Mitigation of Credit Risk in Small & Medium Enterprises

Introduction

At the current moment, various financial institutions and small and medium enterprises use different strategies of credit risk mitigation. The current work provides assessment of these strategies and their application in various situations for the determination of their strong and weak sides. This assessment will show that each company should analyse its performance, financial strength, and long-term and short-term perspectives for choosing the most effective way of mitigating credit risks.

1. Literature Review

The studied literature provides the background for the description and analysis of different credit risk mitigation strategies. This knowledge can be applied to SMEs located in different parts of the world.  Some of the strategies enable financial institutions to provide loans to companies on the background of information concerning their previous performance and predictions based on data concerning performance of similar companies. These strategies are described by Kagwathi et al. (2014) in their work. It is notable that these articles are focused on the description of strategies that provide greater ability to SMEs to obtain financial support; however, they are not directly oriented on the mitigation of credit risks. That is why, the final part of this research paper describes and analyses methods mentioned in the works of Cardone-Riportella, Trujillo-Ponce, and Casasola (2008), including securitisation, collateral transactions, derivatives, and on-balance sheet netting. They are more oriented on the mitigation of credit risks of SMEs in developed countries. However, the authors have provided only the general description of these strategies. Hence, studying of additional information from various articles has been necessary for the determination of strong and weak sides of these methodologies.

2. Analysis

Risk management concerns the ability of a business entity to survive by anticipating and preparing to any changes instead of simple waring to changes and rectification on them. Its main objective is the insurance that “the risks are consciously taken with compete knowledge and clear understanding so it can be measures to help in mitigation” (Raghavan 2005). Hence, it concerns both expected and unexpected events (like uncertainty or financial loss), which may have the negative impact on SMEs. As it is mentioned in the article Risk Management in SMEs, “in business, risk is always measured against capital” (Raghavan 2005). Each small and big enterprise has its own operational performance, assets, previous history, goal, etc. That is why, various credit risk mitigation strategies should be applied for different companies.

Additional attention should be paid to the fact that risks of SMEs are rather specific. Their distinguished characteristics are connected with the size of these companies and their operational activities because SMEs “may not have wherewithal to manage and control risks die to their size and several limitations” (Raghavan 2005). Besides, there is a considerable difference between the method of functioning and the way big companies and SMEs are served on the financial market because they have various critical credit indicators like character and integrity of the owner or promoter (Raghavan 2005). SMEs managers more rely upon the objective-oriented analysis of operational activities of their companies for the determination of any possible risks.

Small and medium enterprises may be subjects of a great variety of risks connected with employees, competition, business entity, account receivables, further technological development, lending by various financial institutions, collateral security, micro finance, etc.

The current research paper will focus on the general description of risks, which have direct influence on financial activities and credits of SMEs. Financial risks are connected with the fact that SMEs usually operate with relatively small budgets. Hence, they depend greatly on the fluctuation of various costs like labour, fuel, marketing campaigns, etc. Some of the companies do not produce sufficient cash flow as they rely more on ongoing operations for generating funds of continuous activities (Duong 2009). Hence, banks and investors are unwilling to credit SMEs because they expect to receive high return rate when these companies can hardly generate it (i.e. they have low leverage capacity). For example, in India loans for big companies grow faster than loans for small and medium enterprises (69% compared to 6.4%) (Panigrahi 2012).

Moreover, this paper will describe risks connected with lending by financial institutions. In some cases, business owners have additional information concerning further prospects of the operational performance of their companies rather than financial institutions. Notwithstanding the fact that owners will have ability and willingness to pay a fair Risk Adjustment Cost of Capital, the asymmetry of information may have the negative impact on Credit Rationing and the whole lending (Raghavan 2005). Usually, financial institutions and banks use such financial characteristics as Loss Given Default and Probability of Default for measurement of the possibility of default of counter party (Raghavan 2005).

