CHAPTER V

Chapter V
Financing a business

W hile not every SME turns into a multinational enterprise,

they all face a similar issue in their early days: finding the
right type of finance at an affordable cost to start and grow the
Figure V.1. SME financing gaps in OECD and non-OECD
countries
(Unit: Per cent)
business. The ability of SMEs to develop, grow, sustain and
100
strengthen themselves is heavily determined by their capacity 90
to access and manage finance. Unfortunately, SMEs in the 90
80
region consistently cite the lack of access to finance as a serious 80
75
obstacle to their development. Therefore, this chapter 70
70
addresses some of the key issues concerning the financing of 60
60
SMEs.
50

This chapter begins by describing the current situation of SME 40

30
financing in the region and the financing needs of SMEs 30
at different stages of growth. Working capital management, 20
obtaining credit and other financial instruments are discussed,
10
as these issues have the most direct impact on SMEs’ cash flow.
The myriad ways that SMEs can obtain capital and the 0
Gap Debt Equity
relationship between the bank and the borrower are reviewed,
together with observations about raising capital. The chapter OECD countries Non-OECD countries
concludes with policy prescriptions. Source: OECD, 2006.
Note: The results are based on a survey in 20 OECD countries and
The importance of cash flow for small businesses can never be 10 non-OECD countries.
over-emphasized; even profitable firms will fail if they cannot
collect the cash that is due to them. Policymakers can have require more collateral for loans (figure V.2) than those in
a significant positive impact on SME survival if they articulate developed countries, regardless of firm size (also see the 87
and enforce a coherent programme of creditor rights. annex to this chapter). The interest rates for loans almost
doubled in developing countries even though the portion of
A. Raising capital non-performing loans was higher in developed countries
(figure V.3). 70 The combination of lower risk and higher
Raising capital is one of the most critical issues for SMEs’ growth borrowing costs implies a high transaction cost in the
and survival. While the gap in financing SMEs is significant both commercial banks of developing countries, adding further
in developed and developing countries, some differences in challenges for SME financing in such countries.
characteristics exist.
Figure V.2. Collateral requirement in developing and
While an OECD (2006) survey of SME financing indicated large
developed countries
financing gaps in both OECD and non-OECD countries, the
overall situation was more severe in non-OECD countries 100 SE
(figure V.1). Further, OECD and non-OECD countries differed ME
significantly on the matter of debt financing: only 30 per cent LE
80
of the firms in the OECD countires felt a gap existed in debt
financing while 70 per cent of non-OECD countries felt the
same. This difference strongly the firms in suggests an 60
Per cent

underdeveloped banking sector, which is the main provider of

debt financing, in non-OECD countries. The equity financing
40
gap was more similar among the two groups, at 75 per cent
and 60 per cent, respectively, perhaps indicating a large
demand for equity financing by advanced SMEs in the OECD 20
countries.

The disadvantages in SME financing in developing countries 0

Developed countries Developing countries
also exist in the lending policies of commercial banks, the most
important source for SMEs’ external financing (Park, Lim and Source: IFC, 2009.
Koo, 2008). The results of the survey conducted by Beck,
Demirgüç-Kunt and Peria (2008) suggested that the financing
gap was greater between countries than between firms of 70
It should be noted that the smaller the size of the enterprises, the
different sizes. In developing countries, commercial banks higher was the portion of non-performing loans.

87
 Figure V.3. Interest rates and non-performing loans in As shown in table V.1, developed economies rank the highest
developing and developed countries in terms of strength of legal rights and depth of credit
information within the region. They have also developed
18
Chapter V

private credit bureaus that provide credit history for almost

16 the entire adult population. East and North-East Asia ranks
second for the first two indicators. The credit information
14
coverage in these countries is relatively comprehensive with
12 the combination of public registries and private bureaus. The
strength of legal rights indicator for the other four subregions
Per cent

10
is not far behind the two leading subregions; however, the
8 lack of public and private credit information is likely to be
a major obstacle for getting credit in those countries,
6
especially in the Pacific, and South and South-West Asia.
4

2
B. Business life cycle and the need for cash

0 Throughout the SME life cycle, each stage – start-up, growth,

SE ME LE SE ME LE maturity, decline, transition and exit – will have varying cash
Developed countries Developing countries flow needs. SMEs may obtain equity capital and debt
financing from various sources at each of those stage.
Best client rates
(Sridhar, 2008). Figure V.4 shows that the particularly crucial
Premium for worst clients
periods of cash drain occurs during the start-up, growth and
% Non-performing loans
transition stages.73
Source: IFC, 2009.
Figure V.4. SME business growth stages and cash flow
The World Bank’s Ease of Doing Business survey measures the
level of enterprises’ credit access in a country. Table V.1 shows GROWTH STAGES
the four main indicators of facilitation of access to financing
Startup Growth Maturity Decline Transition Growth
and availability of credit information:71
POSITIVE

decline
or discon-
(a) Legal rights – the degree to which collateral72 and tinuation
CASH FLOW

88 bankruptcy laws facilitate lending;

(b) Depth of credit information – rules and practices Cash drain Cash drain
affecting the scope, access to and quality of credit
NEGATIVE

information;
(c) Public credit registries’ data coverage of
borrowing history, thus credit worthiness, of Break even point
individuals and firms; and
(d) Private credit bureaus’ data coverage of
borrowing history, and thus credit worthiness, of Source: Authors’ compilation.
individuals and firms.

71 73
A more detailed explanation of the indicators concerning getting This is a simple generalization, though, as real life cycles differ
credit can be found in World Bank, 2011a, p. 48. between individual companies, between growth and non-growth
72
The typology of collateral is given in annex V.1. sectors, and between new and traditional industries (Johnsen and
McMahon, 2005).
Table V.1. Ease of getting credit by subregion

Public registry Private bureau

Depth of credit
Subregion Legal rights* coverage coverage
information*
(per cent adults) (per cent adults)
Developed economies 8.7 5.3 0.0 92.0
East and North-East Asia 7.3 4.5 20.8 41.3
North and Central Asia 5.1 4.0 3.6 14.3
Pacific 6.2 0.7 0.0 4.8
South and South-West Asia 5.1 2.6 4.7 7.7
South-East Asia 5.8 2.7 11.4 20.4
Source: World Bank, 2011a.
* Based on a 0-10 scale with 10 being the most developed.
Notes: (a) Ranking out of 183 economies; (b) developed economies include Australia, Japan and New Zealand; (c) Taiwan Province of China is
included in East and North-East Asia; (d) some Asia-Pacific economies (Democratic People’s Republic of Korea; Macao, China; Myanmar;
Turkmenistan; American Samoa; Cook Islands; French Polynesia; Guam; Nauru; New Caledonia; Niue; Northern Mariana Islands; and Tuvalu) were
excluded from this analysis due to a lack of survey data.; and (e) explanatory notes show all countries by subregion.
The first period (start-up) involves a high mortality rate for relatively quickly in response to growth is a key feature.
SMEs if they cannot find enough initial capital, even though Another salient characteristic is complementarity: SME
the scale of their needs may not be large. In addition to the financing augments traditional sources of financing in many

Chapter V
slow sales that they often face during this stage, it is common contexts. Effective financing mechanisms also contribute to
for (even profitable) SMEs to fail because, while they may sustainability as the financing of successful and profitable
have profits on paper, they do not have the cash in hand SMEs generates additional capital for future SMEs, thereby
from their customers to pay bills or to cover operating costs creating a virtual cycle. SMEs’ financing needs (as both debt
(figure V.5). This time gap is difficult for start-up businesses and equity) may vary (Johnsen and McMahon, 2005; and
to avoid, and survival can depend on a firm’s ability to raise Zavatta, 2008) depending on such factors as:
additional working capital. The inability to survive the time
gap between cash inflows and outflows is a primary cause of (a) Home country;
business failure throughout an SME’s entire life. Apart from (b) Industrial sectors;
personal assets and loans from family and friends, during the (c) Perceived business risk;
start-up stage SMEs may get funds from seed capital, venture
(d) Asset structure (e.g., tangible versus intangible;
capital, business angels and/or government or institutional
capital-intensive versus less capital-intensive; and
sources.
high or low fixed assets);
(e) Debt-to-equity ratio;
Figure V.5. Main reason for SME failure: Time gap between
receivables and payables (f ) Growth rate; and
(g) Profitability.
Receivables Customer
Sales Payment
SMEs can obtain the necessary funds from a number of
Payables Procurement Payment to different financial instruments. These instruments can be
suppliers Time Gap broken down into the six general categories listed in table V.2.

Operating funds needed Informal finance refers to all transactions, loans and deposits
occurring outside the regulation of a central monetary
Source: Authors’ compilation.
authority (Atieno, 2001). Such funds may come from personal
savings, borrowing from relatives or trade credits. Internal
In the second period (growth), SMEs pass the break-even
point and start making money. At this point, they normally Table V.2. Different SME financing sources
require additional financing, such as a large amount of
working capital as well as investment in production facilities Category Examples 89
and human resources. While such financing for growth could Informal financing Personal savings
be supported by short-term loans and working capital Borrowing from family or friends
generation from their daily business, long-term loans from Borrowing from money lenders
commercial banks are usually preferred in order to ensure Trade credit
long-term investment and maintain adequate working
Internal financing Retained profit
capital. Venture capital funds may also become an important
Internal savings
resource for expansion. The availability of other funds
Working capital
could also increase at this stage with local, national and Sales of assets
international financial sources. Entrepreneurs typically
experience difficulty raising funds at this critical stage. Debt financing Short-/long-term loans
Commercial banks do not lend easily to those who still have Line of credit
no, or limited, credit record, and venture capital is not readily Promissory notes
available for small-scale investment in new businesses, Credit cards
Overdraft
particulary in developing countries.
Corporate bonds
In the third period (transition), it is necessary for SMEs that Equity financing Seed capital
are losing money to undertake measures to improve Angel finance
profitability, either by increasing sales or by reducing costs. Venture capital
While long-term financing or working capital generation IPOs
is necessary for continuous enterprise growth and Asset-based financing Factoring
development, immediate short-term financing, perhaps Invoice discounting
through commercial debt financing, is often critical for SMEs Inventory financing
during cash-drain periods.74
Leasing Capital leasing (hire-purchasing)
Operating leasing
C. Overview of SME financing
Government grants and Grants
SME financing refers to a range of mechanisms for funding subsidies Interest subsidies
the development of SMEs. There are a number of notable Credit guarantees scheme
features to SME financing. The ability to increase capital Loan insurance schemes
Loan schemes
74
In financial terms, short term is a period of a year or less while long Source: Authors’ compilation.
term represents more than one year.
 financing is the method of generating funds through schedule for the lessee (the borrower) in exchange of the
a company’s core business, such as through profits and right to use the fixed asset bought by the lesser (lender)
working capital (Wilson, 2011). In developing countries, (Berger and Udell, 2005).
Chapter V

including those in Asia and the Pacific, informal and internal

financing typically dominates SMEs’ financial sources, The public sector actively promote the development of SMEs
particularly for start-ups and micro and small enterprises. by providing grants and subsidies. This financial support has
many flexible forms and is usually delivered to the SME via
Debt financing, which is also a major financial source for financial institutions or government line agencies (RAM
SMEs, typically takes the form of credit lines and term loans Consultancy Services, 2005). Some of the major financial
that must be repaid over time, usually with interest (Helms, instruments for SME development are further reviewed in the
2006). Most of the debt financing is provided by banks, but following section.
it also includes corporate bonds.
D. Forms of finance
Equity financing takes the form of money obtained from
investors in exchange for an ownership share in the business Figure V.6 shows major instruments of SME financing
(Helms, 2006). It includes a wide range of financing sources (Berger and Udell, 2005; IFC, 2009; Szabó, 2005; Women’s
such as business angels, venture capital and initial public World Banking, 2004; and Zavatta, 2008). The figure was
offerings (IPOs). developed to present a comprehensive set of SME financial
instruments, whose features are relevant to the size and credit
Asset-based financing is defined as obtaining funds by history of individual firms. These financial instruments can
pledging a subset of the firm’s assets as collateral or as the also be categorized based on creditors’ perceptions on
primary source of repayment (Berger and Udell, 2005). The risk and return as well as the level of financial sector
most common types of asset-based financing are factoring, sophistication in an economy. These financial instruments are
invoice discounting and inventory financing (Business not exclusive and policymakers often use various instruments
Owners Toolkit, 2012a). in concert to support SMEs. A discussion of these
instruments, beginning with the financial instruments with
Leasing is a common method of financing equipment. It can the lowest financial sector sophistication and progressing to
be defined as a rental contract specifying the payment the highest level, follows.

Box V.1. Development of an SME financing support system in China

90 “Development of an SME financing support system” is an ADB investment percentage, organizational structure and fund
project for developing the comprehensive institutional and operations, which severely inhibited the development of the
regulatory framework of SME financing in China. The main private venture capital industry. ADB proposed drafting new
objectives of this project are to: (a) increase the total amount of laws or making legislative changes in laws relating to the
equity and debt financing available to SMEs; (b) attract private following aspects:
sources of SME financing; and (c) encourage investment by
(a) Organizations and operations of private
increasing the profitability and reducing the risk of loss to the
investment funds and public credit guarantee
lending institutions. After analyzing the existing strengths and
agencies;
weaknesses of SME financing in China, ADB proposed the
(b) Company laws; and
following four main policy recommendations to make the
(c) Bankruptcy and security legislation.
Chinese SME financing system more effective:
3. Equity financing for technology-based enterprises
1. Equity financing for SMEs in traditional sectors
More than 200 public funds for technology-based enterprises
SMEs in traditional sectors such as food processing, retailing and
had been established by regional and local governments but
consumer services are important due to their job-creation
most of them lacked efficiency and had a low level of return on
function. They generally face difficulties in attracting investors
investment. To solve this problem, ADB recommended several
who believe that the potential return on investment is not high
measures for funding operations, including hiring skilled and
enough to justify the risk of loss involved. Government
profit-motivated fund managers, and focusing on investing in
intervention has to focus on either increasing the potential profit
start-ups and SMEs. In addition, ADB recommended competition
of businesses or reducing the risk of loss while providing direct
among fund receivers as well as transparency in the whole
equity financing. To ensure the success of the public equity
selection and operation processes.
funds, specific measures are recommended including:
(a) introducing private co-investors and profit-driven fund 4. Credit guarantee for bank loans to SMEs
managers; (b) increasing the share of return for private investors;
Debt is an important source of SME financing. The establishment
and (c) limiting the investment coverage strictly to SMEs.
of a credit guarantee programme can facilitate SMEs’ debt
2. Legal and regulatory framework financing by sharing the risk with lenders. ADB presented
a comprehensive framework for a loan guarantee programme
The absence of supportive laws and regulations in China
covering legislation, regulation, operating procedures and
severely limits the availability of financing for SMEs, especially
service and liquidation operations. It has also provided some risk
from private and foreign sources. ADB identified many principal
management procedures for such a programme.
barriers of investment in SMEs in the existing legal and
regulatory framework of China. Taking private investment funds
as an example, company laws in China had strict limitations in Source: ADB, 2002.
Figure V.6. Forms of finance for SMEs

Chapter V
Source: Authors’ compilation.

