Access to Finance

FINANCING THE GROWTH OF SMES IN RURAL AND UNDER-SERVED MARKETS IN ARMENIA

Constraints and RecommendationsJanuary 2015

Anthony SinclairDirector, Economic GrowthCardno Emerging MarketsFED Technical Advisor

The Situation

• 50%+ of SME’s do not use formal finance: 60%-70% in rural areas

• 4 out of 5 SMEs report difficulty or have no wish to access formal sources - lack of interest is uncommonly high

• Key sectors under-served: Production, agriculture, construction = 30% of total finance;

• Amounts small: Average loan AMD 4mn; ag < AMD 3mn.

• SMEs rely on personal sources more than any other source (64% of SME’s in ag said they seek personal sources first)

• 30% or less of finance directed for investment

• Banks primary source, but UCOs play important role with market shares 30%-60% in most areas except Yerevan.

• Reliance on donor and state support significant (20%)

Approach: “Access” Defined

Proximity between lenders and SMEs, operating hours, ease of making and keeping in contact, etc.

Supply of funds, willingness of lenders to lend, etc.

Cost of finance, level of borrower risk, management burdens

Suitability of products and services to SME needs

Healthy SMEs have access to formal lenders who are able and willing to offer affordable and suitable financing.

Physical Access

Availability

Affordability

Suitability

Approach: Sources

Roundtables with SME’s and Lenders

Survey of 200+ hundreds businesses

Interviews with market participants

Separate technical studies: legal, supporting services, agriculture

Various documents and studies

Roundtables

Surveys

Interviews

Diagnostics

Other

Opportunities to improve information collection

Approach: Scope of Assessment

Supply-Side Evaluation Enterprise-Side Evaluation

•Legal infrastructure

•Financial regulations

•Products and services

•Financial sector depth

•Supporting services

•State support

Risk

Cost

Knowledge gaps

Market failures

•Financial capacity of SME’s

•Technical/administrative capacity to get credit

•Attitudes and expectations

•SME market structure

Supply-Side Constraints Enterprise-Side Constraints

• Inefficient credit

enforcement

• High costs of financing

• Poor product suitability

• Regulatory issues and lack of incentives

• Few alternative sources of finance

• Weak supporting services

• Limited effectiveness of state and donor funds

FINANCEGAP

•Weakened financial capacity

•Borrower attitudes and risk aversion

•Weak capacity to present business

•Weak SME market leverage

Access Constraints: The Big Picture

Weak Enforcement

Impact of Financial

Regulation

Poor Product

Suitability

Lack of Alternative

Sources

UnderdevelopedSupporting

Services

HighCosts

Supply-side Constraints

Loan lossprovisionrules

Collateral bias

Regulation of non-banks

UncertainImpact of

Capital Rules

WeakEnabling

Environment

Barriers to leasing

Weak inter-firm

financing

Under-developed Cap Mkt

Borrower Attitudes &

Risk Aversion

Information Asymmetry &

Legitimacy

Poor SME Market

Leverage

WeakenedFinancialCapacity

Liquidityissues

Inadequatecollateral

Low risk tolerance

Expectations of state support

Negative sentiment

Weak credit culture

Weak capacity

Informal economy

Co-mingling of finances

Weak national advocacy

Weak negotiating

position

Demand-side Constraints

Unclear reach to SMEs and priority sectors

Bias to larger SMEs and existing bank clients

Significant direct lending – under-leveraged

Some weakness in transparency and SME feedback

Financing Support

Recommendations: Supply-side

During proceedings…

•Amend the law to make it easier to deliver notifications

•Amend the law to eliminate use of erroneous counter-claims to create delays; enable concurrent proceedings

•Improve the legal definition and rules for setting priority of claims; harmonize civil code and enforcement law

•Strengthen the technical capacity of courts to handle credit cases

•Improve consistency and uniformity of enforcement proceedings among different courts; platforms for sharing info on cases

Enforcement of judgments…

•Amend the law to reduce erroneous appeals to delay actions

(more)

Weak Enforcement

Legal loopholes/

delays

Inefficiency in claim recovery

Out of court process

limitations

Collateral regime


Enforcement of judgments…

• Eliminate inconsistency between law on public bids and law on enforcement

• Strengthen enforcement of law concerning creditor notifications

• Develop standards/protocols for enforcement officers in selling assets; consider use of private creditor enforcement officers

• Upgrade electronic auction system to improve transparency and ease of use

• Re-set commission structure to be more incentive compatible

• Eliminate the administrative barrier to re-registering foreclosed property after auction

• Stronger legal deterrents against misappropriation of collateral

Weak Enforcement

Legal loopholes/

delays



limitations

Collateral regime


Collateral infrastructure….

• Finalize development of centralized movable property register

• Establish legal basis for the use of enterprise-wide or floating charges as collateral

• Evaluate the feasibility of setting up alternative collateralization mechanisms, such as the use of bonded-warehouses, trusts, etc.

Extrajudicial enforcement…

• Amend the law to eliminate inconsistencies in reserve price-setting requirements for in-court and our-of-court proceedings

• Continue to improve and promote the use of the arbitration court

Bankruptcy proceedings…

• Various improvements noted in our report

Weak Enforcement

Legal loopholes/

delays



limitations

Collateral regime


HighCosts

Poor economies

of scale

Externalities

Cost of regulatory compliance

Calibrate regulatory requirements to the risks of SME lending (e.g. banks vs. leasing, SMEs vs. Large Corporates)

Apply RIA to financial regulations; consider use “SME test”

Increased investment in shared platforms or services that help to reduce the transaction costs of lending – more to follow…

Gradually reduce reliance on minimum loan loss provisions based on payment status

Streamline prudential requirements for UCOs proportionate to the risks they pose

Harmonize regulatory charges between banks and UCOs (VAT on guarantees branch taxes, ombudsman fees, etc.)

