Study on Financial Institutions Rom

8/9/2019 Study on Financial Institutions Rom

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Drafted by: Victor Chiriac,


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TABLE OF CONTENT

1.INTRODUCTION......................................................................................................................................................4

2.FACTORS INFLUENCING SMALL BUSINESS CREDIT ARRANGEMENTS IN DEVELOPED COUNTRIES.....4

2.1 CHARACTERISTICS OF THE BORROWER ...................................................... ........................................................... ............ 42.2 LOAN CHARACTERISTICS ....................................................... ........................................................... ................................ 52.3 OTHER LOAN TERMS ................................................... ........................................................... .......................................... 52.4 CHARACTERISTICS OF THE RELATIONSHIPBETWEEN THE BORROWER AND THE LENDER ................................................. 52.5 TYPE OF LENDER.......................................................... ........................................................... .......................................... 52.6 OTHER LENDER CHARACTERISTICS ........................................................... ........................................................... ............ 62.7 FINANCIAL MARKET STRUCTURE AND ECONOMIC CONDITIONS....................................................... ................................ 6

3.SUCCESS STORIES OF PARTNERSHIP BETWEEN FORMAL BANKING SYSTEM AND SMES IN EUROPE 6

3.1 CASE OF SAVINGS BANKS ...................................................... ........................................................... ................................ 63.2 SBALOAN PROGRAMS IN THE UNITED STATES OF AMERICA ........................................................... ................................ 8

4.SPECIFICS OF SMALL BUSINESS ACCESS TO FINANCING IN DEVELOPING COUNTRIES.......................10

4.1 ACCESS TO FINANCE .................................................... ........................................................... ........................................ 104.2 PROBLEMS IN SMALL ENTERPRISE FINANCING...................................................... ........................................................... 10

4.2.1Barriers to Bank Lending.......................................................................................................................................... 104.3 SMES PARTNERSHIP OPTIONS AND THE FORMAL FINANCIAL SECTOR ........................................................ .................... 104.4 NEW DEVELOPMENTS IN PRIVATE ENTERPRISE FINANCING...................................................... ........................................ 104.5 COMPLEMENTARY NON-FINANCIAL SERVICES...................................................... ........................................................... 10

5.MICROFINANCE POLICIES DOWNGRADING AND UPGRADING STRATEGIES OF INSTITUTIONALBUILDING ..............................................................................................................................................................10

6.DOWNGRADING STRATEGIES OF INSTITUTIONAL BUILDING HOW TO MAKE A FINANCIALINSTITUTION MORE TARGET GROUP ORIENTED........................................................................................... 10

6.1 FINANCIAL SECTOR REFORM AND DOWNGRADING STRATEGIES ........................................................ .............................. 106.2 PRACTICAL PROBLEMS OF IMPLEMENTING OF DOWNGRADING STRATEGIES .......................................................... .......... 10

7.PRACTICAL EXPERIENCE WITH A DOWNGRADING STRATEGY ..................................................................10

7.1 THE EXPERIENCE OF INTER-AMERICAN DEVELOPMENT BANK.......................................................... .............................. 107.2 THE EXPERIENCE OF EUROPEAN BANK FOR RECONSTRUCTION AND DEVELOPMENT (EBRD) IN THE DEVELOPING

COUNTRIES INCLUDING FORMER SOVIET UNIONS COUNTRIES ........................................................... .............................. 107.2.1 Russia........................................................................................................................................................................ 10

7.2.2Kazakhstan................................................................................................................................................................ 107.2.3Ukraine ....................................................... ........................................................... ................................................... 107.2.4Bosnia and Herzegovina........................................................ .............................................................. ..................... 107.2.5 Albania...................................................................................................................................................................... 107.2.6Kosovo ...................................................................................................................................................................... 107.2.7 Moldova ........................................................... ........................................................... .............................................. 107.2.8Georgia ......................................................... ........................................................... ................................................. 10


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10.2SPECIFIC CONCLUSION AND RECOMMENDATION FOR FINANCIAL SECTOR DEALING WITH THE CREDITING TO SMES ...... 10

11. REFERENCES...............................................................................................................................................10

12. ANNEX 1. TABLE 4.......................................................................................................................................10


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11.. IINNTTRROODDUUCCTTIIOONN

Small business sector is one of the most importantsectors of economy ensuring sustainable economicdevelopment of each country. Actually small businessis a rather prosperous sector in developed countriesthat successfully collaborates with financial and non-financial institutions, as well as with the state.Governments of these countries provide enormoussupport to small business, starting with facilitatedlegal framework and continuing with support throughlending or guaranteeing loans from credit institutions.

Loans to small business vary to the maximum valueof millions US dollars. For instance, in the USA a loanof 500-2000 US dollars is considered a small loan.Developing countries have a different situation. Heresmall business emerged from the idea of povertyreduction, collection of resources for basic needs. Inconditions of macroeconomic unstable environmentand underdeveloped legal framework, risk of lendingto small business is much higher than that in

developed countries. Also, financial institutions do nothave relevant experience in working with smallbusiness; do not have knowledge and bankingtechnologies to co-operate with small business.Banks charge much for servicing loans made to smallbusiness due to more risky type of activity, lack ofcollateral and small size of loans less 2000 USD.In this context, a survey of aspects in developedcountries, given some specific examples, ways ofestablishing informal financial systems of lending tosmall business represent a possibility to improveframework of this activity and its performance in theRepublic of Moldova. Final users of this survey will beformal financial and microfinance institutions, as wellas associations representing interests of smallbusiness entrepreneurs.Materials, data and information used for this study are

accessible to any person requesting for them.Reference to the materials used is made inbibliography enclosed hereto.

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Generally, credit demand by firms is consideredto reflect the profitability of a firm's prospectsrelative to the availability of internal resources tofund these prospects. If a business has profitable

prospects that it cannot fund internally or choosesnot to, then it should borrow if the prospectsremain profitable given the costs of obtaining thecredit. For small businesses, these costs mayinclude owners' guarantees, pledges of collateral,and covenants restricting the firm's behavior.In choosing to extend credit, lenders shouldweight the expected risks and return of a givenloan relative to the lender's current portfolio and

other available lending opportunities. A loan'scredit risk is related to the borrowing firm'sprospects and the condition of its balance sheetas well as to provisions of the loan contract,including collateral, guarantees, and term tomaturity. The profitability of a given loan, however,is also affected by the costs associated withassessing and monitoring these risks as well asby the costs of originating and servicing the loan.When intermediaries develop an expertise inscreening, contracting, and monitoring loans tosmall businesses, they reduce the marginal costsof gathering credit information.

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Certain small business customers may involve

higher information costs for lenders because ofthe types of businesses they are in, theinadequacy of their financial accounting, and/ortheir failure to separate business and personalfinances. And some smaller business borrowersmay represent greater credit risks thanothers, such as newer firms with less-proven trackrecords, Firms with numerous other creditcommitments, or, of course, firms with bad credithistories. Greater costs or risks will translate intoeither more monitoring or crueler uncertainty forlenders to small businesses, but are no directmeasures of the costs and risks of funding agiven firm. Thus, proxies for these factors shouldbe defined and related to observe credit


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The costs and risks of funding a small businessare also conjectured to depend on the size and type

of loan the firm is seeking. Since any fixed costsassociated with making a loan translate into higherper-dollar financing costs for smaller credits, creditterms should be related to loan size. In addition,certain types of loans may involve lower costs andrisks for lenders. For example, vehicle loans tend tobe fairly uniform in contracting features, criteria forapproval, and loan-to-value ratios and can thereforebe evaluated on their own merits rather than on thefirm's merits. To the extent that lenders can reducetheir costs by standardizing loans, smaller firms canobtain better credit terms by taking advantage ofthese credits. Smaller firms can obtain better creditterms by taking advantage of these credits.In contrast, the costs and risks associated with moreidiosyncratic types of lending, such as business creditlines, should be greater than those incurred

on standardized credits or on loans linked to theacquisition of particular assets. Therefore, thevariations in the costs and risks across small businessborrowers may be reflected in the types of loans thatfirms obtain as well as in the interest-rate differentialsthey pay on a given loan product. The differencesin loan products imply that credit relationships shouldsegment small business credit markets along productlines. For example, when one is measuring how

interest-rate differentials are related to firms'characteristics, it is important to look at patterns for agiven type of loan.

