Innovative strategies to finance SMEs

Monday, August 9, 2010, 18:08
Latest News
1 comment

By Souren Ghosal,

Microfinance Focus, August 09, 2010 : Small and medium enterprises (SMEs) are one of the largest employment opportunity provider next to basic industry i.e. agriculture. In India it generates more than 40% of value addition to the manufacturing industries and one third of our exports. In developed countries it would be interesting to note that its role is much higher and rewarding. For example in USA and Japan it provides 67% and 80% employment opportunities and contributes 61% and 72% to the manufacturing output in those countries respectively. It would therefore be interesting to make an in-depth analysis of funding these institutions as these institutions are generally promoted by individual and or family entrepreneurs with limited financial resources but endowed with rewarding innovative ideas and initiatives and therefore need external funding for survival and growth and unfortunately in developing countries they have very limited access to external funds and therefore most of these enterprises suffer and even close down due to high cost, inadequacy and abnormal delay they usually suffer in sourcing external funds.

It is not for nothing such neglect and hesitant behavior has been developed by the funding institutions for these enterprises. In fact these have happened due to:

Poor managerial and marketing skills usually associated with these enterprises;
Unusual vulnerability to market risk and consequent sudden mortality;
Lack of data base with regard to their operation, performance, strength and weaknesses and market volatility on regular basis;
Heavy transaction costs due to inability to access modern technology;
Very low margin as supply chain is not only inadequate but also exploit the high degree of dependence of these enterprises on middlemen operating the supply chain;
Most of them lack education and fund to upgrade technology and volatility of market.

Some Recent Innovations

It has therefore become imperative to address the above issues to make funding of SMEs attractive and user friendly. In recent years it is interesting to note that both governments as well as financial institutions of both developed and developing countries have initiated some positive and progressive measures to hold hands of small and medium entrepreneurs’ to access funds at a reasonable and affordable costs and without any usual hurdles. In fact these initiatives aimed at both reduction of cost of funds and risks associated with such funding. These initiatives could be summed up as follows:

Venture capital funding intuitions have been floated, often called as P.E, funds have been floated to induct fund at low cost, share the risk and to provide management and technology up gradation support to these enterprises;
Credit guarantee and credit rating agencies have been floated to support and empower lending institutions to shoulder the inherent risks unhesitatingly in funding these enterprises adequately and timely;
Innovative products and instruments have been introduced by the financial institutions to enable these enterprises to source fund at low cost and collaterals; and
Improved training modules and lending options have been constantly researched and introduced to make these enterprises more viable and attractive to make these enterprises more and more attractive and viable enterprises to lending institutions.

However despite such recent efforts an in depth analysis would reveal that SMEs still need some more holding hands to be groomed as enterprises that would lead the financing institutions to compete with each other to fund these enterprises as funding these institutions would enable them to earn revenue safely and steadily. In this regard it would be interesting to comprehend some of the existing gaps that have deterred the funding agencies to become aggressive and competitive funding institutions of SMEs. These gaps are as follows:

Funding modules are not developed wherein delivery and amount of funds are not linked with time of needs and growth of these enterprises;
Funding institutions are not prepared to assume the role of partners of these enterprises to share their risks and provide much needed management support at least in their fund management if not for other areas of management ;
Non availability of database to study the inherent risk patterns of these enterprises and inadequate market intelligence that deters these institutions to take timely steps and strategies to offset the impact of market volatility;
Non availability of appropriate market for these enterprises to source equity and debt funds at competitive price.

It is therefore obvious that there is need to bring out some radical changes both in policies, practices and procedures as well as in strategies, structures and stimulus to be imbedded in the financial institutions and financial markets to enable these enterprises to have access to fund, management and market support to achieve robust growth. In this regard following innovative changes need to be adopted by the funding agencies of SMEs.

SMEs need to develop a partnership with funding agencies like micro financing institutions, and or banks to share risk and participate in management and marketing.
A specialized capital market need to be developed to help SMEs to float equity and debt instruments;
Evolve a digital smart card to enable SMEs to access fund as and when they need;
Build market intelligence kiosks at convenient places to assist SMEs to update their market intelligence and accordingly regulate production, price and product supply chain including up gradation of technology to match the changes perceived in design and fashions etc.;
Creating institutions and products to enable securitization of SMEs debts and enhancing their capabilities to have access to liquidity as and when needed;
Developing derivative markets to hedge their price and currency risks.

