Banking on SME Growth - Institute of Policy Studies · 2020. 6. 18. · 6.1.1 Re-orienting Financial Institutions towards SME Lending 16 6.1.2 Improving the Bank-SME Relationship

INSTITUTE OF POLICY STUDIES OF SRI LANKA

MARCH 2015Working Paper Series No. 20

Banking on SME Growth:Concepts, Challenges, and Policy Options toImprove Access to Finance in Sri Lanka

ANUSHKA WIJESINHA AND NIPUNI PERERA

Copyright C March 2015Institute of Policy Studies of Sri Lanka

ISBN 978-955-87080-88-0

National Library of Sri Lanka-Cataloguing-In-Publication Data

Wijesinha, AnushkaBanking on SME Growth: Concepts, Challenges and Policy Optionsto Improve Access to Finance in Sri Lanka/ Anushka Wijesinha andNipuni Perera .- Colombo : Institute of Policy Studies of SriLanka, 201540 p.; 21 cm. .- (Working Paper Series ; No.20)

ISBN 978-955-8708-88-0

i. 332.1095493 DDC 23 ii. Titleiii. Perera, Nipuni jt. au iv. Series

1. Bankers and banking - Sri Lanka2. Small business - Sri Lanka

3. Small and medium-size enterprises - Sri Lanka

Please address orders to:Institute of Policy Studies of Sri Lanka100/20, Independence Avenue, Colombo 7, Sri LankaTel: +94 11 2143100 Fax: +94 11 2665065Email: [email protected]: www.ips.lkBlog: ‘Talking Economics’ - http://www.ips.lk/talkingeconomicsTwitter: www.twitter.com/TalkEconomicsSL

Cover image: by Anushka Wijesinha

Nipuni Perera has a BA (Hons) inEconomics from the University ofColombo. Her research interestsinclude international trade,migration,private sector development andmacroeconomic policy. She wasformerly a Research Assistant atthe IPS.

Anushka Wijesinha is a ConsultantEconomist with a BSc (Hons.) inEconomics from University CollegeLondon, UK and a MA in Economicsand Development from theUniversity of Leeds BusinessSchool, UK. He is a Special Advisoron Industrial Development andYouth Entrepreneurship to theMinistry of Industry and Commerce.He was formerly a ResearchEconomist at the IPS and ActingHead of the Industry,Competitiveness and RegulatoryPolicy Unit.

ANUSHKA WIJESINHA AND NIPUNI PERERA

No.No.No.No.No.

20

INSTITUTE OF POLICY STUDIES OF SRI LANKAINSTITUTE OF POLICY STUDIES OF SRI LANKAINSTITUTE OF POLICY STUDIES OF SRI LANKAINSTITUTE OF POLICY STUDIES OF SRI LANKAINSTITUTE OF POLICY STUDIES OF SRI LANKA

Working Paper SeriesWorking Paper SeriesWorking Paper SeriesWorking Paper SeriesWorking Paper Series

Banking on SME Growth:Concepts, Challenges, and Policy Options to Improve Access to Finance in Sri Lanka

Banking on SME Growth: Improve Access to Finance in Sri Lanka

i

LIST OF FIGURES, TABLES & BOXES II

ACKNOWLEDGEMENT III

EXECUTIVE SUMMARY V

1. Introduction 01

2. Importance of SMEs -- Global Context 02

3. Rationale for Policy Support to SMEs 04

4. The Scale and Nature of the Access to Finance Challenge 054.1 Financing the SME Sector -- A Conceptual Overview 05

4.1.1 Stages of Financing 054.1.2 Types and Sources of Financing 06

4.2 Access to Finance Gap - Exploring the International Evidence 074.3 Access to Finance Gap - Exploring the Sri Lankan Evidence 08

5. Supply and Demand Dynamics Driving SME Access to FinanceChallenge in Sri Lanka 135.1 Unpacking the Problem 135.2 Demand-side Factors: SMEs’ Intrinsic Weaknesses 135.3 Supply-side Factors: Limitations within the Banking Sector 15

6. Policy Options 16

6.1 Policy Options -- Overarching Measures 166.1.1 Re-orienting Financial Institutions towards SME Lending 166.1.2 Improving the Bank-SME Relationship 176.1.3 Reducing Information Asymmetry 18

6.2 Policy Options -- Specific Mechanisms 196.2.1 Credit Guarantee Schemes 19

6.3 SME Credit Scoring and Credit Information 206.4 Business Development Services to Address Access to

Finance Challenges 226.5 Challenges and Risks in Public Interventions to Improve SME

Access to Finance 23

7. Concluding Remarks and Way Forward 25

References 26

TTTTTable of Contentsable of Contentsable of Contentsable of Contentsable of Contents

Working Paper

ii

List of Figures

Figure 1 : Mismatch of Cash Flow Timing 05

Figure 2 : Most Significant Constraints on Businesses as Perceived by SMEs 09

Figure 3 : Current Sources of Finance for SMEs Reporting Access to Finance asMost Significant Constraint 10

Figure 4 : Access to Finance by Province 10

Figure 5 : Support Received from Financial Institutions that Helped Grow the Business 11

Figure 6 : SME Lending by Banks in 2012 11

Figure 7 : Banker’s Traditional Interest in SME Lending 16

Figure 8 : Lack of Business Development Services by Economic Sector 22

List of Tables

Table 1 : Types and Sources of SME Financing 06

Table 2 : Distribution of Respondents by Province 09

Table 3 : SME Loans Provided by Banks in 2012 11

Table 4 : SME Banking Portfolio of Selected Banks 12

List of Boxes

Box 1 : SME Definition: A Tricky Issue 03

Box 2 : Methods and Criteria for Bank Loan Appraisal 15


iii

AcknowledgementThe authors are grateful for the insights and constructive comments received fromseveral individuals during various stages of preparing this paper, including CoraConde of the Association of Development Financing Institutions of Asia Pacific

(ADFIAP) and Suraya Rahman of SME Corp Malaysia, Dr. Joo-hoon Kim, Directorof the Industry and Service Economy Department of the Korea DevelopmentInstitute (KDI), Dr. Seok-il Hong, Research Fellow at Korea Institute on Industrial

Economics and Trade (KIET) and Mr. Jong-goo Lee, Deputy Director(International Affairs Team) at Korea Credit Guarantee Fund (KODIT).

We also acknowledge the valuable insights received from the Sri Lankan bankingcommunity during the many in-depth interviews as well as during the Access toFinance session of the SME Empowerment Forum organized by the Ceylon

Chamber of Commerce. The support of SMEs around the country that willinglyparticipated in the firm-level survey must also be acknowledged. Conducting thesurvey would not have been possible without the gracious support received from

the National Chamber of Commerce of Sri Lanka (NCCSL), particularly the thenSecretary General E. M. Wijetilleke, to whom we are thankful. The authors alsogratefully acknowledge the support of The Asia Foundation (TAF) - Sri Lanka. The

authors benefitted from participating in TAF's Private-Public Dialogues inPolonnaruwa, Nuwara Eliya, and Jaffna and an earlier grant of TAF helped coverthe costs of the survey.

The authors wish to particularly acknowledge the contribution of HariniWeerasekera (Project Intern) who provided excellent research assistance in the

early stages of this paper, and also thank Hasna Munas (Project Intern) forassistance in data entry.

The authors are grateful to IPS Executive Director Dr. Saman Kelegama andDeputy Director Dr. Dushni Weerakoon for their overall guidance, D. D. M.Waidyasekera for editorial support, and Asuntha Paul for formatting this

publication.

Working Paper

iv

Executive SummaryIn Sri Lanka's transition to a middle-

income economy, the growth of thesmall and medium enterprise (SME)sector in Sri Lanka has been

identified as vital to provide moreemployment, bridge regional growthdisparities, and ensure that post-war

growth is inclusive. Globally, SMEscontinue to make significantcontributions to national economies

around the world and have gainedspecial attention due to their relativesize and dispersion within the global

economy. Given their widegeographical spread within a countryas well as their wide sectoral

coverage, SMEs are often a keysource of inclusive economic growth.If given the right environment to

thrive, the SME sector will not onlycreate employment and promoteindustrial development, but alsonurture entrepreneurial talent.

Although SMEs have beenrecognized as an integral component

of Sri Lanka's economic and socialfabric, they are faced with a myriad ofconstraints that impede their ability to

grow. Even though the sector hasreceived much attention fromsuccessive governments as well as

international development agenciesover recent decades, the sector is stillfaced with these challenges that need

to be addressed in a comprehensivemanner. Among them is the criticalissue of the difficulty in accessing

finance. The ability of SMEs todevelop, grow, sustain and strengthenthemselves is heavily determined by

their capacity to access and managefinance. Unfortunately, SMEs in SriLanka consistently cite the lack of

access to finance as a seriousbottleneck. In accessing finance,SMEs are faced with challenges on

many fronts - lack of collateral by

SMEs and unwillingness of banks tolend without it; financial sector'unfriendliness' towards SMEs;

mismatch in funding opportunities vs.SME needs; misunderstandingbetween banks and SMEs on each

others' priorities and constraints; lackof information on financingavailabilities; and lack of mechanisms

to mitigate risks.

A unique contribution of this paper is

that it puts forward a new way oflooking at the access to financechallenge for SMEs. This 'Twin-Pillar

Approach to Access to Finance'argues that improving access tofinance for SMEs is a case of

improving 'availability' on the onehand and improving 'bankability' onthe other. 'Availability' refers toensuring that funds are available for

SMEs to borrow - enhancing overallprivate sector credit, expandinglending volumes to SMEs, and

providing more and more fundinglines and special credit schemes forSMEs. These are often influenced by

the overall monetary policy of acountry, liquidity levels in the market,level of borrowing by the state and

credit availability to the private sector,and the number and nature of SMEloan schemes with lower interest or

concessionary terms. This first pillaris not the main focus of this presentpaper. It largely focuses on the

second pillar - 'bankability'. Thisstems from the understanding that aflush of SME credit alone is not

enough. 'Bankability' is aboutimproving banks' approach to SMElending as well as improving SMEs'

ability to approach banks. Things thatimprove the climate for SMEs toborrow and addresses the following

questions are important - Are banksgenuinely oriented towards the

unique banking needs of SMEs? Arethere specialized branches dealingwith SMEs? Are there mechanisms to

bridge the information and riskasymmetry between SMEs andbanks, like credit guarantees and

credit scoring? Are there schemes toimprove SMEs' financial managementand ability to develop bankable

business plans?

This paper dissects these issues to

better understand the drivers of theaccess to finance challenge, fromboth a conceptual as well as practical

perspective. Some of the key policyoptions put forward are the adoptionof SME-friendly banking practices,

introduction of SME credit rating andCredit Guarantee Fund, andimproving financial literacy and

internal management of SMEs. Thepaper cautions against over-zealouspolicy intervention and argues that

the focus of the government must beto put in place suitable incentives aswell as regulatory frameworks that

encourage greater SME lending.

The paper draws on the latest

insights from recent IPS surveys toprovide evidence for Sri Lanka, andputs forward pragmatic policy options,

considering strategies adopted inEast Asian economies. Through this,the paper aims to inform the ongoing

National SME Policy process of thegovernment as well as future SMEinterventions to be undertaken by

government agencies, financialinstitutions, chambers of commerce,and international development

agencies.


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Working Paper

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njhlu;gw;w epjpaspg;G tha;g;Gf;fs;>


Kaw;rpfSf;Fk;

tq;fpfSf;Fkpilapyhd

Gupe;Jzu;tpd;ik> epjpaspg;Gf;fspd;

fpilg;gdT njhlu;gpy;

,UtUf;fpilapyhd Kd;Dupik

kw;Wk; jilfs; njhlu;gpyhd

Gupe;Jzu;tpd;ik kw;Wk; ,t;thwhd

jilfis eptu;j;jp nra;tjw;F

jilfshf cs;sd.

rpwpa kw;Wk; eLj;ju

njhopy;Kaw;rpfs; Kfq;nfhLf;fpd;w

epjp trjpfSf;fhd gpuNtrk;

njhlu;ghf Gjpa cgha topfis

Nehf;fpa Kd;itg;gpid ,e;j

Mtzj;jpd; Clhf kpf Kf;fpakhd

gq;fspg;ig nra;Js;sJ. rpwpa kw;Wk;

eLj;ju njhopy;Kaw;rpfspd; epjp

trjpfSf;fhd gpuNtrk; vd;w

tplahdJ "epjp trjpfSf;fhd

fpilg;gdT" vd;W xU GwKk;

"tq;fpapay; nraw;ghLfis

Nkk;gLj;jy;" vd;gJ kW GwKkhf

vd;w tifapy; ,t; tplak; ,U NtW

gupkhzq;fspy; tpthjpf;fg;gl

Ntz;ba Kf;fpa tplaq;fshFk;.

