Concepts Of Bank Small And Medium Sized Enterprises
This chapter reviews previous studies and literatures that will be the background information for the current study. This literature reviews explore the concepts of bank small and medium-sized enterprise, lending practices at commercial banks, the importance of factors that affect granting of loan, definitions used in this study and previous studies in the area of the determinants of banks assessment of credit propositions that would better enhance our understanding to the study and its nature.
2.1 SMALL AND MEDIUM-SIZED ENTERPRISE (SME)
The economic and social significance of the small and medium enterprise (SME) sector is well recognized by developed and developing nations. Literatures suggested that most economic activity in the world comes from these SMEs (Wendel and Harvey, 2006). In his study, Kazuyuki (2005) highlighted how SMEs have responded to competitive challenges in the local and global market. He defined SMES "as firms with no more than 300 employees or a 300 million yen capital stock". However, other studies have defined SMEs as “a businesses with six to 50 employees or with annual revenues less than 50 million” (Stein, 2001). According to the European Commission recommendation, the following table presents the definition of SMEs.
Table 1: SMEs definition according to the European Commission recommendation
Annual Balance sheet
1 to 9
< 2 million euro
< 2 million euro
25% or more of the capital or voting rights of another enterprise
10 to 49
< 10 million euro
< 10 million euro
50 to 249
< 50 million euro
< 43 million euro
More than 250
> 50 million euro
> 43 million euro
Conference of ministers responsible for small and medium-sized enterprises (SMES). Available at: http://www.oecd.org/dataoecd/6/6/31919286.pdf
Numerous Studies indicated that in many developing countries, SMEs have limited access to formal credit (Stein, 2001). The processes of banks lending sometime is subjective, for example in sub-Saharan Africa, commercial banking provides loans to only one percent of the population (Stein, 2001). Furthermore, reports explain that in Kenya, there are about 2.2 million of small and medium enterprises of which 88 percent are non-registered. Of this non-registered group, only 23 percent have bank accounts, and only 10 percent have ever received credit from any formal source (SME Banking Sector Report, 2007).
In a study conducted by Steadman Group Research Division (2007), they explained that many SME are reluctant to seek credit. The result of their survey reported that SME indicated that:
The costs of getting a loan are high
Interest rates are very high
It is difficult to meet the requirements for getting a loan
There is a common perception that borrowing from a formal lender will imply losing assets and property
In his study, Desmond (1991) explained that the reason why SME’s loan rejection by commercial bank is related to no accomplishment record of business, too risky industry, performance factor and lack of personal investment. Literatures suggested that past experience considered as the most important factor in influencing the banks decisions in granting or rejecting the SME’s loan propositions (Rosli and Ghazali, 2007). Furthermore, trading experience is ranked the most importance factor that affects accepting SME’s loan propositions (Deakins et. at, 1994; Fletcher,1995)
2.2 BANK LENDING DECISION
Referring to previous literatures and studies, we understand that the relationship between commercial banks and SMEs companies are vital for the economic growth of both developed and developing economies. The problem of SMEs with little history are facing commercial banks and hamper their understanding of many lending decisions (Nguyen, Le and freeman, 2006).
At commercial banks, the lending process is considered as the most important function for the utilization of funds. Commercial banks earn their highest gross profits from loans, while administration of loan portfolios considerable affects their profitability. Without a doubt, the large number of non-performing loans that provides to borrowers is the main cause of bank failure.
Literatures explain that the lending process is a fairly simple series of activities involving two principal parties - the lender and the borrower, whose their involvement differ from the initial loan request to the successful repayment of the loan. Fundamentally it involves the following activities:
Commercial banks realize that credit analysis is the most important step in their lending process, this because that it bases on which lending decisions are made. Literatures reveals that the concept of ‘credit analysis’ refers to “the bank’s effort to investigate factors that may lead to a default in the repayment of a loan” (Shamsudin, Shamsher et. at, 1988). While the ultimate objective of credit analysis is to determine the ability and willingness of a borrower to repay a loan
Studies suggested that commercial banks greatly emphasize highly on the profitability, financial stability and liquidity in order to determine the financial soundness of the company (Berry, Faulkner, Huges and Jarvis, 1993). Related to Pruis (2006), because of the inaccuracy of the financial reporting from a SME’s, Bankers cannot discard factors such as liquidity, profitability, leverage, payment history and longevity. Finally, financial ratios of SME’s are paramount important indicator for revealing the chances of obtaining their loans, what type of loans to require, and how to approach lenders, creditors and investors (Barren, 1992).