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Besides a loan's size and type, contractual loanfeatures are related to the costs and risks incurred by

both borrowers and lenders. For example, anincreased term to maturity allows the borrower'spayments to be distributed over a longer period oftime. Although this reduces the size of the paymentand the costs of renewing the loan, it also extends thetime horizon over which a borrower's focuses maychange All other things equal lengthening the term of

of a guarantee, the claim is on the general networth of the guarantor rather than on specificassets. For corporations or limitedpartnerships, the guarantee creates an explicit

claim where otherwise liability is limited to theowners' equity. Finally, loan covenants limitingactions of the firm that could potentially reduceloan creditworthiness are another means ofmitigating problems associated with imperfectinformation and lender costs. Because thevalue of a firm's credit enhancement to a lenderpartly depends on what has been promised toothers, the willingness of borrowers to limit the

promises made to other lenders can also enhancetheir creditworthiness, albeit at some cost to theborrower.

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The nature of the relationship between a smallfirm and its lender should reflect the creditconditions the firm faces. Lenders should havebetter information about borrowers that they havedealt with previously. Thus, small firms should beable to obtain better credit terms from lenderswith whom they have developed a relationship,whether through a previous credit arrangement or

through the purchase of other business services.Lenders also should have better informationabout borrowers in the markets where they havemaintained a more active presence. Hence,screening and monitoring costs have geographicdimension that is particularly important to smallerfirms.These relationship dimensions of informationcosts suggest that markets for smaller business

credits will tend to be characterized by more-localized and longer-term relationships. All otherthings being equal, business borrowers should beat a greater in for advantage if they seek creditfrom non-localEnders who are not familiar withtheir geographic market or line of business. Not

l ill ll fi f li ht t h


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focus on standardized types of lending, commercialbanks fund a greater share of information-intensivesmall business loans. Researchers contend thatbanks greater share of such loans reflects a costadvantage that banks have as small business lenders.Historically they have provided a wider range ofbusiness services than non-bank intermediaries, andthis may reduce information costs, as banks obtainadditional information through the other financialproducts (such as depository or cash management)that they sell to smaller firms. Banks have ended tooffer a wider range of loan types, which reduce thecost of finding the most efficient credit product for a

business. Finally, the decentralized structure U.S.banking industry may enable small businesscustomers to develop local relationships.For some extent, differences between banks andfinance companies also reflect regulatory policies aswell as market factors. The very different regulatoryenvironments may be manifest in differences inlending strategy and in the contractual features thatcharacterize particular types of loans. For example,

one might expect that fairly low-cost creditenhancements, such as signatory personalguarantees, would be used more frequently byregulated banking institutions, if only to satisfygovernment examiners seeking to limit loan risk.

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Credit terms received by smaller enterprisesshould also reflect the characteristics of the particularlending institution. Within the commercial bankingindustry, 'or example, smaller banks are increasinglyviewed as different commercial lenders from largerregional or money-center banks. If the costs andprofitability of small business lending are related tothe scale and scope of a bank's activities, then thecredit terms obtained by a small business will berelated to the size of loan. Obviously, larger businesscustomers re- quire larger banks to meet their creditneeds. Small banks are constrained by their size tomake smaller loans, given the need for portfoliodiversification and regulatory limits on loans toindividual borrowers. However, some researchers

borrowers. The financial condition of a lender is,of course, related to the condition of its currentloans, hence its current borrowers. Although bankasset-quality problems may be due to a numberof factors, lenders experiencing these problemsmay tighten originator standards for prospectiveborrowers, including small firms.

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Researchers posit that the structural

characteristics and cyclical conditions in loanmarkets should affect financing options. Clearlythe competitive of business loan markets reflectsthe availability of credit alternatives. As statedabove, small ms seeking credit in geographic orproduct markets it are highly competitive shouldobtain better credit. However, if the market isdominated by large e terms that small businessborrowers obtain lay not be as favorable, Credit

availability for small business should alsobe considered in the context of broader financialand economic conditions. Despite public policiesthat promote small business lending, smallerenterprises re considered most vulnerable tochanging conditions over the business cycle.Economic downturns lave the potential to magnifythe problems associated with lending toinformation-intensive small commerce. Asproperty values and income prospects becomeless certain, the ability to use formal guaranteesor collateral to mitigate a lender's risks and costsis likely to decline.

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Specific Savings Banks' initiatives for SMEs -


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some examples of the many initiatives Savings Bankshave developed in support of SMEs in practicallyevery European country.

1. Assessing future SME earnings in GermanyBank loan specialists are often not in a position to judge new and complex technological issues andevaluate their relevant risks when deciding on loans.Therefore, the German Savings Banks and Giroassociation (DSGV) established, in cooperation withthe internationally respected scientific group, theFraunhofer Gesellschaft, a network of highly qualifiedexperts capable of evaluating the risks and

opportunities involved in financing small firms whichare active in transferring innovations at the cuttingedge of technology into products.Quality management systems in Austria and Portugal -the use of ISO 9000The largest Portuguese savings bank, Caixa Geral deDepositos, works closely with Portugal's State agencyfor small businesses when selecting several hundredcompanies per year to become 'Prestige StatusMembers'. The award of this status results inconsiderable advantages for the small firms selected,such as priority assessment and quicker decisions forcredit requests. In Austria, similar advantages are alsooffered by Erste Bank der LesterreichischenSparkassen to SMEs which have passed the ISO 9000inspections. The ISO 9000 certificate is awarded tobusinesses that meet essential standards of quality

throughout all operations - including qualitymanagement systems.

2. Savings Banks' exclusive SME branches inSpainThe Spanish Savings Banks have set up a network ofnew corporate branches exclusively dedicated toSMEs. Often located in industrial sites, these teams ofSME specialists are able to immediately authorize

day-to-day transactions.Furthermore, in June of this year, the Spanish savingsbanks association signed a 5-year agreement with theSpanish Minister of Labor, committing the Spanishsavings banks to job creation within the SME sector,in particular for women and citizens above 45.

program - which involves some evening, weekendand holiday work - was introduced by Swedbankin 1996 to promote greater flexibility andunderstanding when dealing with SME customerproblems.German SME 'Start-up' initiativeOver 40% of company start-ups in Germanyinvolve savings banks. In order to further promotethe establishment of small companies byentrepreneurs, the German savings banks, incooperation with 'Stern' magazine and thebusiness consultancy McKinsey, launched in1997 a competition known as 'Start-up'. Over

2,100 promising entries were received for theprize of professional advice from savings banksand McKinsey. The quality and quantity of theentrants bore testament to the dynamism of theSME sector.

4. Franco-German cooperationIn accordance with the Cooperation Charter,signed by the members of the ESBG on 30 March1990, several Savings Banks have entered intopartnerships with other European Savings Bankson the basis of cooperation agreements. Forexample, since 1997 several French SavingsBanks and Savings Banks from the Baden-Wrttemberg and Rhineland areas of Germanyhave been linked by agreements which promotemutual help for their SME customers in

international dealings. Small and medium-sizedenterprise clients can benefit in their foreignactivities from the fact that the businessrelationship can be taken over by a financialpartner who is very familiar with the local market.

5. International cooperation for SMEsSavings Banks organizations in Germany andPortugal have established Euro Info Centers

authorized by the European Commission to coverthe information needs of SMEs with regard to theeffects of the internal market and the conditionsfor investment and financing in Member States ofthe European Union and the countries of centraland eastern Europe.A E l l h ESBG


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accounts abroad and of various cash managementfacilities.Several European savings banks co-operate withEURO-SOFAC, the European consultancy andtechnical assistance company providing para-bankingservices to SMEs to promote their internationalactivities. EURO-SOFAC services include, amongstothers, helping to secure access to new marketsthrough high quality information and research;securing import licenses and other authorizations,fiscal representation, company domiciliation, andadministrative management of companies. Thecompany, founded in 1984, is a joint subsidiary of the

savings banks' organizations of five countries (Germany,France, Italy, Belgium, Spain), as well as of the ESBGand the World Savings Banks Institute (WSBI). Todate, Eurosofac has developed activities withcompanies from 25 countries in more than 30 economicsectors.

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6. Loan amounts available under SBA loanprogramsEffective December 22, 2000, a maximum loanamount of $2 million has been established for 7(a)loans. However, the maximum dollar amount the SBAcan guaranty is generally $1 million. Small loans carry

a maximum guaranty of 85 percent. Loans areconsidered small if the gross loan amount is $150,000or less. For loans greater than $150,000, themaximum guaranty is 75 percent. Repayment abilityfrom the cash flow of the business is a primaryconsideration in the SBA loan decision process butgood character, management capability, collateral,and owner's equity contribution are also importantconsiderations. All owners of 20 percent or more are

required to personally guarantee SBA loans

7. Who is eligible for an SBA loanAlthough most small businesses are eligible for SBAloans, some types of businesses are ineligible and acase-by-case determination must be made by theA Eli ibilit i ll d t i d b f

personal assets. It should be noted that somebusinesses are ineligible for financial assistance.