"fpilg;gdT" vd;gjd; %yk;

Fwpg;gpLtjhtJ rpwpa kw;Wk; eLj;ju

njhopy; Kaw;rpfSf;fhd epjp

fpilg;gdTfis ngw;Wf; nfhs;sf;

$ba ,aYikia cWjpg;gLj;jpf;

nfhs;sy; - jdpahu; Jiwapd;

nkhj;j fld; gq;fpid Nkk;gLj;jy;>


Kaw;rpfSf;fhd fld; toq;Fk;

mstpid tpupT gLj;jy;> kw;Wk;


Kaw;rpfSf;F nkd; NkYk;

mjpfkhd fld; jpl;lq;fisAk;

tpNrl epjpaspg;G khu;f;fq;fisAk;

toq;Fjy;. ehl;bd; nkhj;j epjpf;

nfhs;iffs;> re;ij jputj;jd;ik

kl;lk;> mur fld; ngwy; kl;lk;

kw;Wk; jdpahu; Jiwf;F

fpilg;gdtpy; cs;s fld; kw;Wk;

Fiwe;j tl;b tPjj;jpy; my;yJ

rYif mbg;gilapy; rpwpa kw;Wk;

eLj;ju njhopy; Kaw;rpfSf;fhd

fld; jpl;lq;fspd; jd;ik kw;Wk;

vz;zpf;if Nghd;wd mbf;fb

nry;thf;Fr; nrYj;Jfpd;wd. ,e;j

rku;gpg;Gg; gj;jpuj;jpd; gpujhd

Nehf;fk; ,e;j Kjy; tplakd;W.

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viii

"tq;fpj; njhopy; fpilg;gdTj;

jd;ik" vd;w ,uz;lhtJ tplak;

njhlu;ghf gue;j mstpy; ftdk;

nrYj;Jfpd;wJ. rpwpa kw;Wk; eLj;ju

njhopy; Kaw;rpfspd; cz;ikahd

Gupe;Jzu;T kl;Lk; NghJkhdjd;W.


Kaw;rpfSf;fhd tq;fpapd; mZfy;

jpwid Nkk;gLj;Jtjw;fhd

nraw;ghlhf "tq;fpj;njhopy;

fpilg;gdTj; jd;ik"

fhzg;gLtJld; tq;fp Nehf;fpa rpwpa

kw;Wk; eLj;ju njhopy; Kaw;rpfspd;

mZF KiwapidAk;

Nkk;gLj;Jfpd;wJ. rpwpa kw;Wk;

eLj;ju njhopy; Kaw;rpfs; fld;

ngWk; #o;epiyapid

Nkk;gLj;Jtjhf ,t;tplaq;fs;

,Ug;gJld; gpd;tUk; tpdhf;fs; kpf

Kf;fpakhdJ vd;Wk; Fwpg;gpLfpd;wJ

-- rpwpa kw;Wk; eLj;ju njhopy;

Kaw;rp gpuj;jpNaf tq;fpj; njhopy;

Njitfis Nehf;fp tq;fpfs;

cz;ikahf Kidg;Gld;

,Uf;fpd;wjh?


Kaw;rpfSld; nraw;gLtjw;F tpNrl

tq;fpf; fpisfs; cs;sjh? fld;

cj;juthjq;fs; kw;Wk; fld;

Gs;spaly; Nghd;wthwhf rpwpa

kw;Wk; eLj;ju njhopy;

Kaw;rpfSf;Fk; tq;fpf;Fk; ,ilapy;

jfty; kw;Wk; ,lu; rkepiyg;gLj;jy;

gpizg;Gf;fhd Kiwiknahd;W

,q;F fhzg;gLfpd;wjh? rpwpa kw;Wk;

eLj;ju njhopy; Kaw;rpfspd; epjp

Kfhikj;Jtk; kw;Wk; ,aYikia

Nkk;gLj;Jtjw;fhd jpl;lq;fs; kw;Wk;

tq;fpj; njhopy; tpahghu

jpl;lkply;fis mgptpUj;jp

nra;tjw;fhd ,aYik njhlu;ghd

jpl;lq;fs; cs;sjh?

vz;zf;fUj;jpay; uPjpahf kw;Wk;

nraw;ghl;L Nehf;fpy; ,Ue;J

ghu;f;fpd; NghJ> epjpr; rthy;fis

mile;J nfhs;tjw;fhd

gy;ypdj;jd;ikapid rpwe;j

Kiwapy; Gupe;J nfhs;sf; $ba

tpjj;jpy; ,e;jg; gpur;rpidapid

,e;j MtzkhdJ gpupj;J

njspTgLj;Jfpd;wJ. rpwpa kw;Wk;

eLj;ju njhopy; Kaw;rpfSldhd

rpNdf G+u;tkhd tq;fpj;njhopy;

nraw;ghLfis gpd;gw;wy;> rpwpa


fld; jug;gLj;jy; kw;Wk; fld;

cj;juthj epjpfspd; mwpKfk;>

kw;Wk; rpwpa kw;Wk; eLj;ju njhopy;

Kaw;rpfspd; epjpapay; mwpT kw;Wk;

cs;sf Kfhik mwpT Nghd;w

tplaq;fspy; Nju;Tfis

nraw;gLj;Jtjy; rpy Kf;fpa

tplaq;fshf fhzg;gLfpd;wd.

mgupjkpjkhd nfs;if ,ilA+Wfs;

njhlu;ghf vr;rupf;ifia ,t;

Mtzk; njuptpg;gNjhL rpwpa kw;Wk;

eLj;ju njhopy; Kaw;rpfspd; fld;

ngwy; Mw;wiy ghupa mstpy;

Cf;fg;gLj;Jk; tifapyhd xOq;F

Kiwg;gLj;jy; Ntiyr; rl;lfk;

kw;Wk; nghUj;jkhd Cf;ff;

nfhLg;gdTfis murhq;fkhdJ

mwpKfk; nra;J Kd;ndLj;jy;

Ntz;LnkdTk; ,t; Mtzk;

tpthjpf;fpd;wJ.

,yq;iff;fhd rhd;Wfis

toq;Ftjw;fhd nfhs;iffs; fw;if

epWtdj;jpd; mz;ika

Ma;TfspypUe;jhd Gjpa Ma;T

KbTfspd; ghy; ftdj;ijr;

nrYj;JkhW J}z;Lfpd;wJ kw;Wk;

fpof;fhrpa nghUshjhuq;fspy;

mKy;gLj;jg;gLfpd;w ajhu;j;jkhd

nfhs;ifj; njupTfs;>

gad;gLj;Jfpd;w cghaq;fs; gw;wpAk;

ftdk; nrYj;Jk; gb

Cf;fg;gLj;Jfpd;wJ. vdNt> ,e;j

Ma;Tf; fw;ifg; gj;jpukhdJ

murhq;fj;jpd; mKypy; cs;s rpwpa


nfhs;if nrad;Kiw gw;wp jfty;

mwpTg;Gf;fis toq;FtJld; rpwpa

kw;Wk; eLj;ju njhopy; Kaw;rpfs;

ghy; mur Kftufq;fs;> epjp

epWtdq;fs;> tu;j;jf rk;Nksdk;

kw;Wk; ru;tNjr mgptpUj;jp

Kftufq;fspdhy; Kd;ndLf;f

,Uf;fpd;w vjpu;fhy jpl;lq;fs;

njhlu;ghfTk; jfty; toq;Ftjw;F

,yf;F itj;Js;sJ.


1

1. IntroductionBroad-based inclusive andsustainable growth with the activeinvolvement of the private sector is

one of the most importantdevelopment strategies opted bymany developing countries.1 It iswidely acknowledged that industrialgrowth matters for employmentgeneration, competitiveness and

inclusive socio-economicdevelopment even in services-oriented emerging economies;international experience suggeststhat a robust industrial policy is in factessential to realize the full potential of

services-led growth.2 Thesedynamics are particularly relevant topublic policy when the pattern ofintra-country growth points tosignificant geographical disparities,as is the case in Sri Lanka.

Policy experience in post-warsituations around the world suggeststhat the private sector is one of themost resilient and adaptableinstitutions for socio-economicreconstruction and revival in the face

of systemic shocks.3 Coming out of aprotracted armed conflict, the role ofprivate sector development in post-war development is a keyconsideration in economic policy.

In this context, cross-country policy

research shows that Small andMedium Enterprises (SMEs) play avital role in generating high andinclusive economic growth, jobcreation, as well as in reducing

inequality and poverty, particularly indeveloping countries.4 Developmentof this sector has been widely

acknowledged as a crucial strategyfor growth both in developed and indeveloping economies of the Asianregion (UNESCAP, 2012). In theirindustrial policies, many countries areincreasingly placing heavier

emphasis on the development of theSME sector.

In Sri Lanka, too, SMEs have beenrecognized as an important sector ofthe economy due to their significantcontribution to national income,

employment, inclusive private sectordevelopment, bridging regionalgrowth disparities and povertyreduction. Since independence,successive governments haveintroduced various support

programmes to facilitate the growthand expansion of SMEs in differentsub-sectors of the economy. However,as the SME White Paper (2002)argued, there has been no deliberatepolicy effort to exploit the full

development potential of SMEs. Manyprivate sector development policies inthe past have continued to focusmore heavily on large-scaleenterprises (through Board ofInvestment and other schemes) over

smaller ones. The SME sector in SriLanka today faces many challenges.Understanding these better anddevising smarter, morecomprehensive and coherent

strategies to overcome them, is nowof paramount importance. This isespecially true of one of the most

critical factors that continue to affectSME development - access tofinance.

Although the importance of growingthe SME sector is now back in thecountry's economic policy discourse,

much of the recent policies andinitiatives for SME development havebeen mostly centred on successiverounds of concessionary creditschemes. Yet, there appears to belimited understanding of the

underlying dynamics driving theaccess to finance problem faced bySMEs, and very little publishedliterature in Sri Lanka on the subject.This paper attempts to fill this void. Itexplores the drivers of the problem,

including conceptual elementssurrounding financing of smallbusinesses. It reviews innovativestrategies adopted by othereconomies to address the problem -particularly those in emerging Asia. It

highlights the scale and nature of theproblem specifically in the Sri Lankancontext, using results from a recentsurvey by IPS, key interviews with thebanking sector, as well as secondaryinformation. It also puts forward

possible mechanisms and policyoptions to tackle the challenge in SriLanka. Through all this, the paperaims to expand the knowledge on thespecific area of access to finance

1 ESCAP (2011), 'Enabling Environment for the Successful Integration of Small and Medium-sized Enterprises in Global Value Chains', United Nations:Bangkok.

2 Sulaman, H. and S. Hassan (2010), "Services-led Industrial Policy for Inclusive Growth and Competitiveness", Competitiveness Review, Vol. 20, No.2.3 MacSweeny, N. (2008), "Private Sector Development in Post-conflict Countries: A Review of Current Literature and Practice", The Donor Committee for

Enterprise Development, available at http://www.enterprise-development.org/page/current-work.4 See for instance: Ardic, P., N. Mylenko, and V. Saltane (2011), "Small and Medium Enterprises: A Cross-Country Analysis with a New Data Set", Policy

Research Working Paper No.5538, World Bank, Washington D.C.; and, Ayyagari, M., A. Demirguc-Kunt, and V. Maksimovic (2011), "Small vs. Young Firmsacross the World: Contribution to Employment, Job Creation, and Growth", Policy Research Working Paper No.5631, World Bank, Washington D.C.

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challenges for SMEs and inform thedesign and implementation of

ongoing and future interventions inthis area by the government, privatesector and international agencies.

The rest of the paper is organized asfollows. Section 2 reviews theliterature on the importance of SMEs

from a global and local viewpoint.

Section 3 sets out the rationale foroverall policy support to SMEs.

Section 4 tackles the scale andnature of the access to financechallenge, starting with setting outsome conceptual issues and thengoing on to review internationalevidence, and more crucially the Sri

Lankan evidence on the access to

finance problem. Section 5 exploresthe supply and demand dynamics

driving the access to financechallenge. Section 6 discusses acomprehensive set of policy optionsto improve SME access to finance,including exploring specificmechanisms and models. Section 7

concludes.

2. Importance of SMEs - Global Context

The aftermathof the globalfinancial crisisof 2008-2009witnessed arenewedinterest inSMEs as anengine ofinclusivegrowth incountriesaround theworld.

5 Fischer, B. (1995), “The Basic Problem in Financing Small Businesses”. In: Brugger, E. A. Rajapathirana. S., (Eds.), New Perspectives on Financing SmallBusiness in Developing Countries, San Fransisco: ICS Press.

6 Ahmed, F. (2011), "Why Small and Medium Enterprises are More Profitable than Big Ones", ICE Business Times.7 Ministry of Science and Technology (2011), Small and Medium Enterprises (SMEs) in India, New Delhi, Department of Scientific and Industrial Research

of India.

The strategic importance of SMEs inoverall economic development hasbeen widely recognized in the past

and has been even more evident inrecent decades, both in developedand in developing nations(UNESCAP, 2012). The aftermath ofthe global financial crisis of 2008-2009 witnessed a renewed interest in

SMEs as an engine of inclusivegrowth in countries around the world.

