FUNDING AND INVESTMENT
Credit Concerns in Financing Indian SMEs
May 29, 2007
N. Sivaramakrishnan, Smaran RiskAnalytics Consultancy & Training

Indian banks are becoming increasingly aware that they must ensure consensus among credit analysts in identifying major challenges and credit concerns in financing the growing small and medium-sized enterprises in India.

In the absence of an approved definition of small and medium-sized enterprises (SMEs) from the monetary authority until 4 April 2007 (since defined to include micro enterprises), the term SME had been understood differently by different credit professionals and banks in line with individual bank's credit policy documents. Also, some banks have been continuously amending their definition and classification of SMEs, with a view to widen their SME space and to ensure increased credit off-take and market share. This has recently given rise to a significant growth in credit to SMEs, who in turn have an increasing appetite for credit risk.

To some extent, this practice helped some key players remain ahead of their competitors in the SME credit markets. The outcome of such developments over the past couple of years has forced banks, credit professionals and credit analytics firms who act as advisers to banks, to reclassify SMEs based on multi-dimensional parameters that vary across different business and asset classes, balance sheet size, sales turnover and growth trends and net worth of business entities. Sometimes, this reclassification was further differentiated by the nature and amount of credit limits enjoyed by SMEs under different banking systems.

Due to various, bank-specific definitions of SMEs and the variation in qualitative and quantitative data across banks, the phenomenal business and credit growth in SMEs is difficult to quantify. However, a positive note is that banks are now more accepting of the unique characteristics of SMEs, which are broadly identified by low capitalisation, limited recognisable assets, geographical diversity, short business lifespan, poor access to capital markets, huge cash intensity in transactions, absence of dependable credit information/history and other internalised issues of promoters, to enable reasonably good credit decisions, poor financial disclosure on tax and other business issues, high credit risk perceptions coupled with high borrowing cost, low concentration on financial and non-financial activities and slow acceptance of changes through technology-based solutions.

SME Credit Process

The issues above demand solutions from credit analysts who otherwise look for a perfect set of information on such client's financial and non-financial status to aid credit decisions. However, a problem of information asymmetry between clients and credit analysts exists and the latter is always at a disadvantage, leading to a credit decision being made with an imperfect set of financial data. Normally, credit decisions are based on clients' historical, actual and projected financial statements using a lot of assumptions. Sometimes, these assumptions may look simple and rational, but they are often incorrect. In a scenario where an information asymmetry exists between the clients' data and the bank's, mainly in respect of treatment of such asymmetrical information, credit analysts have to prepare their database perfectly to facilitate a reasonable and acceptable credit decision. Though all efforts are taken to synchronise the information, further measures such as integrity checks and intelligent traps are required. These may lead to a poor credit call and prove costly, if not analysed properly. It is usually believed that in such credit processes, an error in analysis and its inspection has a far more negative impact on the bank's credit book than other areas.

However, it must be understood that credit decisions are the reflection of a personal judgement about the client's ability to service and repay the loan. It is our decision and we must be comfortable with it, according to our judgement. Though guidelines and credit process flow are well defined in every bank, a credit decision cannot solely be based on these processes or analytic techniques at all times. Every credit analyst needs to exercise common sense and good judgement.

Challenges of SMEs

Studies reveal that the 4.5 million Indian SMEs account for about 40% of the country's industrial output on average. They also indicate that, with the consistent growth in bank credit to SMEs, SMEs are more optimistic about India's economic growth compared to SMEs in other emerging markets in the Asia Pacific region. Indian SMEs are an instrumental part of the growing Indian economy. However, it is estimated that SMEs in India generate about 70% of total industrial pollution, based on the report Strengthening institutions for sustainable growth: Country environment analysis for India, by the World Bank. Recognising the existence of the enormous growth potential of SMEs and the inevitable growth in social and economic factors such as employment, banks are aggressively driving themselves more into SME financing, notwithstanding the environmental issue.

