Mon, 02 Jun 2003


Problems and challenge in providing small credits

Mohamad Nazirwan Contributor Jakarta

Discussing the role of micro, small and medium enterprises (MSMEs) is always interesting and often invites heated debate involving economists, politicians and policy makers.

The reason behind the phenomenon is that MSMEs are regarded as the backbone of the economy in many developing countries, including Indonesia.

This sector plays a leading role in creating jobs and providing income for the majority of Indonesians.

Statistics published by the Ministry of Cooperative and Small and Medium Size Companies state that there are approximately 40 million MSMEs which employ more than 73 million people and make up nearly 55 percent of Indonesia's Gross Domestic Product (GDP).

Interestingly, since the economic crisis struck Indonesia in 1997, the presence of MSMEs has become stronger and they have played an important role in creating economic growth compared to the impact of the corporate sector.

Numerous initiatives have been introduced to promote the role of MSMEs in the country's economy. These have involved government bodies, regional administrations, the Indonesian Chamber of Commerce (KADIN), business associations, the central bank, Bank Indonesia and other institutions.

As a policy framework those programs look attractive. In practice, however, the policies are difficult to execute since a myriad of problems need to be addressed, and a comprehensive solution involving an integrated approach needs to be put forth.

The involvement of financial intermediaries (banks and financial institutions) have actually strengthened the MSMEs sector for a long time, beginning in the early 1970s.

Enormous credit programs for MSMEs have been introduced but only a few have been successfully implemented. A good example was the subsidized credit for working capital and investment program (KIK/KMKP), which was designed to help indigenous people engaged in businesses.

In 1983 the government implemented a liberal banking policy and transformed the BIMAS credit program, which targeted self- sufficiency in rice production, and two off-farm credits (Kredit MINI/MIDI), into a single general rural credit (KUPEDES), and adopted a more commercial approach.

Differing from KIK/KMKP, the KUPEDES, delivered by the BRI, continues to serve millions of micro entrepreneurs and economically active poor, especially in rural areas.

In 1988, the government introduced another liberal banking policy, which increased the number of private banks and banking networks around the country.

Although the number of private banks increased significantly during this period, the role of the banking sector in providing credits for MSMEs was dominated by the five state owned banks until the government set up a policy which required that all banks allocate 20 percent of their loan portfolios for MSME in 1990 through Small Business Credit (KUK).

Since the economic crisis hit Indonesia in 1997, the banking landscape has changed drastically as has the policy on MSME development. In short, the significant change was that the government intervened in the banking industry less and let the market play a larger role in MSMEs lending.

In addition, the government also created a new financial institution called Permodalan Nasional Madani responsible for providing financial assistance to MSME.

Naturally, when dealing with credit transactions, regardless of who the customer is, a bank will face asymmetric information problems, moral hazards and adverse selection.

Asymmetric information is a situation in which bank has only limited information about a borrower. Moral hazard is a situation where a bank suspects that a customer can not be trusted. Adverse selection is a condition in which a customer has hidden information.

In practical terms, when dealing with a credit transaction, the credit officer does not know whether the customer is honest or dishonest, whether the customer can be trusted, or whether the customer will pay back the loan on time and so forth.

In short, when a credit contract has been signed, a bank obviously accepts risks. To overcome potential negative consequences, the bank usually uses the popular 5C's approach before deciding to disburse the loan to a customer. These include Capital, Capacity, Character, Condition of the economy and Collateral. The purpose of this approach is to protect the bank's interest and to minimize risk.

There is a common belief that banks are reluctant to serve MSMEs since this sector is not commercially viable and high risk. In the perspective of banks MSMEs are not always guaranteed to return a profit and fail to meet the criteria of the 5Cs due to not providing accurate and reliable information on financial conditions and performance, a lack of a robust business plan and formal business licenses, and are unable to provide marketable collateral.

On the other hand, when dealing with MSMEs, banks also deal with internal problems such as limited specialized loan officers who understand the characteristics of MSMEs, inappropriate lending technologies and a lack of operational systems that allow MSME to access loans easily. There is also high overhead costs due to the large number of customers with small loans.

In addition, some problems arise beyond the control of banks, such as difficulties with the legal system enforcing loan contracts and compensation.

MSMEs are an important part of the economy and a potential market for the banking industry, however, banks must consider certain issues when doing business with MSMEs.

First, develop lending strategies appropriate to the borrower's characteristics, i.e. use a 3C's approach (Character, Capacity, Condition of the economy) instead of the 5C's.

Second, the size of the loan should meet the needs of MSMEs, i.e. the size of lending should be appropriate for the type of business and the life cycle of the enterprises.

Third, simplify administrative procedures and paper work for micro and small businesses to meet the needs and education levels of the borrowers.

Fourth, set up a relaxed policy on collateral. Instead of physical collateral, banks should develop a loan guarantee system and credit insurance.

Fifth, provide technical assistance in addition to loan services to enhance the capacity of MSME in areas such as marketing and financial management.

Last but not least, the role of the government must be stressed in setting a market friendly economic policy, providing easy access to the legal system, licensing and tax incentives. Bureaucratic procedures should also be relaxed in order to minimize the cost of corruption, collusion and nepotism. (The contributor is a senior microfinance specialist of Bank Rakyat Indonesia)

.rm Table

Enterprises Number % Labor % GDP %

(Thousand Units) (Thousand people) (Million Rp)

Small 40,137 99.85 65,246 88.6 578,359 39.40 Medium 57 0.14 7,993 10.85 225,223 15.34 Sub total 40,194 99.99 73,239 99.45 803,582 54.74 Corporate 2 0.01 406 0.55 664,517 45.26 Total 40,196 100 73,645 100 1,468,199 100