The growing debate on theadvantages of small firms over largerones in developing countries has alsodrawn much attention towards the

SME sector. Fischer (1995) highlightsthat the advantages of smallenterprises over large scaleenterprises in developing countriesare threefold: 1) small enterprisesare labour-intensive and use relatively

simpler techniques of production thatcorrespond to the abundance oflabour and the scarcity of physicaland human capital that prevail inmost developing countries; 2) smallenterprises demonstrate a higher

degree of efficiency in using capitaland in mobilizing savings,entrepreneurial talent, and other

resources that otherwise wouldremain idle; and 3) a large share ofsmall enterprises is also expected toexercise a positive influence on thedistribution of income both infunctional and in regional terms.5

Ahmed (2011) states that being asmall firm as opposed to a large oneis said to have the advantages ofbeing, much more capable than largefirms of overcoming economic turmoiland much more capable than large

firms in achieving faster growth due tothe ability to make faster decisions.6

Various studies highlight theeconomic importance of the SMEsector in national economies. Areview conducted by India's Ministry

of Science and Technology revealedthat 99.7 per cent of all enterprises inthe world are SMEs while largeenterprises only account for 0.3 percent.7 IFC (2010) indicates that formalSMEs contribute up to 33 per cent of


3

GDP in developing economies.8 Onemployment creation, it notes that

SMEs contribute up to 45 per cent ofemployment and adds that, "in thecontext of the internationaldevelopment agenda, and given thecritical importance of job creation inthe recovery cycle following the

Box 1: SME Definition: A Tricky Issue

Definitions of what constitutes an SME vary quite widely from country to country and even within single

countries. Often it depends also on the business sector concerned - e.g., agriculture, natural resources,

manufacturing, services and retailing (ESCAP, 2009). There is no universal determinant of or criterion for

an SME. Much depends on the character of the respective host country, and the profile of its own particular

corporate sector, from which a relative measure of an SME is then typically made, sometimes on a rather

arbitrary basis. The form of ownership profile, type of legal entity or general provenance of the company

is typically deemed irrelevant when creating the definition. While an SME is often imagined as a locally-

owned and privately-held business, there is no reason why it cannot be a state-owned or foreign-invested

enterprise. Some countries will distinguish between a micro-enterprise and a small enterprise, while

others - by not setting a limit for SME size - effectively include micro-enterprises within their SME umbrella

definition. The above notwithstanding, most SME definitions pertain to businesses that are formal in

nature and have been registered in some manner, and exclude small-scale, informal family enterprises

(ESCAP, 2009b). According to a World Bank study, more than 60 definitions of SMEs are used in 75

countries (Indian Institute of Foreign Trade, 2011). Some countries have used the number of employees

as the sole criteria for determining whether a business is an SME or not. Other countries use this same

criterion, plus an additional one based on either the value of the firm's assets or the size of revenue in

local currency. In cases where a currency value is cited (either for assets or revenues) any marked

inflation can pose a problem for the SME definition over time. Some countries recognize this issue and

occasionally update their criteria for SMEs, but most do not (ESCAP, 2009a). The three main parameters

that have been generally applied to define SMEs are: (a) the number of employees; (b) turnover of business;

and (c) capital investment.

recent financial crisis, promoting SMEdevelopment appears to be an

important priority".9 Estimates onemployment creation in Hall (2002)are much higher, indicating thatSMEs, on average, provide between60-70 per cent of all jobs, especiallywithin the Asia-Pacific context.10 The

Asian Association of ManagementOrganizations (AAMO) reports that, in

the Asia-Pacific region, SMEstypically account for nearly 50 percent of all value addition within theeconomy, directly and indirectly.11

8 IFC (2010), "Scaling-up SME Access to Financial Services in the Developing World", October, G20 Seoul Summit 2010. 9 Ibid.10 Hall, C. (2002), "Profile of SMEs and SME Issues in East Asia", in C. Harvie and B.C. Lee (Eds.), The Role of Small and Medium Enterprises in National

Economies in East Asia. Cheltenham, United Kingdom, Edward Elgar.11 Asian Association of Management Organizations (AAMO) (2007), “SMEs in the Asian Region - Harnessing the Growth Potential”. New Delhi, AAMO.

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3. Rationale for Policy Support to SMEsIt is clear that it is not possible todiscuss economic policy withoutrecognizing the role which SMEs playin the rest of the economy and

society as a whole. Yet, it isappropriate to examine the argumentsoften put forward in favour ofgovernment policy support for SMEs.A widely noted reason is that thereare market failures that are peculiar to

SMEs because of their comparativeweaknesses in the market and theirrelative high cost of compliance withgovernment regulations (Bannockand Peacock, 1989). This argument isthat SMEs do merit support not to

give them an undue advantage overother types of enterprise, but simplyto offset the disadvantage which theyexperience by their small size and tooffset perverse effects of othergovernment policies. This is an

important proposition because it goesto the heart of the current discoursein private sector development thatcites the importance of "creating aconducive enterprise environment". Inthis framework, then, addressing

failures like access to finance, amongothers, should become the focus ofpolicy support.

The overall objectives of governmentpolicies to support SME developmentare: (a) create jobs and generate

income; (b) improve SMEperformance and competitiveness;and (c) increase their participation inand contribution to the nationaleconomy. There are a number ofobstacles that need to be overcome

to achieve these objectives. Thefollowing constraints for SMEdevelopment identified by AAMO(2007) are useful to recall here:

1. Poor business environment(e.g., bureaucracy, taxationand unfavourable propertyrights enforcement)

2.Poor infrastructure (e.g.,transportation facilities, powerplants, industrial estates andtelecommunications)

3. Inadequate access to finance(e.g., obtaining loans, securing

collateral and third-partyguarantees and a lack ofalternative sources)

4.Low technological capacities(e.g., rapid technologicaladvancement in markets,

locating sources of appropriatetechnology and acquiringtechnology to developattractive products

5.Too few applications of ICT(e.g., business communi-cations, marketing intelligence

and customer development)

6. Intensified competition indomestic, regional and globalmarkets (e.g., trade andinvestment liberalization, lessprotectionism, freer movement

of goods and capital, lowerimport duties, cuts in subsidiesand cost pressures).

The focus of this present paper isexclusively on factor number 3 above,as the authors believe that this issue

is at the heart of the strength andcompetitiveness of SMEs.Addressing the access to financeproblem more robustly, would havepositive knock-on effects on the otherfactors as well.

The overallobjectives ofgovernmentpolicies tosupport SMEdevelopmentare: (a) createjobs andgenerateincome;(b) improve SMEperformanceandcompetitiveness;and (c) increasetheir partici-pation in andcontributionto thenationaleconomy.


5

4.The Scale and Nature of the Access toFinance Challenge

4.1 Financing the SME Sector - A Conceptual OverviewFinancial inclusion is a prerequisite

for growth of the country and itscommercial sector.12 For SMEs inparticular, financial inclusion throughbetter access to finance is important.The ability of SMEs to grow andimprove competitiveness greatly

depends on their potential to invest indevelopment of the business,restructuring, innovation,improvements, and diversificationover time (UNESCAP, 2012). All ofthese investments need short- and

long-term capital. Therefore, accessto finance is a central issue in SMEdevelopment. Improving access tofinance means enhancing the degreeto which financial services becomeavailable to all, through ways that are

easier to access, appropriate, andaffordable.

First, the study takes a conceptualoverview of the various stages ofSME financing and the typical typesand sources of SME financing,

4.1.1 Stages of FinancingThe financing needs of an SME mayvary throughout each stage of its lifecycle - start-up, growth, maturity,decline, transition and exit.13 SMEsmay obtain equity capital and debt

financing from various sources ateach of these stages (Sridhar, 2008).

In the first stage (start-up), SMEscould face a high probability of failure

if they cannot raise sufficient capital,

even though the scale of their needsmay not be that large. In this stage, afirm may have limited sales revenuesand also profits may only be on paperand cash in hand may be strained,leading to inability to pay wages, bills

and other operating costs, Thismismatch of cash flow timingcontinues throughout the life cycle ofan SME (see Figure 2). Survival inthis stage could depend on a firm'sability to raise additional working

capital from the banking system.Apart from personal loans from familyand friends, during the start-up stageSMEs may get funds from seedcapital, venture capital, governmentand/or institutional sources.

In the second period (growth), SMEspass the break-even point and startmaking money at which point theyneed additional financing includingsignificant working capital loans(short-term) as well as investmentloans (longer-term) to expand

production and staffing. Theavailability of other funds could alsoincrease at this stage with local,national and international financialsources. Venture capital funds mayalso become an important resourcefor expansion. Entrepreneurs typicallyexperience difficulty raising funds atthis critical stage. Commercial banksdo not lend easily to those who stillhave no, or limited, credit record, andventure capital is not readily availablefor small-scale investment in newbusinesses, particularly in developingcountries and non-IT enterprises. Inthe third period (transition), it isnecessary for SMEs that are losingmoney to undertake measures toimprove profitability, either byimproving efficiency and productivity(cutting costs, streamliningoperations, etc) and increasing salesthrough enhanced competitiveness.While long-term financing or workingcapital generation is necessary forcontinuous enterprise growth anddevelopment, immediate short-termfinancing, perhaps through

12 IFC (2013), 'Promoting Financial Inclusion', International Finance Corporation: Colombo.13 This is a generalization for the sake of demonstration. Real life cycles may differ between individual firms and between sectors/industries.

Figure 1Mismatch of Cash Flow Timing

Source: ESCAP, 2012.

Receivables Sales

Payables Procurement

Customer Payment

Time Gap

Operating funds needed

suppliersPayment to

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6

commercial debt financing, is oftencritical for SMEs during cash-drainperiods.

So it is now clear that SMEs requireaccess to finance of various types atvarious stages of their life cycle, andobtaining timely and sufficient loansis a key part of this.

4.1.2 Types and Sources ofFinancingSMEs obtain financing via a numberof different financial instruments.While this paper largely focuses onlyon a sub-set of these, particularlyformal debt financing through loansfrom the banking system, it is useful

to take a brief overall look at theseinstruments, in the interest ofcompleteness.

Short- and long-term loans,especially from commercial banks,are the predominant form of financingfor SMEs. Short-term loans are themost common form of bank loans forstart-ups and small businesses, ascommercial lenders are generally lesswilling to take large risks with newcompanies. They have a maturity ofone year or less, although many arerepaid within a shorter timeframe(Peavler, 2012). They are usuallytaken out for a specific expenditure,for example, to purchase a piece ofequipment or to pay a particular debt.In this context, a fixed amount ofmoney is borrowed for a set time witha fixed interest rate (BusinessOwner's Toolkit, 2012a). In general,the sources of short-term financingfor SMEs include a line of credit,promissory notes, other short-termbanking instruments (e.g. , overdrafts)and loans from other financialcompanies. Short-term financing iseasier to arrange, has lower costsand is more flexible than long-termfinancing. However, short-termfinancing is more vulnerable tointerest rate swings, requires morefrequent refinancing and requiresearlier repayment. SMEs tend to rely

on short-term loans to meet suddenfinancial needs or to gain additionalworking capital, especially if theyface a temporary cash crisis or anunexpected delay in receipts from adebtor. Long-term commercial loansusually refer to those with tenurebeyond one year. This type of loans,also called 'project loans', enablebusinesses to invest and expandtheir business with less financialuncertainty, and increases workingcapital while reducing the amount ofinstalments. Longer-term commercialloans are used for a variety ofpurposes, such as purchases ofequipment and plant facilities,business expansion and acquiringspecialty raw materials for a newproject. Lenders require significantcollateral because the risk increaseswith the term length. It is moredifficult for SMEs to obtain long-termloans due to the lack of adequate

assets to use as collateral and theinsufficient supply of such long-termloans, particularly in developingcountries (IFC, 2009). The obviousconsequence of difficulties inaccessing long-term loans is thatSMEs are unable to plan on a long-term basis, thereby constraininggrowth plans and long-terminvestment decisions (Obamuyi,2007).

Informal sources of finance also playan important role for SMEs. Informalfinancing refers to all transactions,loans and deposits occurring outsidethe regulation of a central monetaryauthority (Atieno, 2001). Althoughrarely seen in the Sri Lankan SMEsector, equity financing is also anoption for SMEs. In equity financing,investors provide a capital infusion inexchange for an ownership share inthe business. It includes a wide rangeof financing sources such as business

Source: Authors.

Category Type of Instrument

Informal financing Personal savingsBorrowing from family or friendsBorrowing from moneylendersTrade credit

Internal financing Retained profitInternal savingsWorking capitalSales of assets

Debt financing Short-/long-term loansLine of creditPromissory notesCredit cardsOverdraftCorporate bonds

Equity financing Seed capitalAngel financeVenture capitallPOs

Asset-based financing FactoringInvoice discountingInventory financing

Leasing Capital leasing (hire-purchasing)Operating leasing

Government grants and subsidies GrantsInterest subsidiesCredit guarantee schemesLoan insurance schemesLoan schemes

Table 1Types and Sources of SME Financing


7

Against this backdrop, SMEs

consistently cite lack of access tofinance as a severe handicap(UNESCAP, 2009a). While the gap infinancing SMEs is significant both indeveloped and developing countries,some differences do exist. A survey ofSME financing by the OECD (2006)

indicated large financing gaps in bothOECD and non-OECD countries, butthe situation was more acute in non-OECD countries. Further, there weresignificant differences between OECDand non-OECD countries on the

matter of debt financing. While only 30per cent of the firms in the OECDcountires felt a gap existed in debtfinancing, 70 per cent of non-OECDcountries felt this. This suggestsunderlying weaknesses in the

banking sector - the main provider ofdebt financing - in dealing with smallfirms in non-OECD countries. Park,Lim and Koo (2008) confirm this, andfurther explore the disadvantages inSME financing due to the lending

policies of commercial banks, themost important source for SMEs'external financing. A surveyconducted by Beck, Demirgüç-Kuntand Peria (2008) confirm this by

showing that in developing countries,commercial banks require morecollateral for small business loansand charge higher interest rates thanthose in developed countries,regardless of firm size. Their findings

imply that the transaction cost in thecommercial banks of developingcountries is high, adding furtherchallenges for SME financing in suchcountries.