Some critical challenges based on recent lending experience and various empirical studies conducted by many banks before they launched SME financing models, and a few suggested workable solutions to meet these challenges are given below:

No.	Challenges	Suggested workable solutions
1	Vulnerable to market fluctuations and low transaction values	Build up linkages with large corporates, growing niche markets, high vintage, liability led relationships
2	Low capital base and absence/low transparency in transactions	Collateral based lending Corporate comfort Identify top leaders in growing sectors using credit proxies
3	Existence of high cost credit and need for faster resolution of issues - fast turnaround time (TATs)	Use credit scoring models Programme based lending for each SME sector Umbrella finance models Parameterised credit granting models based on validated parameters relevant to each SME business segment Restructuring existing credit granting powers to ensure less TATs
4	Personalised relationship, due to resistance or ignorance or poor understanding of high technology based banking solutions	Develop clusters within SMEs to ensure timely, need based and apt technology based end-to-end solutions Set up pool of personal relationship managers for each cluster at all bank locations
5	High cash intensity based transactions	Target liability products Cross-sell of products, pricing cash pick-ups, credit card products, etc.
6	Need to include qualitative market inputs	Design credit scoring model (short/medium term) with proper weights for quantitative and qualitative factors governing all SME segments
7	Control on distribution cost	Centralised operations to ensure economies of scale
8	Need for close monitoring of account and business operations	Set up centralised operation, credit monitoring and collateral management units with sound solutions backed software

Credit Concerns in SME Financing

Apart from the importance of need-based solutions, as listed above, it is now believed that there is understandably a more convincing level of consensus among banks, credit professionals and credit analytics firms, in their views with respect to a few major credit concerns in financing SMEs. Such concerns are summarised with a view to emphasise the need for a healthy SME credit portfolio.

Ensure a proper credit rating and evolution methodology:

• Ability to evaluate credit risk of a particular SME segment, such as a credit risk differentiation process for various credit exposures to large, medium and small scale business segments.
• Structure all low rated (for example, triple-B) SMEs into a separate pool and fund them as a whole with some parameterised schemes which may reduce probability of default (PD) rate - important in Basel II set up.
• Complexity of market - it calls for a deeper understanding of the market dynamics on a continuous basis.
• Poor understanding of SME business, such as: "Are we funding the right type of unit?" - subject credit units in banks to credit quality tests through the development of modules for asset quality tracking.
• Empower credit decisions at the front end (credit manager) levels to speed up needy and timely credit delivery.

Segmentation and credit processes:

• Time and resource allocation for the credit granting process consumes a large share, disproportionate to the value added by this segment. In this case, adoption of six sigma strategies may render a solution. Alternatively, establishing pre-approved credit limits to certain categories of clients whose risk profile may qualify for such facility may ensure faster TAT.
• Lack of co-ordination between various decision-making verticals within the bank. Individual banks can easily address this by streamlining the credit process flow.

Market/environmental sensing and information:

• Absence of an effective credit information bureau to track client history and hence, business leads are dependent on transaction history from an internal database, if any exists and/or data flow from corporate banking and cash management services groups for dependable business leads.
• Huge attrition rates among middle and junior level credit managers leave the entire asset portfolio at the hands of new inexperienced incumbents and affect the established rapport and confidence level with SMEs - a human resources (HR) issue to be tackled.
• Need to capture learning from the lending experience in the system for the benefit of banks and credit managers. This will help restructuring, even product lines specifically designed for SME segments.

Exit strategy:

• The lack of coordination in the credit and documentation processes between banks and markets. This calls for a change in internal metrics to benchmark market needs and also setting up building blocks for buy/originate/hold/sell-down strategies where warranted and timely action thereof.

Portfolio refining approach:

• Internal policies on SME lending are to be robust enough to ensure that the conceptual framework is free from ambiguity. There needs to be some experimentation and stop-loss-approach based guidelines to finance SMEs with emphasis on sound understanding of their business and revenue models and lesser dependence on collaterals.

Conclusion

Of all the credit concerns in lending to SMEs, it is important to remember that there has been a shift in credit culture in Indian banks' lending - be it to SME or to large industrial clients. Increasingly, banks, as well as clients, have equipped themselves with sound knowledge on global best credit practices and principles and this has resulted in a noticeable paradigm shift from the earlier existing traditional defensive conservatism to an acceptable level of responsible aggressiveness in their approach to lending. This is expected to serve as a prelude to development of robust risk management practices that will undoubtedly be needed in future.

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