1. Personal net worth or saving Prior to borrowing from the financial sector, SMEs can
manage their working capital to generate cash for operations.
The first step in accessing capital is to fund the venture with This is particularly important for SMEs because they often do 91
the entrepreneur’s own assets, e.g., savings. After investing not have easy access to financing from external sources. SMEs’
his/her own money the entrepreneur then typically turns to skilful management of working capital can increase cash
family and friends (or banks) for personal loans (Shane, 2008). flows and minimize the short-term need for external debt
It is important to highlight for policymakers the fact that financing (see figure V.7). For example, SMEs could delay
entrepreneurs and small business owners will generally go to paying vendors while also collecting their receivables more
formal financial institutions only if personal sources have actively in order to increase available working capital (this is
been exhausted. They will finance their businesses from called trade credit; see the next subsection for more details).
personal savings first; thus, policies that protect individual They could also attempt to minimize their inventory and/or
wealth, such as tax reforms75 and property rights, indirectly reduce operating costs, or sell unnecessary or unproductive
assist the financing of SMEs. assets to gain needed cash. Financial institutions, in addition
to providing funds to SMEs, can offer SMEs consulting
2. Working capital services in working capital management, including
techniques of cash flow forecasting, and rescheduling or
Working capital represents the excess of current assets over refinancing of existing loans.
current liabilities such as debt, where “current” is a time span
Figure V.7. Examples of working capital management
of a year or less. A high level of working capital indicates
significant liquidity, and it is frequently used to measure Sales of
a firm’s ability to meet current obligations (Scott, 1997). Profitable unproductive
business assets
Positive working capital requires the maintenance of steady
operating cash flows. Saving on
Inventory
operational
reduction
costs
Working capital is a necessity for enabling all businesses to
continue functioning, particularly new businesses. This is Increased working
capital
commonly overlooked in business planning. For example,
growth intentions are often not supported by sufficient
Cash flow Late payment to
working capital. Rapid growth needs high inputs of capital, forecast suppliers
which can be difficult for SMEs to secure and sustain. It is
essential that each firm has proper working capital
Refinancing/ Quick customer
management (ESCAP, 1997). rescheduling of payment
loans
75
Refer to annex III.2 for further discussion on this aspect. Source: Authors’ compilation.
 3. Trade credit (the finance company) owns or will buy for
renting to the lessee;
Trade credit, or buyer’s credit, is an important source of (b) The finance company is the legal owner of the
Chapter V

capital and is the second largest funding source for SMEs after asset during duration of the lease;
banks and private lenders (Campbell, 2009). Trade credit is an
(c) The lessee has the control of that asset to use
arrangement between businesses to purchase goods or
during the lease period;
services on account without making immediate payments.
The agreement is provided by suppliers to buyers to bill the (d) The lessee pays monthly rental or installments for
buyer for payment at a later stage. A specific fixed period the use of that asset;
(e.g., due between 30 days and 90 days after the invoice date) (e) The lessor recovers a large part or all of the cost
is agreed upon within which the customer is required to of the asset plus earns interest from the rentals
make full or partial payment. Trade credit conditions are paid by the lessee; and
usually industry-specific; however, it is underpinned by (f ) At the end of lease period, the lessee has the
collaboration between businesses to make the use of capital option to acquire ownership of the asset (i.e.,
more efficient and effective. transfer of title after paying the last rental or
bargain option purchase price).
Trade credit serves as a valuable source of finance especially
in the developing world. The “buy-now-and-pay-later”
5. Factoring
mechanism, in particular, holds many advantages for SMEs.
One of the most important advantages is that it helps to
Factoring is a relatively new form of asset-based financing for
increase working capital by postponing the amount of
increasing working capital in Asia and the Pacific, and refers
monetary expenditure in order to create positive cash flows
to the sale of accounts receivables by a company to a third
(figure V.8) while reducing capital investment requirements
party (called a factor) for immediate money and finance
(Tradecredit, 2008). A further advantage is that it allows
(Sridhar, 2008). A bank or a specialized financial institution
businesses to focus on growth and other productive activities
may purchase accounts receivable from an SME with
with the assurance of sufficient investment and without
adequate trustworthiness for cash at a discount from the face
restrictions on their development and expansion (Tradecredit,
value, thus assuming the risk on the ability of the buyer to
2008).
pay and handling collections on the receivables. This practice,
called factoring, may increase SMEs’ short-term cash flows,
Figure V.8. Trade credit
while reducing administrative costs of accounts receivables
Working capital (Sridhar, 2008).
92 Time gap There are three main differences between factoring and bank
Customer loans. First, the emphasis is on the value of the receivables
Receivables Sales payment
instead of the firm’s creditworthiness. Second, factoring is
Payment to a purchase of financial assets rather than a loan. Finally,
Payables Procurement suppliers factoring involves three parties (i.e., a firm, a buyer/customer
and a factor) while a bank loan only involves two (i.e., a firm
Source: Authors’ compilation.
and a bank) (EURO-Phoenix, 2011).

4. Leasing SMEs, especially start-ups and those with poor credit

histories, may find factoring attractive because it places less
In order to help small borrowers, some banks, non-banking reliance on collateral. The key value of factoring is that
finance companies and other financial institutions offer underwriting is based on the risk of the receivables (e.g., the
leasing. Leasing is a convenient option to assist SMEs in buyer) rather than the risk of the seller (Klapper, 2006).
obtaining business equipment for a smaller cash outlay than Factoring may be particularly suited for those SMEs holding
an outright purchase. The SME can finance up to 100 per cent account receivables from large or foreign firms whose credit
of the equipment value without collateral. Repayment risk is far lower than the sellers themselves (Sridhar, 2008).
schedules can be adjusted according to cash flow.
Documentation requirements and approval time are Factoring is an expensive form of financing in comparison
relatively simple and short. to bank loans and therefore may not be the ideal choice
when other sources of financing are viable. The rate of return
There are two basic types of lease: capital and operating.
should be considered in advance and factoring may be
A capital lease, or hire-purchase, treats the leased equipment
adopted only when the expected return of capital is higher
as an asset owned by the lessee (an SME), whereas an
than the cost. Factoring often requires the endorsement of,
operating lease does not. Both types of leases can be useful
or notification to the buyers in advance; this may signal
for increasing the cash flow of the lessee, but only the capital
financial weakness.76
lease confers ownership of the asset on the lessee at the end
of the lease period. 76
Invoice discounting is a similar asset-based instrument as
factoring, in that the invoice discounter advances an agreed
A leasing arrangement typically involves the following (CIMC, percentage of the invoice value (receivables). The main difference is
2011): that invoice discounting allows SMEs to continue administering their
sales ledger rather than transferring this responsibility to the factor,
(a) The lessee (borrower) selects an asset (e.g., and the service is usually undisclosed to customers (Asset Based
equipment, vehicle or software) that the lessor Finance Association, 2011).
6. Short- and long-term loans according to a pre-determined schedule, such as monthly or
quarterly. The clauses of a promissory note are simpler than
Short- and long-term loans, especially from commercial those of a loan agreement; therefore, a promissory note is

Chapter V
banks, are a very common form of financing for SMEs. The more flexible and negotiable than loan agreements.
length of the loan generally depends on the collateral,
guarantee or credit history of the borrower. Credit through credit cards, which are often used by SME
owners, are also a form of short-term loans. Credit cards are
Short-term loans are the most common form of bank loans a convenient means of making payments and tracking
for start-ups and small businesses, as commercial lenders are expenses but have higher interest rates than other forms of
generally less willing to take large risks with new companies. short-term borrowing. Sometimes it works as a substitute for
They have a maturity of one year or less, although many are other types of loans by SMEs, because small firms and start-
repaid within a shorter timeframe (Peavler, 2012). They are ups usually have little credit history to ask for commercial
usually taken out for a specific expenditure, for example, to loans. In addition to a personal credit card, there are business
purchase a piece of equipment or to pay a particular debt. cards with more specific functions for business operations
In this context, a fixed amount of money is borrowed for a but which can more expensive and more difficult to qualify
set time with a fixed interest rate (Business Owner’s Toolkit, for (Dratch, 2011). Based on a survey in the United States,
2012b). In general, the sources of short-term financing for a personal credit card was widely used among the smallest
SMEs include a line of credit, promissory notes, other short- firms, while the use of business credit cards generally
term banking instruments (credit cards and overdrafts) and increased with firm size (Mach and Wolken, 2006).
loans from other financial companies.
Overdraft financing is provided when businesses make
Short-term financing is easier to arrange, has lower costs and payments from their business current accounts that exceed
is more flexible than long-term financing. However, short- the available cash balance (Touch Financial, 2000). The
term financing is more vulnerable to interest rate swings, overdraft limit needs to be negotiated with banks, and the
requires more frequent refinancing and requires earlier amount borrowed is repayable on demand by the bank.
payment. Compared to long-term financing, short-term Depending on the size of the overdraft, a bank may require
financing allows a business to operate with more flexibility the SME to provide some collateral.
and sufficient freedom, and it is usually less expensive.
Therefore, SMEs can rely on short-term loans to operate on Long-term commercial loans usually refer to those repaid
thin cash reserves, to meet sudden financial needs or to gain beyond one year and up to three years (Business Owners’
additional working capital, especially in such situations as a Toolkit, 2012d). This type of loan enables businesses to invest
temporary cash crisis or delay in an expected payment from and expand their business with less risk of financial
a debtor (ShortTermLoans, 2011). In addition, one source may uncertainty, and increases working capital while reducing the 93
be more suitable than the others because of differences in amount of installments. Longer-term commercial loans are
their interest rate and collateral requirements; thus, SMEs may used for a variety of purposes, such as purchases of major
consider using one or more short-term sources in a given equipment and plant facilities, business expansion or
circumstance. acquisition costs. Lenders require significant collateral
because the risk increases with the term length.
A related form of short-term borrowing, which is typical in
developed countries, is a line of credit that sets a maximum It is more difficult for SMEs to obtain long-term loans due to
amount of funds available from the bank to be used when the lack of adequate assets to use as collateral and the
needed for working capital or other cash needs. This allows insufficient supply of such long-term loans, particularly in
the business to borrow funds quickly up to a certain limit with developing countries (IFC, 2009). The obvious consequence
floating interest, which they pay only on the outstanding of a long-term loan shortage is that SMEs are unable to plan
balance (Business Owners’ Toolkit, 2012c). If the business does on a long-term basis, thereby constraining growth plans and
access this credit, it must make monthly payments of interest long-term investment decisions (Obamuyi, 2007). One
and principal towards the debt. A line of credit gives SMEs solution involves government intervention through
flexibility and typically lasts for three years, subject to renewal. mechanisms such as credit guarantees (see next subsection)
or direct long-term loans.
Beyond lines of credit, another typical short-term borrowing
instrument that is common in some Asia-Pacific countries Some government agencies and international institutions are
(e.g., India, Japan and the Republic of Korea) is a promissory also devoted to helping to solve this problem. An apt
note, a negotiable instrument payable to the bearer on example is two-step loans. These are often designed to
demand. It details the terms of a promise by one party (the support development in specific sectors in developing
borrower, sometimes also called the maker, obligor, payer or countries. It takes its name from the process whereby funds
promisor) to pay a sum of money to the other (the lender, or are first provided by the public sector to a local financial
sometimes payee, obligee or promisee) (Self-Counsel Press, institution and are then disbursed to multiple end-
2009). An SME with adequate creditworthiness can issue the beneficiaries (Association for Promotion of International
note and will repay the principal in a fixed future time, e.g., Cooperation, 2011). In general, the maturity of this type of
three months later, according to the demand of the lender loan is quite long and the interest rate is lower than the
together with interest, or may make interest payments market rate (Okuda, 1993).
 7. Credit guarantee levels of leverage (five times or more in developed countries)
(Levitsky, 1997). In practice, the credit guarantee is often
Loan credit guarantee schemes (CGS) have been recognized a soft loan.78
Chapter V

as one of the most effective ways of providing assistance to

SMEs’ debt financing. 77 Various governments, often in While many countries in the Asia-Pacific region have been
cooperation with international financial institutions, employ operating CGS, some for many years, the operational
CGS to serve as long-term mechanisms for SME support by experiences of these schemes have been mixed. Despite
cushioning banks from the risks associated with lending to the best intentions of policymakers, CGS have often failed
small businesses. These schemes help entrepreneurs to to inspire confidence among banking institutions. Issues
secure both short-term and long-term credits with less surrounding the system of guarantee include: (a) moral
collateral or even without collateral. Another policy objective hazard; (b) high administrative costs due to complicated
of the schemes is to provide an opportunity for banks to learn procedures and fragmented clients; (c) staff reluctance to deal
more about SMEs – their problems and operations – and to with SME loan portfolios; (d) delays in paying claims; (e) low
help improve handling of their SME loan portfolios. Through demand by SME borrowers; and (f) limited outreach by banks.
their direct association with SMEs, financial institutions can As such, experience shows that banks have not always
gradually learn how to lend independently to SMEs. chosen to utilize these schemes and sometimes have had to
be forced by the government into cooperating. Some of the
Levitsky (1997) analyzed various types of CGS and found that problems identified above could be resolved if staff were
most schemes had guarantees for between 60 per cent and better trained and motivated to deal with SMEs. The
80 per cent of the loan amount; the key factor underpinning administrative costs of credit appraisals and monitoring SMEs
their success was a strong cooperative relationship between could also be reduced by outsourcing these activities to
guarantors and lenders. Apart from the benefits already providers, such as chambers of commerce and federations of
mentioned, one of the major arguments in favour of these industries. Last, the risk of moral hazard/non-repayment
guarantee schemes is that these funds can reach important might be reduced via relationship development and/or lower
loan guarantees.79
77
Other major pubic support schemes for facilitating SME debt
78
financing include interest subsidies, credit insurance schemes and Soft loans are provided by the public sector at lower-than-market
promotion of promissory notes, which are delivered to the SME sector interest rates.
79
either via commercial banks or non-banking financial institutions (RAM However, lower loan guarantees may discourage financial
Consultancy Services, 2005). institutions to participate in the guarantee schemes.

94 Box V.2. Japan’s SME credit guarantee schemes

The Credit Guarantee Corporation (CGC) of Japan, which was Japan’s credit guarantee scheme is characterized by two key
established in 1937, aims to help SMEs raise funds from financial functions: (a) a credit guarantee function; and (b) a credit
institutions by providing credit guarantees on commercial loans. insurance function. The credit guarantee function is illustrated
The National Federation of Credit Guarantee Corporations in figure V.9 with nine steps. Following the submission of the
comprises of 52 local CGCs, with at least one in each of the 47 SME loan application (1) and its corresponding creditworthiness
prefectures of Japan, which engage in activities that support check (2), a guarantee certificate is issued to the financial
local businesses, promote standardized guarantee systems and institution (3), and the SME is then required to pay a guarantee
respond to specific local needs. fee to the CGC before the loan is extended (4). Successively, the

Figure V.9. Credit Guarantee Corporation’s credit guarantee function

5. Loan repayments
Financial 4. Loans
Institutions 1. Loan applications SMEs
De App e o sts f und
po lica f cr or p er
1. Issu ue nts

s
sit tio edit ay gua
3. eg me

ni ee s on
m nt eck ati
s n s g u m e ra n
6. Pay
R

d e ra h l i c
7.

ed

y)
in ua s c p
of f g es ap

r
es fee
ish

ve
fo ar nt te

t s t o h i n te e

bl

o
r c an s u e

ec
ta
g h e n o r t ra n

r
re te n ( S

nd
di e de ub

8. Pay ditw gua

ty
t g ce r

(fu
u a r t i g u ro g a

4 . re d i t

ts
ra f i c a ra t i o

en
2 . . C re
nt at n

ym
e e e s te e n )

Ri m

pa
C

e
nr
oa
9 .L

CGCs

Source: CGC, 2011.

