Phase+I+Consultation+Brief

							                                                CONSULTATION BRIEF 1

                           THEME – REGULATORY AND SUPERVISORY FRAMEWORKS1



Introduction

The legal and regulatory framework establishes the rules within which all the financial institutions, instruments, and
markets operate in a given country. It includes banking, insurance, leasing, factoring, and security laws, as well the
respective bodies of secondary regulations and guidelines. Sound legal and regulatory frameworks (which are effectively
enforced) promote market development and competition, while subjecting financial institutions and agents to sound and
appropriate prudential regulation and rules of conduct in order to protect consumers and depositors as well as to ensure
market stability. Thus there are several objectives that need to be balanced, of which access to finance is one. The legal
and regulatory framework can be used deliberately to promote access to finance (e.g. through requirements to provide
basic, low cost bank accounts as in the UK, or to open bank branches in rural areas as implemented in Pakistan for
example), although these are not always in line with efficient market outcomes, and some such policies are now
considered to be counterproductive, such as interest rate ceilings or directed lending.

Financial services for SMEs are best served by strong banking and non-banking institutions that can develop business
models to achieve the optimal balance between risk, reward, and cost to serve the SME segment. The more supportive
the overall enabling environment in a given country is, the larger the size of the bankable SME space, which provides
incentives for financial players to engage in this space, and increases odds of success and demonstration effects.

The G20 Principles for Innovative Financial Inclusion provide the following guidance for regulatory and supervisory
frameworks:

       Proportionality: Build a policy and regulatory framework that is proportionate with the risks and benefits involved
        in such innovative products and services and is based on an understanding of the gaps and barriers in existing
        regulation.
       Framework: consider the following in the regulatory framework, reflecting international standards, national
        circumstances and support for a competitive landscape: an appropriate, flexible, risk-based Anti-Money
        Laundering and Combating the Financing of Terrorism (AML/CFT) regime; conditions for the use of agents as a
        customer interface; a clear regulatory regime for electronically stored value; and market-based incentives to
        achieve the long-term goal of broad interoperability and interconnection.

The G20 Report, ‘Scaling-Up SME Access to Financial Services in the Developing World’ (subsequently referred to as the
G20 Stocktaking Report throughout this brief) discusses several examples of legal and regulatory measures that have been
taken to promote SME lending, including the development of leasing legislation in Jordan and Kosovo, and the use of
mandatory SME lending targets for banks in India (e.g. see Boxes 4.5 and 4.6). It also discusses three countries (France,
Korea, and Malaysia) which have implemented an integrated programme of interventions aimed at creating a more
conducive environment for SMEs (see Table 4.3 of the report).




1
 These draft Consultation Briefs were prepared by the Overseas Development Institute (ODI), Policy Leads, Ina Hoxha (World
Bank) and Douglas Pearce (World Bank). These will inform the Virtual Consultations held from May 30-June 03, 2011, and will
provide the basis for this section of the SME Finance Policy Framework.
SUB-THEME 1. PRUDENTIAL REGULATION, BASEL II/III AND SME FINANCE

Policy Leads: Katia D’Hulster, World Bank; Valeria Salomao Garcia, World Bank.


Overview

Prudential regulation is the regulation of deposit-taking institutions and supervision of the conduct of these institutions
which sets down requirements that limit their risk-taking. The aim of prudential regulation is to ensure the safety of
depositors' funds and maintain the stability of the financial system. It includes licensing requirements, risk management
requirements, capital adequacy requirements, loan classification, provisioning, suspension of interest and limits for
connected lending. Regulators set standards of adequacy for key parameters (such as the amount of capital a financial
institution requires), specify supervisory processes for assessing the risk of each financial institution with regard to key risk
exposures, and set clear lines of responsibility and accountability.

The IMF and World Bank have endorsed internationally recognized standards and codes in 12 areas, many of which relate
to the financial sector2. Reports on the Observance of Standards and Codes (ROSCs) are prepared in relation to these.
ROSCs covering financial sector standards are usually prepared in the context of the Financial Sector Assessment Program
(FSAP), an in-depth analysis of a country’s financial sector undertaken by the IMF and World Bank. FSAPs have two
components: a financial stability assessment, which is the responsibility of the Fund, and a financial development
assessment, the responsibility of the World Bank. The Basel Committee on Banking Supervision (BCBS) is one of the
standard setting bodies, and the Basel Core Principles for Effective Banking Supervision are the global de facto standard
for sound prudential regulation and supervision of banks3.

