Banking on SME Growth

Prepared by: Yuresh Nadishan

 Introduction
• In this context, cross-country policy research shows that Small and Medium Enterprises (SMEs)
play a vital role in generating high and inclusive economic growth, job creation, as well as in
reducing inequality and poverty, particularly in developing countries.

• In Sri Lanka, too, SMEs have been recognized as an important sector of the economy due to
their significant contribution to national income, employment, inclusive private sector
development, bridging regional growth disparities and poverty reduction.

• Although the importance of growing the SME sector is now back in the country's economic
policy discourse, much of the recent policies and initiatives for SME development have been
mostly centered on successive rounds of concessionary credit schemes.
 Importance of SMEs - Global Context

• The growing debate on the advantages of small firms over larger ones in developing countries
has also drawn much attention towards the SME sector.

• Advantages of small enterprises over large scale enterprises in developing countries are
threefold:
1) Small enterprises are labor-intensive and use relatively simpler techniques of production that
correspond to the abundance of labor and the scarcity of physical and human capital that
prevail in most developing countries.
2) Small enterprises demonstrate a higher degree of efficiency in using capital and in mobilizing
savings, entrepreneurial talent, and other resources that otherwise would remain idle.
3) A large share of small enterprises is also expected to exercise a positive influence on the
distribution of income both in functional and in regional terms.
 Rationale for Policy Support to SMEs
The overall objectives of government policies to support SME development are.

(a) Create jobs and generate income

(b) Improve SME performance and competitiveness
(c) Increase their participation in and contribution to the national economy

The following constraints for SME development identified by AAMO

• Poor business environment (e.g., bureaucracy, taxation and unfavourable property rights
enforcement).

• Poor infrastructure (e.g., transportation facilities, power plants, industrial estates and
telecommunications).

• Inadequate access to finance (e.g., obtaining loans, securing collateral and third-party
guarantees and a lack of alternative sources)
• Low technological capacities (e.g., rapid technological advancement in markets, locating
sources of appropriate technology and acquiring technology to develop attractive products.

• Too few applications of ICT (e.g., business communications, marketing intelligence and
customer development)

• Intensified competition in domestic, regional and global markets (e.g., trade and investment
liberalization, less protectionism, freer movement of goods and capital, lower import duties,
cuts in subsidies and cost pressures).
 Financing the SME Sector - A Conceptual Overview

Access to finance is a central issue in SME development. Improving access to finance means enhancing the
degree to which financial services become available to all, through ways that are easier to access, appropriate,
and affordable.

Stages of Financing
• The financing needs of an SME may vary throughout each stage of its life cycle - start-up, growth, maturity,
decline, transition and exit.

• SMEs may obtain equity capital and debt financing from various sources at each of these stages.

In the first stage (start-up), SMEs could face a high probability of failure if they cannot raise sufficient capital,
even though the scale of their needs may not be that large. In this stage, a firm may have limited sales
revenues and also profits may only be on paper and cash in hand may be strained, leading to inability to pay
wages, bills and other operating costs, Thismismatch of cash flow timingcontinues throughout the life cycle of
an SME. Survival in this stage could depend on a firm’s ability to raise additional working capital from the
banking system. Apart from personal loans from family and friends, during the start-up stage SMEs may get
funds from seed capital, venture capital, government and/or institutional sources
In the second period (growth), SMEs pass the break-even point and start making money at which point they
need additional financing including significant working capital loans (short-term) as well as investment loans
(longer-term) to expand production and staffing. The availability of other funds could also increase at this stage
with local, national and international financial sources. Venture capital funds may also become an important
resource for expansion. Entrepreneurs typically experience difficulty raising funds at this critical stage.
Commercial banks do not lend easily to those who still have no, or limited, credit record, and venture capital is
not readily available for small-scale investment in new businesses, particularly in developing countries and
non-IT enterprises. In the third period (transition), it is necessary for SMEs that are losing money to undertake
measures to improve profitability, either by improving efficiency and productivity (cutting costs, streamlining
operations, etc) and increasing sales through enhanced competitiveness. While long-term financing or working
capital generation is necessary for continuous enterprise growth and development, immediate short-term
financing, perhaps through commercial debt financing, is often critical for SMEs during cash-drain periods.
Mismatch of Cash Flow Timing
 Types and Sources of Financing
• Short- and long-term loans, especially from commercial banks, are the predominant form of financing
for SMEs.