 Box V.2. (continued)

SME is required to make repayments according to the agreed a credit insurance premium to JFC and will get a subrogated

Chapter V
terms and conditions of loan with the financial institutions (5). amount from JFC if it makes payments on behalf of an SME
However, in the event that the SME is unable to make all or part under the guarantee scheme.
of the repayments within the agreed term, the financial
institution can request the payment from CGC under the While the operations of CGCs are financed primarily by the
guarantee (6 and 7). Afterwards, CGC will obtain the right of guarantee fee and capital gains on CGCs’ assets, the national and
indemnity against the SME (8) and recover the loan repayment, local governments also provide financial support to the National
often through assisting the SME to rebound (9). To facilitate the Federation of Credit Guarantee Corporations and CGCs to
process, CGCs place certain deposits with the participating promote their operations and enhance the management base.
financial institutions. As figure V.10 shows, the national and local governments and
JFC provide credit insurance funds, various subsidies, deposits
To spread the risk, a loan is automatically insured by Japan and compensation for losses. With the active engagement of
Finance Corporation (JFC) when a CGC approves a credit CGCs and the support from government organizations, more
guarantee. This serves as the credit insurance function of the than a million cases were approved by CGCs in the fiscal 2010,
credit guarantee and is maintained by public funds. CGC pays to the amount of ¥ 14.17 trillion (approximately $ 13 billion).

Figure V.10. Institutional framework of Japan’s credit guarantee schemes

National Government
Local Governments Ministry of Finance
Subsidies for Ministry of Economy, Trade and Industry
CGC'S fund
(Small and Medium Enterprise Agency)

Supervision Subsidies for compensation

Supervision Supervision assets Supervision

Contributions/Loans National Federation of

Credit Guarantee
Corporations (NFCGC
Compensation
for the loss Fund for Credit Insurance
95

Credit Guarantee Japan Finance

Corporations Corporation
Insurance (JFC)
(52 CGCs) Contracts

Guarantee Credit Guarantee

Contract Consignment Contract

Loans
Financial SMEs
Institutions
Repayments

Source: CGC, 2011.

8. Microfinance borrowers and 5.8 million depositors in select developing

countries in East Asia, South-East Asia and the Pacific80 with
Microfinance, as described by the Consultative Group to an average loan balance of $ 306.5 per borrower. In contrast,
Assist the Poor (2011), comprises a wide range of financial the average loan balance in South Asia81 is only $ 144 per
services geared towards the poor and low-income group as borrower, but there are 53.7 million borrowers and 26 million
well as micro, small and start-up enterprises. Microloans,
savings and micro-insurance are examples of such financial 80
Those countries include Cambodia, China, the Lao People’s
services, which are aimed at providing access to formal Democratic Republic, Malaysia, Papua New Guinea, Philippines, Samoa,
finance and facilitating financial inclusion for these Thailand, Timor-Leste, Tonga and Viet Nam.
businesses. The Microfinance Information Exchange (2010) 81
South Asia comprises of Afghanistan, Bangladesh, Bhutan, India,
reported that as of 2010 there were 15.8 million active Nepal, Pakistan and Sri Lanka.
 Box V.3. Examples of credit guarantee schemes: India, Pakistan and Turkey

A. Credit guarantee fund for micro and small enterprises, to the following: (a) individual SMEs on a retail basis; (b) overall
Chapter V

India portfolios for SMEs; portfolios earmarked for a priority sector;

and (c) programme lending schemes for specific clusters. In
The micro and small enterprise (MSE) sector in India includes an general, guarantees issued by CGF are only partial in nature.
estimated 26 million enterprises, providing employment to Proportions of risk to be borne by the respective parties are
approximately 60 million people. Despite the size and 50 per cent for CGF, 30 per cent for banks and 20 per cent for
importance of this sector, access to bank finance is often very SMEs through collateral. CGF may also issue full guarantees, in
low due to the perceived high risk of default. To protect line with the specific needs of disadvantaged regions and
themselves from defaults, banks insist on collateral; SMEs sectors.
struggle to provide it. In order to facilitate collateral-free credit
and make it available to the MSE sector, the Government of India CGF works closely with its partner banks in ensuring that
launched the credit guarantee fund for SMEs in 2000. As of processes have minimal potential risks. First, banks carry out
March 2010, there were 112 participating lending institutions credit checks and risk assessments of all applications. Following
registered with the fund, comprising banks, institutions and this due diligence by banks, applications are forwarded to CGF
corporations. for their own processing. If the application passes both
processes, a guarantee will be issued by CGF and forwarded to
This fund offers both term loans and working capital facilities its partner bank.
up to Rs 10 million (approximately $ 190,000) per borrowing
unit, which can be extended without any collateral security or Apart from CGF, the Credit Guarantee Scheme, offered by the
third-party guarantee to a new or existing unit in the MSE sector State Bank of Pakistan, is implemented to endorse accessibility
by a single lending institution. Any credit facility covered under of financing for low-end fresh and collateral deficient borrowers.
the scheme is not eligible for additional coverage. The extent of
credit guarantee ranges from 62.5 per cent to 85 per cent, Source: Presentation by the Small and Medium Enterprise
depending on the borrower category and the credit facility. The Development Authority, 29 June 2011, Bangkok.
guarantee under the scheme runs through the agreed term
loan/composite credit, and has a tenure of five years or as five- C. Credit guarantee fund, Turkey
year blocks, depending on whether the working capital facility
In 1993, Turkey established its credit guarantee fund under the
is standalone or not.
auspices of the Small and Medium Industry Development
In 2009-10, 151,387 credit guarantee proposals were approved Organization – one of the major organizations responsible for
with a total credit amount of Rs 68,751.1 million (approximately the SME policy of Turkey and a major stakeholder in the fund.
$ 1,317 million). The cumulative number of proposals since The other main shareholders include the Union of Chambers and
96 the establishment of the scheme in 2000 is 303,982, which Commodity Exchanges of Turkey and 20 major banks in Turkey.
accounts for Rs 118,354.1 million (approximately $ 2,270 million)
The main objective of the fund is to support SMEs by providing
guaranteed for SME loans.
a guarantee for their financing and by increasing their credit
usage in general. The guarantees are targeted at supporting
Source: Ministry of Micro, Small and Medium Enterprises, 2011.
youth and woman entrepreneurs, promoting innovative
B. SME Credit Guarantee Fund, Pakistan investments and high-tech SMEs, encouraging exports,
increasing the rate of employment and contributing to local
The SME Credit Guarantee Fund (CGF) of Pakistan was development. Since its foundation, the fund has helped nearly
incorporated in 1984 as a public-private partnership company. 10,000 SMEs with guarantees of more than $ 1 billion.
As a subsidiary of the Small and Medium Enterprises
Development Authority of Pakistan, CGF aims to facilitate SME Apart from the credit guarantee fund, the Small and Medium
access to finance. Industry Development Organization also provides direct loans
under its loan programmes. The key features of the programmes
The endowment fund of CGF was created by pooling equity are zero interest rates, easy payment periods, clear non-payment
investment of PRs 10 billion by the Government and partner terms and pre-defined maximum limits. These loan programmes
banks on 1:1 basis. Funds are invested in deposits and securities. are mainly conducted in the areas of export promotion, new
Returns are used to meet the operational expenses and offset employment, digital infrastructure, relocation of the leather
subrogation losses of CGF. The upper limit of guarantee sector in industrial zones and machinery and equipment credit
exposure may be up to 10 times that of the endowment fund for the food sector.
(e.g., PRs 100 billion).

CGF provides credit guarantees for both working capital Source: Republic of Turkey Small and Medium Enterprises
financing and capital investment. Guarantees are primarily given Development Organization (undated).

depositors. Overall, the microfinance sector in Asia and the Pacific is that microfinance institutions specifically set women
Pacific showed impressive growth rates during the past few as a target client group. In 2010, the percentages of female
years, with an increase in borrowers of more than 100 per clients in East Asia (and the Pacific) and South Asia were 56.76
cent from 2005 to 2010. Three of the top five countries of and 91.54 per cent, respectively (Microfinance Information
microfinance recipients in 2010 were Asian nations: China Exchange, 2010).
($ 14 billion borrowed), India ($ 5 billion borrowed) and
Viet Nam ($ 5 billion borrowed) (Microfinance Information Among the notable large-scale microfinance projects in the
Exchange, 2010). Another feature of microfinance in Asia and region the Microfinance Initiative for Asia stands out (IFC,
2012a). Under the Microfinance Initiative for Asia, the KfW information is lacking and the national bond market is not
Development Bank of Germany and the International Finance developed. Furthermore, the bond market is not always
Corporation (IFC) agreed in 2007 to invest $ 1 billion during accessible to SMEs, or simply does not exist.

Chapter V
the course of three to five years. Using debt and equity
investments, structured finance and consulting services for Corporate bonds have substantial issuance costs, including
Asian micro-financing institutions (MFIs), the Microfinance a large fixed-cost component (Altunbas, Kara and Marques-
Initiative for Asia targets two main objectives: (a) the creation Ibanez, 2010) (table V.3 for detailed cost items). The scale of
and enhancement of the institutional capacity for sustainable debts for a single SME may not be large enough for achieving
microfinance delivery; and (b) the strengthening of linkages cost efficiency and the issuance costs therefore become
between domestic and international capital markets. a major obstacle for accessing such a financing instrument.

Many types of organizations provide microfinance. Among

MFIs, not-for-profit organizations, self-help groups, state- Table V.3. Issuance costs of corporate bonds
owned banks and commercial institutions can be found. Recipient Typical cost item
While these organizations differ considerably in their
operating models, they often share one important common Regulator or Stamp duty, issue licence fee (may take
characteristic: high repayment rates. By applying innovative government the form of a prospectus reviewing fee,
solutions, such as a shared liability model and collateral-free securities registration fee and so on)
lending, MFIs are able to keep the average default rates as Stock exchange Listing fee
low as 2.4 per cent worldwide (Microfinance Information Intermediaries Underwriting, management and
Exchange, 2010). An apt example is the Group Model applied placement fees (“gross spread”), trustee
by the Grameen Bank. In this model, the borrowers are fee, payment agent fee, listing agent fee
divided into five member groups and each group jointly and intermediaries’ out-of-pocket
assumes debts. Consequently, peer pressure and collective expenses
responsibility can help to control the default risk (Grameen Professionals Legal fee, accountant’s fee and rating fee
Bank, 1998). Many MFIs have successfully proved that the Miscellaneous Prospectus printing expenses, road show
poor are “bankable” and that the base of the pyramid, e.g., expenses and staffing costs
the poor and micro enterprises, is a financially viable market.
Source: Endo, 2008.
The nominal interest rates charged by most MFIs in the
Asia-Pacific region range from 30 per cent to 70 per cent A plausible solution to the inherently higher credit risk and
per year, which are very high compared with the rates of the scale problem may involve pooling a group of SMEs for
commercial banks and subsidized lending organizations
(Fernando, 2006). The high nominal interest rate is mainly
corporate bond issuance (Park, Lim and Koo, 2008). The
combination of SMEs with various degrees of risk exposure
97
due to the high cost of funding, inflation and high cost to the economic cycle may lower the risk to an acceptable
of administration and operation associated with MFIs level for investors. The high issuance cost could also be
(Microfinance Information Exchange, 2010). Microfinance lowered with a sufficiently sized deal.
remains attractive to SMEs because it specifically caters to this
sector, is more accessible and most loans are still cheaper 10. Seed capital
than informal or black market financing sources. More
recently, the debate about whether it is ethically justifiable For entrepreneurs, seed capital – the financing of direct
to profit from the poor (Grameen Foundation, 2010) and the equity capital for start-ups – is needed to establish their
serious problem of market saturation and over-indebtedness business. It can come from various forms of equity and debt
have led to more stringent scrutiny of microfinance (Kappel, such as convertible equity loans and soft loans.82 The main
Krauss and Lontzek, 2010). Nonetheless, microfinancing underlying characteristic of this form of financing is that the
remains a powerful tool for financial inclusion, particularly for capital provider may not seek high rates of return and may
SMEs. be satisfied with modest returns on investment. This is usually
the case with public agencies that have the mandate to
9. Corporate bonds provide seed capital for business start-ups (UNCTAD,
2001b).83
A corporate bond is a debt instrument issued by
a corporation, the holder of which receives interest from The providers of seed capital have evolved into partnerships
the corporation periodically for a fixed period and repayment between governmental agencies and banks, with the former
of the principal together with the interest due at the end of acting as a mediator and the latter as a source of lending
the maturity period (Securities and Exchange Board of India, capital. Banks usually allocate a certain amount of seed
2010). Corporate bonds are a good source of longer-term capital through funds designated for SME development;
debts, with medium and long-term maturities. Compared however, these funds usually do not provide enough variety
with bank loans, corporate bonds are more flexible because of financing packages, nor the full capital, needed by the
a company can determine the terms and the date to maturity. SMEs (UNCTAD, 2001b). Therefore, public sector assistance is
Another advantage is that the issuance of corporate bonds often needed to fill this gap.
can raise funds without affecting shareholders.
82
However, seed capital typically comes from entrepreneurs’ savings
It can be difficult for SMEs, particularly in developing and/or informal loans from their associates.
countries in Asia and the Pacific, to issue bonds. Investors are 83
There are dangers of moral hazard if policymakers extend soft
not interested in bonds when disclosure of financial loans as well as exposed risks taken by public agencies.
 For example, ING Bank of the Netherlands has established eventually become angels themselves,” the members have
a seed capital fund that exposes the bank to only 50 per cent invested about S$ 18 million in almost 80 start-up enterprises
participation in the financing of any SME. Another example (BANSEA, 2012). The early stage companies that manage to
Chapter V

