Introduction

1.1 Origin of the Report:
In recent days the Small and Medium Enterprise (SME) Financing has become an important area for Commercial Banks in Bangladesh. To align its corporate policy with the regulation of Central Bank, banks have become more concerned about SME and opened windows to conduct business in this particular area. This study has been conducted to fulfill the requirements of sixth term MBM program and gain an insight about the present condition of small and medium enterprise in the economy of Bangladesh and their financing scenario in light of Bangladesh Bank regulation.

1.2 Background of the Study:
After Liberation of Bangladesh, intensive efforts were undertaken to accelerate the rate of industrialization in the country. At the beginning, import substitution and subsequently export-led economic growth strategy was pursued for industrialization. In order to attain this objective, large amount of industrial credit was funneled to the industrial sector. But the whole exercise of industrialization came to a halt with the massive diversion of resources to other non priority sectors. Policy makers, of late, have come to recognize the contribution of SME sector towards economic development in the country. Small and medium enterprises have been recognized as one of the most important means for providing better economic opportunities for the people of least developing countries like Bangladesh. A developing economy like that of ours suffers from many peculiar problems such as disproportionate pressure of population on agriculture due to lack of rural industrialization, unemployment and underemployment of human and materials resources, unbalanced regional development etc. The contribution of small and medium enterprises in the solution of these problems is beyond doubt, provided they are organized and run on scientific basis. Small and medium enterprises are particularly suitable for densely populated countries like Bangladesh where SME sector can provide employment with much lower investment per job provided. Out of 11% employment of the civilian labor force provided by the manufacturing sector, about two thirds are estimated to be provided by the small and cottage industries sector. Again, development of small industries facilitates the effective mobilization of capital and labor resources. They also help in raising standards of living

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of people in rural areas. Contribution of SME sector to GDP remained above 4% during the period from 1985-86 to 1999-00. Moreover, the present contribution of SME sector to GDP is approximately 5% and SME sector employs 25% of the total labor forces, thus this sector is the present available sector for creation of jobs (Saha, Sujit R. 2007). Research papers developed by Bakht, Zaid (1998) and Ahmad, Salahuddin et al. (1998) described that the policy environment within which SMEs in Bangladesh operate accompanies legal, regulatory and administrative constraints to employment creation by SMEs. The robustness of SME contributions to employment generation is a common phenomenon in most developing countries in that the magnitude varies between 70% to 95% in Africa and 40% to 70% in the countries of the Asia-Pacific region (Ahmed, M.U. 1999). Liberalization of industrial and trade regimes along with globalization are likely to have had significant effects on Bangladesh’s SMEs (Ahmed, 2002; Bhattacharya et. al., 2000). Various recent studies (Ahmed, M.U. 2001, ADB 2001, USAID 2001) show that SMEs have undergone significant structural changes in terms of product composition, degree of capitalization and market penetration in order to adjust to changes in technology, market demand and market access brought by globalization and market liberalization. The official data show that the share of private investment in Bangladesh’s GDP in the late 1990s, which may be considered as the post-reform era, has remained more of less constant at around 15% (Bhattacharya, 2002). This may be interpreted as an evidence of stagnant private sector activities in the country. The recent private sector survey estimates the contribution of the micro, small, and medium enterprises (MSMEs) is 20-25% of GDP (Daniels, 2003). While SMEs are characteristically highly diverse and heterogeneous, their traditional dominance is in a few industrial sub-sectors such as food, textiles and light engineering and wood, cane and bamboo products. According to SEDF sources quoted from ADB (2003), food and textile units including garments account for over 60% of the registered SMEs. Despite these contributions in the economy of the country, Banking sectors are not interested in financing the small and medium enterprises; rather there is a decline in the amount of advances by the Banking sector. There are approximately 52 Banks operating

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in our country and all are serving large enterprises rather than SMEs though only the small enterprise’s contribution is 5% in GDP of Bangladesh in 2007. But why? What are the causes for which Banks are not interested in financing this sector? From recent statistical data of Sonali Bank of Bangladesh, we see that the credit recovery rate is 51.44% in this sector. Why this recovery rate is not large enough? Why the SMEs are failing to payback their credit to the lenders? We have tried to find out the answer of these questions in this research paper.

1.3 Objectives of the Study:
Based on the above discussion the following objectives are set for the study : • • • To review the role of SMEs in the economy as well as current status of SMEs and their financing by Banks in Bangladesh. To find out the reason why the Banks are not interested (problems) to finance the SMEs. To review the present role of Regulatory Authorities in SME financing and development.

1.4 Methodology of the Study:
The study was conducted mainly based on secondary information although some information relating to entrepreneurs have been collected primarily. The sources of data include Office Records, BIBM - Library, Different Research Paper regarding SMEs, Different Publications on SMEs of different banks and some websites. Sample banks of DNCBs, PCBs, and FCBs from the sample frame, was selected purposively considering the amount of loan size, interest rate, loan processing fees, period of loans, mode of finance and management. Policies relating to SME financing such as fiscal policy, monetary policy and internal policies of commercial banks was examined thoroughly with a view to find out the influence of existing policies on SME financing. Trend and pattern of bank financing to SME was analyzed by classifying the financing in terms of areas, rate of interest, types, category, and banks.

1.5 Limitations of the Study:
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Since this research is only for academic purpose, there were some limitations in this study. These are mentioned below: 1. Discussion about the Small and Medium Enterprises is a vast subject, but only some selected areas are covered in the research paper. 2. The study is basically based on secondary data. 3. Time was enough but it was not possible to give full concentration in this regard due to continuous pressure from other courses.

1.6 Organization of the Report:
This paper is divided into ten chapters. The first chapter is the introduction of the report. The second chapter focuses on the current status of SMEs in the economy. The third chapter explains the current status of SME financing by banks in Bangladesh. The fourth chapter explains why banks are not interested in financing the SMEs. The fifth chapter shows minimum requirements for SME financing according to Bangladesh Bank. The sixth chapter contains prudential regulations for SME financing by Bangladesh Bank. The seventh chapter shows guidelines by Bangladesh Bank for SME financing. The eighth chapter describes other developmental activities for SME financing. The ninth chapter explains constraints of SME financing. The last chapter contains the concluding remarks of the report.

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Current Status of SMEs in the Economy
2.1 Brief Macro-economic Review:
Bangladesh, mainly backed by the growth of manufacturing, construction and service sector has achieved a year-upon-year GDP growth of 6.51% in 2006-07, as compared with the 6.63% in FY 2005-06, and 5.38% in 2004-05. Per capita GDP recently surpassed $500. From 1% during the 1970s, growth rate of GDP per capita has ramped up to over 3% since the early 1990s and, since 2003-04, even higher, to 4 off percent. Growth has been more stable too; Bangladesh among the handful of countries that sustained positive per capita growth in each year since the early 1990s. This performance has been underpinned by rising agricultural and non-farm rural output and a rapid expansion in export of readymade garments (RMG). Faster economic growth has helped Bangladesh to reduce the poverty rate by about 1 (one) percentage point per year since 1990. Poverty fell from 60% in 1990 to 50% in 2000. Although the latest poverty data are still being collected, proxy indicators suggest that good progress on poverty reduction and social development has continued in recent years. Many MDGs are also on track for being met. (World Bank 2005) The rate of gross investment in GDP in 2007-07 is 24.33%. The relative share of private sector in gross investment, which has been growing secularly, is 18.73% in 2006-07. Between 2005-06 and 2006-07, credit to the private sector grew by 11.2%. The population growth rate averaged 1.5% or so; the literacy rate has averaged at 62% during this decade. Growth rate of manufacturing output of Bangladesh is on an increasing trend. Manufacturing growth during 1992-96 averaged 8.21%. In the next four years, the corresponding growth averaged more than nine percent annually. Service sector grew at an average rate of 4.9%, which is lower than that of industries (manufacturing) sector. The quantum index of SMEs has grown by 5.4%. The export of readymade garments (RMG) both woven and knitwear has picked up a commendable mode of growth, which earns over 76% export earnings.

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2.2 Current Status of Small and Medium Enterprises in Bangladesh :
The Small and Medium Enterprises worldwide are recognized as engines of economic growth. The commonly perceived merits often emphasized for their promotion especially in the developing countries like Bangladesh include their relatively high labor intensity, dependence on indigenous skills and technology, contributions to entrepreneurship development and innovativeness and growth of industrial linkages.

2.2.1

Definition :

According to the latest circular of BANGLADESH BANK (Date – 26/05/2008), the definition of Small & Medium Enterprise sector is given below:

Small Enterprises – Small enterprises refer to those enterprises which are not any
Public Limited Companies and which fulfill the following criteriaService Concern - Having an investment of Tk. 50,000 to Tk. 50, 00,000 excluding land & building and / or employing up to 25 workers. Business Concern - Having an investment of Tk. 50,000 to Tk. 50, 00,000 excluding land & building and / or employing up to 25 workers. Manufacturing Concern - Having an investment of Tk. 50,000 to Tk. 1,50,00,000 excluding land & building and / or employing up to 50 workers.

Medium Enterprises – Medium enterprises refer to those enterprises which are not
any Public Limited Companies and which fulfill the following criteriaService Concern - Having an investment of Tk. 50,00,000 to Tk. 10,00,00,000 excluding land & building and / or employing up to 50 workers. Business Concern - Having an investment of Tk. 50,00,000 to Tk. 10,00,00,000 excluding land & building and / or employing up to 50 workers. Manufacturing Concern - Having an investment of Tk. 1,50,00,000 to Tk. 20,00,00,000 excluding land & building and / or employing up to 150 workers. SMEs in Bangladesh are also defined for purposes of industrial policies by Ministry of Industries (MOI). Historically, this definition has been in terms of fixed investment brackets, and a dual mode definition is in place, separate for manufacturing establishments, and service establishments. 6

According to the Industrial policy 2005, small and medium enterprises shall be categorized using the following definitions:

a. Manufacturing enterprise: Small enterprise – an enterprise should be treated as small if, in current market prices,
the replacement cost of plant, machinery and other parts / components, fixtures, support utility, and associated technical services by way of capitalized costs (of turn key consultancy services, for example), etc, excluding land and building, were to be up to tk. 15 million;

Medium enterprise - an enterprise would be treated as medium if, in current market
prices, the replacement cost of plant, machinery and other parts / components, fixtures, support utility, and associated technical services by way of capitalized costs (such as turn key consultancy services), etc, excluding land and building, were to be up to tk. 100 million;

b. Non-manufacturing enterprise: Small enterprise – an enterprise should be treated as small if it has less than 25
workers, in full time equivalents;

Medium enterprise - an enterprise would be treated as medium if it has between 25
and 100 employees.

2.2.2 Overview of the SMEs in the economy of our country:
There is a great interest in small and medium enterprises (SME) as a major plank of poverty reduction in Bangladesh. The government has formulated a comprehensive industrial policy 2005 by putting special emphasis for developing SMEs as a thrust sector for balanced and sustainable industrial development in the country to help deal with the challenges of free Market economy and globalization. Some data with a national scope that are pertinent to characterizing SMEs in Bangladesh as of 2001-2003 are presented in Table – 1. The highlight of this table is the following: There are some 78,440 private sector establishments of various sizes in Bangladesh with some 3.5 million workers employed in them. The urban Bangladesh accounts for some

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60% of units and 76% of employment in the private-sector enterprises. Rural Bangladesh accounts for the rest. 93% of all units in Bangladesh belong in the SME category, i.e. have between 20 and 99 employees. However, SMEs account for only 44% of the total employment of the enterprise sector. Private companies limited by liability account for strictly a very small proportion of the total number of SMEs in Bangladesh. Table – 1: Number of units and levels of employment in small and medium enterprises, 2001-03
(All numbers are in thousands)

Description No of units % Of total number of

Small 39.9 50.9

Urban Medium 3.17 4.0

Large 4.036 5.1

Small 29.0 38.1

Rural Medium 1.29 1.6

Large .88 1.11

Small 68.96 87.9

Total Medium 4.46 5.7

Large 5.01 6.4

units Employment 740.4 % Of total employment
21.14

211.5 6.0

1712.67 48.9

516.8 14.8

85.85 2.4

234.66 9 6.7

1257.2 35.9

297.4 8.5

1947.3 55.6

Source: BBS Census of Enterprises, 2001/2003.

