SME Financing in Bangladesh: Reasons, Constraints, Benefits, Risks etc.

Dr. Md. Mosharref Hossain

Introduction
The economic and social importance of the Micro, Small and Medium Enterprise (MSME)
sector is well recognized in academic and policy literature. MSMEs play a very significant
role in the economy in terms of contribution toward balanced and sustainable growth,
employment generation, development of entrepreneurial skills and export earnings.
Bangladesh economy is characterized by low per capita income, high level of unemployment,
mass poverty and social deprivation. In these circumstances, higher growth of MSMEs can
reduce poverty to a satisfactory level by creating jobs for the skilled and unskilled manpower
in this sector. For most of the developing and transition economies, the common challenges
that MSMEs typically confront include barriers related with access to finance in the formal
financial sector, institutional, legal and administrative barriers. However, nowadays
commercial banks and other non-bank financial institutions are coming forward with a good
number of initiatives to finance MSMEs.

Project Characteristics

There is a way we characterize businesses, which may be more meaningful in addressing

client needs. The characteristics cited below will not be valid in all Markets, at all times, but
show the range of international experience:
Micro: Informal businesses operated by low-income people, particularly women; few barriers
to entry; line of business is steady, not rapid growth; records typically are not written and
business operators may be illiterate.
Small: Usually registered; operated by a family or close group; business owner is the day-to-
day decision maker; formal business records are available but may not be accurate and are
rarely audited.
Medium: Business is large enough that decision-making must be delegated; financial record-
keeping is more transparent and accurate; in addition to audits, firms may have a director of
finance.
Credit from banks is the major source of finance from formal sources (not from family and
friends, or trade credit) for small enterprises. These businesses are not large enough to issue
debt (bonds or short-term notes) or equity in the capital markets. In this sense they are forever
captive bank clients.

It is important to realize that small enterprises do not mean “new”. Most small enterprises
remain small because the owners like running their own business, and do not want to bring in
outside investors. These businesses may be very successful and lucrative, as measured by

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Return on Assets (ROA) and Return on Equity (ROE), and may have a substantial operating
history.

Common Threats Faced By SMEs

Here are some common issues. How many of them apply to your own company?
 new competition
 increased cost of raw materials
 changes to the economic landscape: taxes and inflation
 catastrophic events (so-called acts of God): fire, flood
 theft (shoplifting, burglary, embezzlement by employees)

In addition to these things, you probably have unique and more specific threats that you can
identify.

Reasons to Enter the SME Banking Market

There are many attractive reasons for banks to enter the SME banking market. Perhaps the
most important of these is volume as SMEs typically make up more than 90% of the
registered businesses in any country. There are several other reasons as well, however,
including:
Diversification of Revenue: The bank is not wholly dependent upon revenue from larger
businesses or from a consumer market; within the SME sector the businesses are in a variety
of industries, so a downturn in a single industry is not felt as sharply.

Diversification of Credit Risk: Because loans are relatively smaller, the bank has less
exposure in the event of default of a single borrower. From a risk point of view the
performance of the portfolio is more important than the performance of individual loans. The
portfolio is less risky because the customers are in different lines of business and are not
interdependent.

Opportunity to Cross-Sell a Range of Products: Because the business owner is making all
the decisions for the business, a call on the business can result in deposit, fee-based services,
and loan sales to the owner, his family, employees, and the owner’s network of contacts. SME
business owners are a great source for referrals.

Good for the Economic Growth of the Community: As the bank makes more loans to local
SME businesses, those businesses can increase their sales, buy more assets, and hire more
employees, which in turn benefit more businesses and the community as a whole.

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Good Alternative to Corporate Lending: The corporate banking sector is often overly
competitive.

Constraints to SME Lending

There are real and perceived problems in lending to small enterprises and these must be
addressed or minimized for small enterprises lending to be an attractive line of business.

Cost to Serve: The cost of analyzing a SME loan is the same as analyzing a large loan. Since
this cost of lending is fixed, large loans are relatively more profitable. This can be addressed
through changing analysis procedures and expense control.

Lack of Information: The smaller the business, the less likely it is to have audited
statements. In addition, important information may be often in the owner’s head. This is
addressed by using substitutes for formal financial statements.

Higher Failure Rate: While this is generally true, failures are more common at startup
(within the first three years of the business life). However, the bank can avoid this problem by
not lending to start-up businesses.

Higher Interest Rates SMEs are willing to pay higher interest rates to cover the additional
costs. However, if the interest rates are too high, the better performing businesses (not the less
profitable businesses) drop out and portfolio tends to become riskier.

