Comments and suggestions

Aug 25 - 31, 2003

The State Bank of Pakistan (SBP), keeping in view the important role of Small and Medium Enterprises (SMEs) in the economic development of the country and to facilitate flow of bank credit to this sector, on 20th June 2003 issued draft Prudential Regulations (PRs) for SMEs. SBP explained its philosophy and approach for SMEs finance in the Preface to the PRs as under:

1. PRs specifically tailored for SMEs shall encourage banks to develop new financing techniques and products which can meet the financial requirements of SMEs and provide a viable and growing lending outlet for banks.

2. The banks should recognize that success in SME lending requires much more extensive involvement with the SMEs than the traditional lender-borrower relationship. The banks are, thus, encouraged to work in close association with SMEs. The banks should assist and guide the SMEs to develop appropriate systems and effectively manage their resources and risks. The banks are encouraged to prepare a lending program (including detailed eligibility criteria) for each specific sub-sector of SME in which they want to take exposure in a significant manner. For this purpose, the banks may conduct/arrange surveys and research to determine the status and potential of the specific SME sub-sectors. It is expected that banks would prepare comprehensive guidelines/manuals and put in place suitable mechanism/structure, aided by proper MIS, to carry out the activities related to SME financing in an effective way.

3. This should, however, not stop banks from lending to SMEs before undertaking the steps mentioned above as the banks may start soft lending operations or test marketing campaigns, as they feel appropriate, to gain experience and necessary know-how. The factors mentioned above gain more importance and become critical for success of a bank in SME lending, as exposure of the bank on SMEs becomes a significant portion of its loan portfolio.

4. SBP encourages banks to lend to SMEs on the basis of asset conversion cycle and future cash flows. A problem, which the banks may encounter in this respect, is the lack of adequate information. In order to overcome this problem, banks may also like to prepare general industry cash flows and then adjust those cash flows with the specific borrowers, keeping in view their conditions and other factors involved.

5. Presently most of the SMEs in Pakistan lack sophistication to have reliable and sufficient data and financial information. In order to capture this data and information, banks will need to assist and guide their SME customers. The banks may come up with the minimum information requirements and standardized formats for this purpose as per their own discretion.

6. In order to encourage the close coordination of the officials of the banks and SMEs, the banks may require the concerned dealing officer to regularly visit the borrower. For this purpose, at a minimum, the dealing officer may be required to pay at least one quarterly visit and document the state of affairs of the SME. In addition, an officer senior from the one conducting these regular visits, may also visit the SME at least once in a year.

7. State Bank will closely monitor the situation on an ongoing basis and work proactively with banks to make SME financing a success. During this process, we will keep on reviewing regulatory framework to ensure that any impediment is immediately removed, while ensuring that banks observe due prudence and necessary monitoring of their SME loan portfolio.

Draft PRs issued by SBP are in two parts. Part-A contains definitions which provide basis for clear understanding of the key words and the terminology used. Part-B contains ten regulations covering the following areas: (i) source and capacity of repayment and cash flow backed lending; (ii) personal guarantees; (iii) limit on clean facilities; (iv) securities; (v) per party exposure limit; (vi) aggregate exposure of a bank on SME sector; (vii) credit report; (viii) proper utilization of loan; (ix) restriction on facilities to related parties and (x) classification and provisions. Draft PRs cover many important areas pertaining to credit operations and SBP initiative may be appreciated by the stakeholders.

Different stakeholders have presumably submitted comments to SBP. Some of these comments have also been reported in the press. While some comments are on the policy initiatives adopted by SBP, others pertain to the definition of Small and Medium, the exposure limits, assistance and monitoring by the lending banks and ways and means to avoid possible malpractices in the approval and disbursement of loans. In view of the importance of the SMEs for economic development and employment generation of any country, it is imperative that proper PRs are put in place, that guide the financing of SMEs by the banks and at the same time are not unduly restrictive for the entrepreneurs. With this in mind, comments and suggestions on certain important aspects of draft PRs on SMEs are being offered as under:

1. (Overall-PRs): Small and Medium Enterprises (SMEs) are a mixed bag of small and medium industries. The range and scope of the two taken together is very wide. Logically, there should be separate Prudential Regulations for the small and the medium industries, due to: (a) Some of the prescribed requirements, with reference to the medium industries, are considered appropriate but appear to be hard for the small industries. Preparation of the cash flow for a medium industry may possibly be attempted for a medium industry. However, it would not be easy in case of a small industry and therefore the banks might not be able to comply with the prescribed requirements; (b) Per party exposure limit prescribed in R-5 may be quite attractive for the small industries but this may not be adequate for the medium industries; and (c) Valuation of assets of small industries with large number of projects might be a problem whereas it would be manageable for medium industries; and (d) Classification and provisioning of small industries would not be easy. Therefore, separate PRs for the small and the medium industries should make both the PRs better focused. Also then the banks would find it easier to comply with the respective requirements. For promotion of small industries on sustained basis, SBP might also consider taking up with the tax authorities for prescribing simplified rules and requirements for levy and collection of tax dues.

