The Bank | Policies & Strategies | SME Strategy

Financing Strategy for Development and Cooperation

Introduction

As stated in the preamble to the Agreement Establishing the Bank, the member states of BSTDB have agreed to establish the Bank “in order to promote private and entrepreneurial initiative and to further the implementation of reforms in the financial sector”. Article 2, which establishes the functions and powers of the Bank, mentions, among other functions, the financing of productive projects and enterprises, in cooperation with other international development institutions and national finance and development agencies, for promoting economic development of the region and of the member states.

BSTDB started operations in June 1999. Within a period of only 18 months it built up a portfolio of 15 operations for a total value of more than a hundred million USD. Small and medium sized enterprise financing reached at the end of year 2000 25.4% of the overall Bank’s portfolio and the Bank gained experience offering both debt and equity SME financing.

At the basis of the strategy rests: (i) the experience gained by BSTDB; (ii) the comprehensive understanding of SME developments, operational environment and market demand as resulted from analysis of data supplied by member countries; (iii) review of the existing literature on the topic; and (iv) the analysis of the role of IFIs in SME lending as well as of the competitive position of BSTDB.

The main strategic objective of the BSTDB in financing SME is to contribute to the development of this sector by providing financing and facilitating cooperation between the small enterprises in the region directly linking the financed companies, as well as through provision of pre-export financing through the Bank’s Trade Facilitation Programme.

The BSTDB SME strategy takes into consideration the natural limitations, such as:

• limited resources
• no technical assistance funds available
• strong market competition

The BSTDB SME Financing Strategy takes fully into account the Conclusions and recommendations of the EXPERT MEETING ON BEST PRACTICE IN FINANCING SME, which was held between 14-15 May 1998 at the Palais des Nations, Geneva, in the organization of the UN-ECE.

SME Sector Characteristics in BSTDB Member Countries
In many countries SME are synonymous to the private sector. In BSTDB member countries development of an entrepreneurship culture is reflected in SME sector development. SME are of a strategic importance because: (i) contribute to employment growth in the long-term, while in the short-term are an unemployment mitigating factor, reducing thus the negative social impact of large enterprise restructuring; (ii) favor large-enterprise restructuring, enabling them to abandon non-core activities; (iii) offer flexibility in the provision of services; (iv) increase the competitiveness of the market; and (v) provide the fertile soil for the appearance and growth of domestic capital and consequently of a middle class which values economic freedom and democratic principles.

SME are not a homogeneous group and the definition varies from country to country. For the purpose of this strategy document we will use a definition derived from that used in the European Union. This means that enterprises, in order to qualify for being considered SME must concurrently meet the following criteria: (i) must be fully registered as legal businesses, in conformity with the relevant legislation in force in the country of incorporation; (ii) must have up to 250 employees; and (iii) must not be majority owned subsidiaries of large enterprises, either domestic or foreign based. We will further consider enterprises with 1 to 9 employees as being micro-enterprises, those with 10 to 49 employees as small enterprises, and those with 50 to 250 employees as medium sized enterprises. Enterprises with more than 250 employees will be treated as large enterprises.

Operating Environment of SME in BSTDB Member Countries

Small and medium-sized enterprises (SME) are the key sector for generating employment opportunities and growth. On aggregate in BSTDB member countries over 98% of registered companies in the private sector are SME. Over 95% of the SME are very small and they may be classified as micro-enterprises employing between 1 and 10 employees.

Most SME (especially micro-enterprises) are in retail trade being owner operated, representing mainly a way to increase family income. Often they represent only a secondary occupation, with hope from the owner that it’s just a temporary solution. These SME are an expression of necessity rather than of entrepreneurial spirit.

The majority of medium sized enterprises (50 to 250 employees) are established in industry, construction and services. These companies are in their early stages of existence, have good growth prospects and as they grow they would create employment.

Financial Environment of SME

As opposed to the EU where the majority of external financing for SME is provided by banks, in our region financing comes from owners, sponsors or the informal sector. The banking system for the financing of SME has always been characterized by higher collateral requirements. SME usually have to pay higher interest rates than their larger counterparts. In practice there is often an inverse correlation between enterprise size and interest rates paid.