Table – 2 shows the average employment per establishment within each of the small and medium classes for urban and rural Bangladesh in 2001/2003. The following results are worth highlighting. Let it be noted that these are weighted averages. First, the average employments per establishment for small establishments have values of between 17 and 20 workers across all industries. We find a similar a narrow range of between 65-69 employees for average employment size for medium enterprise.

Table – 2: Average head-count per establishment across Bangladesh’s industries, 200103

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(All numbers are in thousands)
Small Medium SME Large All

Food and Tobacco Textile manufacturing Ready to wear apparels Wood, leather & paper printing Chemicals and plastics Non-metallic mineral products Fabricated goods, electrical & means of transport Mining and manufacture Various personal services Education/healthcare All industries
Source: BBS Census of Enterprises, 2001/2003.

18.6 19.1 17.8 17.0 19.1 26.0 17.0 24.6 17.5 18.1 18.2

65.1 66.2 70.3 66.8 67.0 70.3 65.7 65.5 66.0 65.5 66.7

21.0 21.9 22.9 19.7 22.7 41.5 20.3 32.7 19.9 20.3 21.2

470.5 490.9 512.7 373.9 367.2 196.8 282.5 227.7 293.3 292.4 288.5

38.9 56.6 249.6 38.0 58.0 83.4 35.1 58.9 28.2 26.7 44.6

Table – 3 shows the percentage importance (in terms of both number of units and the employment level) of SMEs in the overall world of enterprises. The numbers of SME units predominate the numbers of large enterprises: typically more than 90% of all enterprises are in the SME class-class. However, the percentages share of SMEs in total employment controlling for the location is almost always less than for the number of units. Table – 3: The structure of “industries” in Bangladesh with respect to size of firms, 2001-03
(All numbers are in thousands) % Of establishments Small Medium Large % Of total persons employed Small Medium Large

Food and Tobacco Textile manufacturing Ready to wear apparels Wood, leather & paper printing Chemicals and plastics Non-metallic mineral products Fabricated goods, electrical & means of transport Mining and manufacture Various personal services Education/healthcare All industries

6.7 14.2 1.8 2.9 1.7 1.6 4.6 0.2 13.6 31.1 87.9

0.4 0.9 0.2 0.2 0.1 0.9 0.3 1.2 1.5 5.7

.03 1.2 1.7 0.2 0.2 0.9 0.3 0.8 0.8 6.4

2.8 6.0 0.7 1.1 0.7 0.9 1.6 0.1 9.3 12.6 35.9

0.5 1.3 0.3 0.2 0.2 1.3 0.5 0.1 1.8 2.2 8.5

3.1 13.2 20.1 1.4 1.7 4.0 1.7 0.2 5.1 5.2 55.6

Source: SME Cell, using data from BBS Census of Enterprises, 2001/2003.

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Table – 4 show that the relative importance of SMEs, both in terms of numerical importance of establishments or employment, in the context of all enterprises with employment size of exceeding 9 workers remains roughly similar across an urban-rural divide. The role of SMEs in production is therefore not affected by geography. Table – 4: Proportion of SMEs in enterprise population, and in employment, by administrative Divisions of Bangladesh, 2001-03
(All numbers are in thousands)

Divisions

Urban (% Of SMEs in the number of urban units) 93.8 93.7 95.3 93.8 96.6 95.7 94.8

Urban (% Of SMEs employment in urban areas) 61.2 54.2 65.9 59.1 68.6 69.4 63.1

Rural ((% Of SMEs in the number of rural units) 95.6 62.4 97.9 95.8 91.9 97.8 95.2

Rural (% Of SMEs employment in rural areas) 65.3 69.1 81.3 70.5 41.5 82.7 68.4

Dhaka Chittagong Rajshahi Khulna Sylhet Barisal All divisions

Source: BBS Census of Enterprises, 2001/2003.

Table – 5 shows the percentage structure of small and medium enterprises, taken separately, across a large number of industries. Like in the discussion of Table – 3, we again see the quantitative importance of food, beverage, textile manufacturing, nonmetallic mineral products among manufacturing sub-sectors as providing the basis for small and medium enterprises in Bangladesh. Once again, the importance of services is highlighted. Table – 5: Industrial structure of small and medium enterprises in urban and rural Bangladesh, 2001-03
(All numbers are in thousands)

Sectors

Proportion of small enterprises in the total Rural Urban enterprises enterprises

Proportion of medium enterprises in the total Rural Urban enterprises enterprises

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Mining Food and Tobacco Textile MFG Wearing apparels Wood products Tanning etc Paper and printing Chemicals and plastics Non-metallic mineral products Fabricate products Electrical equipment Mfg. Transport equipment Utility service Construction Trade Eaterties Transport and Communication Finance and Banking Real Estate

0.4 16.6 58.7 0.3 0.2 1.1 0.1 0.4 6.1 0.7 0.0 1.6 0.2 0.1 2.4 1.4 1.2 8.4 0.2

0.2 9.3 8.4 4.6 2.6 0.8 3.3 4.2 1.1 3.9 0.7 0.5 5.0 0.5 4.9 7.1 22.0 16.9 3.9

1.2 7.4 29.2 1.0 0.4 0.1 0.4 0.7 47.9 0.6 0.2 0.9 1.9 0.6 0.5 0.3 2.8 3.8 0.3

1.0 9.0 17.5 3.3 1.8 0.2 3.4 4.6 3.1 5.8 0.7 0.7 3.0 1.8 4.4 5.2 7.6 13.5 7.5

Source: BBS Census of Enterprises, 2001/2003.

2.2.3 Contribution of SMEs in the Economy:
In view of present economic development effort in Bangladesh the SME sector plays an important role. These are reflected in the following performance /activities of this sector: During the Fourth Five year plan, a total of 0.35 million jobs were created against the target of 0.4 million.

Contribution of SME sector to GDP remained above 4.5% during the period from 2000-01 to 2004-2005 despite decline in the amount of advances by the banking sector to this sector. SME sector employs 25% of the total labour force. As a result, this sector is the present available sector for creation jobs. SME sector help alleviate poverty, increase income level of rural people and promote agro-industrial linkage in Bangladesh. SME sector requires lower energy supply, lower infrastructure facilities and this sector imposes less environmental risk. They contribute towards better utilization of local resources and skills that might otherwise remain unutilized. 11

Small industries being labour oriented are capable of generating more employment. They are necessary to maintain and retain traditional skills and handicrafts. They are the only medium for diversification of rural economy and for peaceful and concurrent socio-economic development of all classes of people.

 

From the above discussion, we can say that SMEs are playing an important role in our economy in various ways.

Current Status of SME Financing by Banks in Bangladesh
3.1. Current Status of SME Financing by Banks in Bangladesh
The NCBs are disbursing significant amount of credit under various programs like Small Enterprise Development Project, Self-help Credit Program, Projects for Small Entrepreneurs, Special Investment Program and Agro-based Supervisory Industrial Credit etc. for the promotion and development of SMEs. The investment of private sector banks in financing SMEs remains insignificant in Bangladesh. Of all the private sector banks, BRAC Bank, Eastern Bank Ltd. (EBL), Prime Bank Ltd, Dhaka Bank Ltd, Mercantile Bank Ltd, Dutch-Bangla Bank Ltd, Islami Bank Bangladesh Ltd, IFIC Bank Ltd. have the leading role in SME financing. Bank of Small Industries and Commerce Bangladesh Ltd. (BASIC) is entrusted with the responsibility of providing medium and long-term loans for

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promotion and development of small-scale industries. The memorandum and Articles of Association of the bank stipulates that 50% of loanable funds shall be used for financing small scale and cottage industries. The outstanding credit of BASIC stood at Tk158.9 crore at the end of December 2001 for small and cottage industries sector that rose to Tk178.7 crore by 12.46% at the end of December 2002. Table-6 gives an idea of the role of small and medium enterprises as destinations for bank credit in 2004 and 2005. Bangladesh’s classification of bank advances lumps medium enterprises with the large enterprises, while small units are lumped with cottage-based units. As such, unfortunately, it is not possible to speak of the access to finance issues for SMEs per se. We know however separately that SCIs corresponds to more than 99% of all productive establishments in Bangladesh. Out of 3.8 million establishments of all kinds in Bangladesh, only 10,798, or just about 0.3% happen to fall in either medium or large establishment size class based on employment size. The percentage is even much lower in manufacturing or trade---the two sub-sectors from which the case studies in this paper are drawn. And yet, such staggering smallness of the proportion of medium and large establishments is coupled with a preponderance of large and medium enterprises in total credit disbursements from the banking system. It is quite safe to assume that of total credit disbursed to large-andmedium class, an overwhelming majority ---perhaps, 80% or so---is arrogated by large establishments. It becomes quickly clear that SMEs, for all their numerical superiority among establishments, receiving bank credit is the exception and not the rule. Why is the access to finance for the SMEs in Bangladesh not even based on neutral ground, not to speak of rosy or good? This is because the issue of bank credit is based on the ownership of collateral: bankers insist on immoveable property for collateral. Only about 15-20% of the owners of SMEs own any immoveable property at all in which the bankers are interested. This automatically excludes about 80% of SMEs from being among the privileged client of a bank loan. Table – 6: Percentage distribution of advances made by PCBs, FCBs and DNCBs in 2005 and 2004: By receiving sectors
(Numbers are percentages; last row shows the disbursements in Tk. crores)

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DENATIONAME OF SECTORS AND TYPE OF FINANCING PRIVATE COMMERCIAL Banks, 2005 PRIVATE COMMERCIAL Banks, 2004 FOREIGN COMMERCIAL Banks, 2005 FOREIGN COMMERCIAL Banks, 2004 NALISED COMMERCIAL Banks, 2004

DENATIONALISED COMMERCIAL Banks, 2005

Agriculture Large & Medium industry SCI WC large/medium industry WC for SCI Construction Transportation Storage Trade financing Miscellaneous Total

0.8 14.0 0.7 17.2 .9 8.7 1.8 0.2 46.6 9.1 100.0

0.6 11.4 .6 14.4 .7 15.7 7.8 1.6 39.0 8.2 100.0

0.1 10.9 .6 27.2 1.4 0.9 2.2 0.0 24.9 31.7 100.0

0.1 11.1 .6 26.3 1.3 0.8 1.0 0.0 21.2 37.6 100.0

56.7 17.9 .9 7.1 .4 1.6 0.2 3.0 7.7 4.6 100.0 10637

10.8 21.1 1.1 17.9 .9 6.7 0.8 1.3 30.2 9.3 100.0 37662

Total advances 53029 40298 7819.8 6629 Note: SCI stands for small and cottage industry; WC stands for working capital

Source: All estimates are based on trade estimates, and not based on detailed survey(s).

In Banglaesh, some banks have come forward to finance SMEs for their development, but many of them do not have good experience regarding loan servicing in this sector. In the next page, small and cottage industry credit position in overall industrial credit of Sonali Bank has been shown. Table – 7: Small and Cottage Industry Credit Position in overall industrial credit of Sonali Bank as on 2003
(Taka in crore) INDUSTRY SMALL & COTTAGE INDUSTRY SCI CREDIT AS % OF IC

Sanctioning Disbursement Recoverable Recovered Overdue Outstanding

1858.56 1258.57 1121.85 427.84 694.01 2260.00

523.08 456.68 556.68 220.12 336.56 685.39

28.14 36.28 49.62 51.44 48.49 30.32

Source: Bari, M. A. & Jamal, Sabera A. Reading materials of the course on Financing of SME, BIBM

From the above table, we found that the recovered amount of credit is very low i.e. the recovery rate of disbursement is very poor. Small and Cottage Industry sector is facing a huge overdue of credit that are disbursed to this sector.