Basel II is a framework providing harmonised rules for the calculation of regulatory capital measures. The purpose of
Basel II, which was initially published in June 2004, was to create an international standard determining the amount of
capital banks need to put aside to guard against the types of financial and operational risks banks face. Capital
requirements ensure that financial institutions have enough capital to sustain operating losses while
still honouring withdrawals, and thus help protect the international financial system from the types of problems that
might arise should a major bank or a series of banks collapse.

During the consultation period on Basel II, some empirical studies supported claims that the more risk-sensitive nature of
Basel II would reduce the availability and increase the cost of finance for SMEs, in particular unrated SMEs, as banks would
be required to hold relatively more capital for SME exposures. In response, the Basel Committee made some specific
changes to accommodate SME Finance in its final version, including: (i) at a given probability of default, exposures to SMEs
require relatively less capital than larger firms in risk-weighting calculations; (ii) SME exposures classified as retail have a
specific risk weight curve; (iii) the risk weight for non-mortgage retail exposures was reduced under the standardized
approach; and (iv) credit risk mitigants such as collateral and guarantees were better recognized. The debate on the
impact of Basel II on SME Finance has abated since the release of the final version of the Basel II Framework. The changes
largely succeeded in addressing the main concerns about the potential impact of Basel II on SME Finance, and the impact
studies of the Basel Committee have suggested that broadly speaking capital requirements for SMEs would not be
significantly higher than those under Basel I.

Basel II was primarily aimed at “internationally active banks”. Many developing country supervisors are still struggling
with the core principles, as well as problems relating to capacity, independence, legal protection etc. To accommodate
smaller banks with less sophisticated risk management systems, approaches for a simpler and more prescriptive risk
management system similar to Basle I were developed. However, banks in developing countries will also be subject to
more stringent capital requirements (with greater reliance on core tier capital), leverage ratios, and other rules being
proposed at the international level by the BCBS if they choose to implement Basel III. This should not pose an immediate
problem, as emerging country banks are generally better capitalized and less leveraged than banks in developed

2
    A list of areas covered is available at: http://www.imf.org/external/standards/scnew.htm.
3
    Available at: http://www.bis.org/publ/bcbs129.pdf).
countries, but these banks will need to build up more capital in order to meet the growing needs of their economies,
including the demand for credit by SMEs. Emerging country banks will also need to strengthen their risk governance in line
with the more stringent standards being currently proposed by the BCBS.

Basel III is a new global regulatory standard on bank capital adequacy and liquidity agreed by the BCSB in response to the
deficiencies in financial regulation revealed by the global financial crisis. Basel III strengthens further the bank capital
requirements that were introduced under Basel II and introduces new regulatory requirements on bank capital, liquidity
and bank leverage. It will be phased in over the period 2011-20194.



Recommendations, Outstanding Issues

Recommendations on implementation of Basel II5

It is advisable that LIC regulators proceed cautiously in implementing Basel II.

Political support may be needed for that, so that LICs do not rush to implement the more complex approaches, which are
favoured by the international banks.

LIC regulators need to carefully assess the broader implications of Basel II, for banking stability, for credit policy, for access
to credit for SMEs, and on competitiveness of national versus international banks.

Higher levels of technical assistance to LICs are required.

Regional collaboration is desirable, in the mode of the Caribbean Group of Regulators, allowing for the possible
development of a uniform approach, and to forge a common position on specific issues.

Other more detailed recommendations on prudential regulation and supervision are set out in the 25 Basel Core Principles
for Effective Banking Supervision.

Capacity problems, issues related to consolidated supervision, independence of the supervisor, legal protection for
supervisors etc. need to be addressed.

Application of the Basel Capital Framework in Africa

Regulators from 25 African central banks noted the following at a workshop on the Implementation of International
Standards for Banking Supervision and the Basel Capital Framework, in Uganda, April 2011:

        International standards provide an important orientation and point of reference for the long-term reform agenda,
         but should not be seen as blueprints for the reform process in African countries. Maximizing regulatory
         effectiveness and financial stability under resource constraints requires appropriate sequencing and prioritization
         of building blocks of financial regulation and supervision. Rather than adopting international standards wholesale,
         African regulators need to judge which elements of the standards could provide useful and effective building
         blocks within the current country and regional context.
        While many African countries intend to move to adopt the Basel II capital framework the focus should be on
         implementing the supervisory processes outlined under Pillar 2 and Pillar 3. The importance of enhancing
         supervisory capacity as a precondition for adopting the more complex rules under the Basel capital framework
         was emphasized. Further, it was recognized that the adoption of Basel II does not constitute a necessary
         precondition for the implementation of important elements of Basel III. Financial stability might better be



