Policies for improving MSME finance options

The role of government intervention is vital in expanding MSME finance spaces. This is especially relevant in developing countries as they usually have less efficient financial markets than their more developed counterparts. However, it is equally important to minimize the potential distortions brought along by improper actions. Governments should keep in mind that government intervention aims to achieve an efficient market rather than address market imperfections and failures.²⁴⁴ Identifying the market failure and setting intervention boundaries is the critical prerequisite to designing an appropriate strategy. In all cases, government intervention should be appropriately designed to avoid any disincentive for private sector providers of financial services to serve the MSME segment. Following are the policy recommendations to enhance MSME financing:

• Developing country-specific diagnostics and strategies, creating a supportive legal and regulatory framework, strengthening the economic infrastructure, designing effective government support mechanisms, building consistent and reliable data sources on MSME finance, and building the capacity of the financial institutions.
• Leveraging state-owned financial institutions, including state-owned banks, DFIs, and specific MSME banks, to serve MSMEs. The state-owned financial institutions have more incentives and willingness to suit particular market segments. Compared to their private counterparts, some state-owned financial institutions have less-developed MSME lending technologies, lower levels of profitability and higher costs.²⁴⁵ In addition, many state banks' failure can also be explained by political interference, excessive risk exposure due to irrational development goals, and internal operational inefficiencies.²⁴⁶ Therefore,  it is essential to impose independent corporate governance, efficient operation and proper MSME lending and risk management technologies to improve access to MSME financing.
• Implementing direct lending and programmes in collaboration with other financial institutions in the form of soft loans, lines of credit, co-financing and equity funds. Such programmes should also be carefully designed to minimize the subsidy component, political interference and crowding-out effects on the private sector. A good financing programme requires precisely defined performance targets, an independent governance structure, clear selection criteria for beneficiaries and collaborating institutions, and a very high-quality management team.²⁴⁷ The operation of the programme needs to be market-oriented, and a commercial interest rate should be applied. The mission and products of the programme should be flexible and adapted according to market maturity.²⁴⁸
• Creating an overall enabling environment that offers incentives for financial providers to fill the MSME finance space. This requires a proper regulatory and supervisory framework that balances the risk and benefits of providing innovative MSME financial products while narrowing the existing financial gaps. 
• Building reliable and comprehensive financial infrastructure, such as accounting and auditing standards and credit information systems, reduces the information asymmetries and legal uncertainties in MSME financing.²⁴⁹ In addition, governments and MSME agencies may facilitate MSME capacity and creditworthiness by providing localized training and consultation services in collaboration with local financial service providers to meet the specific needs of both the supply and demand sides.²⁵⁰
• Increasing government procurement from MSMEs is another effective measure to enhance MSME creditworthiness and viability by avoiding receivable payments and improving cash flow.²⁵¹ Box 13 illustrates how sound policy can assist MSMEs in accessing finance in India.

Major issues for policy interventions
While several schemes exist that address MSME financing gaps, they are contingent upon: (a) an attitudinal environment that welcomes innovation and entrepreneurship, (b) formal legal institutions that protect property rights, and (c) institutional financing procedures that are consumer-friendly. Policymakers, therefore, need to ensure that the current overall business climate is conducive for people to engage in entrepreneurial activities with adequate and timely financial assistance. To achieve this, policymakers need to consider the following best practices for adoption:

• Maximizing working capital 
  In some developing countries in Asia and the Pacific, the sophistication of their financial sector remains low, and capital and equity markets have yet to be developed adequately; thus, formal, institutional financing is complex for MSMEs to access. For those economies, one of the most effective policy options in the short term would be to maximize the working capital of MSMEs through the effective utilization of both informal and internal financing. Informal financial instruments, including entrepreneurs’ savings and assets and borrowing from parents, relatives and friends, are crucial for new and small businesses during their seed and start-up phases. Trade credit or buyer’s credit, another informal financial instrument, has been a significant financial source for MSMEs in developed countries and could be used by MSMEs in the Asia-Pacific developing countries to increase their cash flows. Internal financing refers to generating funds through an enterprise’s retained earnings, which requires a profitable business model. Internal fundraising could be achieved by various measures, such as increasing sales, reducing operational costs, minimizing inventory and physical assets, correctly forecasting cash flows, and reducing external debt financing. Policymakers can encourage MSMEs to use those financial instruments to maximize their working capital by (i) cultivating entrepreneurship culture; (ii) developing a pro-business regulatory framework and tax system; (iii) protecting property rights; and (iv) improving the managerial skills of entrepreneurs and MSME owners. Within this context, policymakers may wish to collaborate in providing services and training through an existing web of business associations such as local chambers of commerce and industry.
• Narrowing the gap in MSME financing 
  In developing countries, the financial gap has been growing between commercial debt financing and microfinance.²⁵² MSMEs, including startups, have been in a disadvantaged position to access institutional debt financing. Small and micro-enterprises are increasing between those target groups of commercial banks and microfinance institutions. They have difficulty in raising funds from commercial banks because they have inadequate collateral and financial record. Yet, they are not satisfied with microfinance loans due to their small loan size and high-interest rate. To narrow the gap, policymakers may consider several options: (1) expand microfinance by providing large loans with discounted interest rates to MSMEs, and (2) encourage commercial banks extend their financial services to MSMEs, perhaps in cooperation with public credit guarantee agencies, where public support is required.
• Develop and balance both debt and equity markets 
  Although the roles of debt and equity markets are theoretically clear, in practice, these two financial systems differ widely across countries in Asia and the Pacific. In general, countries with bank-centred debt financing systems tend to be less conducive than stock market-centred systems to entrepreneurial activity. However, a bank-centred system may be a preferable option for countries with poor information infrastructures. On the other hand, stock markets take more time to develop but tend to encourage more entrepreneurial, high-growth ventures (based on the experience of developed countries). The majority of the innovations by MSMEs have been successfully commercialized through stock markets, especially in the United Kingdom and the United States. Some of the major stock markets in Asia-Pacific (i.e., China; Hong Kong, China; Indonesia; India; Republic of Korea; Singapore; Sri Lanka; Taiwan Province of China) are well established. The other developing economies are working hard to strengthen their stock markets. Policymakers in Asia-Pacific countries need to primarily focus on MSME access to debt through their banking sector and establish regulations essential to a functional stock market (e.g., financial reporting requirements and statutes protecting minority shareholders). Box 8 illustrates how MSMEs are incorporated into the equity markets in New Zealand.

