SME FINANCING IN PAKISTAN

4.1     SME Finance

Governments of growing economies are increasingly recognizing the potential of SMEs in providing jobs and in poverty alleviation. With the increase of population the unemployment becoming a serious problem, specially for the young generation, In many countries close to 50% of the population is younger than 16/17 years of age hence the pressure for rapid job creation.[1] So SMEs playing key role for job creation, in other word bring about reduction in unemployment rate.

Data for developing and developed countries indicate that SMEs account is between 60-90% of all enterprises. The same percentage of workers is employed by SMEs (excluding agricultural workers). Their contribution to GDP, however, is not as large. In Pakistan this is about 30%. But therein lays the opportunity and the reason for Government’s attention. A reduction in unemployment would lead to a higher contribution from SMEs to GDP. In Pakistan access to finance is still a case for SMEs, and competes in high value markets because they lack necessary skills, knowledge, technology, market information and financial resources. Business support services such as training, market information and consultancy are often of poor quality or undervalued by SME’s.[2]

Quite often the impression amongst the informed population is that SMEs are an observable fact of lesser developed economies, that due to lack of resources and skill workers big enterprises don’t exist in sufficient numbers. SMEs are major contributors to GDP In the developed countries and private sector employment contributing as much as 60% to workforce. In developing countries, they employ more than 70% of labor force. The abundance of labor and the shortages of capital which are characteristics of developing countries are comparable with the SMEs labor intensive character.[3]

There are about 4 million SMEs in Pakistan. SMEs account for over 90 percent of all private enterprises, contribute to 30 percent of GDP, and account for 25 percent of exports of manufactured goods. In spite of their importance in the economy, financing to SME still accounts for only 43 percent of total Development Finance category. Credit to Pakistan small enterprises has much potential to expand, relative to the international experience.[4]

4.2     Condition of SME financing in Pakistan

SMEs lending grows more slowly then other lending market segments. Such as consumer finance, specially small, as opposed to medium, enterprises.  One reason of theis is the complexity of risk assessment process. Specially in a dynamic environment and less relible information. The another is that Banks consider SMEs laiding as a part of corporate finance activities, Sme lending will only works when more attention is given to efficiency then risk assessment process. Many Banks behaves like minicorporate with Smes. And using the same tool of risk assessment. This becomes expensive as well as ineffective.[5]

According to the report of SBP at the end of 2008 Total of Rs. 884.2 Billion has been appropriated in the Development Finance category. Out of the total Development Finance portfolio SMEs receive the major chunk with 43.3% followed by Infrastructure & Housing Finance with 38.4% by the end of December 2008. The following table shows the Development Finance Group portfolio composition of last two quarters

Outstanding Break up of outstanding Advances (domestic) in Billions. Dec 2008 Amount % Share SMEs 383 43.3% Agriculture 155.5 17.6% Microfinance 6.4 0.7% Housing 339.3 38.4% Total 884.2 100% Source SBP.

The quarterly review report shows that the SME sector’s outstanding credit stood at Rs. 383 billion in absolute terms, constituting about 12% of total credit of the banking industry. Though SME financing had witnessed negative quarterly growth of 8% by the end of third Quarter of current year; however, a positive growth of 5.92% has been registered by end of Dec‐2008.

4.3     Banks in SME Financing in Pakistan

The banking industry’s exposure towards SME sector is the second largest after corporate finance. At the end of fourth quarter of 2008, the SME sector’s outstanding credit stood at Rs. 383 Billion. About 48% of this amount has been availed by the Manufacturing SMEs, followed by 36.4% amount by the Trading SMEs and the rest by the Services SMEs. The share of short term loans (unto one year) constitutes about 70.9% and long term loans (exceeding 3 years) were about 19 % and the rest was the share of Medium term Loans (1-3 years).