4
 For further information see: http://www.bis.org/bcbs/basel3.htm
5
 Gottschalk (2007), “Basel II implementation in developing countries and effects on SME development” IDS, available at:
http://www.icrier.org/pdf/issuespapers_Gottschalk.pdf
        achieved by focusing on increasing supervisory capacity and adding those provisions from the new Basel III
        framework that are of higher immediate importance for African financial systems.



Key References

Saurina, J. and C.Trucharte. 2003. “The Impact of Basel II on Lending to Small and Medium-Sized Firms: A Regulatory Policy
Assessment based on the Spanish Credit Register”. Bank of Spain, Madrid.

Jacobson, T., J. Linde, and K. Roszbach. 2004. ‘Credit Risk versus Capital Requirements under Basel II: Are SME Loans and
Retail Credit Really Different?’ Journal of Financial Services Research, 28(1/2/3):43-75.

Altman, E.I. and G. Sabato. 2005. “Effects of the new Basel Capital Accord on bank capital requirements for SMEs”. Journal
of Financial Services Research 28, 15–42.

Ayadi R, 2005, ‘The New Basel Capital Accord and SME Financing: SMEs and the New Rating Culture’, Centre for European
Policy Studies, November 2005. Basel III: A global regulatory framework for more resilient banks and banking systems
(December 2010) BIS

Beck, Thorsten, A. Demirgüç-Kunt, and R. Levine. 2005. “Law and Firms' Access to Finance”. American Law and Economics
Review. 7 , 211-252.


Consultation questions

1. What still needs to be taken into account in the application and interpretation of Basel II/III to avoid disincentivizing
SME lending? There should be an objective assessment to determine if there is disincentivising of SME lending. And if
there is, is this is justified?

2. Do SMEs represent relatively high credit risks compared to retail or corporate lending?
SUB THEME 2. COMPETITION
Policy Lead: Maria Soledad Martinez Peria, World Bank

Overview

Competition can act as a stimulus to banks to move beyond financing Governments and large Corporates, to developing
methodologies and skills to serve smaller creditworthy enterprises, if banks have sufficient information on potential
borrowers to determine credit risk. Literature has shown that higher levels of bank competition are associated with lower
prices for banking products, increased access to finance, and greater bank efficiency. At the same time, recent studies
have shown that bank competition can also be good for stability by limiting the emergence of “too big to fail” institutions
that take excessive risks.6

As with other products and services, a competitive market helps to ensure efficiency and cost minimisation in the
provision of financial services. In the financial sector this is more complex however, as both theory and empirics suggest
there is a trade-off between competition and stability, and an appropriate balance must be struck7. A sound regulatory
framework is important to minimise these risks. For example, capital requirements and provision requirements can
slow down the growth of lending that might be motivated by competition, while competition may generate incentives
for excessive lending. A positive balance can be promoted by imposing disclosure and information requirements and
predatory lending regulation that places the burden of avoiding bad loans on the lender8.

Good Practices and Examples

An effective legal and regulatory framework will support a competitive environment by avoiding overly restrictive
licensing requirements and allowing international and regional banks with better SME lending technologies and
downscaling capacity to enter the market. It will also enable the growth of institutions that have proved profitable, such
as mutual banks, and promote the development of alternative lending technologies such as leasing and factoring. Finally,
an effective legal framework promotes the development of securities markets and institutional investors as an alternative
to bank lending for the largest firms, thus producing positive spill—over effects to SME lending.

Competition among financial sector players can be promoted further by introducing technological platforms in key areas,
facilitating a variety of financial products and services, driving down the costs of financial access, and reaching previously
untapped markets. A competitive marketplace for SME finance should include financial institutions as well as non-financial
institutional providers with extensive business networks meeting appropriate criteria.

Of course, competition should not be introduced at the expense of prudential safeguards. Minimum capital requirements,
adequate fit and proper tests, and other regulations would still apply. Moreover, banks in developing countries will also
be subject to more stringent capital requirements (with greater reliance on core tier capital), leverage ratios, and other
rules being proposed at the international level by the Basel Committee for Banking Supervision (BCBS). This should not
pose an immediate problem, as emerging country banks are generally better capitalized and less leveraged than banks in
developed countries, but these banks will need to build up more capital in order to meet the growing needs of their
economies, including the demand for credit by SMEs. Emerging country banks will also need to strengthen their risk
governance in line with the more stringent standards being currently proposed by the BCBS.

