REVIEW OF SME CREDIT POLICIES AND PRACTICES. Emerging Collateral Practices in Countries with Reformed and Unreformed Secured Transactions Frameworks

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1 REVIEW OF SME CREDIT POLICIES AND PRACTICES Emerging Collateral Practices in Countries with Reformed and Unreformed Secured Transactions Frameworks The International Finance Corporation, Small and Medium Enterprise Department December, 2006

2 The findings, interpretations, and conclusions expressed in this work are those of the authors and do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments of the countries which they represent. The information in this work is not intended to serve as legal advice. The World Bank Group does not guarantee the accuracy of the data included in this work and accepts no responsibility for any consequences of the use of such data. Acknowledgments The preparation of this study was led by Alejandro Alvarez de la Campa, from the Small and Medium Enterprise Department of the World Bank Group. The content of the study was developed jointly with Robin Bell, an international consultant and banking expert. We are grateful for the comments and review provided by Gilles Galludec, Matthew Gamser, Tom Jacobs, Ary Naim, Sevi Simavi and Murat Sultanov from the International Finance Corporation; Aurora Ferrari and Adolfo Rouillon from the World Bank; and Martin Holtmann from CGAP. Final Draft: November 4, 2006 Page 1 of 50

3 TABLE OF CONTENTS EXECUTIVE SUMMARY 3 I. BACKGROUND 6 A. OBJECTIVE OF THE STUDY 6 B. DEFINITION OF MARKET SEGMENTS 6 C. COUNTRY SELECTION 7 D. COMMERCIAL BANK CREDIT TO PRIVATE SECTOR IN SELECTED COUNTRIES 8 II. INTRODUCTION: IMPORTANCE OF COLLATERAL IN SME LENDING 10 A. DOES COLLATERAL REALLY MATTER? 10 B. POWER OF COLLATERAL 11 III. GENERAL CREDIT POLICIES AND PRACTICES OF FINANCIAL INSTITUTIONS _ 13 A. CREDIT PRODUCTS 13 B. CREDIT EVALUATION APPROACH AND GUIDELINES 15 C. COLLATERAL POLICIES 19 IV. FI S PERSPECTIVE: KEY ISSUES IN SECURED TRANSACTION FRAMEWORK 32 A. PERFECTION OF SECURITY INTERESTS 32 B. ENFORCEMENT OF SECURITY INTERESTS 33 V. CONCLUSION: EMERGING FI STRATEGIES IN SME LENDING 36 APPENDIX I: LEGAL ORIGINS 40 APPENDIX II: REFORMED SECURED TRANSACTION SYSTEMS 42 APPENDIX III: INTERVIEWS 43 BIBLIOGRAPHY 48 Final Draft: November 4, 2006 Page 2 of 50

4 EXECUTIVE SUMMARY IMPORTANCE OF COLLATERAL IN SME LENDING In the past, collateral based lending was common in many countries and to some extent, such practices still exist. However, prevailing lending practices in a diverse group of countries confirm that during the credit evaluation process, the primary focus of FIs is on the SME s capacity to repay the loan (cash flow) and the SME s character. Though collateral is an evaluation criterion included in the 5Cs of credit it is of secondary importance. Notwithstanding its secondary importance during the evaluation process, collateral does have great importance because collateral is typically considered a condition precedent in loans of any material size (an estimated 70% or more of loans). It is commonly believed that SMEs can t access finance because they don t have adequate collateral. In reality, SMEs do have assets which could easily be used to secure loans movable assets such as the goods produced or processed by the enterprise, the machinery used in the manufacturing process, present and future accounts receivable from clients, intellectual property rights, and warehouse receipts. In some countries these movable assets are excellent sources of collateral. However in most countries, real estate is the preferred collateral; specifically identifiable movable assets such as machinery, equipment or vehicles can in some cases serve as collateral. COMMON CREDIT POLICIES AND PRACTICES OF FINANCIAL INSTITUTIONS Most FIs around the world have reasonably competitive credit products for consumers (e.g. salaried employees); microenterprises and SMEs. When collateral is offered, larger amounts, longer terms, lower interest rates are provided. Whereas the principles of good credit are the same for corporate, SME and micro lending, the approach to successful micro and small business credit is fundamentally different from traditional corporate banking or lending to medium sized business which frequently uses modified corporate banking approaches. In OECD countries many FIs use statistical scoring models which are heavily based on credit history to approve and price smaller consumer and business credits. For larger business loan amounts, additional information is required (e.g. financial statements, pro forma cash flows and tax returns) to perform a more thorough cash flow analysis; business scoring models are commonly used to support this process. In emerging markets, increasingly FIs are using judgmental scoring models to evaluate a business credit application. Such scoring models utilize data from the business balance sheet and income statements. They rarely include significant credit information on the business or business owner aside from the business history with the FI. Although FIs correctly prioritize the valuation of the SME s capacity to repay (cash flow analysis) and creditworthiness, collateral is a condition of most loans. Collateral policies of many FIs in the unreformed countries (or countries with recent reforms not yet fully implemented) still tend to be restrictive, both in terms of the types of assets that are accepted as collateral and the loan amounts visà-vis the market value that FIs are willing to offer. The reasons for this are generally attributable to factors external to the FI and beyond its control, namely: differing risks associated with the enforcement of the security interests by asset type; marketability of the collateral; and prudential norms relating to loan loss provisioning. In countries with developed secured transactions frameworks such as the U.S., Canada or New Zealand, FIs are willing to accept as collateral the full range of movable assets to secure SME credits. In the other OECD countries, regardless of legal origin, FIs accept movable assets such as machinery, equipment and Final Draft: November 4, 2006 Page 3 of 50

