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					CREDIT RISK MANAGEMENT –SME
              SECTOR
 (Specific reference to credit risk
             insurance)

           Dr. B.YERRAM RAJU
          REGIONAL DIRECTOR,
       PRMIA, HYDERABAD CHAPTER
              www.prmia.org
          hyderabad@prmia.org
Snapshot of the Presentation

   Current concerns
   Credit Risk Management (CRM) practices
    currently in vogue–and Reengineering
   Risk Mitigation instruments
   Credit Risk Insurance practices



    7/7/2011   Yerramraju@prmia.org   2
Why SMEs and Risk twin up?
   Engines of Economic Growth
   Sources of Innovation
   Incubators for new entrepreneurs and new
    workforce
   Motivators of free market competition
   Suppliers of materials, components, products
    and services to other businesses
   Generators of value addition and export
    earnings
   Sources of employment and income distribution
   They take RISK and spread RISK


    7/7/2011   Yerramraju@prmia.org         3
Risks that abound for SMEs…

   Enterprise-Choice of Business organization
   Marketing: Domestic, International, Branding,
    co-branding
   Technology: Inadequacies; Inappropriateness
   Pricing and the last
   Financial



    7/7/2011   Yerramraju@prmia.org          4
  Contribution of SMEs
•More than 65 ways in which the SMEs are defined over the world
 Centering round Investment, Employment, and Turnover
•8 out of 10 Jobs                                     U.S.
•78% of Manufacturing Employment                      Japan
•34% of Total Value Addition                          Singapore
•42% of total exports                                 Korea
•53% of Total Exports                                 Taiwan
•40% of Manufacturing production &
•39% of total exports                                  India
•98% of enterprises and >45% of exports                Malaysia
•99% of business enterprises employing 55% of
 total workers contribute 32% of GNP with 9 out of
10 export firms                                        Philippines


     7/7/2011   Yerramraju@prmia.org                 5
Facilitation around the Globe
   US: Small Business Administration
   South Korea: SME Basic Law for Protection and Promotion
   Taiwan: SME Guidance System
   Hong Kong: Special Finance Scheme for SMEs
   Philippines: Magna Carta for SEs (RA6977);SMED Council;
                 Small Business & Guarantee Fin Corpn
   Malaysia: Credit Guarantee Corporation and Fund for
    SMEs(RM1.25bn) New Entrepreneurship Fund (RM900mn)
   India:
      NSIC,SFCs (1950s); SIDBI (1994); SMERA (2004)
      MSME Development Act 2006
      Credit Guarantee Fund Trust for MSMEs under which
        up to Rs.5mn collateral free loan can be extended.



    7/7/2011   Yerramraju@prmia.org                 6
Still………
   SMEs thrive on private high-cost credit
   Survive on low margins and low profits
   Exit fast
   According to a Study presented by Mr.
    Supriya Sithikong nearly 77% of new
    entrepreneurs exit in the first five years
    of setting them up
   Exit rules in many developing economies
    are hostile.


    7/7/2011   Yerramraju@prmia.org       7
Still………
   Several supports from the governments in Asia did not get
    adequate support from the financing institutions.
   In India, all the positive policy reforms did not take
    beyond 6.34% (US$2.9bn) credit to the SMEs by 2006-07
    despite NPLs going down from 21 % in 2001-02 to 5.4%
    in2006-07.
   After the entry of Basel II norms Banks’ preference
    weighed in favor of firms that wouldn’t entail excess
    provisioning of capital and this is driving away some of
    the erstwhile well-run SMEs seeking exit.
   Competition driven by new trade rules, new FTAs, WTO,
    high-end games




    7/7/2011   Yerramraju@prmia.org                  8
    Indian Economy
   A sustainable growth of over 8.6 percent in the short term and
    9-9.5 percent in the medium term; targeting 10% next Plan
   Growth in manufacturing at 7% at end June08 – down from
    11.8% last year due to the US recession and downward global
    demand curve.
   Eloquent on economic reforms and tardy on implementation
    agenda
   International Rating Agencies have scaled up the rating for
    viewing the country as a good destination for future
    investments. (S&P;Moodys;Fitcher)
   Dun&Bradstreet Business Optimism index moved up -13.3%
    growth
   Call for convergence, competitiveness & efficiency