9. Size of businesses eligible:

The Small Business Act defines an eligible smallbusiness as one that is independently owned andoperated and not dominant in its field of operation.The Act also states that in determining what is asmall business, the definition shall vary fromindustry to industry to adequately reflect industrydifferences. The SBA has therefore developedsize standard that define the maximum size of aneligible small business.

As apparent from the following generaldescription of SBA's size standards, mostbusinesses are considered small. However, theserepresent general definitions that in some casesare further defined by specific SIC code.

Table 1: United States SBA size standards

INDUSTRY SIZE

Retail and Service $3.5 to $13.5 millionConstruction $7.0 to $17.0 millionAgriculture $0.5 to $3.5 millionWholesale No more than 100 employeesManufacturing 500 to 1,500 employees

If a potential borrower is close to these standards,size eligibility should be discussed with the localSBA office. Also note that the standards for aparticular business may change from time to timeand some exceptions do apply.When affiliations exist with other companies (forexample, through common ownership,directorships, or by contractual arrangements),the primary business activity must be determinedboth for the applicant business as well as for theentire affiliated group. In order to be eligible for

financial consideration, the applicant must meetthe size standard for its primary business activityand the affiliated group must meet the standardfor its primary business activity.

10. Use of proceeds:The proceeds of SBA loans can be used for most


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to make payments to owners or pay delinquentwithholding taxes;

to pay existing debt unless it can be shown that therefinancing will benefit the small business and thatthe need to refinance is not indicative of imprudentmanagement. (Proceeds can never be used toreduce the exposure of the participant in the loansbeing refinanced.)

11. Special circumstances:Certain other considerations apply to the types ofbusinesses and applicants eligible for SBA loanprograms.

Franchises - are eligible except in situations where afranchisor retains power to control operations to suchan extent as to be tantamount to an employmentcontract. The franchisee must have the right to profitfrom efforts commensurate with ownership.

Recreational Facilities and Clubs - are eligibleprovided: (a) the facilities are open to the general

public, or (b) in membership only situations,membership is not selectively denied to any particulargroup of individuals and the number of membershipsis not restricted either as a whole or by establishingmaximum limits for particular groups.

Farms and Agricultural Businesses - are eligible;however, these applicants should first explore

Farmers Home Administration (FmHA) programs,particularly if the applicant has a prior or existingrelationship with FmHA.

Fishing Vessels - are eligible; however, thoseseeking funds for the construction or reconditioning ofvessels with a cargo capacity of five tons or moremust first request financing from the National MarineFisheries Service (NMFS), a part of the Department of

Commerce.

Medical Facilities - hospitals, clinics, emergencyoutpatient facilities, and medical and dentallaboratories are eligible. Convalescent and nursinghomes are eligible, provided they are licensed by theappropriate government agency and services

perhaps, in preserving its existence. Loanscannot be made when proceeds would enable aborrower to purchase: (a) part of a business inwhich it has no present interest or (b) part of aninterest of a present and continuing owner. Loansto effect a change of ownership among membersof the same family are discouraged.

Aliens - are eligible; however, consideration isgiven to the type of status possessed, e.g.,resident, lawful temporary resident, etc. indetermining the degree of risk relating to thecontinuity of the applicant's business. Excessive

risk may be offset by full collateralization. Thevarious types of visas may be discussed in moredetail with the local SBA office.

Probation or Parole - applications will not beaccepted from firms where a principal (any one ofthose required to submit a personal historystatement, SBA Form 912):

(1). Is currently incarcerated, on parole, or onprobation;

(2). I t is a defendant in a criminal proceeding; or(3). Whose probation or parole is lifted expressly

because it prohibits an SBA loan.

This restriction would not necessarily preclude aloan to a business, where a principal hadresponded in the affirmative to any one of thequestions on the Statement of Personal History.These judgments are made on a case by caseevaluation of the nature, frequency, and timing ofthe offenses. Fingerprint cards (available from thelocal SBA office) are required any time a questionon the form is answered in the affirmative.

12. Ineligible Businesses:

Businesses cannot be engaged in illegal activities,loan packaging, speculation, multi salesdistribution, gambling, investment or lending, orwhere the owner is on parole.Specific types of businesses not eligible include:

Real estate investment and other speculative


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and dealing in commodities futures, when not part ofthe regular activities of the business. Dealers of rarecoins and stamps are not eligible.

Lending Activities include banks, finance companies,factors, leasing companies, insurance companies (notagents), and any other firm whose stock in trade ismoney.

Pyramid Sales Plans are characterized by endlesschains of distributors and sub-distributors where aparticipant's primary incentive is based on the salesmade by an ever- increasing number of participants.

Such products as cosmetics, household goods, andother soft goods lend themselves to this type ofbusiness.Illegal Activities are by definition those activities whichare against the law in the jurisdiction where thebusiness is located. Included in these activities is theproduction, servicing, or distribution of otherwise legalproducts that are to be used in connection with anillegal activity, such as selling drug paraphernalia or

operating a motel that permits illegal prostitution.Gambling Activities include any business whoseprincipal activity is gambling. While this precludesloans to race tracks, casinos, and similar enterprises,the rule does not restrict loans to otherwise eligiblebusinesses, which obtain less than one-third of theirannual gross income from either: 1) the sale of officialstate lottery tickets under a state license, or 2) legalgambling activities licensed and supervised by a stateauthority.Charitable, Religious, or other Non-Profit oreleemosynary institutions, government-ownedcorporations, consumer and marketing cooperatives,and churches and organizations promoting religiousobjectives are not eligible.

SBA Loan Maturities

SBA loan programs are generally intended toencourage longer term small business financing butactual loan maturities are based on the ability to repay,the purpose of the loan proceeds, and the useful lifeof the assets financed. However, maximum loanmaturities have been established: twenty-five (25)years for real estate and equipment; and generally

construction of at least one-third of the currentvalue of the property.)

Interest Rates Applicable to SBA Loans Interestrates are negotiated between the borrower andthe lender but are subject to SBA maximums,which are pegged to the Prime Rate.Interest rates may be fixed or variable. Fixed rateloans of $50,000 or more must not exceed PrimePlus 2.25 percent if the maturity is less than 7years, and Prime Plus 2.75 percent if the maturityis 7 years or more.For loans between $25,000 and $50.000,

maximum rates must not exceed Prime Plus 3.25percent if the maturity is less than 7 years, andPrime Plus 3.75 percent if the maturity is 7 yearsor more.For loans of $25,000 or less, the maximuminterest rate must not exceed Prime Plus 4.25percent if the maturity is less than 7 years, andPrime Plus 4.75 percent, if the maturity is 7 yearsor more.

Variable rate loans may be pegged to either thelowest prime rate or the SBA optional peg rate.The optional peg rate is a weighted average ofrates the federal government pays for loans withmaturities similar to the average SBA loan. It iscalculated quarterly and published in the "FederalRegister." The lender and the borrower negotiatethe amount of the spread which will be added tothe base rate. An adjustment period is selectedwhich will identify the frequency at which the noterate will change. It must be no more often thanmonthly and must be consistent, (e.g., monthly,quarterly, semiannually, annually or any otherdefined, consistent period).

Fees associated with SBA LoansTo offset the costs of the SBA's loan programs to

the taxpayer, the Agency charges lenders aguaranty and a servicing fee for each loanapproved. These fees can be passed on to theborrower once they have been paid by the lender.The amount of the fees is determined by theamount of the loan guaranty.At December 22 2000 when the loan amount is


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13. Prohibited fees:Processing fees, origination fees, application fees,points, brokerage fees, bonus points, and other feesthat could be charged to an SBA loan applicant areprohibited. The only time a commitment fee may becharged is for a loan made under the Export WorkingCapital Loan Program.

Guaranty PercentsFor those applicants that meet the SBA's credit andeligibility standards, the Agency can guaranty up to 85percent of loans of $150,000 and less, and up to 75percent of loans above $150,000 (generally up to a

maximum guaranty amount of $1,000,000).

Prepayment

Effective for all loans where the applications werereceived by the lender on or after December 22, 2000,a new prepayment charge paid by the borrower toSBA ("subsidy prepayment fee") has been added for

those loans that meet the following criteria:

have a maturity of 15 years or more where theborrower is prepaying voluntarily;

the prepayment amount exceeds 25 percent of theoutstanding balance of the loan; and

the prepayment is made within the first 3 years afterthe date of the first disbursement (not approval) ofthe loan proceeds.

