Ishrat Husain: SME financing - issues and strategies
Welcome address by Mr Ishrat Husain, Governor of the State Bank of Pakistan, at the Conference on
SME Financing: Issues and Strategies, Lahore, 10 May 2005.
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Mr. President,
Distinguished Guests,
Ladies and Gentlemen:
It is an honour for me to welcome you all and particularly Mr. President to this Conference on SME
Financing: Issues and Strategies. I wish to thank you Mr. President, Sir, for your continued support in
our efforts to develop a vibrant SME sector as an integral part of the poverty reduction strategy. You
have spelled out this strategy on several occasions very clearly and I would like to dwell upon it this
morning. But I would like to assure you that this conference is a modest contribution towards the
fulfillment of that strategy. I would also like to welcome our foreign speakers and wish them a pleasant
stay in our country.
The overall objective of the Conference is to bring together all the stakeholders in the SME sector to
generate debate on the issues confronting the sector and look at the various strategies being
developed at the regulatory and policy level to increase the flow of credit and financial services to this
very important sector of our economy. The speakers of this Conference will provide us with valuable
insight into main issues as well as some of the "nuts and bolts" of how to do SME finance more
profitably, as the State Bank is not going to force the banks to undertake lending operations which are
not profitable. The international speakers will share with us the best practices that have successfully
worked elsewhere and we can explore ways of adapting them to our own situation. Let me also remind
you that lending to SMEs, if developed and practiced on modern lines shall primarily remain a
profitable options for banks and can guarantee earning for banks at a rate higher than the lending to
corporate clients.
There exists strong evidence that SMEs expansion boosts employment more than large firm growth
because SMEs are more labour intensive. In Pakistan, the SME sector contributes 30 percent towards
the country's GDP, along with agriculture provides 90 percent of the jobs, accounts for 35 percent of
the value added in the manufacturing industry and generates 25 percent of manufacturing sector
export earnings ($ 2.5 billion). Given its huge potential for generating employment, the Government
has identified the SME sector as one of the leading sectors along with agriculture and construction
and housing which will spearhead its efforts towards generating employment to alleviate poverty in the
country within the framework of the Pakistan Poverty Reduction Strategy Paper.
While the sustained and long-term growth of the SME sector in Pakistan remains constrained by a
number of factors that include skills shortage, scarcity of capital goods, poor management, lack of data
on the sector, resistance to change and marketing difficulties especially for export-oriented SMEs; by
far the biggest problem facing the sector is the unavailability of adequate financing facilities. The
problem of limited access to credit for the SMEs is not exclusive to Pakistan as a recently conducted
World Business Environment Survey covering 4000 firms in 54 countries found that SMEs cited
inadequate access to finance as their primary constraint to growth. This sector is characterized by
information asymmetries; the creditors' search costs, information acquisition and processing costs
exceed the returns. Hence, there is risk aversion by the banks towards extending credit to small and
medium enterprises. It is relatively easy to lend to large corporates where the economies of scale,
published financial information, collaterals and creditworthiness parameters favour such types of
lending. As the small businesses cannot offer adequate collateral, the banks are unable to determine
whether the borrower possesses technical, managerial and marketing skills that will allow him to
generate adequate cash flows and repay the loan on time. The process of financial intermediation
therefore breaks down for the SME borrowers.
A sustainable solution requires that we take a more holistic view of this problem, instead of looking at
the issue of financing to the SMEs in isolation. A large number of players have to be involved in
contributing to the success of the SMEs. There are number of different stakeholders who have to work
together in a coordinated and cohesive manner to ensure that these market failures in case of SME
credit market are removed and the process of financial intermediation takes place. These include the
government and the regulatory agencies such as the Small and Medium Enterprise Development
Authority (SMEDA) and SBP, provincial and local governments, SME Bank and other commercial
banks engaged in SME financing.
First of all, the government and the regulatory agencies such as the State Bank of Pakistan need to
provide a conducive and enabling environment for SMEs to operate. This requires that the macro
economic policies are sound, the regulatory regime is supportive and the legal system is able to
enforce contracts and property rights. There ought to be a level playing field for both the small and
large entrepreneur and there is no preferential treatment for any particular class. In the past the SROs
were being used to favour certain individuals or tariffs were raised to protect selective groups or banks
loans were given to supporters of the ruling parties. In the past five years, however, these practices
have been done away and a level playing field now exists for all businesses - small or large - in the
economy.