Streamline regulations for leasing to be more in line with EU practices; develop separate guidelines for banks involved in leasing

Apply RIA to existing regulations as well as new ones

Improve info collection on SME lending

Consider SME impact when setting Basle III requirements


Impact of Financial

Regulation

Loan lossprovision

rules

Collateral bias

Regulation of non-banks

UncertainImpact of

capital


On lending suitability and funding…

Incentives for investment in SME lending and expansion to under-banked markets

Accelerate development efforts to develop national platforms for mobile and e-banking (Separate FED report)

Consider government support/sponsorship for the development of a new share-technology platform for credit scoring/screening Comprehensive strategy for improving dinar-based funding

On improved risk intermediation…

Government-financial sector-donor collaboration on expansion/ development of risk management tools

State aid in the form of foreign exchange or interest rate risk offset programs may have use in lieu of direct lending

Poor Product

Suitability

Unsuitablelending models

Unsuitablefunding

Poor risk inter-

mediation

Weak SMEknowledge


On improving knowledge of SME markets…

Poor Product

Suitability

Unsuitablelending models

Unsuitablefunding

Poor risk inter-

mediation

Weak SMEknowledge

Improved information and data collection on the SME sector

More collaboration by business associations (including bankers association) in doing research on the SME sector


Streamline regulations for UCOs

Reform regulations on leasing and related tax and accounting rules to make leasing cost competitive

Promote financial intermediation between banks and UCOs – e.g. in whole sale lending and loan participations

Promote increased use of Dram-based funding by

UCOs; more access to donor funds, assistance in hedging FX risk

Support for value-chain based credit arrangements – next section

Opportunities with diaspora

Lack of Alternative

Sources

WeakEnabling

Environment

Barriers to leasing

Weak inter-firm

financing

Under-developed Cap Mkt


On appraisal services…

Consider changing licensing from firms to individuals

Revise conduct standards, set continuing education requirements, and strengthen sanctions

Strengthen capacity of the register to monitor and sanction appraisers

Create a centralized database of all information collected on real estate and make it available to appraisal profession

Map the service area appraisers and monitor national coverage


Services

Quality ofappraisal services

Quality ofAccounting/

auditing

Gaps in info services


On accounting/auditing services…

Minimize use of staffing thresholds in audit firm licensing – 5 staff may be too high in small markets

Strengthen the capacity of MoF for oversight or transfer full oversight/sanctioning to private association

Promote widespread implementation of the new IFRS standards for SMEs for lending

Update professional certification requirements in line with international standards

Move to implement the measures in the latest ROSC assessment and set out by the FIRST Initiative


Services



auditing



On information services…

Support ACRAs expansion and promote the develop of new reporting templates for rural and ag markets

Reduce delays in lending by quickly fixing errors and omissions in the property registries – create a program to “fast track” easily verifiable corrections

Improve the search functions of the business registry to support lending

Explore opportunities for public-private partnerships to improve the quality and type of information services that support financing.


Services



auditing


Recommendations: Financing Support

Strengthen coordination and tactical use of state aid

Enhance design and structure of products and programs; less direct lending more collaboration with the UCO sector; use these support mechanisms to catalyze innovation

Strengthen communications with the SME sector; focus groups

Strengthen information collection and distribution on SME financing

Recommendations: Demand-side

Various measures to improve liquidity conditions:

• VAT tax payments based on cash not invoice• Reduction of payment delays through public sector

supply chain, etc.• Quicker enforcement of inter-firm credit claims

Better education for SMEs on collateral management

Fast-track permitting for qualified real estate collateral

WeakenedFinancialCapacity

Liquidityissues

Inadequatecollateral

More communication and collaboration needed between lenders and SME’s (+professional services community)

Improvements in credit enforcement will help to reduce the personal exposures of borrowing

Public-private collaboration in improving public awareness and helping to promote positive credit culture

Support for entrepreneurship and belief in SMEs needs to be explicit and promoted by government


Borrower Attitudes &

Risk Aversion

Low risk tolerance

Expectations of state support

Negative sentiment

Weak credit culture

Training and support to business organizations to build capacity of members

Training and outreach by lenders and more engagement by the professional services community

Targeted incentives to get businesses out of informal economy


Information Asymmetry &

Legitimacy

Weak capacity

Informal economy

Co-mingling of finances

Business associations to take a more active role in advocating for specific reforms to improving access to members

Business associations to take on intermediary functions in working with banks and members to facilitate credit flows

More education for SME about to organize and make joint approaches to lenders

Public-private initiatives to promote value chain-based financing

Large corporations should help with solutions


Poor SME Market

Leverage

Weak national advocacy

Weak negotiating

position

Next Steps

Many recommendations are achievable in

the short and intermediate term … at minimal cost

Set priorities

Integrated plan with responsibilities

Platform for public-private cooperation/feedback

Financial and private sector undertakings

Government-wide commitment

Tell businesses about progress

A Final Observation

SME’s have played a catalyzing and socially-stabilizing role in the development of almost

every major industrialized economy we know in the world.

www.armeniafed.com

Economy & Finance

Access to Finance