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INTERVIEW In r, tr , Bannerghatta Road, Bangalore a relationship with the SME, using both ‘hard’ and ‘soft’ information; and whether the size that banks can play in developing the SME sector in India. as a strong and vibrant SME sector provides a good foun- dation for entrepreneurship and innovation in the economy. 0970-3896 ª 2010 Indian Institute of Management Bangalore. All rights reserved. Peer-review under responsibility of Indian Institute of Management Bangalore. doi:10.1016/j.iimb.2010.04.011 1 In this paper, we use SME to refer to the micro, small and medium enterprises, although in the Indian context, MSME (referring to micro, small and medium enterprises) is commonly used. ava i lab le at www.sc ienced i rec t . com journa l homepage : www.e IIMB Management Review (2010) 22, 93e101 Context of interview Introduction In recent years, while the Indian economy has been growing at over 6%, the production from micro, small and medium enterprises has been growing at over 11% between 2002e2003 and 2007e2008 (Ministry of Micro, Small and Medium Enterprises, 2008e2009). In India, banks are the dominant channel for providing funds to industry. However their importance in funding smaller firms is even more pronounced since most small and medium enterprises (SMEs1) are not able to access the capital markets for funds. In recent years, govern- ments and policy makers have been giving considerable attention to facilitate the development of the SME sector, * Tel.: þ91 80 26993280; fax: þ91 2658 4050. E-mail address: thampy@iimb.ernet.in ª 2010 Indian Institute of Management Bangalore. All rights reserved. and origin of the bank affect the availability of credit to SMEs. Ranjana Kumar, a prominent Indian banker who also served, till recently, as the Vigilance Commissioner in the Central Vigi- lance Commission, speaks on some aspects that are raised in the paper, such as the importance of the credit appraisal and risk assessment processes in today’s banking landscape and the role the financing of SMEs in the Indian context, such as the information asymmetry facing banks and the efficacy of measures such as credit scoring for SMEs; whether transaction lending Ashok Thampy* Associate Professor, Finance and Control Area, Indian Institute of Management Bangalore 560 078, India Available online 12 June 2010 Abstract A major bottleneck to the growth of the vital Indian small and medium enterprises (SME) sector is its lack of adequate access to finance. This paper examines the major issues in would be adequate to address the information issues or would lending have to be based on Financing of SME firms in Interview with Ranjana Kuma Vigilance Commissioner, Cen dia Former CMD, Indian Bank; al Vigilance Commission INDIAN INSTITUTE OF MANAGEMENT BANGALORE IIMB l sev ie r . com/ loca te / i imb 94 A. Thampy The SME sector in India The census of micro, small and medium enterprises (MSME) in 2006e2007 reveals that there are about 26 million MSMEs in India providing employment to 80 million people. The MSME sector contributes 8% of India’s GDP, generating 45% of manufactured output and 40% of exports (Economic Survey, 2009e2010). The Government of India enacted the Micro, Small and Medium Enterprises Development Act 2006 to provide a policy framework for the development of the MSMEs. The Micro, Small and Medium Enterprises Development Act 2006 groups MSME firms into manufacturing enterprises and service enter- prises. A manufacturing firm with investment in plant and machinery not exceeding Rs. 25 lakhs (2.5 million) is considered a micro enterprise. Firms with investment in plant andmachinery between Rs 25 lakhs and Rs 5 crores (50 million) are considered a small enterprise, and medium enterprises are those where the investment is in the range of Rs. 5 crores to Rs 10 crores (100 million). In the service group, for investment in equipment of less than Rs 10 lakhs (1 million), the firm would be in the micro category, if it is between Rs 10 lakhs to Rs 2 crores (20million), then it would fall in the small enterprise category; if investment in equipment is in the range of Rs 2 crores to Rs 5 crores, then it would fall in the medium enterprise category. In order to get a sense of international comparison, the Basel Committee on Banking Supervision defines an SME as a legal entity, sole proprietorship or partnership where the reported sales for the consolidated group of which the firm is a part is less than V50 million. (Bank for International Settlements, 2006, paragraph 273). Financing SMEs in India: directed lending and credit rationing One of the major bottlenecks to the growth of SMEs in India is access to finance. Banks are the dominant channel for funding SMEs and in this paper, we survey some of the major issues in the financing of SMEs in the Indian context. While banks in India are not provided with a specific target for lending to SMEs, the bank loans