5 vehicles because such assets can be specifically identified. However, such is not the case for generally described, present and future accounts, intellectual property and so forth. The recently reformed secured transaction systems of Romania and Bosnia & Herzegovina permit the pledging of the full range of movable assets. While preferences for real estate as collateral persist for loans in excess of $36,000 ( 30,000), financing of tangible movable assets (e.g. machinery, equipment and vehicles) has become much more widespread. Pledges of future and fluctuating assets (e.g. inventory, accounts receivables, etc.) are typically not yet accepted as primary collateral, but are accepted as additional or supplementary collateral. The lack of this type of financing appears to be common in a number of recently reformed countries, not just Romania and Bosnia. In unreformed countries like Kenya and Tanzania, the overwhelming majority of SME credits are secured by cash or real estate, whether the loans are for working capital or investment purposes. Even though FIs frequently finance the SME s working capital requirements (e.g. for inventories, accounts receivable, and so forth) or equipment purchases, they are unwilling to accept such assets as primary collateral. Movable assets, including machinery, equipment and vehicles, serve only as additional or supplementary collateral and no value is typically assigned to such assets. The exception is micro loans (less than $15,000) that are secured by non-traditional collateral and/or machinery, equipment and vehicles. Notwithstanding the above, some asset finance is available through leasing/hire purchase agreements. Loan to value (LTV) ratios tend to be much higher in countries with legal reforms and secondary markets for assets pledged as collateral. In the U.S. LTV ratios on SME credits tend to be in the following ranges: Commercial real estate: up to 80% of market value Vehicles: up to 100% of purchase price or blue book value Equipment: up to 80% of purchase price or 50% net book value, in the case of refinancing Accounts receivables (less than 90 days): up to 80% Inventory (or work in process): up to 50% of book value Although SME credits based on the asset value of accounts receivables and inventory is rare across many of the OECD countries as well as other countries with reformed secured transaction systems, financing for real estate and movable assets such as machinery, equipment and vehicles is available in similar proportions. In unreformed countries the LTV ratios tend to be comparatively low, due to the time and expense associated with enforcement of the security interest and the lack of a secondary market for such assets. In Kenya and Tanzania FIs typically lend against the forced sale vale (FSV) which tends to be substantially below market value. As a result, the loan to market value can be as low 20% and as high as 70%. The borrowers that access the higher LTV ratios tend to be those that have a good credit history with the FI or those that provide additional collateral such as chattel mortgages or charges against their business assets. LTVs on the acquisition of vehicles, machinery and equipment trough leasing or hire purchase agreements are higher to the extent that the cost of recovering leased asset is lower. FI S PERCEPTION OF KEY ISSUES IN SECURED TRANSACTION FRAMEWORKS Though a comprehensive secured transaction framework is desirable, the difficulty in perfecting and enforcing security instruments (e.g. seizing, storing and selling collateral) in a timely and cost effective manner was unanimously cited as the key constraint to increased SME finance. Final Draft: November 4, 2006 Page 4 of 50

6 EMERGING FINANCIAL INSTITUTION STRATEGIES IN SME LENDING Relationship Management. The key strategy adopted by FIs is to develop a total banking relationship one based on reciprocity with the SME customers. The credit relationship grows gradually over time as the SME demonstrates both its capacity and willingness to repay. Most FIs don t just want the credit relationship, rather they also want the deposit account. Leasing. One FI has recently started to experiment with a new leasing program for both new and used equipment. Its approach to recovery is essentially to get the landlord s written approval up front allowing it to enter the premises to seize the equipment so that judicial action will not be required. Though it is too soon to know if this approach is indeed viable (no defaults have yet occurred), the vast majority of SME s business premises are leased, so the cooperation of the landlord could conceivably facilitate expedited recovery. Mix of Movable and Immovable Collateral. The more aggressive FIs that take inventory, accounts receivable and so forth as supplementary collateral for SME credits, actually assign a value to such collateral. In such cases, traditional collateral (real estate, machinery, equipment, vehicles, etc.) tends to cover at least % of the loan, but the inventory for example, provides the remaining margin of coverage (e.g % of the loan). FIs that operate successful micro lending programs gradually shift from non-traditional collateral in microcredit to traditional collateral in SME credits. In both micro and SME credits, inventory may be taken as collateral, whether or not it is recoverable or enforceable under the law. Combination of Secured and Unsecured Exposure. Another FI operating throughout Africa has begun to experiment with new policies regarding its unsecured exposure. Though it does not assign any value to the movable assets, real estate, can cover in theory, as little as 20% on a credit limit of up to $800,000 in Kenya and $375,000 in Tanzania. Alternative Guarantees. Personal guarantees of the business owner and/or directors (in the case of limited liability companies) are generally required to be executed in all the countries surveyed. The use of guarantors and other peer pressure mechanisms are widespread as well. Disbursement Before Perfection of Security Interest. One recent entrant in to Kenya s small business lending is testing the viability of disbursing loans before registration is concluded. As soon as the lawyer issues a legal opinion that the documents have been fully executed and that there should not be any issues, then the FI moves to disburse the loan. Scoring/Behavior Modeling. Though FIs are not accepting inventory, accounts receivable and so forth as primary collateral for SME credits, some FIs Romania are taking the full range of collateral, so as to gain important knowledge and experience which, when measured statistically, can eventually be incorporated into their collateral policies. Establishment of Auction Center. Through the bankers association, FIs in Bosnia are hoping to establish an auction center which will eventually help them to bypass the courts and seize, store and sell pledged assets. Defensive Strategies. Given the challenges involved in enforcing security interests and the courts tendencies to favor the debtors, some FIs respond with defensive strategies. In addition, to avoid many of the problems associated with the court process, many FIs work diligently to restructure loans to the greatest extent possible. In cases where the property is not the personal residence, they encourage the borrower to sell the property and support that process in any way it can. Final Draft: November 4, 2006 Page 5 of 50