    7/7/2011    Yerramraju@prmia.org                        9
      CURRENT CONCERNS
                                             BANKS
      GOVERNMENT, RBI                          HIGH RISK
        WIDEN & DEEPEN THE SME                HIGH TRANSACTION COSTS
         PORTFOLIO                             ASYMMETRY OF INFORMATION
        INCREASE THE REACH                    MORAL HAZARD
        RATIONALISE COST OF LOANS             LOW ON COLLATERALS &
        MAKE USE OF CART & RAM OF              GUARANTEES
         SIDBI                                 DEMAND CONCUSSION
        LIBERALISE POLICIES                   HUGE DATA REQUIREMENTS
        BANKS TO DISPLAY FACILITIES           POOR COMPLIANCE
         AT BRANCHES
                                               HIGHER CAPITAL
        CLUSTER DEVELOPMENT &                  ALLOCATION
         TECH MODERNIZATION

2008-RBI set up Working   Group to suggest more sustained strategies for
SME growth and to rehabilitate the sick SMEs on firm and faster footing.
The Report is under consideration.
         7/7/2011     Yerramraju@prmia.org                       10
SME sector in India
   The sector currently contributes 40 percent of
    the total industrial production in the country and
    over 39 percent of national exports.
   The total number of small-scale industrial units
    and small business enterprises is 11.39mn
    accounting for nearly 95 per cent of the total
    industrial units of the country, providing
    employment to nearly 27.13mn people, which is
    nearly 86 percent of the total employment in the
    country.
    7/7/2011   Yerramraju@prmia.org            11
With Reengineering Credit
processes
   They will reposition themselves through
    the new financing facilities to earn more
    profits and expand their businesses.
   Win-win situation for Banks,
    Entrepreneurs and National
    Economy


    7/7/2011   Yerramraju@prmia.org     12
The New Direction
   The overall context and direction of
    commercial bank lending can be
    epitomized as follows:
   Growing competition in Financial industry
    leading to emphasis on total banking solutions
    to customers
   Risks managed more prudently because of
    diversified Portfolio reflected in capital adequacy
    ratio of >9% for most banks in India



    7/7/2011   Yerramraju@prmia.org             13
    Approach To Risk
   RISK BY CHOICE AND NOT BY CHANCE
   INTEGRATED, NOT FRAGMENTED APPROACH
    (ASSET, LIABILITY, OFF-BALANCE SHEET
    ITEMS)
   INTEGRATED APPROACH TO MARKET AND
    CREDIT RISKS
     -- MOTIVES AND ROLES OF FINANCIAL
        INSTITUTIONS AND CORPORATE
        TREASURY
     -- IMPLICATIONS



    7/7/2011   Yerramraju@prmia.org   14
The credit process:
   Banks use two basic methods for
    determining credit-worthiness- or –
    assessing the bank’s risk level:
    Judgmental or Credit Scoring Method.
   On the basis of training & personal experience,
    the loan officer attempts to predict the
    likelihood that the applicants will be good or bad
    credit customers.
   The scoring method draws profiles from the
    bank’s lending experience using statistical
    techniques.
    7/7/2011   Yerramraju@prmia.org            15
Change on Cards
   Building new customer base of SMEs could earn
    relatively higher margins and soaks some excess
    liquidity
   New equilibrium between supply and demand of
    loanable funds at higher price – Depositors also
    benefit.
   Prudence and Profitability – Two Pillars on which
    SMEs are built
   Risk aversion will drain banks’ profitability

    7/7/2011   Yerramraju@prmia.org           16
Change on Cards (contd)
   Lack of access to capital
      Has not allowed SMEs to modernize their production
       techniques:
      To hire skilled human resources, upgrade the quality
       of management and invest in new equipment.
   Separate Stock Exchange for SMEs is on cards.
   LLP Act tabled in the Parliament
   SMEs can accomplish new product mix to meet the
    demands of domestic and export markets.
   The credit provided to them will enable them to acquire
    new technology and improve the quality of their products
    to meet the future needs.

