Minimize Risk: Finance MSMEs

By Tarek Kamal, Managing Partner

Even as excessive levels of competition erode interest rate spreads, financial institutions continue to flock to what they consider safe space, namely loans to large businesses. As spreads decline, financial institutions have to rely on higher exposures to a single business just to break even. If the spreads were the only casualty of the competition, it might still have been understandable. More disturbingly, another casualty is often credit quality. When there are many suiters, businesses have the upper hand and as such can begin to chip away at the credit culture of financial institutions hungry for business. When funds become easy to access, imprudent use of funds may be the result.

Prudential lending limits and caps on exposure to a single obligor are mandated by regulators in order to protect a financial institution from this type of risk. However, businesses don’t have similar mandates and although financial institutions are aware of the total liabilities that a business has, compromised credit culture can force financial institutions to make mistakes. This is particularly true of smaller financial institutions competing against financial behemoths for a piece of the large borrowers pie.

It only takes one! One large business showing signs of failing can have a devastating effect on the financial sector because, more often than not, multiple financial institutions have exposure in that entity. Suddenly, it’s bail outs galore because of the imprudence of the financial institutions flocking to and fawning over what was once considered a low risk exposure.

The graphic above shows two loan portfolios of equal value. The portfolio of loans to large enterprises contains three loans whilst in the portfolio of loans to MSMEs the risk is spread across 30 loans.

Even one of the large loans being defaulted on will have a considerable impact on the financial institutions’ profitability and possible even its sustainability. By comparison, as long as the financial institution assesses and monitors their MSME portfolio adequately, it is unlikely that all 30 or even most of the MSMEs will fail and certainly even less likely that this will happen at the same time.

This may be considered diversification of exposure in terms of the number of loans as opposed to sectoral or geographical diversification. Although it is true that a catastrophic event may cause all those MSMEs to fail, large businesses would be impacted similarly.

This is not unknown to financial institutions. In in too many countries around the world, the main reason for the counter intuitive behaviour of financial institutions to aggressively target the same large businesses is the perception that MSMEs are too risky to finance.

A paradigm shift in the way financial institutions think about MSMEs needs to be brought about through awareness creation among the financial institutions that MSME entrepreneurs stake everything they own in their business and have to work as hard as necessary to ensure that they are able to repay their loans and keep their business in operation because if the business should fail, they will have lost everything. This issue is discussed in a little more detail in a previous post, MSMEs: Always All In!

Even if this were true in the case of an individual MSME, the mitigation of risk possible through diversification in terms of a portfolio of a large number of small loans combined with prudent management of industry/sector/geographic concentration make MSME financing risk as low as possible. The ability to earn a greater spread from these loans is icing on the cake and makes a solid business case for financing MSMEs.

In reality, the perceived riskiness of MSMEs is a result of the financial institutions not managing their financing processes appropriately. MSMEs not only need to be managed differently from large companies, exposures in micro, small and medium enterprise loans have to be administered in a different way as well. The somewhat higher assessment and monitoring costs are offset by the higher interest rates that financial institutions charge on loans to MSMEs. Often well-meaning interest rate caps on MSME loans are often counterproductive because they take away the incentive of financial institutions to lend to MSMEs. This issue is discussed in a little more detail in a previous post, Interest Rate Caps: A Tool for Financial Exclusion.

Article also published on Linkedin on October 1, 2020
Picture Credit: Tarek Kamal