Best Practice: Coherence between competition policy and regulatory policy

“All this calls for close collaboration between the regulator (in charge of financial stability and prudential regulation and
supervision) and the competition authority (in charge of keeping the market competitive).

•First, regulatory requirements and competition policy need to be coordinated.



6
  Anzoategui, Peria and Rocha(2010), Koskela and Stenbacka (2000), Beck, Demirguc-Kunt and Maksimovic (2004), Beck,
Demirguc-Kunt, and Levine (2006), Cetorelli and Strahan (2006), Carletti, Hartmann, and Spagnolo (2007), Schaeck and Cihak
(2008).
7
  Vives (2010) available at: http://www.voxeu.org/index.php?q=node/5534
8
  Bond et al (2008) available at: http://www.philadelphiafed.org/research-and-data/publications/working-papers/2008/wp08-
24.pdf
•Second, a protocol for cooperation between the regulator and the competition authority should be developed. This is
particularly important in crises. The competition authority can commit to addressing too-big-to-fail problems that lead to
competition distortions; the regulator can address the too-big-to-fail issue and moral hazard through systemic capital
charges, effective resolution procedures, and restrictions on the scope of banking activities that target conflicts of
interest.
•Finally, crisis procedures should be established that define liquidity help from recapitalisation and conditions for
restructuring to avoid competitive distortions. Entities close to insolvency should be tightly regulated (and activities
restricted) in a framework permitting prompt corrective action.”

Source: Vives (2010)

Financial sector liberalisation and banking regulations that allow the entry of sound and efficient banks (both foreign and
domestic) and promote market competition may reduce margins and interest rate spreads, and may also promote
dynamism within the banking sector as providers facing tough competition from new entrants seek new markets, and it is
often argued that this encourages local banks to look beyond traditional business lines and thus may incentivise them to
develop SME banking, though the evidence for this is mixed9.

At a national level, openness to foreign banks may serve to increase access to capital, but also potentially increases the
risk of contagion from financial crises originating elsewhere, thus again, a sound regulatory framework is an essential
complement to financial liberalisation measures. The 1989 World Development Report provided a summary of sequencing
strategies that should be followed in liberalising financial sectors, to minimise the risk of instability.

Competition considerations are also important in relation to the institutional framework for the financial sector, for
example in terms of avoiding the creation of a ‘closed club’ or limited number of providers in the payments system or in
the credit information sharing business. Legislation that promotes leasing and factoring also promotes access to finance
by SMEs, especially in environments where financial infrastructure remains deficient. Similarly, legislation that facilitates
bond and equity finance for large firms may promote competition to bank lending, reducing bank margins on traditional
business lines and perhaps inducing banks to diversify lending to SMEs.

A stricter approach to regulation and supervision of large exposures and connected lending would also need to be
considered in order to reduce loan concentration and improve competition. At the same time, it may increase
informational/regulatory burden for SME's if they have to deal with multiple banks.

Recommendations, Outstanding Issues

   Financial sector liberalization and banking regulations that allow the entry of sound and efficient banks and other
    types of financial providers contribute to a dynamic financial sector.
   A sound prudential regulatory framework is an important complement to competition in the banking sector.
   Coherence between competition policy and regulatory policy is important.
   Competition authorities (where they exist) are usually responsible for competition issues across all product and
    service markets in a country, although the financial sector is sometimes excluded from their remit, and covered
    instead by the financial sector regulator. Coherence between competition policy and financial regulatory policy is
    important.

Key References

De la Torre, Augusto, M. Martínez Pería, and S. Schmukler. 2009. "Drivers and Obstacles to Banking SMEs: The Role of
Competition and the Institutional Framework". CESifo Working Paper Series CESifo Working Paper No. 2651, CESifo Group
Munich.

Cetorelli, N. (2004). Real Effects of Bank Competition. Journal of Money, Credit, and Banking 36 (3): 543-558.

Brown, M. and Rueda Maurer, M. (2005). Bank Ownership, Bank Competition, and Credit Access: Firm-Level
Evidence from Transition Countries. Mimeo. Swiss National Bank.