7 I. BACKGROUND A. OBJECTIVE OF THE STUDY The Small and Medium Enterprise Department of the IFC provides support to the existing IFC Project Development Facilities (PDFs) and Private Enterprise Partnerships (PEPs) around the world. One of the areas of focus for this support is Access to Finance for small and medium-sized enterprises (SMEs). IFC Facilities work directly in building the capacity of Financial Institutions (FIs) operating in developing countries. One of the areas that is increasingly drawing the attention of the IFC Facilities is the establishment of secured financing systems in developing countries and what is from the banks perspective the best way to approach the issue of collateral lending. Independently of the existing legal framework in a particular country, the methodologies and policies that FIs use when dealing with secured lending are a very important part of the equation. The attitude of FI towards movable collateral may affect the dynamism of the credit market for SMEs. Therefore, it is important to understand what collateral lending means for financial institutions dealing in both friendly and difficult legal environments. The overall objective of this study is to document information gathered on practices and methodologies used by financial institutions in the evaluation of SME credits and on the role of collateral in the overall credit decision and risk management process. B. DEFINITION OF MARKET SEGMENTS The focus of the study is primarily on FI s practices relating to credits to SMEs. However, brief mention is provided on credits provided by FIs to consumer and microenterprise market segments as there is frequently some level of overlap. Moreover, the inclusion of the consumer and microcredit products also provides some insights into the extent and nature of unsecured credits available to non-corporate entities in the various countries visited. In some emerging markets it has been estimated that up to 10% of consumer credit finances micro and small enterprise activity; either the business owner or the owner s spouse or parent has access to the more favorable terms and conditions that consumer credit offers as compared to micro credit (described in Chapter III). Similarly, a significant number of SMEs mostly small, not medium sized enterprises access micro loans which have more flexible collateral requirements than SME credits. 1 Most international organizations define micro, small and medium sized enterprises in terms of number of employees, annual sales, and on occasion, total assets. Though FIs may acknowledge governmental definitions for compliance purposes, most FIs internally tend to define the market segments in terms of annual sales (the source of cash flow, and hence repayment of the loan) and the loan amount (the asset that generates the revenue for the FI). Common definitions used by FIs are summarized in Table 1. 1 MFIs that have been incorporated as banks have been included in the study e.g. Equity Bank (Kenya), Cooperative Bank, of Kenya Akiba Bank (Tanzania), National Microfinance Bank (Tanzania), ProCredit Bank (Romania and Bosnia), etc. Each of these MFIs use microenterprise best practice technologies as regards individual credits Final Draft: November 4, 2006 Page 6 of 50

8 Table 1: Definitions of Market Segments Used by Financial Institutions Market Segment Personal/ Consumer Micro enterprise Small Enterprise Definitions used by FIs Typically salaried employees. Also includes lending to professionals and SME business owners for consumption or personal use. Number of employees: Typically less than 4 employees. Annual sales: Typically < $100,000, though some put the limit as high as $150,000. Loan amounts: In most emerging markets throughout Africa, Asia and Latin America, the upper limit tends to be less than $10,000; 90% or more of the credits are < $5,000, 2 The upper limit in Eastern European emerging markets tends to be as high as 15,000 (approximately $18,000) Number of employees: Typically less than 20 employees (though most FIs do not include this in their definition of the market segment) Annual sales: In most emerging markets throughout Africa, Asia, Eastern Europe and Latin America, the limit is typically up to $1-$1.2 million (one FI in Eastern Europe put the limit as high as 2.5 million or approximately $3 million). Loan amounts: In most emerging markets throughout Africa, Asia and Latin America, the upper limit tends to be in the range of $50,000 to $150,000, whereas the upper limit in Eastern European emerging markets tends to be in the range of 150, ,000 (approximately $180,000-$250,000). Number of employees: Typically less than 100 employees (though most FIs do not include this in their definition of the market segment). Medium Enterprise Annual sales: In most emerging markets, the limit is typically up to $10 million. In Eastern European emerging markets the limit is changing from 8 million (approximately $10 million), to the EU limit of 50 million (approximately $60 million). Loan amounts: The upper limit for FIs tends to be in the range of $2.5 million. With the introduction of the new EU definition of SMEs and the increasing availability of long term financing, this limit will likely increase for the Eastern European countries. C. COUNTRY SELECTION Given the objective of the study was to understand collateral lending practices in both friendly and difficult legal environments, financial institutions in four emerging market countries were interviewed as part of the study (Kenya, Tanzania, Bosnia and Herzegovina and Romania). In addition to these countries, practices of numerous other FIs from Africa, Asia, Latin America and Eastern Europe have been incorporated based on the experience of the Consultant (both as an independent consultant and as a consultant with the global consulting company, DAI). The countries were selected in a manner that took into account diversity in the following areas: Regional distribution (Eastern Europe and Africa); and Legal origin (common law/english and civil law/german and French) Degrees of reform in secured lending procedures and availability of centralized collateral/pledge information; 2 Enterprises with annual sales of less than $100,000 generally don t qualify for more than $5,000 given the comparatively shorter loan terms typical of microcredits. This is supported in practice. For example, in Ecuador where statistics on microcredits made by the formal financial sector are collected by the Central Bank, 97% of microcredits are less than $5,000. Bank Rakyat Indonesia, perhaps the world s largest microlender using individual credit technologies defines the upper limit for microenterprise credits as less than $50 million rupiah (approx. $5,000). Final Draft: November 4, 2006 Page 7 of 50