New and innovative financing solutions are still missing or are only at an experimental stage. This is an area where BSTDB, in conjunction and coordination with other donors, can help to fill the gap and support through various financing measures and instruments the institutional building and capacity development to improve SME access to financing.

Promoting SME: an effective way to create growth and employment
The promotion of widespread entrepreneurship through the setting up of small and medium-sized enterprises is crucial for the transformation to a market economy and for economic and social development. Small and medium-enterprises are of special importance because they are considered as the cradle of entrepreneurship.

SME are the embryos of the new healthy economy these countries aim to create and develop. SME are an engine of economic growth and a source of sustainable development, in particular for the creation of jobs, and provide income-generating opportunities to alleviate poverty.

Reasons that justify a special attention on SME financing

• Offsetting market failures and imperfect competition

While there is no evidence that SME are better performers than other enterprises, they do represent a large part of the economy and employment. The SME are also the emerging private sector in most BSTDB markets and therefore form the basis for a private sector-led growth. It is why their promotion is important, at the first place.

The key reason why the SME should be treated separately from the rest of companies is the presence of a number of market failures, typical for the BSTDB region, which often affect the SME more than the larger firms. Among others, such failures include limited access to information and financial resources. Therefore, a tailored SME promotion may offset some of these failures and lead to a more competitive overall economic environment.

• Social and equity justifications

SME in transition countries are a direct result of the process of economic transformation. Failure to support their healthy development may have disastrous social and economic consequences, as public support for continuing and deepening reforms may weaken, poverty may increase, inflation may soar, and the economy may enter a period of prolonged recession.

Important for the promotion of entrepreneurship and development of domestic capital – and as a consequence of a medium class – the development of SME require sufficient and well targeted financing.

BSTDB role and priorities

BSTDB has at the center of its policy to focus on the financing of small, but with potential to grow into medium, companies in manufacturing, construction, services with high earning potential.

Although the Bank does not intend to pick winners or to promote specific economic sectors, giving utmost importance to local conditions and trying to respond to local market needs, it will use its limited resources only on those activities that provide the maximum of economic and social development benefit.

In direct correlation with its size and outreach capability, the Bank would concentrate on small and medium size enterprises, without neglecting micro-enterprises, and would give priority to delivering finance through both traditional (commercial banks) and innovative (non-bank) financial institutions.

Financing Solutions for SME

General Priorities

The Bank will promote intra-regional investment and networking with a view to promote economic growth through regional cooperation. Fostering stronger links between SME in the region will be a facilitating factor of increased trade flows and would provide a basis for economic integration. Furthermore, the Bank would

make all efforts to bring together large enterprises with SME, with a view to facilitating technology and know-how transfer. The Bank will, therefore, support subcontracting and clustering.

SME operations will represent about 30%, but not less than 20% of the total operational portfolio of the Bank. This share reflects the importance of the SME in private sector development in the member countries and tries to adequately respond to the demands expressed by member countries authorities and business representatives. It also reflects the specific risks involved in SME financing, and the overall strategy of the Bank towards broader sector and product diversification. SME financing has to strike the right balance between commercial profitability and development impact.

The Bank will actively maintain dialogue with governments, donors and the local financial and business community, in order to achieve the intended results, among which the most important are:

• build export capacity and joint ventures
• create legal and institutional environment conducive to private sector development
• mobilize domestic and foreign resources
• mobilize resources and local commitment for SME financing
• facilitate technology and know-how transfer
• create jobs
• generate income
• foster private-public sector partnership

The Bank will cover all its member countries as the market requires and it will strive to have an as equitable distribution of operations as possible, with at least one SME operation in each country. Even in the most developed member countries there is a strong need for SME financing at affordable terms.

With the exception of the Russian Federation, where the bank focuses attention on the three regions in the vicinity of the Black Sea, the Bank does not intend to concentrate its activities on specific regions.

Prerequisites to SME development

In order for the private SME sector to growth and evolve into the driving force for economic development, it is necessary that a certain number of preconditions are satisfied. These include: (i) macroeconomic stability; (ii) favorable business environment; (iii) access to finance; and (iv) effective legal system.

