Analysis of NPP’s proposal on a bank for small businesses
The National Peoples Power (NPP) has proposed introducing a new development bank which will provide young entrepreneurs with loans without collateral or guarantees. NPP Leader MP Anura Kumara Dissanayake stated this during an event held last September at Monarch Imperial at Battaramulla where it was mentioned that this will lend to small businesses without collateral
It is well known that previous governments tried twice to set up banks to lend to SMEs without collateral. First, the government set up Lankaputra Development Bank in 2006 for this purpose. The other attempt by the government to create a bank for lending without collateral was the establishment of the SME Bank. Both attempts became utter failures due to, inter alia, the following reasons: Incorrect lending model; Inexperienced and unprofessional lending officers; politically-appointed unprofessional top management; and political interference in lending.
Credit from the banking sector is an essential requirement for maintaining the existing level of economies and also to increase the level of economies globally. Investors in most developing countries who make long-term investments in productive enterprises face difficulties in accessing finance.
Lending by banks carries risks and hence banks demand collateral to mitigate risk of default. Banks demand collateral mainly due to following reasons:
1) Reduce the possibility in adverse selection – One of the problems that lenders face is that they lack clear information about the actual extent of risk a loan application contains. The lender has no information about the borrower to assess his creditworthiness. This is known as “asymmetric information. In such a case, collateral will reduce the risk involved in a loan application.
2) Reduce moral hazard risk – Misuse of loan proceeds: Another problem that the lenders face is, if the borrower uses the loan proceeds for purposes not stated in the loan application, which purposes may be riskier than the specified purpose in the loan application. In this case, the collateral obtained will compel the borrower to make repayments as specified.
3) Lessen losses - Collateral plays the function of compensation for the lender’s losses if there is a default in the loan payment by the borrower. In this situation, the banks or financial institutions can forfeit the assets put up as security and recover the amount by selling these off.
4) Lessen systematic risk - In the case of default of loan repayment, the bank could recover the losses by selling off the assets put up as collateral. If the collateral is sufficient to cover the loan’s total value, the lenders will not suffer losses. It is especially important for banks when they need to return funds to their depositors, as and when they want to withdraw their money. If the bank suffers losses and is unable to settle the withdrawal requests of its depositors, this might have knock-on consequences in the whole financial sector.
5) Need for Sustainability of lenders /lending programmes: If the NPP Government is to start a new development bank to lend to SMEs without collateral , the government will have to use state funds and loans obtained with government guarantees to capitalise the bank and un-collaterised lending programmes . The most essential requirement of a lending institution /lending programme is its sustainability and financial self-sufficiency.
6) Ensuring recovery of loans granted without collateral: As mentioned earlier, internationally and locally, development banks which lent without collateral failed due to non-recovery of loans resulting mainly from the usage of incorrect and inappropriate lending models. In designing a lending model for lending to SMEs without collateral, one aspect, the planners/designers should keep in mind is the behaviour of small borrowers in money matters. I have engaged in SME lending for more than 40 years in Sri Lanka and several other countries in Asia (Maldives, Cambodia and Bhutan), the Pacific (PNG, Fiji, and Timor Leste) and Africa (Lesotho and Somalia). Some of my observations during my career are:
- There is saying among bankers: “Before the money is given the borrower is at the mercy of the lender and once the money is given the lender is at the mercy of the borrower.”
- There are two types of defaults. One is willful default and the second is the defaults due to genuine reasons arising from business and cash flow difficulties of the business. My experience is that the majority of defaults on SME loans are willful. As bankers, we should always be helpful to the borrower if the default is due to genuine business reasons and be very strict with willful defaulters. If we allow a few borrowers to escape without paying and without any punishment, the majority who pay regularly will wonder why they should pay when others default, and they face no repercussion. This is known as “moral hazard” in banking jargon.
- Some borrowers when they get settled well in their businesses and start making regular income become greedy and feel like retaining money without honouring their commitments to the bank. They tend to think” why should I pay what I earned to bankers” if nothing adverse happens to him due to non- payment. When this happens the lender needs a mechanism to compel the borrower to pay. Some “arm twisting” is required to compel the borrower to pay if the default is willful.
7) The Grameen model of group lending and how it works: Most people in Bangladesh are poor. The banks demanded tangible collateral on borrowings. Most poor people did not have any tangible assets to offer as collateral, and hence borrowing from financial institutions was very difficult. Prof. Mohammad Yunus of Bangladesh produced a solution and introduced a lending model called Grameen Model of Lending. This is also known as Group Lending. Grameen Bank concept was born in the village of Jobra, Bangladesh, in 1976. Prof. Yunus began this model of lending. Grameen group lending means a lending mechanism which allows a group of individuals generally five people – often called a solidarity group, to provide collateral or loan guarantee through a group repayment pledge.
The Government needs to appoint a team of experts of development bankers to handle the establishment of the new Development Bank. This team could consider two options namely whether an existing bank like the Regional Development Bank (RDB) could be converted to implement the proposal or whether a new entity is to be established. If a new entity is to be created a detailed feasibility report must be prepared by the expert team.
(The writer is a banker with around 40 years of experience in SME and Microfinance banking with international experience.
He can be reached at lionel.somaratne@gmail.com)
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