9 Countries with differing legal origins have adopted different approaches to secured lending transactions. Though an in depth legal analysis of civil and common law is outside the scope of this study, a brief review of the approaches to secured transaction law as it relates to legal origins is described in Appendix I given that such legal approaches do indeed affect FIs collateral policies. The degree of reform is also an important determinant in FI s collateral policies. For example, EBRD, in its countries operations, has supported the undertaking of reforms in secured transactions: the state of secured transaction reform in the countries of EBRD operations can roughly be divided in the following four groups: Table 2: State of Secured Transaction Reform Advanced Modern Secured Transaction Systems Albania Bulgaria Hungary Latvia Lithuania Romania Slovak Republic Modern Secured Transaction Systems with Some Defects Bosnia & Herzegovina FYR Macedonia Kyrgyz Republic Moldova Poland Serbia & Montenegro Ukraine Source: EBRD Regional Survey of Secured Transactions, 2005 Inefficient Secured Transaction Systems Croatia Czech Republic Estonia Kazakhstan Slovenia Malfunctioning Secured Transaction Systems Armenia Azerbaijan Belarus Georgia Russia Tajikistan Turkmenistan Uzbekistan All of the countries with Modern Secured Transaction Systems (including Romania and Bosnia & Herzegovina) have embraced the key concepts of the North American model described in Appendix I even though these countries were of either German or French civil law tradition. A brief summary of the key features of reformed secured transaction systems is provided in Appendix II. D. COMMERCIAL BANK CREDIT TO PRIVATE SECTOR IN SELECTED COUNTRIES Over the past several years, all of the countries surveyed have experienced significant growth in commercial bank credit to the private, albeit in different degrees. Romania s growth in credit has been the strongest, perhaps because it has not only reformed, but has had more time to reap the benefits of such reform. Non-governmental credit in Romania has grown from $2.9 billion (7,500 RON million) in 2000 to $21.3 billion (61,864 RON million) as of December 2005; an average annualized rate of growth of 52.5% for the period and 48% in Financial intermediation or non-government credit/gdp has grown from 9.3% in 2000 to its current level of approximately 24%. Household credit accounted for over 35% of non-government credit with its share continuing to increase or widen. (Source: National Bank of Romania). In Bosnia, commercial bank credit to the private sector grew at an average annualized rate of approximately 22.6% from December 2001 to Growth in 2005 the year after the secured transaction reforms and the implementation of the movable assets registry increased to 27.3%. As a proportion of total private credit, credit to private households increased from 36.4% to 50.9% (December ); in 2005 the proportion remained fairly constant. Kenya and Tanzania, countries with no reforms, experienced more modest growth in commercial bank credit to the private sector grew. Kenya s credit grew at an average annualized rate of approximately 10.8% from 2001 to 2005; in 2005, it grew 8.8%. Credit to private households has grown comparatively more rapidly and accounts for an increasing proportion of credit. As a proportion of total private credit, Final Draft: November 4, 2006 Page 8 of 50

10 claims on private households increased from 3.8% to 11.7% (December ). This comparatively low level in Kenya could potentially be an indicator of a lack of overall depth in its financial markets. Even though Tanzania had an impressive 34.4% growth in commercial banks credit to the private sector in 2005, its private credit/gdp only grew from 4.9% in 2001 to an estimated 11% in Though each of the country s growth and/or depth of private credit may very well be affected by the degree of reform in the secured transaction legal framework, it is beyond the scope of this report to evaluate to what extent the framework impacted on such growth. Many variables impact such growth, including but not limited to credit information laws (refer to text box 1 below), bankruptcy laws, etc. Rather, the purpose here is to contextualize the operating environments of the FIs that were interviewed as part of this study. Text Box 1 CREDIT INFORMATION OF EMERGING MARKETS SURVEYED Credit information indices of the emerging markets surveyed ranged from 0-5 on a possible scale of 6 (Doing Business report). Yet none of the registries offer comprehensive, accurate information (e.g. positive and negative information for a period of more than 2 years) on a significant percentage of adults or credits outstanding. The relatively new bureau in Bosnia is comparatively the most sizeable, but the leading FIs do not subscribe or participate because they allege that the reports contain limited information from the financial sector and are unreliable (e.g. contain a lot of inaccuracies). Credit Information Indicators U.S. U.K Romania Bosnia & Kenya Tanzania Herz. Credit Information Index Public Registry/Private Bureau 100% 76.2% 2.4% 19.3% 0.1% 0.0 Coverage (% of adults) Source: Rankings/ Final Draft: November 4, 2006 Page 9 of 50

11 II. INTRODUCTION: IMPORTANCE OF COLLATERAL IN SME LENDING A. DOES COLLATERAL REALLY MATTER? In the past, collateral based lending was common in many countries and to some extent, such practices still exist. However, prevailing lending practices in a diverse group of countries some with reformed collateral systems and others with unreformed collateral systems confirm that during the credit evaluation process, the primary focus of FIs is on the SME s capacity to repay the loan (cash flow) and the SME s character. Though collateral is an evaluation criterion included in the 5Cs of credit described below, it is of secondary importance, at least during the evaluation of a credit. Capacity: An analysis of the SME s capacity to repay the loan. Qualitative indicators include an evaluation of management capacity whereas quantitative indicators include inventory turnover, profitability, cash flow analysis, debt service coverage ratios, etc. In the case of microcredit, the qualitative evaluation of management capacity carries comparatively less weight than for a SME credit. Text Box 2 EVALUATION OF CAPACITY IN PRACTICE: CASH FLOW PROFIT The projected cash flow of the business is without a doubt a determining factor in best practice lending bankable SMEs must have the projected future cash flow to meet the loan payback criteria so as to make the loan self-liquidating. Leverage is also an important related factor (included in the analysis of Capital) as FIs carefully weigh whether there are prior claims on a business cash flow and to what extent cash flow is absorbed with debt service obligations. Cash flow and profitability are not necessarily synonymous. Profitability is an important factor, yet contrary to expectations, increasing profitability does not necessarily improve the business chances of securing credit. In several country and bank surveys, a larger proportion of firms with rising profits had their applications rejected and successful ones often received smaller loan amounts than less profitable firms. Given information asymmetry, FIs simply do not place a lot of confidence in the validity of SME profitability figures, whether they are audited or not. Concrete visible trends such as cash flow coming in and out of a business (and a bank account) or other trends such as sustained growth in employment are far more relevant to them. Character: An analysis of the SME s willingness to repay based on past credit repayment history of the business and the principal business owners together with an analysis of business and personal stability (e.g. length of time in business, length of time at residence, etc.). The creditworthiness and character of the SME s principal owners is perhaps the most important indicator of repayment risk on small business lending is (namely do the owners honor their debts and pay on-time). In the case of microcredit where past credit history of the business or the business owners may not exist or is comparatively more limited, the qualitative analysis of the personal and family stability tends to have a greater weighting. Capital: An analysis of the amount of equity capital the SME has invested in the business (leverage) or the proposed project to be financed. Indicators include, but are not limited to debt/equity, debt/total assets (both with and without the proposed credit), and percentage of project to be financed (where applicable). Collateral: A qualitative evaluation and economic valuation of the assets that are pledged by the borrower to secure a loan. Though the weightings assigned to collateral are similar for both micro and SME credits, the approach to collateral is different. In the case of microcredit, non- Final Draft: November 4, 2006 Page 10 of 50