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Scheduled banks in Bangladesh continued to provide credit to the small-scale industrial sector. But it is evident that deployment of resources in large and SME sector in the recent years is disproportionate compared to their relative contribution to GDP. Table – 8 shows the disproportionate picture. It shows from the table, that deployment of bank credit to large industries increased gradually from 32.40% of total advances in 2000-01 to 39.60% of total advances in 200405. But advances to Small industries rose very slightly from 1.70% to 2.00% although contribution of Small industry sector to GDP remained well above 4.5% during the same period. Table – 8: Contribution of industries in GDP and their relative financing by banks
(In percent)

Year

Contribution of industry to GDP

Contribution of large scale industry to GDP

Contribution of small scale industry to GDP

Scheduled banks advances to industry

Scheduled banks advances to large scale industry

Scheduled banks advances to small scale industry

2000-2001 2001-2002 2002-2003 2003-2004 2004-2005

15.40 15.90 16.60 17.10 17.80

11.06 11.41 12.04 12.51 13.19

4.54 4.51 4.56 4.59 4.61

34.10 34.90 36.10 38.40 41.60

32.40 33.20 34.30 36.50 39.60

1.70 1.70 1.80 1.90 2.00

Source: i) Scheduled Bank Statistics, Bangladesh Bank different issues. ii) Economic Survey, Ministry of Finance, Govt. of the Peoples Republic of Bangladesh, different issues. iii) SME Foundation (Chowdhury and Miah,2006)

Outstanding advances by Denationalized Commercial Banks (DNCBs) depicted a rising trend. The following table shows the amount of outstanding advances of DNCBs during the last few years. Table – 9: Amount of outstanding advances of DNCBs during the last few years
(Tk in million)
Sonali Bank Industria l sector Large & medium industry 3150 2531 1288 2327 2912 1300 1531 1298 620 564 5219 3507 2006 4053 2007 3321 2008* 1801 2006 2341 Janata Bank 2007 2954 2008* 1308 2006 2042 Agrani Bank 2007 2137 2008* 1151 2006 582 Rupali Bank 2007 5251 2008* 3518

15

Small & cottage industry

903

790

513

14

42

8

511

839

531

18

32

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Source: Resume of Activities of Banks and Financial Institutions, Ministry of Finance, Govt. of the Peoples Republic of Bangladesh, different issues.

3.2 Comparative analysis of SME Credit Scheme of Six Different Banks currently available in Bangladesh 3.2.1 Loan documents needed for SME financing by banks
Criteria for loan selection are similar among financial institutions. Most frequently requested documents by financial institutions as a part of the loan application process include: Personal guarantee Business plan Appraisal of assets to be financed Purchase agreement Cash flow projection Personal financial statement Formal application for financing Business financial statement Tin certificate Citizenship certificate Bank solvency certificate Vat certificate Export license

            

3.2.2 About the Sample Banks 3.2.2.1 Dhaka Bank Ltd.
The Bank started branch operations at Belkuchi Sirajgonj in April 2003. Prior to the Bank’s intervention, the weaving community did not have the financial strength to stock their products till “Eid ul Fitr” when the annual sale takes place. Traders were taking advantage to the situation by buying up entire productions at low prices and liquidating stocks just before “Eid”. With financial services from Dhaka Bank Limited, the weavers

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have converted to power looms, significantly increased profitability and reduced the involvement of middlemen. Already they have identified several clusters and are working on improving access to finance within these clusters.

3.2.2.2 Dutch-Bangla Bank Ltd.
Dutch-Bangla Bank Limited (the Bank) is a scheduled commercial bank. The Bank was established under the Bank Companies Act 1991 and incorporated as a public limited company under the Companies Act 1994 in Bangladesh with the primary objective to carry on all kinds of banking business in Bangladesh. The Bank is listed with Dhaka Stock Exchange Limited and Chittagong Stock Exchange Limited. DBBL a Bangladesh European private joint venture scheduled commercial bank commenced formal operation from June 3, 1996. The Bank commenced its banking business with one branch on 4 July 1996. The bank opened SME windows in 2001

3.2.2.3 Prime Bank Ltd.
As per decision of the Board of Directors of Prime Bank Ltd. in its 78th meeting held on 17.11.1999, “Small & Medium Enterprise (SME) Cell” has already been established at Head Office under the Credit Division. Now the bank can replicate quality anywhere in the world. So, the competitive differentiation comes from swiftness to market and innovation. And in this regard, small companies right down to the individual can beat big bureaucratic companies ten out of ten times.

3.2.2.4 Mercantile Bank Ltd.
Mercantile bank is a third generation commercial bank. It has opened SME windows in 1999 to encourage the small business activities.

3.2.2.5 Eastern Bank Ltd.
Small and Medium Enterprises (SME) in Bangladesh contributed 25% of gross domestic product (GDP) and 80% of the industrial jobs of the country in 2004. According to ADB, the country's estimated 6 million SMEs and micro enterprises firms of less than 100 employees have a significant role in generating growth and jobs. This is a sector that has its own distinct needs and requires specialized focus. Eastern Bank Ltd. (EBL) has launched SME Banking in early 2005 with this view in mind. Eastern Bank Ltd. Services in SME:

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• • • •

Provide SMEs with easy access to financing. Deliver products that ensure superior returns to our customers. Orient customers with industry trends, regulatory issues etc, for their success. Value long-term relationship banking.

3.2.2.6 BRAC Bank Ltd.
The BRAC Bank ltd started its operation in 2001. The SME portfolio includes  Prothoma Rin Exclusively designed for women  Anonno Rin This is a small-scale loan  Apurbo Rin In order to help our SME  Supplier Finance

3.2.3

Criterion for Sample Selection :

The banks for comparative analysis have been chosen in the basis of the following criterion:

3.2.3.1 Loan size
1. Prime Bank Ltd – Taka 1 Lac to Taka 75.00 Lacs 2. Dhaka Bank Ltd - Taka 0.50 Lac to Taka 50.00 Lacs 3. Eastern Bank Ltd- Taka 1 Lac to Taka 300.00 Lacs 4. Mercantile Bank Ltd- Taka 0.50 Lac to Taka 2.00 Lacs 5. Dutch-Bangla Bank Ltd- Taka 3 Lac to Taka 50.00 Lacs 6. BRAC Bank Ltd- Taka 3 Lacs to Taka 30.00 Lacs Among the banks EBL offers the highest loan amount to the customers where as the BRAC bank offers the lowest loan to its customers.

3.2.3.2 Rate of interest
1. Prime Bank Ltd – 13% to 15% p.a. 2. Dhaka Bank Ltd - 12% to 13% p.a. 3. Eastern Bank Ltd- 14% to 15% p.a. 4. Mercantile Bank Ltd- 15% p.a. 5. Dutch-Bangla Bank Ltd- 13% to 15% p.a. 6. BRAC Bank Ltd- 18% to 24% p.a.

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In terms of interest rate the Dhaka Bank Ltd offers the lowest rate of interest to its customers. The highest rate is charged by BRAC Bank Ltd. The Mercantile Bank Ltd. have the only bank that offers fixed rate for any loan customers.

3.2.3.3 Loan processing fees
1. Prime Bank Ltd – .50 % of the loan amount. 2. Dhaka Bank Ltd - .00 % of the loan amount. 3. Eastern Bank Ltd- not available 4. Mercantile Bank Ltd- not available 5. Dutch-Bangla Bank Ltd- not available 6. BRAC Bank Ltd- .50 % of the loan amount All the banks do not provide data about loan processing fees to their customers. The prime bank and BRAC bank limited only charges .50% as loan processing fess

3.2.3.4 Period of loan
1. Prime Bank Ltd – 1 to 5 years. 2. Dhaka Bank Ltd – 1 to 3 years. 3. Eastern Bank Ltd- up to 1 year. 4. Mercantile Bank Ltd- up to 2 years. 5. Dutch-Bangla Bank Ltd- 1.5 to 5 years. 6. BRAC Bank Ltd- 1 to 3 years. Among the banks the highest loan maturity date is offered by DBBL and Mercantile Bank Limited offers the lowest maturity period

3.2.3.5 Mode of Finance
1. Prime Bank Ltd – Term loan and working capital loan 2. Dhaka Bank Ltd – Term loan and working capital loan 3. Eastern Bank Ltd- Only working capital loan 4. Mercantile Bank Ltd- Only term loan 5. Dutch-Bangla Bank Ltd- Only term loan 6. BRAC Bank Ltd- Only term loan All the Banks providing SME financing facilities do not provide long-term loan to its customers. Among the banks Prime and Dhaka Bank limited both provides term loan and working capital loan to their customers. Other bank either provides term loan or working capital loan to its customers.

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3.2.3.6 Management
Overall the management of the banks engaged in SME banking is efficient and have diverse knowledge of banking sector. BRAC bank has initiated to provide training of staffs for well managing the SME customers.

3.2.4 Portfolio Size of different banks in SME Sector
(Tk in crore)

Serial No 1 2 3 4 5 6

Name of the Bank BRAC Bank Ltd. Eastern Bank Ltd. Prime Bank Ltd. Dutch-Bangla Bank Ltd. Mercantile Bank Ltd. Dhaka Bank Ltd. Total

Portfolio Size 950.00 300.00 108.44 16.38 6.63 5.72 1,387.17

Source: Annual Repots of Prime Bank Ltd., Dhaka Bank Ltd., Eastern Bank Ltd., Mercantile Bank Ltd., Dutch-Bangla Bank Ltd. and BRAC Bank Ltd. 2007

From the table we can see that the BRAC bank has the highest investment in the SME sector followed by Eastern Bank Ltd. in second position. While the Prime Bank Ltd., Dutch-Bangla Bank Ltd., Mercantile Bank Ltd. and Dhaka Bank Ltd. are third, forth, fifth and sixth respectively. Graph 1: Portfolio Size of Six different banks in SME Sector

Portfolio Size
0.5% 7.8%

21.6%

1.2% 0.4% 68.5%

Brac Bank Ltd. Eastern Bank Ltd.

Dhaka Bank Ltd. Mercantile Bank Ltd.

Dutch-Bangla Bank Ltd. Prime Bank Ltd.

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In the next page the following points are analyzed in the tabular form for the better understanding.  Comparative analysis of SME credit scheme of six different banks (Policy part) for year the 2007.  Comparative analysis of SME credit scheme of six different banks (Example of a loan) for year the 2007.  Comparative analysis of SME credit scheme of six different banks (Performance part) for year the 2007.

Year 2005

Table – 10

COMPARATIVE ANALYSIS OF SME CREDIT SCHEME OF

DIFFERENT BANKS (Policy part )
Particulars Loan Size Prime Bank Ltd. Tk.1.00 Lac to Tk.75.00 Lacs 13.00% 15.00% p.a. Dhaka Bank Ltd. Tk.0.50 Lac to Tk.50.00 Lacs 12.00% -13.00% p.a. Eastern Bank Ltd. Tk.1.00 Lac to Tk.300.00 Lacs 14.00% -15.00% p.a. --------Mercantile Bank Ltd. Tk.0.50 Lac to Tk.2.00 Lacs 15.00% p.a. --------Dutch-Bangla Bank Ltd. Tk.3.00 Lacs to Tk.50.00 Lacs 13.00% 14.00% p.a. --------Year 2007

BRAC Bank Ltd. Tk.3.00 Lacs to Tk.30.00 Lacs 18.00% 24.00% p.a. 0.50% of the Loan amount (once for the whole period) ---------

Rate of Interest Loan Processing Fee Risk Fund

0.50% of the 1.00% of the Loan amount Loan amount (once for the (once for the whole period) whole period) --------1.00% - 2.00% p.a. of the Loan amount 1.00% - 2.00% p.a. of the Loan amount 0.75% p.a. (Semiannually Charged) 01 Year to 05 Year Term Loan as 1.50% .p.a. (Quarterly Charged) 01 Year to 03 Year Term Loan as

---------

Supervision Fee Utilization Fee Period of Loan Mode of

---------

--------Up to 01 Year Only

1.00% of the Loan amount (once for the whole period) 1.00% of the Loan amount (once for the whole period) --------Up to 02 Years Only Term Loan

---------

---------

---------

--------1.5 Year to 05 Year Only Term Loan

---------01 Year to 03 Year Only Term

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Finance Past Experience of the Owner Security: a) Primary b) Secondary

well as Working Capital Loan 02 Years

well as Working Capital Loan 03 Years

Working Capital Loan 02 Years

Loan 02 Years 02 Years 02 Years

Personal Guarantee Collateral Security provision depends on case-to-case basis.