is of the partnership between Enterprise Ireland and the Bank pitch successfully to investors receive funds in the range of
of Ireland, with the Enterprise 2000 Seed Capital Fund, that S$ 100,000 to S$ 1 million (BANSEA, 2012). While not every
offers a combination of equity loan financing (in a 1:3 ratio) SME will meet the investment criteria of business angel
to start-ups. The loan amount ranges from € 32,000 to networks or individual angel investors, angel finance
€ 125,000. The fund, a partnership between the State and represents an increasingly important source of funding for
private funds, does not require personal guarantees, but a selected number of SMEs in Asia-Pacific.
does require a post investment follow-up (European
Commission, 2000). In India, the State Bank of India (SBI) 12. Venture capital
provides interest-free seed capital of up to Rs 1 million to
entrepreneurs under a scheme aimed at encouraging SME Venture capital is a form of investment finance designed to
development in India. The scheme offers the matching seed provide equity or quasi-equity funding to private SMEs,
capital for entrepreneurs to secure traditional banking where the primary return to investors is from capital gains
loans for their business, and has a five-year moratorium on rather than from dividend income. Venture capitalists are
repayment of that initial seed capital (Sikarwar, 2010). actively involved in the operations and management
of such SMEs to ensure the success of their investments.
Direct government support for equity financing typically They generally possess experience with investing in previous
experiences difficulties in making equity investments start-ups and general business expertise – as such venture
effective. The issues include unclear SME beneficiaries, lack capital which is a long-term risk finance operation
of business expertise, inappropriate organizational structure (Ross, Westerfield and Jordan, 2008; and UNCTAD, 2001b).
and cultural mismatch between government and business. Investors are attracted to venture capital investments
due to the potentially large gains from future sales of shares
11. Angel finance of the company and are therefore willing to accept the higher
risks involved, compared to traditional banks (UNCTAD,
At the very early stage of the business life cycle, SMEs without 2001b). It is not uncommon that in a portfolio of 20 companies
a proven track record can find it especially difficult to access only one will return anything to the venture capitalist;84
finance. In such cases, angel finance can be a potential source the hope is that the one company will provide a big payoff.
of funding worthy of exploration. Angel investors are
described as high net-worth individuals with extensive A distinction is usually made between seed capital and
entrepreneurial experience, who provide seed capital for venture capital, with seed capital referring to the financing
98 early-stage ventures in return for convertible debt or an of direct equity capital for start-ups in the initial stages to
equity stake (Freear, Sohl and Wetzel, 1994; and Avantage supplement the shortfall in capital needed by the firms. On
Ventures, 2011). the other hand, venture capital refers to the next one or two
phases of finance needed to achieve company stability and
Unfortunately, as Scheela and Isidro (2009) pointed out in ensure strong growth potential (UNCTAD, 2001b). Venture
their study on business angels in emerging Asia-Pacific capitalists do not necessarily invest their own money
economies, there is a dearth of well-documented reports (Thunderbird Angel Network, 2010).
on this particular topic. Due to the absence of reliable
quantitative data on business angels in the Asia-Pacific A venture capital fund would typically invest in an SME within
region, an accurate assessment of indicators such as a high-growth sector that seeks to expand its operations.
availability of funds and number of deals is lacking. However, Alternatively, they can also partake in buyouts of more
considerable descriptive and anecdotal data exists that established companies. The duration of involvement of
provides valuable insights into this field. Among other things, a venture capitalist is usually between two and four years,
the field of angel finance is frequently characterized as being after which the venture capitalist will typically sell the shares
financially risky, with only 10 per cent to 20 per cent of the of the company on a stock exchange (e.g., an IPO), as a trade
investments bringing a return. In the assessment of the sale to other companies, through a management buyout to
prospective investee, the angel investor demands a solid transfer managerial control or by selling the whole stake in
business plan, entrepreneurial leadership and growth the company to a more established competitor or other
potential (SPRING Singapore, 2011b). In addition to the venture capitalists.
financial incentive, SMEs should not overlook the great
benefit of having an angel investor as a mentor and who can To lower their risk exposure, venture capitalists typically
gain access to the investor’s network. provide financing in stages, with each installment sufficient
enough to reach the next development stage (Ross,
In striving for a more organized and professional approach Westerfield and Jordan, 2008; and Zavatta, 2008):
to angel finance, a number of local and regional business
angel networks have been set up in Asia and the Pacific (a) Start-up – additional funding for marketing and
during the past decade. The Business Angel Network South- product development expenses for an early-stage
East Asia (BANSEA) is among the more established and firm;
prominent networks of angel investors in the region. Based
in Singapore, BANSEA was founded in 2001 and has about 84
In the authors’ interviews with venture capitalists, the typical
50 members. With a vision of “fostering a vibrant start-up outcomes they described for a 20-firm portfolio was that 5 would lose
ecosystem in which angel investors fund entrepreneurs who money, 14 would either break even or produce modest profits, and
only one firm would be “successful, i.e., yield the type of return they seek.
 (b) First round – financing for prototype production mutual funds, since venture capital funds have a
and manufacturing plans; long-term involvement in their target companies.
(c) Second round – major investments needed in Nevertheless, an exit mechanism is necessary for

Chapter V
order to begin manufacturing, marketing and venture capitalists to benefit from capital gains.
distribution of product; This is difficult in almost all developing countries
in Asia and the Pacific, except those with fairly
(d) Third round, also called the mezzanine level – the
developed stock markets. Other mechanisms
expansion funds required for a newly-profitable
such as guaranteed buy-backs are not realistic for
company; and
SMEs.
(e) Fourth round, also called bridge level – intended
to finance the “going public” or IPO process. The United States pioneered the use of venture capital and
is still the world leader in terms of money invested and
Venture capital has the potential to offer valuable sources of number of deals, but other countries are now developing
finance that complement the more traditional credit finance their own venture capital funds (UNCTAD, 2001b). Venture
provided by commercial banks. Some of the factors hindering capital is a familiar source of funding for SMEs in Europe and
SMEs’ access to capital from traditional credit institutions are Israel, and the amount of venture capital utilized in China has
less important to those venture capitalists willing to take on risen tremendously during the past five years (Zero2IPO,
greater risks. Some of the advantages for venture capitalists 2010). Some countries, such as India, have set up sector-
for SMEs are (UNCTAD, 2001b): specific venture funds for the ICT industry and biotechnology
sector (Small Industries Development Bank of India, 2011).
(a) Venture capitalists are willing to accept higher
risks than traditional banks in exchange for 13. Stock market and initial public offerings
potentially large gains from the future sale of
shares of the company;
The stock market is a financial source for SMEs at a later stage
(b) Venture capitalists do not require collateral from of development, and an IPO is the main way to go public.
borrowers; Access to the stock market is a key stage in the growth
(c) Operating costs are lower due to the absence of of SMEs, especially for the high-tech, high-growth firms.
high interest rate payments; In an IPO, a company raises capital by issuing shares to
(d) Venture capital is a long-term or at least investors for the first time and subsequently becomes listed
medium-term capital commitment in contrast on a stock exchange (Government of Canada, 2003). In these
to short-term loans from banks; and transactions, shares are sold to investors to provide equity
capital for the company in return for company ownership.
(e) The managerial know-how provided by venture
capitalists can, in some cases, be more valuable
Going public through an IPO gives SMEs access to a pool of 99
capital that is much larger than a relatively small group of
to the start-ups than the actual financing.
original owners and investors. It provides an alternative way
to raise long-term capital instead of debt financing.
However, there are also some disadvantages:
IPOs give extra credibility to suppliers and customers, help
(a) Because of the high-risk nature of venture capital
boost employees’ morale, and may attract other financing
and the timeframe for returns as well as a lack of
sources. More importantly, an IPO is by far the most preferred
adequate skills and corporate information, finding
exit mechanism for early stage investors such as business
initial investors may be difficult, particularly in
angels and venture capitalists (Zavatta, 2008). An efficient IPO
Asia-Pacific developing countries; and
mechanism can encourage risk-taking investments and more
(b) The need for highly-liquid capital markets is not capital flows into innovative, high-growth-potential firms
as pressing, compared to open-ended funds or (Riding, 1998).

Box V.4. Pros and cons of equity financing for SMEs

Equity finance is raising funds for enterprise activities by selling However, raising equity finance can be costly and time-
shares to individuals or institutional investors who receive consuming, particularly for small businesses, and may take
ownership interests in the enterprise. It is notable that there is management focus away from the key business activities. Also,
a trade-off between the benefits and potential shortcomings of management time has to be invested to provide regular
equity finance. feed back to investors as part of the monitoring process.
Moreover, a certain amount of control over the management
A significant advantage of equity finance is that it does not need and decision-making has to be shared with investors (Business
to be repaid and there is no interest rate on the money. Investors Link, undated). In general, equity investment is associated with
can also bring with them valuable skills, networks and high risks; therefore, equity investors would expect a rate higher
experience, and assist with developing business strategies and than publicity trade investors, even though the expected return
decision-making. Moreover, as the business grows, it can be of equity injection declines for each round as the risk becomes
supported with follow-up funding by investors already involved lower (Sridhar, 2008). This characteristic may reduce the
and knowledgeable about the firm (Business Link, undated). possibilities for SMEs in conservative lines of business to access
In addition, equity finance can help SMEs to reach the minimum the equity sources in the early stages.
equity requirement set by banks, thus increasing the
opportunities to obtain bank loans (Sridhar, 2008).
Note: Specific forms of equity financing can be found in Zavatt, 2008.
 Figure V.11. Sources of start-up funds in Japan
(Units: Percentage and amount)
90 40
Chapter V

77.8 Percentage (left axis) Median value of amount of funds raised (right axis)
80
70 30
60

(¥ 1 million)
Per cent

50
20
40
30 25.1
17.0 12.0 10
20 11.9
12.0
8.3 6.6
10 4.5 3.2 2.1 2.0 0.5
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als t
d

ng
n

es
n

es
Su
wi

du e

Bo
Inv

wi
rro

rro
Bo
t

Ind nve

Bo
I

Bo

Source: JSBRI, 2011.

Going public also brings new challenges to SMEs. They must The sources of start-up financing in Japan, including the
report to the public because of the new management amounts involved, are presented in figure V.11. Informal
structure, and maintain high growth potential to avoid financing (e.g., own funds; loans from relatives and friends)
undervaluation of their stock and poor medium-term returns. is the major source of finance for supporting the capital
Considerable costs are also associated with IPOs, including needs of entrepreneurs, although the amounts are relatively
significant time and money invested in both the initial small. Public support also provides substantial amounts of
process of issuing shares and the ongoing requirements for funds to start-up businesses in Japan, reflecting its well-
disclosure and shareholder relations (Riding, 1998). developed public assistance to entrepreneurs. While
commercial loans from the banking sector play a smaller role,
To take full advantage of this approach, the prerequisite is to they provide relatively large amounts of funds to start-ups.
100 have adequately developed capital and stock markets in
terms of depth and liquidity (Park, Lim and Koo, 2008). An
It is noteworthy that venture capital provides by far the
largest amounts of funds among financial sources although
expanded venture capital market and financing would, in coverage is still limited.
turn, encourage more IPOs because venture capital supports
the growth of firms to a later stage and provides adequate Table V.4 illustrates the financing sources for Malaysia SMEs
financing resources for IPOs (Government of Canada, 2003). in different life cycle stages. Almost 68 per cent of SMEs in
Governments and SME agencies may also facilitate this the sample make use of self-financing during their start-up
approach by establishing information sharing systems to period but this falls quickly with the growth of the firms.
improve investment information transparency and by Venture capital shares a similar trend as self-financing,
providing consultation services to reduce issuance costs.
Table V.4. Financial sources for Malaysian SMEs, 2004
E. Sources of funds
(Unit: Per cent)
While commercial banking plays a key role in formal Phase of life
SME financing, informal financing such as own funds cycle/financing Start-up Established Mature
as well as loans from relatives and associates, and internal sources
financing such as retained earnings and trade credit,
Self-financing 68.0 21.0 25.0
dominate the financial sources of SMEs. For example, in
Government schemes 7.8 13.0 9.0
ASEAN countries 75 per cent to 90 per cent of SMEs rely on
informal financing and internal financing (RAM Consultancy Venture capital 10.8 8.5 4.5
Services, 2005). In China, entrepreneurs’ personal savings Short-term loans 20.8 28.6 23.1
provide between 50 per cent and 80 per cent of start-up from banks
capital, while approximately 20 per cent and 15 per cent of Medium-term 10.4 32.6 21.8
capital comes from bank loans and borrowing from friends, loans from banks
relatives and other individuals, respectively (Hussain, Millman Long-term loans 7.4 23.7 37.2
and Matlay, 2006). from banks
Non-bank financial 8.7 7.1 10.9
This section provides some quantitative evidence of major institutions
financial sources for SME development. For this purpose, two Source: Rozali and others, 2006.
countries from Asia and the Pacific (i.e., Japan and Malaysia) Notes: Short term loan is granted for less than one year; medium
and one country and one regional grouping from outside the term loan is for one to three years; and long term loan is for more
region (i.e., the United States and the European Union) are than three years. As multiple choices can be selected, total exceeds
taken as examples. 100 per cent.
even though the percentage is much lower. In comparison, Figure V.12 shows the major institutions used by Europe
long-term loans become more and more accessible to Union-based SMEs to obtain capital. Banks are by far the most
established and mature SMEs, and bank loans are the most popular financial institution when SMEs need financing. Close

Chapter V
important source for them. Other financial sources such as to 8 out of 10 companies surveyed went to a bank in order
government schemes and non-bank institutional financing to obtain capital (79 per cent). Around a quarter of SMEs
are equally distributed among SMEs in each stage of approached leasing or renting companies (24 per cent),
development at around 10 per cent. and 1 in 10 go to public institutions supporting investment
(11 per cent) (EOS Gallup Europe, 2005).
Table V.5 compares financial sources used by small businesses
in the United States in 1998 and 2003. In the United States, Another study supports this trend in the European Union.
the banking industry is highly developed; thus, small Figure V.13 shows the employment of financial sources by
businesses can access a wide range of credit services (e.g., line SMEs in the European Union. Debt financing through
of credit, term loans and credit cards). Trade credit is also a commercial banks (via overdrafts, lines of credit and bank
main source for small business finance, and more than 60 per loans) is the most important source of SMEs’ external
cent of SMEs employ it to finance their businesses. Around financing. Trade credit, an informal financing instrument, is
30 per cent of business owners use their own assets as a key also adopted by more than 25 per cent of SMEs. Moreover,
financing source. Only 8.7 per cent of small business received the usage of other financial instruments such as leasing,
capital lease services in 2003. hire-purchase and factoring increased from 2009 to 2011 is
now used as frequently as bank loans.

Table V.5. Financial sources of SMEs in the United States, 1998 and 2003
(Unit: Per cent)

Line of Loan Credit card Loan from Trade

Year Leasing
credit Mortgage Vehicle Equipment Personal Business owner credit

2003 34.3 13.3 25.5 10.3 46.7 48.1 8.7 30.3 60.1
1998 27.7 13.2 20.5 9.9 46.0 34.1 10.6 28.1 61.9
Source: Mach and Wolken, 2006.

Figure V.12. Institutions used by European Union-based SMEs to obtain capital, 2005

(Unit: Per cent)

101
Banks
79
Leasing/renting
companies 24
Public institutions
supporting investment 11

Private investors 7
Private financing companies
(other than banks) 4

Venture capital companies 2

Other 2

0 10 20 30 40 50 60 70 80
Source: EOS Gallup Europe, 2005.
Notes: Percentage of respondents; conducted in 15 European countries, namely Belgium, Denmark, Germany, Greece, Spain, France, Ireland, Italy,
Luxemburg, Netherlands, Austria, Portugal, Finland, Sweden and the United Kingdom.