9
  See Cali et al, (2008) available at http://www.odi.org.uk/resources/download/2610.pdf and De La Torre et al, (2009) available at
http://www.cesifo-group.de/portal/pls/portal/docs/1/1186302.PDF
Consultation questions

   1. Please share examples of effective competition measures that have stimulated improvements or expansion in
      provision of financial services.

   2. What are the priorities for Competition Frameworks - bank entry/exit, transparency of information, effective
      competition enforcement, enabling regulations for NBFIs, or other?

   3. What is your jurisdiction's approach to competition policy? How do you measure and enforce competition?

   4. What are in your view the pillars for effective competition - bank entry/exit, transparency of information,
      effective competition enforcement, enabling regulations for NBFIs, or other?

   5. How do you think competition affects access to financial services, in particular SME finance?
SUB-THEME 3. REGULATORY FRAMEWORK FOR NON-BANK FINANCIAL INSTITUTIONS SERVING SMES

Policy Lead: Leora Klapper, World Bank

Overview

Improvements in access to finance for SMEs are not dependent on banks, and can be achieved through a range of non
bank financial institutions (NBFIs). NBFIs of different types provide a wide range of services, including: hire purchase
transactions including leasing of machinery or equipment; the factoring, or discount purchasing of accounts receivable and
other forms of supply chain finance; and new equity to invest in companies. Provision through NBFIs can be enhanced by
introducing an enabling tax, legal and regulatory environment, and technological platforms, which allow a wider variety of
financial products and services to be developed, drive down the costs of financial access, and reach previously untapped
markets. The IFC provides detailed guidelines for emerging economies on developing the leasing sector10.

Factoring is an important complementary source of working capital finance for SMEs, especially in jurisdictions where the
financial infrastructure is deficient. Factoring entails the purchase by the lender of a firm’s accounts receivables and the
collection of invoices from the parties that owe money. Factoring addresses the problem of SME opacity by focusing on
the quality of the obligor. In recent years, the concept of reverse factoring as a financial instrument has become popular.
With reverse factoring, the financial institution purchases receivables only from high credit quality buyers, resulting in the
provision of low risk loans to high risk suppliers (SMEs). Reverse factoring is particularly useful for SMEs in countries with
underdeveloped contract enforcement regimes and weak credit information systems.11

Likewise, leasing appears as an important complementary source of investment finance, particularly in countries where
the information infrastructure are weak. This is particularly the case for smaller firms as suggested in Figure 3.2 (“Other
Financing”). An advantage of leasing lies in the fact that it focuses on the firm’s ability to generate cash flows from
business operations to service the leasing payment rather than on its credit history or ability to pledge collateral. A further
guarantee for leasing providers in case of payment default is the repossession and sale of the leased asset.

Private equity can be an important source of financing for small and high-growth firms. There are advantages for firms to
have venture capital (VC) investors, such as the influence of professional and foreign board members on corporate
governance, the establishment of oversight and audit committees (or provision of mentoring, for smaller SMEs), and the
hiring of better CEOs. In addition, investors may use personal relationships to assist the firm in accessing bank financing.
The government’s role is to improve the environment for private equity funds, such as removing tax penalties on VC
capital gains and formalizing the private placement market, as an alternative exit strategy.

Good Practices and Examples

Leasing: Strengthening the legal framework for leasing can be achieved through a specialized leasing law combined with
appropriate changes in related pieces of legislation. Among others, the definition of leasing needs to be clear and a fair
balance established between the rights and responsibilities of the parties to a lease. It is important to establish
regulations for other forms and types of leasing such as sale and lease-back and sub-leasing. In addition, a leasing law
should generally address the following elements:

        First, the process for registering leased assets should be strengthened. One of the first priorities entails the
         development of registries in which lessors may publicize their interest in the leased asset and protect its
         ownership rights. Ideally, there should be a unified registry for movable collateral where all security interests are
         recorded, and lessor’s interests in leased assets would be recorded in this unified registry.
        Second, repossession procedures may need to be defined and enforced. The right of the lessor (as owner) to
         repossess a leased asset expediently should not depend on the type of breach committed by the lessee. Should a
         leasing agreement be rescinded for any reason or if the lessee does not exercise his right to purchase the leased
         asset, then the lessee must return the asset to the lessor. If the leased asset is not returned, then the lessor
         should have the means to repossess the asset.




