—the real constraint with small business financing is more of a financial market problem
Today’s article is inspired by the concerns raised in the press a few weeks ago by the Small Business Bureau (SBB) in an article carried in the print media titled, Commercial banks’ squeeze on small business lending strangling entrepreneurial ambitions, job creation.
Commercial banks are naturally risk averse because they are deposit-taking institutions – thus, having the responsibility to protect depositors’ funds, which means they have to engage in prudent lending. Compounding the situation in which access to financing is apparently difficult for small and medium-sized enterprises especially; it is not necessarily the inherent nature of the commercial banks per se, but rather, a series of limitations with respect to the businesses themselves and by extension the management and owners of the said enterprises – so it can be regarded as twofold.
In the conduct of credit assessment, a borrower needs to fulfil certain qualifying criterion before the decision to approve a loan is made. One of the primary requirements in this process is collateral, and in many instances, this is one of the main limitations – lack of adequate and tangible collateral. Instantly, this may be a deterrent – much to the disadvantage of the prospective borrower.
It must be noted, also, that having healthy collateral is not always a decisive factor in the loan approval process. The more important decisive factors in this regard are premised upon the borrower’s ability to repay – debt servicing ability, and, this other element might sound surprising – but in reality – the most crucial of them all is the borrower’s willingness to repay.
With experience over the last 25 years or so, bankers have recognised that borrowers are not disciplined as they were for the period prior to 1992. This is undoubtedly one of the key reasons loans are consistently in arrears and also non-performing in some cases. This notion hinges on the fact that there has been, over this period, a paradigmatic change in the socio-cultural construct of the market within which the banks operate – that is, the customers.
In respect of the technical limitations of businesses, most small and medium-sized firms lack crucial expertise in the industry within which they operate; such as, sound financial management practices, and particularly, cash flow management. These, therefore, inevitably disqualify such entities from accessing financing through the commercial banks.
The problem of access to financing is not so much an interest rate problem or cost of capital. The broader problem about access to capital is not because of commercial banks: it is because of Guyana’s underdeveloped financial system. It is important to understand and acknowledge that commercial banks are inherently different in their structure. They are not designed for microfinance. Commercial banks do, in fact, help and contribute to some extent, but micro financing is usually risky.
If at all the notion of “notoriously high” interest rates hold any merit as posited in the referenced article, which it doesn’t hold much in this author’s view, then institutions like the Institute of Private Enterprise Development (IPED) would have been a failure today.
IPED was founded specifically for the purpose of microfinance and it is doing extremely well today. To this end, one ought to therefore pause to examine the structure of IPED. Ironically, if we want to talk about notorious interest rates then guess what is IPED’s on microfinance? 20-30 % in some cases. Of course IPED’s interest rates are reflective of high risk nature of such businesses and poor collateral. Commercial banks’ interest rates are way below that. Now, in terms of IPED’s structure, the way they operate is to take a hands on approach to help their clients manage their business, extensive field work and they even have training programs for their clients. Commercial banks don’t do this and they don’t have the incentive to so do.
Another important factor with IPED’s structure is that they hold anything from household effects to cars, or any asset as security which the banks cannot do because of the Financial Institutions Act. The contention is this: if we want to deal with the issue of microfinance, that’s not for commercial banks, we need more microfinance institutions like IPED, and this comes right back to capital market development. Moreover, IPED’s financing structure that is, the source of its financing is different from the commercial banks. Meaning, it is not a deposit taking institution, its capital is actually shareholders money and it reinvests its profits. Unlike the commercial banks which take savings from ordinary people (householders) and firm. So the source of financing and the way microfinance institutions versus commercial banks are designed, are all different. The SBB is therefore suggesting that commercial banks should in effect function as a micro-finance institution and that of a venture capital firm. Unfortunately, it doesn’t and cannot work like that. Commercial Banks can’t take the savings from householders and lend it as it like. It has to be done very prudently.