Figure V.13. External financing sources of European Union-based SMEs, 2009-2011

(Unit: Per cent)
45
H1 2009 H2 2009 H1 2010 H2 2010 H1 2011
40
35
30
25
20
15
10
5
0
Overdrafts and credit Bank loans Trade credit Leasing, hire-purchase
lines and factoring
Source: European Central Bank, 2011.
Notes: Data for the preceding six months and percentage of respondents. The data are a survey conducted in Austria, Belgium, Cyprus, Estonia,
Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Malta, Netherlands, Portugal, Slovakia, Slovenia and Spain.
 F. Financial institutions for SMEs and their region, totalling $ 10.7 billion (IFC, 2010b). In East Asia and
challenges the Pacific, IFC has committed $ 416.6 million in 2010, and
SME financial institution clients had taken out 86,000 loans,
Chapter V

In the Asia-Pacific region, depending on the economic status totalling $ 17.2 billion by the end of 2009 (IFC, 2010c).
of the country, the financial sector contains various financial
institutions.85 Some of the main institutional providers of SME While financial institutions supporting the development of
financing consist of the following (Fliiby, 2009; World Bank, SMEs in the Asia-Pacific region have become increasingly
2005): active in the past few years, the banking sector remains the
most important source of external financing for SMEs (Park,
(a) Development financial institutions (DFIs) for long- Lim and Koo, 2008). Banks offer diversified loans with
term loans; different terms and various supplementary financing
instruments such as export credit and discounting.
(b) Commercial banks extending both long–term
Commercial banks in some countries also provide special
loans and short-term finance for daily operations;
loans targeted at priority sectors and key segments of
(c) Specialized financial institutions (usually licensed the population as identified by the government, including
for limited operations, activities, or services to SMEs.
differentiate them from full-service commercial
banks), such as export and import banks that However, SME development funds through commercial
provide trade finance and export credit,86 as well banks and financial institutions are not typically successful.
as rural banks, microfinance banks and non-bank Small bank loans and loans to SMEs as a percentage of total
finance companies; lending declined the past decade (Hall, 2009). Table V.6
(d) Government programmes or agencies for rural contains data based on a global survey of 91 banks in
finance, microfinance or SME finance; 45 countries, conducted in 2008. It indicates that SMEs are
(e) Membership-based cooperative financial strongly discriminated against by banks during loan issuance
institutions (CFIs); (also Table V.3). The survey result supports a commonly shared
idea that the smaller the size the higher the risk. It partially
(f ) Postal savings banks (PSBs) or institutions; and
rationalizes banks’ discriminatory behaviour towards SMEs.
(g) Public and private credit guarantee institutions.
From the banks’ perspective, the scarcity of funds for loans,
Some Asia-Pacific countries have opted to set up apex banks especially in developing countries, means there is less
for SMEs, generally known as SME banks, exclusively to cater incentive to seek out the profitable SMEs when larger and
to the needs of the SME sector. Non-banking/non-profit more qualified clients are available. Formal financial
102 financial institutions and microfinance institutions have also institutions often face higher transaction costs when dealing
cropped up to serve select sectors and categories of small with the rather fragmented SME sector because the credit
borrowers. Some DFIs have also become more active in monitoring process requires an extensive branch network
providing short-term loans and micro-lending in recent years. with more staff. The poor accounting system of many SMEs
and insufficient collateral due to limited fixed investment
International financial institutions, such as the World Bank also create obstacles to meeting the terms and conditions
and ADB, also devote resources to specialized financial for borrowing from banks (ESCAP, 1997). Lack of risk
institutions for lending to SMEs. International financial management skills related to SME lending has contributed to
institutions have become particularly active in the region. For significant non-performing loan problems in the past,
example, the International Finance Corporation (IFC) in 2010 demonstrating an inconsistency between commercial banks
committed $ 86.3 million to micro, small and medium-sized and SMEs, and discouraged banks from further lending to
enterprises in South Asia. By the end of 2009, IFC’s SME SMEs.
financial institution clients had taken out 374,000 loans in the
85
In addition to the general case shown in the last two right-
For those financial institutions and their characteristics, see
Reserve Bank of Australia, 2010, at http://www.rba.gov.au/fin-stability/ hand columns of table V.6, the Asia-Pacific region has also
fin-inst/index.html#funds. seen a rising percentage of non-performing SME loans in the
86
Trade finance is discussed in chapter VIII. past few years. In China, the China Banking Regulatory

Table V.6. Different bank loan features of different-sized enterprise, 2008

Share of total loans Loan fees Share of non-performing loans

(per cent) (per cent of size of loan) (per cent of total loans)
Mean for Mean for Mean for Mean for Mean for Mean for
developed developing developed developing developed developing
countries countries countries countries countries countries
Small enterprise 12.0 2.5 0.4 1.2 11.0 7.0
Medium enterprise 10.1 13.7 0.4 1.0 8.4 5.5
Large enterprise 27.9 32.8 0.2 0.8 2.5 4.1
Source: Developed from Beck, Demirgüç-Kunt and Peria, 2008.
Commission reported that non-performing loans (NPLs) to undated). The SME Bank in Malaysia (also known as the Bank
SMEs hit 22.1 per cent by the end of July in 2008, about two Perusahaan Kecil & Sederhana Malaysia Berhad) specifically
times the average 14.7 per cent of China (Xinhua Economic targets SMEs and provides comprehensive advisory services

Chapter V
News, 2008). The State Bank of India, the country’s largest to complement products offered by commercial banks. Some
lender, also reported that NPLs were rising, particularly in the examples of these services are in-depth entrepreneurship
SME sector (Choudhury and Rodrigues, 2010). The State Bank training programmes for graduates, vendors, mentors and
of Pakistan reported that NPLs in the SME sector increased women (Bank Perusahaan Kecil & Sederhana Malaysia Berhad,
by PRs 5.1 billion to PRs 96 billion by the end of 2010 (Daily 2012). Indonesia Eximbank, an export financing institution in
Times, 2011). Indonesia, has also developed technical assistance that
includes quality improvement of products, product
The need for financial institutions to provide more suitable processing, packaging and marketing. Korean Eximbank
products and services for SMEs, develop comprehensive risk assists stakeholders with capacity-building in the form of
management skills and improve information transparency training and guidance in connection with export and trade
has been recognized. A number of financial institutions have financing activities (Korea Eximbank, 2011). The Korean
also moved to offer non-financial assistance to SMEs for their Development Bank (KDB), a state-owned DFI in the Republic
capacity-building to enhance their profitability. For example, of Korea, facilitates the management and normalization of
the SME Bank of Pakistan offers a range of business troubled corporations through corporate restructuring and
development services in the areas of marketing, accounting, consulting services that covers public, development and
product design and business planning (SME Bank Pakistan, overseas projects (KDB, 2010).

Box V.5. SME finance in Sri Lanka

The present financing structure of SMEs in Sri Lanka is shown institutions, such as the Central Bank of Sri Lanka and Industrial
in figure V.14. Debt institutions, e.g., DFIs and commercial banks, Development Board, do not provide credit directly to SMEs but
are the major providers of financial services to SMEs but the facilitate the lending process with credit guarantee schemes and
emphasis of each type is different. DFIs such as DFCC Bank and technical expertise for SME lending. Commercial banks mainly
the National Development Bank offer longer-term, project-based offer short-term loans to SMEs because of the short-term nature
credits for SMEs with relatively low interest rates. Medium-term of their deposits. Several commercial banks function as
financing providers consist of NGOs, cooperatives and participating credit institutions in implementing SME credit
government institutions. A large number of local and schemes and provide their own schemes to assist SMEs. In
international NGOs are engaged in microfinance activities, and addition, equity market, debenture market and venture capital
some have now transformed their microfinance operations into companies act as supplements in SME financing by providing
separate entities. equity and debt financing to SMEs and start-ups; however their 103
influence is limited.
Thrift and Credit Co-operative Societies and other cooperatives
advance loans largely from mobilized savings. Government

Figure V.14. Present institutional financing structure of SMEs in Sri Lanka

Development Financial NGOs, Coops & Govt. Commercial banks

Institutions Institutions (Mostly short-term loans
(Mostly long-term financing) (Mostly medium-term and overdraft)
financing)

SMEs

Equity Market Debenture Market Venture Capital

(Not significant) (Not significant) (Not significant)

Sources: JICA, 2009 and GTZ, 2009.

 Box V.6. Challenges of development finance institutions

For decades, DFIs, which are specialized financial institutions resources are much more limited than those from commercial
Chapter V

established by governments with specific development banks (Wattanapruttipaisan, 2003). DFIs also have experienced
mandates, have played a significant role in the development of difficulties in raising resources at competitive rates compared
emerging and advanced economies. DFIs can provide SMEs with with those offered by commercial banks (AAMO, 2007).
a range of specialized financial products and services in the form
of medium and long-term loans, equity capital and guarantees In response to these challenges, some DFIs have transformed
for loans (Bank Negara Malaysia, 2012). They help small themselves into commercial banks in order to be able to
businesses to graduate to become medium-sized enterprises mobilize more funds, both for short- and long-term lending. In
where feasible, and then large enterprises. India for example, the Industrial Credit and Investment
Corporation of India Bank (undated), a former development
Table V.7 provides a comparison of the key differences between financial institution, moved towards universal banking in the
DFIs and commercial banks. Compared to commercial banks, 1990s to offer more diversified financial services. Similarly, the
one significant difference of DFIs is that they do not restrict Industrial Development Bank of India (undated), after serving as
themselves to providing only credit but also offer technical a DFI for 40 years, decided to function as a commercial bank in
consulting and advisory services for the development of SMEs addition to its original role of a DFI in 2004. Furthermore, the
(Bank Negara Malaysia, 2012). Instead of basing the lending Industrial Finance Corporation of India (2008), the first
criteria solely on the financial viability of a proposal, DFIs pay development financial institution in India, transformed in 1993
considerable attention to the socioeconomic impact of their from a statutory corporation to a company to fulfill its need for
financing operations. Furthermore, DFI consideration is given funds and direct access to capital market.
largely to government economic strategies, rather than simply
the maximization of profits (Malik, 2008). The risk and uncertainty of commercial banks’ common policy
“borrowing short and lending long”, and DFIs’ unique
While DFIs have many valuable strengths compared to commercial contribution of more comprehensive, long-term contributions
banks, there are also some difficulties and shortcomings. First, to SMEs, including non-financial measures, suggests that DFIs
DFIs have come under rigorous challenge from commercial converting themselves into commercial banks may not be ideal
banks, which increasingly aim to become universal banks, and for SME financing; similarly, neither is commercial banks playing
have gradually entered into the realm of long-term lending that a dual role (AAMO, 2007).87 Policymakers should strive to promote
was traditionally the domain of DFIs (Benston, 1994). a vibrant commercial banking sector as well as sound DFIs.88
Furthermore, DFIs lack a diversified range of institutional
products and services. In addition, due to their shortage of Source: Persaud, A. (2011) “Our future financial salvation lies in the
adequate and independent resource bases, their lending direction of Basel”. London, Centre for Economic Policy Research.
104
Table V.7. Comparison of commercial banks and development banks

Commercial banks Development financial banks

Driving force Market Government
Primary goal Maximization of profit Overall socioeconomic development
Product and service Diverse Limited
Loans Short term Medium and long term
Interest rate High Low
Resource base Extensive and independent Dependent and inadequate
Lending criteria Financial viability of proposal Socioeconomic impact
Sources: Malik, 2008, and Wattanapruttipaisan, 2003.

G. Credit rating scheme (c) A composite appraisal/condition indicator and

size indicator;
Some countries in Asia and the Pacific, such as Malaysia and (d) Categorization of an SME, based on industry and
Singapore, have facilitated loans to SMEs via credit ratings. size, for evaluation against its peers;
This encourages greater transparency about the SMEs’ credit
(e) Quality and characteristics of leadership; and
risks, thereby instilling more confidence in financial
institutions to lend to SMEs (Alhabshi, Khalid and Bardai, (f ) Tools that enhance the market standing of an
2009). A standardized process of rating SME credit results in SME among trading partners and prospective
greater consistency and reliability in lending. The credit rating customers (e.g., technologies, production
process consists of: facilities, knowledge and distribution channels).

(a) A comprehensive assessment of the overall 87

Basel III has however recently introduced a fundamental reform
condition of an SME; that requires banks to be better insulated from periods of financial
market illiquidity and a better matching of maturities of lending and
(b) A review of the financial condition and several borrowing (Persaud, 2011).
qualitative factors that have bearing on the 88
Potential new areas for DFIs are: social infrastructure development,
creditworthiness of an SME (e.g., management environmental protection and support for SMEs, in addition to the
skills; and reputation and goodwill); traditional financing to conventional industries.
In the Asia-Pacific region, India has recently been proactive a disincentive for banks to lend to SMEs. This situation thus
in formalizing a credit rating scheme for SMEs. Businesses requires government intervention to ensure SMEs’ survival.
with both the highest operating performance and financial

Chapter V
stability are entitled to a reduction of 100 basis points Almost all governments are aware of SMEs’ financial
(1 per cent) from the annual interest rate on their borrowing difficulties, and financial support measures have been
if they participate in the credit rating scheme, while those adopted to boost their capital. The single most vulnerable
with strong performance and stability are rewarded with area affected due to adverse economic conditions relates to
a reduction of 0.5 per cent (Petkar, 2010). The Government is quick access to finance in adequate quantities. Within this
subsidizing up to 75 per cent of the cost of the credit rating context, some governments have taken post-crisis measures
scheme in order to encourage SMEs to improve performance such as increases in credit guarantee coverage, extension of
and credit rating. The SME Rating Agency of India Ltd. was credit guarantee terms, rehabilitation credits and more liberal
jointly set up by National Small Industries Corporation trade/export credits. One effective policy measure may also
Ltd., financial institutions, commercial banks and other be to introduce incentives for lending to the SME sector,
stakeholders as the country’s first rating agency that focuses especially export credit to recapture global markets. These
primarily on the SME sector (SME Rating Agency of India, measures must be accompanied by rigorous monitoring
undated). mechanisms to prevent the misuse of such incentives.

H. Financial support during economic downturns As a response to the 1997 Asian financial crisis, for example,
a number of the Asia-Pacific governments issued laws and
SMEs are generally more vulnerable during economic
decrees, and shored up governmental agencies to improve
downturns (e.g., the Asia financial crisis in 1997-1998 and the
the financial conditions of SMEs. Typical cases involve the new
global economic crisis in 2008-2009). In addition to the direct
SME basic laws in the Republic of Korea and in Japan, the
shock of decreased demand, SMEs suffer from liquidity and
credit guarantee scheme for small businesses in Thailand and
credit problems due to tight money supply. Delinquent
specialized SME banks in a number of countries in the region
accounts receivable hit SMEs more severely than large
(Ying, 2009).
enterprises as SMEs typically have higher debt-equity ratio
and less cash on hand. Export-oriented SMEs are also
Direct financial support, including additional credit lines and
vulnerable to variations in exchange rates. All these factors
loan guarantee schemes, are widely used to facilitate the
tighten cash flows and trap them in financial difficulties,
financing of SMEs, and greater budgets are generally
which make financing SMEs one of the most important issues
allocated to these schemes during a financial crisis. For
during an economic crisis.
example, the Government of Kazakhstan allocated 25 per
This problem cannot be solved by market mechanisms alone cent of its emergency spending, amounting to approximately
due to the shortage of capital in most SMEs and the frailties $ 956 million, to SMEs in response to the global financial crisis 105
of the banking sector. On one hand, the lack of transparency of 2008 (Pasadilla, 2010).
of financial conditions and managerial/marketing skills marks
SMEs as high-risk clients. On the other hand, banks in crisis Indirect financial support, such as tax incentives and lower
suffer their own financial problems and tend to be more risk- interest rates, are also common steps taken by governments
averse in issuing credit to the high risk and low profit to increase the cash flows of SMEs. Tax-related policies mainly
segments of their clientele such as SMEs. These two factors include tax credits, cuts, deferrals and refunds. During
combine to produce an environment where there is a financial crisis, temporary tax measures are taken and tax

Box V.7. Japan’s comprehensive policy framework to support SMEs during the global economic crisis, 2008 and 2009

