Small and Medium Enterprises free essay sample

Granularity: This refers to a situation where the risk grading system at banks does not have the requisite capability to discriminate between good and bad risks. The consequence is tightening of Y. Srinivas (The author is Manager, Compliance Group at ICICI Bank. He can be reached at srinivas. [emailprotected] com) Small and Medium Enterprises (SMEs) play a very significant role in the economy in terms of balanced and sustainable growth, employment generation, development of entrepreneurial skills and contribution to export earnings.However, despite their importance to the economy, most SMEs are not able to stand up to the challenges of globalisation, mainly because of difficulties in the area of financing. With the opening up of the Indian economy, it has become necessary to consider measures for smoothening the flow of credit to this sector. The article provides a crosscountry perspective in this regard and highlights the Indian scenario with reference to SME lending. We will write a custom essay sample on Small and Medium Enterprises or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page rs or managers know more about the prospects for, and risks facing their business than their lenders) exists, lenders may respond by increasing lending margins to levels in excess of that which the inherent risks would require. However, the sheer ticket size of SME lending makes it inviable for banks to invest in development of information systems about SME borrowers. In such situations, banks may also curtail the extent of lending even when SMEs are willing to pay a fair riskadjusted cost of capital. The credit terms, or an increase in prices, or both.From the borrower’s perspective, this leads to an outcome where the bank is over-pricing good risks and under-pricing bad risks. The fact that most banks in India have not developed adequate expertise in SME lending risk assessment exercises leads to the problem of granularity when it comes to SME lending. (c) Pecking Order Theory: Pecking order theory ? ows from the above two issues, which makes SME lending highly dif? cult fo r banks. Un- der this hypothesis, SMEs, which face a cost of lending that is above the true risk-adjusted cost, will have incentives to seek out alternative sources of funding.Evidence suggests that in such situations SMEs prefer to utilise retained earnings instead of raising loans from banks. (d) Moral Hazard: Even when loans are made to SMEs, it may so happen that the owners of these SMEs take higher risks than they otherwise would without lending support from the banks. One reason for this situation is that the owner of the ? rm bene? ts fully from any additional returns but does not suffer disproportionately if the ? rm is liquidated. This is referred to as the moral hazard problem, which can be viewed as creating a situation of over-investment.The moral hazard problem may, thus, result in SME lending turning bad in a short period of time, a situation that all banks would like to avoid. (e) Switching Costs: SMEs may ? nd it harder to switch banks, when countered with any issue. It is a known fact that the smaller the business, the more signi? cant the switching costs are likely to be and, therefore, it is less likely that the bene? ts of switching outweigh the costs involved. This situation results in SME lending becoming a sellers market, which may not be attractive to SME borrowers. Steps for Smooth SME Lending In order to ensure that the 36 The Chartered Accountant September 2005 above issues do not stand between SMEs and Bank Finance, the following steps could be taken as remedial measures: Collateral: Existence of collateral that can be offered to banks by SMEs could be one effective way of mitigating risk. Banks could, therefore, look at collateral when pursuing the question of SME lending. It can also be stated that a borrower’s willingness to accept a collateralised loan contract offering lower interest (relative to unsecured loans) will be inversely related to its default risk. However, not all SMEs would be able to offer collateral to bank s.Hence, Reserve Bank of India (RBI) allows banks, with a good track record and ? nancial position on SSI units, to dispense with collateral requirements for loans up to Rs. 25 lakhs. (a) Relationships: The length of the relationship between a bank and its SME customers is also an important factor in reducing information asymmetry, as an established relationship helps to create economies of scale in information production. A relationship between a SME and a bank of considerable duration allows the bank to build up a good picture of the SME, the industry within which it operates and the calibre of the people running the business.