Lending for the SMEs
The View From Taft
September 20, 2001
The classical role of finance in economic theory is to bridge the gap between those with excess funds, the savers, and those with excess opportunities, the borrowers. The financial infrastructure of the country is intended to transfer resources so that the economy as a whole is far better off, with funds being channelled to good opportunity investments beneficial to the population.
The infrastructure comes in two forms, financial intermediaries and the financial markets. The first group is made up of banks and other credit institutions while the latter is the securities market. Ideally, these two agents must be well-formed so that both internal competition as well as the market versus intermediary interplay lead to the best use of resources. However, many developing countries, the Philippines included, have an imbalanced infrastructure where banking and other credit institutions are dominant.
The superior position of banks in mobilizing savings gives them a primary role in the allocation of credit to investment opportunities. For practical considerations, therefore, while it seems idyllic to exert effort in inducing a more developed capital market, the priority approach to address problems in funding investment opportunities is by improving the role of financial intermediaries.
This problem of funds flow is all the more aggravated in the case of small and medium enterprises (SMEs). We have witnessed a litany of complaints from SMEs on the difficulty of obtaining loans from banking institutions. And when loans are available, the complaint is either high interest rates or lack of collateral acceptable to the financial intermediaries.
The bias against SMEs can be attributed to many reasons. One major reason is the risk perception of small borrowers. There appears to be a so-called "lemon gap" where the level of risk associated with the riskiest small business tends to be applied to all small businesses.
Another reason is transaction cost. Banks complain that the same costs are incurred to credit-investigate, review and document a Php10 million loan and a Php100,000 loan. The earning potential of the bigger loans thus makes the anti-SME bias natural.
As a result, government is being engaged on to intervene in behalf of SMEs. A recent news article, for example, cites a major business group asking government to find ways to reduce interest rates charged to SMEs. It also asks government to make it easier for SMEs to obtain loans.
And there lies the bigger problem. The supply-demand situation for funds to SMEs is the result of a systemic situation. The finance players are acting in a rational, logical way, in accordance with the merits and demerits of the incentive structure between fund providers and potential users. In truth, there are no villains here but market participants dancing the way they do because the tune calls for it.
The solution is to look for the hero's intervention. We want government to lower interest rates. We want government to lend directly to SMEs, and at a lower costs. In short, we want direct government intervention in the form of subsidies to small firms. Sometimes, said intervention works but, often in an unsustainable way.
It is about time our solutions attack the overall finance infrastructure. In the language of economists, we ought to work on deepening and broadening the financial sector and give special attention to our SME clients. Deepening means increasing the financial assets available to our sector. Broadening means building and increasing the number of participants and instruments for our SMEs. Together, the two set a new dance for our financial infrastructure.
The objective of such a systems approach is to promote domestic capital formation and to allocate the same to the most economically and financially productive borrowers. This means we need to prove and demonstrate that SMEs are indeed productive for only in so doing can we reduce the "lemon gap." The bottom line is that we must be able to show that lending to SMEs is profitable.
The components of a strategy for developing the financial infrastructure for SME lending would include:
|Lowering the transaction costs, including innovations in the lending process, consisting of credit review, evaluation, inventory, collection and payment.|
|Reducing the perceived risks in the appreciation of SME loans by minimizing the asymmetry of information. SME borrowers know about their ability and willingness to repay the loan more than the lenders. This translates into improving transactional efficiency, where access to information is enhanced through rating agencies and incentives for the SMEs to improve their data gathering and accounting systems.|
|Reviewing public policy and regulations that discriminate against small businesses or that increase the fixed costs of certain transactions, thereby providing competition disincentives against small firms. A good example would be government procurement procedures to make bidding accessible to SME firms.|
|Strengthening the capacity of private financial institutions to evaluate SME credits at least cost through technology transfer as well as policy incentives.|
|Promoting the development of well-funded guarantee agencies, which should be able to operate within the laws of large numbers to engage in more risk than normal.|
|Encouraging technology development and learning diffusion through systems that serve to educate the formal finance sector about the inherent benefits of profitable, and therefore, sustainable SME loans. If the private sector can increase its exposure and improve its understanding of its deals with SMEs, it should be able to find the inherent attraction in maintaining SMEs as part of the normal loan portfolio.|
In other words, government's role must be to create the necessary conditions for the success and inherent attractiveness of SME lending. Government must address both environmental (thus macroeconomic and structural) adjustment and the improvement of institutional constraints in order for small firms to get sufficient attention. The overall objective must be to allow the number of SME-oriented financial institutions to flourish. Ultimately, the intervention will work only if the market itself begins to appreciate that moving funds to SMEs represents the best use of the economy's savings.