The Lehman crisis of September 2008 seriously affected 18 per cent for two years during the global financial crisis
Japanese SMEs by sharply limiting their financing channels and (Deloitte, 2010).
severely reducing the demand for their exports. The Small and
The SME Agency also provides emergency employment
Medium Enterprise Agency (SME Agency) of Japan played an
subsidies, designed to prevent SME employees from losing their
important role in the recovery of SMEs by easing their financial
jobs and to stabilize employment, amid the deterioration of
burden.
employment conditions with the rapid economic downturn.
In October 2008, the SME Agency, in collaboration with the The subsidies include a temporary layoff allowance or wage
Japan Finance Corporation and Shoko Chukin Bank, launched equivalent per person per day, training expenses and
emergency guarantee and safety-net (soft) loan programmes to a temporary transfer allowance, all of which can be claimed for
support SMEs whose business stability was threatened by up to 300 days within three years.
external factors (e.g., reduced orders from major customers, Another SME Agency measure is the provision of information
delayed payments and/or bankruptcy, the impact of a disaster, and consultation services for SMEs. During the financial crisis,
failure of the main bank etc.). Additional credit guarantees were the SME Agency offered information and advice on various tax
made available with a total budget of ¥ 36 trillion used to and accounting measures to help SMEs take advantage of new
guarantee loans to SMEs in all industries – raising the coverage tax incentives. Specifically, it provided information and advice
from 80 per cent to 100 per cent of loan losses (CGC, 2011). related to the new Companies Act, including programmes such
It also issued safety-net loans to SMEs temporarily facing cash- as the accounting adviser system, that significantly benefitted
flow problems due to a radical change in the business SMEs’ financial management.
environment with a budget of ¥ 21 trillion. The regular corporate
income tax rate was also lowered for SMEs from 22 per cent to Sources: JSBRI, 2010, and SME Agency of Japan, undated.
 rebates are often used to promote exports. For example, (b) developing more efficient procedures to evaluate SME
China increased its tax rebate seven times within 10 months credit risks; (c) providing more assistance to government
from August 2008. The experience of OECD countries agencies and other service institutions for SMEs; and
Chapter V

indicates that governments should consider cutting “profit- (d) exploring new channels for SME financing, such as equity
insensitive” taxes that are paid regardless of whether SMEs financing and asset-based financing, as discussed above.
are recording a profit or loss (e.g., payroll taxes, licensing fees
and capital taxes). Thus, the ability of SMEs to finance working SME financing policies should also pay more attention to
capital internally will increase (OECD, 2009b). Related to this, helping SMEs achieve long-term survival and competi-
an interest rate decrease would also reduce the cost of SME tiveness. Even though short-term measures, e.g., soft loan
financing. With this in mind, the Central Bank of Indonesia schemes mixed with expanded credit guarantee coverage,
gradually decreased its benchmark interest rate from help alleviate the immediate financing problems of SMEs and
9.5 per cent in November 2008 to 7 per cent in June 2009 increase their immediate cash flows, such emergency fund
(Bank Indonesia, 2011). provisions are unsustainable and may be detrimental to the
long-term interest of SMEs. For example, data from the SME
Governments may also consider measures to reduce risks Bank of Thailand (2003) indicates that 40 per cent of the
and transaction costs for banks, and provide them with non-performing loans to SMEs came from loans provided
centralized SME credit information and technical assistance during the Asian financial crisis years (1997-2001) in support
needed for lending SMEs. Other measures include: of the government policy to resolve liquidity problems in the
(a) simplifying the application and grant procedures; financial system. In this sense, long-term measures are

Box V.8. Urgent policy interventions by Japan and Thailand for SME rehabilitation in disaster-hit areas, 2011

A. Japan immediate phase, short-term phase and long-term phase) with

a budget of more than $ 10 billion to promote the economic
In addition to enormous human and physical damage, the Great recovery.
East Japan Earthquake in March 2011 inflicted damage to
approximately 740,000 SMEs within the affected prefectures. In The objective of the immediate phase was to help people and
addition, the earthquake had an impact on SME operations businesses adjust to the flood situation within two months. In
nationwide due to supply chain disruptions and electricity addition to rehabilitation activities, several economic measures
shortages, leading to decreased production and exports. At the were introduced, consisting of developing the skills of labour,
same time, the demand side of the economy was weakened by restoring infrastructure, regulating prices and water management.

106 radiation leakage rumours related to the nuclear power plant

accidents and this led to a subsequent decline in consumer
The short-term phase lasts for one year. The focus of this phase
is to provide financial support to people and businesses affected
confidence.
by the floods and investment incentives and other measures to
Specific measures, which mainly focused on financial and facilitate affected business operations. The specific measures
employment support, were quickly undertaken to maintain include:
SMEs’ liquidity and to revitalize the private sector. As for financial
(a) Individual and enterprise loans for reparation of
support, the Japan Finance Corporation and Shoko Chukin Bank
residences and reconstruction;
jointly established a special recovery loan programme with
a separate credit line, extended grace and repayment periods (b) Loans for the development of flood-protection
and reduced interest rates, particularly for small businesses. systems for industrial estates and manufacturers;
(c) SME loans and credit guarantees from the Small
Credit guarantee corporations also established a special Business Credit Guarantee Corporation;
guarantee programme, with a 100 per cent credit guarantee to
(d) Two-step loans and safety-net loans with
support emergent working capital needs of SMEs that had
guarantees provided by the Japan Bank for
received a disaster victim certificate. These were issued by the
International Cooperation for the recovery of
local municipalities, certifying that an SME was partially,
businesses, especially SMEs;
extensively or completely damaged by the earthquake or the
tsunami. Employment support included special unemployment (e) Consideration by the Board of Investment of
benefits for disaster-affected employees, subsidies to maintain Thailand on the extension of the incentive period
SMEs’ employment and job fairs for new graduates in the regions and the investment benefits for affected investors;
that were affected by the disaster. (f ) Facilitation of visa applications and employment
licensing procedures; and
Sources: JSBRI, 2011, and Ministry of Economy, Trade and Industry (g) A plan of action for the removal of water and quick
of Japan, 2011b. reconstruction of the affected industrial estates.
B. Thailand The long-term phase provides a comprehensive framework
of water management and flood prevention. Through the
The flooding disaster in central Thailand in 2010 was one of the
development of a water management system, flood warning
worst in Thai history, with one-fifth of the country becoming
system and a better infrastructure design, the Government is
inundated, including several major industrial estates. The
determined to ensure industrial confidence and economic
unprecedented level of flooding not only threatened the supply
development in the long term.
chain and food security, but also seriously affected a large
number of SMEs. To restore the country’s stability and prosperity,
the Government prepared a three-phase strategy (i.e., Source: Thailand Today, 2011.
needed to ensure the survival of SMEs, including: Entrepreneurs also face various constraints to source
(a) identifying new markets; (b) investing more in research, financing, including specific problems related to short- and
development and innovation; (c) the provision of consultancy long-term loans.

Chapter V
and information, especially on operations and financial
management; (d) supporting education and training (e.g., (a) Specific problems related to short-term loans:
TVET); and (e) building up comprehensive legal, tax and (i) Delays in sanction and inadequate limit
regulatory frameworks for an enabling business environment sanction;
(Eurofund, 2011). (ii) Inordinate gap between commissioning of
the project and availability of working
I. SMEs’ view of major constraints capital;
(iii) Complex and lengthy documentation;
Despite various financial schemes and informative
(iv) Improper mix of fund-based and non-fund
mechanisms, access to “timely and adequate” credit and
based facilities;
establishing a good relationship with bankers are two
(v) High cost of credit; and
persistent major problems for SMEs. According to a 2009
Asian Development Bank survey of SMEs in 13 countries, (vi) Insistence on high margins and collateral.
obtaining capital is the top constraint for firm formation and
growth (ADB, 2009). There are several reasons why this is so. (b) Specific problems related to long-term loans:
(i) Delay in appraisal of projects;
Recent market developments and trends show that in the (ii) Rigid and complex procedures;
name of single window assistance many banks, including (iii) High cost of credit;
DFIs, have entered the arena of term lending, including short- (iv) Delays in disbursements;
term loans to SMEs. Despite this progress, there is a wide time
(v) Unwillingness to exercise delegation of
lag between the approval of SME loans and the disbursement
powers by functionaries;
of funds. Since a portion of these loans pays for operating
expenses, SMEs barely manage to survive while they wait. (vi) Insistence on higher margin money;
This scenario again underscores the importance of cash flow. (vii) Insistence on more than 100 per cent
collateral; and
Although most of the governments in the Asia-Pacific region (viii) Non-availability of working capital sanction
have formulated well-structured policies and placed letter from commercial banks.
well-developed institutional financing agencies on the
ground to meet the needs of SMEs, there is a gap in the actual As shown in figure V.I5, the growth ability of small firms tend
implementation of these policies. Bank management may not to be more vulnerable to financing constraints than those of 107
appreciate the dire need that SMEs have for cash. Banks may large firms. When facing the same financing problems, the
be willing to help but their SME clients get lost in the shuffle reduction of growth is more severe if the size of an enterprise
as bank management caters to larger, wealthier customers. is small. In general, financing obstacles result in an average
Unfortunately, the SME-banker relationship may then decline of ten per cent in growth for small firms compared
become adversarial, further defeating the best intentions of with six per cent for their larger counterparts. The figure also
policymakers. Part of the intransigence often lies with the indicates that for bank requirements and conditions for
owner of the SME, who may not be able to communicate financing, together with access to different financing modes,
effectively with the banker or present their needs in a way small firms still report a larger decrease in growth than larger
that would give incentives for the bank to cooperate. firms in each situation.

Figure V.15. Effect of financing constraints on growth

Small firms Financing obstacle

Large firms Collateral requirements
Bank paperwork or bureaucracy
High interest rates
Need special connections with banks
Banks lack money to lend
Access to foreign banks
Access to financing for leasing equipment
Access to long-term loans

-12 -8 -4 0 4
Per cent change in firm growth
Source: ADB, 2009.
Note: This figure shows the effect of different financing obstacles on firm growth for small and large firms, measured at the average constraint for
the two group sizes.
 J. Potential market distortion by public financial markets compared to their more developed
interventions in SME financing counterparts. However, it is equally important to minimize
the potential distortions brought along by improper actions.
Chapter V

Many governments use direct and indirect public Governments should keep in mind the fact that the goal of
interventions to promote SME financing. Direct interventions government intervention is to achieve an efficient market
made by governments are typically in the form of grants, (Ganbold, 2008). Identifying the market failure and setting
subsidies and tax breaks, and are often delivered through intervention boundaries is the key prerequisite to designing
dedicated governmental agencies. Some governments also an appropriate strategy. In all cases, government intervention
provide financing assistance via commercial or state-owned should be carefully designed to avoid any disincentive for
banks and non-financial institutions including cooperatives private sector providers of financial services to serve the SME
and governmental agencies. This assistance can be in the segment. They also need to be evaluated carefully to measure
form of soft loans, interest subsidies and ceilings, credit achievements in terms of outreach and leverage (IFC, 2011b).
guarantees and credit insurance, seed capital, venture capital,
loan quotas, loan waivers and through the promotion of State-owned financial institutions, including state-owned
banks and development financial institutions, are widely used
promissory notes (RAM Consultancy Services, 2005).
to serve SMEs as they have more incentives and willingness
Additionally, there are measures for facilitating SME financing
that do not provide direct credits but concentrate on to serve certain segments of the market. Compared to their
private counterparts, some state-owned financial institutions
strengthening the financial regulatory framework, building
have less-developed SME lending technologies, lower levels
financial infrastructure and enhancing SME capacity-building
and creditworthiness (IFC, 2011b). of profitability and higher costs (Rocha, 2011). The failure of
many state banks can be also explained by political
The rationale for government intervention is to address interference, excessive risk exposure due to irrational
deficiencies and market failures in the SME finance space. development goals and internal operational inefficiencies
Well-designed government interventions can improve (IFC, 2011b). To take advantage of state-owned financial
financial regulatory frameworks and financial infrastructure. institutions for SME financing, independent corporate
It is also necessary when there is a lack of financial resources governance, efficient operation and proper SME lending and
for particular groups (e.g., start-ups with little collateral risk management technologies are essential. A less distorted
and credit history, and women entrepreneurs) that cannot solution to the SME financing problem may be a well-
be easily solved by the markets. As discussed above, designed credit guarantee scheme with an adequate capital
interventions are also warranted during periods of instability base (IFC, 2012b).
and crisis, where there is an actual or potential collapse of
Direct lending as well as programmes collaborating with
financial intermediation by private agents (IFC, 2010a).
108 other financial institutions in the form of soft loans, lines of
Public interventions in SME financing may cause negative credit, co-financing and equity funds will likely continue to
market distortions and long-term losses to the financial be a popular interventions for SME financing in developing
sector. First, it is often difficult to ensure that financial support countries, due to their simple structure and fast rate of
reaches the target group. This is especially problematic when implementation (IFC, 2012b). Such programmes should also
the target group cannot be well defined, which is often the be carefully designed to minimize the subsidy component,
case with the SME sector in the developing countries in political interference and crowding-out effects on the private
Asia and the Pacific. Thus, the fiscal costs of the support could sector. A good financing programme requires precisely
be high – often much higher than predicted before defined performance targets, an independent governance
implementation (World Bank, 2008b). structure, clear selection criteria for both beneficiaries and
collaborating institutions, and a management team of very
Second, public interventions may lead to weaker financial high quality (Levy, 2002). The operation of the programme
discipline in the SME debt market because with grants needs to be market-oriented and a commercial interest rate
and subsidies both lenders and borrowers suffer less should be applied. The mission and products of the
direct losses when defaulting (Hallberg, 1999). As a result, programme should be flexible and adapted according to
a “non-repayment culture” may be created among beneficiary market maturity (Levy, 2002).
enterprises. “Moral hazard” may also be created and inhibit
financial institutions from implementing and improving risk Most of the related literature emphasizes that the key role of
management techniques. government in improving access to finance is to offer a policy
environment that allows competitive and diverse financial
Third, such measures may distort competition in the financial service providers to flourish (Ganbold, 2008). For SME
market and result in a “crowding out” effect, as they financing, the least distortionary method may be that
discourage firms from using non-subsidized financial government performs a market facilitation role to narrow the
institutions (i.e., private financial providers if the subsidies are gap between SMEs and the financial sources. The primary
exclusively for DFIs) and non-subsidized forms of financing objective for the government is to create an overall enabling
(e.g., personal savings) (Hallberg, 1999). This “crowding out” environment that offers incentives for financial providers to
effect may lead to significant long-term losses that give few fill the SME finance space. This requires a proper regulatory
incentives both to SMEs to operate transparently, and to and supervisory framework that balances the risk and
financial institutions to lend to SMEs. benefits of providing innovative SME financial products while
narrowing the existing financial gaps.
The role of government intervention is important in
expanding SME finance spaces. This is especially relevant in Governments also have the responsibility to build reliable
developing countries as they usually have less efficient and comprehensive financial infrastructure, such as
accounting and auditing standards, and credit information their working capital by: (a) cultivating entrepreneurship
systems, in order to reduce the information asymmetries and culture; (b) developing a pro-business regulatory framework
legal uncertainties in SME financing (World Bank, 2009a). In and tax system; (c) protecting property rights; and (d)