The second player in this process is the Provincial and the local Governments. They have to allocate
and earmark land for setting up industrial estates and deliver the infrastructure facilities in these
estates. The economies of agglomeration dictate that if clusters of same industries are relocated in the
same vicinity the suppliers of raw materials and components, and providers of services and marketing
of output also move to the same areas. The logistics management and reduction in transportation cost
reduce the unit cost of production and distribution for a single enterprise and also improve the
reliability and timeliness in the delivery of products. In many countries such zones and clusters have
worked very well and helped small and medium enterprises to become more competitive.
Thirdly, organizations such as SMEDA have to play a critical role in the business developments
support, advisory services and managerial training of SMEs. For example, most small enterprises do
not maintain proper accounting of their operation and do not have a trained accountant on their staff.
This impedes their ability to access credit from commercial banks. SMEDA can organize training
courses in accounting and assign these certified trainees to work on a part-time basis with a number
of enterprises. Simple accounting software packages are now available for small businesses and
these can be profitably used in a large number of SMEs. SMEDA can design simplified standardized
book keeping, inventory management and ledger forms which can aid in the preparation of financials.
The SME Bank, which was established in the public sector in 2002 to provide financing to the SME
sector, is another important player in the sector. However, it alone cannot cater to the needs of the
entire sector but it could develop a prototype of program lending, credit appraisal and delivery
methodology, standardized documentation, monitoring mechanisms, which can be replicated and
followed by other commercial banks. The SME Bank can produce experienced and skilled
professionals who are specialists in the SME credit for the whole industry.
The commercial banks, leasing industry, modarabas themselves have to develop dedicated groups for
servicing the SMEs. They should establish their presence and branches at the clusters and places
such as Daska, D.I.Khan, Wazirabad, Khairpur, Kotri, Gwadur which have large untapped potential. If
the SME branches of the banks remain limited to a few big cities you will never be able to make a
profitable business out of the SME sector. The balance sheet, cost of funding, the geographical
spread do confer a big advantage to the big banks and if they do not make innovative use of
technology, skills, systems and procedures to capitalize on this advantage they will soon be
marginalized by the intrusion of more agile and nimble small private banks. The banking industry has
to invest in people, processes and systems to minimize their risks and enhance their returns on the
SME segment.
Besides banks and DFIs, Leasing Companies and Modarabas are also the right vehicles for delivery of
credit to the SME sector. Unfortunately with the exception of one or two leasing companies they have
limited their activities so far to large urban areas and have not opened up their doors for business in
those cities and towns where the clusters of SMEs do exist. As they face tough competition from
banks in leasing business, it is expected that they would diversify both in product lines as well as in
geographical coverage.
Lastly, there is a widespread network of technical and vocational training institutes and polytechnics
throughout the country. Those who graduate from these institutes are unable to find suitable
remunerative jobs. On the other hand, the SMEs lack adequate technicians and trained manpower
who have the requisite skills to help them in the production of their goods and services. Thus, there is
a mismatch between the demand and supply of this type of manpower. The provincial governments
who own these institutes should examine the contents and curriculum, pedagogical tools, evaluation
and assessment procedure, incentive structure for the faculty members and bring about the necessary
changes to align the supply of the graduates with the emerging needs of the SME sector. Synergies
can be generated if some of the institutes are located in the clusters and apprenticeship and internship
programmes are instituted to give practical hands-on training to the students.
SME financing and SBP - achievements and strategies
In recent years, the SBP has reviewed its own role to determine whether or not it was creating any
hurdles in the way of lending to SMEs. We found out that the same prudential regulations which were
applicable to corporate borrowers were also made applicable to consumer, SME and micro finance
although the requirements were different for each market segment. We therefore decided to formulate
a separate set of regulations for SMEs, which were developed after extensive consultations with the
SME Associations, SMEDA, provincial departments and have been in force since January 2004. With
the enforcement of these regulations a number of constraints in SME financing have been removed
and the banks now in a better position to disburse loan to SMEs without fear of violating the prudential
norms. The new prudential regulations for SMEs do not make it mandatory for banks to require
collateral but allow them to take into consideration asset conversion cycle and cash flow generation as
the basis for loan approval. We would be willing to further improve and strengthen these regulations if
any practical difficulties arise in their implementation.