    7/7/2011   Yerramraju@prmia.org                  17
Migration to Automated
Processing of Applications:
   Banks that receive many applications, typically process
    and score them with automated systems, with the help of
    data entry terminals.
   A preliminary score may decide whether a Credit Bureau
    report is required.
   Some banks use automated processing for handling
    applications but use a judgmental method for the final
    credit decision.
   Approvals are followed by Credit Review functions
    including, Credit Origination, Extension, Customer Service,
    Security and Collections.
   Internal scoring is the most preferred option for SMEs

    7/7/2011   Yerramraju@prmia.org                    18
Current Credit Risk
Management Practices:
   Existing SME Loan Products and their nature:
    Term Loan:
    This is being sanctioned by the Banks and financing
    institutions for setting up the plant and machinery,
    modernization and purchase of new technology for a
    period of 3 to 7 years repayable in monthly, quarterly or
    half yearly installments.
   Working Capital:
    Cash Credit in form and content-mostly based on Balance
    Sheets and the related ratio analysis or the normative
    lending prescribed by the RBI.


    7/7/2011   Yerramraju@prmia.org                   19
Credit Appraisal
Technology for SMEs:
   Main tools for credit appraisal
    o      Portfolio Approach
    o      Program Lending
    o      Credit Scoring Methodology
    Credit analysis to develop competencies other
    than
    o      Balance sheets
    o      Audited Financial Statements
    o      Value of Collaterals
    Doing sensitivity analysis


    7/7/2011   Yerramraju@prmia.org          20
Credit Appraisal
Technology for SMEs:
   Re-engineer from the micro level: Regulatory and
    infrastructure support
           This we call change in mindset
           Monitor the borrower instead of Account
           Restructure repayments if unexpected exogenous
    shocks occur
           Rigid approach & insistence on original schedules
    despite genuine difficulties of borrower will only build
    NPAs – Avoiding them is imperative.
           Use information technology as an aid to monitor
    & follow up.


    7/7/2011   Yerramraju@prmia.org                  21
Credit Appraisal
Technology for SMEs:
   Bank Staff have to do hand holding of the
    borrowers and help in building their capacity.
    (Less attempted)
   This new kind of relationship between bank and
    customers will alone assure success of SME
    lending
   Learning from international best practices
    We don’t have to reinvent the wheel but
    carefully examine what has worked elsewhere
    and what hasn’t worked.
    7/7/2011   Yerramraju@prmia.org         22
Credit Appraisal
Technology for SMEs:
   Risks from changes in domestic and international
    polices
    Examples: Policy to import components under low
    tariffs led to exit of a few hardware manufacturing
    electronic units; vegetable oil import policy & tariff
    policies leading to some oil expellers shutting down the
    shutters.
             Production & yield risks of the dependent Agri
    sector in some trade cycles leading to closure of small
    units – maize, corn, rice, wheat, Soya bean, cotton,
    tobacco as raw material


    7/7/2011   Yerramraju@prmia.org                    23
Credit Appraisal
Technology for SMEs:
   Market & Price Risks
    Price uncertainty due to market fluctuations is particularly
    severe where information is lacking and where markets
    are imperfect (Ellis, 1988; peasant Economics, Farm
    Households and Agrarian Development, Cambridge, New
    York, Port cluster, Melbourne, Sydney)

   The vendee – a large industry to be competitive and stay
    in the market suddenly changes its technology and
    production focus and the vendor would not be able to
    readjust quickly to the demand raised on him/her.