Cofinancing and Technical Assistance

Cofinancing will be primarily sought from domestic sources, to ensure cooperation with the local funds, banks, governmental agencies, as to build credible commitment from the part of local players and to lay the ground for sustainability when the Bank withdraws. At the same time contribution of foreign investors as well as mobilization of resources from outside the region will remain a priority. To the extent that the Bank mobilizes technical assistance funds, those will be used for preparation of projects, transfer of know how, and non-financial services.

SME strategy and environment

The strategy towards sustainability requires a wide range of instruments including:

i. Legislation to set environmental standards;

ii. Economic instruments to encourage the production and use of environment friendly products and processes;

iii. Horizontal support measures, such as education, Research & Development, information; and

iv. Financial support measures

The Black Sea Trade and Development Bank should take a leading role in improving the flow of environmental information and create special instruments supporting start-up and growth of small businesses in the field of environment protection. In this respect the Bank would use in principal the cooperation opportunities with EBRD and the World Bank Group.

Key factors for success:

• Self-commitment of the SME towards ecology and environment protection;
• Taking into consideration the process of globalization in the world market, the relation of the entrepreneurial activities with the environment is unavoidable and linking these issues in a mutually supportive manner will facilitate integration into the world trading system;
• SME supporting institutional infrastructure, i.e. chambers of commerce and industry, financial intermediaries, etc. should play more active role in assisting SME also in the field of environmental protection through inter alia; a) preparing and disseminating environmental guidelines for different sectors/activities and b) helping to overcome obstacles on the way ranging from innovation to products and services;
• Create appropriate financial instruments including for innovation, know-how and environmental protection;
• Make SME’ access to medium and long-term finance easier, especially by applying environmentally advanced technologies;
• Encourage the development of industrial and technological parks, in order to make them environmentally oriented through operation within a concerted framework integrating prevention and pollution control while expanding production.

Security Structure

Considering the specific risks of lending to SME: (i) reduced reliability of information; (ii) weak financial management skills; (iii) unavailability of collateral; (iv) weak and under developed financial systems; (v) risk of low disbursement rates, the Bank will consider from case to case security structures which would include - but will not be restricted to - one, or a combination, of the following:

• Assignment of collateral – possible or alternatives
• Escrow accounts
• Sovereign guarantees
• Pledge of government securities
• Bank guarantees
• Assignment of insurance rights
• Assignments of receivables
• Personal guarantees
• Pledge of shares
• Property
• Warehouse receipts

Such security can be provided by the intermediary, final beneficiary, sponsor, individually or jointly. Notwithstanding the importance attached to the amount and solidity of the security, its provision will not form the basis for the Bank’s decision to lend; rather it provides only additional comfort that the Bank’s exposure could be recuperated in case of undesirable developments.

Implementation

In order for BSTDB to have clear SME sector support programme and a consistent set of guidelines to favor implementation, it needs to establish:

• Objectives;
• Monitoring indicators; and
• Instruments Objectives

Among the most important objectives of the Bank intervention in support of SME are:

• Providing financial support at affordable terms to fast growing small and medium size-companies in manufacturing, food processing, transportation, construction, telecommunication and hi-tech sectors, market and social services.
• Increase export capacity.
• Promote job creation and revenue generation.
• Increase competitiveness of firms in the member countries.
• Promote intra-regional investment.
• Facilitate know-how and technology transfer.
• Mobilize external capital to the region.
• Facilitate networking.
• Improve financial sector ability to deal with and supply financing to SME.

The above mentioned objectives could be achieved by adequately addressing the following technical and institutional arrangements:

• Development of retail lending capacities in the participating financial institutions;
• Institutional arrangements to deliver the necessary technical assistance, where necessary;
• Support for the development of micro-finance and specialized small enterprise finance institutions; and
• Leasing as a financial technique.

Monitoring Indicators

For SME interventions to be effective, the evaluation of results has to go beyond traditional measures that have focused on number of loans, average size of loan and repayment rate. Acknowledging the importance of the above mentioned indicators, measurement of the successfulness of direct interventions must include:

• Cost-effectiveness of operation;
• Transaction costs;
• Coverage;
• Sustainability;
• Magnitude of intended effects;
• Developmental impact (Jobs, Know-how and technology transfer, up and downstream linkages, networking, export growth)

Instruments

Credit Guarantee Funds

These are profit maximizing private sector ventures benefiting of financial support and technical assistance from donor institutions and governmental agencies. They provide maximum benefit when express genuine public private sector partnership, which is governments demonstrated commitment to the development of strong SME sector.

