Problems and challenge in providing small credits

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.