• In general, the sources of short-term financing for SMEs include a line of credit, promissory notes,
other short-term banking instruments and loans from other financial companies. However, short-term
financing is more vulnerable to interest rate swings, requires more frequent refinancing and requires
earlier repayment. SMEs tend to rely on short-term loans to meet sudden financial needs or to gain
additional working capital, especially if they face a temporary cash crisis or an unexpected delay in
receipts from a debtor.

• Long-term commercial loans usually refer to those with tenure beyond one year. This type of loans,
also called 'project loans', enable businesses to invest and expand their business with less financial
uncertainty, and increases working capital while reducing the amount of instalments. Longer-term
commercial loans are used for a variety of purposes, such as purchases of equipment and plant
facilities, business expansion and acquiring specialty raw materials for a new project. Lenders require
significant collateral because the risk increases with the term length. It is more difficult for SMEs to
obtain long-term loans due to the lack of adequate assets to use as collateral and the insufficient
supply of such long-term loans.
Informal sources of finance also play an important role for SMEs. Informal financing refers to all
transactions, loans and deposits occurring outside the regulation of a central monetary authority. Although
rarely seen in the Sri Lankan SME sector, equity financing is also an option for SMEs. In equity financing,
investors provide a capital infusion in Exchange for an ownership share in the business.

Types and Sources of SME Financing

 Access to Finance Gap - Exploring the Sri Lankan Evidence

• Access to finance was the second most cited 'business environment constraint.

• A significant proportion (40 per cent) of firms interviewed mentioned that insufficient access to finance
had been a main obstacle either when starting or expanding their business.

• Majority of SMEs said they had more difficulty in accessing finance for development/expansion, while
those who stated it was more difficult to access working capital were relatively fewer.

• Due to the insufficient finances most of employees who belonged to SMEs had not received sufficient
training.

• Majority of SMEs noted that formal channels were their main source of financing and state banks the
preferred option.

• Informal sources were acknowledged by nearly 40% of SMEs as a source of finance with the majority
coming from friends/ relatives and local moneylenders.
This is not unusual. While commercial banking plays a key role in formal SME financing, informal financing
often dominate the financial sources of SMEs because of the very nature of their structure and networks

Most Significant Constraints on Businesses as Perceived by SMEs

The most common reasons for using informal financial sources were listed as high interest rates and the
inability to provide collateral requested by formal banking institutions, with seemingly little relief from
development banks.

Current Sources of Finance for SMEs Reporting Access to Finance as Most Significant Constraint
Access to Finance by Province Support Received from Financial Institutions that Helped Grow the
Busines

Manufacturing-oriented SMEs in the Western Province noted that while only 44 per cent of enterprises sought
access to finance and the majority of those that did, sought it from commercial banks. Of those that did not seek
finance from formal credit channels, the second most-cited reason (19 per cent) for it (the first being that the
enterprise had sufficient capital) was that 'application procedures were too complex'. Other reasons included 'need
for formal registration' (15 per cent), 'interest rates not favorable' (4.6 per cent), 'collateral requirements were too
high’ (1.3 per cent), 'did not think it would be approved' (2.6 per cent), and 'size of loan and maturity were
insufficient'
• Women entrepreneurs in the SME sector revealed very strongly that support received from financial
institutions to start and grow their businesses was not satisfactory.

• According to both male and female entrepreneurs nearly 60 per cent disagreed or strongly disagreed
with the statement that 'support received from financial institutions were good’.

• SMEs that had applied for a loan in 2013, development banks were the main source of funding.
Furthermore, of the women SME entrepreneurs in this survey who had started their own businesses,
very few of them had obtained finance via bank loans or local-level finance companies. He majority
(70 per cent) had raised capital from informal sources like friends, relatives, neighbors, spouses,
parents, children, siblings, and also through pawning.

• In line with Government efforts to promote the SME sector in recent years, the banking sector of Sri
Lanka has diverted more attention towards serving this segment. It appears that private sector banks
have been the major driver of SME financing in the country.
• National Development Bank originally set up as a development bank to finance sectors such as SME,
demonstrated only a 10% to 15% SME loan portfolio. Meanwhile, the other development bank, DFCC,
demonstrated an over 50% average SME lending ratio over the last four years. Commercial banks like
Nations Trust Bank (22%) and Sampath Bank (40%) have been steadily raising their SME lending as
well.

