from Rs 16,800 crore in March 1991, when the structural reforms began, to Rs 58,300 crore in respect of public sector banks. PSBs and foreign banks have an additional outstanding SME portfolio of more than Rs 10,000 crore. The Government has initiated a comprehensive policy package for SMEs, which includes fiscal, credit, infrastructure and technological measures.

Lending to the SMEs, if developed and practised on modern lines, will be a profitable option for banks and can guarantee higher earnings than the lending to corporate clients.

Banks are now better equipped to handle the varied needs of the SME sector due to better technology and risk management. As recommended by the Ganguly Committee, the Government has asked banks to adopt a full-service approach to cater to the diverse needs of the SME sector. This, it recommends, may be achieved by extending banking services to recognised SME clusters by adopting the 4-C approach: Customer focus, cost control, cross-selling and containing risk.

Rating mechanism

To enable the lending institutions take more objective decisions, the Government plansto introduce a rating mechanism for designated industrial clusters; this may be designed jointly by Crisil, IBA, Sidbi and SSI Associations. This would enable institutional funding to be channelled through homogenous recognised clusters.

There is a critical need to devote substantial resources to improving the skills and capabilities of banks' lending officers, especially with regard to the analysis of the SMEs' financial statements. Understanding the nature of the borrower's business and the cash-flow required is paramount to preventing the creation of NPAs.

Another way of extending loans to the SMEs is the relationship-lending rule, where the lending partly bases its decision on proprietary information about the firm and its owner through a variety of contacts over time. The information may be gathered from such stakeholders as suppliers and customers, who may give specific information about the owner of the firm or general information about the business environment in which it operates.

NPA management

Insufficient data on the SMEs, the lack of credible published information about their financial health, the high vulnerability of small players in a liberalising market and the inadequacy of risk management systems in banks are factors leading to higher NPAs and lower profitability than potential in SME lending. This can be overcome by collection of authentic data on the SME segment, educating the enterprises on the need for reliable financial data, evolving suitable risk models and close monitoring of accounts

Banks should come out of the asset-based lending mindset, while devising cash-flow or collateral-based lending models. The line-of-credit approach should be popularised by banks. Simplified assessment/appraisal models must be introduced (like 20 per cent of the turnover as working capital limits, 75 per cent of the project cost as term loan, etc.) Small and medium outfits need transaction-banking and trade finance services in addition to lending. They are increasingly using products such as derivatives to manage their forex flows. Banks need to offer sophisticated products to the SMEs in a simplified manner.

They need to innovate their delivery platforms by using Internet banking, mobile banking and card-based platforms for delivery of transaction-banking as well as credit products, and enhance the service element. SMEs look for convenience and simplicity in their banking requirements and banks should deliver these through an effective use of technology.

(The author is a Senior Manager with Federal Bank, Regional Office, Mumbai.)

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