Private Banks

According to the Report of SBP the private banks doing well in SME financing, recording consistent growth. The share of private banks stands at about 80% of total outstanding SME finance portfolio reported at the end of 2008. The absolute outstanding amount of the private sector banks was Rs. 309.7 billion of the total SME finance. Among the private Sector Banks Habib Bank Ltd is on the top shearing 13.7% of total SME finance, followed by NIB bank with 8.6%, Bank Alfalah 8%, UBL with 7%, and ABL 6.6% respectively. 32.54%, Trading SMEs 51.65% Manufacturing SMEs and 15.81% Services SMEs, accounts are in Private Banks’ SME financing.[6]

Specialized Banks

Specialized Banks objective is to promote SMEs in the country and to develop those providing special products for financing SMEs. SME Bank, ZTBL, PPCBL and IDBP. To act as a catalyst for the SME market, in 2002 the GOP created SME Bank Ltd through the merger of two failed Development Financial Institutions, the Regional Development Finance Corporation (RDFC) and Small Business. SME Bank and other specialized banks focusing SMEs. Although at the end of December 2008 these Banks consists of the absolute amount outstanding of the specialized banks towards SME sector mounts to Rs. 10 billion constitutes about 2.6% of the SME total portfolio of the banking industry. By having a close look at SME finance performance of the specialized banks it is evident that their portfolio has been hovering around Rs. 10 billion for the last few quarters. SME Bank has the largest portfolio of Rs.7.5 billion constituting about 2% of total SME finance.[7]

Foreign Banks

Financing to SMEs the foreign banks also participating, like Albaraka Islamic Bank, Deutsche Bank, Bank of Oman, HSBC, Bank of Tokyo Mitsubishi, and City Bank. These Banks share in SME financing is been reported at the end of 2008 were 0.5% outstanding of 1.8 billion.[8]

Public Sector Banks

The share of public sector banks i.e. NBP, which is a state-owned bank with the largest branch network (1,243 branches) in the country. Its total assets exceeded $12 billion in 2007.[9]  Including NBP and other public sector banks like FWBL, BOP and BOK constitute about 14.3% of the total SME finance portfolio at the end of the period under review. In absolute terms, the outstanding amount of public sector banks were Rs.54.8 billion at the end of 4^th quarter, 2008. Among the public sector banks, NBP has the lion’s share of about 68%, followed by BOP with 20% of total public sector banks’ SME finance outstanding. A positive quarterly growth of 19.8% has been registered by the public sector banks for 4th quarter, 2008; however, the share of public sector banks recorded a decrease of 4.6% in SME finance, from Dec, 07 to Dec-08. While only NBP and FWBL witnessed a positive growth of 4.9% and 9.7% respectively during the same period.[10]

Islamic Banks in SME Financing:

Islamic bank’s share has enhanced considerably from an outstanding amount of Rs. 1.4 Billion to Rs. 6.8 Billion during the period December 2005 to December 2008 constituting around 1.8% of the total SME outstanding amount. Islamic banks SME portfolio has witnessed an impressive growth of 33% for the period December 2007‐ Deceomber 2008. In this category, Meezan bank leads with a share of 67.5%, Bank Islamic 12%and Dubai Islami Bank with 8% at the end of the period under consideration.

In 2002 first time Islamic banking license was issued to MEEZAN Bank. Currently there are six full Islamic and 12 convetional Banks with stand alone Islamic Banking branchs. There are 288 Islamic Banks Branchs in the country. They contributing in the banking activities in the country.

Islamic Banking Players

The most popular instruments of Islamic Banking system are Musharaka, Ijara, diminishing musharaka financing.[11]

Islamic Banks facing number of problems, like lack of liquidity management instruments specific Islamic Banks prudentional regulations, depositor’s risk, clarity with more complex financial instruments like foreign currency accounts, letter of credit and future contracts etc. Although Islamic Banks has 4.82% share of SME financing portfolio.[12]

4.4     Improving Financial Access for SMEs

There are 3 million SMEs in Pakistan; they constitute more than 90 percent of all private enterprises in the industrial sector, employ nearly 78 percent of the nonagricultural labor force, and contribute over 30 percent to GDP. Small and micro enterprises have seen a worsening of access to finance; they internally finance 90 percent of working capital and 81 percent of new investment. In contrast, medium-size enterprises and those with a credit history have seen an improved access to finance. Studies estimate a 423SME credit demand gap of Rs 277 billion (compared with current SME credit of Rs 400 billion).

