The key challenge is to support banks in extending credit facilities
Micro, Small and Medium Enterprises (MSMEs) play a major role in economic development, particularly in emerging countries. There is heightened attention by the international community on the MSME sector. This is primarily because of the critical importance of job creation in the recovery cycle following the recent financial crisis, and the MSMEs’ potentials in that respect.
Yet, lack of access to finance is a major obstacle to their growth. Although the situation can differ among countries and individual businesses, the financing gap for SMEs in the developing country has a few well-accepted causes. These include information asymmetries, higher risks, sizeable transaction costs and a lack of adequate collateral. These factors can be exacerbated by institutional factors within a country. Finally, there are a number of ‘demand side’ considerations that deserve more attention.
The following three factors play a considerable role in perpetuating the MSME financing gap—the poor quality of projects seeking funding; the inability of MSMEs to make the best possible use of available resources of funding; and the negative attitude displayed by MSMEs towards equity financing.
Unfortunately, there is no authentic data available about the SME financing gaps. The informal segment within the SME sector is so vast and, by definition, no authentic information about them is available. However, various data sources and studies indicate that most of the small firms rely on internal financing and informal sources.
A study by the IFC and McKinsey and Company suggests that there are close to 365-445 million MSMEs in emerging markets, of which 25-30m are formal SMEs and 55-70m are formal micro enterprises, while the rest (285-345m) are informal enterprises. According to the same study, close to 45 to 55% of the formal SMEs (11-17m) in the emerging markets do not have access to formal institutional loans or overdrafts despite a need for one.
The finance gap is far bigger when considering the micro and informal enterprises; 65-72% of all MSMEs (240-315m) in emerging markets lack access to credit. The size of the finance gap varies widely across regions and is particularly daunting in Asia and Africa. Some studies about SMEs in India have reported that as high as 93% of their financing needs are met by internal and informal sources.
In order to scale up the best practices in SME finance, the G-20 SME Finance Sub-Group executed a global SME finance stocktaking exercise with various SME finance models. This exercise entailed the collection of 164 SME finance models spanning across a broad spectrum of interventions, including: (i) legal and regulatory framework; (ii) financial information infrastructure; (iii) public support schemes; and (iv) private sector initiatives.
The stocktaking exercise confirms the rise in various parts of the world of specific business models aimed at providing financial services to SMEs in a cost-effective manner. From micro-finance up-scaling to bank down-scaling, including community banks, these models share common characteristics: they reduce cost to serve through intensive use of technology and/or the adoption of cost-effective client-relationship models; they combine offering of savings, transactional, and credit products, with a view to increase generated income; they use advanced risk management technology to maximise the risk/reward balance; and, they achieve strong focus on the small and/or medium enterprise segment, to help implement excellent execution capabilities in the above areas.
Hence, the key challenge is to support banks in extending credit facilities to SMEs. It will be a greater challenge to reach informal SMEs. This is due to SME intrinsic weaknesses, flaws in delivery models and, most importantly, lingering deficiencies in the enabling environment for financial services: i.e. the financial infrastructure covering accounting and auditing standards, credit reporting systems, and collateral and insolvency regimes.
Some other ideas
* Reaching informal businesses will have to be built on microfinance approaches. It all has to start with account relationship. The financial inclusion programmes like PMJDY will facilitate key information inputs to banks about the existence of the MSMEs, whether in formal and in informal segments. Banks should leverage these data to identify potential MSMEs for suitable financing opportunities.
* Banks will also need to develop ingenious and innovative products suitable for the MSMEs. I strongly believe that this aspect needs to be grounded more at the grass root level. Based on broad parameters given by their central offices, the actual packaging of the products will have to happen closer to the field. Key elements of such packaging will have to include risk-sharing facilities.
* Banks will also have to play a much larger role than being the financiers. MSMEs often lack management skills, tools and financial planning expertise. Banks will have to help these entrepreneurs leverage the RSETI like institutions to fill the gaps.
* Another major weakness that inhibits the growth of this sector is the lack of good records management by the MSMEs; this often results in poor credit ratings and a perception of risky business. Some innovative solutions using cloud computing have been tried successfully in some countries like Ghana. Perhaps this can be studied and adapted for Indian environment.
These interventions need to be accompanied by enhancements to the enabling environment for MSME lending, such as improved credit bureaus, and collateral and insolvency regimes. For the success of effective SME financing models, it is imperative that suitable supporting environment for the financial sector is in place. In particular, financial information and the ability to enforce collateral are seen as critical necessities. Weaknesses in these areas appear to impede more aggressive financial services growth in developing markets.
We are very aware of these requirements and have taken several measures in that direction. Our recent guidelines, based on Aditya Puri committee recommendations, envisage that credit information now will flow to all credit bureaus simultaneously and therefore the financial entities can have a holistic view about any prospective borrower at one go.
As regards collateral registry, steps have been initiated in this direction. The Central Registry of Securitisations, Asset Reconstruction and Security Interest of India (CERSAI) has come on the scene for registering security interests over property. Other types of registry and inter-linking registries are also being debated. As regards insolvency, especially for MSMEs, as announced in the last Budget, a committee is working out an insolvency framework.
Public support schemes (funded facilities, guarantee schemes, and state banks) represent the large majority of the collected models. India has also adopted these strategies. Measures like CGTSME, MSME lending as a priority sector lending for banks, etc, have been in line with this thought.
Although MSME financing and microfinance models have started yielding desired results, equity financing remains a challenge. Given that banking and lending services represent the bulk of SME financing in the developing world, especially for small firms, equity financing presents an opportunity for the development of a complementary financial product.
The author is deputy governor, RBI.
(This article is excerpted from his valedictory speech at a Crisil workshop in Goa on Jan 30, 2015)