Chapter V
addition, governments and SME agencies may facilitate improving managerial skills of entrepreneurs and SME
SME capacity and creditworthiness by providing localized owners. Within this context, policymakers may wish to
training and consultation services in collaboration with local collaborate in providing services and training through an
financial service providers to meet the specific needs of both existing web of business associations such as local chambers
the supply and demand sides (IFC, 2011b). Increasing of commerce and industry.
government procurement from SMEs, instead of direct
financing support, is another effective measure to enhance 2. Narrowing the gap in SME financing
SME credit-worthiness and viability by avoiding delays in
receivable payments and by increasing cash flow (IFC, 2011b). Some agencies have pointed out that in developing countries
the financial gap has been growing between commercial
K. Major issues for policy interventions debt financing and microfinance (IFC, 2010a; and JFC, 2011).
They argue that micro and small enterprises, including
start-ups, have been in a disadvantaged position to access
While a number of schemes exist that address SME financing
institutional debt financing. While the traditional term loans
gaps, they are contingent upon: (a) an attitudinal environment
have focused on financing large firms or SMEs with relatively
that welcomes innovation and entrepreneurship; (b) formal
healthy performance and sufficient financial records,
legal institutions that protect property rights; and
microfinance targets the poor, low-income groups and the
(c) institutional financing procedures that are consumer-
informal sector with small-sized loans as well as high interest
friendly. Policymakers therefore need to ensure that the
rates. Between those target groups of commercial banks and
existing overall business climate is conducive for people to
microfinance institutions, small (and micro) enterprises are
engage in entrepreneurial activities with adequate and timely
growing. They have difficulty in raising funds from
financial assistance. To achieve this, the following topics are
commercial banks because they have inadequate collateral
suggested for consideration in the light of global best
and financial record, yet they are not satisfied with
practices.
microfinance loans due to small loan size and high interest
rate. Figure V.16 illustrates the financial gap in SME financing.
1. Maximizing working capital
Figure V.16. Financial gap in SME financing
In a number of developing countries in Asia and the Pacific,
the sophistication of their financial sector still remains low,
and capital and equity markets have yet to be developed
adequately; thus, formal, institutional financing is difficult for Microfinance
Financial gap
Commercial 109
SMEs to access. For those economies (e.g., least developed
debt financing
Poor Micro and small
countries), one of the most effective policy options in the low-income Medium and large
enterprises and
short term would be to maximize working capital of SMEs informal sector enterprises
startups
through the effective utilization of both informal and internal
financing.
Source: Modified from JFC, 2011.
Informal financial instruments, including entrepreneurs’ own
savings and assets as well as borrowing from parents, To narrow the gap, policymakers may consider some options.
relatives and friends are particularly important for new and First, microfinance, as it has been growing rapidly in the region
small businesses during their seed and start-up phases. Trade and may expand its operations to target small businesses,
credit or buyer’s credit, another informal financial instrument, providing large-size loans with discounted interest rate.
has been a major financial source for SMEs in developed Second, commercial banks may wish to extend their financial
countries and could be used by SMEs in the Asia-Pacific services to those small players perhaps in cooperation with
developing countries to increase their cash flows. public credit guarantee agencies, where public support is
required. Third, governments could launch and further
Internal financing refers to the generation of funds through develop various forms of financial assistance to them.
an enterprise’s retained earnings, which requires a profitable
business model. Such internal fund-raising could be achieved 3. Develop and balance both debt and equity
by various measures, such as increasing sales, reducing markets
operational costs, minimizing inventory and physical assets,
forecasting cash flows properly and reducing external debt Although the roles of debt and equity markets are
financing. theoretically clear, in practice these two financial systems
differ widely across countries in Asia and the Pacific. In
Neither informal financing nor internal financing requires general, countries with bank-centred debt financing systems
external creditors and investors’ involvements to raise funds tend to be less conducive than stock market-centred systems
for SMEs, so the existence of well-developed capital and to entrepreneurial activity. However, a bank-centred system
equity markets is not necessary. Such financial instruments may be a preferable option for countries with poor
could provide large flexibility to SMEs’ working capital information infrastructures. On the other hand, stock markets
management mainly by reducing the needs of external take more time to develop but tend to encourage more
financing (e.g., bank loans). Policymakers can encourage entrepreneurial, high-growth ventures (based on the
SMEs to use those financial instruments in order to maximize experience of developed countries). The majority of the
 innovations by SMEs have been successfully commercialized offerings of SMEs unless policymakers implement expensive
through stock markets, especially in the United Kingdom and safeguards. It is costly and inefficient for individual lenders
the United States. In contrast, other developed countries rely or investors to collect the information. SMEs, however, usually
Chapter V

more heavily on their banks – with Germany and Japan as lack financial administrative skills to provide this information,
prime examples (Benston, 1994). Within Asia-Pacific, some of or may even lack the basic knowledge about what type of
the major stock markets (i.e., China; Hong Kong, China; information should be prepared.
Indonesia; India; Republic of Korea; Singapore; Sri Lanka;
Taiwan Province of China) are well established, while other Policy intervention can be essential in addressing this issue.
developing economies are working hard to strengthen their The possibility for SMEs to obtain financial support from
stock markets. Policymakers in most Asia-Pacific countries institutional lenders and equity investors should be increased
should focus on SME access to debt primarily through their to provide enough incentives for SMEs to produce credible
banking sector, but with an eye towards establishing the accounts and operate transparently (OECD, 2006).
regulations essential to a functional stock market (e.g., Policymakers not only need to educate SMEs about related
financial reporting requirements and statutes protecting regulations, standards and practices, they must also strive to
minority shareholders). streamline them. There is a careful balancing act that
policymakers must consider between the needs of creditors
SMEs list on stock exchanges for a variety of reasons, and investors to feel secure and informed, and the ability of
including gaining access to funds outside traditional sources SMEs to meet these needs.
(e.g., commercial banks), to spread the risk of high growth
strategies and to increase corporate profiles (Pacific Economic Governmental organizations and SME agencies also need to
Cooperation Council, 2003). As such, the following example initiate or pursue a dialogue with financial industries at the
from New Zealand illustrates a successful initiative national level about methods for achieving better
undertaken by policymakers to incorporate SMEs into the understanding, e.g., possible codes of conduct or specific
equity markets. information tools. Policies are needed to promote transparent
lending terms and conditions of financial institutions. Training
Small New Zealand companies, with high-growth potential, and information programmes, based on different information
face difficulties in listing on the main local stock exchange, requirements of various financial institutions and investors,
the NZX Limited. To ease their burden, policymakers in 2005 can also be implemented to assist SMEs in dealing with
initiated a new stock market, the New Capital Market, to financing issues.
address the equity needs of SMEs by providing a structured,
cost-effective and fast initial public offering mechanism The credit history of SMEs is also an important piece of
(NZVIF, 2011; PECC, 2003). The Seed Co-Investment Fund in financial information. The credit rating scheme discussed
110 New Zealand was also established to support SMEs with above can provide effective indicators for the credit history
strong potential for high growth (Ministry of Economic of SMEs. An information-sharing mechanism among
Development, 2009). Overseen by the New Zealand Venture institutional lenders and investors, such as databases
Investment Fund Ltd., the Seed Co-Investment Fund aims to containing SME credit information and borrowing history,
accelerate the seed capital market for start-up companies to could be adopted by policymakers to increase information
the point of self-sustainability and to foster investment sharing and transparency. Such measures may automatically
inflows into innovative start-up firms. Some of the key reduce the default risk of SMEs, because they need to
provisions include (NZVIF, 2011): maintain good credit records to further access financial
resources.
(a) Co-investment with accredited investment
partners, in a 50:50 matching scheme; 5. Facilitate equity funding
(b) Investment into the seed- and start-up stages of
businesses; and Many governments have programmes for the direct injection
(c) Investments must be made into New Zealand of equity (or start-up capital) into SME ventures; however, the
businesses. operational results of such programmes are not encouraging.
Direct government programmes generally lack both the
As of November 2011, the Seed Co-Investment Fund had appropriate incentive structures and the expertise to
a capital allotment of $ 48 million and 13 accredited Seed administer the programme in a professional manner (OECD,
Co-Investment Partners. The fund and its investment partners 2009b). A better alternative is for policymakers to work
have invested, on a one-to-one basis, in 64 New Zealand alongside private sources of equity, such as the Business
companies that have successfully established their business Angel Network South-East Asia (BANSEA),89 in order to meet
operations. These 64 SMEs are part of a diverse group of SME needs, while building the institutional capacity of equity
industries, ranging from biotechnology, information markets with pro-business securities regulation. Transparency
technology, marine safety, bottling and semiconductors to and shareholder protection allow higher-end types of
commercial cleaning services (NZVIF, 2011). financing, such as venture capital, to flourish while being
comprehensible enough to invite SME participation, albeit
often with professional legal counsel.
4. Reduce information asymmetry
Within this context, the public sector is expected to serve as
Inadequate or insufficient information is one of the main
a conduit for building trust between SMEs and private capital.
obstacles hampering financing for SMEs. With information
asymmetry, banks cannot be sure of the creditworthiness of 89
For the details of BANSEA see the earlier section in this chapter
SMEs, and potential equity investors may forego the equity on angel finance.
For example, the Business Development Bank of Canada 6. Combine financial services and business
(BDC), a state-owned specialized development bank, focuses development services
on leveraging private sector funding by running various

Chapter V
equity and non-equity programmes (BDC, 2011). The most Banks tend to charge SMEs higher interest rates and demand
notable feature of BDC is its cooperation with the venture collateral relative to the asset base as a risk management
capital industry in Canada in addition to providing direct technique (Beck, Demirgüç-Kunt and Peria, 2008). As
equity investment to SMEs. Good examples involve capital mentioned above, this is a response to the lack of
injection into private equity funds that target certain transparency regarding the creditworthiness of SMEs. Beyond
objectives (e.g., high-tech, life science and start-ups), credit rating schemes, policymakers should encourage SMEs
supporting angel groups to professionalize their industry and to seek BDS providers, including various business associations
helping venture capital to develop global networks and such as chambers of commerce and federations of industries,
connect with potential stakeholders (BDC, 2011). and to work with banks to resolve financial and operational
issues. A suitable combination of financial and non-financial
A more comprehensive programme, such as the European services for SMEs is the most needed support. In this regard,
Risk Capital Action Plan, to improve entrepreneurs’ access financial institutions should consider: (a) developing
to risk capital finance could be an effective way of dealing capacities to provide information on markets and training
with fragmented equity markets (European Union, 2006). facilities; (b) evaluate joint venture proposals; (c) assist in the
Compared to the BDC, the Plan does not provide funds development of business expansion plans; (d) guide financial
directly, but encourages investment from stakeholders by and taxation matters; and (e) advocate the cause of SMEs at
creating a favourable equity investment environment. The appropriate forums. Such an approach would obviate many
Plan concentrates on introducing a modern and flexible set difficulties in the SME sector.
of legal and administrative rules, designing appropriate tax
regimes, facilitating the establishment of public risk capital Over time, BDS providers can also add value to bank lending
and investment funds at all levels, and developing innovative and SME development due to their proximity to their clients
sources of investment such as angel investors and employee as well as their direct knowledge of the enterprises’ financial
financial participation (European Commission, 2003). status and past performance. BDS providers are often better

Box V.9. SME financing through public-private partnership in Japan

A number of city-level chambers of commerce and industry in asset investment. In addition to their good financial record, one
Japan have provided non-collateral loans to their small business of the major requirements for small businesses is that they have
members in collaboration with state financial institutions. For to receive training and counselling by the chamber before 111
example, the Kyoto Chamber of Commerce and Industry receiving loans. The advantages of this system are that the
facilitates the engagement of its small-sized business members chamber can understand the conditions of small business
(with no more than 20 employees) with JFC for long-term loans members better than financial institutions, thus securing their
of up to $ 200,000 or equivalent. Such SME loans can be repayment without collateral, while improving the capacity of
provided without any collateral and personal guarantee, and the members. The institutional framework of the partnership is
with a discounted interest rate for both working capital and illustrated in figure V.17.

Figure V.17. Institutional framework of public-private partnership in Japan

Recommendation
for loan
Chamber of commerce and industry
Screening
Assessment
Internal approval

Managerial advice
Training Japan
Finance Corporation
Loan
application

Small business Loan

members

Sources: Kyoto Chamber of Commerce and Industry, undated; and JFC, 2011.
 placed than financial institutions for identifying potential (European Commission, 2007). Another example involves
clients, ascertaining their creditworthiness, imparting the SME Centre for Asia in the Philippines, which provides
professional financial and accounting techniques and other a training framework for financial institutions dealing with the
Chapter V

services germane to lending and repayment of debt. This SME sector, comprising seminars, exhibits and a venue for
complementary nature between BDS providers and financial banks to build linkages with SME entrepreneurs (SME Centre
services helps to minimize both the risk and transaction costs for Asia, 2011).
to creditors and investors, and makes access to credit and
equity less costly and cumbersome for SMEs. Business The following recommendations are made for designing
development services are the central focus of the next chapter, a capacity-building training programme:
which addresses many of these key issues in greater detail.
(a) Research, identify and review existing training
A number of BDS programmes, such as EMPRETEC – the materials;
Spanish acronym for emprendedores (entrepreneurs) and (b) Adapt materials and prepare draft training
tecnología (technology) – address the business development packages;
requirements of SMEs. EMPRETEC is a capacity-building (c) Field-test draft packages by running a few pilot
programme established by UNCTAD to promote the creation programmes;
of sustainable support structures that help promising
(d) Evaluate and refine programme contents based
entrepreneurs build innovative and internationally
upon the field test;
competitive SMEs (EMPRETEC, 2008). The central product
of this programme is entrepreneurship training workshops (e) Run training-for-trainers programmes;
that provide participants with an opportunity to learn (f ) Collaborate with selected trainers from
from successful entrepreneurs and apply these lessons developing countries in their first programme;
to their own business behaviour. The core goal of this and
entrepreneurship training is for SMEs to improve their (g) Disseminate training packages and obtain
creditworthiness and attractiveness to potential investors feedback on their utility for further refinements.
from venture capital funds and financial institutions
(UNCTAD, 2001b). The key issues and suggestions for strengthening bank-SME
relationships are summarized in table V.8.
Enterprise Africa, a UNDP programme modelled on
EMPRETEC, also encourages the private sector, such as large 8. Introduce a four-tier national financial system
corporations, banks and consulting firms, to support SMEs
through activities such as providing financial contributions,
112 enhancing access to credit and contributing to training and
Today’s global economy exhibits unparalleled dynamism
and experiences rapid changes. These changes affect SMEs
post-training programmes and services (United Nations, more than larger firms due to the fact that they have fewer
2011). A key feature of this programme is the joint credit resources to cope with the volatility. In addition to the
delivery scheme whereby Enterprise Africa provides support traditional forms of term loans and working capital, they
and capacity-building services, and assumes responsibility for require new forms and instruments to remain competitive. In
loan referral and monitoring – thus reducing lending costs this environment, national economies must hasten to keep
for partner financial institutions and improving SMEs chances pace and realign their own financial system accordingly;
of securing access to finance (UNCTAD, 2001b). otherwise countries will start to lag behind.