10
   Fletcher et al., (2005) “Leasing in Development: Guidelines for Emerging Economies”,IFC, available at:
http://www.ifc.org/ifcext/sme.nsf/AttachmentsByTitle/Leasing_in_Dev_Nov05.pdf/$FILE/Leasing_in_Dev_Nov05.pdf
11
   Klapper (2005); IFC Board paper on Warehouse Receipt Financing and Supply Chain Financing, 09.09.2010.
       Third, tax rules should be clear and neutral, removing bias, if any, against leasing. The income tax treatment of
        leasing and loans should be similar, as there is little difference between leasing and loan finance, and valued
        added tax rules should clarify that a leasing operation is a financial service, not the sale of a good or a rental.
       Fourth, insolvency regimes must clarify the rights of lessors and lessees under bankruptcy. The consequences of
        default should be clearer. In particular, lessors’ rights under bankruptcy should be preserved, as lessors are a
        particular class of secured lender – leased assets do not belong to the insolvent company and should be returned
        to the owner (the lessor).

Fostering SME Lending Through Leasing

“Jordan’s Ministry of Industry and Trade, in coordination with IFC, introduced an initiative in 2006 with the objective to
improve the leasing environment in Jordan, and to promote and increase the volume of leasing activities. The project’s
main activities include: (i) provide support to policymakers to draft, lobby, and promote leasing legislation based on best
practices; (ii) build capacity of leasing stakeholders (e.g., FIs, equipment suppliers, investors) through consultations and
training; (iii) increase awareness of benefits of leasing to MSMEs to finance business assets; and, (iv) promote and
facilitate leasing investments. As a result of the initiative, four laws were introduced: Law on Leasing, Movable Leased
Assets Registration Instructions, and Registration Instructions for Leased Vehicles and Internal Procedures for Land
Registration. Financial leasing has become more favourable and the leasing market has grown substantially.”

Source: G20 Stocktaking Report, World Bank


Factoring can be a powerful tool in providing financing to high-risk, informationally opaque sellers, which are often SMEs.
Factoring’s key virtue is that underwriting is based on the risk of the receivables (i.e. the buyer) rather than the risk
of the seller. Therefore, factoring may be particularly well suited for financing receivables from large or foreign firms
when those receivables are obligations of buyers who are more creditworthy than the sellers themselves. Factoring
can provide important export services to SMEs in both developed and developing countries. Like traditional forms of
commercial lending, factoring provides small and medium enterprises (SMEs) with working capital financing.

Also critical is that factoring only requires the legal environment to sell, or assign, receivables and depends relatively
less on the business environment than traditional lending products. Another merit of factoring in a weak business
environment is that the factored receivables are removed from the bankruptcy estate of the seller and become the
property of the factor. In this case, the quality and efficacy of bankruptcy laws are less important.

However, factoring may still be hampered by weak contract enforcement institutions and other tax, legal, and
regulatory impediments. For example, factoring generally requires good historical credit information on all buyers; if
unavailable, the factor takes on a larger credit risk. In general, a small firm sells its complete portfolios of receivables
in order to diversify its risk to any one seller. In fact, many factors require sellers to have a minimum number of
customers in order to reduce the exposure of the factor to any one buyer and to the seller’s ability to repay from
receipts from other buyers, in the case that a buyer defaults. However, this diversified portfolio approach requires
factors to collect credit information and calculate the credit risk for many buyers. In many emerging markets the
credit information bureau is incomplete (i.e. may not include small firms) or non-bank lenders, such as factors, are
prohibited from joining. In the case of exporters, it might be prohibitively expensive for the factor to collect credit
information on firms around the world. (Ina, See attached Trade Note, which talks about the enabling environment)


Fostering SME Lending Through Reverse Factoring

“Initiatives: Reverse Factoring at Nacional Financiera — NAFIN (Mexico): NAFIN is a local development bank in Mexico that
offers on-line factoring services to SME suppliers. In 2001 Nafin developed a “Productive Chains” program that works by
leveraging the links between large corporate buyers and small suppliers. The program allows small suppliers to use their
receivables from big buyers to receive working capital financing, effectively transferring suppliers’ credit risk to their high-
quality customers to access more and cheaper financing. Two types of factoring are offered: (i) Factoring offered to SMEs
without any recourse, collateral, or service fees, at variable risk-adjusted rates; and (ii) Contract Financing, which provides
financing up to 50 percent of confirmed contract orders from big buyers with NAFIN supply chains, with no fees or
collateral, and a fixed rate. Financial training and technical assistance are also offered under the program. As of mid-2009,
the program comprised 455 big buyers (about 51 percent in the private sector) and more than 80,000 SMEs, and had
extended over USD 60 billion in financing. About 20 domestic lenders participate in the program, including banks and
independent finance companies.”

