Many SMEs in emerging markets often rely on informal sources of capital, such as borrowing from relatives, to meet finance needs. However, when a small or medium enterprise does access formal channels, it typically looks to a bank as its primary source of financial services. Banks have begun to turn their attention toward this untapped market and their service of SMEs is a major factor in increasing SME access to finance. Although, numerous issues surface when it comes to SME lending, banks, by employing a range of measures, such as risk adjusted pricing, credit scoring models, and SME-tailored non-lending products are developing ways to mitigate risks, lower costs, and increase the overall benefit accrued from SME banking.
Question 1: Why Banks should lend to SMEs?
SME banking is an industry in transition. From a market that was considered too difficult to serve, it has now become a strategic target of banks worldwide. The “missing middle,” describing the gap in financial services provided to SMEs, is shrinking. SME banking appears to be growing the fastest in emerging markets (low- and middle-income countries) where this gap has been the widest. More and more emerging market banks are developing strategies and creating SME units. IFC’s committed portfolio of investments in SME financial institutions has grown dramatically over the last five years — by 271 percent — totaling $6.1 billion as of end of FY09. The SME market has been perceived in the past by banks as risky, costly, and difficult to serve. However, mounting evidence suggests that banks are finding effective solutions to challenges such as determining credit risk and lowering operating costs, and are profitably serving the SME sector. For these banks, unmet SME demand for financial services has become an indicator of opportunity to expand their market share and increase profit.
Following are the important reasons why banks look forward lending to SMEs: * Competition in other markets is one reason cited for commercial banks moving “downstream” to serve SMEs. Many of the banks are targeting this sector. A number of tools are being used to increase banks' focus on the sector including undertaking and publishing market research, a shift toward more emphasis on relationship management and greater use of performance measures at relationship manager level aimed at growing the SME loan book. * Governments around the world now recognize the importance of the SME sector and have worked to support its access to finance, sometimes by addressing legal and regulatory barriers or building credit infrastructure. Considering the growth potential of Indian SMEs, the Government of India has asked public sector banks to achieve a minimum 20 per cent year-on-year growth in the funding of SMEs that will lead to double the flow of credit to the sector from `67,000 crores in 2004-2005 to `1, 35,000 crores by 2009-2010. * Banks are unlocking some of the potential in the market is that they are reporting higher returns on assets from their SME operations. For example, leading banks reported ROAs of 3–6 percent for their SME operations compared with 1–3 percent bank-wide. There is a renewed focus by banks on the SME market. This involves packaging different banking services into a combined service offering, providing more economic and business related information to their SME customers and renewed emphasis on relationship management. Banks are 'defending' existing client relationships. This includes more regular reviews of facilities and pricing reductions to match competitive offers. Key to the growth of SME banking may be that banks are starting to understand the particular needs and preferences of SMEs, and are developing tailored approaches to overcome the historical challenges of high credit risk and cost to serve. Also, contrary to common perception, the SME market is served by a wide spectrum of banks, not just smaller banks with...