However, enterprises do not seem to be excluded from financial markets because of poor performance.

Instead, an incomplete legal and regulatory framework and non-SME-friendly products and procedures hamper increased SME lending. Indirect costs legal fees, collateral registration, and documentation make bank lending expensive for SMEs. A typical small business loan requires up to 27 steps for the bank and nine meeting with clients.

An enabling role has been played by the expansion of Credit Investment Bureau’s (CIB) scope in 2006; the SME Policy 2007, which emphasizes SME access to finance; and, above all, the new SBP Prudential Regulations for SMEs. However, banks continue to find it difficult to serve SMEs profitably for several reasons. First, the legal framework (namely, the secured transactions regions and, to a lesser extent, the credit information infrastructure) limits the pool of potential applicants. Second, bank products are not tailored to SMEs, resembling instead corporate lending practices. Finally, banks do not have organizational structures and monitoring tools conducive to achieving high efficiency. SME demand-side factors, including limited SME accounting, budgeting, and planning capacity further constrain the market. Continued promotion of an enabling environment for SME lending and a large-scale downscaling effort involving both the public and private sectors can forge rapid growth in SME lending. Increasing access to finance for SMEs could also be facilitated by attracting an institutional investor with a track record in SME lending and assisting other banks to go down market. [13]

4.5     Government Policies to Improve Financial Access to SMEs[14]

The Government of Pakistan (GOP) and SBP have introduced policies to improve the legal framework and create a demonstration effect. The GOP and SBP have launched a number of initiatives to support the growth of SME lending. These can be broadly grouped in two areas: initiatives aiming at facilitating SMEs provision of collateral and credit history and activities aimed at creating a demonstration effect for other financial institutions, that is, financing technical assistance for selected financial institutions to increase SME lending, thus showing to other market participants that the SME segment is indeed a profitable one and ultimately creating competition in the segment. Finally, to monitor

SME lending, the SBP has introduced a more detailed SME definition on a pilot basis and requires banks to report on their SME portfolio on a quarterly basis.

SBP has made two unsuccessful attempts to increase lending to SMEs:[15]

Firstly through the creation of an effective secured transactions system and secondly through the relaxation of collateral requirements. The traditional corporate lending products of Pakistani banks emphasize security, especially immovable collateral, audited financial statements, and business plans, rather than doing firsthand research on cash flows and business performance. This makes it more difficult for financial institutions to extend loans to SMEs, whose collateral is limited and movable, and which do not find financial statements and business plans easy to produce. The general resistance of banks to accept movable collateral is compounded in Pakistan by a secured transactions system that makes it unsafe to lend to a sole proprietor by collateralizing the loan with a movable asset. Currently, only limited liability companies can register, and hence notify to the public at large, a lien over movable assets. They do so in the company registry, which is not available for unlimited liability companies, as these are not registered

To remove this barrier for sole-proprietor SMEs, the SBP has attempted to introduce a registry for liens over movable assets. However, encountering delays insetting the new system in place, the SBP introduced a regulation in 2004 allowing uncollateralized lending for loans up to Rs 3 million and without financial statements for loans up to Rs 10 million.

Despite the new legality of this lending, the lending practice is proving too risky for conservative Pakistani banks.