Personal Guarantee Up to Tk.5.00 lacs Collateral Free (Case to Case) Above Tk.5.00 lacs Collateral Mandatory

Personal Guarantee Collateral Security Mandatory

Personal Guarantee ---------------

Personal Guarantee Collateral Security Mandatory (Forced Sale Value 1.25 Times of Loan amount)

Personal Guarantee Up to Tk.8.00 Lac without Collateral Security & above Tk.8.00 Lac with Collateral Security

Source: Primary sources (Data are collected from banks through personal communication)

Table - 11 COMPARATIVE ANALYSIS OF SME CREDIT SCHEME OF DIFFERENT BANKS- (EXAMPLE OF A LOAN)
Year 2007
Example of a Loan Principal Amount Period of Loan No. Of Installment Installment Size Total Installment Payment Loan Processing Fee Risk Fund Supervision Fee Utilization Fee Total Payment ----------------Tk.750.00 Tk.1,08,986.00 Tk.2,000.00 Tk.2,000.00 Tk.1,500.00 Tk.1,13,672.00 ------------------------------Tk.1,08,300.00 Tk.1,000.00 Tk.1,000.00 ----------Tk.1,10,300.00 ------------------------------Tk.1,07,736.00 -----------------------------Tk.1,10,516. 00 Tk.500.00 Tk.1,000.00 ----------------------------Prime Bank Ltd. Tk.1.00 Lac 01 Year 12 Tk.8,978.00 Tk.1,07,736.00 Dhaka Bank Ltd. Tk.1.00 Lac 01 Year 12 Tk.8,931.00 Tk.1,07,172.00 Eastern Bank Ltd. Tk.1.00 Lac 01 Year 12 Tk.9,025.00 Tk.1,08,300.00 Mercantile Bank Ltd. Tk.1.00 Lac 01 Year 12 Tk.9,025.00 Tk.1,08,300.00 Dutch-Bangla Bank Ltd. Tk.1.00 Lac 01 Year 12 Tk.8,978.00 Tk.1,07,736.00 BRAC Bank Ltd. Tk.1.00 Lac 01 Year 12 Tk.9,168.00 Tk.1,10,016. 00 Tk.500.00

Source: Primary sources (Data are collected from banks through personal communication)

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Table – 12 COMPARATIVE ANALYSIS OF SME CREDIT SCHEME OF DIFFERENT BANKS (PERFORMANCE PART)
Year 2007

Performance

Prime Bank Ltd.

Dhaka Bank Ltd.

Eastern Bank Ltd.

Mercantile Bank Ltd.

DutchBangla Bank Ltd. 2001 16.38 Crore 99%

BRAC Bank Ltd. 2001 950.00 Crore 98% (Actual 92%) 24

Year of Operation Disbursement (Up to 31.03.07) Rate of Recovery

2001 108.44 Crore 100%

2001 5.72 Crore 100%

2001 300.59 Crore 97%

1999 6.63 Crore 79%

No. Of Manpower at H/O Level

02

03

02

03

03

Source: Primary sources (Data are collected from banks through personal communication)

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Why Banks are Not Interested in Financing the SMEs
4.1 Why Banks are not interested in financing the SMEs
In Bangladesh, several Banks are financing the SME sector but as mentioned earlier, many of them do not have good experience regarding the loan servicing in this sector. Banks lend the projects for making profit, but if the principal amount does not come back to the bank, then there will surely be adverse affect in the balance sheet of the bank. This is because of bank’s general function. A Bank’s general function is intermediation between borrower and lender. Bank takes deposit from the surplus unit i.e. lender and deploy fund or credit to the deficit unit i.e. borrower. It is very clear that the amount that a bank provides to the deficit units may not be its own. So, it must repay the amount to the depositors on demand. But if the disbursed amount does not come back to the bank, then it may incur loss. This is the reason why banks are so conscious while lending any project. In recent years, it is observed that there are many defaulters in the SME sector. Many banks are facing this default problem today. Still many banks are willing to invest in this sector. Though mentioned earlier, from the table – 07, we see that Sonali Bank’s credit recovery rate from Small and Cottage Industry sector is only 51.44% compared to the Industrial Credit. The bank has a huge outstanding of credit in the SCI sector. Actually this is the main reason behind why banks are not interested in financing in SME sector. Banks feel unsecured in financing this sector. Because the credit recovery rate from this sector is not good enough.

4.2 Problems for financing SMEs:
SME sector faces a number of problems (Ahmed, 2000) to facilitate institutional credit. These problems were looked into from the perspective of both borrower and lenders.

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4.2.1 Problems from borrowers perspective:
 Access to loan  Collateral  Complexity increases cost of loan  Extremely short grace period  Absence of comprehensive guidelines  Longer loan processing time and associate cost of uncertainty  Lack of basic infrastructure, inputs, managerial efficiency and inadequate sanction

4.2.2 Problems from lenders perspective:
 

Lack of information on loan application requirement among the SME loan seekers Absences of an appropriate and clear-cut legal framework for enforcing quick recovery.

In addition, the following problems are identified in the SME sector: a. Inadequate allocation of fund for public sector. b. Lack of co-ordination among lending agencies. c. Shortage of long-term credit. d. Unstable share market. e. Lack of technological information. f. Lack of uniform delivery model and training. g. Absences of utilization of BSCIC services of NCBs for utilization of surplus fund. h. Lack of technology assessment, innovation and adaptation of technology. i. Lack of marketing effort and exploring new markets. j. Competitive product market because of market economy. As we see from the pints noted above, borrowers of SME loans are facing some severe problems that are discussed below:

4.3.1 Access to loan:
SMEs encounter great difficulties while rising fixed and working capital because of the reluctance of banks to provide loans to SMEs. Banks are shy to lend to SMEs because of high processing and monitoring costs of loans to SMEs. The loan application forms for investment financing from banks are long, tedious, and redundant. Since the removal of the interest rate subsidy without the removal of interest band, financial institutions find 25

little incentive to lend to SMEs. SMEs find it difficult to use non real estate assets as collateral to obtain loans from the banks. In the past, the government has attempted to provide SMEs with access to finance through targeted lending. There was a government directive that 5 per cent of a bank's loan portfolio be set aside for small and cottage industry financing. A new bank, namely, the Bank of Small Industries and Commerce Bangladesh Ltd (BASIC) was set up in 1988 with the objective of financing the small and cottage industries. There were also attempts to channelize fund received from international agencies such as the Asian Development Bank (ADB) to the sector through private banks. There were provisions of favorable debt equity ratio, special interest rates and credit guarantee scheme. The central bank also issued directives to both public and private commercial banks regarding working capital loans, use of standardized documentation procedure and time limits for credit sanctioning and loan disbursement.

4.3.2 Collateral:
The main problem of SMEs is that, they do not have enough collateral for getting fund from the bank. The banks have some regulation of taking a minimum amount of collateral against credit, but many small and medium entrepreneurs cannot fulfill the requirement. That’s why banks are also reluctant to provide credit to them, as it would be violation of their policy regulation.

4.3.3 Lack of experience:
Small and Medium Industry Entrepreneurs, in Bangladesh, have lack of experience in the business field. They do not have any training programs and they do not even have any business exposure. As a result, they cannot follow the right way of entrepreneurship in the related field. So they incur loss in many cases.

4.3.4 Extremely short grace period:
In our country, grace period of repaying any credit is very low. According to the SME entrepreneurs, almost all the Banks structured the loan in such a way that entrepreneurs have to start the repayment of credit within a very short time after disbursement of credit. This is really a big problem for the entrepreneurs because the entrepreneurs are bound to generate profit instantly to fulfill the Banks requirement. But this is impossible, as a business needs a minimum time to be in a stable position and to generate profit.

4.3.5 Cost of loan:
Another problem is that extremely high interest rate for the entrepreneurs. Many entrepreneurs is having problem because of high interest rate. Banks, in many cases,

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maintain high spread as a result there remains reckless competition of making more profit from the Banks perspective. And, sufferers are general entrepreneurs who borrow from the Bank.

4.3.6 Absence of comprehensive guidelines:
Another problem is that, there is an absence of comprehensive guidelines in the SME sector. Most of the SMEs do not have any guidelines for controlling their business. They do not maintain any deliberate procedure in managing the enterprise; rather they go on with the time-to-time changes in the business operation. As a result they cannot generate expected profit from the business and fail to payback credit to the banks. Hence, Banks are reluctant to provide credit to them.

4.3.7 Longer loan processing time and associate cost of uncertainty:
Credit in this sector requires longer processing time. Though it is Small and Medium Enterprise Sector, processing time for loan is not short. As a result banks are unwilling to enter in this sector. Moreover, associate cost of uncertainty is also another issue and banks do not want their funds to be invested in an area where recovery of the fund is uncertain.

4.3.8 Lack of basic infrastructure, inputs, managerial efficiency:
Most of the SMEs do not have basic infrastructure of their own i.e. there is a lack of planned infrastructure in this sector. Inputs of the production are also not planned and insufficient. Moreover, managerial efficiency is also a big issue in this regard. If there is poor managing efficiency, then the organization will never prosper in associate field. For better performance, good managing efficiency is needed.

4.3.9 Inadequate sanction:
And, inadequate sanction of loan should also be stated here. The loan provided to this sector is inadequate. As almost all SMEs do not have enough capital to start the business, they need adequate amount of fund in order to support the unexpected loss initially. But as they do not get that, they cannot absorb the initial loss and eventually fail to payback the bank credit. In addition, some problems identified as these are from lenders perspective:

4.3.10 Lack of information on loan application requirement among the SME loan seekers:
As credit application requires availability adequate information, most of the SMEs do not have adequate information. They do not maintain their financial statement appropriately 27

of the business; even they do not feel the necessity of doing so. That’s why Banks are not getting appropriate information regarding their business and themselves as well.

4.3.11 Absence of an appropriate and clear-cut legal framework for enforcing quick recovery:
Even Banks do not have appropriate legal framework in order to recover their disbursed credit. Their recovery framework is not clear-cut as a result they fail to control the servicing of loan. These are the reasons why Banks are reluctant to finance the SMEs in Bangladesh.

Minimum Requirements for SME Financing according to Bangladesh Bank

5.1. Minimum Requirements for SME Financing according to Bangladesh Bank:
Apart from the specific regulations given under each mode of financing separately, the banks while undertaking Small Enterprise financing should also follow general requirements laid down here. It may by noted that these are the minimum requirements and should not in any way be construed to restrict the role of the management processes through establishing comprehensive credit risk management systems appropriate to their type, scope, sophistication and scale of operations. The Board of Directors of the banks are required to establish policies, procedures and practices to define risks, stipulate responsibilities, specify security requirements, design internal controls and then ensure strict compliance with them.

5.2 Pre-Operation:
Before embarking upon or undertaking Small Enterprise financing, the banks shall implement/follow the guidelines given below. The banks already involved in Small Enterprise financing will ensure compliance with these guidelines within six month of the date of issuance of Small Enterprise Financing Prudential Regulations.

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Banks shall establish separate Risk Management capacity for the purpose of Small Enterprise financing, which will be suitably staffed by personnel having sufficient expertise and experience in the field of consumer finance/business. The banks shall prepare comprehensive Small Enterprise credit policy duly approved by the Board of Directors, which shall interalia cover loan administration, including documentation, disbursement and appropriate monitoring mechanism. The policy shall explicitly specify the functions, responsibilities and various staff positions, powers/authority relating to approval/sanction of consumer finance facility. For every type of Small Enterprise finance activity, the bank shall develop a specific Product Program Guide (PPG). The program shall include the objective/quantitative parameters for the eligibility of the borrower and determining the maximum permissible limit per borrower. The PPG will also indicate the maximum permissible exposure banks will take against each product. Bank shall put in place and efficient computer based MIS for the purpose of Small Enterprise finance, which should be able to effectively cater to the needs of Small Enterprise financing portfolio and should be flexible enough to generate necessary information reports used by the management for effective monitoring of the bank's exposure in the area. The MIS is expected to generate the following periodical reports: Reports interrelating delinquencies with various type of customers of various attributes of the customers to enable the management to take important policy decisions and make appropriate modifications in the lending program. Quarterly product wise profit and loss account duly adjusted with the provision on account of classified accounts. These profit and loss statements should be placed before the Board of Director in the immediate next Board Meeting. The branches of foreign banks in order to comply with these conditions shall place the reports before a committee comprising of Chief Executive Officer, Chief Finance Officer and Head of Small Enterprise. The banks shall develop comprehensive recovery procedures for the delinquent loans. The recovery procedures may vary from product to product. However, distinct and objective triggers should be prescribed for taking pre-planned enforcement/recovery measures.