The prepayment fee calculation is as follows:

during the first year after disbursement, 5 percent ofthe amount of the prepayment;

during the second year after disbursement, 3percent of the amount of the prepayment; or

during the third year after disbursement, 1 percent of

the amount of the prepayment.

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beginning as micro-businesses, are unable toobtain loans, or any form of financing from formalinstitutions. They start their business by investingtheir own savings and/or using funds obtained fromrelatives or friends. This might be supplemented byloans from informal lenders or by credit from suppliersof materials.It is only when the business has been operatingfor some time, usually as a micro-enterprise or ona small scale, that an attempt is made to seekfinancing from a bank for further development andexpansion. Only then is there any likelihood of obtainingaccess to funds from such financial services, although

it will never be easy

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Obstacles in access to finance by smallenterprises typically include:High transaction cost for financial institutions to

provide many small size loans as opposed tofewer but larger loans:

Riskness of borrowers due to lack of credithistory, lack adequate collateral, uncertaintyabout entrepreneurial ability and repaymentcapacity linked to market constraints, deficiencyin the legal system in case of loan delinquency,etc.

Cost of lending (including the time factor) ascompared to the profitability of the businessopportunity for which a loan is sought;

Inadequacy of investment projects submitted tobanks;

Weakness or limited outreach of financialinstitutions and of instruments focused onraising capital such as stock exchanges,

investment funds, etc.; Macro-economic instability and policy bias such

as interest rates controls, preferential treatmentof larger/state-owned customers;

Difficulties in access due to cultural barriers(gender, disadvantaged groups), remoteness(rural areas)


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funds for difficult periods that may arise and makes itvirtually impossible to build up reserves for future investmentand development of the business.There are other forms of finance for businesses, apartfrom credits made available through the bankingsystem. Part of the working capital can certainly be financedfrom supplier credits and, in some situations or sectors, byadvances from customers. Working capital is often financedby small businesses by bank overdraft facilities. All thesemay be acceptable ways of financing current needs ofsmall businesses but must be under control and it isimportant that those who manage these businessesknow exactly what their cash flow commitments are and

how they intend to cover these.As to the fixed assets, entrepreneurs quite often over-estimatetheir proposals for investments in business premises andequipment which can result in poor utilization of facilities. It canalso call for debt repayments at an unsustainable level. Forlack of adequate accounts and figures, working capital isusually underestimated, which may be linked to a desireto obtain the maximum amount for acquisitions of fixedassets and to over-optimism as to how much time might

elapse before the income of the business will be able to payfor its operational expenses and service debt. Inexperiencedstaff in banks may compound the problem by accepting,without questioning, data submitted by SMEs in applyingfor loans. Advisory services can contribute significantly toavoiding these problems by demonstrating to owners ofSMEs how to prepare a realistic business plan.It is important both to be realistic in assessing that the financialresources sought by an SME can create the revenue in areasonable time to cover the expenses (both direct andindirect), and, at the same time, that the debt servicingburden incurred is manageable. This may requireadjustment of business plans to a scale - not in every case theoptimum - that can ensure that the debt burden will notstrangle the business in the future.There is no doubt that the cultures and politics of somesocieties breed a belief that friendship with powerful and

politically controlling individuals can both ensure success inaccess to funds and will protect businesses, if a point isreached where there are arrears or defaults in payment ofdebts. This is a dangerous view of the linkages ofbusiness and political power, all too frequent also indeveloping countries. Financial institutions that allow they tobe the subject of such political influences sooner or later

towards wider business development and creating moreemployment and ultimately raising living standards inMoldova.

44

.

.22

.

.11 BBAARRRRIIEERRSS TTOOBBAANNKKLLEENNDDIINNGG

(1). For some lenders, the location of business ina low income target area can be anunarticulated reason for denial of a loan

(2). Banks are not a source for start-up capital(3). Lack of equity on the part of the borrower(4). Educational/experience needs for start-ups(5). Adequate technical assistance for start-ups(6). Poor Management of SMEs(7). Lack of relations with the micro financing

institutions

44..33 SSMMEESS PPAARRTTNNEERRSSHHIIPP OOPPTTIIOONNSS AANNDD TTHHEEFFOORRMMAALL FFIINNAANNCCIIAALL SSEECCTTOORR

SMEs constitute a vital element of thedevelopment process and their contribution interms of production, employment and income in bothindustrialized and developing countries is widelyrecognized. Limited access to the requiredfinancial resources to start, survive and grow isone of the challenges faced by SMEs, aheterogeneous group of businesses with varyingneeds at different stages of enterprise development.

A healthy formal financial sector is one of theingredients of an environment conducive to enterprisedevelopment and growth. It represents the sum total of allthe intermediary institutions offering financial services tothe business community and the population at large.Unfortunately, in many former Soviet Unionscountries the financial sector is not yet welldeveloped, although macro-economic reforms and

bank restructuring have in recent years led to healthychanges in the financial sector landscape, in the form ofimproved regulatory framework, reduction of directcontrol over interest and exchange rates, lessinterference in directing bank lending etc.. Pursuanceof such reforms including privatizations of state-ownedbanks and development of credit rating are expected to


13/36


organizations, credit unions and some venture capitalcompanies are the main providers:

a) Central BanksThe degree of independence of central banks differs fromcountry to country; some were less independent in theirrelationships with the Treasuries and Finance Ministries andwere unable to introduce the necessary legislation on theoperation of banks and the standards required for settingup a formal financial institution. This led, in a number ofcountries, to the setting up of banks without a sound financialstructure, with far too low capitalization and high indebtednessright from the start. This indebtedness only grew as some of

the banks were unable to recover a dangerously highproportion of the loans they issued.

b) Commercial BanksCommercial banks are the main formal providers of financialservices to the business community. They act as financialintermediaries by mobilizing deposits and savings and then on-lending these resources for personal and business loans.Larger commercial banks offer varied financial services-not

only savings, deposits, credits but also foreign transfers andexchange transactions., bill payments, handling investmentsand advising on investment portfolios, factoring and leasing.The main lending of commercial banks in most countriesrelates to the provision of short-term working capital, sincethe deposits they use for their funding are, in turn,also of a short-term nature. The extent to which they arewilling and able to provide longer term loans depends, to a

great extent, on the character of the deposits which they areusing as funding. As in most parts of the world, smallbusiness is perceived as risky, since the failure rate is high.The lack of documentation available makes it difficult toobtain a clear picture on the financial situation andprospective success of such businesses. The transactioncosts of lending to SMEs is high in relation to the size ofloans, making such lending in many cases unprofitable,especially if the interest rates are controlled and loan recovery

entails costly collection efforts. It is not surprising, therefore,that most commercial banks in former Soviet Unionscountries - both state owned and private prefer dealing withlarger trading companies, rather than with small strugglingmanufacturing enterprises.One of the requirements for banks to engage inl di t i ki t i f b i i

management of donor credit lines, to ensure that thebeneficiaries conformed to the original target group laiddown when the donor loans were approved and to theterms and conditions on which the credit was approval.Donor support and intervention have also resulted in stafftraining and upgrading, thus contributing to improving theoperation of some commercial banksSome of the services offered by commercialbanks are highly profitable and can subsidizeothers which produce less/slower net incomesuch as lending to SMEs. In a similar way, largerurban branches that serve bigger populations cancross-subsidize smaller branches in rural area

that hardly break-even. The larger branchnetworks that commercial banks have make iteasier for smaller and medium enterprises to gainaccess. The cost of making a journey to visit abank, together with the preparation of data anddocumentation, may be out of proportion to thevolume of financial help sought if it involvestraveling a few hundred kilometers to a capital cityto discuss a small transaction. At the same time, it

can take considerable time and effort for smallerbranches to break even.Finally, there is a tendency to lump all commercialbanks together but, in reality; this category offinancial institutions encompasses a broad varietyof different types of organizations. Within the titleof commercial banks can be included cooperativebanks, and people's banks or banques populaires.Also, there are credit unions such as the Savingsand Credit Associations of Citizens which combinesavings and lending to a relatively small number ofparticipating members. Credit unions created byspecific trades, such as small private farmers,rural entrepreneurs etc., do play an important rolesince they can be organized for bulk purchases bymembers and for joint marketing activities.