To commercial banks payment performance and late payment is a warning sign that a SME’s is in trouble (Lloyd, 2006). Studies suggested that the bank manager saw credit policy of the borrower as an important features because it spells the success or failure of SME’s credit and collection policies (William, Haka, Bettner 2005). The cash flow of the borrower is vital in order for the commercial banks to assess whether the SME’s is capable to pay interest, tax and dividends, and to either repay the loan principal or keep its overdraft within a prescribed limit (Coyle, 2000). To make sure of all these procedures, banks thus incorporated different software and programs that assist their work.
Literatures reveal that the use of secured lending by commercial banks to control their exposure (Bery, Grant and Javis, 2001; Binks and Ennew, 1996). In his study, Chen (2006) explains that the riskier SME will pay more due to security and risks. One way that SME’s can reduce risks and increase securing is using government guaranteed loan programs, and requiring conservative loan-to-value ratios (McGovern, 1993).
In the middle of 1990s, the commercial banks all over the world was incorporated Data Envelopment Analysis (DEA) as the principal method for assessing bank loans efficiency. DEA program is a linear-programming technique that primarily developed by Charnes et al. (1978) to measure the comparative performance of banks loans and profits from loans. In his study, Thanassoulis (1999) explain that commercial banks were increasingly using Data Envelopment Analysis as a tool for assessing, monitoring, and improving performance of their loans and profits from loans. Literature suggested that DEA is a tool for assessing corporate banking performance (Sherman and Gold, 1985; Berg et al., 1993; Ferrier and Lovell, 1990).
Furthermore, commercial thus are learning to review their risk portfolios using different criteria laid down such as Basel II (Rehm, 2002). Studies indicated that Basel's goal is to urge commercial banks to improve their risk management capability, including how the commercial banks price its services, reserve for loss, and control their operations (Rehm, 2002).
However, since the financial services industry is rapidly evolving as banks engage in new activities, it giving rise to refinements and alternative models to bank credit analysis studies reported that credit analyst incorporates the so-called ‘CAMEL approach’ to better analyze borrower credit (Golin, 2001). Furthermore, since credit analysis has becoming even more complicated new methods such as Basel Capital Method has incorporated by commercial banks (Lee, 2004).
Literatures suggested that measuring the output of a loan officer is the key to improving lending performance at commercial bank (Boucher, 1996). Loan sales of loan officer are quarterly measure to depict productivity. Loan officer at commercial banks can use this information to quarterly investigate the loan officers' productivity.
Finally, studies reported that of commercial banks around the world have adopted various systems such but primary the credit scoring system to assess the creditworthiness of the borrowers. In his study, Isaac, (2006) explain that credit scoring method is based on real date and statistics, thus it more reliable than judgmental methods (e.g. loan officer subjective), as it treats all applicants objectively (Isaac, 2006).
Credit scoring system is based on principle that a borrower collects points for a number of predetermined variables. If the borrower (e.g. small enterprise company) scores exceed the cut-off point that but by loans officers of commercial banks, the loan will be approved. Sometimes even though the credit scores exceed the cut-off point, it is still subject to banks further investigation. Studies that investigated credit officers reported that the credit proposition must be subject to the approval officers from credit and business units, in accordance with the predetermined authority limits (Chai, 2005). The benefit of this system is a more effective way of checks and balances, which should result in better credit decisions.
In his study, Schrader (1992) uttered that commercial banks will always looking for the credit scoring system that are obviously accurate and therefore, valid in their application. Furthermore, he explains that such system is sometime subjective, where commercial banks approve loans based on other indicators such as committee’s perceptions and expectations.
In his study, Chai (2005) reported that some of the decision-making is based primary at Head office where the commercial branch manager has little or no approving power in approving the credit proposition. The fundamentally role of Head office of commercial banks is mostly at the advice level, while the approval is lie on the credit controller and loan committee that are the head office personnel.
Furthermore, literatures suggested that adopting a scoring system decrease the need for judgmental assessment in making credit decisions. Nevertheless, some risk assessment decisions in the lending environment may be contrary to the credit score recommendation. For the application credit score, these “overrides” of the credit score can be classified as high-side and low-side overrides (Sangha, 1998). In our contemporary institutions, more and more credit decisions are being made using automated systems. Commercial banks comprehend the benefit of implementing scoring systems to lower costs associated with traditional underwriting, decrease credit losses, and provide consistent credit decisions across groups of borrowers (Mays, 1998).
