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«K C Chakrabarty: Credit scoring – an effective way to ensure availability of timely and adequate credit to Micro and Small Enterprises (MSEs) ...»

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K C Chakrabarty: Credit scoring – an effective way to ensure availability

of timely and adequate credit to Micro and Small Enterprises (MSEs)

Keynote address by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at

the Training Workshop on Credit Scoring Model with support from IFC for MSE Lending,

Mumbai, 29 November 2013.

* * *

Assistance provided by Ms. Lily Vadera is gratefully acknowledged.

Accompanying chart and tables can be found at the end of the speech.

1. Ms. Jennifer Isern, Manager, South Asia Advisory Services, International Finance Corporation (IFC); Shri S.K. Dubey, CMD, Canara Bank; Shri H.S.U. Kamath, CMD, Vijaya Bank; Smt. Archana Bhargava, CMD, United Bank of India; Shri Ashwini Kumar, CMD, Dena Bank; Shri S.R. Bansal, CMD, Corporation Bank; Shri Sushil Muhnot, CMD, Bank of Maharashtra; Dr. Deepali Pant Joshi, Executive Director, Reserve Bank of India; Executive Directors and other senior officials from various commercial banks; Mr. Suresh Sankaran, Mr. Neil Ramsden and Mr. Cameron Evans, the resource persons from IFC ; colleagues from Reserve Bank of India; ladies and gentleman! It is, indeed, a pleasure for me to be amidst you this morning to deliver a keynote address on a very topical issue of ensuring availability of timely and adequate credit to Micro and Small Enterprises. It is a subject that is very close to my heart and hence, I am extremely happy to flag off this workshop on credit scoring models which is fundamentally aimed at capacity building in the banking sector by imparting practical knowhow to people who are expected to use it in their day-to-day operations.

2. As you are all aware, fostering a dynamic micro, small and medium enterprise sector for sustenance of economic development is a priority for the policy makers, in both developed and emerging economies. In India too, Micro, small and medium enterprise (MSME) sector plays a pivotal role in generating employment, increasing cross – border trade and fostering the spirit of entrepreneurship. The sector contributes to economic development in a variety of ways such as creating employment opportunities for rural and urban population, providing goods & services at affordable costs by employing innovative solutions and supporting the export initiatives of the country. In fact, it is increasingly being recognized by the policy makers that if India has to regain its high growth trajectory, it needs a vibrant MSME sector. However, it is deplorable that despite recognizing a widespread need for supporting the sector, the progress on the ground is extremely lackluster and the extent of financial exclusion in the sector is very high. Part of this reluctance of the formal financial sector to reach out especially to the MSEs arises from their own inability to assess the potential of companies in this sector. It is in this context that credit scoring models can prove to be a valuabletool in better understanding and appraising the sector. As you might have discerned from the schedule, the purpose of today’s training workshop is to drive home the advantages of credit scoring model in decision making for lending to the SME sector and the bevy of experienced practitioners from IFC would hold technical sessions through the day to help you understand the nuances of the process. In my address today, I intend to highlight the problems faced by the sector insofar as accessing institutional finance is concerned, give an overview of the credit scoring model and attempt to dispel some common misunderstandings surrounding credit rating and credit scoring models.

3. The statistics compiled in the Fourth Census of MSME sector revealed that only 5.18% of the units (both registered and unregistered) had availed of finance through institutional sources, 2.05% had finance from non-institutional sources and the majority of units i.e. 92.77% had no finance or depended on self finance (see Chart-1.1).

1 BIS central bankers’ speeches A. Constraints in access to finance by micro and small enterprises 4. As I mentioned earlier, the sector has been facing constraints in accessing finance from the banking sector. This has also partly to do with inadequate penetration of banking facilities in the remote unbanked/under banked areas that RBI is encouraging banks to bridge through structured Financial Inclusion Plans. Another issue which is a constraining factor is the pricing of credit. In our view, the credit pricing for the MSE sector is not very transparent and also not very affordable. A sample study of the median interest rates charged to borrowers by select major banks as on March 31, 2013 worked out to 13%.

B. Lack of alternate source of finance

5. The ability of MSMEs (especially those involving innovations and new technologies) to access alternate sources of capital like equity finance, angel funds/risk capital is extremely limited. At present, there is almost negligible flow of equity capital into this sector, which poses serious challenge to development of knowledge-based industries, particularly those that are promoted by first-generation entrepreneurs with the requisite expertise and knowledge. Venture /Risk capital is, therefore, often a more appropriate financing instrument for high-growth-potential and start-up SMEs. However, access to this type of financing is often not available to them. In the absence of alternate sources of finance, the SMEs’ reliance on debt finance is very high. The availability of debt finance, however, is not adequate as viability of these small units is a major issue. Besides, the high reliance on debt, combined with high cost of credit adversely impacts the financial viability of start-ups, particularly in the initial years, thereby threatening their long-term survival and sustainability.

C. Constraints of banks in lending to the sector

6. One of the major challenges faced by the MSMEs and more particularly, the micro and small enterprises (MSEs), is access to timely and adequate credit from the banking sector.

The lenders are reluctant to service the MSEs for a number of reasons, the foremost of which emanates from a general perception amongst banks that the credit risk in lending to small and medium borrowers is very high. This, in itself, is a wrong notion that I have been trying to dispel through my presentations supported by hard data. While the headline numbers of non-performing assets (Gross and Net NPAs) are higher in this segment, if one reckons the extent of restructuring and write-offs that are resorted to in the medium and large borrower segments, the credit risk would appear to be much lower in the MSE sector. A comparative table indicating the extent of NPAs, restructuring and cumulative write-offs in micro and small vis-à-vis medium and large segments during the last five years is given


The data clearly highlights the fact that in the recent scenario of rising impairment of assets in the banking sector, it is the MSEs that have demonstrated better credit discipline resulting in lower impairment.

