by Benel P. Lagua / Free Enterprise –

WHILE microfinance is an apparent good approach to push the agenda of entrepreneurship, it is distinctly different from SME (small and medium enterprise) finance. What works for microfinance clients will not necessarily work in the SME finance arena, and vice versa. For this reason, we should caution the incoming new leaders of the land to recognize the policy divergence of the two.

In the first place, the target clientele are not necessarily the same. Microfinance is singularly targeted toward lower-income clients, including the self-employed. Other characteristics are small-scale production or service products, few employees usually within the family, basic or no business record, no collateral, no access to formal services of credit, and active in informal borrowing from usurers.

Because of this target market, the financial services are designed to fit the preferences of low-income entrepreneurs by way of short-term loans with successive repeat transactions in small loans amounts.

The program also must provide for motivational systems that ensure loan payments such as guarantees access, graduated loan sizes and preferential pricing. This motivational concern leads to methodologies that require regular group meetings and more interaction between lenders (through account officers) and borrowers, usually at least weekly.

Paradoxically, while the poor is the target, microfinance lending rates are generally higher due to the costs of administration. It will appear to be more expensive because sustainability will require full cost pricing.

Observers who balk at the apparently higher interest rates charged should realize that access comes at a price. At the end of the day, the rates still reflect a substantial improvement over the usurious 5 percent to 6 percent rates of informal lenders which run into the 100 percent to 1,000 percent per year range. Microfinance loans at 24 percent to 36 percent per year represents a big improvement to borrowers who benefit from a service not normally available to the stakeholders.

Scholars have even studied that despite the high rates, microfinance clients keep on exhibiting a borrowing persistence pattern. In theory, households should equalize rates of return across all margins. If they are borrowing at this rate, their rates of return on all other margins, on their investments and consumptions, must be as high as this. Otherwise, there is an anomaly somewhere.

Microfinance lending technologies have also evolved in recent years. Although the hallmark of the technology is group lending with group liability, the original Grameen concept of Nobel Prize winner Dr. Mohammad Yunus, there have been major changes in its application. For all the advantages of the group lending system, newer studies have revealed some excesses like good clients being discouraged from borrowing, higher dropout rates and different membership direction in demands for credit as the group matures.

New approaches have evolved such as the ASA program, which still adopts informal group methodology but allowing for individual lending. Or, we have strictly individual lending based on character review (using borrower and peer group information) as well as cash-flow analysis based on borrower’s present cash flows taking into account high and low seasonality. There has been a clear graduation of methodologies modified to adjust to the local culture.

Given all these factors, it will be foolhardy to simply adopt microfinance processes to SME finance. SME finance is a lot more different and covers a wider range of entrepreneurial clientele. More important, by size alone, SME finance clients represent a bigger risk exposure to the financial institutions.

Specialization in SME finance will require a different skill set for the account officers and a more sophisticated credit review process for the institutions. It is the middle market for which banks and formal financial institutions must develop a unique set of competencies to be able to serve well.

Today, SB Corp. is the primary advocate for a risk-based lending (RBL) program and a borrower risk rating (BRR) technology specifically aimed at the regular SME finance. RBL looks at the traditional five Cs of credit (character, capacity, condition, capital and collateral) through a scoring mechanism which relegates collateral to what it should be—a second way out. RBL puts more weight on the two important Cs—capacity to pay of the project and character.

The BRR, in turn, uses data or observed borrower characteristics to calculate probability of default and sort out borrower into different risk classes. RBL and BRR, combined with a strong package on SME financial literacy, should serve as the foundation on which to push SME finance forward.

If the incoming government wants to truly improve SME finance, it must provide for it through stimulus packages similar to what our Asian neighbors are doing. We must benchmark with them. SME finance has received a lot of lip service, but what will work for the better is a resolve to allocate funds, including risk money, for the sector.

(Benel P. Lagua is the president and chief operating officer of the new Small Business Guarantee and Finance Corp. He is, likewise, an active member of Finex. Feedback and comments are welcome at benellagua@alumni.ksg.harvard.eduThis e-mail address is being protected from spambots. You need JavaScript enabled to view it ).

Free Enterprise is a rotating column of members of the Financial Executives Institute of the Philippines, appearing every Wednesday and Friday.