• Yet, what cannot be determined from these numbers is the lending to small enterprises vs. lending to
medium-sized enterprises. As there is no regulation to report information in this manner, together
with the added complication of a lack of a consistent SME definition, this information cannot be
ascertained.
 Supply and Demand Dynamics Driving SME Access to Finance Challenge in Sri Lanka

Currently SMEs are facing four sub-sets of financing problems, namely, availability of funds and other
credit instruments, access to loan capital, cost of borrowing and management of finances.

The lack of venture capital and equity financing options for Sri Lanka are said to compel SMEs to depend
mostly on bank loans (aside from informal sources). The problem of poor SME access to funds is said to
attribute to factors such as the inability of SMEs to produce collateral with proper titles, the lack of
development orientation on the part of both commercial and development banks, and the lack of proper
skills among SMEs to make bankable project proposals.

The third problem of cost of funds is said to attribute mainly to the high risk credit profile of SMEs which
inevitably lead to high interest rates being offered to the segment, while the problem of management of
finances is said to attribute to several factors including insufficient equity base, high cost of finance, over-
ambitious business acceleration, lack of financial management experience, nonseparation of business and
private expenditure, over-expenditure on status symbols such as cars, and unexpected policy changes.
 Demand-side Factors: SMEs' Intrinsic Weaknesses

When considering the demand-side factors, the lack of collateral seems to be the most significant constraint on
SME access to credit. Financial sector institutions surveyed observed that the high non-performing loans (NPL)
ratio of SME customers have prompted them to demand higher collateral when giving out SME loans, in order
to cover potential default losses.

Banks assert that although they have tried alternatives to collateral-based lending, like cash flow-based and
risk-based lending, the NPL ratio was higher for such lending and felt that collateral is necessary in order to
exert pressure on SME customers to repay their loans.

The banks also expressed a concern that effective credit guarantee schemes, which would ease high default
risks of the SME segment, were not available in Sri Lanka, but if introduced would improve the SME credit
climate by allowing banks to lend collateral-free.

The lack of transparency and financial discipline among SMEs was considered as the second most significant
demand-side factor. SMEs are hesitant to fully comply with preparing financial reports due to the fear of
exposure to government regulatory matters like taxes. Tax implications appear to be causing reluctance among
SMEs to disclose proper financial accounts to banks.

Preparing financial reports based in a standardized manner is also a challenge for many SMEs as they do not
have dedicated and large accounting and finance departments.
The lack of proper financial data makes it virtually impossible for banks to evaluate the creditworthiness of
SMEs and has thus constrained the amount of credit given to the sector.

SMEs often do not have a proper management or organizational structure. The enterprise could be
comprised of just a handful of individuals or set up as a 'one-man show' with no specific skilled
professionals for financial management and reporting. This may be an off-putting characteristic for banks.

The lack of access to markets, market information, and effective supply chains are considered as 'intrinsic
characteristics' constraining SME growth.

This in turn, has made SME business plans less feasible prompting banks to refrain from lending to SMEs
due to inadequate and/or poorly-prepared business plans. The lack of sufficient knowledge of business
practices such as the effective financial management, business planning, bookkeeping, etc., prevent SMEs
from making bankable business proposals.

Banks have begun making efforts to address this issue by conducting training programs and establishing
special SME centers to assist SMEs in preparing proposals.
 The lack of access to markets, market information, and effective supply chains are
considered as ‘intrinsic characteristics’ constraining SME growth.

The interviews also highlighted the fact that administrative delays and difficulties in obtaining permits
and licenses from government institutions enforces problems for SMEs in obtaining credit because the
banks are unable to provide credit without proper documentation.

Our findings suggest that the lack of proper insurance coverage for the SME segment is yet another
critical factor limiting SME credit. Banks feel that the insurance providers of Sri Lanka seem to have
given very little emphasis to the SME segment as most SMEs have been unable to obtain proper
insurance coverage.

