This is the challenge of providing SMEs greater access to financing --- we have to change the way people think.
In this particular instance, the mindsets of both the borrower and the lender must be changed. Without the change in mindset, SME lending will remain to be collateral oriented and will be biased towards those who have collateral to the detriment of profitable and promising enterprises.
We say this because we ourselves have come to a change in mindset since we started using risk-based lending technology in extending credit to SMEs.
First, let us discuss what risk- based lending is all about.
Risk-based lending is a system of lending to SMEs that is based on an accurate assessment of credit risk in which the loan package i.e. loan amount, interest, and term, is determined and influenced by the credit risk level of the enterprise, specifically the quality of the borrower and the debt repayment capacity of the enterprise. In this type of lending, collateral is not a determinant of loan approval, but impacts on the pricing of the loan. More importantly is the quality of the borrower and his capacity to repay the loan. Under this system of lending, the lender is able to assess, price, and manage the credit risks to ensure repayment.
Risk-based lending requires the use of a credit risk rating tool. In SBC, we have a Borrower Risk rating tool which we call CAMP analysis because in it we examine the Cash, referring to the financials of the enterprise, the Administration, referring to the quality of management, Market, referring to the buyers of the products, and Production, referring to the capacity and efficiency by which the enterprise produces and delivers its products and services.
Using the BRR helps the lender come up with a risk rating of the borrower and with this rating identify its competitive advantages and its weaknesses or areas of risk. Our BRR is a 10 grade rating system with 1 as the least risky and 10 is the most risky. On this basis, the lender knows beforehand the quality of the borrower and decides to lend or not on this assessment of credit risk.
With the use of the BRR, the lender will know how “real” the business is, or how honest the borrower is in his declarations about the enterprise. So borrowers beware about the truthfulness of your declarations and disclosures. Using the CAMP analysis, the AO will surely uncover irregularities including fraud if not fully disclosed by the borrower.
In addition, the lender has identified the sources of loan repayment, and knows whether or not the borrower can repay the loan.
In this system, no amount of collateral can influence the lender to lend to a bad borrower unless, the lender has decided to accept the risk of non-repayment and has provisioned the account for eventual losses. Or he has priced the risk of lending to a bad borrower. In this system, the higher the credit risk, the higher the interest rate (pricing it right) and the stricter the loan covenants (monitoring the business and mitigating the risk).
While in risk-based SME lending lenders are able to manage credit risks well and may lend to all types of borrowers, there are certain non-negotiables such as: 1.) if the risk is so high for both BRR and FRR that it cannot be priced, then the Bank should not grant the loan at all; 2.) If the credit risk cannot be mitigated, don’t finance; and 3.) Do not lend if borrower does not have debt servicing capacity.
The last condition is the most important of all because debt servicing capacity will decide whether the enterprise will be lent how much and for what purpose. The DSC is not based on forecast and projections but on the current state and historical performance of the enterprise. The lender will know whether the borrower, as it operates now, will be able to repay the loan given its present income.
It is a change in mindset because using the technology will destroy all our traditional thinking and practice in lending to SMEs. While many of us will think this is revolutionary--- it is not. Many of these changes are actually reflection of good banking practices on the part of the lender.
Here are some examples of this new mindset:
• Collateral should be from the assets that were the object of financing
It is not bad to require collateral or security for the loan, but it should not be beyond what the loan is financing. Requiring REM or hard collaterals has no direct relationship with low probability of default. Whatever it is that is the object of financing is good enough to secure the loan. If the loan is for working capital, then ARs or inventories would suffice to secure the loan. These assets should then be closely monitored to forewarn the Bank of any problems which may be encountered by the SME and which may hamper loan repayment.
• Equity, not loan, should finance expansion
In general, this principle means that if the SME does not have enough capital, then it cannot support an expansion program. Expanding the business may be ill-timed if it cannot support the expansion from its net income and from equity. Banks are ill-advised if they grant a loan for project financing without looking at how the SME will be able to repay the loan from its existing level of operations. In these instances, the Bank should evaluate the SME’s present equity and DSC levels and their projections and make sure that the repayment for the loan can be financed from its equity and DSC. Ideally, according to this principle, project expansion should not be financed by a loan, but rather by equity.
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• REM as collateral does not necessarily prevent the occurrence of default
Unknown to many of us, but shown by studies on Banks and their loan portfolio in developed countries, it is a fact that REM as collateral does not mitigate the occurrence of default, nor does collateral have any correlation to default. Default is a function of debt servicing capacity of the borrower not the loan value or quality of the collateral. It is by this fact alone that the absence or lack of collateral should not hinder the SME from accessing credit for its growth. In fact a culture of collateral oriented lending contributes to the failure of most SMEs.
• SMEs should not be overtrading
Always look at the sales trend or its movement over a series of time periods. Normally, sales should only increase at a rate of about 10 percent. A steep climb (if increase is more than 50%) will always mean possible overtrading on the part of the SME.
Overtrading means a situation in which a SME is growing its sales faster than it can finance them. This usually leads to enormous accounts payable or accounts receivable and a lack of working capital to finance operations. SMEs may service larger orders only if it has the equity to support these orders.
A common scenario is for the SME to take the orders and try to squeeze its suppliers because it does not have the financing or the equity to support sales expansion. When this happens, the suppliers may stop supplying the SME.
And the SME is in trouble because it not only cannot meet its orders, but could not pay its creditors as well.
It is an established fact that 60 percent of all bankruptcies in U.S. and Canada are due to overtrading.
• Don’t finance expenses; only assets
This principle simply means that before we finance an SME’s needs, be it working capital or fixed asset, we must first look at the whole enterprise and see if it has enough assets to generate the net income that would serve as source of repayment. Does it have enough inventories? Recievables? Is it an operating concern? These questions when answered in the affirmative assures the lender that it is financing a business and not just any want the borrower needs to satisfy. It is also important that the Bank will not finance on the basis of expenses because these are supposed to be paid from the revenues of the business, not from a loan. The Bank should only lend on the basis of assets used to generate income for the SME; never expenses.
• Finance the business, not the transactions; Restructure the business, not the loan
This principle is really about looking at the big picture of the business, or getting the “global” view of the SME when financing, restructuring, or rating the SME. When financing, do not focus on the transaction alone. We need to look at the other aspects of the business most especially, its assets whether they are the kind that can generate the net income needed to repay the loan. Or in restructuring, see if the business can still generate enough business to meet the restructuring requirements. Don’t just focus on the loan amount and how this can be restructured to the benefit of the borrower. The most important point is whether the business as a whole can continue to exist and see the restructuring to the end. If in both instances, when the answer is in the negative, then easily, we should decide against extending or working out the loan. The situation in this case should be to focus on recovery and collection.
While risk-based lending technology is new to SBC and has been used for about three years, we can say that it has a positive impact on our past due ratio. In short, using risk-based lending has significantly reduced our past due ratio. It has also enabled us to make our pricing and our product features more responsive to risks. This has made financing more accessible to SMEs because collateral is no longer a determinant of whether to approve a loan or not.
While lenders must have a change in mindset, borrowers will have to make the same adjustments in the way they think. They must understand that this technology will weed out the fraudulent borrowers from the true entrepreneurs. And this will require their utmost cooperation when the AO will insists on the submission of records and documents pertaining to their operations. Or when the AO will have to ask a lot of questions about the business and do frequent project visits. The borrower must realize that these things are part of the evaluation and risk rating and management process, and it is only this way that more of them (SMEs) will be able to gain access to credit.
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