Credit Guarantee Funds may be an example of an effective public-private sector partnership, where under private management, but under favorable public sector sponsored legislation, a blend of private and public funds could be put to work to determine banks to expand their lending to the SME sector.

Experiences of successful credit guarantee institutions in Central and Eastern Europe show that there are six requirements for a good programme:

i. clearly defined mission and strategy;

ii. appropriate selection of the target group;

iii. effective use of resources;

iv. provision of technical assistance to borrowers;

v. strong commitment to local businesses and person-to-person relationship with the borrowers; and

vi. strong leadership in implementing credits

Microfinance/SME Specialized Financial Institutions

The appropriate institutional and legal infrastructure for microcredit institutions has not been adequately developed in BSTDB member countries. Microcredit organizations in BSTDB member countries need a combination of capacity-building, funding, policy development and performance-based objectives to develop into professionally managed, permanent and self-sustainable institutions. Specialized SME banks and specialized SME departments in commercial, savings and development banks are key requirements for effective and sustainable SME access to finance.

Providing credit, training and counseling could have a positive impact on the private sector and its corresponding financing institutions development. The Bank could benefit from the cooperation and co-financing of microcredit institutions with other IFIs active in the Region and/or bilateral official donor agencies. Microcredit programmes should be considered alternatives to poverty alleviating programmes, because they promote self-employment and economic self-reliance of poor and low-income families.

Venture capital/Equity Investment Funds

By participating in Venture Capital/Equity Investment Funds, BSTDB would benefit of certain economies of scale especially in the form of: lower costs; more regional approach; increased synergies among the recipient companies, which in turn would result in increased regional co-operation.

While an equity investment is inherently riskier than straight debt financing, it potentially provides higher returns in the medium to long term. On the other hand, being in a position to obtain in depth knowledge about investee companies’ operations and financials could potentially provide opportunities to limit risk beyond what is realistically possible in our countries of operation for debt instruments. In our countries of operation registration of security, foreclosure procedures and market realization of security/collateral require long and cumbersome procedures with unpredictable outcome. A lender is a passive observer of outcomes after all information becomes publicly available; on the contrary, a shareholder is an active participant in the decision making process having the ability to influence it positively. Also exit from an equity investment – at least theoretically – is easier than from a corresponding long term loan. However, exit possibilities and the right to exercise any of the pre-agreed options should be clearly established.

Venture capital firms are profitable investment vehicles in environments where the private sector is developing rapidly, the economy is export oriented, markets are liberalized, and the capital market is well structured and regulated adequately.

Return from equity investment is higher than from a loan, but the cash-flow income does not come with the periodicity of interest; most of the times the bulk of profit is realized at exit due to the fact that capital gains are more important

than dividend flows. Despite this “negative” characteristic of equity investment when compared to lending, the implicit developmental impact, positive externalities, job creation, promotion of member countries capital and more broadly speaking SME promotion are positive elements in favor of promoting equity financing.

A mid-sized company in our region would prefer obtaining equity financing, as opposed to debt financing, for the following reasons:

• To attract a reliable, experienced or reputable entity as an equity partner in the venture; in this respect, the presence among shareholders of an IFI or a multinational fund would be perceived by other interested investors as a “certificate” and would therefore help the company raise additional funding in form of both equity and/or debt.
• To increase the capital base of the business, so that banks can be in a position to provide further debt financing (increasing the leverage base; “healthy balance sheet”). Companies in our region are generally speaking over-leveraged; that is, the amount of debt is excessively high when compared to the given level of equity capital contributed by shareholders and therefore the ability to obtain any new debt is severely constrained.

Leasing

When repayment of loans looks problematic and equity investment risky, leasing (usage rights to the lessee and property rights to the lessor) could be appropriate.

Financial Leasing is a contractual arrangement between a party (the lessee) allowed to use an asset and the leasing company owner of the asset (the lessor) in exchange for pre-established periodic payments. These payments cover the cost of purchasing the asset by the lessor, interest cost and a profit margin. A leasing contract may or may not include a purchase option at the end of the contract.