c) Development BanksThe earliest examples of development bankswere in the 1960s/70s when the first such bankwas set up in Africa with a World Bank loan inEthiopia.Most development banks, like their commercialcounterparts have suffered from severe


14/36


funding. Very frequent, they were subject toconsiderable government pressure in both thegranting of loans and in their recovery. Some of theirmajor clients were loss-making para-statals,producing losses in the development banks andmaking them more and more reliant on 'bail cuts' fromdonors or government, or from both. In most cases, tobecome profitable, such institutions need torestructure themselves, to be re-capitalized and tobroaden the range of financial services they offer.They will also have to become more independent ofgovernments.Although privately owned development banks are few,

at least in Africa, there are a number of Africancountries, where development banks andcorporations in donor countries (examples are France,Germany, the Netherlands and Sweden), becameequity partners in the creation of DevelopmentFinance Institutions (DFIs). By the 1990s, it hasbecome increasingly evident that many special donor-supported DFIs were unable to achieve sustainability.

d) Credit Guarantee SchemesCredit guarantee schemes aim to share risks withlending institutions so that the lender will becompensated for all or part of the loss on a loandefault. Such schemes are intended to help thoseentrepreneurs who have sound viable projects butcannot offer satisfactory collateral to meet therequirements of a lending bank to obtain credits.Experience has shown that such guarantee systemsmust be designed and implemented so that claimscan be made and settled against default withoutundue delay or bureaucratic problems. For aguarantee scheme to be attractive to a bank, it shouldnot increase the costs of loan processing for thelender. Usually, credit guarantee schemes create aspecial fund to be used to meet claims, although thereare some successful schemes in developed countries

where no specific funds exist, but only a commitmentby the government that the loss guaranteed will bepaid if there is a default.The creation of a guarantee fund has the addedadvantage that it can be invested in some relativelyliquid form and so earns income for the organizationmanaging the scheme Furthermore a guarantee

institution must assume a proportion of the riskinvolved. Here, best practice seems to indicatethat lenders should assume at least 25% - 40% ofthe risk and not less than 20%.Of late there have been moves by guaranteeschemes to overcome reluctance of banks toparticipate and to reduce delays by authorizingparticipating banks to approve a guaranteewithout reference to the guarantor, once the bankhas been "accredited" by the guarantor. This"accreditation" is usually based on recognition ofsoundness of the bank's financial structure andcapitalization, the quality and number of its staff,

their competence to screen SME loan applicantsand to appraise their projects, and acceptablelevels of loan portfolio performance. The lendermay then be allowed to approve a guarantee for alower percentage.Fees charged for the guarantees to the bank -butmostly passed on to the borrowers- are the mainsource of income; the most usual level of fees isbetween 1% and 2% of the loan amount on

application. In most cases part of the fee is notreturned, even if a guarantee is not approved andis considered a levy paid to cover the cost ofscreening and approving the borrower andappraising the project for a guarantee. An annualfee of 1% - 3% is then levied for the repaymentperiod of the loan on the actual amount of theguarantee. Too high a level, either for the front-end fee or for annual payments would tend to actas a deterrent in the use of the guarantee scheme.

44..44 NNEEWW DDEEVVEELLOOPPMMEENNTTSS IINN PPRRIIVVAATTEEEENNTTEERRPPRRIISSEE FFIINNAANNCCIINNGG

a) Leasing/hire-purchaseLeasing and renting refers to a form of financing

whereby premises, equipment, vehicles etc. aremade available against a regular, usually monthly,payment. In agriculture and construction, sucharrangements are quite common. In recent years,computers have been leased out too. In leasing,there is no transfer of ownership, but usually thelessee is entitled to buy the goods at a low price


15/36


collateral to obtain a loan. It can also help thebusiness to react more flexibly to fluctuations inchanges for demand in certain products as in theobsolescence of certain types of equipment. Leasingalso allows businesses to free a larger part ofresources for working capital finance. In the case ofshort-term leases or rentals, this can solve theproblem, particularly with mobile equipment, for peakdemands or contract work where the period in whichone will use machinery can be relatively short andwould not justify the outright purchase.Leasing is to be encouraged as a means of solvingshortages of equity finance and difficulties of

obtaining loans for smaller firms. In some of the moredeveloped countries, some major equipment suppliersengage primarily in leasing out their products ratherthan selling them. Banks or other financing institutionssometimes have leasing subsidiaries. There is need,however, for legislation to protect lessees, particularlyagainst high down-payment requirements orexorbitant leasing fees.

b)Venture capitalVenture or risk capital is the name given to equityinvestments in businesses by outsiders who are notthe main owners. Venture capital investmentsparticipate in the risks of success or failure of thebusiness and, because they face such risks, it is to beexpected that they will look for high returns (high risk -high return). Venture capital 'nurtures' enterprises intheir early stages, typically when the marketing of newproducts is launched. In the early stages of abusiness, there is little prospect of significant incomereturn and the venture capitalist foregoes thecontinuous assured income that might be derivedfrom lending the capital sum, in favor of increasedreturns through capital gains in later years and whenthe investment is finally sold. At the institutional level,Venture Capital Funds (VCF) make available equity

investments in smaller businesses that areconsidered to have strong potential for significantgrowth. It is considered that in the course of time, theywill yield satisfactory financial returns in relation towhat might be obtained through depositing the moneyin a fixed interest account.Some of the venture capital may come from family

Because of the difficulties faced by venturecapitalists in making equity investments in smallerfirms in former Soviet Union, there is a strongcase for special tax concessions or treatment toencourage venture capital investment. As anexample, one may quote the case of the Republicof Korea, which has special legislation toencourage venture capital activities. Companiesin which venture capital firms have invested,benefit from full exemption from corporation tax inthe first four years of operation and a 50%reduction for the following two years. Up to 50%of the venture investments made each year can

be set against taxable profits (Yung Yoon Park,1992).

44..55 CCOOMMPPLLEEMMEENNTTAARRYY NNOONN--FFIINNAANNCCIIAALLSSEERRVVIICCEESS

Financial intermediaries and BusinessDevelopment Services Providers need to work

together for the following reasons:In the early years of support for SMEs, emphasiswas placed on the creation of public SME supportinstitutions. These are now rarer. Many havedisappeared after becoming ineffective with poorstaffing, minimal outreach and little impact.The BDS may include information and referral,general business counseling, specialized advisoryservices such as facilitation of business linkages,technology acquisition and use, enterpriserestructuring etc. The challenge is to install andmaintain a business-like orientation of the serviceprovider to enable survival on fees generatedfrom services delivered to SMEs combined withsome degree of subsidization. Whereas in amarket economy most BDS is expected to beprovided by the market, public support is called

for when the market is not addressing theproblems faced by existing and potentialentrepreneurs.There are, however, still many challenges thatremain in this field of non-financial assistance, tohelp the financial intermediaries offer moreeffective financial services for SMEs:


16/36


outreach, impact and cost-effectiveness and findsuitable cooperative relationships with financialinstitutions;SMEs have to seek BDS providers from as wide arange of sources as feasible. These may include both

formal and informal sources - consultants, universities,business centers and associations, and possibly alsosuppliers, distributors, research institutes and largecorporations - whoever in fact can help them improvetheir performance;There must be recognition of payment for BDS. Thismay be full or partial payment and at times there maybe subsidies, but enterprises who benefit from BDS

help must recognize that they have to make somecontribution to the cost of such services. In turn, theenterprise will learn to appreciate the value of suchservices and use them only when they are of benefit.

55.. MMIICCRROOFFIINNAANNCCEE PPOOLLIICCIIEESS DDOOWWNNGGRRAADDIINNGGAANNDD UUPPGGRRAADDIINNGG SSTTRRAATTEEGGIIEESS OOFF

IINNSSTTIITTUUTTIIOONNAALL BBUUIILLDDIINNGGFactors influencing upon lending arrangements arethe same in developing countries. But the situation isaggravated by primarily due to persistence of someadditional and very influencing factors. These factorsare: unstable macroeconomic environment,pauperization of the major part of population, lack ofexperience and banking technologies in lending tosmall business, lack of liquid collateral Thissituation makes relations between financialinstitutions and small business completely different indeveloped and developing countries. All this broughtabout the necessity of involving donors to resolutionof persisting problems.Up to 1970s, development finance was notparticularly concerned about poor target groups. On

the contrary, the main thrust was to transfer capital 10developing countries in order to fill that was assumedto be a structural gap in capital formation.Foreign funding served almost exclusively to financelarge industrial and infrastructural projects. However,it was believed that this growth inducing foreignsupport would also benefit the poor by initiating a

projects which were meant to make creditavailable to the poor.The "moderate" version Downgradingis of thispolicy consisted in the establishment of specialdevelopment banks for small farmers and small

business people, or at least the creation of smallloans departments at existing development banks.Downgrading is a general strategy to increase thewillingness and the ability of a formal financialinstitution to reach the target group andsupply with suitable financial services.The more radical version Upgradingof thispolicy of target group-oriented financing, which

gained particular prominence starting in the 1980s,consisted in setting up credit programs largelyoutside of the banking sector as well as outside ofthe reach of governments. is a strategy of makinga target group-oriented institution which is notcurrently a bank more sufficient and more "bank-like". This was the heyday of non-governmentalorganizations (NGOs) and all kinds of self-helpgroups (SHGs) as conduits of donors funds.