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The institutions starting consumer financing are encouraged to `impart sufficient training on an ongoing basis to their capability regarding the various aspects of Small Enterprise financing. The banks shall prepare standardized set of borrowing and recourse documents (duly cleared by their legal counsels) for each type of Small Enterprise financing.

5.3 Operations:
Small Enterprise financing, like other credit facilities, must be subject to the Bank's risk management process setup for this particular business. The process may include, identifying source of repayment and assessing customer' ability to repay his/her past dealings with the bank, the net worth and information obtained from a Credit Information Bureau approved by Bangladesh Bank. At the time of granting facility under various modes of Small Enterprise financing, banks shall obtain a written declaration from the borrower divulging details of various facilities already obtained from other institutions. The banks should carefully study the details given in the statement and allow fresh finance/limit only after ensuring that the total exposure in relation to the repayment capacity of the customer does not exceed the reasonable limits as laid down in the approved policies of the banks. The declaration will also help banks to avoid exposure against an enterprise having multiple facilities from different institutions. Internal audit and control function of the bank, apart from other things, should be designed and strengthened so that it can efficiently undertake an objective review of the Small Enterprise finance portfolio from time to assess various risks and possible weaknesses. The internal audit should also assess the adequacy of the internal control and ensure that the required policies and standards are developed and practiced. Internal audit should also comment on the steps taken by the management to rectify the weaknesses pointed out by them in their previous reports for reducing the level of risk. The banks shall ensure that their accounting and computer systems are well equipped to avoid charging of mark-up. For this purpose it should be ensured that the mark-up charged on the outstanding amount is kept separate from the principal.

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The banks shall ensure that any repayment made by the borrower is accounted for before applying mark-up on the outstanding amount.

5.4 Disclosure/Ethics:
The banks must clearly disclose all the important terms & conditions. Fees, charges and penalties, which are internal including interest rate, pre-payment penalties and the conditions under which that apply. For ease of reference and guidance of their customers, banks are encouraged to publish brochures regarding frequently asked questions.

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Prudential Regulations for SME Financing By Bangladesh Bank
6.1 Prudential Regulations for SME Financing By Bangladesh Bank:
Prudential regulation establishes the outside limits and constraints placed on banks to ensure the safety and soundness of banking system. They are the key elements to prevent, limit or stop the damage caused by poor management. The establishment of an appropriate regulatory framework is essential to ensure that government supervisors can carry out and enforce their responsibilities. In the following prudential regulation of Bangladesh Bank has been given by which supervisors can smoothly check and balance the operation of SME in Bangladesh.

Regulation -1 6.1.1 Source and capacity of repayment and cash flow backed lending:
Banks shall specifically identify the sources of repayment and asses the repayment capacity of the borrower on the basis of assets conversion cycle and expected future cash flows. In order to add value, the banks must assess conditions in the particular sector / industry they are lending to and its future prospects. The banks must be able to identify the key drivers of their borrowers businesses, the key risks to their businesses and their risk mitigates. The rationale and parameters used to project the future cash flows shall be documented and annexed with the cash flow analysis undertaken by the bank. It is recognized a large number of SMEs will not be able to prepare future cash flows due to lack of sophistication and financial expertise. It is expected that in such cases banks shall assist the borrowers in obtaining the required information and no SE shall be declined access to credit merely on this ground (for details, refer Regulation – 10).

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Regulation -2 6.1.2 Personal guarantees:
All facilities to SMEs shall be backed by the personal guarantees of the owners of the SMEs. In case of limited companies, guarantees of all directors other than nominee directors shall be obtained.

Regulation -3 6.1.3 Per party exposure limit:
The minimum and maximum exposure of a bank on a single SE shall remain within the range of Tk 2 lac and Tk.50 lac respectively subject to the following:

In case of working capital finance - Maximum up to 100% of the net required working capital or 75% of the sum total of inventory and receivables whichever is lower.

In case of fixed assets purchase - Maximum up to 90% of the purchase price.

Regulation -4 6.1.4 Aggregate exposure of a bank on small enterprise sector:
The aggregate exposure of a bank on SE sector shall not exceed the limits as specified below:
% OF CLASSIFIED SE ADVANCES TO TOTAL MAXIMUM LIMIT 10 times of equity 6 times of the equity 4 times of the equity Up to the equity PORTFOLIO OF SE ADVANCES a. Below 5% b. Below 10% c. Below 15% d. Up to and above 15%

Source: Prudential Regulations by Bangladesh Bank for SME Financing, Bangladesh Bank Quarterly April-June 2006

Regulation -5

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6.1.5 Limit on clean facilities:
In order to facilitate growth of smaller loans, banks are free to determine security requirements for loans up to Tk.5 lac. Guidelines for security requirements for loans of amounts more than Tk.5lac are given in Regulation-6.

Regulation - 6 6.1.6 Securities:
Consequent to the regulation stated in Regulation -5, facilities provided to SEs shall be secured by banks as follows: For loan amounting Tk. 2 lac to Tk. 5 lac

As a minimum banks must take charge over assets being financed.

For loan amounting Tk. 5 lac to Tk. 50 lac a) Hypothecation on the inventory, receivables, advance payments, plant & machineries. b) Equitable mortgage over immovable properties with registered Power of Attorney. c) Personal Guarantees of Spouse/Parents/other family members. d) One third party personal guarantee, e) Post dated cheques for each installment and one undated cheque for full loan value including full interest.

Regulation - 7 6.1.7 Loan documentation:
For all facilities, banks must obtain (as applicable) and not limiting to following documents before disbursement of loan can be made: 1) Loan Application Form duly signed by the customer. 2) Acceptance of the terms and conditions of Sanction Advice. 3) Trade License. 4) In case of Partnership Firm:

34

Copy of Registered Partnership Deed duly certified as true copy or partnership Deed on non-judicial stamp of Tk.150 denomination duly notarized. 5) In case of limited company: a) Copy of Memorandum & Articles of Association of the company including Certificate of incorporation duly certified by Registrar Joint Stock Companies (RJSC) and attested by the Managing Director accompanied by an up-to-date list of Directors, b) Copy of Board Resolution of the company for availing credit facilities and authorizing Managing Director/ Chairman/Director for execution of documents and operation of the accounts, c) An Undertaking not to change the management of the company and the memorandum and articles of the company without prior permission of the bank. d) Copy of last audited financial statement up to last 3 years (as applicable and subject to Regulation-10) e) Personal Guarantee of all the Directors including the Chairman and Managing Director, f) Certificate of registration of charges over the fixed and floating assets of the company duly issued by RJSC, g) Certificate of registration of amendment of charges over the fixed and floating assets of the company duly issued by RJSC in case of repeat loan or change in terms and condition of Sanction Advice regarding loan amount, securities etc., 6) Demand Promissory Note 7) Letter of hypothecation of stocks and goods 8) Letter of hypothecation of book debts & receivables 9) Letter of hypothecation of plant & machinery 10) Charge on fixed assets. 35

11) Personal Letter of Guarantee 12) Wherever practical, insurance policy for 110% of the stock value covering all risks with bank’s mortgage clause in joint name of the bank and client.

Regulation -8 6.1.8 Margin requirements:
Banks shall adhere to the minimum margin requirement as prescribed by Bangladesh Bank (if any).

Regulation -9 6.1.9 Credit information bureau (CIB) clearance:
While considering proposals for any exposure, banks should give due weightage to the credit report relating to the borrower and his group obtained from a of Bangladesh Bank. The condition of obtaining CIB report will be governed by rules & regulations as prescribed by Bangladesh Bank from time to time.

Regulation -10 6.1.10 Minimum conditions for taking exposure:
Banks shall, as a matter of rule, obtain a copy of financial statements duly audited by a practicing Chartered Accountant, relating to the business of every borrower who is a limited company or where exposure of a bank exceeds Tk.40lac, for analysis and record. However, financial statements singed by the borrower will suffice where the exposure is fully secured by liquid assets. It is recognized that a large number of enterprises other than limited companies (i.e., sole proprietorship/partnership firms etc.) may not have proper books of accounts including balance sheet, profit & loss account and they may not be able to prepare current and future cash flows due to lack of sophistication and expertise. It is expected that in such cases, banks shall assist the borrowers in obtaining/developing such books of accounts as per forms/formats prescribed by each bank. Reference with regard to how the formats should be prepared has been made in the development guidelines. Each Bank shall develop its own Loan Application Form and ‘Borrowers Basic Fact Sheet. Banks shall not approve and/or provide any exposure (including renewal, enhancement and rescheduling) until and unless the prescribed Loan Application From is

36

accompanied by a ‘Borrower’s Basic Fact Sheet under the seal and signature of the borrower.

Regulation -11 6.1.11 Proper utilization of loan:
The Bank should ensure that the loans have been properly utilized by the SEs and for the same purposes for which they were acquired / obtained. Banks should develop and implement an appropriate system for monitoring the utilization of loans.

Regulation -12 6.1.12 Restriction on facilities to related parties:
Banks shall not take any exposure on a SE in which any of its director; shareholder, employee or their immediate family members is holding 5% or more of the share capital of the SE.

Regulation -13 6.1.13 Classification and provisioning for assets:
Loans / Advances
Banks shall observe the prudential guidelines given at in the matter of classification of their SME asset portfolio and provisioning there-against. In addition to the time-based criteria, subjective evaluation of performing and nonperforming credit portfolio shall be made for risk assessment and, where considered necessary, any account including the performing account will be classified, and the category of classification determined on the basis of time based criteria shall be further downgraded. Such evaluation shall be carried out on the basis of credit worthiness of the borrower, its cash flow, operation of the account, adequacy of the security, inclusive of its realizable value and documentation covering the advances. Apart from specific provisioning requirement as prescribed above, banks will create adequate general provision over the entire credit portfolio of Small Enterprise business. Therefore, all banks shall maintain at all times a general provision of 5% of SE assets outstanding in its books. 37

Submission of returns
Banks shall submit the borrower-wise annual statements regarding classified loans/ advances to the Banking Inspection Department.

Timing of creating provisions
Banks shall review, at least on a quarterly basis, the collectibles of their loans / advances portfolio and shall properly document the evaluations so made. Shortfall in provisioning, if any, determined, as a result of quarterly assessment shall be provided for immediately in their books of accounts by the banks on quarterly basis.

Reversal of provision
The provision held against classified assets will only be released when cash realization starts exceeding.
  

In case of loss category the net book value of the assets. In case of doubtful category 50% of the net book value of the assets; and In case of sub-standard category 25% of the net book value of the assets.

Further, the provision made on the advice of Bangladesh Bank will not be reversed without prior approval of Bangladesh Bank.

Verification by the Auditors
The external auditors as a part of their audits of banks shall verify that all requirements of Regulation- 12 for classification and provisioning for assets have been complied with. Bangladesh Bank shall also check adequacy of provisioning during their on-site inspections.

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Guidelines by Bangladesh Bank for SME Financing
7.1 Guidelines by Bangladesh Bank for SME Financing:
The purpose of the Development Guidelines is to provide directional guidelines to the banks that are considering introduction of Small Enterprises financing to entrepreneurs all across Bangladesh. These Guidelines will assist banks to develop and implement pragmatic and value added products, efficient Credit Approval & Risk Management processes, sound organization structure, strong credit administration and robust collection procedures. It may be noted here that these are the minimum requirements and should not in any way be construed to restrict the role of the management processes through establishing comprehensive credit risk management systems. The Process Guidelines have been organized into the following sections:

Policy Guidelines
1. Product Program Guidelines 2. Segregation of Duties 3. Credit Approval

Procedural Guidelines
1. Approval Process 2. Credit Administration 3. Risk Management 4. Collection & Remedial Management

Preferred Organizational Structure & Responsibilities
Senior executives of retail banking from different foreign, private sector and nationalized commercial banks prepared these guidelines. It is the expectation of Bangladesh Bank that these guidelines will assist banks towards creating a long term sustainable and a 39

profitable Small Enterprises business in Bangladesh.

