The SME Lending Puzzle: Why Banks Fall Short

Let us consider the following hypothetical scenario:

ABC & Co., a small services firm, began operations in mid-2011. It reported a 40% jump in annual turnover from Rs. 5 Cr in FY 2012 to Rs. 7 Cr in FY 2013. As a startup, the company has not yet broken even and reported losses for consecutive years. The promoter is well educated, previously worked in organizations of repute for over a decade before deciding to float this venture. The short-term finance requirement of ABC & Co is about Rs. 40 lac for 90 days, but does not have any physical collateral to offer as security. At this stage, the promoter of ABC & Co. decides to approach banks and NBFCs in the market to fund this debt gap.

What would this promoter’s experience be in today’s scenario? Would he be successful in securing the necessary funds?

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According to a recent statistic, 33% of companies operating in the Micro, Small and Medium Enterprises sector have access to banks and financial institutions, while the rest remain excluded and are compelled to raise money through informal channels.

This debt gap is alarming especially in the backdrop of the fact that SME segment contributes nearly 10 percent of the country’s gross domestic product and 45% of all industrial output.

Till date, banks and NBFCs have not been able to finance this debt gap effectively. What has prevented or restricted them from profitably penetrating this sector? Is it due to inherent credit risk in the segment, lack of collateral, government regulation and laws, or simply because there are greener pastures elsewhere to lend money?

Lets us understand the debt requirement of the SME segment (both early-stage as well as mature entities) before we try to further dissect this issue. In our example, ABC & Co. could require financing for primarily two reasons:

1) Capex, i.e. medium to long-term finance for business expansion, product diversification, renovation of business premises, or purchase of machinery.

2) Working Capital i.e. to cover short-term immediate cash flow needs arising from day-to-day business operations.

To cater to this demand, banks and financial institutions already have specific products (both fund and non-fund based) that can be broadly categorized into two categories for the sake of simplicity:

1) Simple lending products, which would typically cater to the first requirement of SMEs for Capex. These are medium to long-term financing products in the form of equipment and machinery loans, high yield unsecured business loans, Loan against Property etc.

2) Specialised lending products, which typically include factoring, trade finance, cash management services, project finance, bank guarantee, or letters of credit, which typically cater to the second requirement of working capital finance.

As is evident from the above, it is not the lack of “products” that explains the under-penetration of finance flowing to the SME sector. Rather, it is in the design, applicability and administration of these products to the SME sector that banks have fallen short.

In an effort to go deeper, we can identify four key reasons among others, for this shortfall:

1)  Sole Focus on Financials: The current approach to SME lending in most institutions is still heavily dependent on business financials- i.e. looking at historical data to predict future creditworthiness. Typically this involves a lot of paper work and many visits to the applicant.

This approach has not been very successful in the SME sector to-date due to the fact that the financials provided by the applicant are often opaque given the cash nature of business transactions and incentives to under report income to save on taxes. ABC & Co., on this parameter alone (aside from business vintage) would be filtered out as the current financial position reflecting business losses would not be very appealing to most financiers.

2)  Bureau Reporting: There are two kinds of credit bureau reports that can be generated by member banks and NBFCs – Individual and Corporate. While individual records are provided by most bureaus, only CIBIL currently provides reports for corporate entities in India. Valid records for SME entities are still not very evolved in the country. And while the bureaus can provide data on credit worthiness of the individuals involved in any given company, they cannot give relevant insights about an applicant who is a first time borrower.

Since ABC & Co. is newly established, there would not be any bureau record on the company. The application would then have to be judged on the strength of the individual records for the promoter as well as the business viability of ABC & Co.

3)  Selective Segmentation: The implication of the above two factors is that only the “upper layer” of the medium to large enterprise segment is able to pass through banks’ and NBFCs’ credit assessment parameters, leaving aside the major chunk of “small” entrepreneurs and entities whose need for adequate finance is more pronounced. These small entities could be major links in the supply chains of large players, and their inability to access finance could have the ripple effects across the value chain.

4)  Lack of Collateral Security: Lending in India traditionally has relied on taking adequate collateral as a “risk mitigant” to cover the credit risks associated with SME lending and the ambiguity around appraising this segment. The Loan to Value ratio (LTV) becomes the yardstick to segregate and approve or reject cases based on risk. This ratio is inversely proportional to the risk perception of the applicant.

Since ABC & Co. does not have any physical collateral such as property or machinery to offer and the promoter has pitched in whatever money he had in the form of initial capital into the business, his application would be rejected by most banks and NBFCs in the market today.

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This problem of access to finance for SMEs in India is even more accentuated for early-stage companies or startups such as ABC & Co. In their case, past financial performance would be not a correct indicator of the future potential of the enterprise. After initial round of equity funding from family and friends or seed investors, working capital requirements or ad-hoc needs for short term finance would inevitably kick in and must be dealt with in a timely manner to keep the firm operational.

To conclude, traditional lending to the SME sector in India can best be described as a “One Size Fits All Approach.” The risk management techniques used by banks and other financial institutions today are invariably more suitable for medium and large corporate entities. The same set of rules when inadvertently applied to small and early-stage enterprises result in a faulty output, i.e. the systemic rejection of most SME loan applications like ABC & Co. Given the intense nature of competition in the lending industry today, the consequence is that too many banks and financial institutions end up chasing the same set of “good” customers, leaving aside a much larger untapped segment of SMEs in the process.

Watch this space for more articles on the subject as well as suggested ways to underwrite “small” and
“early-stage” entities in the SME sector.

(Image credit: http://blog.directcapital.com/misc/small-business-loan-video/)