Towards 'SAAF' SME-lending

Pakistan has a very low rate of commercial bank financing to SMEs. The sector received some attention during 2003-08 due to deregulation and privatization of banks; but high infection ratio in the aftermath of the 2008 crisis forced banks to restrict lending to SMEs. In 2016, SBP made half-hearted attempts to push banks by setting non-mandatory targets that saw little success. Lately, the government has lowered the taxation on SME lending by banks, but there is still no significant movement. Successes in SME lending during the last decade were confined to government (incumbent and past) schemes; however, banks remain reluctant to lend on purely commercial terms.

Now SBP has come up with a different approach through a generous scheme to lure banks towards SME financing. Recently, a circular has been issued on SME Asaan Finance (SAAF) scheme where the central bank has asked FIs to submit expression of interests (EoIs). SBP believes that not all banks are interested in SME lending and instead of forcing all FIs, it wishes to support those banks that express interest in building a robust SME portfolio.

Under SAAF, the central bank is offering both refinance and credit guarantees for three years - a unique model, as the global model is to offer either one of the two. Both incentives are available for working capital as well as term financing. This is a first scheme in Pakistan (outside exports) where refinancing has been offered for working capital.

The problem is that historically, local banks have approached SMEs through a conventional relationship-based lending model. The Relationship Manager (RM) based model works for corporate where loan ticket size is significant. It becomes cost inefficient for smaller ticket-size. For example, with a monthly salary of Rs 300,000 dealing with five group clients (average loan size of Rs1 billion) generates 3-4 times the revenue in terms of his salary. Against an RM for SME portfolio - with an estimated monthly salary of Rs 100,000 and dealing with 50 SME clients (average loan size of Rs 5 million).

For smaller loans, programme-based lending is the way to go. This is happening in the consumer sector in Pakistan where personal and auto loans are programme-based. In this model, features of eligible borrowers are well defined. Marketing people bring application, back-office processes these, and based on credit scoring model, a loan is generated.

SBP wants those banks that are willing and eager to lend to SMEs to adopt this model. For that to happen, these banks must invest into developing systems and hiring teams catering to the segment. This is SBP's justification for the liberal 8 percent spread allowed to banks; by providing refinancing at 1 percent and allowing them to charge up to 9 percent from borrowers. The higher spread has been offered so banks may be able to invest into IT and credit scoring systems and develop human resource - to move away from usual cookie cutter (suited booted, lazy RMs) approach.

Yet, it appears that the 'masterminds' behind SAAF believe that even the refinancing may not be enough, and banks would need additional credit cover to offer collateral free - a long-term dream for the central bank - loans. Thus, the federal government is forced to offer a credit cover of 40-60 percent of portfolio.

This sweet deal is a dream come true for banks, but risks create serious moral hazards. On one hand, banks will greatly benefit from the supremely cheap cost of funds - just one percent. Moreover, in a 5-year term loan (or a periodically rolled over working capital facility) the highly generous 8 percent spread allowed over cost of funds will allow banks to recover their principal invested within 3-5 years. On top of this, the fifty percent credit guarantee will make the risk adjusted return on SME credit highly luring, and may lead to risky lending behaviour. SBP would be wise to create safeguards against the same.

Coming to the details of the facility. The maximum loan size in the scheme is Rs10 million and is divided into three categories -smaller the size, higher the portfolio coverage - 60 percent for loans up to Rs4 million, 50 percent for loans between Rs4-7 million and 40 percent for loans ranging Rs 7-10 million.

These two factors - refinancing and credit guarantee-are likely to entice banks to venture into the segment seriously. One of the main issues for SMEs to get loan is lack of acceptable collateral availability, as banks ask for real estate in most cases as collateral. Though, lately, after establishment of collateral registry by SECP, banks comfort on lending to SMEs against pledge of plants and machinery has improved. Nonetheless, cash flow-based lending is still not popular at all.

SBP's objective is to increase penetration of cash flows-based SME lending. For that to happen, banks need to invest in technology to form credit scoring models. In the past, the experience of credit scoring based model to SMEs (by NIB-Salam banking in 2007-09) was horrible. There were designing flaws as decision making was assumed by branch and area managers, with managerial incentives aligned to the number of loans issued. These managers colluded with willful defaulters and created fake documentation. The result was mushrooming of bad loans. Though the bank extended loans to over 40,000 borrowers, within two years non-performing loans (NPLs) were around 25 percent.