given to the micro and small enterprises is part of the priority sector lending. Indian banks are required to achieve a target of 40% of adjusted net bank credit to the priority sector, while foreign banks have a target of 32% exposure to the priority sector (Reserve Bank of India, 2009). Information is a key input that goes into the credit decision of banks and one of the challenges for banks is to acquire information about the credit risk of the borrower, as borrowers have more information than the lender about the projects (Myers & Majluf, 1984). This fundamental information problem is a key concern that needs to be addressed in the allocation of loans; the absence of a mechanism to bridge the infor- mation asymmetry between the borrower and the lender would lead to a failure to allocate loans efficiently. This information asymmetry becomes more pronounced for loans to the SME sector as this sector is considered more opaque for reasons that would be discussed later in the paper. Bankers consider two aspects of the loan in their credit decisiondthe interest rate on the loan and the credit risk of the loan. However, as Stiglitz and Weiss (1981) have argued, the interest rate itself affects the risk of the loan due to two factors. First, is adverse selection; that is, only more risky projects would come forth for loans at higher interest rates; and second, moral hazard, as borrowers who have been granted the loan at a higher interest rate would undertake a more risky project in order to earn higher expected returns. As a result, at higher interest rates, the expected return from a loan would start decreasing after a point due to higher defaults. Thus, in the presence of information asymmetry in the market for loans and costly monitoring, banks would not use interest rates alone to equate demand and supply, but would ration credit. Carbo, Rodrı´guez, and Udell (2008) argue that the issue of bank competition and credit availability may matter most to SMEs for two reasons. First, SMEs are more vulnerable to information problems. Second, SMEs are much more bank-dependent than large enterprises. Carbo et al.’s (2008) study of a large number of Spanish SMEs suggests that constrained firms with restricted access to the bank loan market may turn to the trade credit market to exploit their investment opportunities, while uncon- strained firms would turn to the bank loan market. Addi- tionally, they analyse the supply side of the trade credit market by testing whether the extension of trade credit is sensitive to bank lending. They find that there is a signifi- cant sensitivity of the extension of trade credit to bank lending for unconstrained firms, thereby, suggesting that these financially unconstrained firms may act as‘lenders’ due to their easier access to a less costly source of funding (bank loans). Banerjee, Cole, and Duflo (2003), using a 1998 enhancement in investment limit as eligibility criteria for preferential bank loans for SMEs in India, find that firms that newly came under the preferential lending criteria were able to obtain more loans with a consequent benefi- cial impact on increase in sales, suggesting that that these firms were previously credit constrained. The other argument is that SME firms have lower profitability and therefore banks are reluctant to lend to them. Bhattacharya, Faiz, and Zohir (2000) identified that banks are averse to lend to SMEs as they do not consider them as attractive and profitable undertakings. SMEs are also regarded as high-risk borrowers because of their low capitalisation, insufficient assets, and high mortality rates. Framework for analysing SME financing Berger and Udell (2006) have proposed a conceptual framework for the analysis of SME credit availability issues. They argue that in the context of loans to SMEs, two factors affect the availability of loans and the nature of the credit facility. First is the lending technology which refers to the combination of primary information source, screening and underwriting policies and procedures, loan contract structure and monitoring mechanisms which are used in the lending business. Second is the lending infra- structure which includes the information environment all sizes and its creation is an important step in the would comprise largely of family businesses. It is estimated that in India, family businesses account for 70% of the total sales and net profits of the biggest 250 private-sector companies (The Economist, 1996), and almost all MSME Financing of SME firms in India 95 improvement of the asset quality of banks and financial institutions. The Small Industries Development Bank of India (SIDBI) in association with ten banks and Dun and Bradstreet has set up the SME Rating Agency of India Ltd (SMERA) as an exclusive rating agency for MSMEs. Love and Mylenko (2003) find that the existence of private credit registries is associated with lower financing constraints and a higher share of bank