While banks tended to define the SME segment in their own way, the RBI has defined the small scale industry and small business enterprises for purposes of inclusion in the priority sector on the same lines as in the Micro, Small and Medium Enterprises Development (MSMED) Act, 2006 (MSMED Act, 2006). Accordingly a manufacturing enterprise with investment in plant and machinery not exceeding Rs10 crores and a service enterprise with investment in equipment does not exceed Rs5 crores falls under the definition of an SME appropriately classified as micro, small or medium scale based on the exact amount of the investment. Although medium enterprises are included in the SME sector, credit to medium enterprises is not included under the priority sector.
Hemant B. Bhattbhatt, Partner, Deloitte Haskins & Sells
Banks generally look at promoter (vintage, competency, networth, track record), industry (growth, risk, cyclical trends, profitability), business unit (turnover, profitability, debt/ equity, liquidity) and transaction history (overdues, cheque returns, statutory overdues etc) and security (tyep and quality of collateral).
The SME sectors preferred by bankers for lending include bulk drugs, knitwear and auto-ancillary goods. Textiles, pharmaceutical companies, chemicals and dyes sectors also continue to find favour with banks as these businesses are thriving. Enterprises like gems and jewellery, seafood processing, sports good etc are not preferred, as banks have suffered huge non-performing assets on account of lending to these sectors over the past few years.
Bank loans are secured by charge of current assets, collateral property and promoter’s personal guarantees. In case of defaults such security is enforced, if required through suits in legal courts and in certain cases under the asset recovery acts prevalent. Also details of all defaulters are advised to RBI, which maintains a defaulters list. Banks are not allowed to lend to companies with promoters who find mention in the defaulters list.
The SME sector faces huge challenges like fragmented markets in respect of their inputs as well as products; vulnerability to market fluctuations; limited access to technology and product innovations; lack of awareness of global best practices; considerable delays in the settlement of dues/payment of bills by the large scale buyers, non-formal business practices and above all a lack of transparent financial information. This causes inadequate access to finance due to; lack of access to private equity and venture capital; lack of access to inter-state and international markets.
With the deregulation of the financial sector, the ability of the bank to service the credit requirements of the SME sector depends on the underlying transaction costs, efficient recovery processes and available security. Thus the higher risk perception is due to low transparency in balance sheets, poor governance norms and tendency to hold assets outside the balance sheet. Promoters also tend to keep low equity contribution in the balance sheet and take on more than prudent level of debt. If promoters can satisfy banks as to transparent information, properly capitalised balance sheets and good governance mechanisms, banks would be ready to lend.
The financial needs of smaller businesses are often underserved, which can be a constraint to their growth. SMEs contribute more than 90% of industrial output, are one of the largest employers and contribute to product innovation besides 35% of exports. There is an immediate need for the bank to focus on credit and finance requirements of SMEs.
An IFC study, which began in 2005, benchmarked SME banking practices at 11 banks across developed and emerging markets. It identified competition in corporate and retail segments as a key factor that drives banks to offer services to small businesses. It also showed that SME banking is proving to be profitable, generating a higher return on assets than total bank portfolios. The study found that senior management commitment and focus at the operational level are both crucial factors in the success of SME banking. It also emphasized need for specialization among participating banks, which typically employ dedicated small business staff.
Various banks have specialized products addressed to SMEs like business instalment loans, trade services and working capital, pre-shipment credit (180 days), post shipment credit (90 days), express trade, International trade account, term loans, forex services, loan / overdraft against property etc. In addition to bank loans, SMEs can avail of equity financing, finance from agencies like factoring and unsecured corporate loans, subsidy from government etc.
Most small and medium companies rely on extremely expensive funds sourced from the unorganized financial sector. As indicated earlier, lack of financial transparency and dependability is the key concern. Credit rating addresses that issue. Most banks are encouraging SMEs to get rated so that they can improve their access to finance. Some banks are giving interest concessions to the extent of 0.25% p.a etc. The SMERA impact is yet to be fully felt.
SME finance is set to grow substantially in the future with the Indian economy growing at more than 8-9% p.a. Part of the reason why bank credit is denied to many small units, despite repayment capacity not being suspect, is that lenders often do not have the capability to assess their risk. Rating agencies are a step in this direction.
With a brand new government package, reworked guidelines for lending by the RBI and the facility of rating enterprises for their creditability and debt repayments, banks can now refocus on the SME sector. Credit risk in the SME sector is widely dispersed and Banks get better yield from SME advances as against the traditional advances where the spread is getting gradually reduced. The SME clientele base could also be utilised by the branches to step-up “cross selling” of various other products including technology-enabled products.
Basel II norms dictate that for externally rated SMEs, the capital to be provided by banks as loans to such SMEs is lower than for loans to unrated SMEs. Thus, if SMEs are rated, the capital provisioning would be lower and banks would be willing to lend more. Consequent upon the announcement made in the Annual Policy Statement for the year 2007-08, all State Level Banker’s Committee (SLBC) Convenor banks were advised to review their institutional arrangements for delivering credit to the SME sector, especially in 388 clusters identified by the United Nations Industrial Development Organisation (UNIDO) spread over 21 States in various parts of the country. Further, in order to improve credit delivery to SMEs, banks were urged to review their institutional arrangements for delivering credit to the SME sector, especially in identified clusters in various parts of the country, and to take measures to strengthen the expertise in and systems at branches located in or near such identified clusters with a view to providing adequate and timely credit.
SMEs need to specialize and remain focused. The urgency to grow faster results in lack of internalization of the expertise required to deliver world-class quality product at competitive rates and relegates them to gaining market share using price competition. As a consequence, margins shrink and erode the financial strength of the business model rendering the SMEs vulnerable to financial trouble. While SMEs can improve their competitiveness in the global market by competing on better skills at lower cost (as proved by sectors like garments, auto components, pharma, jewellery etc.) the more suitable strategy would be to go for quality and build brand that commands premium in niche segments. Strive for profitable growth – not just growth!
The author is Hemant B. Bhattbhatt, Partner, Deloitte Haskins & Sells