The SBP has geared up its efforts towards providing policy advice to relevant stakeholders in the SME
sector especially the banks/DFIs. For this purpose, a separate SME Department has been recently
established in the SBP, which will organize itself internally to respond to the financing needs of SMEs
by inducting skilled manpower and training of younger staff. The newly established department is
tasked with creating a conducive macro-prudential environment for banks/DFIs to increase the flow of
credit to SMEs; to promote a strategic focus on SMEs on the part of the banks/DFIs and to help
banks/DFIs adopt best practices in the development of their SME business lines.
Our short-to-medium term strategic plan also envisages Financial Sector Deepening and Broadening
of Access to formal sources of finance by the SMEs as one of our top priorities for the next five years.
For the SMEs, as an initial step, delivery of credit by banks will be monitored and
intermediary/technical support organizations will be encouraged to assist the SMEs in preparing
bankable proposals. In the medium term, the staff of the banks will be trained in program lending. SBP
will also endeavor that a guarantee scheme is established by the Government of Pakistan (GoP) to
share the credit risk of the financing banks. To pursue this strategy, close coordination will be
established with the SMEDA.
The SBP is also expanding the scope and coverage of its existing on-line Credit Information Bureau by
including all loan amounts. This database will be a powerful tool for all the banks and financial
institutions in mitigating risks in lending to SMEs. Under the framework of our strategic plan for
2005-2010 we will also explore the possibility of allowing the setting up of private sector credit bureaus
that will incorporate a lot more information on credit history and behaviour of borrowers.
The State Bank, with the help of ADB's SME Sector Development Program, will also provide capacity
building support to a select group of banks for SME lending including SME Bank. This project will
revitalize the SME lending by the participating financial institutions and will be a prototype for other
financial institutions who could see financing to SMEs as profitable business ventures.
The SME Bank is being restructured under the SME Sector Development Program of ADB making it a
viable Bank catering to the needs of SMEs in the country. SBP has also issued a commercial banking
license to SME Bank. We hope that SME Bank would take a lead in developing innovative lending
technologies and program lending tools where standardized credit scoring methodology may be used
for each sub-sector rather than always relying on the current method of scrutiny and appraisal of each
individual proposal. The present methods and documentation are onerous for small entrepreneurs and
relatively costly for the banks. SME Bank has to experiment and come up with the standardized set of
easy to fill but fully informational documentation, specification of risk parameters, credit appraisal and
delivery techniques.
Today, most big industrial establishments depend on SMEs for their value addition. It is on record in
most emerging markets that the fastest growing export industries (cotton weaving, textiles, surgical
instruments, carpets, leatherwear, etc) have been dominated by SMEs. Thus, SMEs have played very
significant roles in reducing the poverty levels in many developing countries. Emphasis has been
placed on pro-poor growth led by the private sector especially through SMEs. Sectors such as
agriculture, services, manufacturing with heavy content of labor-intensive activities have received
much support by the Governments because of their potential for reducing poverty. These countries
have also successfully integrated their SMEs with the large corporate sector through sub contracting.
Sub contracting by the large firms has proved to be an extremely useful and efficient way of integration
across the size and scale. Automobile industry provides an excellent example of this business model
whereby 60-70 percent of the components and parts in the manufacturing of cars and 90-95 percent in
case of motorcycles are provided by small vending industry. A vast network of showrooms and service
stations again owned by small entrepreneurs are the example of forward linkages between the large
manufacturers and SMEs. This model can be replicated in case of other industries also. This will
ensure that both the large manufacturing and SME sectors grow organically through the forces of
interdependency. There is no substitute for economics of scales and the SMEs due to smallness of
their size cannot excel in it and harvest its benefits. This makes their integration with the corporate
sector more vital. I would urge upon the SMEDA and other government sector organizations involved
in the SME policy formulation to take up this challenge of integrating SMEs with the corporate sector.
Let me conclude by restating the fact that SMEs will continue to play a very important and vital role in
our economy where the twin problems of unemployment and poverty constitute major development
challenge. Well targeted government intervention in this sector remains indispensable provided such
interventions do not displace the private sector. Given the quality of participants in the conference, I
am convinced that useful policy recommendations will emerge at the end of the different sessions. I
thank you Mr. President once gain for vision and leadership in the economic revival of this country and
your personal support to the State Bank of Pakistan. I look forward to your guidance in creating an
enabling environment for the promotion of SMEs in the country.