7. The other reasons why MSEs are regarded as high-risk is on account of insufficient assets and low capitalization, vulnerability to market fluctuations and high mortality rates.

Information opacity arising from MSEs’ lack of accounting records, inadequate financial statements or business plans also makes it difficult for potential creditors to assess the creditworthiness of MSE applicants. Besides, high administrative / transaction cost of lending small amounts also queers the pitch for banks insofar as MSE financing is concerned.

Notwithstanding the merits of the reasons mentioned above, I would say that a major constraint in the banks’ lending stems from the fact that the existing system of banks’ credit appraisal and related processes are not geared to appraise the financial requirements of MSE sector.

8. Nonetheless, over the years, there has been a significant increase in credit extended to this sector by the banks. As at the end of March 2013, the total outstanding 2 BIS central bankers’ speeches credit provided by all Scheduled Commercial Banks (SCBs) to the MSE sector stood at Rs.6847 billion as against Rs.5276 billion in March 2012, registering an increase of 29.77%.

Despite the increase in financing to the sector there is still a considerable credit gap which needs to be bridged. In terms of the Report of the Private Sector Investment for MSME Sub Group under Working Group for the 12th Five Year Plan (2012–2017) the credit gap as a percentage to total demand is estimated at 56% in 2013–14 for the MSME sector as may be seen from the table.

9. In the absence of alternate source of funding for the sector, the role of banks is very crucial in bridging this funding gap. In this context, it is important for the banks to look beyond their existing customer base and the large corporates and to reach out to the vast number of micro and small enterprises which are presently deprived of bank credit. Alongside extending the reach of their banking services, there would be a need to improve and customize the products offered, fine tune the pricing aspects and enhance the quality and efficiency of services. For this, banks need to have a proper business plan and delivery model that would harness the benefits of technology. This would help in planning product delivery and building lasting customer relationships which will translate into higher revenues. The costs of banking transactions need to be dramatically reduced just as in so many other fields such as telecom, after the advent of technology.

D. Need for alternate appraisal techniques 10. Having appreciated the criticality of the sector in terms of its contribution to employment generation, manufacturing and exports, it is important for us to ensure that lending to the sector is appropriately stepped up. Here, we need to appreciate that the credit process in case of micro and small entrepreneurs cannot be identical to that of large corporations, where the borrower is able to provide detailed information about business plans and the firm’s financial statements and the lender carefully reviews the data using analytics that are time-consuming and expensive. In view of the relatively small size of the loan, banks do not find it worthwhile to conduct an elaborate appraisal of SME credit proposals both in terms of value and profit. Therefore, in order that the banks can quickly conduct appraisal of SME loan proposals without expending too much resources, it would be imperative to ensure the efficiency of the appraisal process. An important dimension to efficiency in the context of lending decisions is the speed with which any individual lending decision is taken. Efficiency is improved by better evaluation of future payment performance so that the lender is able to choose whom to accept and whom not to accept.

11. Financial institutions in the developed countries use a number of different lending techniques to address this challenge and provide funding to small firms. The banks, in these countries, use a version of a computerized loan-evaluation system, referred to as credit scoring, to assess would-be borrowers. The credit scoring approach, which is based on use of computer technology and mass production methods, was originally designed to handle consumer loans, but are now being used effectively for lending to small businesses by predicting their potential loan delinquency. Credit scoring offers a modern alternative for the traditional method of evaluating loans for small businesses where loans were approved on the basis of the banker’s qualitative judgment and the financial condition carried significant weight in the appraisal process.

12. With a view to expediting the flow of credit to the MSE firms, RBI, as a proactive measure, issued guidelines in May 2009, advising banks to start using scoring models for making lending decisions in case of all advances up to Rs.2 crore. However, despite, our instructions having been issued nearly five years back, we find that use of credit scoring model in the real sense has not really taken off in India. Our assessment is that perhaps the lack of conceptual clarity on the subject could be one of the reasons for banks’ reluctance in using the credit scoring model for making MSE lending decisions. In fact, very often credit scoring is misunderstood or confused with credit rating. In the next segment of my talk today, 3 BIS central bankers’ speeches I would, therefore, attempt to answer three questions viz. What is credit scoring? How it works? And what are its benefits?

E. What is credit scoring?

13. Credit scoring is a statistical technique that combines several financial characteristics to form a single score for assessing a borrower’s credit worthiness. The score does not predict a company’s ability to pay, but rather its willingness to pay in a timely fashion.1 The probabilities of delinquency, as estimated by the model, are based on the analysis of previous applicants with similar characteristics. Credit scorecards are “tools used to predict the behavior of new applicants based on the performance of previous applicants” (U.S. Comptroller of the Currency, 1998). Scorecards can also be used to predict the performance of existing accounts, based on past experience of accounts with similar characteristics.

14. Credit scoring, is a model applied by banks in their assessment and approval or decline of the loan requests by SMEs. As there is a strong link between the payment behavior of the business owner and that of the business, SME credit scores usually include financial characteristics from both the business and the business owner. Credit scoring is based upon information like how the repayment of the previous loans has gone, what is the current income level of the enterprise, what are the outstanding debts, if any? It focuses on the credit history of the enterprise. As part of the process, the lenders see whether the enterprise/ business owner has the reliability and honesty to repay the loan. It also examines how the enterprise has used credit before, its record for repayment of bills, including utility bills, how long the enterprise has been in existence, assets possessed by the enterprise and sustainability and viability of the activities that the unit is engaged in. Credit scoring model draws inputs from historical information on the performance of loans with similar characteristics.

Background of credit scoring

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