    7/7/2011   Yerramraju@prmia.org                     24
Credit Appraisal
Technology for SMEs:
   Risk of Loan collateral limitation
    Banks have of late been seeking excessive
    collaterals and specific collaterals to hedge their
    risks in appraisal and lending because of the
    powers conferred on them to realize the assets
    by sale of collateral in case of loan default.
    MIS support:
    Most Indian Banks are yet to build data bases
    on risk events, loan default rates sector-wise,
    area-wise, like probability of default, loss given
    default, exposure at default.
    7/7/2011   Yerramraju@prmia.org             25
SCORING VS RATING
SCORING                              RATING
  USED IN THE REALM OF RETAIL        USUALLY INTENDED FOR
   FINANCE                             WHOLESALE BANKING
  HUMAN JUDGEMENT, DECISION
   TREE ANALYSIS; STAT
   METHODS LIKE DISCRIMINANT         -JUDGEMENT-BASED
   ANALYSIS OR LOGISTIC                 METHODS, ARTIFICIAL
   REGRESSION ANALYSIS                  INTELLIGENCE SYSTEMS &
  NEUTRAL NETWORKS: BASED
   ON HISTORICAL CREDIT
   ANALYSIS A COMPOSITE SCORE        -STATISTICAL
   CARD IS BUILT.                       METHODS:STRUCTURAL,
  kNN-k NEAREST NEIGHBOR               REDUCED FORM AND
   ANALYSIS                             HYBRID MODELS



  7/7/2011    Yerramraju@prmia.org                      26
Credit Appraisal
Technology for SMEs:
   The cash-strapped SME sector is still in the process of
    appreciating the advantages of rating.
   Banks are yet to market this strategic tool among the user
    population with appropriate incentives.
   SIDBI developed a rating product for internal use by
    Banks-Credit Appraisal Rating Tool (CART)
   To give special focus, SIDBI and Dun & Bradstreet
    promoted SMERA as an exclusive SME rating institution in
    2004. It has rated 1400 enterprises and conducted
    detailed studies of 14 prominent clusters.


    7/7/2011   Yerramraju@prmia.org                   27
IT IS BETTER TO BE APPROXIMATELY
  RIGHT THAN PRECISELY WRONG




 7/7/2011   Yerramraju@prmia.org   28
RISK MEASUREMENT


   A NEW SCIENCE
   FALLIBLE
   AN APPROXIMATION
   IMPRECISE


    7/7/2011   Yerramraju@prmia.org   29
     Credit Risk Measurement
                                            Transforms credit
Collateral
                                            Risk to asset risk




Third Party                                Risk transfer from
Guarantee                                   Only borrower to
                                          Borrower + Guarantor



                                            Allows corrective
Covenant
                                                 action




        7/7/2011   Yerramraju@prmia.org             30
MODELS
   PROVIDE ‘AN INEVITABLY INCOMPLETE
    DESCRIPTION OF REALITY’ AND THEIR ROLE IS
    TO ASSIST INTUITION
   NO MODEL CAN PRECISELY CAPTURE THE
    BEHAVIOUR OF AN ENTREPRENEUR
   IT CAN AT BEST REDUCE UNCERTAINTY
   PROVIDES AN OBJECTIVE BASE
   VALIDITY OF STRESS TESTING COULD BE
    ERODED BY THE SUBJECTIVITY OF
    ASSUMPTIONS.
    7/7/2011   Yerramraju@prmia.org    31
WHAT TO DO?

   RISK TEAMS SHOULD LOOK AT HOW TO
    DEMYSTIFY RISK PRACTICE, BUILD
    BRIDGES WITH BUSINESS UNITS AND
    INTEGRATE OPERATIONAL RISK
    MANAGEMENT MORE CLOSELY WITH
    THE DAY-TO-DY CONTROL
    ENVIRONMENT

    7/7/2011   Yerramraju@prmia.org   32
   PRINCIPLES ARE REQUIRED TO DEFINE
    THE EXPECTATIONS, GOVERNANCE AND
    COMMON LANGUAGE OF RISK
    MONITIORING AND MITIGATION.
   ‘WE NEED TO ELEVATE RISK ABOVE THE
    TRADITIONAL SILOS TO ENSURE WE
    ARE ASKING THE RIGHT QUESTIONS.’




    7/7/2011   Yerramraju@prmia.org   33
        New Paradigm on Risk Management
        left SMEs in Deep Trouble
   SMEs that cannot offer adequate guarantees and collaterals are hurt
   Banks continue to view SMEs as high risk entities despite policy
    encouragement from the government and their contribution to the
    growth of the economy
   Venture Capital and Angel Capital firms distance from them because
    they do not assure that yields they look for and exit routes are not
    clear.
   Still, many rating institutions rate the SMEs on Balance sheet
    performances.
   Many financing institutions too assess credit requirements of SMEs
    on the basis of Balance sheet ratios in several Asian economies and
    not on the basis of cash flows.