7.2 Policy Guidelines:
Before embarking upon Small Enterprises financing, banks shall develop fully documented product program guidelines. These guidelines shall include objective/quantitative parameters for the eligibility of the borrowers and determining the maximum permissible limit per borrower. These fundamental guidelines will be the key elements that would support each banks credit culture and they will dictate bank’s behavior when dealing with customers and managing lending portfolio of such loans. Any deviations from these guidelines must in all cases, will require approval from competent authority. Fundamentally, credit policies and procedures can never sufficiently capture all the complexities of the product. Therefore, the following credit principles are the ultimate reference points for all concerned bank staff making consumer-financing decisions: • • • • • • • Assess the entrepreneur’s character for integrity and willingness to repay Only lend when the entrepreneur has capacity and ability to repay Only extend credit if bank can sufficiently understand and manage the risk Use common sense and past experience in conjunction with thorough evaluation and credit analysis. Do not base decisions solely on customer’s reputation, accepted practice, other lender’s risk assessment or the recommendations of other officers Be proactive in identifying, managing and communicating credit risk Be diligent in ensuring that credit exposures and activities comply with the requirement set out in Product Program A generic Product Program Guideline (PPG) has been developed for Small Enterprises Financing. Banks should take this as a reference and have the right to alter/amend these guidelines in terms of their own policy with out compromising the fundamentals of credit principles.

7.2.1 Product Program Guideline
Banks have the right to alter / amend these guidelines in terms of their policy with out 40

compromising the fundamentals of credit principles. While developing Product Program Guidelines (PPG) for any product - the following guidelines must be included in the PPG documents. The guidelines are suggestive but not limited to this list, based on the requirements further guidelines to be incorporated in the PPG to ensure that the PPG is covering all the aspects of risk and return for the particular product.  PPG Guideline No. 1: Customer Segment  PPG Guideline No. 2: Purpose  PPG Guideline No. 3: Nationality  PPG Guideline No. 4: Age Limit - Minimum age (years) / Maximum age(years)  PPG Guideline No. 5: Minimum Income  PPG Guideline No. 6: Loan Size  PPG Guideline No. 7: Loan to Price Ratio  PPG Guideline No. 8: Security/ Collateral  PPG Guideline No. 9: Legal Documents  PPG Guideline No. 10: Interest Rate  PPG Guideline No. 11: Maximum Term of Loan  PPG Guideline No. 12: Repayment Method  PPG Guideline No. 13: Disbursement Mode  PPG Guideline No. 14: Disbursement pre-condition  PPG Guideline No. 15: Debt Burden Ratio (DBR %)  PPG Guideline No. 16: Verification of Personal Details and Quotation  PPG Guideline No. 17: Substantiation of Income

7.2.2 Segregation of Duties
Adequate segregation of duties is a prerequisite of an effective system of internal control. To be adequate, segregation must ensure that persons independent of each other perform the following functions, although, within limits, certain may be combined so long there is adequate supervision:
 

Credit approval, monitoring and recovery – by Credit unit Credit documentation and administrations – Loans processing and disbursement unit Sales and marketing – Sales and Branch 41

Credit recovery – by Credit unit

The credit approval team will be independent from the sales and branch team who will evaluate and approve the loan. The Credit Administration under Operations department will check and ensure the documentation and disburse the loans. This will ensure the better control of the bank asset and mitigate the risk of compromise of the duties.

7.2.3 Credit Approval
Applications are received at Credit Approval unit from sales team / branches. As mentioned in Regulation- 10 part 2, banks should develop their own set of comprehensive Loan Presentation Forms (LPF), which should at minimum include the following documents: a) Credit Memorandum b) Work sheet for Working Capital Requirement c) Income Statement d) Balance Sheet e) Cash Flow Statement f) Financial Ratios g) Checklists Applications will bee evaluated / assessed by Credit Analysts / Managers on the basis of a fully documented Loan Presentation Forms (LPF). The evaluation process is carried out based on the agreed and standard guidelines for different loans product and the documents checklist as per the PPG. The detailed credit and risk assessment should be conducted prior to the approving of any loans. The sales team / branch staff responsible for loan sales and should be the owner of the customer relationship, and must be held responsible to ensure the accuracy of the loan application submitted for approval. They must be familiar with the bank’s Lending Guidelines and should conduct due diligence on new borrowers, purpose of the loans and guarantors. All banks should have established and Money Laundering guidelines, which should be adhered to at all times. Credit Applications should include, as a minimum, the following details: • • Amount and type of loan(s) proposed. Purpose of loans.

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• •

Loan Structure (Tenor, Covenants, Repayment Schedule, Interest) Security (if any)

7.2.4 Credit Approval Authority
Lending Authority is delegated to individual credit analysts and credit manager or senior credit executives by the Head of Consumer banking responsible for the Consumer business. Records of such authority are retained with country credit manager. Copies of all Delegation of Lending Authorities are also retained by Loan Administrations Department.

7.3 Procedural Guidelines:
This section outlines the main procedures that are required to ensure compliance with the policies contained in Section 1.0 of these guidelines.

7.3.1 Approval Process
Credit approval authority must be delegated in writing from the Head of Small Enterprise responsible for the Small Enterprise business, acknowledged by recipients and records of all delegation retained. The credit approval function should be separate from the marketing / sales function. Approvals must be evidenced in writing, or by electronic signature. Approval records must be kept on file with the Credit Applications. Credit approval should be centralized within the Credit function. Regional credit centers may be established, however, all large loans (as defined in the PPG) must be approved by the Head of Credit or delegated Head Office credit executive. Any credit proposal that does not comply with Lending Guidelines, regardless of amount, should be referred to Head Office for Approval. Any breaches of lending authority should be reported to MD/CEO, Head of Internal Control, and Head of Credit. It is essential that executives charged with approving loans have relevant training and experience to carry out their responsibilities effectively. As a minimum, approving executives should have: • At least 5 years experience working in Branch / Sales team as a relationship manager or account executive.

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• • •

Training and experience in financial statement, cash flow and risk analysis. A good working knowledge of Accounting. A good understanding of the local market.

A monthly summary of all new facilities approved, renewed, enhanced, and a list of proposals declined stating reasons thereof should be reported by Credit Team to the Business Head. Duplication of Check All approved applications must be checked against bank’s database to identify whether the applicant is enjoying any other loan in other account apart from the declared loans. Maintenance of Negative Files Two negative files – one listing the individuals and the other listing the employers - are to be maintained to ensure that individual with bad history and dubious integrity and employers with high delinquency rate do not get loan from banks.

7.3.2 Credit Administration
After approval, Credit Team will send / forward the approved application along with the security and other documents to the Credit Administration Department under Operations Unit for processing. The Credit Administration function is critical in ensuring that proper documentation and approvals are in place prior to the disbursement of loan facilities. Under Credit Administration there may be two-sub unit, Documentation & QC and Loan Administration Dept who will process the document and disburse the loan. Credit Documentation Credit Documentation dept is responsible: • • To ensure that all security documentation complies with the terms of approval. To control loan disbursements only after all terms and conditions of approval have been met, and all security documentation as per the checklist of approved PPG is in place. • • • To maintain control over all security documentation. To monitor borrower’s compliance with agreed terms and conditions, and general monitoring of account conduct/performance. Upon performing the above, Documentation dept will forward the Limit Insertion 44

Instruction to the Loan Administration unit for limit and other information to input into the bank’s main system. Disbursement Loan Administration dept will disburse the loan amounts under loan facilities only when all security documentation is in place. CIB report is obtained, as appropriate, and clean.

Custodial Duties Loan disbursements and the preparation and storage of security documents should be centralized in the regional credit centers. Security documentation is held under strict dual control, in locked fireproof storage. Compliance Requirements • • • All required Bangladesh Bank returns are submitted in the correct format in a timely manner. Bangladesh Bank circulars/regulations are maintained centrally, and advised to all relevant departments to ensure compliance. All third party service providers (valuers, lawyers, insurers, CPAs etc.) are approved and performance reviewed on an annual basis.

7.3.3 Risk Management
Credit Risk The credit risk is managed by the Credit & Collections unit (CCU), which is completely segregated from business/sales. The following elements contribute to the management of credit risks: The credit risk associated with the products is managed by the following: 1. Loans will be given only after proper verification of customer’s static data and after proper assessment & confirmation of income related documents, which will objectively ascertain customer’s repayment capacity. 2. Proposals will be assessed by independent Credit division (CCU) that is completely separated from business/sales. 3. Every loan will be secured by hypothecation over the asset financed, and customer’s authority taken for re-possession of the asset in case of loan loss. 4. The loan approval system is encouraged to be parameter driven as much as

45

possible which will substantially eliminate the subjective part of the assessment procedure. 5. There will be dedicated ‘collection’ force that will ensure timely monitoring of loan repayment and its follow up. 6. The Credit & Collection activities will be managed centrally and loan approval authorities will be controlled centrally where the branch managers or sales people will have no involvement Contact Point Verification: Contact Point Verification should be done wherever possible for all applicants. The external CPV includes residence, office and telephone verifications. All verifications are done to seek/verify/confirm the declared/undeclared information of the applicant. Third Party Risk In case of third party deposits/security instruments, banks should verify third party’s signature against the specimen attached to the original instrument and bank will also send the instrument to the issuing office for their verification and written confirmation on lien marking and encashment of the instrument. Therefore, any inherent risk emanating from accepting third party deposits/security instruments is minimal. Fraud Risk There is an inherent fraud risk in any lending business. The most common fraud risks is: Application Fraud The applicant’s signature may not be verified for authenticity. However, the applicant’s identity should be confirmed by way of scrutiny of identification and other documentation. A Contact Point Verification (CPV) agency should be in place to verify applicant’s residence, office and contact phone numbers etc. There always remains the possibility of application fraud by way of producing forged documents. Considering the current market practices and operational constraints, it may not always be feasible to validate the authenticity of all documentation. However, banks/ NBFIs should be aware of this threat and may consider validating the bank statement (the most important and commonly provided income document) through CPV agent. Liquidity And Funding Risk This risk should be managed and the position monitored by the Asset Liability Committee

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headed by the Managing Director / CEOs of the banks. Political And Economic Risk Political and economical environment of a country play a big role behind the success of business. Banks should always keep a close watch in these areas so that it is able to position itself in the backdrop of any changes in country’s political and economical scenario. Operational Risk For consumer loans, the activities of front line sales and behind-the-scene maintenance and support are clearly segregated. Credit & Collections Unit (CCU) will be formed. CCU will manage the following aspects of the product: a) inputs, approvals, customer file maintenance, monitoring & collections; b) the Operation jobs like disbursal in the system including raising debit standing orders and the lodgment and maintenance of securities. Type ‘a’ jobs and type ‘b’ jobs will be handled by separate teams within CCU; therefore the risk of compromise with loan / security documentation will be minimal. It will ensure uncompromising checks, quick service delivery, uncompromising management of credit risks and effective collections & recovery activities. Maintenance Of Documents & Securities CCU or Operations Unit will hold the applications and other documents related to SE loans in safe custody. All this documents will go under single credit file per customer developed before launch of the product. The physical securities and the security documents will be held elsewhere inside fireproof cabinets under CCU’s or Operation’s custody. The dual-key system for security placement and retrieval will have to be implemented. Internal Audit All Banks should have a segregated internal audit department who will be responsible with performing audits of all departments. Audits should be carried out on a regular or periodically as agreed by the Management to assess various risks and possible weaknesses and to ensure compliance with regulatory guidelines, internal procedures, Lending Guidelines and Bangladesh Bank requirements.

