SME ACCESS TO FINANCING: ADDRESSING THE SUPPLY SIDE OF SME FINANCING REPSF Project No.

04/003
Author: RAM Consultancy Services Sdn Bhd FINAL MAIN REPORT July 2005

EXECUTIVE SUMMARY
Small and medium scale enterprises (SME) are the backbone of many successful developed nations such as Japan, Chinese Taipei, Germany and the Republic of South Korea. ASEAN countries too have touted SME as the new engine of economic growth and development. In the last decade or so, various ASEAN governments have formulated national agendas and development polices addressing all aspects of demand and supply to promote the SME sector. However, ASEAN SMEs contribution to the economy has not reached a level on par with SME in developed countries. Various challenges and impediments prevent SME from developing to their full potential. One of which is the access to formal sector financing. This study seeks to discover the factors that inhibit SME lending by financial institutions by examining the institutional, legal and regulatory framework present in ASEAN member countries. Concurrently, the research also examines the viability of credit scoring in improving access to finance for SME and surveys the interest of financial institutions to undertake credit scoring for SME loans. The report draws on the findings of the research and fieldwork survey to recommend appropriate strategies to improve access to financing. SME in ASEAN draw financing primarily from internal funds and the informal sector. Formal sector financing makes up less than 25% of funding needs. This figure is even lower in the transition economies where banking intermediation is still relatively low. A survey of financial institutions throughout ASEAN revealed that many banks and non-bank institutions are generally keen to lend to SME as they realise that on a portfolio basis, SME loans provide higher returns and lower risk compared to large corporate loans. However, these funding institutions face several impediments in financing SME. Naturally, financial institutions attribute most of the impediments to either the government, the prevailing legal and regulatory framework, or the SME. The objective view is that no party is entirely free from blame. Governments in ASEAN have generally been supportive of SME development by initiating various financing programmes and support measures. These have taken the form of interest subsidies, grants, credit guarantee schemes, loan quotas, export financing, development finance institutions, specialised institutions and the like. By and large, the general consensus is that these government supported initiatives have not been as successful as intended, as indicated by the low rate of formal sector financing achieved by SME. Many have argued that despite the good intentions of government, public sector measures have generated negative trade-offs and encouraged the emergence of a dependency syndrome, which more than offset the massive subsidies committed to the sector. More often than not too, financing programmes for SME have been compromised by the lack of coordination of governments development policies or their ad-hoc implementation.

REPSF Project 04/003: Final Main Report Executive Summary

SME Access to Financing: Addressing the Supply Side of SME Financing

The legal and regulatory framework existing in many ASEAN countries also fails to provide the right support infrastructure to facilitate SME lending by the formal sector. The lack of protection for creditors and enforcement of collateral rights, lack of commercial dispute settlements and arbitration, archaic laws which are not business friendly, lack of fiscal incentives for small enterprises, strict prudential regulations which restrict flexibility of banks, unduly complex or onerous administrative procedures and even simply the lack of a consistent definition or enabling law for SME are some of the impediments to SME financing. It has been pointed out that SME are actually caught between a rock and a hard place: they are large enough to be regulated yet not large enough to enjoy the benefits that are reaped by large enterprises. As for financial institutions, the study found that some are risk adverse to lending to informationally opaque SME, while others simply do not have the skills needed to understand and evaluate SME. In some large banking institutions, the prevailing mindset is still one of bigger is better. As a result, they demand for collateral, require onerous documentations and subject the SME to the same evaluation criteria as they would large and structured corporations. The poor information environment in many ASEAN countries does not help either. Non-bank financial institutions (such as finance or credit companies) and smaller boutique banks are usually found to be more perceptive and knowledgeable about SME financing than their larger cousins. However, a positive trend is appearing among financial institutions armed with the lessons learnt from the Asian Crisis and faced with greater competitive pressure, they are increasingly looking to increase lending to medium and small sized enterprises. The availability of newer technologies such as credit scoring has facilitated the progress of some banks foray into this segment. As such, most financial institutions are supportive of applying credit scoring to SME loans. In fact, more than 70% of survey respondents in ASEAN-6 economies have implemented some form of rating or scoring for SME loans. However, only a handful of financial institutions are deploying objective scorecards that do not require subjective inputs. Notwithstanding the positive feedback of survey respondents toward the use of credit scoring for SME loans, this report poses the question of what is the real benefit of credit scoring in this context. The benefits of credit scoring are obvious for high volume low value loans and in the risk management of such portfolios. But if SME generally do not have high disclosure standards and are informationally more opaque by nature, would the use of credit scoring really make a difference to the loan decision? The research concludes with several recommendations that could facilitate greater access to financing by SME at the national level. According to their respective needs, countries could consider to, among other measures, improve the outreach of credit guarantee programmes, promote greater engagement by non-bank financial institutions, standardise SME definition and promote informal debt workout mechanisms for SME while banks in the region could facilitate SME financing by improving the credit evaluation skills of their officers, establish specialised SME units and consider greater interaction with SME associations. The detailed recommendations for each country are found in the individual country reports. Given the diversity in the economic development and institutional framework of ASEAN member countries, it is quite difficult to recommend regional initiatives that are practical and yet readily adopted for action. Regional initiatives that will materialise into tangible actions require more than mere talk but great effort and real commitment on the part of the respective stakeholders. As such, the recommendations made in this report for regional initiatives are necessarily high level but will hopefully plant a seedling for a practical idea to take off in the near future. The plausible regional initiatives that ASEAN members could perhaps consider include capacity building of newer ASEAN members, organising regional financial forums, establishing a common regional SME definition, creating a reporting

REPSF Project 04/003: Final Main Report Executive Summary

SME Access to Financing: Addressing the Supply Side of SME Financing

framework for SME statistics, creating a regional database for SME in ASEAN and procuring national governments to consider a simplified accounting standards for SME.

July 2005

REPSF Project 04/003: Final Main Report Executive Summary