The effectiveness of credit risk management depends on the awareness of the decision maker about industry characteristics, organisational strategy, and performance. This awareness is necessary for the effective and relevant assessment of company’s threats and opportunities (Kagwathi et al. 2014). Generally, mitigation strategies are reflected in “the recognition of future uncertainty, deliberating risks, possible manifestation and effects, and formulating plans to address these risks and reduce or eliminate its impact on the enterprise” (Ntlhane1995).

One of the credit mitigation strategies that is successfully realised in Kenya is the use of credit scorecards. The realisation of this strategy in Kenya is based on the understanding that the majority of companies there have limited access to formal credit because 88% of them are non-registered (Kagwathi et al. 2014). In such complicated conditions, financial institutions have no any ability to perform a reliable and effective assessment of SMEs risks. That is why, before the implementation of the credit scorecard strategy, lenders usually did not provide financial support to SMEs or charged high interest rates. The development of the credit scorecard system has the aim of enabling lenders to predict behaviours of SMEs on the basis of their previous performance (Kagwathi et al. 2014). Two basic types of scorecards have been developed in Kenya: judgmental (or expert-based) and statistical. The first type is represented in the form of the set of quantitative formal criteria that are based on the most effective practices of employees of the credit department. They are used for simplification, standardisation, and speeding of providing credits to SMEs. The second type of credit scorecards is created on the background of the information concerning actual loans and applications. This information is essential for the determination of the probability of company’s default.

This strategy of credit risk mitigation is directed on solving such issues as non-receiving of credits or obtaining credits at overstated interest rates. However, the strategy of credit scorecards has several weak sides. It requires a thorough assessment of the previous and present organisational performance of the company and similar SMEs. Besides, it creates the situation when the emphasis is placed on general trends instead of a precise analysis of the concrete company.

One more strategy of mitigation of credit risks that will be described in the current research paper is used by IDLC Finance Ltd (Bangladesh) (Alam 2012). This company makes a special appraisal report for the determination of the strength of a borrower and possible risks related to the loan and ways of mitigation of identified risks by using special software “Flexccube” (Alam 2012). Information in the program represents data collected from various financial sources like Credit Information Bureau (Alam 2012). This strategy enables to analyse customer’s ability to perform repayment, predict cash flows, assess previous dealings with various financial institutions, and identify key drivers of borrowers and major risks of their business. Much attention is also paid to the identification of the source of repayment. It is notable that IDLC provides financing for the time period not exceeding ten years (Alam 2012). This is connected with the company’s inability to build reliable prospects of SME’s performance for longer periods of time. It should also be noted that financial support is rendered to companies that have a trade license, i.e. are officially registered.

This implementation of this strategy of mitigation of credit risks is rather beneficial because it enables financial institutions to analyse the great extent of information from various financial sources. Unlike the strategy realised in Kenya, the methodology applied by IDLC Finance Ltd enables the company to base its decisions on more reliable information because the analysis of SMEs’ performance is grounded on more reliable information instead of general trends. SMEs with a good previous financial history (like absence of outstanding debts and stable operational performance) obtain an ability to receive loans with a reasonable interest rate. At the same time, this strategy has several weak sides. SMEs should be officially registered for obtaining loans. Besides, they could not receive financial assistance for the period of more than 10 years due to the inability of IDLC Finance Ltd to build predictions for a longer period of time. Moreover, the average loan size is relatively low (from USD 8,000 to USD 11,000) (Alam 2012).

Various strategies of mitigation of credit risks are provided by the Basel Agreement II (also known as BII). This agreement has the aim to establish special requirements to capital, which will help to identify possibilities of risks and mitigate these possibilities more effectively. Proposed strategies are the following: on-balance sheet netting, securitisation, collateral transactions, credit derivatives and guarantees, etc. (Cardone-Riportella, Trujillo-Ponce, & Casasola 2008). The effect of the application of these mitigation techniques is reflected in the lowering of capital requirements. The use of these strategies enables performance of the grounded estimation of requirements regarding regulatory and economic capitals. The IRB approach is performed by financial institutions, which measure internal credit ratings. The standardised approach is based on external credit ratings made by rating agencies (Cardone-Riportella, Trujillo-Ponce, & Casasola 2008).