financing. They also find that small and medium firms, as well as younger firms, benefit from bank financing in countries with private credit registries. Thus, the availability of credit scores for SMEs would lead to greater use of transaction technology for lending to SMEs in India. While transaction lending such as asset based lending, factoring and leasing have been in use to fund SMEs for some time, there is some evidence of relationship lending in India. In developing countries, the private economy including the quality of accounting information, the legal, judicial and bankruptcy environments, the social environ- ment, the tax environment and the regulatory environ- ment in which financial institutions operate in a given country. The government policies influence the lending technology used in different countries, through the lending infrastructure. The lending technologies employed to lend to the SME sector in India would thus be influenced by the government policies and the lending infrastructure prevalent in the country. Lending technology is categorised into two types: transactions lending that is based on ‘hard’ quantitative data and relationship lending which is based on ‘soft’ qualitative information. Transaction lending would rely more on quantitative data such as financial statements, small business credit scoring, asset based lending, factoring, fixed asset lending and leasing. Transactions lending and relationship lending Petersen and Rajan (2002) find that small firms, though informationally opaque, have been borrowing from insti- tutions further away, and they attribute this to the development of firms such as Dun and Bradsteets, which specialise in rating small businesses. The possible reason is that credit scoring helps to reduce the information asymmetry, particularly with respect to small firms and hence geographic proximity of the borrower and lender is not crucial to loan decisions. Other studies also find that credit scoring tends to enhance SME access to debt capital (Berger, Frame, & Miller, 2005a; Frame, Sriniva- san, & Woosley, 2001; Frame and Woosley, 2004). Rec- ognising that better credit information can directly increase the amount of financing for SMEs by reducing the risk and costs arising from information asymmetries, the Credit Information Bureau of India Limited (CIBIL) has been established as a publiceprivate partnership to enhance the availability of credit information to member financial institutions. (The shareholders of CIBIL are State Bank of India (40%), Housing Development Finance Corporation Limited (40%), Dun and Bradstreet Informa- tion Services India Private Limited (10%), and TransUnion International Inc. (10%).) CIBIL is mandated to collect and disseminate credit information on individuals and firms of would be family firms. Inter-family relationships and family succession play an important role in the performance of family firms, and banks would need to take this into account in their credit decisions2. A study by Marisetty, Ramachandran, and Jha (2008) finds that family businesses in India where succession takes place without fights and splits show higher profitability. This would suggest that a credit officer should also be aware of inter-family rela- tionships as the souring of these relationships could signif- icantly change the credit risk of the family firm. Bank size and lending to SMEs A major policy concern in recent times is the impact of the growth in size of banks on availability of credit to the SME sector. A number of studies have analysed the relationship between bank size and the credit flow to firms of different sizes. Berger et al. (2005b) find that large institutions have comparative advantages in transactions lending to more transparent SMEs, while small institutions have compara- tive advantages in relationship lending to informationally opaque SMEs, based on soft information. Competitive banking markets can weaken relationship building by depriving banks of the incentive to invest in soft informa- tion. Therefore, less competitive markets may be associ- ated with more credit availability (Petersen & Rajan, 2002). Morris, Basant, Das, Ramachandran, and Koshy (2001) argue that there are strong structural underpinnings to the inadequate flow of funds to the SME sector. They argue that the organisational structure of banks in India and processes within them, have taken them far from task orientation, and have created a specific bias against small loan portfolios. Another observation that is relevant to the problem of the Indian financial system is that there is no transparency regarding the financial conditions of SMEs. Therefore, banks hesitate to give loans to small scale units. There is evidence to establish that a fairly significant proportion of loans given to small enterprises in the past have compounded the problem of non-performing assets (NPAs) of banks. Unless fairly detailed information on small firms is available, banks