12 traditional collateral is accepted. 3 From the FIs perspective, such collateral is taken more for its intrinsic or psychological value than for its economic value (refer to text box 3 below). Text Box 3 ILLUSTRATION OF INTRINSIC VALUE OF COLLATERAL IN MICROFINANCE Typically a microentrepreneur will purchase a television on credit (rent to own or hire purchase). Typical terms of financing in emerging markets will be for a period of up to 2 years (or more) and at effective interest rates of up to 100% (or more). In such a case, a microentrepreneur will have paid approximately $940 or more for a $400 television that after two years may only be valued at $200. From an FI s perspective, it will be liquidated for less than $200; from the microentrepreneurs perspective, the intrinsic value is far greater, not only because he/she paid $940 or more, but because replacing it will be similarly expensive (NB: if the microentrepreneur does not have the loan installment to pay the lender, he/she is unlikely to have the money for a cash purchase of another television). FIs involved in microcredit understand this and hence ensure that the collateral with the highest intrinsic value to the microentrepreneur is always pledged. Conditions: An analysis of a number of tangible and intangible factors, including the firms ability to obtain market share and to compete with other similar businesses. The location of the business, form of ownership, purpose of obtaining the loan, overall health of the economy, interest rate levels, the demand for money and so forth are also factors. The latter ones typically have a more significant weighting in SME credits than in microcredits because deterioration in the overall health of the economy tends to have a more significant impact on the performance of SME portfolios than on microcredit portfolios (refer to text box 4 below). Text Box 4 IMPACT OF ASIAN FINANCIAL CRISIS ON MICROFINANCE PORTFOLIO OF BRI The Asian financial crisis had no negative effect on loan repayment at the Bank Rakyat Indonesia unit desa (microfinance) system, testifying to the resilience of both the BRI village units and their farmer and microenterprise customers. The 12- month loss ratio (2.16%) during the crisis period (9/1997-8/1998) was virtually identical with the long-term loss ratio since 1984 (2.17%). Moreover, during the crisis year 9/1997-8/1998 total savings deposits in BRI almost doubled. Given the uncertainty, people reportedly were cautious to take up new loans, hence the increase in the credit portfolio was only nominal. The Microbanking Division of Bank Rakyat Indonesia: A Flagship of Rural Microfinance in Asia, 2004 by Hans Dieter Seibel B. POWER OF COLLATERAL Though the collateral citerion is secondary to criteria of character and capacity during the evaluation process, collateral does have great importance in the eventual approval and disbursement of a credit. This is because for loans of any material size (be it in relation to the capital of the enterprise or in absolute terms as defined by the institution), collateral is typically considered a condition precedent, not just an evaluation criterion included in the 5Cs of credit. It is estimated that in middle and low income countries, between 70-80% of loans require some form of collateral. The same holds true in high income countries as well for example 70% of loans issued in the United States are secured with collateral. 4 As will be presented in Chapter III below, the majority of unsecured credits include: consumer loans to salaried employees, micro loans secured by non-traditional collateral which FIs and banking agencies do not consider as collateral, in the conventional sense thereby 3 In emerging markets FIs typically define traditional collateral as land and buildings or machinery, equipment and vehicles for which title registries exist. Non-traditional collateral on the other hand refers to movable assets owned by the microentrepreneur typically a mix of business and household assets (e.g. household appliances, electronics, electric equipment, etc.). 4 Final Draft: November 4, 2006 Page 11 of 50

13 Loan size, term Interest rate resulting in the classification of such credits as unsecured and working capital facilities for large enterprises. Heywood Fleisig et al of CEAL have described in numerous publications how loans secured by collateral, all other things equal, have more favorable terms and conditions than unsecured loans. For the exact same borrower, secured loans will be larger than unsecured loans; the interest rate will be lower for a secured loan than for an unsecured loan, and the term to maturity will be longer than for an unsecured loan. Fleisig has demonstrated this using the loan terms and conditions available at the IFC/Bank/Fund Staff Federal Credit Union. As Graph 1 reflects, loans secured by movable property (vehicles) or real estate, interest rates are about half the rate on an unsecured loan (right hand scale). For any given borrower income, a loan secured by real estate is about 10 times greater than an unsecured loan, while a loan secured by movable property is about 4 times greater. The loan secured by real estate can be repaid over a period of 5 times longer than an unsecured loan. This is the power of collateral. 5 Graph 1 Terms on loans from a U.S. federal credit union January 2006, Unsecured Loans = Personal loan =100 Car loan Mortgage 0 Term Loan size Interest rate Source: Bank Fund Staff Federal Credit Union, 1/2006, Washington D.C. This power of collateral not only prevails in consumer loan product sets but in SME product sets as well. One can verify this by simply comparing loan terms at any local bank branch, in almost any country in the world (refer to Tables 3 and 4 in Chapter III which also confirm this). 5 For more discussion, see Fleisig, Heywood, The Power of Collateral: How Problems in Secured Transactions Limit Private Credit for Movable Property, Viewpoint series, Note 43 (World Bank, Vice Presidency for Finance and Private Sector Development, Washington, D.C., 1995) and Fleisig, Heywood, de la Peña, Nuria and Safavian, Mehnaz:. Draft: How to Reform Collateral Laws, World Bank. January 2006 Final Draft: November 4, 2006 Page 12 of 50