The lack of proper management and leadership plans was found to be yet another demand-side
shortcoming constraining SME access to credit.
 Supply-side Factors: Limitations within the Banking Sector

Most of commercial banks stated the lack of effective government support and/or incentives given to the
banking sector for promoting SME lending as a key factor limiting SME credit.

The banks stated that the extremely risky nature of the SME market makes it difficult for banks to serve
the segment and that, incentives were needed to make it worthwhile for them to serve such a risky
market.

This was a surprising observation given the number of concessionary and SME-specific loan schemes
available in the market, particularly those refinanced by the Central Bank of Sri Lanka or international
development agencies. Banks expressed their disappointment in the current refinance facilities provided
by the government as they were found to be ineffective and unprofitable for banks. They also felt that the
government needs to take a more proactive role in providing necessary credit lines for SME lending.

The lack of staff that is skilled in SME lending emerged as a critical supply side constraint. SME lending is a
service that calls for a different kind of banking approach. A more analytical, patient, and small business-
oriented banking attitude is required for SME lending.
SME bankers require more training in handling SME customers than a normal corporate customer since SMEs
do not possess the capacity to produce reports on tight deadlines set out by the banks.

Banks are often ultra-cautious when it comes to SME clients, owing to information asymmetry and lack of
understanding. Often, a key reason for default among the SME segment is poor credit origination, i.e., credit
evaluation that has not correctly ascertained the applicant’s background, project potential, and economic
conditions.

The limited range of SME-focused or SME-friendly financial products offered seems to be a factor constraining
SME credit.

The banks also expressed concerns about the policies adopted by the government with regard to financial
markets such as imposing credit ceilings and high interest rates as a constraint on SME lending.

The banks believe that a favorable financial environment with less interruption is needed so that they will be at
a position to follow strategic plans to promote the SME sector.
 Policy Options - Overarching Measures
Re-orienting Financial Institutions towards SME Lending

Banks' discriminatory behaviour towards SMEs is quite rational. From their point of view, the scarcity of
credit in most developing economies (savings-investment gap) means there is less incentive to seek out
SMEs when larger and more qualified clients are available.

Banks often find that dealing with SMEs incur higher transaction costs because the credit monitoring
process requires more capacity at the local branch level, and this is further complicated by the poor
financial management and accounting systems of many SMEs that was highlighted earlier.

Banker's Traditional Interest in SME Lending

Even though there has been a recent shift in the focus of banks (especially in Sri Lanka), from large
corporates to a newer, smaller, but yet lucrative, segment of SMEs, the banking procedures and practices
carried out by Sri Lankan banks seemed to have not changed accordingly to best suit the new SME focus.

SMEs, who are most often than not, unskilled in preparing business plans find themselves unable to
complete even the first step of the traditional banking process and often do not succeed beyond the first
step of the process.

The high rate of failure of SME applications at the project viability stage is said to owe mainly to the
inability of bank staff in accurately assessing the business proposals as they lack entrepreneurial skills to
assess the projects.

Most loan applicants are start-ups with no prior financial statements; thus SMEs lack the necessary records
to prove their financial strength. It remains questionable if SMEs should be evaluated based on the same
criteria imposed by traditional banking procedures.

Given the inability of the traditional banking procedure to meet the demands of the SME clientele, the
need to streamline Sri Lanka’s banking procedure to best suit SME customers is essential.
Banks and other financial institutions need to develop more SME-friendly products, services and
processes, develop comprehensive risk management skills and improve information transparency.

Increasingly, these institutions would have to move towards offering nonfinancial assistance to SMEs as
well - helping them with capacity-building to enhance their profitability.

Improving the Bank SME Relationship

For instance, banks may not appreciate the SMEs' dire need for quick capital, while SME owners may
not understand bank policies and procedures when it comes to SME lending and mitigating risk.

PFIs and other intermediaries may lack either the incentive or the competence to build and sustain
bank-SME relations.

Banks may often be more interested in focusing on their standard loan products rather than special
SME ones. To bridge these gaps, communication and awareness creation are important, for both SMEs
and banks on a sustained and ongoing basis.
 Reducing Information Asymmetry

One of the main underlying drivers of the access to finance challenge for SMEs is the asymmetry of
information, which impinges on the banks' ability to discern the creditworthiness of SMEs.