7. Strengthening the bank-SME relationship Within this context, a four-tier national financial system
is proposed as follows (figure V.18; see also figures II.5
Despite the efforts of policymakers to enable SMEs to access and V.6):
bank loans, there is still much room for improvement. As
mentioned above, banks may not appreciate the SMEs’ dire (a) First tier – an apex bank (or agency) for SMEs
need for quick capital, while SME owners may not understand that oversees policy prescriptions, credit
bank policies for mitigating risk. While policymakers may craft guarantee schemes, new financing schemes and
effective strategies, their efforts may be frustrated when programmes, business development services and
applied in practice. Intermediaries may lack either the training and the flow of credit (and equity) to the
incentives or the competence to build and sustain bank-SME sector. Above all, the apex bank should augment
relations. financial resources for all the concerned players
and provide them with institutional support from
Communication and education are important, both for SMEs time to time;
and for banks. What is crucial is the consistency of these (b) Second tier – national financial institutions,
efforts. There needs to be an ongoing programme of commercial banks, specialized DFIs such as exim
communication and education that policymakers implement. banks, credit guarantee agencies, credit
Such a programme must be both convenient and relevant information providers (e.g., credit registries),
to both SMEs and banks in order to be credible. For example, venture capital associations/networks and
a research programme has been conducted in Sweden since support institutions, such as national BDS
1999 to foster better relationships between the credit sector provider associations/networks and national
and SMEs through interactions and information exchange chambers of commerce and industry, should play
between the two groups: (a) banking representatives, SMEs, the role of credit providers or facilitators to the
auditors and tax authorities; and (b) academic representatives organized sector of SMEs. In addition, corporate
Table V.8. Issues and suggestions for strengthening bank-SME relationships

Issue Bank SME

Chapter V
Insufficiency of O Fear of non-payment should be addressed via O Careful planning for credit needs based on a
credit proper assessment of risk and moral support specific, workable business plan.
from relevant government agencies. O Supporting documents for verification should
O Update credit databases to include SMEs. be kept ready.
O Joint appraisal with commercial banks/DFIs O Be open to banks in discussing all financial
and BDS providers. problems.
O Prepare thoroughly for presentation, interview
etc.
Delays in credit O All data requirements for credit appraisal O Produce all data requirements and documents
sanctions should be communicated to SMEs in one in one installment.
installment. O Keep financial records current and accurate.
O The appraisal process should be explained in O Extend cooperation to the bank in complying
the initial interview. with the head office guidelines.
O The appraisal should continue even if a credit
officer goes on leave but one person should
ultimately be accountable for each SME
application.
O A single-window approach should be followed
for appraisal.
O The appraisal process should be focused on
continuous improvement, including the
models used for risk measurement.
Collateral O Get a second opinion on need for collateral, O Work with the bank and BDS providers to
requirement is too perhaps from a BDS provider. Consider future reduce risks.
high cash flow as the primary security for SMEs. O Offer some collateral if feasible.
Information O Checklist of information on requirements to O Keep financial and operating records current
requirements are too be prepared for SMEs with due care. and accurate.
high or not available O Use of computers for data storage and analysis. O Use computers where feasible.
O Standardize the data requirements for loan O Appreciate data needs of the bank. 113
applications across different institutions.
Compliance with loan O Arrange audits to minimize inconvenience to O Cooperate with the bank since post-sanction
agreement, including borrowers. formalities are also for their benefit.
audits O Explain timing and procedures for loan O Regular submissions of statements and returns.
compliance.
Source: Asian Association of Management Organizations (AAMO), 2007.

Box V.10. Methods and criteria for bank loan appraisal

There are two major appraisal methods for loan applications – that banks consider specific factors in evaluating commercial
transaction lending and relationship lending. The main loan applications (Beck, Demirgüç-Kunt and Peria, 2008). In
difference between the two methods is that the former is general the following criteria are used:
primarily based on quantitative data (e.g., financial statements,
bank accounts, credit scores, size of equity, assets and cash flow (a) Financial assessment of the business;
prediction) while the latter is based on qualitative data (e.g., (b) Firm’s credit history with the bank;
management skills, leadership, owners’ characters, banking
(c) Characteristics of the firm’s owner (age, sex,
relationship, reputation and quality of human resources) (RAM
leadership, managerial skills etc.);
Consultancy Services, 2005).
(d) Purpose of the loan;
In practice, particularly in developing countries in Asia and the (e) Collateral;
Pacific, these two methods are often used by commercial banks
(f ) Firm’s credit history from a credit registry; and
in a mixed way to fit in with their unique operating environment.
The World Bank’s global survey on the banking sector reveals (g) Size of the loan.

bond markets (and stock markets in an extreme a manageable specified region or a command
case) also fall within this category for open area for serving the specific sector; and
market borrowing (and share offering); (d) Fourth tier – at the base of the pyramid, MFIs
(c) Third tier – subnational development financial cover the unorganized microenterprises and
institutions, regional banks, BDS providers, and self-help groups through the provision of
local chambers of commerce and industry have microcredit. MFIs have been placed at the base of
 the system because they have to cover the in giving financial support while enhancing their relationship-
biggest segment as well as largest number of building with the SME sector, based on mutual trust.
enterprises and individual entrepreneurs in
Chapter V

the field. The MFI system is experienced and 9. Other policy responses: What works and what
best-suited to keeping close contact with clients does not?
and to ensuring full recovery of loans. It is also
equipped to give non-financial support to The policy reviews in this chapter provide guidance on how
entrepreneurs. policymakers can approach issues of access to finance by
SMEs. Some of the key observations are set out below:
Figure V.18. Four-tier financial system for SMEs
(a) The public sector and financial institutions must
understand the corporate life circle and
Apex associated cash requirements of SMEs. They need
SME to place emphasis on the policies that assist in
Bank
financing SMEs during their cash drains and to
National DFIs, take measures to ease funding constraints due to
Commercial Banks the time gap between receivables and payables
Specialised DFIs, Exim by employing various financing instruments;
Bank, Venture Captial,
Support Institutions (b) Governments should provide a knowledge-
sharing and communications platform for
Regional DFIs and different stakeholders (e.g., government, SME
Regional Banks agency, financial institutions and SMEs) in order
to increase mutual understanding and to share
experiences;
Microfinance Institutions (c) Governments need not operate financial
(MFIs)
assistance programmes for the SME sector
directly, but they should work as a facilitator. In
particular, policymakers should avoid introducing
Source: AAMO, 2007.
direct lending and credits at subsidized rates.
Such programmes can go through the process of
The suggestions made above establish the significance and financial intermediation;
114 importance of restructuring the institutional network of the
financial sector into a simplified framework for clear division (d) Commercial banks have been found to incur large
of labour, so that its reach and institutional coordination are losses on account of publicly subsidized interest
further improved. In addition to having the apex bank for rates and non-payment by borrowers;
SMEs, the role of MFIs in this framework also assumes greater (e) Loan waivers by governments eventually distort
importance. They should be given national recognition and the credit culture;
legal status in the country’s financial system to enable them (f ) Market failures should not be tackled with
to serve an increasing number of microenterprises. government finance. Governments should
intervene and work with/through commercial
A central question emerges regarding what limits access to, forces to correct the distortions;
and use of the formal financial institutions by SMEs for the
provision of financial products. Among the factors that hinder (g) Policymakers must give adequate attention to
SMEs from accessing formal financial institutions are: (a) lack the protection of creditors’ rights by introducing
of transparency in SME management; (b) information a suitable set of laws that protect lenders from
asymmetry; (c) low managerial capacity; (d) low collateral; non-payment. Without creditors’ rights, the
(e) small capital base; (f ) small economies of scale; and market for credit can be expected to remain
(g) high transaction costs. underdeveloped;
(h) Governments should promote a collateral and
Lack of trust looms large in the minds of both banks and third-party guarantee-free or reduced lending
SMEs. The scarcity of term loans from banks and higher loan system, suitably backed by credit guarantee
default rates by SME customers compound this attitude. schemes or cash flow-based financing to
However, policymakers can facilitate re-building this trust. encourage lenders to assist SMEs;
Merely exhorting the financial sector to innovate, change and (i) Governments should concentrate policies on
lend liberally will not make the SME sector thrive. Success lies promoting the availability of risk capital to
in a “two-way” traffic system of promoting mutual trust and innovative, high-growth SMEs, mainly during the
cooperation. early stages of financing;

Giving support to DFIs and BDS providers, both at the (j) Public sector funds could still be used to leverage
national and regional levels is a good start. These institutions private sector financing in order to reduce the
will have to project an image of member SMEs as: financing gap;
(a) profitable; (b) dependable; (c) creditworthy, with economic (k) Policymakers should recognize the need for
viability; and, above all, (d) timely repaying entities. This will proximity between lenders and borrowers,
help to build adequate confidence among lending institutions particularly in the case of small-scale loans.
Table V.9. Matrix of policy measures facilitating access to finance by SMEs

Policy measure Type Intervention

Chapter V
SME Act Legal Introduce a national Act for development of SME sector.
Property rights Legal Proper property registration facilitates loans with collaterals.
SME development regulations Regulatory Suitable regulations create enabling environment for SMEs.
Financial sector reforms Regulatory Financial sector reforms facilitate timely and adequate finance
to SMEs.
Central banking directives Regulatory Central Bank directs banks and financial institutions to support
SME sector as priority sector.
SME development policies Regulatory A set of comprehensive development policies and programmes
including financial support and exit policies for SMEs.
Fiscal incentives Indirect government Fiscal and taxation policies increasing working capital and
support encouraging SME investments.
International cooperation for fund Indirect government Encourage international funds and TNCs for lines of credit and
support and FDI support FDI.
Capital market and stock exchange Regulatory Encourage SMEs for market borrowing and equity support.
development
Information and credit scoring Financial intermediation National network for credit and credit scoring of SMEs.
Financial intermediation Financial intermediation Specialized financial institutions for assisting SMEs, such as
development SME banks, EXIM banks, venture funds, MFIs etc.
Financial services package Financial intermediation Enabling government policies encourages the financial system
to offer a full range of financial services including debt, equity
and innovative finance to SMEs and to offer BDS.
Source: Authors’ compilation.

Regional and local equity initiatives (e.g., help to reassure financial institutions to lend to
subnational funds) are appropriate for such types SMEs. 115
of lending;
(l) Governments should take emergency measures A brief summary of general policy measures for SME
and facilitate extra credits to help SMEs through financing is provided in table V.9.
economic downturns. In addition, they should
take measures to help SMEs build up long-term L. Summary
survival capacity and enhance long-term
competitiveness; Financial capital is a critical input for businesses in general,
(m) Governments must carefully design all the and SMEs in particular. Without adequate and timely finance
intervention policies to avoid market distortion; there can be no start-up, much less expansion or long-term
sustainability. This chapter began by emphasizing the need
(n) Policymakers should provide information and for cash. An SME can show legitimate profits on its books but
consultation services for SMEs to obtain funds will ultimately fold if it is not collecting the cash from
(focusing on available sources of financing, customers. While this may seem obvious, collecting cash is
understanding and meeting different criteria for a tedious process that new business owners often fail to
different sources and dealing with legal and consider in their planning. They assume that as long as they
contract issues); offer a product that consumers want, the cash will simply
(o) Governments should provide training on appear; however, the reality is that extensive follow-up may
accounting and financial management skills while be required to get the cash from the sale. The rule of thumb
raising SMEs’ awareness of the importance of cash for policymakers is to favour policies that provide quick cash
flow management; enhance their ability to obtain to SMEs as opposed to policies that offer deferred benefits.
funds; help them use different financing sources
efficiently; This need for cash was then linked to the life cycle stages of
the firm. Entrepreneurs may obtain the funds necessary for
(p) Governments should facilitate the designing of
start-up from their own savings or loans from family and
financial services that are suitable for SMEs;
friends, but the crucial period occurs soon after operations
(q) Governments should facilitate FDI to the SME begin. There is a gap between when suppliers must be paid
sector; and and receivables are collected; this gap is the foundation of
(r) Governments should, in association with private working capital management (figure V.4). Policymakers at the
sector associations, chambers of commerce and local level need to educate new business owners about the
BDS providers, encourage small businesses to necessity of working capital management; this should be
maintain and report reliable information. This will included in business and entrepreneurship curricula.
 The various financing options available to SMEs were then Beyond the balance of debt and equity, the chapter proposes
discussed. In addition to informal and internal financing, such other major areas of policy intervention. SMEs can increase
as personal savings, working capital and trade credit, the working capital by improving their managerial capacity and
Chapter V

traditional way involves using the banking system for debt utilizing financial techniques such as trade credit, thus
financing. When new business owners cannot find the capital reducing their need to borrow money from external sources.
to expand within their own networks, they turn to banks. The Reducing information asymmetry is a key; often SMEs do not
usually tense relationship between banks and SMEs is noted, know what financing options are available or how to access
as both parties are often insensitive to the needs of each them. Financial institutions have difficulty gauging the
other. There is ample room in such a situation for the creditworthiness of SMEs. Policymakers need to bridge these
involvement of policymakers, primarily as facilitators. Banks knowledge gaps. It is not sufficient to provide financing, as
need credit guarantees and other forms of risk mitigation. The lack of managerial know-how can lead to wasting loans.
most effective policies make credit information available for Policymakers should package financial capital with business
markets to use. Direct intervention (e.g., government loans development services, an issue that is addressed in greater
and blanket guarantees) generally suffers from moral hazard detail in chapter VI.
and high administrative costs and is therefore less effective.
However, on occasions, such direct intervention can be The relationship between banks and SMEs was explored in
necessary; this is highlighted by the given examples of table V.8. It is noted that there is a role for both commercial
successful credit guarantees provided by the Governments of banks and DFIs in supporting SMEs; policymakers should not
India, Japan, Pakistan and Turkey. favour one at the expense of the other. Robust competition
in the financial sector will help SMEs and the overall economy.
Additional financial measures include leasing, factoring, The authors suggest that the national financial system
corporate bonds and seed capital as well as equity financing should follow the AAMO (2007) four-tier model depicted in
such as angel finance, venture capital and IPOs. These figure V.18, with an apex SME bank supported by various
methods are common in advanced economies and are levels of DFIs and banks and a foundation of microfinance.
gaining traction in the Asia-Pacific region. Naturally they
require the highest level of investor protection policies and The chapter concluded with a review of policy responses:
rule of law as well as sophisticated capital and equity markets. what works and what does not? Table V.9 sets out a matrix
As a matter of systemic improvement, policymakers should of policy measures facilitating access to finance by SMEs. It
strive to balance the use of debt and the use of equity for is re-emphasized that government officials should adapt
supplying capital to their nation’s businesses. Over-reliance these general recommendations to the unique circumstances
on the banking sector is a hallmark of the Asia-Pacific region; of their respective countries.
future development should see more of a mix.
116
 Annex V.1
Typology of collateral

Chapter V
Collateral is usually requested by lenders to serve as credit through the borrower or directly to the bank
enhancement to reduce the risk of a borrower’s default. The depending on the contract arrangements (SBA,
main types of collateral that the borrowers can use are: 2009);90
(d) Life insurance – the cash value of a life insurance
(a) Property – a borrower may pledge property as policy serves as collateral. The borrower can get
security for a loan. If the loan is not repaid at credit from the insurance company directly or
maturity, these securities may be sold to assign the policy to a bank (SBA, 2009); and
reimburse the lender. Acceptable property and
(e) Third-party loan guarantee – under a third-party
financial assets include any or a combination of
guarantee agreement, the guarantor has an
real estate, equipment, inventory and precious
obligation to pay the lender the amount owed if
metals (Holdsworth, 2009);
the borrower defaults on the loan (Rocks, 2010).
(b) Financial assets – it is possible to get a loan by In some cases, several guarantors are required by
assigning financial assets to the bank. In this the bank to co-guarantee one loan to ensure the
situation, the bank keeps the assets until the safety of the credit; and
borrower has repaid the loans. Common financial
(f ) Public credit guarantee – government agencies
assets used for this purpose include savings
provide public credit guarantees to target groups
accounts, certificates of deposit, stocks and bonds
(e.g., SMEs). Generally, the borrowers need to
(SBA, 2009);
satisfy several criteria to obtain the guarantees, so
(c) Accounts receivable – sometimes banks lend that participating banks can issue corresponding
money against accounts receivable. The borrower credits to the successful borrowers.
can select some of the larger and better accounts
receivable and assign them to the bank or the 90
For more detailed information, see the discussion on factoring in
financial institution. The purchaser may pay this chapter on page 92.

117