One of the first steps any business must take in order to gain funding from a bank is to obtain a credit risk assessment. No real assessment model exists for SMEs and alternative models are expensive and often discriminatory. Serov Vasiliy, Credit Controller, KN Ibrakom and Dr. Dayanand Pandey, Head of Finance and Banking Program, British University of Dubai (BUiD), talk to Mike Byrne about how this process can evolve to better serve SMEs.
In the UAE in 2009 there was a decree passed whereby the minimum capital requirement for setting up a business was abandoned in order to try and encourage more business growth – it had been originally set at AED 150,000 but there has since been more flexibility with the removal of this price cap.
This has undoubtedly had a positive effect and statistics will show that generally the SME sector has accelerated its drive out of the recession faster than other larger businesses. However, at the core, financing concerns for SMEs seems to rest within the same repetitive vicious circle.
SMEs are reluctant to approach credit risk assessment agencies and banks because of the cost. So, if they can’t afford to go through this rating process then this will have a knock-on effect as banks will often not consider an application without the credit rating first. “What you then have is this gap between the one who wants to borrow and the one who wants to lend – there is nothing in between to assist with the smooth transition from one to the next,” says Serov Vasiliy.
As it stands, the procedural formula for credit risk assessment can also vary according to agency or bank you approach. With the existing Altaman model, which is used in many developing countries and emerging markets, there is an equation used, whereby certain data is extracted and a ratio is calculated and a score set. The problems with using this model for assessing an SME are wide–ranging.
“This score defines whether a loan will be given or not. It can be quite discriminatory in nature, especially where SMEs are involved because their data is neither complete, audited nor integrated and so they are, from the outset, at a disadvantage. The SME may indeed have some of these financials in place and maintained but the quality then comes into play. Information asymmetry is one of the main deterrents when it comes to the bank extending money to SMEs,” says Dr. Dayanand Pandey.
There have been suggestions in recent years that new models for assessment are needed where SMEs are concerned. Instead of strict objective formulas based on rather complex algorithms, something much simpler and more subjective, for a case-by-case analysis, would better serve justice for the smaller business.
“Assessing SMEs based on the potential of default is just not realistic because there is often no market data by which to base an SME’s ability to remake payments. The large majority are not listed, are not trading and so the information is not freely available,” says Serov.
Serov and Dr. Pandey stress that practices are often determined by regional factors, whereby loans and credit extensions are granted by banks to SMEs that are “known”.
“What we see in this region is the banks’ lending to some SMEs based on whether they are well known; if they are then a loan or credit extension may be afforded to them and with a lower interest rate. If you are unknown then the interest rate will be much higher. Not only will interest payments be higher, but the conditions attached will be much stricter and this will impugn the versatility of the SME even further,” says Dr. Pandey.
And what are the short and long term affects of a much higher rate of interest and more restrictive covenants attached to the loan? “The business model and the day-to-day operations can then get disturbed. Therefore, what the lending institutions are essentially doing is driving the SMEs into a situation where defaulting on payments becomes almost inevitable,” says Serov.
What is clear from this discussion is that the existing models cannot possibly continue to partially serve the SME sector. A new model must be introduced that is not only cost effective, but also easily understood by the banks, assessment agencies and the SMEs. It is often the case that managers will simply not adopt models for assessing SMEs because they find it them hard to understand and to enforce.
“What is advisable is that a government entity step in to fill this void and assess what is needed to bridge the gap – they have the necessary local resources and knowledge to help with the situation. It’s all about creating a confidence for the banks and for this to realistically happen the system needs to step in and help. In conjunction with setting up this rating agency, if projects in certain sectors could be allocated to the SME sector, for example food and beverage and certain types of construction,” says Serov.
However, both men are quick to point out that the area of credit risk assessment cannot be judged as simply placing it in the hands of the public sector over the private sector – one has to naturally compliment the other and where the public sector agency differentiates itself is by providing the assessment at a reduced rate. It is then up to the SME to choose where they receive their rating.
“A central warehouse or database needs to be established by the governments in this region. This could be fed through multiple channels and help establish an effective rating agency where everything is funneled into. Here in the UAE the central bank is pushing for this credit bureau, so that things can be monitored. It been introduced for consumer loans, where tracking is in place for personal loans, but as yet has not been followed through for SMEs,” says Dr. Pandey.
Considering the SME sector constitutes over 85% of the businesses in the UAE, contributes over 80% of the GDP and is responsible for close to 70% of those employed, the establishment of such a governmental agency would seem justified. Having such an influential impact on economy growth, it has also been suggested in recent years that banks should allocate 20% – 30% of their loan funds to SMEs.
Indeed this idea had been discussed prior to the economic recession but the subsequent downturn means that it was sidelined and not seen as a pending priority. But as the SME sector continues to accelerate faster than larger businesses out of the downturn, perhaps it is time to revisit the idea in order to not only continue recovery, but also to ensure future growth.
So how does one persuade banks to cooperate with any government initiative of this nature? “The Basel Committee has proposed improvements to the Basel II Framework concerning internal value-at-risk models. It has further aligned the language with respect to prudent valuation for positions subject to market risk with existing accounting guidance. As present, the standardised regulations under Basel are not due to be enforced for quite some time in this region,” says Serov.
What will persuade the banks to change their methods of assessment is forward thinking says Dr. Pandey. “It would be a great benefit if the banks here started to formulate better credit risk assessment formulas, which fall under the regulations of the Basel II agreements, ahead of schedule – it would make any future transition easier for the banks and for SMEs,” he says.
Serov Vasiliy is a finance specialist, holding an MSc in Finance and Banking Degree and is currently employed as Credit Controller by KN Ibrakom FZCO, part of Kuehne+Nagel Group.
In 2003 he received a Diploma in Economics and completed BSc in Economics Degree in 2005 with London School of Economics and Political Science.
This year Serov graduated with distinction from British University in Dubai and obtained MSc in Finance and Banking Degree, offered in collaboration with Cass Business School.
Dr. Dayanand Pandey is currently Head of Finance & Banking program at the British University in Dubai (BUiD), Honorary fellow of the University of Birmingham, UK and Consultant-Risk & Training at Bank Melli Iran, UAE.
Prior to the BUiD, he was Head of Risk Management &Training at Bank Melli Iran (BMI), Regional Office in Dubai.
Previously, he has worked as the Coordinator Master of Applied Finance and Banking Program with the University of Wollongong in Dubai and as a senior lecturer at the Emirates Institute for Banking and Financial Studies in Sharjah, UAE.
Dr. Pandey has published a number of books and scholarly articles in journals .He has authored a book on Managerial Economics published from Pearson Education, Economic Environment of Business and Risk management from Excel Publications.