Their main strength was seen in their ability,unmatched by other types of institutions, to reallyreach the small and very small borrowers.A inkage strategy appears to rest on theconviction that establishing organizational linksand good working relationships between banksand target group-oriented institutions wouldpermit each type of institution to benefit fromthe strengths of the other. In their standard form,downgrading, upgrading and linking all seek tomake more attractive institutions available forthe provision of financial services to the targetgroup.Around 1990 a couple of fundamental questionsconcerning the field of small and micro businessfinancing started to emerge. This new viewcomprises three core elements: institution

building approach, financial sectorperspective and commercial approach.A focus on institution building:This element isthe most basic one. according to the new view,aid efforts should not be directly orientedto provision of financial services to the targetgroup but rather to the creation of financial


17/36


A commercial approach:There is no point in settingup credit programs which will create a small "boom"in the area they serve and then, a short time later,simply vanish. This is exactly what used to happenwith small and micro-lending programs in the past,

and the approach on which they were baseddisregarded the importance of a continuous andreliable supply of the relevant services for the targetgroups: if they cannot count on their provider of creditto still be in existence in the years to come, manysmall entrepreneurs will refrain from making in assetssuch as machinery which they will be unable to useunless they have continuous access to working

capital loans. A commercial approach to small andmicro-lending is necessary because only an institutionwhich, at least over the medium term, is able to coverits cost can hope to remain in existence and to reallyprovide benefits to its clients. The essential elementsof a commercial approach are that the institution triesto keep its costs as low as possible and that such aninstitution is able and willing to charge interest ratesand fees which are commensurate with its total costs.

It is part of the new view that it is legitimate to chargesuch high rates and fees and that this does notamount to exploitation of the borrowers.A financial systems orientation: All activitiesgeared to improving the access of poor target groupsto financial services have to view things in the broadperspective of the entire financial system of therespective country, and this for two reasons. The firstone is that the demand for financial services whichpoor target groups may have should be satisfied bysome element of the financial system, but that it neednot be the specific institution under consideration in aspecific development aid project. Specialization offunctions between different institutions may beadvisable and should therefore be considered as arelevant option. The second reason is that in order toprovide financial services on permanent basis, the

institution that provides these services must be ableto survive in the competitive environment representedby the respective country's financial system.

66.. DDOOWWNNGGRRAADDIINNGG SSTTRRAATTEEGGIIEESS OOFFIINNSSTTIITTUUTTIIOONNAALL BBUUIILLDDIINNGG HHOOWW TTOO MMAAKKEE AA

program. The essential elements of financialsector reform are a change in the monetary policyregime and in the status and structure of thecentral bank; strengthening of bank supervision; arestructuring of financially weak al banks; the

closing of many - in some countries, all -development banks; and, last but not least, a

liberalization and deregulation process, above allwith respect to interest rates and credit targets.There can be scarcely any doubt that all of thefinancial reforms that have been undertaken havehad an effect on the opportunities of medium-sized modern small businesses to gain access to

financial services. Typically, these effects arepositive in the sense of improving the supplyof credits and other services to these firms.For the target group small business, reformshave not had the direct effect of making accessby the target group to formal sector credit anyeasier than it had been before. Theestablished banks which were able to "survive"the reforms have so far not tried to gain small and

micro businesses as new customers. Instead,they have opened up other new fields of activitysuch as consumer lending to wage- and salary-earners employed in the formal sector. in tact, inmany countries it has become even more difficultfor the members of the target group to obtainaccess to the formal banking system, as most ofthe banks which would have at least consideredgiving them a loan have been closed in the faceof pressure exerted by the relevant internationalorganizations.Financial sector reforms have, however, hadcertain positive impacts, in terms of improving thesupply of financial services to the targetgroup. First and foremost, there is now scope forbanks to start lending to the target group, eventhough hardly any have already begun doing so.

The essential point is that interest rate ceilings -which formerly ensured that such activities wouldbe unattractive for a bank - have been abolished.In the context of downgrading as an institutionbuilding strategy, downgrading is an institutionbuilding strategy which entails equipping a bankwhich has so far not provided credit to the target


18/36


is a further reason why a downgrading strategy mayencounter resistance. Deciding whether this kind ofsubsidization is acceptable or not is one exampleof choices donors will have to make.The idea of downgrading presupposes that there is a

formal financial institution, a public- or private-sectorbank, which could at least in principle providefinancial services, especially credit, to the targetgroup, so far not served this segment of the market,and whose owners and/or management would bewilling to adopt this new approach and revise theiroverall business policy accordingly. This tendency onthe part of formal-sector institutions to broaden

their customer bases is a positive development andone which it may be possible exploit in the interest ofthe small and micro business sector: iftargeted measures are undertaken in the frameworkof international development programs to strengthenand improve individual financial intermediaries, it maybe feasible to accelerate this process andinduce formal sector institutions to serve the financingneeds of the target group scale. If their ownership

structure is such that they are not in effect controlledby a strong economic group, and if they havea management team, it is precisely the new banks,most of which are small, that are the most attractivepartners for a downgrading project. And because theymust carve out a niche for themselves in a marketwhose top end is largely the domain of older, moreestablished intermediaries, they are the institutions,which are most likely to go after the business of

smaller enterprises. In such a situation, a carefullydesigned downgrading project has a good chance ofgetting the kind of attention it deserves from both thedonor and the participating bank. It is not reallyimportant whether the bank is private commercialbank or a government bank. The important thing is toensure that it is subject to pressure to expand itsclientele and to take innovative steps. In fact, a

downgrading project with an innovation-minded bankis attractive from the standpoint of the bank if it helpsthe institution in a competitive advantage in a marketwith considerable growth potential. As the presentsituation in several developing countries clearlyindicates, banks are indeed under pressure to findnew fields of activity and new applications for the

precisely this type of bank is involved. It is notonly good for the participating banks, but also forthe target group of small business people.

66..22 PPRRAACCTTIICCAALL PPRROOBBLLEEMMSS OOFF IIMMPPLLEEMMEENNTTIINNGGOOFF DDOOWWNNGGRRAADDIINNGG SSTTRRAATTEEGGIIEESS

There are some practical problems posed by adowngrading strategy. First of all entrepreneursfrom the small and micro business sector are notthe only group which has had difficulties access toformal bank credit, but the informal sector are

considered to be the most difficult group to lendto. Therefore, in their search for new fields ofactivity, commercial banks are inclined to developother new market segments such as consumerloans to wage- and salary-earners employed byformal sector begin granting credits to smallbusinesses at all, they certainly prefer to lend tothe larger and more modern small the trulyinformal ones. A downgrading strategy

should therefore, take very seriously theconcerns which even innovation-minded banksmay have with regard to small business andinformal sector lending and find out precisely whythey have so far chosen not to enter thismarket. Only if a given bank's fears regarding therisks and costs associated with small businesslending can be allayed should a design beprepared for a specific project which will enable itto take up this new line of business.Two concerns of banks regarding credit extensionto small and micro enterprises are particularlycommon. The first one is that, because of the ofconventional credit securities and because of theinformal nature of the borrowers' businesses,lending to small and micro enterprises issimply not possible, or too risky, or too expensive.