2. (SBP Philosophy/Policy): SBP in the Preface to the draft PRs states that presently most of the SMEs in Pakistan lack sophistication to have reliable and sufficient data and financial information. In order to capture this data and information, the banks are being asked to assist collecting data and to guide their SME customers. This approach of the banks spoon-feeding the project-related information to SME borrowers has potential legal problems for the concerned banks. SMEs fail more often. In case the bank financed projects fail, the SME borrowers may hold the banks responsible for the failure and lodge claims for losses as well as the damages. Therefore the banks may not be required to do it. Let the borrowers engage professional advisors for collecting data and provide authentic information to the banks for project appraisal. Government agencies such as SMEDA as well as the industry / trade associations such as the FPCCI should take responsibility to make available reliable information for the purpose of setting up SMEs. They should also educate the entrepreneurs.

3. (Venture Capital): The world over Venture Capital plays big role in the promotion of small and medium industries. The traditional DFIs used to provide such support for nurturing the industries/entrepreneurs but rarely benefited like the traditional Venture Capitalists in the developed countries. The Venture Capital institutions operating in Pakistan appear not to have made the full impact for which these were set up. Venture Capital activities and culture has to be developed including framing of appropriate rules if we intend to promote SMEs on a fast track. SBP and SECP can play a pivotal role in this. The small entrepreneurs with bright ideas would get needed finance from the Venture Capitalists, without risking their homes as security. If his ideas worked and the project proved to be a success, both the partners i.e. the entrepreneur and the venture capitalist shall benefit. In case of failure, the entrepreneur would lose the business but still have his home and the venture capitalist would write off the loss against profits made from other businesses so financed.

4. (Definitions): While defining the SMEs, value of total assets excluding land and buildings has been used in the criteria. Land and buildings owned by the borrowers provide lot of comfort to the lending banks. Value of land and buildings may be suitably incorporated in the criteria as well as in the analysis. This will also preclude borrowings by those who are doing business in rented premises. Separate criteria may be devised for accommodating the borrowers who are carrying out manufacturing or trading activities in the rented or leased premises.

5. (R-2-personal guarantees): Personal guarantees of the owners and of the directors in case of limited companies are required. It is felt that there should be separate requirements for the Small and the Medium industries. Moreover, such personal guarantees would be more meaningful if the assets owned by these owners / directors are assessed and some sort of restrictions imposed on their disposal during currency of the loan.

6. (R-6-aggregate exposure of a bank on SME sector): Limits the aggregate exposure of a bank on SME sector with credit rating less than 'AA' to twice the equity of the bank. Money mobilized through deposits would often be the main source of financing the SMEs. SBP might consider linking the credit rating of the banks with the aggregate deposits the banks can raise. Let us say banks with 'AA' rating are allowed to raise deposits say 10 times of the equity. For banks with higher ratings, this may be raised to say 12 times. For banks with lower rating lower than 'AA' it should be lower.

7: (R-8-proper utilization of loan): The banks have been asked to ensure that the loans have been properly used by the SMEs for purposes they were acquired and that the banks should develop and put in place an appropriate system for monitoring the utilization of loans. The DFIs used to follow this practice but faced problems. For SMEs there shall be a large number of cases and so it would be cumbersome for the banks. Presently there are two 'models' for medium and large projects. The World Bank is all for monitoring the procurement process whereas the International Finance Corporation (IFC) leaves it to the borrower companies. The pros and cons of both the 'models' might be considered before finalizing the matter.

8. (General): Some of the stakeholders are of the opinion that to avoid possible malpractices in sanctioning and disbursement of loans, the banks may be required to settle the loan cases within 30 days for small enterprises and 60 days for medium enterprises after completing the formalities and submission of required information by the borrower. Such requirements have not worked in the past and there is no guarantee that these would work this time. Transparency in policies / operations, proper motivation including extensive training of bank employees, close monitoring by the seniors and system of quick accountability might assure better services to the SMEs.

9. (General): One institution has suggested change in the definition of 'Small Enterprises' which should mean: An entity, not being a public limited company, which does not employ more than 100 permanent employees in case of manufacturing concerns and in case of trading or service concerns the number of employees must be 50. The institution has also proposed change in the definition for 'Medium Enterprises'. It is considered that insertion of the world 'permanent' with the number of employees of SMEs would create problems. Often, there are many contract or temporary employees in SMEs and therefore the banks might be confused. Moreover, in these days of high-tech manufacturing, the number of employees would keep on decreasing whereas the value of fixed assets and the volume of sales would keep on increasing. As such, the definitions included in the PRs appear alright.

10. (General): Some of the comments appearing in the press pertain to enhancing the initial financing limits, overall exposure limits, clean exposure limits, etc. It would be prudent that the limits stated in the PRs are considered for change only after actual experience of financing of SMEs for about six months.

11. (General): Large bad loans are being written off by the banks these days in the country. Write offs are a part of the banking operations but the volume has to be kept to the minimum. The banks might have lesser bad loans on SMEs if they restrict fresh loans to entrepreneurs who have about five year's history of satisfactory credit relationship with the banks in respect of the micro or cottage businesses. Fresh loans to small businesses might be for expansion purposes. These and similar other precautions might keep the volume of bad loans within safe limits.