To promote the creation of formal credit histories by small businesses, SBP founded a public CIB in 1992. The CIB records both positive and negative information about companies, as well as all the assets they use as collateral for the loans. CIB performance was enhanced in 2006 with the introduction of an e-CIB system, which improved speed, reliability, and security of data. In that same year, CIB coverage was expanded to all loan sizes. In addition to the state-owned CIB, two privately owned credit bureaus now operate in the country. Despite their improved performance, credit bureaus cover only 10-20 percent of the borrowers and very few SMEs requiring loans smaller than Rs 6 million. This is partly because the banks lend to this segment and partly because the bureaus do not collect information from the telecom and utility companies, which could substantially contribute to building a credit history for SMEs.

To create a demonstration effect for other market participants, the GOP has supported the creation of a specialized SME Bank, which, in three years since its inception, has served a mere 1 percent of the market. To challenge the market and demonstrate that the SME segment is not only viable but very profitable, the GOP created a bank dedicated to serving only SMEs. SME Bank was created by merging two failed state-owned banks. In 2007, two years after starting operations, SME Bank had only 2,200 clients (1.2 percent of total SME borrowers) and offered less than 2 percent of total SME finance extended by the banking sector.

4.6     Problems Faced By SMEs[16]

The SME sector in Pakistan has always been taken as risky and non-bankable, even though they have default rate that is far less than that for Large Scale Enterprises (15% for SMEs against 65% for Large Scale Enterprise). Despite strong figures favoring SMEs, financial institutions have been shy of providing finance to SMEs because of following reasons:

·                    Poor record keeping by SMEs, particularly accounting information and other business documentation.

·                    Low productivity and their inability to improve quality of products over time.

·                    Poor operational performance.

·                    Problems with packaging bankable loan requests by SMEs.

·                    Limited knowledge of financing options for SMEs.

·                    Lengthy and cumbersome application procedures, which discourage both SMEs and Banks.

·                    High transaction costs owing to size of transaction, vis-à-vis volume of transactions which discourages banks.

·                    High turn around time owing to lack of timely and quality information from SMEs.

·                    Lack of skills in banks for identifying needs and structuring the delivery of financial assistance to SMEs.

·                    Lack of expertise in banks for appraising/structuring SME Projects.

·                    Stringent collateral requirements and other banking regulations.

·                    General risk aversion by banks.

All these factors have created a gap between lenders and SMEs. This has deprived SMEs from getting financing for setting up, or the expansion of the business.

4.7     SME Development – Recent Steps by the Government

In the recent past SMEDA stands out as a significant step towards GOP commitment to SME development. Created as an autonomous institution with private sector led governance structure, SMEDA promises to become an important institution spearheading Government’s SME development efforts. However, in absence of a coherent SME development policy framework it is unreal is tic to expect a single organization such as SMEDA, to be able to implement aggressive SME development initiatives because:

Ø                  Issues to be addressed for SME development fall within the purview of a large number of Ministries and Department s at the Federal , Provincial and Local government level s. SMEDA has no institutional jurisdiction or linkage with such institutions ; and

Ø                  SMEDA has limited budget and manpower , posing restrict ions on its capacity to launch capital intensive initiatives and extend its out reach Creation of the SME Bank also marks the Government’s commitment towards SME development agenda. The Bank, however, is in its early days of a major restructuring exercise and focuses on a single is sue faced by SMEs, i.e., access to finance, and that too on a very limited scale.

Thus to provide a coherent policy mechanism, there is a need to develop a comprehensive SME Policy for Pakistan that defines the role of concerned public sector institutions. Such a Policy framework will provide the required direction and focus for achieving SME led economic growth resulting in job creation and reduction n poverty. Private sector growth in SME sector (as opposed to the large scale manufacturing will result in lesser investments per job created, wider geographic and social spread of investments and better income distribution.

4.8     Mudaraba Sector of Pakistan

Globally the Islamic Financial Services Industry has witnessed a phenomenal growth. In Pakistan, the Mudaraba sector has established its place and has been able to create a market niche for itself in the corporate sector. This model is enjoying a unique recognition in Islamic Financial Industry world over due to its well designed structure with proper rules and regulations defined from the regulators.