Benefits of SME Lending

Some of the benefits of small enterprises lending suggest that it can be a lucrative strategy for
the bank. These benefits include:
Less Price Sensitivity: Just as the bank has a fixed cost for analyzing each loan, the small
enterprise business owner incurs a fixed cost in establishing a banking relationship. The
owner, or the director of finance, would rather not go through an application process with
several banks and incur the fixed cost of doing this every time the business needs a loan. The
price of the loan (interest rate) is not that important. Convenience and flexibility are much
more important.
Customer Loyalty: The bank gets to know the business better over time, which mitigates the
problem of lack of information, thus loans become less risky.

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Cross-Selling Opportunities: Lending can lead to the use of other services, including
deposits and fee-based services, from the business, the owner, the employees, the owner’s
family, and other potential clients referred by the owner. In analyzing a loan request, the bank
will get to know enough about the business to sell other services as well. In this sense the cost
of acquiring information can be spread over several services.

What Do Small Enterprise Want?

Small enterprises by and large are looking for reliability, flexibility, and convenience. In
particular:

Relationship with the bank: The small enterprise is willing to make an investment to attain
an enhanced relationship with the bank. The bank and the banker can be sources for advice
and education on financial matters for them.

Reliable and Consistent Availability of Credit: In developed countries, banks tend to rotate
staff more often than the business owner would prefer. Small enterprise requires a bank/loan
officer who understands the risks and opportunities of the business, so that the business owner
does not repeat requirements constantly (and re-incur the fixed cost of establishing the
relationship).
Rapidity and Proximity of Decisions: Small enterprise planning timetables are often quite
quick – loan funds are needed immediately and a lengthy decision process can be a major
constraint. The closer to the client that the decision is made (fewer approval levels) the faster
the decision is made.
One Size Does Not Fit All: Small enterprises need a financial institution that is able to
recognize credit needs and provide appropriate funding. There should be flexibility in bank
products to meet client needs.

Types of Risk in SME Businesses:

Some of the risks that SME face are overhead cost, cost of equipment, expected sales volume,
salary cost, taxes, price charged for service or product, competitor's actions, the local
economy, changing trends, risk that the product may become obsolete. Other risks include
damages from fire, water, natural calamities, intentionally inflicted damages, loss of data and
property due to theft, machine breakdown forcing work to come to a standstill, cash flow
problems that may force a business to close. The risks of small enterprises can be classified
under top major heads as follows:

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Internal Risks
Credit Risk
Liquidity Risk

External Risk
Market Risk
Interest rate risk
Growth Risk
Market Demand
Competition
Commodity Risk: Supplement or substitute
Government Policy (The Govt. May Permit import of the same product or
substitute product.
Project Risk
Legal Risk (Legal Product, Legal Location, Labor Law)
Security Risk (Collateral. Asset is)
Marketing Risk (Distribution)
Operating Risk (Technology used in the project, Management Efficiency)
Others
Environmental: Bird Flu. Sars, Sidr, Flood
Family Risk: Succession, Dependent and Supportive members
Health Risk: Risky waste. Environmental Pollution. Govt. may ban production

Other things to be considered of an entrepreneur

a) Honesty and Integrity
b) Experience
c) Achievement
d) High Energy Level
e) Motivation.

The Management of Lending SME:

The effective management of lending to small enterprises can contribute significantly to the
overall growth and profitability of banks. There has been considerable research and analysis
into the methods by which banks assess and monitor business loans, manage business
financing risks, and price their products – and how these methods might be further developed
and improved. There has been particularly intensive scrutiny of the kinds of business financial
information that banks use in making lending decisions and how reliable that information
actually is.

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Banks have traditionally relied on a combination of documentary sources of information,
interviews and visits, and the personal knowledge and expertise of managers in assessing and
monitoring business loans. However, when assessing comparatively small and straight
forward business credit applications banks may largely rely on standardized credit scoring
techniques (quantifying such things as the characteristics, assets, and cash flows of
businesses/owners). Using such techniques – and also centralizing or regionalizing business-
banking operations generally – can significantly reduce processing costs. Standardized
computer-based assessment may also be more accurate and fairer than reliance on the
personal judgments of local bank managers. As a result, banks may now be able to offer more
loans, faster and in larger amounts, and reduce previously high security requirements.

However, business lending as a whole is substantially more diverse and complex than (say)
personal and residential mortgage lending. This coupled with the large size and inherently
risky nature of many business loans tends to limit the scope and desirability of computerized
credit scoring in assessment and monitoring.