Thoughts & Ideas

Wednesday, December 07, 2005

Lending to SMEs

The conceptual framework under which most bank lending takes place in India, including lending to the SME segment with its stress on the current ratio and insistence on collateral security is flawed. First, this approach considers the borrower as a “gone concern” rather than a “going concern” a transgression of a fundamental accounting principle. Second, it does not take into account that due to the weak foreclosure laws and a time consuming legal system, virtually the only security the banker has is a “going concern” and the key skill is ability to entrap cash flows. Third, project finance through debt for start-ups confuses venture capital funding from debt with consequent mismatch in pricing.

The fact that banks can make money in the lending business only by lending to the so called perceived higher risk category borrowers was initially suggested by George Ackerlof in his essay “The Market for Lemons” way back in 1971 (which also gave him a Noble 30 years later). Subsequent research and experience has only added to reinforce this understanding. As such, since the perceived risk in lending to the SME market segment is higher than in lending to the large corporate segment, this should be seen as an opportunity by the Indian banking sector.

Credit risk, i.e., the risk that a borrower will not repay principal and interest arises due to information asymmetry between the borrower and the lender. In other words, there always is and would be a gap between the true worth of the borrower (in terms of his intentions and capability to repay the loan) and what is apparent to the lender.

Asymmetric Information leads to 2 kinds of risks, (a) Risk of Adverse Selection and (b) Risk of Moral Hazard. Adverse Selection is an asymmetric information problem that occurs before the transaction occurs. Potential bad credit risks are the one who most actively seek out loans. Thus the borrowers who are the most likely to produce an undesirable outcome are most likely to want to borrow money.

The larger and more well known a borrower is, the more sources of information (not just financial statements, but also customers, suppliers, equity analysts, employees etc) is available and tracked by all stakeholders, and consequently information asymmetry is lower. As such, the more well-known a borrower is, the more number of banks chasing him so as to lend money. Conversely those entities on whom information is not available readily, have difficulty in raising institutional credit. A direct result of this in the Indian markets is that since banks are not able to readily distinguish good borrowers from bad, large amounts of funds have been invested in low yielding government securities. (And we always thought that the primary purpose of banks was to channelise savings towards loans and advances for productive purposes to enable the economy to grow and create employment and not to put the funds in low yielding government securities.) At the same time there are vast swathes of unorganised industry and agriculture where availability of credit is much more critical than cost and interest rates from 3% to 5% per month are the norm.

The solution to adverse selection problem in financial markets is to eliminate asymmetric information by furnishing people supplying funds with full details about the individuals or firms seeking to finance their investment activities. However, the system of private production and sale of information does not completely solve the adverse selection problem because of the free-rider problem. The free rider problem occurs when people who do not pay for information take advantage of the information that others have paid for. As such, the recent trend of having a credit rating system for SMEs is expected to have limited impact in either differentiating good borrowers from bad or in increasing the flow of bank credit to this sector.

One solution to the free rider problem is the existence of market intermediaries whose functioning is such that they are able to overcome the free rider problem. For example, a bank which becomes an expert in the production of information about firms so that it can sort out good credit risks from bad ones, can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. As a result, the Bank earns a profit, which allows it to engage in this information production activity.

An important element in the ability of banks to profit from the information it produces is that it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market. Because a private loan is not traded, other investors cannot watch what the bank is doing and offer lower interest rates to the point where the Bank receives no compensation for the information it has produced. The bank's role as an intermediary that holds mostly non-traded loans is the key to its success in reducing asymmetric information in financial markets.

Moral Hazard arises after the transaction occurs. The lender runs the risk that the borrower will engage in activities that are undesirable from the lender's point of view because they will make it less likely that the loan will be paid back. For example, once borrowers have obtained a loan, they may take on big risks (which have possible high returns but also run a greater risk of default) because they are playing with someone else's money.

The solution to the Moral Hazard Problem is to write out debt contracts with restrictive covenants, and monitoring and enforcement of these covenants. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior.

Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it completely. It is almost impossible to write covenants that rule out every risky activity. Furthermore, borrowers may be clever enough to find out loopholes in restrictive covenants that make them ineffective.

Another problem with restrictive covenants is that they must be monitored and enforced. A restrictive covenant is meaningless if the borrower can violate it knowing that the lender won't check up or is unwilling to pay for legal recourse. Because monitoring and enforcement of restrictive covenants are costly, the free-rider problem arises in the debt securities (bond) market just as it does in the stock market. If one knows that the bondholders are monitoring and enforcing the restrictive covenants, others can free-ride on their monitoring and enforcement, so the likely outcome is that not enough resources are devoted to monitoring and enforcing the restrictive covenants. Moral hazard therefore continues to be a severe problem for marketable debt.

Banks have the ability to avoid the free rider problem as long as they primarily make private loans. Private loans are not traded, so no one else can free-ride on the bank’s monitoring and enforcement of restrictive covenants. The bank therefore receives the benefits of monitoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts. The existence of moral hazard is an important reason why banks play an important role in channeling funds from savers to borrowers.

In lending to the SME sector, the key issue is that banks need to make a paradigm shift in what constitutes credit risk, similar to the paradigm shift made in micro finance lending. However, since the SME structure is different from the micro finance segment, similar parameters would not be relevant.

Therefore, if banks in India have to remain profitable in their lending business, they have to develop expertise in lending to the SME sector. And the lending expertise should encompass proactive search for lend able entities, appraisal, structuring, monitoring and exiting. This sector is not only large in size but also provides ample opportunities for profitable and safe lending provided the risks involved in their appraisal and monitoring are thought through and appropriate processes are devised to handle them. It is ironic that the older less tech savvy public sector banks with poor conceptual skills have intuitively developed various mechanisms over time to handle information asymmetry and as such are better placed in lending to the SME sector. While the foreign and new generation private sector banks have so far restricted themselves to peripheral SME lending, such as, financing of supply chain of established corporates or the immediate personal requirements of the promoters of the SME sector etc.

In the process both industry and the banking sectors are losers with banks losing great opportunities for profitable lending and industry (including agriculture) being starved for funds. And in the end society (that is all of us) looses with lower levels of growth, income and employment because of lower levels of transfer of savings for productive investment.


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