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19/01/2011 23:39:00

Can credit rating be panacea for the

SME industry?
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by Ashek Ishtiak Haq

ACCESS to finance has always ranked high in any survey that tried to find out the key hindrance to the
development of small and medium enterprises. Inability to access finance may be one of the reasons
why we do not see a robust correlation between SME prevalence and economic growth, says the World
Bank. A MIDAS survey in 2004 found that only 18 per cent of the total funding for the SMEs is coming
from the banking channel. Numerous microfinance institutions have emerged to lend money to the
hardcore poor (whether it has done them any good is a debate we will not get into) and, at the same
time, large corporations continue to be pampered by a crowded banking industry. Although SMEs
consist of 90 per cent of all enterprises, provide employment for 87 per cent of the total industrial
labour force (40 per cent of total population), contribute 25 per cent of the total GDP (Tk 741 billion in
2003), it draws only 20.17 per cent of the total loan disbursed.
Bankers consider SME a profitable sector which records high in credit risk. Regulators on the other
hand think its a winning formula to create employment opportunity (a 2005 study by the World Bank
found that almost 48 per cent of employment in low-income countries is generated by the informal
economy and SMEs), eradicate poverty (SMEs provide three quarters or more of the household income
in both urban and rural areas in Bangladesh) and technology transfer. The regulators who generally
appear reticent to most of the issues have in fact adopted a more gung-ho approach towards the
development of SMEs. Efforts such as the establishment of the SME Foundation, creating a Tk 665
crore SME refinancing fund in the Bangladesh Bank (Tk 1,541 crore has been refinanced up to April
2010), adopting a SME Credit Policy (the central bank set a target to disburse Tk 240 billion worth of
loan for the SMEs), and opening up an SME department in the central bank are definitely laudable.
Banks have enough reason to enter these segments, because, through financing SMEs, they can move
into a huge untapped market, earn higher interest spread (six per cent), diversify their portfolio, access
refinancing facilities, realise the yield and growth potential, comply with the regulations put forward by
regulators, and earn CSR brownie points. However, SME financing is not a walk in the park as some
might have imagined in the beginning. The industry has its own challenges and peculiarity. The sheer

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size and the lack of information make it a daunting task for anybody to sort out the real, deserving
candidates from the unwanted ones. A clear-cut effort has not been made to identify the multiple needs
of the multiple segments. To cater to them a common practice is to design one size fits all products
which often appear wanting in fulfilling SME needs. The SME ecosystem presents unique demand on
the skill set of banks and financial institutions because of the assumption-based accounting practices
they need to adopt, increased dependence on close monitoring they need to implement, absence of
industry benchmarks necessary to properly analyze loan proposals, and lack of the information that
would have helped them form proper industry understanding. Because of the unstructured nature of
the business and lack of professionalism, most entrepreneurs tend to dip into the financing of the
business for personal use.
The greatest challenge for the financial institutions is to create enough ground for the SMEs to get the
loan, as they often fail to provide the much needed financial information that are needed to assess their
riskiness, credit needs, collateral requirements and other credit requirements. To overcome these
challenges, FIs have adopted their own method to assess the SMEs financial health. In the absence of
proper book of accounts, one common practice is to extrapolate the whole years performance (profit
and loss accounts, balance sheet etc) from some basic seasonal numbers. Another more conservative
approach is to depend wholly on the ventures bank statement to make credit decisions. This approach
is much better than the previous one because it is based on institutional data that is easily verifiable.
However, this makes loan procurement impossible for a new venture or for a venture that doesnt
maintain any bank account.
These factors not only lead to a harder access to finance regime but also increase the amount of nonperforming SME loans. In the absence of real data, lets assume that 20 per cent (same as the
percentage of SME loan compared to total loan) of the total FI industrys Non Performing Loan is
coming from SME. This means that, by a very simplistic assumption, SMEs contribution to the
industrys total NPL can be Tk 48.2 billion. SME credit rating can play a pivotal role in saving at least a
portion of this amount by identifying the level of real risk behind each SME case.
The concept of credit rating is quite common in the financial world, but the Bangladeshi SME
ecosystem is yet to open up to the idea. A credit rating estimates an entitys credit worthiness. It is an
evaluation made by a credit bureau or agency (one needs a license from the Securities and Exchange
Commission to operate an agency) by making a detailed analysis of the borrowers credit history. The
general idea is to run the financial data through an analytical model that delivers a risk matrix resulting
in an accurate assessment of the ventures risk level.
A credit rating by an independent agency has a lot of virtues. First, by decreasing the turnaround time
for risk assessment it will speed up the loan disbursement process. Second, the rating will reduce the
subjectivity associated with FIs internal credit assessment process. Third, it will enable FIs to identify
the key risk factors of a venture; facilitating the setting up of a relevant covenant and adopting right
credit enhancement measures. Fourth, basing on risk level, FIs will be able to reward an SME with

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lower interest rate or penalise it by increasing it. Fifth, it will provide a neutral, third-party and
unbiased opinion on the borrower. Sixth, a rating model that is dynamic enough to assess industrial risk
factors will churn out ratings that will serve to mitigate not only business risk but also industry-specific
risk. Seventh, it is possible to gear up the model to assess location-specific risk factors, enabling it to
mitigate geographical risk. Eighth, the benchmark set for each sub-sector by the agency will help shed
some light on the data vacuum in which the FIs have to operate. Ninth, the authentication of the SMEs
key documents by the rating agency will save FIs time and effort. Tenth, the rating will help FIs to
simplify their lending norms.
Benefits of SME credit rating do not end with the FIs; it has utility for the SMEs as well. For the first
time, with the aid of credit rating, SMEs will be able to shop around for better credit terms. SMEs with
good ratings will be able to enjoy a relaxed collateral requirement and will find it easier to raise
adequate capital. Through a comprehensive rating report, SMEs will be able to find out the
shortcomings in the business model and take corrective measures. The rating will immediately enhance
the SMEs credibility and acceptance among the FIs. It will help them to gain the trust of the
international trade community and will also make the enlistment with the
customers/vendors/lenders/investors much easier.
SME focused credit rating agencies are operating successfully around the world (DP Credit Rating
Singapore, Credit Bureau Malaysia etc). One bright example is the SME Rating Agency of India
Limited, jointly established by Small Industries Development Bank of India, Dun & Bradstreet India
and several leading banks. This award winning agency is Indias first rating agency to focus solely on the
Indian Micro, Small and Medium Enterprises segment. So far SMERA has given rating to 8,200
MSMES.
By signing the BASEL II regime, Bangladesh Bank has clearly agreed that a bank has to keep 125 per
cent provision for loans without credit rating versus only 50 percent for rated firms. So in future rating
of SME will be a reality that everybody has to adhere by. However, if credit rating becomes mandatory
for SMEs, it will impose additional cost on them. Considering the cost saving it can bring for the
industry, regulators (the government, SMEF, industries ministry etc) may contemplate subsidising the
fee for the SMEs (for example, the government of India initially bore with the aid of the foreign
donors 75 per cent of the SMEs rating fee). SME rating has utility that no one can deny and, to ensure
the necessary evolution of the SME ecosystem, it has to be introduced in a comprehensive manner with
proper regulatory support.
____________________________
Ashek Ishtiak Haq is an analyst with a masters degree in business administration from the Institute of
Business Administration at Dhaka University and currently enrolled for the level 2 exam of CFA.
ashanto123@yahoo.com.

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