According to a 2009 Asian

Development Bank survey of SMEs in13 countries, obtaining capital is thetop constraint for firm formation andgrowth (ADB, 2009). There are amultitude of reasons for this, andthese reasons in the Sri Lankan

context are explored later in section6. But Sri Lanka is not an outlier in itsaccess to finance problems. AsESCAP (2012) observes, "althoughmost of the governments in the Asia-Pacific region have formulated well-

structured policies and placed well-developed institutional financingagencies on the ground to meet theneeds of SMEs, there is a gap in theactual implementation of thesepolicies. Bank management may not

appreciate the dire need that SMEs

have for cash. Banks may be willing

to help but their SME clients get lostin the shuffle as bank managementcaters to larger, wealthier customers.Unfortunately, the SME-bankerrelationship may then becomeadversarial, further defeating the bestintentions of policy makers. Part of

the intransigence often lies with theowner of the SME, who may not beable to communicate effectively withthe banker or present their needs in away that would give incentives for thebank to cooperate".

Historically, SMEs around the worldhave frequently had difficulties inaccessing finance. The recent globalfinancial crisis, however, intensifiedthis challenge. According to anEconomist Intelligence Unit (EIU)

survey report on access to financeamong SMEs,14 45 per cent ofrespondents from the Asia-Pacificregion say that the availability offinance has deteriorated in theaftermath of the crisis. According to

the IMF, lending to the sector hasfallen much more sharply than it hasto larger companies.15 The stressesand pains of SMEs owing to the lackof finance seem to have augmented

4.2 Access to Finance Gap - Exploring the International Evidence

14 Economist Intelligence Unit, ACCA and CPA Australia (2009), Access to Finance for the Small and Medium Sized Enterprise Sector Evidence and Conclusions.15 International Monetary Fund (IMF) (2012), World Economic Outlook.

angels, venture capital and initialpublic offerings (IPOs). Asset-basedfinancing is also used by SMEswhereby funds are obtained bypledging part of the firm's assets ascollateral or as the primary source ofrepayment (Berger and Udell, 2005).The most common types of asset-based financing are factoring, invoicediscounting and inventory financing(Business Owners Toolkit, 2012a).Additionally, SMEs often use leasingas a way to financing new equipmentlike machinery or motor vehicles.

A summary of the various SME

financing sources discussed aboveare provided in Table 1 above.

The present financing structure ofSMEs in Sri Lanka consists mainly ofthe development financing institutions(DFIs) and licensed commercialbanks. DFIs such as DFCC Bank andNDB Bank often offer medium- tolonger-term, project-based funding forSMEs, and are often the PartnerFinancial Institution (PFI) fornumerous concessionary loanschemes refinanced by aid donors.

Several commercial banks alsofunction as PFIs in implementingdonor-funded as well as government-funded SME credit schemes, inaddition to providing their ownschemes aimed at SMEs. In addition,equity market, debenture market andventure capital act as supplements inSME financing, but have very limitedreach. Recent venture and angelfinance initiatives like the LankanAngel Network have begin to gainground, but are largely limited to theWestern Province.

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with the tightening of financialregulations in the aftermath of theglobal financial crisis.

A recent IFC study revealed the

severity of the financing issue facedby SMEs, particularly in emergingmarkets. Approximately 45-55 percent of formal SMEs in emergingmarkets were found to be unserved(i.e., they need credit but do not have

access to it) while 21-24 per centwere found to be underserved (i.e.,they have access to some credit butstill identify financing as aconstraint).16 The survey alsoconcludes that only 17 per cent and

32 per cent of small firms in low andmiddle income countries,respectively, had access to a loan/lineof credit from financial institutions,while the corresponding figure forhigh income countries was 50 per

cent.17 Further, the results of theWorld Bank Enterprise Surveysindicate that SMEs in developingcountries are more likely than SMEsin developed countries to reportaccess to finance as a major obstacle

for their development.18 According tothe Enterprise Surveys, 30 per cent ofall countries and nearly 35 per cent ofcountries in South Asia identifiedaccess to finance as a majorconstraint.

ADB (2009) reiterates that the growthpotential of SMEs tends to be morevulnerable to financing constraintsthan large firms. They estimate thatfinancing obstacles result in anaverage decline in growth of 10 per

cent for smaller firms vis-à-vis 6 percent for larger firms.

The access to finance issue certainly

is not a new one in the SMEdevelopment discourse in Sri Lanka.It has been identified in previouspolicy documents as well. Forinstance, the 'National Strategy forSmall and Medium Enterprise Sector

Development in Sri Lanka WhitePaper' (2002) identifies problemsrelated to finance as the foremostimpediment to SME growth in thecountry.19 The report further statesthat the lack of SME access to

finance results in a vicious circlelinking financing problems with theperformance and progress of SMEs,as the lack of finance in turn results inundesirable outcomes such as theuse of outdated technology, absence

of quality control, and weakeningprofitability.20

Several studies by internationalagencies have reported headlinefigures on the access to financeproblem. The World Bank Enterprise

Survey for Sri Lanka (2011) reportedthat among 610 firms surveyed,access to finance was the second-most cited 'business environmentconstraint' (30 per cent of firms).21

Meanwhile, an IFC micro-study of

2010 reported, "a significantproportion (40 per cent) of firmsinterviewed mentioned thatinsufficient access to finance hadbeen a main obstacle either whenstarting or expanding their

business".22

4.3 Access to Finance Gap - Exploring the SriLankan Evidence

Adding to this body of knowledge is a

recent survey of SMEs in Sri Lankaconducted by the Institute of PolicyStudies with the National Chamber ofCommerce of Sri Lanka.23 The surveywas conducted in early 2013 via asemi-structured questionnaire. The

sample was randomly selected using

The accessto financeissuecertainly isnot a newone in theSMEdevelopmentdiscourse inSri Lanka. Ithas beenidentified inpreviouspolicydocumentsas well.

16 International Finance Corporation (IFC) (2010), Scaling-up SME Access to Financial Services in the Developing World.17 Ibid.18 World Bank (2013), Enterprise Surveys.19 Task for Small & Medium Enterprise Sector Development Program (2002), National Strategy for Small and Medium Enterprise Sector Development in Sri

Lanka, White Paper.20 Ibid.21 Survey only covered manufacturing enterprises.22 IFC (2010), 'Assessing Private Sector Contributions to Job Creation: IFC Open Source Study', IFC: Colombo.23 The sample was randomly selected using NCCSL database of members classified by NCCSL as SMEs. Any selection bias is unlikely owing to the strongly

heterogeneous nature of the enterprises surveyed. All are formally registered businesses.


9

NCCSL's database of SME

members.24 The common feature ofthe sample was that they were allmembers of the Chamber andformally registered businesses.Although all respondents come fromthis same enterprise cohort, any

selection bias is unlikely owing to thestrongly heterogeneous nature of theenterprises surveyed. The authorslooked closely at the nature of thebusiness that each respondent wasengaged in to ensure that the results

aren't skewed towards any onebusiness type (i.e., wood work, foodprocessing, etc). This was deemednot to be the case.

The survey received 101 responses,covering all provinces in Sri Lanka

(see Table 2). At the outset, the focusin the sampling was on enterprisesoutside the Western Province, takingthe argument that SME developmentin other regions is particularly difficult.As such, 96 per cent of respondents

were from regions outside theWestern Province.

The aim of the survey was to identifythe key issues faced by SMEs in SriLanka. According to the findings of

24 The size of the database was 400 members. However the authors acknowledge that this does not capture the entire SME population in these Provinces.Such information is not available from government census and statistics data owing to SME definition and classification issues.

who reported they had inadequate

access to finance, 69 per cent saidthey had more difficulty in accessingfinance for development/expansion,while those who stated it was moredifficult to access working capitalwere relatively fewer (around 31 per

cent).

According to the survey results,financial restrictions also contributedto the tightening of other constraintson the working of the business. Of theindividuals that participated in the

survey, more than one-third of thosewhose employees had not receivedany training, credited insufficientfinances as the main reason for it.

The majority of respondents (60 percent) noted that formal channels were

their main source of financing (37 percent) of which government bankswere the preferred option. Informalsources were acknowledged bynearly 40 per cent of all respondentsas part of their financing options, with

the majority coming from friends/relatives and local moneylenders(Figure 3). This is not unusual. Whilecommercial banking plays a key rolein formal SME financing, informalfinancing often dominate the financial

sources of SMEs because of the verynature of their structure and networks(sole-proprietorships, locally-based,etc). A report by RAM ConsultancyServices (2005) on SMEs in theASEAN region revealed that 75 - 90

per cent of SMEs rely on informalfinancing and internal financing.Hussain, Millman and Matlay (2006)report that, in China, 15 per cent offinancing needs of SMEs come fromborrowing from friends, relatives and

other individuals while approximately20 per cent comes from bank loans.

For SMEs examined in our survey, themost common reasons for using such

Table 2Distribution of Respondents byProvince

Province No.

Eastern 9

Central 24

North Western 24

Uva 11

Southern 10

North Central 12

Sabaragamuwa 4

Western 4

Northern 3

Source: IPS-NCCSL Survey.

this survey, 91 per cent of

respondents considered access tofinance as one of the 'top fiveconstraints' on their businesses, whilehalf of all respondents considered itas their 'most significant constraint'(see Figure 2).

The most significant reason for

inadequate access to financeexperienced by most of the surveyrespondents was attributed to theinability of financing development/expansion plans. Of the respondents

Lack of access to finance

Lack of access to technology

Lack of access to markets and information

Lack of business development services

Lack of other facilitation services

Other responses

Figure 2Most Significant Constraints on Businesses as Perceived by SMEs

Source: Survey results.

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sources were listed as high interestrates and the inability to providecollateral requested by formalbanking institutions, with seeminglylittle relief from development banks.The unwillingness of formal banking

institutions to serve SME clients, for anumber of reasons, was anothersignificant motive for usingalternatives. However, the surveyfurther revealed that 75 per cent ofthose currently using informal

sources declared that they wouldprefer using formal financing sourcesinstead.

Two subsequent surveys reinforced

the notion that banks and financialinstitutions are not able to suitably

cater to SMEs' access to financeneeds. An IPS survey focussing onmanufacturing-oriented SMEs in theWestern Province, noted that while

only 44 per cent of enterprisessought access to finance in the lastyear (2013), the majority of those thatdid (79 per cent), sought it fromcommercial banks. Of those that did

not seek finance from formal creditchannels, the second most-citedreason (19 per cent) for it (the firstbeing that the enterprise hadsufficient capital) was that 'applicationprocedures were too complex'. Other

reasons included 'need for formalregistration' (15 per cent), 'interestrates not favourable' (4.6 per cent),'collateral requirements were too high'(1.3 per cent), 'did not think it wouldbe approved' (2.6 per cent), and 'size

of loan and maturity were insufficient'(2 per cent).

Meanwhile, a further IPS surveyfocussing on women entrepreneurs inthe SME sector revealed verystrongly that support received from

financial institutions to start and growtheir businesses was not satisfactory.According to male and female surveyrespondents from five districts(Moneragala, Batticaloa,Anuradhapura, Kurunegala and

Matale), nearly 60 per cent disagreedor strongly disagreed with thestatement that 'support received fromfinancial institutions were good'(Figure 5). Only 20 per cent indicatedsatisfaction about the services

received from financial institutions. Ofthe 44 per cent of women-owned

Figure 4Access to Finance by Province

Figure 3Current Sources of Finance for SMEs Reporting Access to Financeas Most Significant Constraint




11

SMEs that had applied for a loan in2013, development banks were themain source of funding. Furthermore,of the women SME entrepreneurs in

this survey who had started their ownbusinesses, only 34 per cent hadobtained finance via bank loans orlocal-level finance companies - themajority (70 per cent) had raisedcapital from informal sources like

friends, relatives, neighbours,spouses, parents, children, siblings,and also through pawning.

Against this backdrop, it would beinteresting to look at the recentperformance with regard to SMElending in the Sri Lankan financial

system. Recent trends in SMEbanking are certainly encouraging.

In line with Government efforts topromote the SME sector in recentyears, the banking sector of Sri Lankahas diverted more attention towards

serving this segment. It appears thatprivate sector banks have been themajor driver of SME financing in the

country. In 2012, for instance, privatesector banks accounted for 87 percent of total SME lending (Figure 6).Further, SMEs in the industrial sector

have been the recipient of a relativelylarger share of SME loans in 2012,while SMEs in the agriculture sectorhave received the lowest (Table 3).