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7.3.4 Collection & Remedial Management
Monitoring A banks loan portfolio should be subject to a continuous process of monitoring. This will be achieved by regular generation of over limit and overdue reports, showing where facilities are being exceeded and where payments of interest and repayment of principle are late. There should be formal procedures and a system in place to identify potential credit losses and remedial actions has to be taken to prevent the losses. Besides that the systems should be in place to report the following exceptions to relevant executives in Credit / sales and branch marketing staff: • • • Past due principal or interest payments; Timely corrective action is taken to address findings of any internal, external or regulator inspection/audit. All loan facilities are reviewed annually.

Computer systems should be able to produce the reports for central / head office as well as branch review. Recovery The collection process for SE loans will start when the borrower has failed to meet one or more contractual payment (Installment). It therefore, becomes the duty of the Collection Department to minimize the outstanding delinquent receivable and credit losses. This procedure has been designed to enable the collection staff to systematically recover the dues and identify / prevent potential losses, while maintaining a high standard of service and retaining good relations with the customers. It is therefore essential and critical, that collection people are familiar with the computerized system (where applicable), procedures and maintain effective liaison with other departments within the bank. Collection Objectives The collector’s responsibility will commence from the time an account becomes delinquent until it is regularized by means of payment or closed with full payment amount collected. The goal of the collection process is to obtain payments promptly while minimizing collection expense and write-off costs as well as maintaining the customer’s goodwill by

48

a high standard of service. For this reason it is important that the collector should endeavor to resolve the account at the first time worked. Collection also protects the assets of the bank. This can be achieved by identifying early signals of delinquency and thus minimizing losses. The customers who do not respond to collection efforts - represent a financial risk to the institution. The Collector’s role is to collect so that the institution can keep the loan on its books and does not have to write-off / charge off. Identification And Allocation Of Accounts When a customer fails to pay the minimum amount due or installment by the payment due date, the account is considered in arrears or delinquent. When accounts are delinquent, collection procedures are instituted to regularize the accounts without losing the customer’s goodwill whilst ensuring that the bank’s interests are protected. Collection/Monitoring Steps To identify and manage arrears, the following aging classification is adopted:
Days Past Due (DPD) 1-14 15-29 30-44 45-59 Collection Action Letter, Follow up & Persuasion over phone 1st Reminder letter & Sl. No. 1 follows 2nd reminder letter + Single visit


• • •

3rd reminder letter Group visit by team member Follow up over phone Letters to Guarantor, Employer, Reference all above effort follows Warning on legal action by next 15 days Call up loan Final Reminder & Serve legal notice Legal proceedings begin Repossession starts Telephone calls/Legal proceedings continue Collection effort continues by officer & agent Letter to different banks/Association

60-89

• • • •

90 and above

• • • •

As and when an account become delinquent, collection system works together to achieve

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business objectives. At the beginning of the month collection unit has taken the total asset portfolio from the system. Then all X to 149 DPD account has to identify and allocate those accounts to the individual collectors to collect the over dues on a set target basis. The respective collector has got one-month time to recover the overdue on a target-based matrix. During the month, officer collection will generate the fresh arrival to X DPD accounts once in a week and hand over those to the collectors of front end to minimize the delinquency as well as the flow rate.

Supportive Activities for SME Financing
8.1 Policies of SME Financing:
The development of small and medium enterprises (SMEs) in developing countries is generally believed to be a desirable end in view of their perceived contribution to decentralized job creation and generation of output. SMEs constitute the dominant source of industrial employment in Bangladesh (80%), and about 90% of the industrial units fall into this category. The actual performance of SMEs, however, varies depending on the relative economic efficiency, the macro-economic policy environment and the specific promotion policies pursued for their benefit. For the JOBS Program, Bakht, Zaid (1998) and Ahmad, Salahuddin et al. (1998) developed research papers that describe the policy environment within which SMEs in Bangladesh operate. The reports also discuss the accompanying legal, regulatory and administrative constraints to employment creation by SMEs. This paper attempts to highlight the findings of those two studies. To complement the issues discussed in those two papers, a summary of industrial problems, as perceived by entrepreneurs during the past one decade (HIID, 1988; MCCI 1992; World Bank 1994; JOBS 1998), is also presented in this report.

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8.2 SME Development in Bangladesh:
Historically, Bangladesh followed a development strategy in which private investment was controlled through a host of regulations involving investment sanctioning, credit disbursement, import licensing, foreign exchange allocation, etc. While these regulatory barriers thwarted private investment in general, the impact fell unevenly on SMEs. This was because of the relative inability of the SMEs to cope with the regulations compared to their large-scale counterparts. Thus, the policy regime was largely biased against the SMEs although, paradoxically, promoting SME development was a stated objective of successive governments. In a bid to render its industrial sector internationally competitive and to move towards greater efficiency in its production structure, Bangladesh implemented a number of economic reforms during the 1980's, underwritten by the familiar structural adjustment policy. These included deregulation of sanctioning procedure and relaxation of other regulatory barriers, easing of import procedure, reducing trade barriers, following a market oriented exchange rate policy, and implementation of fiscal, monetary and public enterprise reforms. These reforms helped remove a large part of the policy bias against SMEs that prevailed earlier. Recent studies confirm that these reforms had positive impacts reflected in a fairly rapid growth of the sector during the past decade. However, because of their 3 structural weaknesses, the SMEs may need more pro-active policies for their development in addition to the further removal of the policy biases.

8.3 Policy Issues: 8.3.1 Public Development Outlay
Although successive five-year plan documents have mentioned development of small, medium and cottage enterprises as priority area, public development expenditure in this sector has not been commensurate with this declared policy. Thus, in the Fourth Five Year Plan, the revised public allocation to this sector was Tk. 2,016 million, which was a meager 0.58 per cent of the total public development outlay in the plan. What is even worse, only about 69 per cent of this small allocation were actually invested during the plan period. In the current Fifth Five-Year Plan, the share of the sector in total public development expenditure has gone down even further. If the sector has to make much headway, there is need for substantial increase in public investment in the sector

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particularly in the area of training, extension, research, market promotion, etc. A collaborative effort of the government with business associations, non-governmental organizations NGOs and other development partners is recommended in such public outlays.

8.3.2 Trade Policy
During the past decade, substantial reforms have been carried out in the external trade regime of Bangladesh. The import procedure has been greatly eased and deregulated. Import tariffs have been lowered and quantitative restrictions virtually eliminated. All these have facilitated greater access of domestic producers to imported raw materials. This has particularly benefited SMEs as they were affected more adversely by the regulated trade regime. However, import liberalization has also exposed domestic producers to competition from foreign goods. To ensure a level playing field and to enable domestic SMEs to compete effectively with imports, the following policy concerns need to be addressed.

8.3.3 Prior Announcement of Policy Changes
To enable domestic producers, particularly the SMEs, to prepare themselves to face external competition there is need for adequate forewarning about impending policy direction. This is particularly true of trade policy measures. If the government makes prior announcements of its impending trade policy changes, particularly with respect to tariff schedules, investors will be aware of the degree of competition they will be facing with the changes and will make adjustments in their investment and production plans accordingly.

8.3.4 Tariff Rationalization
To encourage domestic production, there should be adequate gap between duty on raw materials and duty on finished products. In fixing duty on finished products, possible under-invoicing and dumping should be taken into account, as otherwise, effective duty rates on finished goods will turn out to be lower than that on raw materials in spite of the higher statutory rate on the finished item.

8.3.5 Appropriate Tariff Valuation
To avert the problem of under-invoicing, a system of tariff value has been put in place for certain categories of imports. There are complaints that these tariff values are often not in

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line with the going world price of these items which sometimes puts domestic producers at a relatively disadvantaged position.

8.4 Fiscal Policy: 8.4.1 Value Added Tax
The main components of indirect tax in Bangladesh are Value Added Tax (VAT), Supplementary Duty and Excise Duty. VAT is imposed on producer; manufacturer, importer, exporter or service rendered under the Value Added Tax Act, 1991, on goods or specified services, at the rate of 15% at every stage of transfer. VAT paid against the input is adjustable against the VAT on output to be collected from the buyers and the net sum stands payable on delivery of goods or specified services to the VAT authority. Exemption is allowed to certain goods or service or certain taxpayers. All cottage industries, except those producing particular products, are exempted from VAT. But, manufacturer, producer or service rendered (other than cottage entrepreneurs), whose annual turnover does not exceed Tk.1.5 million are required to pay Turnover Tax at the rate of 2.5 per cent in lieu of 15 per cent VAT. This limit is too low for small industries. As a result, small industries are subjected to the same 15 percent VAT as their large-scale counterparts. In addition, supplementary duty is imposed at variable rates on certain categories of consumption goods across all size categories. Finally, excise duty applies to a limited number of items irrespective of size classification. Thus, in terms of indirect taxes, there is virtually no differentiation between SMEs and their large-scale counterparts, which is considered inequitable by most SMEs.

8.4.2 Tax Holiday
Similarly, there are no differentiated treatments of SMEs either with respect to duty on capital machinery or direct taxes. There are provisions of tax holidays for enterprises of all size categories subject to rules and procedures set by the National Board of Revenue. To avail themselves of tax holiday, enterprises recommended by the relevant sponsoring agencies have to get the approval of the National Board of Revenue, which is a cumbersome and lengthy process. The tax holiday, however, is not available to sole proprietorship enterprises which are the usual form of small and cottage industries in Bangladesh.

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8.4.3 Wealth Tax
Wealth tax is payable by an individual if his net wealth exceeds Tk.2.5 million. As per existing law, no wealth tax is payable by a company, the usual legal form of a large industry. On the other hand, the legal form of small industries is usually sole proprietorship, and hence these enterprises have to pay wealth tax on their business capital. Thus, fiscal policy in Bangladesh is not particularly tailored to provide support to SMEs, which is pointed out by most SME entrepreneurs as a critical policy constraint hindering SME growth.

Constraints of SME Financing
9.1 Constraints of SME Financing:
SMEs undoubtedly play a very important role in the economy of Bangladesh in terms of output, employment, and private sector activities. In recent years, structural changes suggest a shift from traditional to relatively modern product categories with higher capitalization and use of better production techniques. But implementing SMEs have faced the following constraints. They are: 1. Legal, Regulatory, and Administrative Constraints 2. Financial Constraints

9.2 Legal, Regulatory, and Administrative Constraints:
As mentioned earlier, policy reforms of the past decade have brought about substantial relaxation in the investment sanctioning procedure. No prior approval is now required for investments involving own finance. However, there is scope for further improvement in the following procedural aspects relating to investment regulations:

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9.2.1 Trade License
Investors are required to procure trade license from local government bodies by paying statutory fees. The process involves unnecessary delays, harassment and side payments. The procedure needs to be simplified and the issuance of the license made automatic subject to payment of requisite fees and declaration by the investor that the proposed investment is in conformity with the rules and regulations and zoning restrictions of the local government authority.

9.2.2 Registration under Factories Act
According to the Factories Act 1965, all manufacturing units employing 10 or more workers are required to be registered with the office of the Chief Inspector of Factories and Establishments. The job of the Factory Inspector is to oversee the working condition and safety measures in the factory. In practice, the regulation has proved to be a major source of delay, harassment and unofficial payments for the investors particularly for those in the SME sub-sector as the existing regulations do not differentiate between different size categories with respect to safety and working conditions requirements. To relieve the investors of these problems the requirements relating to safety and working conditions should be defined separately and realistically for the SMEs and the discretionary powers of the Inspector should be minimized. Registration should be automatic once the investor has declared that the requirements have been complied with.

9.2.3 Clearance from the Department of Environment
All industries are also required to obtain a certificate from the Department of Environment in respect of proper arrangement for anti-pollution and safety measures. Here again, the requirements should be clearly stated for the type and size categories of industry and the investor should be allowed to go ahead with investment on the basis of the undertaking that the requirements will be complied with.

9.2.4 Registration with Sponsoring Agency
Registration with sponsoring agencies such as the Bangladesh Small and Cottage Industries Corporation (BSCIC), Board of Investment (BOI) or Bangladesh Export Processing Zone Authority (BEPZA) is voluntary unless an enterprise wants to avail itself of government incentives. To keep track of private investment in various sub-sectors, it would be useful to make registration with the sponsoring agency mandatory. However, to 55

relieve the investors of possible hassles, registration procedure should be simplified requiring minimum information to be provided by the investor, and registration should not be held up until the proof of investment has been produced, as the current practice appears to be.