Source: G20 Stocktaking Report, World Bank (2010)


Agents. The provision of SME finance can also be enhanced through non-financial institutional providers with extensive
business networks meeting appropriate criteria. Innovative business models that reduce the costs of delivery mechanisms
for SMEs include the use of banking agents. A prominent example is the agent banking model in Brazil, where financial
services are successfully provided by private agents using point-of-sale devices, as discussed in the G20 Stocktaking
Report. Regulators can permit the use of bank agents to offer financial services and verify customer identity for know-
your-customer purposes with minimal restrictions on agent eligibility, compensation, and structuring—provided that
regulators hold banks liable for the provision of financial services by their agents (CGAP, 2011).

Recommendations, Outstanding Issues

A good environment for the development of NBFIs should be created by introducing the right tax, legal and regulatory
environment and appropriate technological platforms in key areas. For example, non-bank NBFI’s should be permitted to
access credit information and join public registries. An effective legal and regulatory framework will promote greater
competition between banks and non-bank lenders by avoiding overly restrictive licensing requirements and allowing
international and regional banks with better SME lending technologies and downscaling capacity to enter the market, and
to use low cost delivery mechanisms, including through agents. Competition will also enable the growth of institutions
that have proved effective, such as mutual banks, and promote the development of alternative lending technologies such
as leasing and factoring. Finally, an effective legal framework promotes the development of securities markets and
institutional investors as an alternative to bank lending for the largest firms, thus producing positive spillovers effects to
SME lending.

Key References

IFC. 2005. “Leasing in Development: Guidelines for Emerging Economies”. Washington, DC.

ATISG. 2010. “Innovative Financial Inclusion”. Principles and Report on Innovative Financial Inclusion from the Access
through Innovation Sub-Group (ATISG) of the G-20 Financial Inclusion Experts Group.

Klapper, Leora. 2005. “The Role of Factoring for Financing Small and Medium Enterprises.” World Bank Policy Research
Working Paper 3593. World Bank. Washington, DC.

Factor Chain International. 2008. Data on Total Factoring                    Volume    by    Country.    http://www.factors-
chain.com/?p=ich&uli=AMGATE_7101-2_1_TICH_L968523287

IFC Board paper on Warehouse Receipt Financing and Supply Chain Financing, 09.09.2010.

A new lease on life: Institutions, External Financing, and Business Growth", Gregory Brown, Larry Chavis, and Leora
Klapper, mime

Trade Note No.29, World Bank Group, International Trade Department, Leora Klapper 2006 and updated 2009.

World Bank Development Research Group, “Factoring around the World”, Leora Klapper, Feb 2009.

CGAP, March 2011, ‘Regulating Banking Agents’, Focus Note 68.

Consultation questions

1. The role of agents in extending financial access can be significant. Can LDCs learn from and adopt the approach from
India, Brazil and other countries in enabling agents as financial service delivery mechanisms?

2. Leasing and factoring are not well developed in many LDCs. How can they best be stimulated? What are the
constraints? Are they appropriate for SMEs?
SUB-THEME 4. EQUITY INVESTMENT FOR SMEs

Policy Lead: Alex Berg, World Bank; Peter Tropper, IFC

Overview

Equity funds are pooled investment vehicles that invest in unlisted equity, quasi-equity and, occasionally, debt securities.
There has been an increase in participation in SME equity funds in emerging markets in recent years. Over the last
decade, Development Finance Institutions have expanded their participation in SME equity funds, and evidence suggests
that there are close to 200 investment funds supporting small and growing businesses (SGB) in emerging markets.
However, for the majority of SMEs in emerging markets funding from private equity funds is not generally available.
SME equity funds in emerging markets face particular challenges, including a shortage of experienced fund managers with
the right skill set and market knowledge, and low capital needs of small businesses, making the deal sizes unattractive to
most private equity firms.

