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«The landscape of SME finance in Bangladesh An analysis of providers, products, requirements and constraints What is this resource? This report ...»

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 Access to finance related constraints: High interest rate on bank loans, lack of institutional credit, non-availability of working capital, low levels of technology adoption, and lack of adequate investments  Operation related challenges: Low levels of productivity, lack of skilled technicians and workers, lack of research and development facilities  Institutional issues: A lack of marketing facilities and market access, absence of clearcut government policies, and inadequate infrastructure  The first issue, access to finance, will be dealt with in more detail. The other two issues stem essentially from the fact that SMEs are weak in managing their business (and this matches the perceptions of parties interviewed) - from planning to purchasing, design, production, quality control, marketing, finance, human resources, public relations, new business developments and target growth.

The ADB has highlighted that, along with high interest rates, the collateral requirement is a major hurdle for SME entrepreneurs. It concluded that, in order to serve the subsector, banks need to develop appropriate funding models that match the financing requirements of the clients along with their financial capacity to withstand potential lending risks and enhance productivity and efficiency of the SMEs28.

Such as mind shift amongst banks appears unlikely given the current situation confronting them in Bangladesh, with liquidity tight and demands on their capital from other borrowers being high.

The 2012/13 Budget announced by the Bangladesh Government on 7 June 2012 requires bank funding for the proposed deficit of Tk230bn (US$2.9bn).

ADB (2009) A third report29 highlighted three main problems for entrepreneurs, which would include both IBs and SMEs.

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A. Project Preparation: 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.

Prerequisites, e.g. track record are a real problem for start-ups, business including loan proposal high processing and monitoring costs. The loan application forms are themselves often long, tedious and requiring redundant information.

Agriculture is seen as most at risk by lenders involving factors such as weather, diseases and changes in official policies.

B. 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 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. (Ref. Guarantee Schemes on pages 34-35) C. 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 favourable 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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Khan Atiqur Rahman, Development of small and medium scale industries in Bangladesh: Prospects and constraints, Bangladesh Institute of Bank Management, 2010

Other issues that have been identified include:

 Transparency and accountability: SMEs do not maintain proper accounting records; it has been alleged in Bangladesh that some loans to SMEs “flew to the stock market”.

Leaving aside this issue, there are other shortcomings, such as the ability of the SME to arrange for the auditing of its accounts  Compliance with regulatory requirements: SMEs do not always obtain the necessary licences, such as getting permission from the environment department for any manufacturing enterprise, because to do so can be expensive and time consuming As mentioned in section 4, SMEs in Bangladesh rely more on bank loans than their counterparts in some other economies. Even where equity investors are prepared to support SMEs, many of the same issues will apply. In addition, there is the fact that the SMEs cannot guarantee an exit for the investor, as the capital markets in Bangladesh are relatively undeveloped and Mergers & Acquisitions activity is limited. As a result, there is an “exit risk” that will be passed onto the SME through the pricing of the investment or in some other way.

7.2 Suppliers

Access to formal financing, especially bank financing, for SMEs has been increasing in recent years due to efforts by Bangladesh Bank such as introduction of refinance facilities (see section 6), the Government urging of the banks to open special windows to cater for SME loans and other measures. However, a more uniform approach across the banking sector is still required in regard to bank-SME relationship lending, so that SMEs can access credit in a timely and efficient manner.

Whilst having an SME department is mandated for all banks, not all banks are fully committed to the sector. One issue is the Government involvement in institutions and markets, e.g. in regard to interest rates. Whilst not formally capped anymore, banks are subject to directives from the Government, which are not always clear. This means that the banks cannot actually price the loans for the inherent risk, which makes them favour other lending opportunities.

Secondly, banks and NBFIs need to evolve and expand their financial product lines for SMEs, innovating to meet the product and service needs of SMEs. New product development involves both SME friendly terms, instead of pure asset-based financing, as well as appropriate pricing, based on a proper risk assessment by the lender.

Some financial institutions, including banks and MFIs mentioned in section 4, are beginning to emphasize relationship lending technologies, which are based on “soft” information, more attuned to the characteristics of SMEs compared to banking norms and procedures 30. The soft

information may include:

 The character and reliability of the SME’s owner, based on direct contact over time by the institution’s loan officer  The payment and receipt history of the SME gathered from the past provision of loans, deposits or other services to the SME by the institution, or  The future prospects of the SME garnered from past communications with SME’s suppliers, customers or neighbouring businesses Moreover, even with the current products, many bank field staff require training in SME lending and how to assess loan applications. The focus in this area should be on equipping the SME relationship managers, as they are the interface between the clients and the bank. Given the “ticket size” of SME loans versus the loan administration cost, banks need more efficient loan assessment processes, such as credit scoring use by many MFIs.