           7/7/2011   Yerramraju@prmia.org                   34
What is the Recourse? And
Where are the Risk Mitigants?
   Client Education and Training hold the key

   Cluster Approach

   World Bank reiterates that Factoring helps a great deal.

   Credit Risk Insurance holds promise if the Insurance
    Companies are persuaded to provide guarantee cover
    with subsidized premiums.

   Technology funding, IPR funding, and Brand
    funding with support from the Education and Training
    Institutions would make them globally competitive.


    7/7/2011   Yerramraju@prmia.org                  35
                         The New Paradigm
Banking & Prudential Norms guided by                 Individual Bank Strategy towards AME
overall financial sector reforms                     Cluster Lending

Credit at Lower cost (Collateral                     Increase bank reach, with geographical
requirements & Lower interest rates ) w              intensity of distribution –




                                                                ACCESSIBILITY
                    AFFORDABILITY




                                          3A APPROACH




                                          AVAILABILITY



                               Making loans available at the right
                               quantity at the right time

                               Bank motivation (customer focus)
                               towards higher SME clustering.



                                                                                Source:D&B Study, SMERA (India),2007




  7/7/2011                Yerramraju@prmia.org                                                       36
GoI – MSME DEVELOPMENT SUPPORT
SCHEMES (2008)

   (i) Adequate credit from financial institutions; (ii) funds for technology
    upgradation and modernization; (iii) integrated infrastructural facilities;
    (iv) modern testing facilities and quality certification laboratories; (v)
    modern management practices, entrepreneurship development and skill
    upgradation through appropriate training facilities; etc. The schemes so
    announced include:-
   Tax Holiday Scheme
   Composite Loan Scheme
   Industrial Estate Scheme
   Scheme for International Cooperation
   Scheme of Surveys, Studies and Policy Research
   Scheme of Fund for Regeneration of Traditional Industries (SFURTI)
   Scheme of Product Development, Design Intervention and Packaging
    (PRODIP)
   Scheme of Khadi Karigar Janashree Bima Yojana for Khadi Artisans
   Scheme of Interest Subsidy Eligibility Certification (ISEC)
                          Source: www.laghu-udyog.com




    7/7/2011      Yerramraju@prmia.org                               37
INDIA –MSME (Contd)
Small Industry Development Organization also operates a number
  of schemes for the sector:-

   Credit Linked Capital Subsidy Scheme for Technology
    Upgradation
   Credit Guarantee Fund Trust for MSEs
   ISO 9000/ISO 14001 Certification Reimbursement Scheme
   Scheme for reimbursement of fees to adopt barcoding
   Integrated Infrastructure Development (IID Scheme)
   Scheme for setting up of Mini Tool Rooms
    Scheme for setting up of testing centres
    Scheme for Market Development Assistance (MDA) for
    exporters
   Assistance for Strengthening of Training Infrastructure of
    existing and new Entrepreneurship Development Institutions
   Scheme of Micro Finance Programme

                                      Source: www.laghu-udyog.com


    7/7/2011   Yerramraju@prmia.org                        38
Cluster Based Risk Assessment Framework
                                                                               SMES in the
                BANKS/FI S                                                       cluster




                                           Bank credit flow to
                                                Cluster




                         COMMON                                   Individual

   Risk param eters    RISKS FACING                              RISK FACING           Risk param eters

                             CLUSTER                                SME




    CLUSTER RISK                                                                  SME RISK SCORING
                                          RISK ASSESSMENT
   SCORING/RATING                                                                      RATING


                                                                                      SME SCORE
    CLUSTER SCORE


                                          COMPOSITE SOCRE
                                           CLSUTER + SME




                                               Above
                                              Threshold                               Source: D&B Study,SMERA(2007)
                                                Level



                                   CREDIT SANCTION & DISBURSEMENT


  7/7/2011              Yerramraju@prmia.org                                                              39
Enhancing SME Competitiveness through Cluster Development
Nature of deficiencies in SMEs          Remedies sought through Cluster initiative


Individualistic and non-sharing         Awareness and Trust building interactions among the cluster
                                        participants
Lack of collective thinking             Industry Associations are associated to bring about effective
                                        ideanization and participation; networking both within and outside
                                        the cluster.