9.2.5 Contract Enforcement and Resolution
This is a constraint, which is faced by both large and small firms. Inadequacy in the system for contract enforcement and resolution arises from archaic legal system where procedure of adjudication is long drawn out and cumbersome and the system is corrupt. As a result it is not difficult to delay a scheduled date for hearing. SMEs with low sustaining power often lose out in the long drawn out court battle.

9.3 Financial Constraints: 9.3.1 Access to Finance
SMEs encounter great difficulties while rising fixed and working capital because of the reluctance of banks to provide loans to SMEs. Banks are shy to lend to SMEs because of high processing and monitoring costs of loans to SMEs. The loan application forms for investment financing from banks are long, tedious, and redundant. Since the removal of the interest rate subsidy without the removal of interest band, financial institutions find little incentive to lend to SMEs. SMEs find it difficult to use non real estate assets as collateral to obtain loans from the banks. In the past, the government has attempted to provide SMEs with access to finance through targeted lending. There was a government directive that 5 per cent of a bank's loan portfolio be set aside for small and cottage industry financing. A new bank, namely, the Bank of Small and Cottage Industries (BASIC) was set up in 1988 with the objective of financing the small and cottage industries. There were also attempts to channelize fund received from international agencies such as the Asian Development Bank (ADB) to the sector through private banks. There were provisions of favorable debt equity ratio, special interest rates and credit guarantee scheme. The central bank also issued directives to both public and private commercial banks regarding working capital loans, use of standardized documentation procedure and time limits for credit sanctioning and loan disbursement. Notwithstanding all these arrangements for financing of SMEs, the actual delivery of institutional credit to

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this sector has been grossly inadequate. The following seem to be the key factors inhibiting flow of institutional finance to the sector.

9.3.2 Extremely short grace period
In our country, grace period of repaying any credit is very low. According to the SME entrepreneurs, almost all the Banks structured the loan in such a way that entrepreneurs have to start the repayment of credit within a very short time after disbursement of credit. This is really a big problem for the entrepreneurs because the entrepreneurs are bound to generate profit instantly to fulfill the Banks requirement. But this is impossible, as a business needs a minimum time to be in a stable position and to generate profit. Proper loan restructuring is needed in this regard.

9.3.3 High interest rate
Another problem is that extremely high interest rate for the entrepreneurs. Many entrepreneurs is having problem because of high interest rate. Banks, in many cases, maintain high spread as a result there remains reckless competition of making more profit from the Banks perspective. And, sufferers are general entrepreneurs who borrow from the Bank. This issue must be in consideration regarding loan structuring.

9.3.4 Project Preparation and Evaluation
The first problem entrepreneurs face in seeking institutional finance is with regard to preparation of the project proposal. In spite of directives from the central bank to follow standardized procedure, the loan application process has still remained lengthy and cumbersome. The entrepreneur often lacks the ability to formulate a proper project proposal. Even when he prepares the proposal drawing on outside expert services, there is no guarantee that the proposal will be evaluated properly as the financial institutions themselves lack adequate capability for proper project evaluation.

9.3.5 Collateral Requirements
One of the main factors that have hampered flow of institutional finance into SMEs is banks' pre-occupation with collateral based lending. Traditionally banks have used fixed asset ownership, particularly land ownership as the basis for judging credit-worthiness. This puts SMEs at a relative disadvantage, as large entrepreneurs are often able to get

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around the problem because of their influence and contacts by putting up collateral of dubious valuation. The solution to this problem lies in banks seeking deposit relationship with owners of SMEs and using cash flow rather than asset ownership as the criterion for credit-worthiness. An expanded credit guarantee scheme will have to play a vital role in this regard.

9.3.6 Bureaucracy and Corruption
Because of lack of proper autonomy and accountability the public sector financial institutions are beset with inflexibility, inefficiency, political interventions and corruption. Since the performance of the bank officials is not properly evaluated they lack the incentive to bring a large number of suitable borrowers, particularly those in the SME sector, within the fold of institutional financing. They adopt a passive and inflexible attitude towards the borrowers either to avoid the risk of making an inappropriate lending or to force the borrower to make side payments for more favorable handling of the loan application. Until necessary reforms in the public financial institutions are carried out, the SMEs will continue to bear the brunt of this institutional malice.

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Conclusion and Recommendations
10.1 Conclusion:
As the experiences of SME finance in Bangladesh suggest, there is critical need for putting in place a credit delivery system that evaluates the credit worthiness of borrowers, on a basis other than fixed asset ownership. The evaluation may require examining transaction records of the borrowers, assessing the value of movable assets etc. There will also be the need for enhanced post disbursement monitoring. An effective SME finance policy will have to cover such enhanced cost of credit administration. In addition to credit guarantee or refinancing facility there will have to be adequate rediscount facility for the primary lender to accommodate these costs. The financing scheme should also include special provisions for women entrepreneurs. Indeed, the Implementation of appropriate policies and strategies is a prerequisite to harness sustainable competitiveness of SMEs around the country. Suggestive remarks have been stipulated in this write up. With that paradigm, proactive policy is essential to enact them. The first step this regard is to make firm’s filly aware of the competitive challenges they have to face. The next step is to help SMEs prepare to meet the challenge by understanding their strengths and weaknesses and providing the inputs they need to help them upgrade. The main inputs are finance, market

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information, training, infrastructure development, R&D, management tools, technology, skills and links with institutions for support services. SMEs are considered to be the seedbed for the development of entrepreneurial skills and innovation. Small capital requirement makes easy entry and exit possible and private sector entrepreneurial activities have many important spillover and positive externality effects. However, liberalization of the economy along with rapid globalization has posed severe challenges to SMEs not only in international markets but also in the domestic economy. Since SMEs are based on relatively small investment, their survival depends on readily available markets with easy access. In today’s world, market development is a much more challenging task, which requires coordinated efforts by individual business enterprises and the Government. Bangladesh has failed to maximize the benefits derived from the SME sector, which promises and needs to play a pivotal role in promoting and sustaining the industrial as well as overall economic growth. The failure can be attributed to various reforms and trade liberalization measures that have squeezed the sphere of Government’s activity in business. Consequently, the private sector has to lead the economy in a dynamic growth path. The role of SMEs in providing productive employment and earning opportunities has emerged as an important concern among policy makers, donor agencies and researchers. Regardless of the correct magnitude, SMEs undoubtedly play a very important role in the economy of Bangladesh in terms of output, employment, and private sector activities. They are quite predominant in the industrial structure of Bangladesh comprising over 90% of all industrial units. Together, the various categories of SMEs are reported to contribute between 80-85% of industrial employment and 23% of total civilian employment (SEDF, 2003). However, serious controversies surround their relative contribution to Bangladesh’s industrial output due to paucity of reliable information and different methods used to estimate the magnitude. The most commonly quoted figure by different sources (ADB, World Bank, Planning Commission and BIDS) relating to value added contributions of the SMEs is seen to vary between 45-50% of the total manufacturing value added.

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10.2 Recommendations: 1. Seed Money, Leasing, Venture Capital and Investment Funding:
There is a need for improving different aspects of financial services of SMEs, such as seed money, leasing, venture capital and investment funding. There is a lack of long-term loans; interest rates are high, Guarantee/Security issues, exchange risks etc. All these limit the development of SMEs. Finance, both short and long term, should be provided at market cost of capital. Fund should be made available through encouragement for setting up ‘Venture Capital’ organization in Bangladesh. The concept of venture capital (VC) has successfully operating in the USA, EU countries, and Canada.

2.

Establishment

of

Small

Business

Investment

and

Lending

Corporation (SBILC):
We should start with ‘something effective’ for industrial development in general and the SMEs sector in particular. Such a step, for example, could be the establishment of a separate corporate body. That means a separate financing institution could be developed, with joint ownership of the public and private sector. To make the proposed initiative effective in achieving its goals, government may set up a Small Business Investment and Lending Corporation (SBILC). The SBILC can be formed under Small Business Investment and Lending Act passed through the Parliament. Under SBILC there may have external and Internal Financing policies. Taken from the different countries experiences the different types of financing policies and programme that can be introduced through SBILC, is enumerated below:

Low Doc Loan Programme, which may allows small business to use a simple one-page application for loans up to Tk.50, 000; loans between Tk.50, 000 and Tk.1, 00,000 may require the one-page application plus personal tax returns for three years and a personal financial statement from entrepreneur. Direct loans, this type of loan may be provided directly to the small business with public funds and no participation. The interest rate charged on direct loans depends on the cost of money to the government and it changes as general interest rates fluctuate. It can be limited to a fixed ceiling.

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Immediate participation loan can be made from a pool of public funds and private loans. Guaranteed loan. When private lenders extend loans to small businesses, SBILC in those cases can provide guarantee for repayment in case the borrower defaults on the loan, which may be given for a defined amount of loan and up to certain percentage e.g., 80% or 75% of loans. Seasonal line of credit programme, may be offered for short-term capital to growing companies needing to finance seasonal buildups of inventory or accounts receivable. The maturity period cannot be exceeding 12 months and the company must repay it form cash flow. Accounts receivables and inventory can be collateral for the loan. Contract loan programme, is another short-term loan guarantee, but it is designed to finance the cost of labour and materials needed to perform a contract. Maturity times are up to 18 months. Export working capital programme. Under this prgramme the SBILC may give guarantee 90 percent of bank credit line up to a certain limit. In such case Loan proceeds must be used to finance\e small business exports. Disaster Loans. As their name implies, disaster loans can be provided to small businesses devastated by some king of financial or physical losses (such as tremendous flood, earthquakes). Disaster loan may carry below-market interest rates. Greenline revolving line of credit programme. Greenline programme can be designed to increase small companies’ access to working capital by providing them with revolving lines of credit. It can be different than traditional loans, which may require fixed monthly payments; the Greenline programme may employ highly flexible revolving loans, in which cash-hungry small businesses able to draw on a credit line only when they need the money. This loan prgramme can be designed to provide short-term credit to allow small businesses to finance the sale of their products and services until they can collect payment for them.

3. Periodical Professional Training Courses for SMEs & for Entrepreneurship Development:
Periodical professional training courses should be arranged for technical staff of SMEs. Moreover training in management of small enterprises and efficient marketing can also 62

provided. Islamic Chamber regularly organizes training workshops on management, marketing, procurement of technologies, quality control system and financing of SMEs, for the benefit of representatives of private enterprises and staff of member chambers in different regions of the Islamic World. Training programme / workshop should be organized for the development of SMEs capabilities to acquire enhanced knowledge and skills about how to choose, use and improve technology. At present, no such institution exists except a project of the BSCIC called ‘SCITI (Small and Cottage Industries Training Institute). Training on different aspects of SMEs activities for entrepreneurs is crucial for the development of an entrepreneurial.

4. Establishment of R&D Institute for Enterprise and Entrepreneurship Development, Training and Research Institute:
In a country like Bangladesh, where entrepreneurial initiative is rare and shy, a separate institute for enterprise and entrepreneurship development, training and research should be developed. To make it a ‘centre of excellence’ in SMEs development, it should be designed, involving educational institutions, business associations, relevant government bodies, private research agencies, and individual consultants having experience in SMEs development.

5. Establishment of a separate bank for women entrepreneurs:
Establishment of a separate bank for women entrepreneurs will accelerate the development of women SME through their increased access to formal financial institutions.

6. Minimum quota for women entrepreneurs:
Maintaining a minimum quota for loan disbursement to women entrepreneurs and proactively seek out female clients.

7. Training program for women entrepreneurs:
Increase the capacity of women entrepreneurs through training and awareness raising activities on financial management, business procedures and other regulatory process such as trade license, tax and VAT, etc. At the same time, initiatives should be undertaken to sensitize the people working with respective regulatory institutions so that women SME can easily arrange necessary documents for loan application and other procedures.

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8. Implementation and Monitoring of Policy Measures for SMEs:
Only policy prescription is not the end, if it is not implemented through different measures timely and properly. How far policy measures are implemented, along with, what effect - desired or not - such policy measures has had on the development of SMEs should also be monitored from time to time. This monitoring will provide feedback for taking corrective actions, if necessary, to ensure desired effect of the policy adopted.

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