Figure 6SME Lending by Banks in 2012

Source: Authors' calculations based on Ministry ofFinance and Planning (2013), Annual Report2012 .25

Table 3SME Loans Provided by Banks in 2012 Bank Agriculture Industries Services Other

No. of Amount No.of Amount No. of Amount No. of AmountLoans Rs. Mn. Loans Rs. Mn. Loans Rs. Mn. Loans Rs. Mn.

Bank of Ceylon 12 15.0 356 3354.0 231 2395.0 36 346.0

Peoples’ Bank 3247 6869.9 1607 10393.7 1795 4135.5 1227 3643.4

Regional Development Bank 385 195.0 590 490.0 170 85.0 280 590.0

Lankaputhra Development Bank 42 101.3 241 1120.6 39 243.2 31 113.5

Sanasa Development Bank 22 152.0 42 581.0 9 139.0 61 625.0

National Development Bank 370 1725.8 1098 3346.7 380 1132.9 2817 5748.3

DFCC Bank 487 1445.4 2953 13053.6 1017 5981.1 - -

Commercial Bank of Ceylon PLC 18362 8986.7 31186 50939.9 9724 19224.5 18210 16362.9

Sampath Bank 163 894.9 1828 7746.3 215 1074.3 191 1633.4

Hatton National Bank PLC 4364 9323.8 2553 8800.0 4670 13500.0 10397 31000.0

Nations Trust Bank PLC 132 679.2 537 1129.9 2453 3806.1 8876 10929.4

Union Bank of Colombo Ltd. 2526 756.0 3286 4839.0 1382 2326.0 34873 3680.0

Total 30112 31145.1 46277 105794.6 22085 54042.6 76999 74671.9

Source: Ministry of Finance and Planning (2013), Annual Report 2012.

25 Private sector banks include NDB Bank PLC, DFCC Bank, Commercial Bank of Ceylon PLC, Sampath Bank, Hatton National Bank PLC, Nations Trust BankPLC and Union Bank, while public sector banks include Bank of Ceylon, People's Bank, Regional Development Bank Ltd., Lankaputhra Development BankLtd., and Sanasa Development Bank Ltd.

Very little published data is availablefrom the individual banks as to theirSME lending portfolios. A closer look

at company Annual Reports alongwith key informant interviews revealed

Source: IPS (2014), 'Female Entrepreneurship and the Role of BusinessDevelopment Services in Promoting Small and Medium WomenEntrepreneurship in Sri Lanka'.

Figure 5Support Received from Financial Institutions that HelpedGrow the Business

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determined from these numbers isthe lending to small enterprises vs.lending to medium-sized enterprises.As there is no regulation to reportinformation in this manner, togetherwith the added complication of a lackof a consistent SME definition, thisinformation cannot be ascertained. Itremains questionable if smaller firmsreadily have access to bank financingor if the funds are concentratedamongst the more 'medium' end ofthe SME spectrum. Additionally, whilethe active participation of privatecommercial banks in SME lending isa promising sign, it is unfortunate thatstate banks accounted for only 13 percent of SME loans in 2012 (Figure 6).

The coverage of the formal bankingsystem across the country too hasimproved, post-war. Among just threebanks - NDB Bank, CommercialBank, and Nations Trust Bank - therewas a tripling of the number ofbranches in conflict-affected Northernand Eastern provinces from 13 in2009 to 38 in 2011. For these banks,10-15 per cent of all branches arenow in these provinces, which theIFC (2013) calls 'frontier regions'.

Meanwhile, recent budgets have hadan SME finance focus; the 2012

Budget in particular contained themost number of SME finance relatedproposals in recent years. In Budget2012, the President announced thatstate banks would be requested to setspecialized 'SME Banking Centres' inseveral provinces. Additionally, allbanks were required to set up anInvestment Fund Account (IFA) withthe Central Bank of Sri Lanka todeposit the savings made from tworeductions on taxes on banks -corporate income tax from 35 percent to 28 per cent and VAT onFinancial Services from 20 per cent to12 per cent. Banks were instructed tolend to SME development out of thefunds in the IFA. It was alsoannounced that interest income fromSME banking would enjoy a reducedincome tax rate of 24 per cent (fromthe standard 28 per cent).Additionally, 50 per cent governmentguarantee is given for those banksproviding loans to restructure SMEsand improve their performance.Subsequently, in Budget 2013 arather intrusive move wasannounced, which ordered that anyfunds lying undisbursed in the IFA (asat a stipulated date) would have to betransferred to the Treasury.

Table 4 SME Banking Portfolio of Selected Banks26

Bank 2010 2011 2012 2013

NDB Bank 10.5%(a) 10.2%(a) 11%(b) -

DFCC Bank (c) 48%(d) 52%(e) 61%(d) 49%(f)

Nations Trust Bank 23%(g) 17%(h) 22%(h) -

Sampath Bank - - - 40%(i)

Notes: (a) Includes SME and refinance loan portfolio; (b) Refers to total SMEs portfolio as apercentage of total portfolio; (c) Refers to data pertaining to financial years 2009/2010, 2010/2011,2011/2012,2012/2013; (d) Refers to SME portfolio as a percentage of total credit portfolio;(e) Refers to SME portfolio as a percentage of total portfolio; (f) Refers to SME portfolio as apercentage of total loans and advances portfolio; (g) Includes the SME banking and leasingportfolio as a percentage of the total loan portfolio; (h) Includes Retail/SME loan portfolio; (i)SME loans as a percentage of its total loan book.

Sources: NDB Bank, Annual Report 2011; NDB Bank, Annual Report 2012; DFCC Bank Annual Reports,various years; Nations Trust Bank, Annual Report, various years; Sri Lanka's Sampath Bankplans Myanmar branch, strong credit growth (Online). Available at: http://www.lankabusinessonline.com/news/sri-lankas-sampath-bank-plans-myanmar-branch,-strong-credit-growth/459288551; Banking on SMEs (Online) http://www.island.lk/index.php?page_cat=article-details&page=article-details&code_title=3450 .

25 Banks have been selected based on the availability of data.

Very littlepublished datais availablefrom theindividualbanks as totheir SMElendingportfolios.

It remainsquestionable ifsmaller firmsreadily haveaccess to bankfinancing or ifthe funds areconcentratedamongst themore ‘medium’end of the SMEspectrum.

some information for a few of thelarger banks. As shown in Table 4, thelevels of SME lending in the total loanportfolio differs widely from bank tobank. For instance, the NDB Bank,

originally set up as a developmentbank to finance sectors such as SME,demonstrated only a 10-15 per centSME loan portfolio. Meanwhile, theother development bank, DFCC,demonstrated an over 50 per centaverage SME lending ratio over the

last four years. Commercial banks likeNations Trust Bank (22 per cent) andSampath Bank (40 per cent) havebeen steadily raising their SMElending as well. Yet, what cannot be


13

5.Supply and Demand Dynamics Driving SMEAccess to Finance Challenge in Sri Lanka

5.1 Unpacking the ProblemAs alluded to earlier, the challengesof access to finance broadly includesfour sub-sets of problems, namely,availability of funds and other creditinstruments, access to loan capital,cost of borrowing and management offinances. The problem of availabilityof funds is said to owe partly to'intrinsic weaknesses' within SMEsand partly to the underdevelopednature of Sri Lanka's financialmarkets. The lack of venture capitaland equity financing options for SriLanka are said to compel SMEs todepend mostly on bank loans (asidefrom informal sources). The problemof poor SME access to funds is saidto attribute to factors such as theinability of SMEs to produce collateralwith proper titles, the lack ofdevelopment orientation on the partof both commercial and developmentbanks, and the lack of proper skillsamong SMEs to make bankableproject proposals. The third problemof cost of funds is said to attributemainly to the high risk credit profile ofSMEs which inevitably lead to highinterest rates being offered to thesegment, while the problem ofmanagement of finances is said toattribute to several factors includinginsufficient equity base, high cost offinance, over-ambitious businessacceleration, lack of financialmanagement experience, non-separation of business and privateexpenditure, over-expenditure onstatus symbols such as cars, andunexpected policy changes.27

Sri Lanka currently has a widespreadnetwork of banks covering most ofthe rural corners of the country. In

2011 alone, 194 new branches wereopened across Sri Lanka.28 Hencethe problem of low SME access tocredit is due to reasons that go

beyond merely not having access tothe country's existing bankingnetwork. It has become clear that theweak SME access to credit situationin Sri Lanka stems from both demandand supply-side factors. The authors

conducted in-depth key informantinterviews (KIIs), especially withsenior officials of banking andfinancial institutions in the country, touncover more insights on this issue.The following sections take a closer

look at the findings of this.

5.2 Demand-side Factors: SMEs' IntrinsicWeaknessesWhen considering the demand-sidefactors, the lack of collateral seems tobe the most significant constraint onSME access to credit. Financialsector institutions surveyed observedthat the high non-performing loans

(NPL) ratio of SME customers haveprompted them to demand highercollateral when giving out SME loans,in order to cover potential defaultlosses. Banks assert that althoughthey have tried alternatives to

collateral-based lending, like cashflow-based and risk-based lending,the NPL ratio was higher for suchlending and felt that collateral isnecessary in order to exert pressureon SME customers to repay their

loans. The banks also expressed aconcern that effective credit

guarantee schemes, which wouldease high default risks of the SMEsegment, were not available in SriLanka, but if introduced wouldimprove the SME credit climate byallowing banks to lend collateral-free.

The lack of transparency andfinancial discipline among SMEs wasconsidered as the second mostsignificant demand-side factor. SMEsare hesitant to fully comply withpreparing financial reports due to the

fear of exposure to governmentregulatory matters like taxes. Taximplications appear to be causingreluctance among SMEs to discloseproper financial accounts to banks.Preparing financial reports based in a

standardized manner is also a

The problem oflow SME accessto credit is dueto reasons thatgo beyondmerely nothaving access tothe country’sexisting bankingnetwork.

27 Ibid.28 Central Bank of Sri Lanka (2012), Economic and Social Statistics of Sri Lanka 2012.

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challenge for many SMEs as they donot have dedicated and largeaccounting and finance departments.The lack of proper financial datamakes it virtually impossible forbanks to evaluate thecreditworthiness of SMEs and hasthus constrained the amount of creditgiven to the sector.

SMEs often do not have a propermanagement or organizationalstructure. The enterprise could becomprised of just a handful ofindividuals or set up as a 'one-man-show' with no specific skilledprofessionals for financialmanagement and reporting. This maybe an off-putting characteristic forbanks.

The lack of access to markets, marketinformation, and effective supplychains are considered as 'intrinsiccharacteristics' constraining SMEgrowth. This in turn, has an impact onSMEs' access to finance. Theinterviews revealed that this lack ofaccess to markets, marketinformation and supply chains haveprevented SMEs from making betterevaluations of critical businesscriteria such as their respectivemarket size and market trends.

This in turn, has made SME businessplans less feasible prompting banksto refrain from lending to SMEs due toinadequate and/or poorly-preparedbusiness plans. The lack of sufficientknowledge of business practices suchas the effective financial manage-ment, business planning, book-keeping, etc., prevent SMEs frommaking bankable business proposals.Banks have begun making efforts toaddress this issue by conductingtraining programmes and establishingspecial SME centres to assist SMEsin preparing proposals. However,certain banks expressed concern thatSME entrepreneurs were reluctantand unmotivated to gain such skillsdespite their clear importance.Moreover, the banks also believe that

there is a strong need for governmentattention on this matter, remarkingthat the banking sector alone cannothelp address the challengesufficiently. The findings of theinterviews also reveal that 'intrinsiccharacteristics' within SMEs such asthe lack of proper technology, poorquality products and labour issuesnot only impose major challenges onSME growth but also make SMEsriskier than other segments for banksto serve. This in turn, makes bankshesitant to lend to SMEs. Necessarymeasures need to be taken toovercome such weaknesses in orderto minimize the risk profile of SMEsand thus make banks keener onserving the sector.

The interviews also highlighted thefact that administrative delays anddifficulties in obtaining permits andlicences from government institutionsenforces problems for SMEs inobtaining credit because the banksare unable to provide credit withoutproper documentation. Most banksbelieve that bureaucratic proceduresneed to be reformed so that aspeedier service can be provided forthe SME sector when obtainingpermits/licences.

Our findings suggest that the lack ofproper insurance coverage for theSME segment is yet another criticalfactor limiting SME credit. Banks feelthat the insurance providers of SriLanka seem to have given very littleemphasis to the SME segment asmost SMEs have been unable toobtain proper insurance coverage.The high risk profile of SMEs makebanks hesitant to lend to SMEs thatdo not have proper insurancecoverage.

The lack of proper management andleadership plans was found to be yetanother demand-side shortcomingconstraining SME access to credit.Most SMEs are family run businessesand there seems to be no second lineof management for these businesses

(especially when the children of theSME owner are reluctant to take upthe business). The banks are not in aposition to lend to SMEs without aproper line of management, as anymishap to the entrepreneur wouldmark an end to the business, leavingbanks at a loss.