14 III. GENERAL CREDIT POLICIES AND PRACTICES OF FINANCIAL INSTITUTIONS A. CREDIT PRODUCTS 1. Consumer Credit Products Most FIs around the world have reasonably competitive consumer credit products for salaried employees. Products include unsecured personal loans as well as specific purpose loans for the purchase of assets which secure the credit (e.g. motor vehicles and housing). FIs in the countries surveyed typically offer unsecured personal loans with loan terms of up to 3 years (similar to what is available in the U.S., including the IFC/Bank/Fund Staff Federal Credit Union). On an exceptional basis terms can go up to 5 or 6 years (refer to Table 3). Vehicle and housing loans have comparatively longer loan terms and lower rates. Such trends are consistent with the experience evidenced in most countries around the world, as was described in Chapter II (The Power of Collateral). Table 3: Typical Consumer Loan Terms and Interest Rates Kenya Tanzania Bosnia and Herzegovina Personal Loans Vehicle Loans Housing Loans Up to 12 months salary Up to $275,000 (2) Up to 4 years Up to 10 years 14-19% % Up to 5 months salary Up to 3 years 16-21% declining 17% flat (1) Up to 12 months salary Up to 3 years 15-23% Up to $12,000 Up to 5 years Up to 8-15% Romania Up to $12,000 Up to 6 years % Up to 24 months salary Up to 5 years 15-18% Up to $15,000 Up to 7 years 8-14% Up to $36,000 new or $15,000 used Up to 7 years % Up to 2 years salary Up to 10 years 15-18% Up to $62,000 Up to 15 years 8-12% Up to $250,000 (2) years 10-14% (1) One FI charges interest rates commensurate with its microfinance rates if the loan payment is not remitted directly to the FI by the employer. (2) or subject to FI total debt repayment to net income ratio The approach to consumer lending adopted by many FIs in emerging markets is to operate credit schemes through employers where the employer remits the loan repayment directly to the FI. To the extent that the FI has properly evaluated the financial management of the company, the loan repayment histories of these schemes have been significantly better than the average repayment of direct lending to consumers. The exception has been the performance of schemes through smaller employers (e.g. where employment has tended to be more unstable and the potential for fraud/lack of professionalism of the accountant/bookkeeper has been greater). As a result, the FIs offer the lower range of interest rates to employees of strong companies and to its high net worth individuals with solid records of conduct in both their credit and deposit accounts. 2. Business Credit Products Consistent with prevailing international best practices, amortized loans are provided to microenterprises in gradually increasing amounts over time, together with gradually increasing loan terms and decreasing interest rates. Final Draft: November 4, 2006 Page 13 of 50

15 Interest rates on micro loans are comparatively higher than consumer or SME loans and loan terms tend to be shorter; over time, as the microenterprise establishes its credit history, the gap narrows. SME credits typically include among others: lines of credit and overdrafts (refer to text box 5); business credit cards; term loans; letters of credit or bank guarantee letters; and invoice discounting. Text Box 5 OVERDRAFTS AND LINES OF CREDIT FIs almost universally offer SMEs overdrafts and/or lines of credit. However, such products are frequently not properly managed, and as a result, become what are commonly referred to as evergreen facilities. The term evergreen is used because the facility never goes into a credit balance at least once during the loan period as is typically required. With overdraft facilities, a borrower experiencing difficulty can draw funds from the overdraft back up to the limit for the payment of its interest and other obligations. Moreover, the business may even go bankrupt during the term of the loan, and the FI may not be aware of this until its time to renegotiate the loan. The probability of recovering the full credit amount, at that stage, becomes increasingly remote and as a result, the FI is forced to roll over the facility from year to year or write it off. Interest rates on the majority of SME facilities tend to be variable. Table 4: Typical Business Loan Terms and Interest Rates Microenterprise Loans Kenya Up to $8,000 Working capital: up to 12 months Investment capital: up to 24 months 18-30% flat Tanzania Up to $10,000 (3) 6-24 months, depending on loan cycle 24% declining balance to 25% flat Bosnia and Herzegovina Romania Up to 10,000 (approx. $12,000) Working capital: up to 24 months Investment: up to 36 months 34-76% declining balance Up to 10,000 (approx. $12,000) Working capital: up to 24 months Investment: up to 48 months 19-28% declining balance Working Capital Up to $1 million (1) Up to 12 months and/or renewable annually 14-21% Up to $1million Up to 12 months and/or renewable annually 16-22% Up to $1 million Up to months Base level stock: up to 3 years 7-12% Up to $1 million Up to 12 months and/or renewable annually 12-18% SME Loans Investment Up to $2.5 million (2) Equipment: 3-5 years 14-21% Premises: Up to 7 years 15-17% Up to $2.5 million 2-5 years 18-23% Up to $2.5 million Equipment 3-5 years 8-11% Other capital expenditures: 5-7 years 9-12% Up to $2.5 million Equipment 5-7 years 16-19% Premises: years % (1) Subject to lending criteria for working capital facilities described above. (2) As per the definition of SME described in Chapter I.B above (3) Graduating microenterprises can access SME credits up to $15,000, but with the same non-traditional collateral requirements they have been accustomed to receiving on their microenterprise credits. Interest rates on these larger loans are 18%. Final Draft: November 4, 2006 Page 14 of 50