On one hand, it is too costly and inefficient for individual lenders (banks) to collect this information while on
the other, SMEs usually lack financial administrative skills to provide this information, or may even lack the
basic knowledge about what type of information should be prepared. This creates somewhat of a market
failure.

Addressing this can be a two-step process that happens simultaneously. Firstly, SMEs need to learn to get
better at providing the kind of critical information that banks need when making assessments about
creditworthiness. This goes back to the discussion on 'SMEs' intrinsic weaknesses' like transparent
bookkeeping, credible accounting, business planning, etc.
 Policy Options - Specific Mechanisms
Credit Guarantee Schemes

A key characteristic of SME lending is the relatively higher level of risk and transactions cost. An IFAC-Banker
survey found that lenders do not value information industry trends and clients' business plans nearly as much
as they do cash flow statements, collateral and transaction histories.

SME lending is characterized by asymmetric information; principal-agent issues; higher objective risk; costly
monitoring; etc. In order to deal with these challenges, specifically credit risk and information asymmetry, a
tool often used is Credit Guarantee Schemes (CGS).

Rather than successive rounds of concessionary credit lines, CGS are regarded as long-term mechanisms for
SME support by cushioning banks from the risks associated with lending to small businesses. These schemes
help entrepreneurs to secure both short-term and long-term credits with less collateral or even without
collateral.

Another policy objective of the schemes is to provide an opportunity for banks to learn more about SMEs -
their problems and operations - and to help improve handling of their SME loan portfolios.

Inadequate collateral is a serious issue for lending in the SME sector in Sri Lanka, because banks are
traditional and risk averse in their lending, and are strongly collateral-conscious.
CGS has the objective of absorbing part of the loss resulting from the default of a bank loan. It reduces
the risk of a lender, serves to improve the supply of credit, and facilitates the smooth operation of the
loan market.
Korea Credit - KODIT
Korea has what is widely regarded as one of the most successful CGS in Asia. Korea established the Korea
Credit Guarantee Fund (KCGF) (later renamed as Korea Credit - KODIT) in the very early stages of SME
development. To capitalize the KCGF, the government enacted the Korea Credit Guarantee Fund Act,
mandating that all banks in Korea contribute 0.5 per cent of their outstanding loans to the fund (reduced
to 0.225 per cent in later years). SMEs approach KODIT to obtain a guarantee on a potential loan from a
commercial bank, after which KODIT analysts conduct an assessment of the application (creditworthiness
check, site visit, interview with entrepreneur, etc.), issue a credit rating and offer a certain loan guarantee
percentage (could be as much as 90 per cent). The ceiling of the guarantee could be up to US$ 3 million,
and in some special cases up to US$ 7 million (in sectors designated by the Financial Services Commission
of Korea in line with government policies to promote exports, green growth projects, etc.). KCGF's success
is evident in the increase in loans to SMEs, from 35 per cent of total loans prior to 1975 to 77 per cent at
present.37 Meanwhile, to further strengthen SME lending at the 'Bottom of the Pyramid', the government
introduced 16 regional Korea Credit Guarantee Foundations (KCGFs) since 1996, followed by the Korean
Federation of Credit Guarantee Foundations in 2002 to provide re-guarantee services to the KCGFs. The
16 KCGFs assist in providing finance for promising micro and SMEs as well as consulting services to
address technology and managerial skill needs
Moreover, a critical aspect that determines the success of CGS – and particularly evident from the Korean
case - is that the system must be supported by an adequate branch outreach and human resource
capacity. Without these, the ability to attain a reasonable portfolio scale and the ability to fully assess
loan applications is limited.

There is an urgent need for Sri Lanka to establish a CGS and a national institution for it - an SME Credit
Guarantee Fund (SCGF). The institution ought to be separate from the Central Bank of Sri Lanka and
function independently. Capital (funding) for it can come in part from the government and in part from
private commercial banks. The SCGF ought to have multiple regional branches to cater to SMEs where
they are located and in line with the government vision of developing 'lagging regions'. Like in KODIT and
other examples, qualified analysts, ideally graduates from a business administration or management
background, must staff it.
 SME Credit Scoring and Credit Information

The credit history of SMEs is an important piece of financial information that can help bridge the
information asymmetry and default risk problems that often drive the access to finance challenge.