Conversely, studies suggested that credit scoring approach are like antibiotics; when used appropriately, they bring much benefit, but if not used and managed correctly, they may do more harm than good (U.S. Office of the Comptroller of the Currency, 1998). Some possible disadvantages resulting from improperly use, implemented, or managed credit scoring are:
credit scoring may rely on inaccurate or unreliable data
credit scoring may not be adequately monitored
Loans officers must be professionals and have long experiences to effective manage credit scoring approach.
Commercial banks should guard against a false sense of security and not use scoring as a crutch, because credit scoring approach can lose effectiveness or be inaccurate for a variety of reasons.
2.3 COMMERCIAL BANKS AND ANALYSIS LENDING ACTIVITY
Literatures reveal that the activities in the process of enterprise loans follow 8 steps. These steps are as follow; application stage, credit analysis stage, decision stage, document preparation stage, closing stage, recording stage, servicing and administration stage, and collection stage (Johnson et. at, 1985; Hempel and Simonson, 1999; Koch et. at, 2000). These activities summarized in the following table.
Table 2: Activity and work analysis of each stage of enterprise lending process
Activity of lending process
Activity of enterprise loan
Work analysis of enterprise lending activity
Obtaining the loan request and
Receives loan request
Conducts initial interview and obtains financial statements
Credit analysis stage
Credit department operator and financial analyst
Compare financial statements
Obtain verification of deposits and borrowing history
Obtain credit reports, prepare recommendation reports
Prepare line sheet for loan committee review
Structuring the loan agreement
Makes decision, notifies applicant, negotiates terms, initiates loan authorization, presents loan request and recommendation for loan committee
Document preparation stage
Loan operation operator
Prepares notes, agreements, collateral documents, non-collateral agreements, safekeeping receipts
Making and servicing the loan
Obtains borrowers’ signatures, receives collateral, disburses loan proceeds
Loan operation operator
Prepares general ledger entries
Classifies and codes loan into loan subsidiary system
Reviews collateral for negotiability
Reviews loan for compliance with bank’s loan policy
Places collateral in safekeeping, records collateral instruments, files notes, files receipts
Credit department operator
Files loan authorization in credit file
Servicing and administration stage
Loan operation operator
Prepares loan payment notices, receives payments
Prepares general and subsidiary ledger entries
Prepares monthly delinquency reports for board
Obtains periodic financial statements of borrower
Makes periodic plant inspections and customer calls
Reviews compliance with loan agreements
Credit department financial analyst and operator
Review periodic financial statements
Test compliance with loan agreement
Follows up delinquencies with customers
Adjusts terms and conditions as required
If non-collectible, initiates legal action and foreclosure, as required
Source: Lin Peter Wei-Shong (2006)
The first step of SMEs in obtaining loans from commercial banks is the application, forms, this stage involve the loan officer who make the initial interview with SME’s representative and screening of a loan request. The loan officer at commercial banks try hard to get information as much as their can about the situation of SME’s and their business. SMEs and their business activities, for example, credit history of SMEs, current outstanding loans of SMEs and their financial statement. The loan officer at the commercial banks gathered information about SMEs information, these information cover the legal issue, personnel, the company production methods or services, rivals and company management and practices (Lin Peter Wei-Shong, 2006).
The second stage is the credit analysis implemented by the credit department commercial banks. Analyst officers receive the financial information of SMEs gathered by the loan officer; then they conduct a comparative and historic analysis of the company's financial data. After concluding the financial comparative analysis, the analyst officers write a proposal report for the loan officer about whether the loan should be approved, rejected, or need some further documents to better investigate the company.
In the third step, the loan officer at commercial banks use the credit analysis report to determines if the information and reports precisely describes SME’s capacity and their characteristics. The loan officer then approve the grants the loan with or without considerations of security. The loan officer contact and notifies SMEs of the commercial bank decision and proceeds to negotiate loan terms if the loan is to be granted.
After that, when the loan officer and the borrowing SME’s are settle an agreement, the next step is thus the loan operation. The commercial bank prepares primary annotations, agreements, collateral and non-collateral agreements. If security is necessary, the amount of collateral and the extra collateral files is thus required. Then, in the fifth step, the loan officer at the commercial banks obtains the SME’s signatures and receives collateral; then the loan operation is ended and the loan proceeds.
The next stage is the recording of the loan that conducted by credit department and operation personnel. The stuff of loan operation classify and code the loan for entry into the commercial loan system, and they review the loan for compliance with the bank's loan policies. Finally, the personnel of loan operation and credit department file the loan notes, authorization, and receipts in designated files.