This judgement is largely an outgrowth of theunfortunate experience of ill-conceived,poorly implemented - and even more poorly run -government-sponsored credit programs of thepast. Thus, it is imperative to make it clear tobankers that it would be wrong to draw generalconclusions from this experience The risks that

BBIIZZPPRROO MMOOLLDDOOVVAA


19/36


realistic understanding of the risks associated withsmall and micro-scale lending.Another important concern is that, in order to run amicro loan program in reliable way, a commercialbank would have to charge interest rates far in excess

of normal interest rates, which would expose it topublic criticism for - apparently - exploiting the poorersegments of society. This criticism is clearlyunfounded. It is not better for the target group if thebanks abstain from micro-lending, this because allrelevant alternatives are more expensive for them Abanker who is willing to lend to micro businesses atcost-covering rates is courageous and should be

supported by the donors in his attempt to gain theacceptance and approval of the public for hisnew undertaking. Donors should consider it as part oftheir contribution to the downgrading project tofoster it understanding of the merits of formal sectorfinancing of informal business activity.In this context it is also worth noting that acceptanceproblems will also be encountered within the bankwhen a shift of focus to small and micro credit is

undertaken in the institutions basic business policy.Inside the bank, three different groups have to beconvinced of the necessity of cooperating with thosewho wish to initiate the innovation process, and theymust be given a clear understanding of the problemsinvolved, and an incentive to go along: themanagement; the owners, especially if they alsoserve as directors of the institution; and staffmembers working at various levels. Donors should

try to allay the fears of all three groups, and shouldeven consider purchasing a stake in the bank, notonly in order to demonstrate their owncommitment, but also to facilitate the process ofchanging its organizational structure and corporateculture" in such a way that the bank becomes moreopen to the target group.The core of the donor activities in a downgrading

project consists in introducing and implementing acredit technology which balances policyconsiderations with the bank's interest in ensuringthat 3usiness activities are both economically viableand socially acceptable.Particularly during the start-up phase, when the newlending business is just getting under way the costs

small and micro lending activities by institutionsthat are in principle willing to do so.Thus, development-assistance organizationsshould initially focus on this area and provideshort-term subsidies to enable

participating institutions to carry out the followingactivities:

training of new loan officers who will specializein small and micro-enterprise lending;

implementation of computer-based creditextension and monitoring;

assistance in the establishment of new

branches located in areas where largeconcentration of small and micro enterprises;and

provision of advisory assistance to the bank'smanagement and owners.

The point of these measures, which amount to ashort-term subsidization program, is to ensurethat the start-up costs are not passed on in full to

the institution's small and micro credit customers,even though in some cases be feasible.Also, in the last decade international donors and,especially, EBRD proceeded to establishment ofnew micro-credit banks, named Microenterprisecredit bank, having in vision issues encounteredin relations with traditional banks, especially withstate-owned capital.

77.. PPRRAACCTTIICCAALL EEXXPPEERRIIEENNCCEE WWIITTHH AADDOOWWNNGGRRAADDIINNGG SSTTRRAATTEEGGYY

77..11 TTHHEE EEXXPPEERRIIEENNCCEE OOFFIINNTTEERR--AAMMEERRIICCAANNDDEEVVEELLOOPPMMEENNTTBBAANNKK

Some years ago, the 1DB introduced a new creditfacility earmarked for small-business lendingunder the name "micro-global program". Thetype of projects which this facility was intendedto support can only be called linkage projects asits basic idea was to induce formal banks andNGOs to their respective capacities as providers



20/36


target group or to participating NGO-typeinstitutions, although they were not themselves in aposition to receive the funds for on-lending. Instead, itwas thought that somehow they would act asadvisers or middlemen and help to mediate between

the banks and the small and micro businesses. Thebanks were not given access to the technicalassistance funds because it was assumed that theywould themselves know best how to set up small andmicro-scale lending activities. At the same time, theywere encouraged the IDB to establish links with theNGOs participating in the micro- global schemes. TheIDB believed that the availability of additional

funds on-lending through the micro-global facilitywould be sufficient to ,n the program. For three mainreasons, the early micro-global programs did not workas had been expected:

(1). The assumption concerning the attractiveness ofthe additional foreign funding proved to be wrong.As a consequence of financial sector reforms,loan able funds were less scarce and therefore

less attractive for the banks than they had beenpreviously.

(2). The banks did not bother to, or did not manage to,develop adequate lending technologies.

(3). In most cases, the cooperation with the NGOsproved to be unattractive for the banks as theyfelt that these grassroots organizations did nottake in recovery seriously enough.

As a result, banks did not really participate in themicro-global schemes and the loan facilities neverbecame as "global" as they were meant to be. In fact,the wholesale institutions in several countries wereunable to disburse a sizeable share of the fundsallocated to them due to a lack of' demand on the partof the "retailers". The linkage approach had tobe abandoned. Finally, IBD decided to substitute the

linkage approach with a serious downgrading effort,part of which was certain commercial banks eligiblefor technical assistance funding. In some countriesunder consideration for a micro-global loan,certain private commercial banks are now beingoffered the kind of technical assistance packagementioned above After an initial learning phase

in a position to stall the innovation. As thewholesale institution through which he micro-global activities are coordinated is alwaysclosely related to the government, politicalresistance in the recipient country also has to be

overcome. All this requires a very considerableeffort on the part of the project staff and the donoragency without any guarantee of success.

77..22 TTHHEE EEXXPPEERRIIEENNCCEE OOFFEEUURROOPPEEAANNBBAANNKK FFOORRRREECCOONNSSTTRRUUCCTTIIOONN AANNDDDDEEVVEELLOOPPMMEENNTT((EEBBRRDD)) IINN TTHHEE DDEEVVEELLOOPPIINNGG CCOOUUNNTTRRIIEESS

IINNCCLLUUDDIINNGG FFOORRMMEERRSSOOVVIIEETTUUNNIIOONNSSCCOOUUNNTTRRIIEESS

The EBRD is pursuing a similar downgradingstrategy with respect to network of its "RussiaSmall Business Fund", a program which has onlybeen under way since early 1994.In year 2000 support for the development of

micro and small enterprises (MSEs) became afundamental part of the Bank's mandate and isone of its key operational priorities. MSEs play acrucial role in strengthening private sectordevelopment and overall economic transition inthe Bank's countries of operations. Theygenerate income and new employmentopportunities, de-monopolize the industrialstructure, improve the quality and quantity ofproduction and services, and increaseentrepreneurship and the movement to a marketeconomy. By providing MSE finance through localintermediaries, the Bank is also supporting thedevelopment and diversification of financialsectors in the region. Lack of funding remains oneof the most important barriers to MSEdevelopment in these countries. The Bank has

disbursed over 100,000 loans in its MSE lendingprograms, which operate in 13 countries. TheEBRD has acquired considerable experience instructuring and implementing these projects andall current MSE projects are progressing well. Inevery country, except Moldova, arrears levelsare below 3 per cent and actual loss levels are



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volume of $ 244 .5 million of loans, an averageloan size of just under US$ 5,000.

Table 2. EBRD MSE lending in 2000

COUNTRY PROJECT

NO.OFLOANS

GRANT

US$AMOUNT

GRANTED

US$AVERAGE

LOANAMOUNT

LOANS

OUTSTANDING

NO.OFLOANS

OUTSTANDING

ARREARS%>

30DAYS

Albania FEFAND Bank2,450

16,776,990 6,848 13,948,810 2,569 1.77

Bosnia andHerzegovina

MEB d.d. 3,042 12,031,823 3,955 9,180,765 3,126 0.60

Georgia MBG 2,529 17,421,157 6,889 11,812,442 2,126 0.88

GeorgiaMBG consumerloans

19,691 3,690,300 187 1,060,579 5,337 0.00

Kazakhsatn KSBP 5,458 40,403,907 7,403 27,134,645 4,323 0.26

FR Yugoslavia

(Kosovo)

MEB Kosovo 806 4,824,938 5,986 3,102,857 707 0.00

Moldova MEC 230 1,663,036 7,231 1,108,242 181 0.37

MoldovaSwiss-AmericanProject

74 1,009,092 13,636 901,889 110 10.88

Ukraine Micro lending 2,001 24,578,773 12,283 10,041,279 1,333 0.78

Russia RSBF 13,840 122,115,666 8,823 87,225,814 10,289 2.25

Average 4,879 1.58

77..22..11 RRUUSSSSIIAA

The EBRD's flagship MSE lending program is theeRussia Small Business Fund (RSBF). Afterconsolidating in 1999, 2000 saw the programsurpass re-crisis lending levels, making 13,831 MSEloans worth US$ 122 million, a 104 per cent increase

over 1999. In year 2000 also saw the program passthe half billion dollar mark in sub-loan disbursements.Since the project was began in 1994 almost 45,000loans have been made to Russian small businesses,for a value of US$ 502million.Chapter 1 The RSBF program has been

capitalization, in which the EBRD was a keyparticipant, was completed in December, leavingthis MSE- focused bank well placed to furtherexpand in 2001. The RSBF also continues tocooperate with several smaller regional banksto supplement the nationwideapproach. Sberbank disbursed over 8,000 loansfor nearly US$ 53 million during 2000, a 70 percent increase over 1999. Progress was notso dramatic in the regional banks, whichremain Petrovsky and NBD Bank all continuedto Petrovsky and NBD Bank all continuedto generate stable lending volumes and intotal made over 800 loans worth VS$ 9 2



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DEG Germany) and Triodos Bank (Holland).This capital injection will allow the bank tofurther expand in 2001, and increase itsregional coverage from the 11 branches and

offices currently open across Russia. The RSBF issupported by TC funds provided by the G-7 countries,Switzerland and the European Commission, whichhas also provided 5 million in TC directly to KMB-Bank to branch expansion and loan officer training.