16 B. CREDIT EVALUATION APPROACH AND GUIDELINES 1. Approach Whereas the principles of good credit are the same for corporate, SME and micro lending, the approach to successful micro and small business credit is fundamentally different from traditional corporate banking. Lending to medium sized business can be effective using modified corporate banking approaches; for this reason many FIs in emerging markets define their target market as SMEs with annual sales greater than $1-1.2 million annually. Lending to micro and small businesses, on the other hand, differs in the following key areas. Unlike corporate lending which tends to occur primarily from the head office and regional centers, micro and small business lending is heavily retail/branch based. o o a 1996 Price Waterhouse survey of small business practices of 65 of the top 100 banks around the U.S. found that 65% of small business product and sales occur through the branch; and in most emerging markets, where alternative delivery channels (e.g. internet, call centers and so forth) are not developed, nearly 100% of micro and small business sales occur at the branches as opposed to the head office which is the case for corporate lending. Like corporate lenders, micro and small business lenders create/hire product specialists to manage account relationships. Unlike many traditional corporate banks, micro and small business lenders sell like crazy that is, they break away from the traditional banking approach and develop a sales culture. The SME service delivery approach is a high volume based business which requires a strong information technology foundation, standardization and centralization of processes. The information technology systems draw on the experience from consumer finance, particularly the concept of credit scoring and the use of credit information, along with other technologies that can be used to manage information-intensive flows. Small business lenders (especially in OECD countries) use portfolio based, statistically determined, empirically grounded, data intensive scoring approaches that actually avoid most traditional financial analysis associated with corporate credit decision making and focus instead on a small number of key indicators indicative of repayment risk. Credit information on the principal of a small business is normally the most predictive measure for a credit decision on the small business itself. Small business lenders use back-end monitoring systems that pave the way for portfolio management vs. individual credit reviews used in corporate lending. The models measure the performance of the portfolio and use early warning systems to find suspect loans that are turning sour long before they are past due. Leading small business lenders are now using internet technology to dramatically streamline the cost of processing and administration for small business loans. Businesses submit information on sales, accounts receivables, cash flow, and so forth via internet and the FI monitors them on an exceptions basis only using their exceptions based software systems. Final Draft: November 4, 2006 Page 15 of 50

17 Unlike corporate lenders which place a heavy reliance on collateral, small business lenders place a heavy reliance on non-traditional collateral, personal guarantees, third party guarantees and so forth. o o In OECD countries, personal guarantees play a critical role in SME lending, especially for start-up finance. In such cases, the wealth of the principal owners of the SMEs that the bank can potentially seize in the event of default weigh more heavily than the business history or financial status. In emerging markets with unreformed legal and credit information systems, small business lenders apply the core elements of a successful micro lending program to small business lending operations, e.g. requiring SME borrowers to pledge non-traditional collateral (personal assets with high intrinsic value to the borrower). In many emerging market countries with unreformed legal and credit information systems, small business lending is actually more similar to the individual lending methodology used in microfinance than it is to corporate lending. Whether one is dealing with micro or small business loans, the underlying problems are lack of reliable information, lack of traditional collateral and difficulty of enforcing contracts. Accordingly, the core elements of a successful individual lending program in microfinance are increasingly being applied to small business lending operations, albeit with some modifications. o o For example, in the case of micro lending, information asymmetry can be overcome by conducting a form of credit analysis which takes into account the borrowers entire socio-economic circumstances, including their private households. The same purpose is accomplished in the case of small businesses by conducting a thorough analysis of the firm s ownership structure. Yet this is a difference of practical detail, rather than of principle. Another important modification that needs to be made when adapting micro lending technology to a small business program is that, whereas in the case of microenterprises only the actual cash flow generated by current business operations is taken into consideration when deciding whether or not to approve a loan application, in the case of small businesses it may be appropriate to include the estimated cash flow that is likely to be generated by the planned investment for which the loan is being sought. However, this distinction is relatively minor. In practice, the vast majority of loan officers who were initially trained for micro-lending activities have the potential to become lenders to small businesses also. While additional skills are required in order to deal with the collection and analysis of more formal and complex business data, there is no fundamental difference in terms of the overall information asymmetries. The informational value of official business data (which small businesses are generally able to provide) is usually dubious, except for the fact that they are intended to reduce tax obligations and minimize outside interference. In essence, the credit analyst has to reduce these informational asymmetries for small businesses in the same way as he/she would in the case of microenterprises. (Holtmann, 2000) Final Draft: November 4, 2006 Page 16 of 50