• Reduce information asymmetry 
  Inadequate or insufficient information is one of the main obstacles hampering financing for MSMEs. With information asymmetry, banks cannot be sure of the creditworthiness of MSMEs, and potential equity investors may forego the equity offerings of MSMEs unless policymakers implement expensive safeguards. MSMEs usually lack financial administrative skills to collect the necessary information or even lack the basic knowledge about the type of information to be prepared. Policy intervention can be essential in addressing this issue. Policymakers not only need to educate MSMEs about related regulations, standards and practices, they must also strive to streamline them. Governmental organizations and MSME agencies need to initiate or pursue a dialogue with financial industries at the national level for better understanding, e.g., possible codes of conduct or specific information tools. Policies are needed to promote transparent lending terms and conditions of financial institutions. Training and information programmes based on different information requirements of various financial institutions and investors can also be implemented to assist MSMEs in dealing with financing issues. There is a careful balancing act that policymakers must consider between the needs of creditors and investors to feel secure and informed and the ability of MSMEs to meet these needs.
• Facilitate equity funding 
  Many governments have programmes for the direct injection of equity (or start-up capital) into MSME ventures; however, the operational results of such programmes are not encouraging. Direct government programmes generally lack the appropriate incentive structures and the expertise to administer the programme professionally.²⁵³ A better alternative is for policymakers to work alongside private equity sources, such as the Business Angel Network South-East Asia (BANSEA), to meet MSME needs while building the institutional capacity of equity markets with pro-business securities regulation. Transparency and shareholder protection allow higher-end types of financing, such as venture capital, to flourish while being comprehensible enough to invite MSME participation, albeit often with professional legal counsel. 
• Combine financial services and business development services 
  As a risk management technique, banks tend to charge MSMEs higher interest rates and demand collateral relative to the asset base.²⁵⁴  As mentioned above, this is a response to the lack of transparency regarding the creditworthiness of MSMEs. Beyond credit rating schemes, policymakers should encourage MSMEs to seek business development services (BDS) providers, including various business associations such as chambers of commerce and federations of industries, and to work with banks to resolve financial and operational issues. A suitable combination of financial and non-financial services for MSMEs is the most needed support. Over time, BDS providers can also add value to bank lending and MSME development due to their proximity to their clients and their direct knowledge of the enterprises’ financial status and past performance. BDS providers are often better placed than financial institutions for identifying potential clients, ascertaining their creditworthiness, imparting professional financial and accounting techniques and other services pertinent to lending and repayment of debt. This complementary nature between BDS providers and financial services helps minimize the risk and transaction costs to creditors and investors and makes access to credit and equity less costly and cumbersome for MSMEs.
• Strengthen the bank-MSME relationship 
  Despite efforts of policymakers to enable MSMEs to access bank loans, there is still much room for improvement. As mentioned above, banks may not appreciate the MSMEs’ dire need for quick capital, while MSME owners may not understand bank policies for mitigating risk. While policymakers may craft effective strategies, their efforts may be frustrated when applied in practice. Intermediaries may lack either the incentives or the competence to build and sustain bank-MSME relations. Communication and education are essential, both for MSMEs and for banks. What is crucial is the consistency of these efforts. There needs to be an ongoing programme of communication and education that policymakers implement. Such a programme must be convenient and relevant to both MSMEs and banks to be credible. For example, the SME Centre of Singapore provides consultations on the various government grant assistance programmes to assist business owners in tapping relevant schemes to support their business growth and transformation. The Centre’s financial management workshops are designed to equip MSMEs with the basic knowledge to manage their cash flow better and learn how to draw up a winning business plan for funding and business expansion purposes. Topics cover planning and budgeting, cash flow management, financial analysis and different funding options for MSMEs. The Center offers Capability Workshops & Group-Based Diagnosis. SME Centre@SCCCI and SME Centre@Central organise Capability and Group-based Diagnostic Workshops to help SMEs and heartland enterprises strengthen their business foundations for growth. The four capability areas are Productivity, Marketing, Human Resource (HR) and Financial Management.

The suggestions made above establish the significance and importance of restructuring the institutional network of the financial sector into a simplified framework for a clear division of labour so that its reach and institutional coordination are further improved. In addition to having the apex bank for MSMEs, the role of MFIs in this framework also assumes greater importance. They should be given national recognition and legal status in the country’s financial system to serve an increasing number of microenterprises.

Public interventions in MSME financing may cause negative market distortions and long-term losses to the financial sector. First, it is often challenging to ensure that financial support reaches the target group. This is especially problematic when the target group cannot be well defined, which is often the case with the MSME sector in the developing countries in Asia and the Pacific. Thus, the fiscal costs of the support could be high – often much higher than predicted before implementation.²⁵⁵ Second, public interventions may lead to weaker financial discipline in the MSME debt market because, with grants and subsidies, both lenders and borrowers suffer less direct losses when defaulting. As a result, a ‘non-repayment culture’ may be created among beneficiary enterprises. ‘Moral hazard’ issues may also be made, preventing financial institutions from implementing and improving risk management techniques.

Third, such measures may reduce market competition in the financial market and result in a ‘crowding out’ effect. They discourage firms from using non-subsidized financial institutions and non-subsidized forms of financing. This ‘crowding out’ effect can lead to the opposite of what is desired, in the long-term, of robust and commercially viable banking and finance sector that is willing and able to serve the MSME sector.²⁵⁶ Thus, while the role of government intervention can be crucial in expanding MSME finance spaces, and especially in less developed and developing countries, it is equally important to guard against undesirable market distortions brought by improper actions. Identifying the market (or regulatory) failure and setting intervention boundaries is critical to designing an appropriate strategy. In all cases, government intervention should be carefully designed to avoid any disincentive for private sector providers of financial services to serve the MSME segment. They also need to be monitored and evaluated carefully to measure impact and ensure that the desired effects are occurring.