High Costs                              Consortium approach in procurement of raw materials, contracts
                                        and financing; sharing of costs of common services
Low Quality                             Common testing and R & D facilities; Awareness programmes on
                                        quality management; bench marking
Low Market penetration                  Product innovation; product diversification; market information and
                                        market diversification strategies; and Market research
Lack of or poor brand image              Brand building; Brand imaging; co-branding; and brand
                                         management
Low capital, low debt and Poor financial Improved access to debt markets; Skill building in financial and
management                               accounting management; Build bridges of understanding between
                                         the financing institutions and entrepreneurs for better facilitation;
                                         Innovation of new financial products to suit the specific products
                                         and markets.

Lack of Institutional supports          Institution building and building strong public-private partnership in
                                        building product specific and general infrastructure
Lack of enthusiasm and disinterested    Entrepreneurship Development programmes specifically designed
second generation entrepreneurs         for the cluster


                7/7/2011          Yerramraju@prmia.org                                     40
    Factoring Fundamentals


Factor              Obligation to pay
                                                Buyer



   A/R
                                             Goods

                        Seller
                    yerramraju@prmia.org
                                           Source: World Bank 2007

  7/7/2011   Yerramraju@prmia.org                  41
Credit Risk Insurance

   The need arises from continuing Cash flows in business,
    bad debt reductions, asset reporting and integrity forming
    important charters of credit risk management.
   Ever changing face of trade credit risks accentuated by
    changes in national laws, regulations and licensing
    regimes; WTO, FTAs and other Regional Trade
    Agreements. Keeping track of them is a tough task for the
    Credit Manager.
   The Manufacturing and trading entity as well as the credit
    provider are a happier lot by seeking credit Insurance if
    there is a good provider at affordable price!!




    7/7/2011   Yerramraju@prmia.org                   42
Credit Risk Insurance
   Managing and hedging the default/loss risks inherent in
      National, domestic (inter-state and intra-state),
       export, multinational transactions of firms
   Sovereign, political and economic risks need coverage

   Political risks include: political unrest, widespread
    corruption/bribery; economic instability; accelerated
    inflation rates; currency volatility; regulatory volatility and
    high service costs.

These types of risks are just unthinkable for many SMEs
  irrespective of where they are situated.


    7/7/2011    Yerramraju@prmia.org                      43
Status of Credit Insurance –
Some Illustrations

   Types of Cover                       Countries
      Medium & Long term
                                             U.K
       cover thru ECGD
      High Risk Market
                                             France
       Interest                              Netherlands
      Project Financing                     Spain
      Supplier Credit
       Finance
                                             Portugal
      Bond Insurance                        Canada etc.
      Overseas Investments



    7/7/2011   Yerramraju@prmia.org                         44
Status of Credit Insurance –
Some Illustrations
Focus on SME sector                      U.S
                                             Small Business Policy
                                            SB Environmental Policy
   Political risks                         Umbrella Policy-Export
   Environmental risks                       Insurance for the small
                                              enterprises
   Domestic Credit
                                          Belgium
    Insurance                         
                                            SME Policy – T/O Bfr200m
   Governments of the                        & Exports outside Europe-
    respective countries                      Bfr250m
    extend tremendous                    Netherlands: SMEs with €7mn
    support thru budgetary                and less and for SMEs of ABN-
                                          AMRO
    and exclusive grants to
                                         Germany
    premia subvention.
                                         South Africa


                                                                          45
    7/7/2011   Yerramraju@prmia.org                            45
To sum up
   SMEs and FIs need to share the risks
    equally thru proper mutual understanding
    and better instrumentality – Clusters,
    Factors, Credit Insurance
   Mere mathematics, LGDs, EADs, V@R,
    Rating mechanisms are only poor
    substitutes for client education, client
    understanding as effective risk insurers
    and re-insurers.


    7/7/2011   Yerramraju@prmia.org   46
THANK YOU
     URL: www.prmia.org
 E-mail – hyderabad@prmia.org
     yerramr@gmail.com

				
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