MSME sector: Accessibility and affordability of collateral

The need of the hour is to assist the MSME sector which will bring in massive economic benefits to the country

Based on my personal experience as a banker, I should emphasise, the major risk, which is beyond the control of the financier in microfinance, is the lack of a succession plan of these entrepreneurs and the risk faced by the financiers due to the absence of the borrower as a result of an unforeseen circumstance arising due to the death or disability of the entrepreneur. Such risks could be mitigated, by linking the facility with a life insurance policy covering the life of the individual entrepreneur, as this sector appears to be a neglected category. This will not only ensure the safety of the bank’s exposure; it will be beneficial to the borrower as a compulsory saving for their future and relieve the dependents in case of any unforeseen eventuality

The MSME sector is very much in the news and the Government has announced several financial packages towards assisting this sector. This has prompted me to share my thoughts and expertise for the benefit of all stakeholders particularly the MSME sector in requirement of such financial assistance.

The MSME sector considered as the backbone of the economy, is categorised as high risk sector by the financial institutions. Most of these entrepreneurs and mainly “start-ups” are dependent on one single personality without any succession plan. The moment the aforesaid personality is out of the scene due to death or disability, the exposure of the financial institution will face the risk of non-payment and fall into the NPA category without any prospect of recovery apart from the lack of realisable collateral.

This is the reality and one of the main factors and reluctance of banks and financial institutions to assist such category of borrowers. They may feel comfortable to grant facilities to professionals with dependable income, against acceptable collateral or in some cases on clean basis, (i.e., without any security) as the possibility of default for the aforesaid category is considered remote. This will not only ensure the safety of their exposure, it will greatly minimise their follow-up costs on post monitoring towards recovery. 

Towards achieving this task and boosting their asset portfolio many financial institutions assign targets to their marketing personnel to aggressively canvass such facilities. All such facilities are approved instantly due to less documentation, easy evaluation process, etc., in contrast to the MSMEs, as granting facilities to this sector is a tedious process which requires effective follow-up, constant monitoring apart from the time consuming mechanism towards appraising the facility application.

Assisting the MSME sector the backbone of the economy

At this opportune moment I am prompted in giving an insight and sharing some of my thoughts towards assisting the MSME (Micro, Small and Medium Enterprises) inclusive of many start-ups, in availing facilities from banks which will be beneficial to all stakeholders particularly the relevant authorities entrusted to assist this sector. The accessibility of microfinance to the MSME sector is considered difficult due to their inability to provide acceptable collateral which compels them to seek assistance from various informal channels with high interest which in turn makes their product expensive and unable to compete with big time players.

There is some misconception that banks do not accept movable assets as collateral. Banks do accept movable properties as collateral and continue to do so and have granted billions of credit facilities against the security of movables even though such collaterals are considered high risk.

Banks generally prefer to secure their credit facilities against immovable assets. If a prospective borrower is not in a position to offer immovable property then they do consider the second option which is the movable asset.

This is due to various important factors, since immovable property offered as security provides a variety of comforts to the banks and strengthens its security i.e., easy to monitor, appreciation of value, easy to realise the exposure. In addition there is an underlying factor, as facilities secured against immovable assets result in a compelling motivation on the part of the borrowers to honour their commitment as they do not want to forego a valuable asset by defaulting the advance hence the default rate is low.

On the contrary, if a facility is secured against movable assets, banks are exposed to a major risk. This compels them to have an effective monitoring mechanism until the full recovery of the facility. This relates to calling for monthly statements of movables mortgaged, carrying out regular site inspection at the site to ensure the movables pledged as security are intact.

The major risk is there is a possibility of the same movables being mortgaged to another financial institution. The management cost for the financial institution on movable collateral on post disbursement is high as this process has to be constantly monitored until the full recovery of the advance.

Benefits of the Secured Transactions Registry

The impending implementation of the Secured Transaction Registry will be a major boom for the financial sector and those engaged in the MSME sector, in availing financial facilities from banks and financial institutions. This will be of immense benefit to individuals and MSMEs unable to have easy access to banks in meeting their criteria in providing moveables as collaterals in seeking financial assistance.

Considering the existing risks involved in accepting movables assets, the Secured Transaction Act No. 49 of 2009 is timely and the need of the hour. In compliance with the Secured Transactions (Amendment) Act No: 17 of 2024, the CRIB is in the process of setting up the Secured Transactions Registry (STR). Once the operation of this registry comes into full force, all banks and financial Institutions will be mandated to register their charge with the Secured Transaction Registry. This will completely eliminate the duplication of any charge over movable assets to a variety of financial institutions and prevents the prospective borrower in pledging their collateral (moveable) to multiple lenders as it happens in certain cases now. 

All lending Institutions will be able to electronically register their charge and security interest on moveable instantly. Most importantly the electronic registry will greatly strengthen the enforceability of security interest by enforcing priority rights over such moveable which will eliminate the risks presently faced by the lenders in granting facilities against moveable collaterals.

The lending institutions will be in a position at the click of a button to ascertain the designated moveable collateral is free of any encumbrances. This will strengthen the collateral and one important and major component of the risks faced by the financial institutions will be completely eliminated.

The banks hitherto have no effective mechanism to ascertain whether such movable assets have been mortgaged to any other financial institution or duplication of charge. As an additional precaution banks obtain an affidavit from the borrowers who swear the movables offered are free from any encumbrances.

