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SME financing: credit where credit is (over)due

Updated January 14, 2018


SIALKOT: Employees conduct a final check to fix any cavities in the seams of footballs at a factory. The share of SMEs in total advances extended by the banking sector was only 5.7 per cent at the end of September 2017.—Reuters
SIALKOT: Employees conduct a final check to fix any cavities in the seams of footballs at a factory. The share of SMEs in total advances extended by the banking sector was only 5.7 per cent at the end of September 2017.—Reuters

KARACHI: Small and medium enterprises (SMEs) potentially constitute the most dynamic segment in an emerging economy.

Yet they often face economic, legal and institutional obstacles. Specifically in the context of obtaining access to finance from banks, SMEs in Pakistan face a number of issues on both demand and supply sides. With an emphasis on the demand side for this opinion piece, one of the most widely acknowledged obstacles is the lack of collateral to meet the requirements of banks. Apart from start-ups, this issue also affects established SMEs, which are collateral deficient due to their low capital base and labour intensive nature.

An intuitive explanation is that lenders request collateral in order to alleviate the associated risks. Furthermore, though the Credit Information Bureau has been expanded in recent years to include all loans (irrespective of size), banks additionally require records of collaterals prior to the extension of financing facilities.

However, the collateral registry maintained at the Securities and Exchange Commission of Pakistan (SECP) is for limited companies and fixed assets only.

Limited applicability of the available collateral registry and absence of collateral registries of movable assets has, in turn, created informational asymmetries between enterprises and lenders. The victims of this situation are borderline customers – particularly SMEs.

Informality is also a bane for SMEs looking to obtain financing from banks. In general, they lack segregation of responsibilities and proper organisational structures based on area-specific expertise. Moreover, a lack of organisational hierarchy and proper procedures for internal control render most SMEs as one-person-shows, which are highly dependent on the skills, knowledge base and experiences of their owners – a characteristic that may result in high perceived failure risks from the perspective of banks. To complicate matters further, many SMEs are conventionally run by family members, who may not be professionally sound or well-equipped to provide a strategic vision for the enterprise in a rapidly evolving business environment.

By extension, due to low levels of literacy and high costs associated with maintenance of accounting records, SMEs generally keep track of their performance through cash-based single entry journals, hand-written vouchers and receipts, utility bills etc.

In addition, many SMEs lack working knowledge of financial terminology (for example, calculation of applicable mark-up and comparison of different financing options), as well as the capability to present their project proposals and borrowing requirements effectively.

This breeds reluctance on the part of SMEs to approach banks in the first place. The shyness is compounded by factors like delayed credit approvals and disbursement, cumbersome financing procedures and insistence by banks on collateral and guarantees. While SMEs that have attempted and failed to obtain bank financing in the past may be especially prone to dismiss their prospects of obtaining a bank loan in the future, even those enterprises that have had no firsthand experience of the process may be put off by hearing the experiences of other SMEs, which underscores the importance of perception management.

The distinct nature of SME operations also puts them at a disadvantage. SMEs generally operate in low-margin and labour-intensive sectors with small markets and high price elasticity of their products.

These conditions, along with limited availability of capital, make SMEs more vulnerable to external shocks. In the not-so-distant past, rising energy prices as well as power outages, high mark-up rates and inflation rendered many SMEs liable to losses. Floods in 2010 and torrential rains in 2011 wiped out fixed investment and earning assets of many SMEs, and negatively affected their prospects of obtaining bank financing in the future as well.

While it is not practical to envision an overnight transformation in the way SMEs conduct business, nor of the exogenous developments that impact their performance, a low hanging fruit could be the development of entrepreneurial capacity among SME owners.

In Pakistan, the curriculum by and large does not inculcate a mindset of entrepreneurship in new entrants of the workforce or impart skills to the existing workforce to run their small enterprises better. Instead, the educational system leans toward preparing job seekers. Ultimately, the start-ups that are launched by educated youth are often necessity-driven, and stem from a limited availability of suitable jobs (though there are exceptions, of course, such as opportunity-driven tech start-ups).

While a handful of business schools have set up dedicated incubators for entrepreneurial development, this concept is absent from most institutions.

That said, on a positive note, the Small and Medium Enterprises Development Authority (Smeda) has taken some encouraging initiatives to develop the demand side. These include guidebooks containing practical advice for SMEs on how to approach banks for financing. They also encompass a wide array of pre-feasibility studies, which entrepreneurs can utilise to better understand industry dynamics, prepare projections and estimates for project financing, and ultimately submit more thorough and convincing loan applications, should they choose to avail bank financing.

To conclude, SMEs deserve credit for the resilience they have shown over the years. This is a segment that has survived – and in some individual cases, thrived – with little handholding, especially from the organised financial sector. One can only imagine what the country’s SMEs are capable of if they gain access to adequate financing to scale up their businesses.

The writers are senior economist and senior analyst at the State Bank of Pakistan, respectively.

Published in Dawn, January 14th, 2018