Financial Leasing is an effective financing instrument in cases of companies with limited capital base and insufficient credit history, because the lessor preserves ownership of the assets and relies on the SME ability to pay upon agreed installments purely on the basis of cash-flow. It is a useful instrument to replace medium to long term loans for purchases of equipment and technology, as it overcomes problems related to collateral requirement.

Leasing is an effective instrument to provide medium to long term financing to SME in places where there is in place a conducive regulatory environment. The most important features of a proper legal and institutional environment for the promotion of financial leasing are: (i) clear definition of rights and duties between the lessee and the lessor; (ii) automatic right of repossession of leased assets by lessors in case of lessee’s default; (iii) lessee’s right to use the leased asset without restrictions; (iv) few and clear regulatory requirements for leasing companies (such as minimum capital and debt/equity ratios); (v) possibility for the lessor to depreciate the asset over the life of the lease; and (vi) possibility for the lessees to deduct lease payments from taxable income (lease payments treated like expenditures).

Credit Lines through Selected Financial Intermediaries

Credit lines have the purpose to provide selected banks with medium-term capital not available in the market and to encourage establishment of long term relationship between banks and SME.

The Bank should avoid using Agency Lines (APEX types of loans) as experience of other IFIs with this type of instrument is rather disappointing. On the contrary, credit lines to commercial banks, where the participating bank is assuming the client and foreign exchange risks, and also provides a portion of the financing seem to work much more swiftly, as the participating bank has something of significance at stake.

Financing is to be provided in the form of loans through client commercial banks incorporated in the respective member country with a large branch network and prior good quality experience in SME financing. Sub-loans are to be provided on commercial basis. In order to be eligible for financing, small and medium size enterprises must have adequate financial standing, market demand for their products, and sound management. The funds provided will have to be used in strict accordance with the aims stated in the original stated purpose, and disbursements will be made against presentation of supporting documents.

Funding for SME may be used for the financing of investments in fixed assets and working capital. Eligible SME must be privately owned legal entities. Potential borrowers must demonstrate that: (i) they can generate sufficient cash-flow to cover loan repayment; (ii) they have good operations and financial management skills to profitably run the business; and (iii) they do not have overdue obligations to budgets and/or banks. The debt capacity of the applicant SME is analysed before loans are approved.

In addition to these general eligibility criteria, the local participating bank will require:

• financial and business information on owners/partners of the company;
• financial statements and cash flow for the last three years;
• contracts, orders or other acceptable documentation to justify output levels consistent with the financing requirements; and
• security in the form of pledges, mortgages, etc. as appropriate

Borrowing enterprises/projects should demonstrate:

• significant growth potential, with relatively modest capital requirement
• appropriately experienced sponsors/management with a strong track record
• a sound financial basis and well-structured financing plans
• well-prepared and specific business plans
• a clear programme for project implementation with a relatively short time span
• strong competitive prospects in relevant local/regional markets
• prospective investment returns (internal rate of return/ profitability ratio) over the investment/loan repayment period of at least 30 per cent
• no need for significant technical assistance
• no court litigation underway on environmental liabilities, unclear property rights (lack of title for instance), or similar

Qualifying criteria for participating banks are as follows:

• audited accounts according to international accounting standards (IAS);
• minimum IAS net worth and sound financial performance;
• sound credit policies and approval procedures;
• relevant experience in dealing with SME;
• good management track record;
• it should be in good standing with the supervisory authority of the country;
• good corporate governance and integrity of main shareholders;
• provide BSTDB with the relevant information required by the Credit Risk Department

Participating banks will have to agree to adopt SME lending as a significant part of their business and the loan agreements with the BSTDB will encompass specific performance criteria by which the BSTDB can verify that loans are being used for the agreed purposes. Only commercial banks being authorized by BSTDB as financial intermediaries are eligible to participate as borrowers.

Amounts provided by BSTDB will be used to create a revolving fund. Sub-loans maturity cannot exceed the remaining time to maturity of the credit line. The participating financial intermediaries would use the funds allocated to the revolving fund for extending sub-credits to eligible applicant small enterprises.

Small sub-loans for working capital are usually available with maturities of a maximum of three years and grace period of up to 6 months. Where investment is required for modernization or expansion of capacities, the BSTDB funding would represent up to 50 per cent of the value of the investment. The investment time span is three to five years, one year grace period and an availability period of up to one year.