Some countries have also created SME stock exchanges to facilitate access to public funds, although the performance of
these exchanges has been mixed.12 Over the years, many developed and developing countries have sought to address the
issues faced by SMEs by establishing dedicated stock exchanges, junior market segments or separate trading platforms
exclusively for the SME sector with the aim of facilitating access to capital markets more quickly, with less stringent
eligibility criteria and at a lower all-in cost. However, the performance of many of these junior exchanges, particularly
those in lower-income countries, has been unimpressive, with only a handful of SMEs electing to list on certain markets
and with little or no new capital actually being raised. Notable middle income and high income country examples include
the Alternative Investment Market (AIM) in London, the Growth Enterprises Market (GEM) in Hong Kong, KOSDAQ in
Korea, MESDAQ in Malaysia, TSX in Canada, the MOTHERS market in Japan and the Shenzhen SE in China.

Good Practices and Examples

In general, deal flow and exit opportunities in most of the smaller emerging countries are too limited to support dedicated
single-country funds. Thus, successful SME fund models usually cover more than one country, with a small central team
and local management teams in each country. This structure allows the local teams to focus on investments while
spreading overhead costs over as broad a base as possible. The central “platform” shortens the learning curve for the local
teams and provides necessary services and support in an efficient and cost effective way. Box 4.4 (p. 57) of the G20
Stocktaking Report discusses experience from three different types of Equity Funds.

Example: Developing private equity / venture capital markets

 “The Inovar Program in Brazil was designed in 2001 by Financiadora de Estudos e Projetos (FINEP), which provides
funding to strengthen technological and scientific development in Brazil, in coordination with the Inter-American
Development Bank. The objective of the program is to support the development of new, SME technology-based
companies through the establishment of a venture capital (VC) market and to enhance private investment in technology
businesses. Inovar created a research/knowledge and information dissemination platform and develops managerial
capacity for channelling and accelerating VC investments in small-company funds in Brazil. The program successfully
achieved the creation of a VC portal with information on how to register for different program components, with over
2,650 registered entrepreneurs, and over 200 investors. It also established a Technology Investment Facility where
investors can perform joint analyses and due diligence on VC finds, which resulted in over 50 joint due diligences with
approximately USD 165 million committed/approved in 15 VC funds. The program has also established 20 venture forums



12
     OECD (2006) provides a comprehensive review of equity finance in the early stages of the life cycle.
for SMEs to interact with potential investors and present business plans, resulting in 45 SMEs receiving over USD 1 billion
in VC/PE investments.“ G20 Stocktaking report p. 73.

Setting up SME stock exchanges or junior markets can further improve the supply of equity investment to SMEs, although
most are not considered to be successful. Establishing a trading platform and equipping it with modern systems and
infrastructure is in itself no guarantee of success. Improvements to the wider enabling environment for capital markets
are needed. The SME exchanges that have succeeded globally are those where: (i) the underlying legal and capital market
regulatory frameworks are reasonably well-developed, robust and, above all, trusted by investors, (ii) access to credible
corporate information on SMEs is widely and readily available, (iii) a reasonably broad spectrum of early-stage equity
capital is available from angel, venture capital and private equity investors, and (iv) the size of both the private sector and
the qualified institutional investor community is sufficiently large to support the growth of the market generally. (Mako,
2010)

A variety of policies have been suggested to increase listings and liquidity on SME exchanges, including: (i) the size of
qualified SMEs should not be capped at very low levels, as this may have adverse effects on liquidity and discourage the
participation of fund managers; (ii) the public float should have a minimum size, as an excessively low float will also
constrain liquidity. Some successful SME exchanges impose a minimum float of 10%, but combined with commitments of
market-making and research by the broker; (iii) A large minimum number of shareholders may be required to improve
liquidity; (iv) lock-up periods of 6-12 months or longer during which certain shareholders (with 5 percent or more of the
shares) cannot sell their stake following an IPO would prevent the early exit of corporate insiders and curtail insider
trading; (v) governments may consider tax incentives for SMEs that go public.



Key References

Beck, Thorsten, and R. Levine. 2004. “Stock Markets, Banks and Growth: Panel Evidence”. Journal of Banking and Finance.
28 (3), 423-442. 2. Mako, Bill, 2009, ‘Mobilizing Long-term Finance: Next Steps in Egypt’s Capital Market Development’
World Bank

Mako, William, 2010, ‘Investment Funds’, paper prepared for the MENA Finance Flagship, World Bank



Consultation questions

    1. Capital markets for SMEs have been tried in many developing countries, but have not taken off. What could a G20
       Compact do to promote these?

    2. How can smaller SMEs tap into venture capital and private equity better, including for early stage capital and
       angel finance?