Seeing the experience of NIB and overall SMEs NPLs (peaked at 35 percent in 2012), banks swayed away from SMEs. The banking SME portfolio was Rs 390 billion in 2008 which was 3.7 percent of GDP and 15 percent of total bank loans, and that shrunk to Rs 244 billion in 2013 and the latest number is Rs 438 billion as of June 2021 which is 1 percent of GDP - the ratio is one fourth of 2008.

Even the recent surge in SMEs - 2016 onwards, is mostly misreporting. With SBP pushing banks to lend to SMEs, banks are booking commercial and retail segment loans into 'M' within SME - by playing around with SBP's definition. Market intelligence suggests that in a few banks, SME portfolio recorded within banks is much lower than what is being reported to SBP.

According to SBP's data, currently Rs141 billion loans are extended to SEs within SMEs and the number of unique borrowers stands at 115,000. This implies average loan size of Rs1.2 million. That is too low a size. This means that legacy of bad loans -NIB, SME bank, and other banks, are still reported, as these are not written off of banks' books. Then the loans from government schemes are parked here as well - for example in 2017, 50,000 out of 177,000 SME borrowers were from government of Punjab's Apna Rozgar Scheme offered though Bank of Punjab.

Effective non-defaulted and non-GoP-backed SE loans (financed purely on commercial terms) are thus much lower. According to a study, in 2017 total SME borrowers (barring defunct SME bank's loans, NIB's bad, and Apna Rozgar Scheme) were 65,000. The number today may not be different. Excluding 20,000 MEs borrowers, the number of SEs could be around 45,000 today.

SBP wants that number to increase. According to the Deputy Governor SBP, SAAF scheme may create portfolio of Rs60 billion in three years. But the actual number will depend upon how much banks will bid in their EOIs. The informal talks with SBP and banks suggest that the interest of banks may exceed Rs100 billion. Assuming average loan size of Rs5 million, at Rs100 billion, 20,000 new borrowers can be added to the system. This may increase the existing effective borrowers by 40-50 percent.

SBP is expecting eight banks to participate in the scheme - two each in four categories - large, medium, small and any category of banks collaborating with fintech. It appears that more than eight banks are interested and a few fintech, including Haball and Finja, are eager to do partnerships. Even banks directly participating in schemes can have one of these two (or other) fintech as partners on their own behalf.

SBP expects banks to invest in systems where cash flow assessment and credit scoring models to develop based on big data being fed by these fintech or banks' own systems. By using technology, any possible collusion of branch managers (or credit marketing team) with the willful defaulters would be largely mitigated. Data will talk and walk.

Banks should take this opportunity as a wake-up call to move towards modern banking which is pivoting towards digital tools and efficiencies. To-date, irrespective of size, all banks have similar positioning. They are stuck with obsolete model of lending to government and big corporate. The modern reality is not sinking in as they addicted to easy money and easier profits. Shareholders are happy as well since management is roping in moolah year after year.

SBP hopes that SAAF will serve as a handholding exercise for three years and make banks accustomed to new realities, allowing them to move forward without clutches in future. Since banks are venturing into new segments (smaller loans to new class of borrowers), there could be a case of high NPLs in the beginning. The adequate risk coverage will be achieved through potential loss mitigation. Once, banks have developed systems and have experience of dealing with new category of clients, bad loans would reduce substantially, enabling banks to continue without SBP's help.

The scheme is for three years, but the risk coverage to continue in fourth year to cover the term loans originated in third year. Then the repayment of refinancing by banks will be split in ten equal installments in ten years after the completion of third year.

Ideally, the support should be extended to fintech as they are hoped to serve as pillars of future digital banking. However, SBP by law cannot provide refinancing to fintech. Here banks come into the equation. It is imperative for banks to do long term partnerships with fintechs as the experience of fintech suggests that with screened data lending, the actual NPLs shall be much lower. Some may provide additional coverage to banks if they are still shy from venturing into SMEs lending.

It is strongly urged that banks do not miss the opportunity of expressing interest in the SAAF scheme. The fintech companies need to be proactive in showing life beyond government lending to banks. If this experiment goes right, the lending landscape in Pakistan could change- and that may bring informal borrowers - paying high dividends, to the formal system.

Copyright Business Recorder, 2021