Collateralised transactions are usually applied to the assets of financial nature (like equities and gold), which are subject to a different treatment. Property assets (mortgagee guarantees) secure the loans. Hence, “credit uncertainties weighting of the collateral for that of the company is replaced for the collateralised portion of the exposure” (Cardone-Riportella, Trujillo-Ponce, & Casasola 2008). The major strong side is reflected in the “efficient lowering of the exposure amount by the value ascribed to the collateral allows the fuller offset of the collateral against exposures” (Cardone-Riportella, Trujillo-Ponce, & Casasola 2008).

One of the advantages of this methodology is the reduction of credit risks as the risk of non-payment by the party is mitigated (Financial-edu 2013). Capital savings occur because of the lowering of the amount of the economic capital required for protection of balance sheet and coverage of the risk. However, its major weak side is that it requires availability of the assets of financial nature. Besides, operational risks are increased due to the complexity of the methodology (Financial-edu 2013).

One more strategy concerns guarantees and credit derivative. Only institutions with a lower risk weight can provide guarantees. It results in the mitigation of credit risk of SMEs because “the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider” (Cardone-Riportella, Trujillo-Ponce, & Casasola 2008). At the same time, the underlying company will retain the uncovered part of the loan. This methodology is preferable for the application because it enables to mitigate credit risks and protect financial institutions as the guarantor and SMEs are less likely to default simultaneously. However, this strategy has several weak sides. The first one is reflected in the existence of various difficulties in relationships between SMEs and guarantor. The second one is searching of the entity with the lower risk rate.

The next strategy determines capital requirements on the basis of the information concerning net credit exposures. This strategy can be used only by those banks, which have official netting arrangements. Hence, liabilities are considered as collateral and assets are regarded as exposures. This strategy reduces the capital requirement, economic default risks, and risk margin “as bank price individual transactions according to their level of risks” (Basel Committee on Banking Supervision 2006). However, the existence of numerous requirements to banks represents the major weak side of this strategy. Among the most common requirements, there are the following: availability of a well-founded legal basis for the performance of the described strategy, as well as ability to control roll-off risks and identify liabilities and assets when it is required (BIS 2 Information n.d.).

Securitisation is usually used for the identification of the “regulatory capital requirements on the exposures arising from traditional or synthetic securitisations or similar structures that contain common” (Alam 2012). Banks are forced to compete with institutional investors for the business of prime SMEs. They provide borrowers with various free-earning services, which increase the amount of sales of debt instruments of investors. Besides, banks can agree to purchase only some part of the debt issue.

This strategy provides borrowers with the increased financing flexibility because they can “time the issuance of their securities to coincide with their financial needs” (MBA Knowledge Base n.d.). The borrower determines whether to trade the notes or to hold them for some time. It should be mentioned that currently there are numerous investors who would like to purchase debt securities. Hence, securitisation lowers the overall cost of financing because the securities could be sold at an acceptable price. However, this methodology is connected with the rise of legal issues for borrowers, which are affected by applicable securities regulations and banking regulations. The failure to satisfy of these regulatory requirements can lead to restrictions on security sales. Financial institutions and SMEs should cover additional expenses on the registration procedure in some countries like the United States (MBA Knowledge Base n.d.). Moreover, one more weak side of this strategy is connected with the availability of numerous players that have different information about the performance of the SME (Aschcraft & Schuermann 2008).

3. Conclusion

The current research paper provides the analysis of some strategies of mitigation of credit risks in SMEs. These strategies are effectively used by various financial institutions all over the world. These instruments are the following: using of credit scorecards, specific software, derivatives, securitisation collateral transactions, and on-balance sheet netting. All the strategies described in the current work have strong and weak sides. Their efficiency depends on the operational performance of companies, available financial resources, and many other factors. Each particular SME should thoroughly assess its payment ability, position on the market, and sources for choosing the most suitable strategy of credit risk mitigation.

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