18 Text Box 6 SMALL BUSINESS LENDING IN ECUADOR In Ecuador, there are two FIs which specialize in micro and small business lending (BancoSolidario and Banco ProCredit), as well as a number of mainstream commercial banks that are actively involved in micro and small business finance. As of December 31, 2005 a total of 329,401 micro loans were outstanding in the formal financial sector for a total portfolio outstanding of $363.4 million. Banco de Pinchincha, Ecuador s largest bank had the second largest market share with a portfolio outstanding of $81 million and a portfolio-at-risk ratio >5 days past due of 1.48% (as compared to Banco Solidario s portfolio outstanding of $109 million with a portfolio-at-risk ratio >5 days past due of 5.7%). Pinchincha s success in microcredit prompted it to review its business strategy for small business lending. Though the credit methodology utilized for its small business lending was in many ways an adaptation of its successful microcredit methodology, the overall results of its first year of operations, particularly as regards its scale, were disappointing. This was because Pinchincha had maintained its traditional branch banking approach of waiting for the customers to come to the branch rather than developing the sell like crazy culture that had proven so successful in its microfinance operation. Banco de Guayaquil, is a recent entrant to the micro and small business market. For businesses with annual sales in excess of $1 million, it is using a modified version of its corporate lending methodology (developed with Deloitte & Touche) whereas for small business lending, it will soon begin to use a modified version of its microcredit methodology. 2. Scoring Models In OECD countries many FIs use statistical scoring models to approve and price consumer and small business credits. Many of these models are proprietary models which have been developed by the FIs based on credit repayment histories and a range of other variables that statistically have affected the repayment performance evidenced in their portfolio over time. Though some of the larger FIs in the U.S. have proprietary scoring models, many of the smaller FIs simply use the Fair Isaac & Co. -FICOcredit scoring described in Graph 2 that is based entirely on the personal credit history of the consumer or business owner for smaller loans (e.g. individual loan amounts up to $50,000 or total exposure of up to $150,000). 6 Graph 2 If your FICO score is: Your interest rate (30 year mortgage) is: % % % % % % Source: 6 These limits are typical of a U.S. regional bank; larger banks tend to have higher limits whereas smaller local banks tend to have smaller limits. Final Draft: November 4, 2006 Page 17 of 50

19 For larger business loan amounts, additional information is required (e.g. financial statements, pro forma cash flows and tax returns) to perform a more thorough cash flow analysis. More complex business scoring models are commonly used to support this process (e.g. models developed by Small Business Scoring Service). In addition, the larger US FIs exchange information on small business by participating on the Small Business Financial Exchange (SBFE), a national source of small business credit information. It is a member-owned, not-for-profit trade association that reports and maintains both positive and negative financial information regarding small businesses. In emerging markets, increasingly FIs are using judgmental scoring models to evaluate a business credit application. Such scoring models utilize data from the business balance sheet and income statements. (e.g. as per an illustrative scorecard based on the typical 5 Cs of credit utilized by some FIs in Eastern Europe). They rarely include significant credit information on the business or business owner aside from the business history with the FI. For this reason, the FIs place a heavy reliance on the SME s previous history with the FI, both in the operation of its credit and deposit accounts, over an extended period of time (e.g. greater than 3 years). Graph 3 Source: The Use of Judgmental Credit Scoring Models for SME Lending in Developing Markets: A Case Study 7 Scorecard Structure & Parameters The 5 Cs of Credit Points Weight CAPACITY % CHARACTER % CAPITAL % COLLATERAL % CONDITIONS % TOTAL SCORE % Category Points Weight CAPACITY Historic Financials Turnover <25K Ls KLs 50K+ Ls % Profit as % of Sales 0-5% 5-10% 10+% % Total Debt/Equity < % Current Ratio <1 1-2 > % Inventory Turnover < % Historic Financials Subtotal % Projections Debt Coverage < % Net Cash Flow <0 0-5,000 Ls 5,000+ Ls % Projections Subtotal % Capacity Subtotal % Sub - section Capacity is made up of 7 factors and accounts for 34% of the total score 7 Written by Dean Caire & Robert Kossmann of Bannock Consulting (based on judgmental credit scoring models developed at FIs in Slovakia, Bulgaria, Lithuania and Latvia) Final Draft: November 4, 2006 Page 18 of 50

20 3. Common Guidelines Though FIs have scoring models and many lending guidelines regarding collateral which are described in Chapter III.C below, the key parameters that FIs use when determining the loan amount relate to the capacity to repay, namely: loan repayment net or gross income (commonly used in consumer lending); and net business income loan repayment, also referred to as debt service coverage (the inverse of the above, which is predominantly used in business lending). Other rules of thumb or parameters used by FIs in determining loan amounts typically relate to the SME s overall indebtedness (leverage) or working capital. The indicators used by the FIs surveyed are presented in the table below; though each FI has its own particular guideline or set of guidelines, there are remarkable similarities across OECD and emerging market countries throughout Africa, Asia, Latin America and Eastern Europe. The range appears to reflect differences in the risk profile of the institution more than country differences in risk or legal frameworks. For example, debt service coverage ratios of 1.3 to 1.5 for businesses or consumer loan repayments to gross income of 30-50% are every bit as common in the U.S. as it is in Eastern Europe or Africa. Similarly, working capital facilities of 1 to 1.5 months sales is also very common across countries. Typically the upper limits are offered to higher income clients and/or to repeat clients with an excellent credit history, either with the FI or as evidenced by credit bureau reports. Table 5: Common Guidelines Used by Financial Institutions Debt repayment to gross income Debt repayment to net income Personal 30-50% 30-50% (net income after tax deductions) Microenterprise N/A 50-70% (net household surplus after deductions for estimated living expenses) SMEs % (DSC of ) (business and business owner income and debts combined) 67-75% (DSC of 1.33 to 1.5) (business only) Other 4-12 months salary (personal) or months (vehicle) Debt to equity: 60-80%; Debt to total assets: 30-50% working capital facilities equivalent to: month sales; 2 months purchases; 100% of average monthly banking turnover; or 70-80% of working capital Debt to equity capital: from 1:1 to 3:1 working capital facilities equivalent to: 75%-80% of annual net profit; month sales; 2 months purchases; 60%- 100% of average monthly banking turnover; or 70-80% of working capital Source: compiled by consultant based on interviews with FIs as part of the study. The findings herein are consistent with credit policy and procedure manuals developed by consultant with FIs in emerging markets in Africa, Asia, Eastern Europe, and Latin America. C. COLLATERAL POLICIES FIs correctly prioritize the valuation of the SME s capacity to repay (cash flow analysis) and creditworthiness. However collateral is still generally a condition for most SME loans, both in reformed Final Draft: November 4, 2006 Page 19 of 50