would hesitate to take the risk and may prefer to lend to relatively larger firms to comply with regulation, thus leaving smaller firms significantly constrained for capital. Improving the quality of financial information is an impor- tant requirement for enhancing the flow of funds to the SME sector, as the quality of information also influences deci- sions on loan finance (Das, 2007). Foreign banks and SME lending There is considerable debate about the impact of foreign banks on the availability of credit to small businesses. Some argue that the entry of foreign banks could lead to misal- location of credit, which in turn could negatively affect 2 It is estimated that successful transition of a family business from the first to the second generation happens in only 30% of the cases (Birley, 1986). 96 A. Thampy economic growth prospects as bank credit is a vital input for investment and growth. In a study of the transition economies, Weller (1999) argues that big foreign banks are not going to lend money to SMEs, small traders, the informal sector and farmers but that they tend to serve less risky businesses such as transnational corporations (TNCs) and big corporate groups. The EPWResearch Foundation (2006) in a study of financial inclusion argued that foreign banks tend to follow ‘exclusive banking’ by offering services to a small number of clients, instead of ‘inclusive banking’. Foreign banks charged higher fees from customers for providing banking services and maintaining a bank account in a foreign bank required substantial financial resources. Evidence from Latin America suggests that foreign banks are especially risk averse and that significant market penetration by foreign banks in a devel- opingeconomycontextmight adversely affect creditdisbursal to small andmediumenterprises (Clarke, Cull, Peria, Soledad, & Sanchez, 2005). However, Clarke et al. (2005) also find that some foreign banks make more loans to small businesses than domestic banks. Berger et al. (2005b), in a study of bank organisational form and its impact on lending, find that banks that are large, centralised, and have their headquarters situated abroad may lack the organisational dexterity to engage with small and young firms successfully. However, Banerjee and Duflo (2004) have argued that credit rationing on account of risk averseness is not specific to domestic private and foreign banks. They show, using Indian data, that public sector banks can also exhibit such risk averseness, albeit more on account of the political economy of ‘blame sharing’ in the event of bad perfor- mance of banks rather than the profit motive. In this respect, the working group on banking chaired by M.S. Verma observed that the diffidence that seems to beset banks in taking credit decisions can be attributed to investigations by outside agencies on the accountability of bank staff in respect of NPAs (Tannan, 2001). In other words, the behaviour of banks in the credit markets of emerging economies may not be some monotonic function of ownership; credit disbursal by banks in such (inherently high-risk) markets may depend on a host of other factors. Hence, it is worthwhile exploring the credit market behaviour of banks in emerging market contexts. The lending infrastructure in India The legal environment is also an important factor that impacts the willingness of banks to lend to small firms. Haselmann and Wachtel (2007) find in their study of 20 transition economies that foreign banks are more inclined to lend to small and medium enterprises if creditor protection is strong. In order to strengthen the framework for tackling loan defaults and contract enforcement, India enacted the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act in 2002. The Act empowers secured creditors to foreclose and enforce securities in case of default, without inter- vention of a court or tribunal, and has also created an enabling framework for asset reconstruction companies and securitisation in general. New bankruptcy legislation was enacted in 2003. There are several asset reconstruction companies and along with other banks and institutions, SIDBI has set up a separate asset reconstruction company focussed on asset recovery of SME non-performing loans. The SARFAESI Act and the consequent strengthening of the legal environment should enable an increased flow of credit to the SME sector. The availability of credit scores for SMEs in India should also help to enhance the quality and reliability of financial information enabling more lending to the sector. In India, while the domestic banks are given a priority sector lending target (which includes lending to the micro, small and medium enterprises) of 40% of adjusted net bank credit (ANBC), foreign banks have been set a target of only 32% of ANBC. It has been argued that both domestic and foreign banks should have the same target towards lending to the priority sector in order to provide a level playing fiel