Accounting firms can play a role inaddressing this by assisting infinancial reporting in the simplestformat in order help SMEs toovercome the complexity of financialreporting. The Institute of CharteredAccountants of Sri Lanka is currentlysetting out a simplified version ofaccounting system for smallenterprises to assist in financialreporting, together with the Small andMedium Practitioners (SMPs) in localareas.

Overall, banks are of the notion thatSMEs are substantially riskier thanother enterprises and the cost ofservicing this segment is higher.Recovering non-performingadvances/loans from SMEs is costlyand burdensome. SMEs are alsoseen to be more vulnerable to shocksas they do not possess adequatefinancial resources to weather difficultperiods.

The lack ofaccess tomarkets, marketinformation, andeffective supplychains areconsidered as‘intrinsiccharacteristics’constrainingSME growth.


15

The KIIs revealed several constraintswithin the financial sector itself that

hinder SME access to credit. Majorityof the banks interviewed stated thelack of effective government supportand/or incentives given to the bankingsector for promoting SME lending asa key factor limiting SME credit. The

banks stated that the extremely riskynature of the SME market makes itdifficult for banks to serve thesegment and that, incentives wereneeded to make it worthwhile forthem to serve such a risky market.

This was a surprising observationgiven the number of concessionaryand SME-specific loan schemesavailable in the market, particularlythose refinanced by the Central Bankof Sri Lanka or international

development agencies. Banksexpressed their disappointment in thecurrent refinance facilities provided bythe government as they were found to

be ineffective and unprofitable forbanks. They also felt that the

government needs to take a moreproactive role in providing necessarycredit lines for SME lending. As theIPS survey revealed, the respondentscited reasons like poor credit history,weak past financial performance and

management, and risky/weak marketpotential to be the main grounds onwhich loans were turned down bybanks. So, clearly, banks do have tobattle significant challenges withSMEs' credit worthiness.

The lack of staff that is skilled in SMElending emerged as a critical supply-side constraint. SME lending is aservice that calls for a different kind ofbanking approach. A more analytical,patient, and small business-oriented

banking attitude is required for SMElending. SME bankers require moretraining in handling SME customers

5.3 Supply-side Factors: Limitations within the Banking Sectorthan a normal corporate customersince SMEs do not possess the

capacity to produce reports on tightdeadlines set out by the banks.Moreover, it was highlighted that staffin branches rarely have time to attendto SME customers as they arepreoccupied with achieving strict

monthly targets. Hence, there seemsto be a lack of staff in banks that canand are willing to attend specifically toSME customers and provide aspecialized service to them.

Banks are often ultra-cautious when it

comes to SME clients, owing toinformation asymmetry and lack ofunderstanding. Often, a key reasonfor default among the SME segmentis poor credit origination, i.e., creditevaluation that has not correctly

ascertained the applicant'sbackground, project potential, andeconomic conditions.

Box 2: Methods and Criteria for Bank Loan Appraisal

There are two major appraisal methods for loan applications -transaction

lending and relationship lending. The main difference between the two

methods is that the former is primarily based on quantitative data (e.g.,

financial statements, bank accounts, credit scores, size of equity, assets

and cash flow prediction) while the latter is based on qualitative data (e.g.,

management skills, leadership, owners' characters, banking relationship,

reputation and quality of human resources). In practice, particularly in

developing countries in Asia and the Pacific, these two methods are often

used by commercial banks in a mixed way to fit in with their unique operating

environment. The World Bank's global survey on the banking sector reveals

that banks consider specific factors in evaluating commercial loan

applications. In general, the following criteria are used: (a) Financial

assessment of the business; (b) Firm's credit history with the bank; (c)

Characteristics of the firm's owner (age, sex, leadership, managerial skills

etc.); (d) Purpose of the loan; (e) Collateral; (f ) Firm's credit history from a

credit registry; and (g) Size of the loan.

Source: ESCAP, 2012.

Banks areoften ultra-cautiouswhen itcomes toSME clients,owing toinformationasymmetryand lack ofunderstanding.

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The findings also underscored that

financing facilities provided for theSME segment in Sri Lanka seemed tobe limited predominantly to loans,leasing and pawning. The lack ofdiverse and innovative bankingproducts and services aimed at start-

ups and small businesses are limited,often non-existent, in Sri Lanka'sfinancial markets. The limited range ofSME-focused or SME-friendlyfinancial products offered seems tobe a factor constraining SME credit.

The banks also expressed concerns

about the policies adopted by thegovernment with regard to financialmarkets such as imposing creditceilings and high interest rates as aconstraint on SME lending. The banksbelieve that a favourable financial

environment with less interruption isneeded so that they will be at aposition to follow strategic plans topromote the SME sector. The costand time taken to deal with policychanges are said to take away time

and effort from serving the SME

market, as most often than not, banksare found to be preoccupiedresponding to ad-hoc policy changesrather than following systematic plans.

So, as the preceding sections haveamply demonstrated, the access to

finance challenge in Sri Lanka ismultifaceted, and has both demandand supply features. The paper nowturns to some possible policyinterventions to tackle this.

6. Policy OptionsThe study now attempts to exploresome policy options in tackling thisissue. This section first provides two

overarching areas, which if addressedcan significantly improve the accessto finance climate for SMEs - re-orienting the banking system towardsSME lending and addressing theinformation asymmetry that exists.This section then goes on to put

forward a few specific mechanismsthat could be considered for adoptionand also provides case studies ofinteresting mechanisms adopted byother countries.

Source: Nanayakkara (2011).

6.1 Policy Options - Overarching Measures6.1.1 Re-orienting FinancialInstitutions towards SMELendingBanks' discriminatory behaviourtowards SMEs is quite rational. Fromtheir point of view, the scarcity ofcredit in most developing economies(savings-investment gap) meansthere is less incentive to seek out

SMEs when larger and more qualifiedclients are available. Banks often find

that dealing with SMEs incur highertransaction costs because the creditmonitoring process requires morecapacity at the local branch level, andthis is further complicated by the poorfinancial management and

accounting systems of many SMEsthat was highlighted earlier. Theunderdevelopment of riskmanagement skills related to SMElending has contributed to thiscontinued disincentive among banks

to lend to SMEs.

Figure 7Banker's Traditional Interest in SME Lending


17

Even though there has been a recent

shift in the focus of banks (especiallyin Sri Lanka), from large corporates toa newer, smaller, but yet lucrative,segment of SMEs, the bankingprocedures and practices carried outby Sri Lankan banks seemed to have

not changed accordingly to best suitthe new SME focus. Nanayakkara(2011) reckons that the traditionalbanking functions practised in SriLanka involving SME financing do nothelp in promoting SME lending.29

Nanayakkara (2011) goes on to statethat SMEs, who are most often thannot, unskilled in preparing businessplans find themselves unable tocomplete even the first step of thetraditional banking process and often

do not succeed beyond the first stepof the process (see Figure 7). Thehigh rate of failure of SMEapplications at the project viabilitystage is said to owe mainly to theinability of bank staff in accurately

assessing the business proposals asthey lack entrepreneurial skills toassess the projects.30 Most loanapplicants are start-ups with no priorfinancial statements, thus SMEs lackthe necessary records to prove their

financial strength. It remainsquestionable if SMEs should beevaluated based on the same criteriaimposed by traditional bankingprocedures.

Given the inability of the traditional

banking procedure to meet thedemands of the SME clientele, theneed to streamline Sri Lanka'sbanking procedure to best suit SMEcustomers is essential.

Banks and other financial institutions

need to develop more SME-friendlyproducts, services and processes,develop comprehensive risk

29 Nanayakkara, G. (2011), "Enhancing the Capacity of Banks to Shaping Development of SMEs". In: Association of Professional Bankers Sri Lanka. 23rdAnniversary Convention 2011: Banking Foresight- Shaping Integrated Development.

30 Ibid.31 Bank Perusahaan Kecil & Sederhana Malaysia Berhad (2012),"Corporate Info", Kuala Lumpur. Available at www. smebank.com.my/web/guest/home.

management skills and improve

information transparency.Increasingly, these institutions wouldhave to move towards offering non-financial assistance to SMEs as well -helping them with capacity-building toenhance their profitability. It is with

this in mind that Budget 2012proposed a special SME bank branch(known more commonly now as 'SMEcentres') to be set up by each statebank in all districts. This has alreadycommenced with the specialised

SME Banking Centres set up byPeoples’ Bank. Even though thesemeasures were taken in the rightdirection, the effectiveness of it isuncertain. Interviews conducted byIPS with leading banks unveiled the

difficulties faced by such banks inestablishing SME centres. The banks(including state banks) revealed thatthey are constrained by the lack offinancial and human resources to runthese SME centres.

Sri Lanka's recent efforts can learnfrom the examples in Pakistan andMalaysia. The SME Bank of Pakistanoffers a range of businessdevelopment services in the areas ofmarketing, accounting, product

design and business planning. TheSME Bank in Malaysia (also knownas the Bank Perusahaan Kecil &Sederhana Malaysia Berhad)provides advisory services to SMEs -including entrepreneurship-training

programmes to complement loanproducts.31

6.1.2 Improving the Bank-SME RelationshipDespite successive efforts ofgovernments to increase availabilityof bank loans to SMEs, the lack ofunderstanding between banks and

SMEs often holds this back. Forinstance, banks may not appreciatethe SMEs' dire need for quick capital,while SME owners may notunderstand bank policies andprocedures when it comes to SME

lending and mitigating risk. WhileSME development practitioners andpolicy makers may craft certainprogrammes and strategies, theirefforts may be frustrated whenapplied in practice. PFIs and other

intermediaries may lack either theincentive or the competence to buildand sustain bank-SME relations.Banks may often be more interestedin focussing on their standard loanproducts rather than special SME

ones. To bridge these gaps,communication and awarenesscreation are important, for both SMEsand banks on a sustained andongoing basis. For example, a

Banks and otherfinancialinstitutions needto develop moreSME-friendlyproducts,services andprocesses,developcomprehensiverisk managementskills andimproveinformationtransparency.

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research programme has beenconducted in Sweden since 1999 tofoster better relationships betweenbanks and SMEs through interactionsand information exchange betweenthe two groups: (a) banking

representatives, SMEs, auditors andtax authorities; and (b) academicrepresentatives32 (EuropeanCommission, 2007). Another exampleinvolves the SME Centre for Asia inthe Philippines, which provides a

training framework for financialinstitutions dealing with the SMEsector, comprising seminars, exhibitsand a venue for banks to buildlinkages with SME entrepreneurs .33

As part of the National SME Policy's

access to finance pillar or a futureSME development programme of anaid donor, there can be acomprehensive training and capacity-building module that is implemented.It is recommended that such a

module must include the followingcomponents: 1) researching andidentifying the training needs andexisting knowledge materials (locallyand globally); 2) Adapting suitabletraining materials and preparing

training modules; 3) pilot testing/fieldtesting of training packages with asample of selected banks; 4)conducting training-of-trainersprogrammes and building trainingcapacity within the banks itself; 5)

make training material freely availableonline and/or offer a structured onlinee-learning course to reducemanpower and financial costs ofscaling up training island-wide.

6.1.3 Reducing InformationAsymmetryOne of the main underlying drivers of

the access to finance challenge for

SMEs is the asymmetry ofinformation, which impinges on thebanks' ability to discern thecreditworthiness of SMEs. On onehand, it is too costly and inefficient forindividual lenders (banks) to collect

this information while on the other,SMEs usually lack financialadministrative skills to provide thisinformation, or may even lack thebasic knowledge about what type ofinformation should be prepared. This

creates somewhat of a market failure.

Addressing this can be a two-stepprocess that happens simultaneously.Firstly, SMEs need to learn to getbetter at providing the kind of criticalinformation that banks need when

making assessments aboutcreditworthiness. This goes back tothe discussion on 'SMEs' intrinsicweaknesses' like transparentbookkeeping, credible accounting,business planning, etc. The help of

banks, regional chambers ofcommerce, as well as nationalaccounting and auditing bodies canhelp in this. The government, alongwith national accounting bodies likeCA Sri Lanka would need to look at

the regulatory climate related toSMEs accounting, and see whatbearing does changes to accountingstandards adopted nationally andinternationally have on SMEs.

Policy intervention is also required to

ensure that banks and financialinstitutions are more transparent andresponsible in their lending terms andconditions. At several Private-PublicDialogues (PPDs) hosted by The AsiaFoundation that IPS participated in,

many SME owners cite the difficultiesthey have with understanding the"small print" of the loans theyobtain.34 This was especially true of

SMEs in the North and East. Due toyears of conflict and isolation, manypotential borrowers in the North andEast struggle with lower levels offinancial literacy than borrowers in therest of the country. Throughout the

PPDs, many of the participants wereoften unable to understand thenuances of interest rate calculationsand payment formulas, and accusedthe banks of imposing "hiddeninterest rates". Much of this is

attributable to the lack oftransparency in some banks' lendingpractices, and is a clear case forsimplifying the procedural aspects ofSME banking, while safeguarding theinterests of the banks.

The second aspect of this is the needto introduce mechanisms like SMEcredit scoring, which will be dealt within the next section.