In recent years some initiatives have already been taken by government of India and commercial banks to facilitate funding SMEs by creating credit rating facilities to classify these enterprises on the basis of risk and thereby enabling banks to assess risk in such funding in advance and accordingly fix more flexible terms and conditions for lending these enterprises. Similarly VENTURE CAPITAL funding institutions have also been floated to assist SMEs to assume risk with their support. Further commercial banks have been encouraged to lend to SMEs on the basis of the feasibility and viability of projects rather than appraising them on the basis of collaterals offered for such loans. These are obviously healthy move but much more needed to be done particularly in re-engineering lending strategy. It would be necessary to

Introduce transaction lending technology;
Develop relationship lending methodology; and
Adopt sharing and partnering policy with borrowers.

It is true that these innovative strategies could be introduced gradually as it would need to build appropriate financial, production and marketing environment for enabling SMEs to develop more sustainable model to grow and develop management and marketing expertise and introduce upgraded technology to become more productive with improved quality and enhanced competitive strength. In this regard it would be needless to say that Indian government and financial institutions have to traverse miles to reach the desired goal as has been enumerated above.

In fact in this regard it would be helpful to undertake a study of a very illustrative and educative model developed by JAPAN. In fact much could be learnt from JAPAN as it has been able to respond to the needs of SMEs very successfully and therefore SMEs have grown over there over the years with vision and profit. The policy that has been adopted by JAPAN to give boost to SMEs could be summed up as follows:

It has helped financial institutions to adopt a lending policy on partnership model with additional support of providing the facility of securitization to maintain their liquidity intact and to transfer a part of their risk to other institution;
It has also developed database to assist SMEs to assess both financial and market risks and do away with the present practice of depending on asymmetrical data available from diverse sources; and
It has made arrangement to assess on regular basis the impact of policy changes and also to comprehend problems faced by SMEs from time to time. These studies reveal some of the hard facts that need to be addressed by policy makers to facilitate financing institutions to develop appropriate strategies to counter such issues that are found hindering the growth of SMEs. For example one such studies revealed that SMEs in JAPAN with low return on assets and poor equity ratios have been paying high rate of interest and consequently defaulting and ultimately languishing, these studies have also revealed that adaptation of change in policies as has been highlighted above have impacted well as these have enabled them to source fund at competitive rates and sharing and transferring risks with the financial institutions as and when considered necessary to improve their liquidity and reduce their risks. In fact it has now a proven fact that lending based on collaterals and personal guarantees of entrepreneurs are more risky and therefore need to be replaced by the newly developed strategy that takes into consideration the viability, feasibility, competence and market accessibility of the venture rather than collaterals and personal guarantees as per conventional method of lending. In fact policy emphasis now is to develop relationship banking instead of seeking collaterals and guarantees. Further in JAPAN the credit guarantees offered to SMEs have worked wonder to give boost to financing of SMEs. These studies have also revealed that entrepreneurs need to be assisted in developing viable business enterprises keeping in view their capability and vision as well as passion. Most of the entrepreneurs have the capacity and vision to develop innovative business but in general they lack the capability to translate and implement these as feasible and viable projects. It would be therefore imperative for financial institutions to assume the role of a development bank and assist the entrepreneurs in developing feasible and sustainable project.

This would necessarily need to develop partnership model that would create virtually a partnership of entrepreneurs and banks. The partnership concept would take care of sharing of risks in proportion to their respective financial involvement. Further if it is extended further it would help borrower to source fund at competitive rate if not concessional rate. In fact such partnership would do away ultimately the practice of charging interest on loan as there could be an arrangement of sharing of revenue. In fact this is already in vogue in Islamic banking.

It is obvious therefore that there is dire need to create constantly value addition in delivery model of capital and equity to SMEs. The innovations adopted by JAPAN are worth emulating by India and all other countries that heavily lean on SMEs for their export and GDP growth. In fact banks have no other alternative but to develop innovative models for inclusive growth as recent global financial crisis has mirrored the misery of globalization ignoring inclusive growth.