Rahman (2010) Banks also suffer from other technical constraints. One key one is that, where collateral is required, they confront difficulties in enforcing collateral, due the small size and the complicated legal process. One bank indicated that it is not worth seeking to execute collateral for an amount of less than US$100,000. ADB has commented (2009) that the major bottleneck lies in cumbersome enforcement procedures to sell collateral through public auctions. It suggested that a new secured transactions law will benefit SMEs in terms of enhanced credit delivery since SME debtors possess relatively little land but more movable property collateral.

Such a draft law has been prepared but it has not yet been passed and it may be caught up in the inevitable pre-election hiatus. In the meantime, there is a collateral registry operated by the Registry of Joint Stock Companies and Firms (RJSC) but the service is available only to banks as companies registered under the purview of the RJSC.

The loan monitoring approach also needs to change for SME credits, in areas such as portfolio quality and delinquency management. In addition, banks should move to decentralise operations, with additional branches or other ways to reach clients, such as telephone banking.

At a time of perceived credit squeeze, with the challenging global economic landscape having made matters worse, banks are confronting issues of limited capital. At the same time, there are competing demands for bank loans, including from the Government itself managing a large budget deficit. With MFIs unable to take savings (except for Grameen which is a bank), they do not necessarily have the capital to take up the slack. This suggest that banks should consider other ways of raising funds, such as through syndications and domestic factoring, which have emerged as successful tools of SME financing in many countries.

One common facility in many countries that can help increase access to finance is guarantee schemes. Government provided credit guarantee schemes to SMEs are a common feature both in developed and developing countries. Such a guarantee ensures repayment of any default loan taken by an SME. In addition, a government can directly guarantees loans up to a certain limit to small businesses to purchase land, buildings or equipment. Loans may be made through banks or other financial institutions.

However, such schemes are not evident in Bangladesh. Sonali bank, Agrani Bank and Janata Bank jointly started a Credit Guarantee Scheme with assistance from the Bangladesh Bank a decade ago. A substantial number of loans was disbursed under this scheme but much of that lending went to non-viable projects and turned into bad debts.31 At the present time, both DFID and USAID are examining the introduction of new credit guarantee schemes. However, no information is yet available, and some parties interviewed do not see such schemes as helpful.

Finally, it is not always necessary for the banks to absorb all the costs of getting clients to the stage of being ‘credit ready’ or of building their own capacities. There are donors, NGOs and other agencies willing to help in these areas (see section 5) but coordination between the providers of TA, the SME clients and the banks is not generally good. We will return to this issue of making use of available resources in sections 8 and 9.

Rubayat Jesmin, Financing The Small Scale Industries In Bangladesh: The Much-Talked About, But Less Implemented Issue, Proceedings of ASBBS, Volume 16 Number 1, 2009

8. How SMEs can improve access to finance

8.1 Best Practices for SMES There are a number of steps that SMEs can take to improve their prospects for obtaining funding for their business, based on the analysis of what banks often require. The keys to success revolve around three main initiatives: seeking the best financing product; putting “the best foot forward” in the application process; and changing the business operation for the better.

Seek the most appropriate financial product

The first step is to consider what type of product is needed. This requires the SME to have a full understanding of its future financing needs which, in turn, will require it to develop some sort of a business plan, with details on its operation, products, employees, marketing and processes.

It is then a matter of determining what type of product and what quantum of funding best meets

the SME’s financing needs. Relevant questions include:

 Can it provide collateral, or must it seek a cash flow based not asset backed loan?

 Will the loans involve a priority sector, such as one of the 32 “Thrust sectors” for SME investment, e.g. agro-processing?

 When will the funds be needed and, if not the full amount on Day 1, can a facility with tranches be arranged?

 Is it possible that equity funding would be more appropriate than debt?

 Would other products be important, such as insurance coverage, particularly for agriculture?

Having agreed the appropriate product or products, the SME should then look for the lender and/or provider most aligned with its interests. In section 4, this report examined in detail many of the potential providers, with some indications of those favourably disposed towards SMEs.

Considering the product terms, understanding and comparing interest rates is important and fees that banks charge on top of the stated interest rate must also be considered.

Finally, other terms can be just as crucial as the interest rate. There may be steps that the borrower must take which are time-consuming or expensive, e.g. registration of title or formal business licences. If the required reporting regime (see sub-section B) is too burdensome, this adds to the effective cost of the loan. In addition, the borrower should ensure that the repayment terms of the loan align with its expected cash flows.

Maximising the SME’s ability to qualify

Some of the key elements that a borrower must consider well in advance include:

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