Recently the Islamic financial industry has proved its resilience and has attracted world attention in this time of global financial turmoil. The performance of Modaraba sector during last ending June 2008 remained reasonably when as compared to performance in the corresponding period of previous year.

On June 30^th 2008 the total assets of a Modaraba sector increased form Rs26,009 million to Rs 29,231 million depicting an increase of Rs 3,272 million i.e. 12.58 percent increase. Profitability of the sector have been increased by Rs 213 million and stood at Rs 962 million showing an increase of 28.44 percent over the last year. 24 Modaraba, 18 Morabahas have declared cash dividend between the ranges of 2.5 percent to 40 percent and two Modarabas have declared bonus to the certificate holders. Modaraba sector has contributed immensely to the financial sector in Pakistan, particularly by providing an Islamic mode of financing. The sector has played a leading role in dynamically encouraging growth in the Islamic financial services. The sector has achieved a phenomenal growth in term of profitability as out of 27 listed Modarabas, 18 paid dividends for the ended June 30, 2008; however Modaraba sector should critically evaluate itself and prove to other segments of the financial system that it is truly a robust and viable alternative to the conventional financial system.

Banking and non banking financial sector of the country were nowadays facing difficulties due to world financial turmoil and general business slow down but according to last published results the Modarabas sector so far had remained least affected.

The first agreements for Modaraba products including Musharaka, Murabaha and Ijara were signed in early 90s with the approval of new Islamic financial products. Modaraba sector was introduced in Pakistan some two decades back and now over two dozen Modaraba companies where functioning in Pakistan. Many countries including Malaysia and UK have adopted this Islamic financial system and running it successfully. Modaraba sector could be made more active by introducing a new product with clear understanding; most of the modarabas have been paying cash dividends regularly and paying more than other companies of the financial sector. During the last 2008-09 modarabas declared dividends up to 65 percent. Total cash and stock distribution come to Rs 575 million which constitute an average of 9 percent of paid up capital of modarabas.[17]

References

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[1] Hamayun Murad, (2008) “Leasing – path to a prosperous SME sector” Orix Leasing of Pakistan.

[2]  Khawaja, Shahiab. (2006.) Unleashing the potential of the SME sector with a focus on Productivity Improvements1. SMEDA Pakistan. [Online] [Cited: 5 1, 2009.] www.semda.org.pk.

[3] Shahnawaz Mahmood “Corporate Governance and business Ethics for SMEs in the Developing countries: challenges and way forward” Islamabad Pakistan. www.isbee.org/index.php?option=com_docman&task...

[4] SMEDA “Report of Working Committee on the Business Environment.” Prepared by the Small and Medium Enterprise Development Authority, Lahore.

[5] Taliana Nenova, Cicile thiroro Naiang and Anjum Ahmad. (2009).”Bringing Fianance to Pakistan's poor”.

[6] SBP (2008). “SME finance quarterly review – First quarter 2008.” Issue 02. SBP SME Department.

http://www.sbp.org.pk/publications/index2.asp Accessed Sept 5, 2008.

[7] Ibid page:3

[8] Ibid page:3

[9] National Bank of Pakistan “annual Report 2007.”

[10] SBP 2008. “SME finance quarterly review – First quarter 2008.” Issue 02. SBP SME Department.

http://www.sbp.org.pk/publications/index2.asp Accessed Sept 5, 2008.

[11]  SBP 2007. “Islamic Banking Bulletin.” SBP Islamic Banking Department. July-September 2007,

[12] SBP Figures for 1^st quarter 2008, rescaled to add up to 100

[13] Taliana Nenova, Cicile thiroro Naiang and Anjum Ahmad. Bringing Fianance to Pakistan's poor. May 2009.

[14] Ibid Page-60

[15] Ibid Page-60

[16] SMEDA Pakistan. “SME guide.” [Online] 2005. [Cited: 4 13, 2009.] www.smeda.org.pk/smeguide.

[17] Samiullah, Muhammad. (2009), “ Modarabas show sound resilience.” Money Plus (The Nation), p. 20.

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