32 European Commission (2007), Transparency and Dialogue: Final Report, Enterprise and Industry Publications. EC: Brussels.33 SME Centre for Asia (2011), "Programs & Services’, Makati City, the Philippines. Available at www.smecenterfor asia.com/programs-services.34 Wijesinha, A. (2010), 'Access to Credit: Critical Issue for Conflict-Affected Enterprises', Talking Economics, http://www.ips.lk/ talkingeconomics /2010/10/07/

access-to-credit-critical-issue-for-conflict-affected-enterprises.

Due to years ofconflict andisolation, manypotentialborrowers inthe North andEast strugglewith lowerlevels offinancialliteracy thanborrowers inthe rest of thecountry.


19

6.2 Policy Options - Specific Mechanisms6.2.1 Credit GuaranteeSchemesA key characteristic of SME lending is

the relatively higher level of risk andtransactions cost. An IFAC-Bankersurvey found that lenders do notvalue information industry trends andclients' business plans nearly asmuch as they do cash flow

statements, collateral and transactionhistories.35 As Storey (1994)observes, SME lending ischaracterized by asymmetricinformation; principal-agent issues;higher objective risk; costly

monitoring; etc. In order to deal withthese challenges, specifically creditrisk and information asymmetry, atool often used is Credit GuaranteeSchemes (CGS). This helps todampen the risks associated with

SME lending by sharing it betweenthe government, the lendinginstitution and the borrowing firm.

Rather than successive rounds ofconcessionary credit lines, CGS areregarded as long-term mechanisms

for SME support by cushioning banksfrom the risks associated with lendingto small businesses. These schemeshelp entrepreneurs to secure bothshort-term and long-term credits withless collateral or even without

collateral. Another policy objective ofthe schemes is to provide anopportunity for banks to learn moreabout SMEs - their problems andoperations - and to help improvehandling of their SME loan portfolios.

Through their direct association withSMEs, financial institutions cangradually learn how to lendindependently to SMEs.

As uncovered during the KIIs withbankers - and is no doubt a commonfeature globally - inadequatecollateral is a serious issue for

lending in the SME sector in SriLanka, because banks are traditionaland risk averse in their lending, andare strongly collateral-conscious.CGS has the objective of absorbingpart of the loss resulting from the

default of a bank loan. It reduces therisk of a lender, serves to improve thesupply of credit, and facilitates thesmooth operation of the loan market.The interviews conducted by IPS withthe banking sector of Sri Lanka

confirmed the notion that the bankingsector is dissatisfied by the creditguarantee schemes (CGSs) that havebeen introduced in the past. But theyunanimously agreed that a profitableCGS has the ability to bolster SME

access to finance.

Against this backdrop, it is useful tolook at some examples of CGS fromthe Asian region, particularlyMalaysia, Thailand, India, Pakistanand Korea.

In Malaysia, the CGS offered by theCredit Guarantee Corporation (CGC)enables viable SMEs without or withminimal collateral and no trackrecord, to gain access to financingfrom financial institutions.36 Further,

the SME Credit Bureau established in2008 by the CGC (and supported byDun & Bradstreet, UK) enables SMEsto be aware of their own creditstanding and identify critical areas forimprovement that will enhance their

creditworthiness. It also provides

banks with trade information andprobability of default of a company.

In Thailand, the Small BusinessCredit Guarantee Corporation(SBCG) is responsible for the Small

Industry Credit Guarantee Fund thatprovides credit guarantees tounsecured parts of a loan. Threeguarantee schemes are functional - anormal scheme which guaranteesunsecured loans between 10-40

million baht, a risk diversificationscheme where financial institutionsand SBCG share the risk of loansprovided, and a loan guaranteescheme which guarantees up to 10million baht and payment of up to 10

million baht for a term of 7 years.

In India, the Small IndustriesDevelopment Bank (SIDBI) has acredit guarantee scheme thatprovides financial and deferredpayment guarantees to its MSME

customers. SIDBI, together withIndia's Ministry of MSMEs hascreated the Credit Guarantee FundTrust for Micro and Small Enterprises(CGTMSE). This fund encourageslending institutions to emphasize thefirm's project viability and extend

credit based on primary assets ratherthan secondary collateral. Thus,CGTMSE covers collateral free loansup to 1 Crore (approx. US$ 200,000)to new and existing SMEs and alsoprovides rehabilitation assistance to

the lender, should factors go beyondmanagement's control.

In Pakistan, the SME CreditGuarantee Fund (CGF) incorporatedin 1984 as a public-privatepartnership company operates as a

subsidiary of the Small and MediumEnterprises Development Authority ofPakistan. The fund was initiallyendowed by pooling equity

35 "ACCA, CGA and CPA Australia (2009), Access to Finance for the Small and Medium Sized Enterprises Sector, Evidence and Conclusions.36 University of Malaya (2009),"The Development of Corporate Credit Information Database and Credit Guarantee System: Final Draft Report 2009", University

of Malaya: Malaysia.

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investment of Pakistan Rs. 10 billion

by the Government and partnerbanks on a 1:1 basis. Funds areinvested in deposits and securitiesand returns are used to meet theoperational expenses and offsetsubrogation losses. The upper limit of

guarantee exposure may be up to 10times that of the endowment fund(e.g., Pakistan Rs. 100 billion). ThePakistan CGF operates differentschemes - some offer guaranteeswith as much as 20 per cent required

from the SME as collateral to zero percent from the SME depending on thespecific needs of disadvantagedregions and sectors.

Korea has what is widely regarded asone of the most successful CGS in

Asia. Korea established the KoreaCredit Guarantee Fund (KCGF) (laterrenamed as Korea Credit - KODIT) inthe very early stages of SMEdevelopment. To capitalize the KCGF,the government enacted the Korea

Credit Guarantee Fund Act,mandating that all banks in Koreacontribute 0.5 per cent of theiroutstanding loans to the fund(reduced to 0.225 per cent in lateryears). SMEs approach KODIT to

obtain a guarantee on a potential loanfrom a commercial bank, after whichKODIT analysts conduct anassessment of the application(creditworthiness check, site visit,interview with entrepreneur, etc.),

issue a credit rating and offer acertain loan guarantee percentage(could be as much as 90 per cent).The ceiling of the guarantee could beup to US$ 3 million, and in somespecial cases up to US$ 7 million (in

sectors designated by the FinancialServices Commission of Korea in linewith government policies to promote

exports, green growth projects, etc.).

KCGF's success is evident in theincrease in loans to SMEs, from 35per cent of total loans prior to 1975 to77 per cent at present.37 Meanwhile,to further strengthen SME lending atthe 'Bottom of the Pyramid', the

government introduced 16 regionalKorea Credit Guarantee Foundations(KCGFs) since 1996, followed by theKorean Federation of CreditGuarantee Foundations in 2002 toprovide re-guarantee services to the

KCGFs. The 16 KCGFs assist inproviding finance for promising microand SMEs as well as consultingservices to address technology andmanagerial skill needs.

There is an urgent need for Sri Lanka

to establish a CGS and a nationalinstitution for it - an SME CreditGuarantee Fund (SCGF). Theinstitution ought to be separate fromthe Central Bank of Sri Lanka andfunction independently. Capital

(funding) for it can come in part fromthe government and in part fromprivate commercial banks. The SCGFought to have multiple regionalbranches to cater to SMEs wherethey are located and in line with the

government vision of developing'lagging regions'. Like in KODIT andother examples, qualified analysts,ideally graduates from a businessadministration or management

background, must staff it. The SCGF

can provide between 75 - 90 per centof loan coverage for an SME seekinga loan facility, which is offeredfollowing a credit rating exercise doneby it and possibly also using creditinformation from the Credit

Information Bureau that alreadyexists in Sri Lanka.

Moreover, a critical aspect thatdetermines the success of CGS - andparticularly evident from the Koreancase - is that the system must be

supported by an adequate branchoutreach and human resourcecapacity. Without these, the ability toattain a reasonable portfolio scaleand the ability to fully assess loanapplications is limited. As suggested

by Oehring (1995), credit guaranteeschemes will only functionsuccessfully on the existence ofcertain factors: (i) if they are part ofthe national private sector (includingbanks); (ii) if there are no restrictions

regarding the origin of funds used forthe scheme; (iii) income from feesand investments cover the cost ofrunning the scheme; (iv) guaranteesare granted only to financially soundprojects and companies; and (v) the

schemes consist of backup programsthat provide training, professionaladvice, and other services.38 Thesemust be incorporated into any designof a CGS in Sri Lanka.

37 Author's interview with KODIT's head of international affairs, December 2013.38 Oehring, E. (1995), "Credit Guarantee Schemes for the Small Business Sector". In: Brugger. E. A., Rajapathirana. S. (Eds.) 1995, New Perspectives on

Financing Small Business in Developing Countries, San Fransisco: ICS Press.39 IFC (2010), Scaling-up SME Access to Financial Services in the Developing World.

The credit history of SMEs is animportant piece of financialinformation that can help bridge theinformation asymmetry and default

risk problems that often drive theaccess to finance challenge.

6.3 SME Credit Scoring and Credit InformationIFC (2010) defines credit scoring as amathematical technique that useshistoric credit data to predict a futureoutcome, typically the probability of

default.39 Wells Fargo, a leading bankin the United States, pioneered the


21

use of credit scoring systems for

SMEs in 1992.40 The automatedcredit reports and scoring enabledthe bank to provide a cost-effectiveservice to its SME clientele. Creditscoring involves the process ofgranting a score to an individual/

individual business based onparameters such as length of time inbusiness, nature of business, lengthof time with bank etc. The traditionalbanking process as depicted inFigure 7, typically involves banks

evaluating the creditworthiness ofSMEs based on financial data. Asdiscussed in the previous sections ofthe chapter, asymmetric informationdue to the lack of proper financialdata with regard to SMEs make it

impossible to evaluate theircreditworthiness based on traditionalappraisal methods. Hence the creditscoring method can be used toevaluate the creditworthiness ofSMEs and can help in overcoming

information asymmetry.

The process of SME credit scoringtypically consists of a number offactors: a comprehensive assessmentof the overall condition of an SME; areview of the financial condition and

several qualitative factors that havebearing on the creditworthiness of anSME (e.g., management skills; andreputation and goodwill); a compositeappraisal/condition indicator and sizeindicator; classification of an SME,

based on industry and size, forcomparison against peers;characteristics of leadership quality;and tools that enhance the marketstanding of an SME among tradingpartners and prospective customers

(e.g., technologies, patents,production facilities, knowledge,distribution channels, etc.).

These models are already prevalent

in the East and South East Asianregion. A study showed that morethan 70 per cent of financialinstitutions surveyed in ASEANeconomies have implemented someform of rating or scoring for SME

loans. Banks in some ASEANeconomies were able to increaseloans to the SME sector by 61 percent by 1995 since the introduction ofcredit scoring in 1992.41

The KIIs conducted with banking

sector officials in Sri Lankaunderlined the fact that the topmanagement of banks was aware ofsuch innovative tools. Yet, whatseemed to be lacking was theconfidence to courageously embark

on such schemes due to the typicalrisk-averse nature of Sri Lankanbanks. Even though it is unlikely thatSri Lankan banks would rely solely ona credit score to make a lendingdecision, these models can be

deployed as a pre-screening tool todetermine which applications toinvestigate more thoroughly andwhich applications to rejectcompletely. They could reduce theaverage time spent on processing

applications and the cost ofacquisition - two key factors that limitbanks from lending to the SMEsegment.

However, it should be kept in mindthat several challenges which are

unique to developing countries makethe execution of credit scoringchallenging. The 'Access Finance'Newsletter (World Bank, 2006)identifies four challenges in adoptingSmall Business Credit Scoring

(SBCS) in Developing Countries:42

1. Limited availability of timely,

accurate and reliable data in credit

bureaus and similar data registries

2. Poor record management and MIS

systems in financial institutions

3. Significant investment cost to

develop SBCS tools

4. Bank's reluctance to share

information on SME customers

among peers.

A possible jump start developingcountries can employ is the 'pooled-data' model, by obtaining detailedSME portfolio data from a number oflenders. This method is a low cost

alternative to custom built models.Recent research by the World Bankand the Fair Isaac & Company inseveral Latin American countriessuch as Colombia and Mexico,demonstrates the feasibility of such

pooled data SBCS solutions.

In terms of structuring a credit ratingscheme, Sri Lanka can learn fromneighbouring India. India'sPerformance and Credit RatingScheme, a program that rates small

scale industries was formulated inconsultation with the Small IndustriesAssociations, the Indian Banks'Association and various credit ratingagencies including Credit Rating andInformation Services of India

(CRISIL), Investment Information andCredit Rating Agency of India Limited(IICRA India), and Dun andBradstreet. The rating agenciescombine an evaluation of theperformance and creditworthiness of

the enterprise and includeparameters that measure operational,financial, and business andmanagement risks. Even though eachenterprise is responsible for paying

40 Ibid.41 UNCTAD (2001), Improving the Competitiveness of SMEs in Developing Countries: The Role of Finance to Enhance Enterprise Development, New York and

Geneva, 2001.42 World Bank (2006), Access to Finance Newsletter.

