Credit Risk Assessment of SMEs

Topics: Credit rating, Credit risk, Operational risk Pages: 50 (11559 words) Published: August 16, 2014

Credit Risk Assessment of SMEs: Loan Criteria and Default Probability Final Year Project - I

Aamir Aijaz Memon
10/12/2013

Table of Contents

1 INTRODUCTION
1.1 Background Study
Credit Rating is a very vast and emerging field of finance, it has opened up many new opportunities and challenges for financiers. Credit Agencies has adopted a almost standard set of rules to follow for individuals and big organizations, which has started resolving the default issues in these two categories; but whenever the matter of small and medium enterprises come into account, many of the conflicts take place, whether these should be treated as an individual, big organization or something else. This study is about resolving this issue. 1.1.1 Overview

This research is about the lending practices to the small medium enterprises, specially through financial institutions; as this is the only sources of financing to such types of companies. The equity market for small and medium enterprises is also not well developed in our country, and secondly to finance these types of companies through equity market would cost a lot to them, which would stop the development of this, one of the most important sectors of the economy. This problem doesn't only exist in Pakistan, but in most of the developed countries like Europe, China and many more are still encountering with the same type of problems regarding the small and medium enterprises. The Basel's new accords are also has much more focus on the increasing problem of Credit Risk in the financial institutions, because this always remain one of the most important reason for most of the economy break down factor since Great Depression of 1929. 1.1.2 SMEs in Pakistan

The Government of Pakistan and State Bank of Pakistan keeps encouraging the financial institutions to finance the Small and Medium Enterprises, as these type of industries play very important role in the economy of the country. It is even much more important sector than the heavy industries, because the heavy industries need heavy investment or initial capital to settle that's why they are very low in number. According to the Governor of State Bank of Pakistan the small and medium enterprises sector contributes almost 30% to the total GDP growth and it employees up to 78% of the non-agriculture labor force, and makes 25% of its earning through exports . Now, this major sector of the economy needs to be financed in order to grow and get settled. Financial institutions are to play a vital role in it, but the increasing trend of defaults and infection ratio, which was 31.4 percent in 2011 and 34.6 percent in 2012, is directing the banking sector towards curbing their lending practices. This therefore, shows that the small and medium enterprises are not properly scrutinized before giving loans, and defaults are increasing due to this reason. Consequently, the lending to this sector is now shrinking, which affects the reliable small and medium enterprises as well. 1.1.3 Credit Rating Models

Credit rating has become one of the most focused areas of the financial industry due to recession and down turn of many economies in 2009. Various model of credit rating has been developed earlier, but most of them doesn't fit when small and medium enterprises come into the account; though now many of the new models have been suggested and developed, but still there is a lot of conflicts in those ideas. And, most of the models only fits in some special settings of any specific country, but yet there is no standard model for the credit rating assessment of small and medium enterprises. KMV model is one the example of such type of models, it's stands on the Merton Option Pricing Theory, and it works on the framework that the company would go default, when the liabilities would be higher than assets. This model was a good fit for some companies only, but when it was applied to the whole Chinese small and medium enterprises it...

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