77..22..22 KKAAZZAAKKHHSSTTAANN

The Kazakhstan Small Business Program (KSBP)developed ahead of expectations in 2000, disbursingmore than twice as many is as in 1999. Decemberwas a record month, with close to 800 loansdisbursed to micro and small enterprises. To date,the program has disbursed almost 8,800 loans for atotal of over US$ 65 million. The KSBP, which issupported by technical cooperation from EU Tacis, isworking with seven banks in 14 towns and cities. The

quality of the loan portfolio has remained exemplary,with eligible loan arrears. The KSBP is particularlysuccessful at reaching the smallest borrowers - two-thirds of all loans granted have been for amounts ofless than US$ 5,000. Regional expansion willcontinue to bring the remaining as significant towns inthe country into the KSBP in 2001. TC for theprogram continues to be Bos by the EuropeanCommission.

77..22..33 UUKKRRAAIINNEE

The joint KfW-EBRD Ukraine micro-lending programmade positive progress in 2000 disbursing 2001 loansworth US$ 24.6 million. The over-30-days arrears rateon this portfolio stood at only 0.78 per cent. Theinstitution- building process in the partner banks,which is supported by TC from USAID and EUTacis, is progressing, and a number of banksare increasingly incorporating microlending technologies into their core lendingoperations. In December 2000, the Ukraine MicroFinance Bank (MFB) was registered by the

In Bosnia and Herzegovina, theEBRD's investment in Micro Enterprise Bank(MEB) made solid progress in 2000. During theyear, MEB disbursed 3,042 loans worth over US$

12 million, and the arrears rate on theportfolio remained exceptionally low at 0.6 percent over 30 days. MEB has establishedbranches in Bihac, Ilidza, Sarajevo, Tuzla andMostar in the Federation of Bosnia andHerzegovina. In November, MEB became the firstbank registered in the Federation to open abranch in Banja Luka in Republika Sirbska. Thebank is now offering housing reconstruction loans

to individuals, as well as MSE loans, and demandremains strong across the whole country.MEB has benefited from TC and on-lendingfunding provided by the European Commissionand the Norwegian government.

77..22..55 AALLBBAANNIIAA

The EBRD's investment in FEFAD Bankin Albania was completed in February2000. 7EFAD was set up as a foundation byKfW and has been converted into a dedicatedMSE bank along the lines of MEB in Bosniaand Herzegovina. This conversion into abank, the parallel change of management, andthe injection of fresh capital has all had apositive effect. FEFAD Bank granted as many

loans in 2000 as it had in its previous five years ofoperation. The portfolio doubled in size to US$ 14million at year-end, with an over-30- days arrearsrate of 1.8 per cent. TC support for FEFAD Bankhas come mainly from KfW, and additionalsupport has been provided through the US-supported SME Finance Facility.

77..22..66 KKOOSSOOVVOO

The EBRD has provided technical assistance toMicro-Enterprise Bank in Kosovo (MEBK) viaGennan government almost funds and the US-supported SME Finance Facility. MEBK was



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BBIIZZPPRROO-MMOOLLDDOOVVAA

77..22..77 MMOOLLDDOOVVAA

Tie EBRD has recently made an investment n aspecialized micro finance institution in Moldova. Micro

Enterprise Credit (MEC) was set up as a financecompany under Moldovan law, and there are plans toconvert to a commercial bank operation in 2001.The EBRD currently holds a share of 15.3 per cent inMEC, which will be increased to 20 per cent at thetime of conversion. In the last months of 2000, MECdisbursed 225 loans for a total amount of US$ 1.6million.

77..22..88 GGEEOORRGGIIAA

In Georgia the EBRD provided both equity and debtfunding to Microfinance Bank of Georgia (MBG)during 2000. MBG has developed a highly successfulconsumer loan business, which granted 19,691 loansin 2000, with an average size of just US $ 187. Thebank also makes MSE loans, and granted 2,529 for a

total volume of US$ 17.4 million during the year. Thecapital increase is planned for early 2001.

88.. UUPPGGRRAADDIINNGG SSTTRRAATTEEGGIIEESS HHOOWW TTOO BBUUIILLDDAANN MMIICCRROOFFIINNAANNCCEE NNGGOO AANNDD TTUURRNN IINNTTOO AA

SSMMAALLLL BBAANNKK

88..11 GGEENNEERRAALL OOVVEERRVVIIEEWW

To the study of international experience UpgradingStrategies represent interest as they are based onaccumulated experience of working with difficultclients and small loan by means of creating an NGO provider of financial services. Upgrading strategiesof target group-oriented financing, which gainedparticular prominence starting in the 1980s, consistedin setting up credit programs largely outside of thebanking sector as well as outside of the reach ofgovernments. is a strategy of making a target group-oriented institution which is not currently a bankmore sufficient and more "bank-like". This strategy is

In order to achieve the goal of transformation ofNGO in a formal banking institution threeimportant issues should to be taken inconsideration:

(1). Creating or supporting an NGO andconverting it into a formal institution with aconsistent target group orientation is aprocess which takes a long time to complete.During this timespan the institution has to beable to rely on continuous support of therelevant kind from the donor or, as the casemay be, donors.

(2). The most crucial aspects of the process are

finding the appropriate combination oftechnical al and financial assistance, andensuring that the different forms of support,and especially the provision of funds for on-lending, are forthcoming at the right time.

(3). The process of building up a financialinstitution should lead to a situation in whichthe institution's operating income is sufficientto cover its full costs. Before this stage isreached, there is a need for the donors toinvest in - i.e. subsidize - the institution. Andeven in this final stage, the operating costs,which by then will be passed oncompletely to the institution's customers, arestill likely to be high when measured byconventional standards.

88..22 TTYYPPIICCAALL PPRROOBBLLEEMMSS OOFF GGRROOWWIINNGG TTAARRGGEETTGGRROOUUPP--OORRIIEENNTTEEDD FFIINNAANNCCIINNGG

The tremendous growth experienced by suchinstitutions haves been an uncontrolled process.Indeed, the crisis which was about to come wasnot anticipated by neither the insiders(management and board) nor by the outsiders.

The services offered by such institutions getdiversified too quickly and without enough test.No true planning was made before developingthe some of these institutions. Besides, themultiplication of the lines of credit which couldbe given to a same borrower damaged his/her



24/36


The structures of the group have not been able tokeep up with the growth process. The strategic apexhas kept too much power in comparison with whatwould have been coherent for a organization which

was supposed to be decentralized. The ideologyalso followed a bad path as the sense of taking partto a social oriented program - which is important fora organization which aims at a large developmentprocess of its clients - changed into one where everymember of the organization would first of all takeinto account his/her own personal interests. Besides,the coordination mechanisms have not kept up withthe multiplication of the structures, each entity of the

group lacking some autonomy. The influent outsiders (banks, officials,) have not

followed strictly enough the evolution of the group.This is also true for the equity providers as theyhave not fully played their control function. Theseinstitutions received a lot of support form countriesGovernments and international institutions but thosesupports were not always controlled enough.

As for the dependence to subsidies, it appears thatthis kind of institutions could not have workedwithout subsidies.

Financial management has also experienced someimportant weaknesses. There are variousexplanations to that. First, institutions have waited acouple years before implementing an appropriateinformation system. Last but not least, consideringthe aimed growth, all the entities of the group were

under-capitalized.

99.. CCRREEDDIITT TTEECCHHNNOOLLOOGGIIEESS

The provision of credit is the principal, and often theonly, activity in which the institutions we are looking atengage. It has long been doubted that it is possible atall to extend credit to a target group, which is poor

and also rarely has adequate financial records orbankable securities. The disappointing experience,which many institutions have had with their efforts tolend to small and micro entrepreneurs in the past,seems to confirm these doubts. However, the costsand risks entailed in lending, lo this target group are

t " i " i t d th f ti f

In fact, there is not one single credit technologywhich

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