IFC (2010) defines credit scoring as a mathematical technique that uses historic credit data to predict a
future outcome, typically the probability of default.

The automated credit reports and scoring enabled the bank to provide a cost-effective service to its SME
clientele. Credit scoring involves the process of granting a score to an individual/ individual business based
on parameters such as length of time in business, nature of business, length of time with bank etc.

Asymmetric information due to the lack of proper financial data with regard to SMEs make it impossible to
evaluate their creditworthiness based on traditional appraisal methods. Hence the credit scoring method
can be used to evaluate the creditworthiness of SMEs and can help in overcoming information asymmetry.

The process of SME credit scoring typically consists of a number of factors: a comprehensive assessment
of the overall condition of an SME; a review of the financial condition and several qualitative factors that
have bearing on the creditworthiness of an SME (e.g., management skills; and reputation and goodwill); a
composite appraisal/condition indicator and size indicator; classification of an SME, based on industry and
size, for comparison against peers; characteristics of leadership quality; and tools that enhance the market
standing of an SME among trading partners and prospective customers (e.g., technologies, patents,
production facilities, knowledge, distribution channels, etc.).
Even though it is unlikely that Sri Lankan banks would rely solely on a credit score to make a lending
decision, these models can be deployed as a pre-screening tool to determine which applications to
investigate more thoroughly and which applications to reject completely. They could reduce the average
time spent on processing applications and the cost of acquisition - two key factors that limit banks from
lending to the SME segment.

The 'Access Finance’ Newsletter (World Bank, 2006) identifies four challenges in adopting Small Business
Credit Scoring (SBCS) in Developing Countries.

1. Limited availability of timely, accurate and reliable data in credit bureaus and similar data registries.
2. Poor record management and MIS systems in financial institutions.
3. Significant investment cost to develop SBCS tools.
4. Bank's reluctance to share information on SME customers among peers.

In terms of structuring a credit rating scheme, Sri Lanka can learn from neighbouring India. India’s
Performance and Credit Rating Scheme, a program that rates small scale industries was formulated in
consultation with the Small Industries Associations, the Indian Banks’ Association and various credit rating
agencies including Credit Rating and Information Services of India (CRISIL), Investment Information and
Credit Rating Agency of India Limited (IICRA India), and Dun and Bradstreet.
 Business Development Services to Address Access to Finance Challenges

SMEs’ intrinsic weaknesses are a key contributing factor to their access to finance problem. By addressing
these weaknesses through provision of advisory services, SMEs could better understand how to approach
banks, cater to bank's requirements, and securing financing. By seeking support from business development
services (BDS) providers, SMEs can improve the management of their business, bookkeeping and accounting,
business planning, etc., and be more attractive to banks.

The lack of availability of BDS providers in Sri Lanka was reported as a top constraint by SMEs.

As a second-best solution, business/ trade associations, chambers of commerce and federations of industries,
can help SMEs work with banks to resolve financial and operational concerns that are holding loan approvals
back. Meanwhile, banks themselves may want to engage in some BDS activities as well.

In providing BDS, BDS providers as well as banks and financial institutions should consider the following
elements.

1. Improve management and operational systems to enhance transparency and governance.

2. Address gaps in bookkeeping / accounting.
3. Assist SMEs to develop bankable business expansion plans.
4. Guide SMEs on financial, taxation and other regulatory compliance matters.
Setting up state-owned and funded specialised SME banks may not necessarily solve the SME finance
problem either. For instance, although Sri Lanka set up the specialised ‘SME Bank', it was poorly capitalized
and poorly managed and was later merged with Lankaputhra Development Bank (LDB). Subsequently, LDB
has not been able to make a significant mark on the SME lending landscape. Plagued by delinquent lending
of the SME Bank which it merged with, and continued practices of non-prudent politically motivated
lending, has led to very high non-performing loan ratios (from 19 per cent in 2009 to over 45 per cent by
end 2013).

The guiding principle of government intervention in SME financing should be ensuring that financial
intermediation is efficient and works for SMEs. For this, it must properly identify the market failure. If the
market failure is in the form of asymmetric information for instance, the appropriate intervention could be
to push through an SME Credit Guarantee Fund and/or SME Credit Scoring schemes.
Thank You