There have been instances where borrowers have mortgaged such assets to more than one financial institution. The banks have no control over such instances. A large percentage of non-performing loans are secured against such movable assets and the banks are unable to realise its exposure due to the unavailability of the movables at the time of the conclusion of the litigation process.

Important follow-up on moveable collateral

The new procedure under the STR and the electronic registration will eliminate one aspect of the risk in obtaining movable assets and the banks will be relieved of one major risk. However they have to strengthen their follow-up mechanism effectively to constantly ensure the availability of the movables at all times, ascertain its value, etc.

It should be emphasised it will be responsibility of the lending institutions to ensure the collateral is intact by carrying out frequent surprise inspections, calling for regular stock statements, insurance compliance etc., all of which needless to say will be a costly exercise.

Important lessons to be learnt

It should be noted during the COVID pandemic and the economic crisis, many lending institutions were exposed to serious risks due to their inability to locate the movables mortgaged to them. Moveables notably stocks-in-trade pledged as collateral became ‘zero’ overnight due to such moveables being moved to unknown locations without the concurrence of the lending institutions. This makes the compelling necessity for the lending Institutions to ensure effective follow-up, inspections etc., are in place at all times.

This should be a good lesson for all lending institutions and particularly the managers and officers engaged in credit assignments of the risks involved in obtaining movables as collateral and regular inspections which will prevent any unauthorised removal of the moveable.

National credit guarantee

The establishment of the National Credit Guarantee Institution will be a major boom for the MSME sector in availing credit facilities from the financial institutions since it will share a major component of the envisaged risk faced by the financial Institutions. This will pave the way for them to lend to credit worthy MSMEs unable to provide acceptable collateral and will be an important instrument in balancing the risk faced by the financial intuitions in assisting the MSME sector.

During the ’80s a similar Credit Guarantee Scheme issued by the Central Bank of Sri Lanka was available for the banks which were entrusted with the responsibility of assisting the SME sector. 60% of the exposure was guaranteed by the aforesaid Credit Guarantee which contributed for a large amount of borrowers in the SME sector to avail facilities from banks (it was restricted to only five designated banks). Many such entrepreneurs and start-ups are today competing with global players and some of their products are household brands. I am personally aware of their success stories. It has now been reported 13 banks and financial institutions have already been identified towards assisting this sector under the National Credit Guarantee Scheme.

According to the Director General of the ADB, as quoted in the media the MSME sector represent 52% of the GDP and contribute to around 45% of employment in the workforce and over 75% of active enterprises. Yet they received only 9% or Rs. 704 billion of private sector credit in 2024 showcasing the vast financing gap that continues to hinder their full potential. This shows there is tremendous opportunity for the financial institutions to assist this sector by utilising the existing mechanism to assist this sector by minimising their risks.

Establishment of a development bank

The proposal of the Government towards setting up a development bank exclusively to assist this sector is commendable. During the ’70s the National Development Bank was established exclusively to assist Small and Medium scale enterprises(SME) and all funds received from the Asian Bank was channelled through the aforesaid bank to five designated commercial banks at highly concessionary rate of interest. Billions of facilities were disbursed towards assisting new industries which brought in tremendous benefit to the country. We could expect a similar economic activity once this development bank is established as all existing commercial banks will be compelled to compete with the new entrant in assisting the MSME sector.

Mitigation of major risk

Based on my personal experience as a banker, I should emphasise, the major risk, which is beyond the control of the financier in microfinance, is the lack of a succession plan of these entrepreneurs and the risk faced by the financiers due to the absence of the borrower as a result of an unforeseen circumstance arising due to the death or disability of the entrepreneur. Such risks could be mitigated, by linking the facility with a life insurance policy covering the life of the individual entrepreneur, as this sector appears to be a neglected category.

This will not only ensure the safety of the bank’s exposure; it will be beneficial to the borrower as a compulsory saving for their future and relieve the dependents in case of any unforeseen eventuality.

Opportunity for the insurance industry

The insurance industry should explore the possibility of introducing special life insurance covers, with disability benefits, to this sector at affordable cost and the term should be extended to the maximum. What matters is the comfort it will provide in case of an eventuality to the financiers and the dependents of the entrepreneurs. This is the concern faced by many financiers involved in microfinance when appraising facilities for start-ups.

This life insurance cover should not be equated to the term decreasing/mortgage reducing policy, which is obtained by banks to secure mainly the housing loan facilities. Such policies protect only the loan in the eventuality of death and if the borrower survives after the settlement of the facility the amount expended by way of premium, which in most cases is a one single substantial premium goes waste.

The insurance sector should make use of the existing environment in introducing innovative life insurance covers with wider benefits exclusively designed for the MSME sector. This will mitigate the risks faced by banks and financial institutions in assisting the entrepreneurs under microfinance.

If such policies are available and linked to MSME, it will be a major boost to the MSME sector. Insurance cover will give adequate comfort to the banks and financial institutions in case of an unforeseen eventuality.

Marketing and identification of MSME

The time is now opportune for banks and financial institutions to utilise the existing environment to identify the entrepreneurs who could be assisted under microfinance especially start-ups.

The expertise of the marketing personnel of the banks and financial institutions should be availed to identify such category in need of assistance which will be a major boom to the economy. The need of the hour is to assist the MSME sector which will bring in massive economic benefits to the country.

The economic benefits the country could derive is greater as it will not only create greater employment opportunities, it will bring in valuable foreign exchange if such products are able to compete in the international markets.

(The writer is the author of “Pinnacle of Five Decades of Banking – A Journey Beyond” and “Lending Against Collateral – What you should know”.)