Over the years, SMEs have been characterised by their traditional strengths of relatively low investment requirements, effective resource utilisation, greater operational flexibility, mobility and higher innovativeness. They are present as a part of the value chain in almost all distinguished industry sectors like automotive, gems & jewellery, IT, garments and textile, leather, drugs & pharmaceuticals industry, etc.
Still, SMEs’ access to formal finance is difficult, owing to the high administrative costs of small-scale lending, asymmetric information, high risk perception and the lack of collateral.
The issue of cheap, adequate and timely access to funds for SMEs has been debated; however, a level-playing field still eludes them. Funds are always hard to come by, be it for new projects, expansion & modernisation, diversification, or execution of sudden orders, investments in R&D or marketing.
While adequate finance is a critical issue for SMEs, there are a host of other problems like (i) getting the right information related to sources of finance, (ii) structuring proposals for obtaining finance from banks, (iii) managing available collateral for getting the best deal from lenders, (iv) convincing lenders about the projects, (v) managing finance and cash flows, and (vi) managing information requirements of lenders.
The problems are primarily because of the very nature of the SMEs. Although clubbed as SMEs, each project is unique in its own way and requires critical information, time and proper understanding from an investor?s/ lender?s perspective. All this requires time and resources, which invariably adds up to the cost, making loans either inaccessible at the right time or accessible at a considerable cost.
The concept of Credit Guarantee
The problem of credit rationing for SMEs can be overcome with the help of a Credit Guarantee, which is a financial product that an entrepreneur can buy as a partial substitute for collateral. It is a promise by a guarantor to pay all or part of the loan if the borrower defaults and it motivates banks to lend to groups that cannot access credit under normal circumstances.
The recent global financial meltdown has brought into sharper focus the growing relevance of Credit Guarantee Organisations in providing a strong and supportive mechanism to instill greater confidence among the financial and banking sectors. World-wide experience has shown that guarantee organisations are more successful when they operate in a decentralised fashion, that is, on a local or regional basis, which expedites decision making,and is more adaptable to the needs of local small business.
Mutual Credit Guarantee Scheme
Mutual Credit Guarantee (MCG) provides a means to help entrepreneurs who have sound business ideas, but have difficulty in finding finance. While MCG gives banks the comfort to lend to SMEs for setting up new units, expansion, diversification, modernisation, etc., the mechanism also extends a host of non-guarantee business development services.
Mutual Credit Guarantee Scheme (MCGS) is operated through Mutual Credit Guarantee Organisations (MCGOs) which have proved to be an effective tool to address the financial problems faced by SMEs.
These MCGOs are solidarity groups established by SMEs in the form of consortia or co-operatives. The members directly contribute to create a guarantee corpus fund, which is used to leverage mutual guarantees to the members for borrowing finance from the banking system. (For instance, the Association of Lady Entrepreneurs of Andhra Pradesh?ALEAP?has formed the ALEAP Credit Guarantee Association to help its members obtain collateral-free loan.)
Additional funds are contributed to the corpus by external supporting entities, such as government, large corporate, industry associations, chambers of commerce, banks, etc. As not all members require a loan at the same time and only a small percentage of borrowers are likely to default, members? contributions can have a significant leverage effect.
MCGOs are also supported by counter-guarantee structures which help them to further share their risks and also leverage the corpus many times over. Its operating logic relies on mutual responsibility, decision-making by peers and risk sharing. The key principle is that credit risk, if mutually shared, brings advantages both to banks and SMEs, filling the gap or, at least, mitigating the effects of information asymmetries.
Some of the key features of MCGS are as under:
MCGOs address both pre-default and post-default issues in the entire lending cycle of SMEs. The services in the pre-default domain include providing information on possible finance options available to SMEs; assist SMEs in preparing project report/ application for bank finance; carry due diligence/ project evaluation/ risk assessment; furnish recommendation/ risk rating report and guarantee to lenders; provide financial and legal assistance to members; negotiate loan covenants with lenders; monitor the performance of members; act as an intermediary between SMEs and lenders; organise need-based skill development programmes; and pursue defaulting borrowers for loss recovery. They do not, however, extend credit directly to their members.
Loan guarantees enable access to loans for borrowers who do not have sufficient collateral, thereby sharing the credit risk with the bank. MCGOs back the repayment of loans up to a conventional percentage in case of default by the borrower. As such, in a post-default scenario, the guarantees act as a substitute for the collateral.