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the special "small-scale industriesfee" set by each credit rating agency,the Ministry of Micro Small andMedium Enterprises subsidizes 75per cent of the fee charged. Further,the Ministry funds an initiative to

create awareness amongst MSMEsabout the strength and weaknessesof their existing operations andprovides them an opportunity toenhance their organizationalstrengths. The ratings have improved

access to banking finance by at least20 per cent of rated clients, andcollateral requirements havedecreased by 10 per cent of ratedcases.43

Businesses with both the highest

operating performance and financialstability are entitled to a reduction of100 basis points (1 per cent) from theannual interest rate on their borrowingif they participate in the credit ratingscheme, while those with strong

performance and stability arerewarded with a reduction of 0.5 percent (Petkar, 2010).

Figure 8Lack of Business Development Services by Economic Sector


43 IFC ( 2010), Scaling-up SME Access to Financial Services in the Developing World.

6.4 Business Development Services to AddressAccess to Finance ChallengesAs highlighted in Section 5.2, SMEs'intrinsic weaknesses are a key

contributing factor to their access tofinance problem. By addressing theseweaknesses through provision ofadvisory services, SMEs could betterunderstand how to approach banks,cater to bank's requirements, and

securing financing. By seekingsupport from business developmentservices (BDS) providers, SMEs canimprove the management of theirbusiness, bookkeeping andaccounting, business planning, etc.,

and be more attractive to banks.

The lack of availability of BDSproviders in Sri Lanka was reportedas a top constraint by SMEs. The lackof access to business developmentservices limited business operations

in over 40 per cent of SMEs thatparticipated in the survey conductedby the IPS-NCCSL (Figure 8).

As a second-best solution, business/trade associations, chambers of

commerce and federations ofindustries, can help SMEs work withbanks to resolve financial andoperational concerns that are holdingloan approvals back. Meanwhile,banks themselves may want to

engage in some BDS activities aswell. For instance, the newlyestablished SME Banking Centres ofPeople's Bank attempts to doprecisely this.

In providing BDS, BDS providers as

well as banks and financialinstitutions should consider thefollowing elements:

(a) improve management andoperational systems to enhancetransparency and governance

(b) address gaps in bookkeeping/accounting

(c) assist SMEs to developbankable business expansionplans

The lack ofaccess tobusinessdevelopmentservices limitedbusinessoperations inover 40 per centof SMEs thatparticipated inthe survey.

Lack of BDS top constraint

Lack of BDS a constraint

% o

f res

pond

ents

Agriculture Manufacturing Services


23

(d) guide SMEs on financial,taxation and other regulatory

compliance matters.

If the government is keen onembarking on programmes to boostBDS provision, a useful model to lookat is the EMPRETEC capacitybuilding programme established by

UNCTAD. EMPRETEC - the Spanishacronym for emprendedores(entrepreneurs) and tecnología(technology) - addresses thebusiness development requirementsof SMEs with the aim of making them

globally competitive. The entre-preneurship training workshops

conducted under the programmehave helped SMEs improve theircreditworthiness and attractiveness topotential investors from venturecapital funds and financialinstitutions. Meanwhile, a UNDP

programme modelled on similar linescalled Enterprise Africa, encouragesthe large private sector companies,banks and consulting firms, tosupport BDS provision for SMEsthrough training and post-training

programmes and services. A keyfeature of this programme is theprovision of support and capacity-building services, and assumes

responsibility for loan referral andmonitoring - thus reducing transactioncosts for partner financial institutionsand improving SMEs' chances ofsecuring access to finance (UNCTAD,2001). Additionally, the government

can embed BDS provision in currentgovernment departments as well. Forinstance, by installing an SME deskat Provincial Inland RevenueDepartments, Central Bank RegionalOffices and Industrial Development

Board branches, SMEs can gainspecialised advice on regulatory andother matters relating to governmentservices.

6.5 Challenges and Risks in Public Interventions to Improve SMEAccess to FinanceIn devising suitable SME financingsupport strategies, governments mustguard against twin risks. The first,being the assumption that successiverounds of concessionary SME creditlines will solve the problem. And

secondly, being overly zealous in thegovernment's role in improving theSME access to finance environment.

Governments have a suite of toolsthat they often use to promote theSME sector - special loan schemes or

subsidized credit, tax breaks orreduced tax rates, easier access toland and buildings in industrial parks,special tariffs for electricity, grants fortechnology upgrading, etc. In thisregard, Sri Lanka is no different.

Recent years have seen many ofthese being used, for instance cuttingtax rates on SMEs to 10 per cent(Budget 2011), providing interest freeloans up to Rs. 250,000 for womenentrepreneurs (Budget 2013), and

reducing electricity tariffs for SMEs by25 per cent (Budget 2015). Among themost consistent measures used bygovernments, however, are those thatrelate to SME access to finance.

Governments use both direct andindirect interventions to promote SMEfinancing. Direct interventions includegrants, subsidized credits, refinanceschemes, special loans by statebanks, etc. Indirect interventions

include setting mandatory SMElending ratios, instituting creditguarantee schemes, setting up newfinancial infrastructure for SMEs toraise capital (for instance, a specialSME board on the stock exchange),

and using SME-mandated publicinstitutions to build SME capacity andcreditworthiness.

However, direct public interventionsare not always a panacea. Withconcessionary loan schemes and

subsidized credit programmes it is noteasy to ensure that the financialsupport reaches the targeted SMEgroup. This is especially difficult whenthe target group cannot be welldefined, like in Sri Lanka's context

where no consistent definition forSMEs exists and no database ofSMEs is available. Hence, any publicinterventions could end up beingcostly, poorly funded, and have sub-

par impact. Moreover, governmentrefinanced SME loan schemesadministered through private PFIsmay not reach lower-level SMEs if theincentives of the PFIs are misaligned.These PFIs would pay more attention

on selling their own proprietary loanproducts than a loan product of amulti-bank programme.

While recognizing the desire of thegovernment to provide concessionarySME lending, it is important to guard

against potential distortions it couldbring to the financial markets.Government intervention should becarefully designed so as to avoid anydisincentive for private sectorproviders of financial services to

serve the SME segment.

Mandatory lending ratios for SMEs --another tool used by governments --may be well intentioned, but may nothave the desired effect. While it wouldcertainly nudge more banks towards

more SME lending, it might also haveperverse effects. It may encourageriskier lending by some banks thatare less prudential, just to meet the

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mandatory ratios in the absence of

good projects. It may also result inbanks choosing somewhat less risky"medium" segment firms and lendinglarge volumes to a few firms in thissegment, just to meet the mandatoryratio.

Setting up state-owned and fundedspecialised SME banks may notnecessarily solve the SME financeproblem either. For instance, althoughSri Lanka set up the specialised 'SMEBank', it was poorly capitalized and

poorly managed and was latermerged with LankaputhraDevelopment Bank (LDB).Subsequently, LDB has not been ableto make a significant mark on theSME lending landscape. Plagued by

delinquent lending of the SME Bank

which it merged with, and continuedpractices of non-prudent politically-motivated lending, has led to veryhigh non-performing loan ratios (from19 per cent in 2009 to over 45 percent by end 2013). As warned by IFC

(2011b), "the failure of many statebanks can be also explained bypolitical interference, excessive riskexposure due to irrationaldevelopment goals and internaloperational inefficiencies". More

generally too, many state banks havefared less impressively than privatebanks when it comes to SME lending.In fact, during the last two yearslending by private banks to the SMEsector has outpaced that of state

banks by around seven times.

The guiding principle of governmentintervention in SME financing shouldbe ensuring that financialintermediation is efficient and worksfor SMEs. For this, it must properly

identify the market failure. If themarket failure is in the form ofasymmetric information for instance,the appropriate intervention could beto push through an SME CreditGuarantee Fund and/or SME Credit

Scoring schemes. Undoubtedly, aless distortionary public interventionto the SME financing problem wouldbe a well-structured and adequatelycapitalized credit guarantee fund,similar to the KODIT of Korea. But in

the absence of a suitable private-public partnership approach, themechanism may not attain thenecessary scale or effectiveness. Thebanking system must contribute tocapitalize the fund at the start, and

continue to make small contributionsthroughout the lifespan of the fund.The fund must be professionallymanaged and investments madeprudently. Its fund must not be set upas a fully government-owned entity,

or as a scheme under the CentralBank (like in the case of previous

Whilerecognizing thedesire of thegovernment toprovideconcessionarySME lending, itis important toguard againstpotentialdistortions itcould bring tothe financialmarkets.

credit guarantee schemes), but ratheras a separate company.

Overall, the role of the government orthe nature of public intervention inSME financing should be to create agood enabling environment that

incentivizes financial providers toprovide financing options that meetSME needs. Meanwhile, thegovernment can facilitate SMEpromotion agencies, banks, and otherstakeholders in the SME space to

provide capacity building and trainingfor both financial institutions as wellas SMEs to improve the bank-SMErelationship to address the issues onboth the supply and demand sides ashighlighted in Section 5.

The guidingprinciple ofgovernmentintervention inSME financingshould beensuring thatfinancialintermediationis efficient andworks for SMEs.For this, it mustproperly identifythe marketfailure.


25

7. Concluding Remarks and Way ForwardA unique contribution of this paper isthat it puts forward a new way of

looking at the access to financechallenge for SMEs. This 'Twin-PillarApproach to Access to Finance'argues that improving access tofinance for SMEs is a case ofimproving 'availability' on one hand

and improving 'bankability' on theother. 'Availability' refers to ensuringthat funds are available for SMEs toborrow - enhancing overall privatesector credit, expanding lendingvolumes to SMEs, and providing more

and more funding lines and specialcredit schemes for SMEs. These areoften influenced by the overallmonetary policy of a country, liquiditylevels in the market, level ofborrowing by the state and credit

availability to the private sector, andthe number and nature of SME loanschemes with lower interest orconcessionary terms. This first pillarwas not the main focus of this presentpaper. It largely focussed on the

second pillar - 'bankability'. Thisstems from the understanding that aflush of SME credit alone is notenough. It has to do with things thatimprove the climate for SMEs toborrow and addresses questions like

- are there a good reach of SMEbranches? Are there specializedbranches dealing with SMEs? Arebanks genuinely oriented towards theunique banking needs of SMEs? Arethere mechanisms to bridge the

information and risk asymmetrybetween SMEs and banks, like creditguarantees and credit scoring? Arethere schemes to improve SMEs’financial management and ability todevelop bankable business plans?

Overall, the second pillar of'bankability' is about improving banks'approach to SME lending as well as

improving SMEs' ability to approachbanks.

This paper has attempted to explorethe current evidence on the access tofinance problem faced by SMEs in SriLanka; the questions around whatlimits access to formal finance(particularly bank lending) for SMEs;

and possible solutions to tackle thechallenge. The findings of the surveyand our interviews suggest that thedifficulties in access to credit forSMEs in Sri Lanka owe both toshortcomings within SMEs as well as

shortcomings in the financial systemand the overall access to financeenabling environment. The former isdriven by poor knowledge on financialmanagement, poor financial literacy,lack of transparency in SME

management, etc., while the latter isdriven by a highly risk-averse bankingsystem, lack of understanding ongenuine SME-oriented bankingpractices, and insufficientmechanisms to improve information

asymmetries in SME banking. Eventhough the steps taken in recenttimes by both the Government andSME lenders are steps in the rightdirection, it appears that much moreneeds to be done.

This paper has not attempted toprovide any assessment of theefficacy of ongoing or completedconcessionary SME loan schemesoffered by the government or byinternational development agencies

in partnership with local banks.Previous IPS publications likeWilliams (1999) have for instance,evaluated the impact of World Bankcredit schemes on small andmedium-scale industries in Sri Lanka.

This approach in this paper wasintentional. The paper focussed on

the need to look beyond the typicalSME finance 'quick fix', the go-to

policy tool, which is theconcessionary SME loan scheme.The paper has argued for the need toapproach SME access to financefrom a much more holistic viewpoint -an approach that calls for improving

the overall context that underpinsSME lending.

As this paper has discussed, thedynamics driving the problem aremulti-faceted, and arise from both thesupply and demand sides. Both

dimensions must be addressedsimultaneously. The Government,together with the financial sector,should create an enablingenvironment for SME lending in thecountry through innovative initiatives

like a Credit Guarantee Fund andCredit Scoring, for instance. Thebanking sector needs to boldly adoptmore SME-friendly bankingapproaches. Both of these will go along way in addressing the lack of

trust that is looming large in theminds of both banks and SMEs in SriLanka. Meanwhile, support must belent to SMEs to ease their 'intrinsicweaknesses' that lead to adisadvantaged position in accessing

formal finance.

As Sri Lanka aims to achieve rapidgrowth over a sustained period in aninclusive manner, the contribution ofSMEs to the growth process isparamount. By tackling the SME

access to finance problem in thisholistic manner, much more progresscan be made in improving the abilityof SMEs to find the finance they needto start, run, and grow theirbusinesses and make a stronger

contribution to growth anddevelopment in the country.

Working Paper

26

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Documents

Banking on SME Growth - Institute of Policy Studies · 2020. 6. 18. · 6.1.1 Re-orienting Financial Institutions towards SME Lending 16 6.1.2 Improving the Bank-SME Relationship