Pakistan’s small and medium enterprises (SMEs) are the backbone of our economy. With over 5.2 million businesses spread across manufacturing, services, and trade, SMEs contribute nearly 40 per cent to the GDP and employ more than 80pc of the non-agricultural labour force. From the furniture makers of Gujrat to the tech startups of Karachi, these businesses reflect the diversity and potential of Pakistan’s economic landscape.

Yet, despite their significant contribution, many SMEs are unable to reach their full potential. The journey from potential to performance remains difficult for many, primarily due to structural and systemic barriers. While there have been positive efforts by both public and private sectors to support SMEs, including initiatives from the State Bank of Pakistan (SBP) and the SME Development Authority (SMEDA), many small businesses continue to face considerable challenges.

After reviewing hundreds of SME financing proposals over the years, one theme consistently stands out: potential is not the problem — access is. Many businesses struggle to scale due to obstacles such as limited credit access, weak legal frameworks, and insufficient enabling infrastructure.

Small businesses account for the majority of private sector activity but receive less than 7pc of private sector credit, one of the lowest ratios in South Asia

Access to capital remains a persistent barrier for the sector. SMEs account for the majority of private sector activity in Pakistan but receive less than 7pc of private sector credit, one of the lowest ratios in South Asia. The core issue lies in how “bankable” businesses are defined.

Traditional lending models in Pakistan are collateral-based, meaning banks prefer assets such as titled land or property. However, most SMEs operate from leased premises, home setups, or shared spaces — meaning their largest assets, such as inventory, receivables, and talent, don’t qualify as acceptable collateral.

Take the example of Ali, a furniture exporter from Gujarat, who landed a sizable export order from a UAE client, with an upfront partial payment and healthy profit margins. Yet, when he applied for a Rs10m loan to fulfil the order, he was denied as he didn’t own a property in major cities like Lahore or Karachi. Despite a strong business case and verified buyer, the exporter couldn’t meet the rigid collateral-based requirements of a traditional lending system. Ali’s story, however, is not unique. Many businesses with real potential are being held back not by a lack of demand, but by outdated lending norms.

Banks are waking up to the reality that the SMEs need far greater support — and that their financing struggles have gone unaddressed for far too long. What’s needed now is a broader shift in how we assess creditworthiness. It’s time the entire industry moved towards expanding cash-flow-based lending, where financing is tied to a business’s revenue stream rather than physical assets alone.

Additionally, expanding credit guarantee schemes, where risk is shared between the bank and the SME, can encourage more lending to this vital sector. Institutions such as the Pakistan Credit Guarantee Company continue to play a key role in this area, but a wider adoption of these models is crucial for SME growth.

Another challenge the SME sector faces in Pakistan is the weak legal enforcement and recovery framework. Even when banks are willing to lend, recovering loans from SMEs is often a painful process. One of the core issues is Pakistan’s weak foreclosure framework, which allows defaulters to delay or avoid repayment, discouraging banks from increasing their SME exposure.

A key element in this story is Section 15 of the Financial Institutions (Recovery of Finances) Ordinance, introduced in 2001 to allow banks to recover collateral without going through drawn-out court procedures. It aimed to speed up loan recovery and reduce the risks of lending. However, in 2013, the Supreme Court struck it down, stating that foreclosure without judicial oversight violated Article 10-A of the Constitution — the right to a fair trial. For the next three years, banks operated without a clear legal pathway to recover collateral. This legal vacuum severely impacted SME financing, as lenders grew wary of the risk.

In 2016, Section 15 was reenacted by the government, with a few amendments providing the right to a fair trial to customers, as per the spirit of Article 10-A; however, the same was immediately challenged before the higher courts. The Lahore High Court upheld it in March 2020, and in October the same year, the Supreme Court dismissed appeals against it. This reaffirmed banks’ rights to foreclose on collateral.

However, in practice, recovery remains slow and uncertain due to court delays, frivolous litigation, and a lack of enforcement. Legal ambiguity continues to paralyse the very purpose Section 15 was meant to serve.

A real-life example illustrates the problem clearly. A textile SME in Faisalabad defaulted on a Rs50m loan. The lending bank initiated recovery under Section 15, but the borrower filed a false claim of repayment and secured a stay order. Over the next four years, the case remained stuck in court while the borrower moved assets and continued operations under a different name. The bank eventually absorbed the financial loss and, unsurprisingly, reduced its future SME lending. This is not an isolated case — it reflects a broader pattern across the financial sector.

To address this issue and unlock SME financing, targeted legal reforms are essential. First, stay orders should be time-bound — limited to two to three months unless there is a compelling reason to extend. Second, courts must ensure both parties are heard before granting a stay, to prevent misuse. Third, fast-track procedures should be introduced with fixed timelines for collateral auctions. Lastly, tax incentives should be offered to auction buyers by removing or reducing the seller’s tax liability, increasing participation and speeding up asset realisation.

Unless these reforms are implemented, banks will continue to avoid SME lending, depriving the economy of its most dynamic growth engine. Fixing the foreclosure framework is not just about protecting lenders, it’s about creating a healthier, more inclusive financial system for Pakistan.

The future of Pakistan’s economy will be shaped not in boardrooms but in workshops, warehouses, and small offices across the country. If we want truly inclusive and sustainable growth, empowering SMEs is not optional — it is essential.

The writer is the President & CEO of JS Bank and a member of the Steering Committee of the Pakistan Banking Summit – an initiative of the Pakistan Banks Association

Published in Dawn, The Business and Finance Weekly, August 18th, 2025