The seventh stage is loan servicing and supervision conducted by the following; a loan officer, credit department personnel, financial analyst and loan operation personnel. The loan operation employees prepare the loan payment notices to notify the SME’s and are responsible for receiving periodic payments. The loan officer schedule periodic visits to SME’s to obtain new financial statements and provides that information to credit department and checks the loan for conformity with the loan agreement. The financial analyst and the credit department also receives and reviews the SME’s periodic financial statements. Finally, at the last stage, the loan officer receives adjust loan terms and conditions if it’s necessary, while legal action taken only if non-collectible procedures and foreclosure on the loan are required.
2.3 Six CS OF CREDIT
The previous literatures reveals that the traditional approach to the assessment of credit proposition of the SME borrowers is based on the loan officer judgments. Loan officer judgments thus, based on years of experience that enables him to identify solution quickly without going through an analytical process (Rosli, 2000).
Literatures suggested that the factors for evaluation that used by commercial banks in this situation are implemented by using the 6C’s principles of basic lending. 6C’s refer to character, capacity, capital, collateral, conditions and control (Rosli, 2000). The 6C’s is important reference indexes for commercial banks when analyzing a credit to decide whether or not SME’s is worthy of a loan and they are able to repay. Character assessment performs to determine the willingness and desire of borrowers to repay debt. While capacity explains as the borrower’s capacity to borrowers and also their repayment capacity. Economic conditions will also affect the borrower’s ability to repay the loan. Bank wills normally asking for collateral as security against the loan. Capital requirement of the business indicates the financial net worth of the borrower.
Studies reported that by analyzing a SME’s situation using the 6Cs method, the difficult situations encountered by loan officers at commercial banks become easier to comprehend (Rosli, 2000). In his study, Rosli (2000) Loan officers need to incorporate the 6C’s to better understanding and analysis SME’s information and investigate whether any future changes may impact the financial circumstances and the loan repaying ability of SME’s. Figure 1 present the outputs of each lending activity.
Figure 3: Outputs of each lending activity
Source: Rosli (2000)
Finally, when a loan officer at commercial banks finished their visiting report, they involved the activity of credit analysis. The fundamentally outputs of this activity are the financial analyst report and loan officer recommendation report. The credit analyst and the financial analyst have to both analyze the financial information of SMEs and related papers that collected by the loan officer, and convert them into relevant financial reports.
At this point, the implementation of internal measurements underpins the quality of the loan proposal report, as prepared by the financial analyst at the credit department using the 6C information. In short, we can say that all-inclusive description about SME’s situation and financial situation should be included and presented to the committee regarding how to conduct the analysis and whether to approve or object to the loan.
Finally, when the commercial bank committee approve of the loan, the loan officer notify SMEs and then move on to the lending conditions and negotiation. At this stage, the interest rate of the loan is thus considered as the internal measure for banks outputs. The interest rate based on the anticipated risk associated with SMEs, as a result, the commercial banks negotiation for the higher interest rates on the lending to guarantee the higher the value of the outputs. In attempts to reduce any asymmetric information, commercial banks puts high lending interest rates are thus associated with high loan risk. Furthermore, commercial banks monitoring the employees and accurately assess the SMEs management capability and its strategic fit.
2.4 CREDIT INFORMATION
Information considered significant by commercial banks to accept or reject a SME’s loan proposition includes audited account and bank record (Berry et. at., 1993). SME’s have less required financial transparency than do big companies such as international and global companies have, and thus offer a higher level of risk (Nail, 2003).
Previous studies suggested that the decisions to provide SME’s credit are often made on the basis of hard information that is easily quantifiable such as financial statements, Bank records credit, Bureaus checking and no financial or soft information, which is more difficult to measure, such as assessments of the owner’s character (Jonathan, 2006).
Furthermore, studies conducted on banking reveals that non-quantifiable information could be acquired by the loan officer throughout communication, interaction with the firm, its owner, suppliers, creditors and inter bank checking (Berger et. at, 2002).
Recent literatures reveal that if the owner’s personal credit is strong, then SME’s business is likely strong as well (Meder, 2007). Studies suggested that the benefits of adopting a relationship approach when completing commercial loans is importance. literatures reveals that the length of the relationship reduces the cost of the loan (Berger et. at,1995). In their study Rosli, Ghazali and Nora (2003) reveal that commercial banks in developing countries do not really understand the needs of SME’s customers.
Commercial banks thus urged to assess management skills when making business-lending decisions and particularly when making small business lending decision (Berry, et. at, 1993). Commercial banks should identify differences in management depending upon the stage of development of SME’s business and the specific skills required to manage at each stage of the development. Commercial banks have thus required understanding SME’s life cycle (Daft, 2004), and also various aspects of the skills needed to assess SME’s business such as; Technical, Human, and conceptual (Stoner et. at,1995).
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