The inherent design of MCGOs allows it to function as a credit guarantee provider, a rating agency, a potential regional credit bureau, a credit appraisal and screening agency, recovery facilitator and above all a potential business provider, all rolled into one.
The most important characteristic of MCGOs is that their social proximity with borrowers allows them to directly asses the problem of asymmetric information and provides them with the opportunity to create networks, reaching out to a significant number of small businesses. The social proximity to borrowers also allows MCGOs to have a competitive advantage in screening and monitoring borrowers as well as in post-claim loss recovery over other forms of guarantee organisations and banks. Moreover, MCGOs are based on the ethos of cooperation with strong local ties and support from business/ industry associations creating social capital in addition to the financial capital.
MCGOs, designed as parallel delivery channels for SMEs, work primarily as interface between the entrepreneurs and banks. The scheme aims to assist SMEs in their growth process through extension of both guarantee and non-guarantee services. Being regional and mutual in nature, with local knowledge and reach, they can give the lenders the last mile delivery advantage. The last mile delivery, local knowledge, domain expertise and the inherent peer bonding makes the model a unique and effective tool. The tool has been very successful in Europe, especially Italy.
Overtime, the organisation can also become a very effective depository of soft and hard industry-related information which could be used for the common benefit of industry. These MCGOs could also be utilised by public institutions for channelising State funds and economic policies.
As such, MCGOs address both pre- and post-default situations, the ?event of default? and ?intensity of default? and the vast rage of handholding and mentoring needs of the SMEs which are hitherto un-addressed by any single agency. Vanilla credit guarantee products, in contrast, address only the post-default issues by reducing the ?intensity of loss? to an extent.
To summarise, MCGOs play a pivotal role in a ?win-win? business model by pulling down the credit risk for the bank; giving SMEs additionality to their loans; lowering the cost of funds for SMEs; enhancing the credit-worthiness of SMEs; and increasing business opportunities for banks.
MCG ensures access to quick and adequate finance for SMEs. It also provides non-guarantee services like counselling/ hand-holding services for project details, information about lending/equity arrangements, information about available bank schemes/ sector-specific government subsidies and possible new business partnerships.
It also opens up the scope for collective bargaining, by way of favourable loan covenants, reduced interest rate, lower collateral requirements, reduction of other costs, improved knowledge through advisory services & consultancy inputs, reduced operational costs through access to group insurance products, group machine and equipment purchase, etc. and access to finance for intangible assets like IT investment, R&D, training, and the like. All this leads to improved competitiveness and efficiency.
Further, the close relation between the members creates an environment in which technological, productive and managerial knowledge is shared and innovation is fostered. In addition, MCGOs have extensive knowledge of the operating sector of a member and are thus aware of factors such as competition within the sector, market trends or production techniques. MCGOs are, therefore, often able to make better-informed decisions than banks.
From a lender?s perspective, MCG opens up various options for a host of bulk structured lending products/new business opportunities designed for local needs of the industry. Since members? financial contribution is at stake, there is an incentive to ensure that only credible borrowers receive guaranteed loans. This ensures a low default rate.
Besides, MCGOs help reduce duplication of work for banks, leading to quicker decisions and improved credit delivery because of lower process time. It also leads to reduced transaction costs (reducing duplication of work related to credit screening, appraisal, follow-up and recovery).
Further, lenders benefit through quality portfolio (new ?risk mitigation tool? leading to lower defaults, credit guarantee, recovery facilitation leading to lower post default losses). Through peer monitoring and peer pressure, MCGOs can ensure better recoveries and lower probability of default. MCGOs are better equipped to distinguish between the unwillingness and incapacity of borrowers to repay which requires detailed knowledge of economic and social situation.
The larger units outsourcing through the SME supply chain would gain by enhanced and improved capacities of their suppliers. Besides, large units that depend on ancillaries/ subcontracting operations of smaller feeder units can feel more secure that their supply chain is financially secure and able to evolve over time as the markets change. In addition, MCGOs can also prove to be information centre/ database for prospective sourcing of customised products.
The author is the National Expert on Mutual Credit Guarantee for Unido?s Consolidated Project for SME Development in India. m.sinha@unido.org