Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

CREDIT RATIONING AND RISK MANAGEMENT FOR SMES:

THE WAY FORWARD FOR SOUTH AFRICA
Ashley Mutezo*

Abstract

Small and medium enterprises are increasingly seen as playing an important role in the economies of
many countries. Studies identify adequate and accessible financing as a critical component of SME
development. Many SMES are unable to access loans from the commercial banks due to lack of
financial knowledge, collateral and credit history. The drive to minimise risks informs the decision of
banks to minimise loan approval for SMEs. The question that now arises is how to strike a balance
between financial intermediation towards achieving economic development, while reducing
operational and credit risks that confront financial intermediation at large, especially banks. The aim
of this paper is to investigate the factors affecting the SME lending-decision process of commercial
banks and uncover the possible way forward for South Africa.

Keywords: Credit Rationing, Risk Management, SMEs, South Africa

* Department of Finance, Risk Management and Banking, College of Economic and Management Sciences, University of South
Africa, Preller Street, Muckleneuk Ridge, City of Tshwane. P.O. Box 392 UNISA 0003 South Africa
Tel: +27 12 429 4595;
E-mail: muteza@unisa.ac.za

1. Introduction the decision of banks to minimise loan approval for

SMEs. The question that now arises is how to strike a
Small and medium enterprises (SMEs) are balance between financial intermediation towards
increasingly seen as playing an important role in the achieving economic development, while reducing
economies of many developing and emerging operational and credit risks that confront financial
countries including South Africa. South Africa is intermediation at large, especially banks.
characterised by a low growth rate, high inflation and South Africa has one of the world’s highest
a high rate of unemployment of 25% in 2011 (EIU, SME failure rates. More specifically, about 75% of
2011). According to Rogerson (2008), SMEs employ SMEs in South Africa fail within the first two years of
half of the working population and contribute about operation due to a number of challenges that impede
50% to gross domestic product (GDP). It is argued their growth (Brink, Cant and Ligthelm, 2003;
that SMEs offer an important vehicle to addressing Herrington, Kew, and Kew: 2009). These challenges
unemployment problems as they promote growth and include poor management, high wage rates and a lack
equity globally, and more specifically, in South Africa of financial and non-financial support (Scarborough
(Finmark Trust, 2006). Studies identify adequate and and Zimmerer 2003). While a series of challenges
accessible financing as a critical component of SME have been identified as creating impediments to SME
development (Fatoki, 2010). Financing is needed for growth in South Africa, constrained access to bank
business start-up, expansion and growth yet a lack of credit is prominent. Research suggests that restrictions
funds inhibits the growth of small businesses. The to access external funding by SMEs are however a
largest portion of the SME sector is unable to access global phenomena (Baas and Schrooten 2006).
loans from the commercial banks due to lack of According to Statistics Canada (2007), approximately
financial knowledge, collateral and credit history. 45% of SMEs are able to access commercial lines of
Foxcroft, Wood, Kew, Herrington, & Segal (2002) credit.
indicated that lack of collateral security in South Traditionally it is widely believed that SMEs are
Africa emerged as an obstacle hindering the access to financially constrained. However, the one commonly
finance for SMEs. cited hindrance to funding of small businesses is
With inability to access needed capital from constrained access to finance (Fatoki and Odeyemi,
formal sources, SMEs are unable to grow into 2010). Bearing in mind that banks are profit-making
sustainable businesses in the long run. Whilst profit institutions, the overarching objective of these
maximisation is the prime objective of banks, they financial institutions is premised on profit
view SME financing as risky due to default risk and maximisation and risk minimisation – a cautionary
lack of collateral. The drive to minimise risks informs investment paradigm. In line with this, most SME

153
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

owners are misjudged by financial institutions, rationing and risk management principles. The
essentially on the ground of information asymmetry. theoretical issues relating to these two principles is
The problem of discriminatory funding is worsened presented in section 2 which contains the theory of
by the inability of SMEs to provide commercial banks credit rationing and risk management that underpin
with sufficient information on their operations and this study. Section 3 briefly discusses the factors that
potential risks and benefits therein, which is essential determine the credit rationing behaviour of banks.
for banks to expediently evaluate their Section 4 deals with the empirical literature on credit
creditworthiness. This also enables the bank to rationing and 5 focus on the role played by risk
evaluate the risk profile and susceptibility of the management in the credit–granting process by banks.
business/owner to risk, as a way of determining a The paper concludes by briefly addressing the new
reasonable cost of capital. This explains why high strategies and business models that banks are
interest rates are charged on a few successful SME engaging in with the hope of penetrating the unserved
applications. Conversely, high interest rates increase and underserved SME market.
the operational costs of SMEs, and ultimately
decrease their profitability, thereby defeating the 2. Literature review
merits of external funding. The cost of debt financing
of SMEs in South Africa is significantly high, since 2.1 The theory of Credit Rationing
they raise funds through mortgage rather than
unsecured loans. The majority of SMEs do not have The theoretical model of equilibrium with credit
sufficient or suitable collaterals for security purposes. rationing is based on the work of Stiglitz and Weiss
Bearing in mind that the financial sector in (1981). It has been argued that when interest rates are
South Africa is liberalised, the existence of imperfect controlled, banks automatically ration credit through
information in the credit market may be used to non-price means (Gonzales-Vega, 1976). However, if
explain the lending behaviour of banks to maximise interest rate controls are lifted, the existence of
profits. The credit needs of borrowers, particularly imperfect information in credit markets creates risk
SMEs, have not been met despite the increase in and therefore makes credit rationing rational, profit
financial resources and regulation of the legal and maximising behaviour for banks. It is therefore
institutional environment. The borrower’s major argued that the prevailing circumstances resulting
complaint is constrained access to credit, rather than from existence of imperfect information make it
its price, implying that banks do not lend just to necessary for banks to apply credit rationing in their
anyone who can afford the price of credit. Clearly lending operations (Lapar and Graham, 1988). Credit
banks appear to exercise some degree of credit rationing occurs when loan demand is greater than
rationing by non-price mechanisms. Credit rationing supply, resulting in a situation where some borrowers
occurs when loan demand exceeds supply, and some receive no loans or less than the amount applied for at
borrowers receive no or less the amount of credit the prevailing interest rate (Freel, 2007).
applied for at prevailing market rates (Stiglitz and There is well established literature arguing that
Weiss, 1981). Thus, the existence of imperfect imperfections in the SME credit market stem from the
information in credit markets creates risk and presumed high level of risk due to higher relative
therefore makes credit rationing logical, profit- probability of failure, greater scope for information
maximising behaviour for banks. asymmetry and moral hazards (Ennew and Binks,
The constrained access to bank credit negatively 1995), transaction costs in assessing applications for
impacts on the growth of the SME sector, with serious finance, and other institutional and market failures.
implications on poverty and unemployment According to Stiglitz and Weiss (1981) agency
alleviation. The SME sector credit is generally problems and information asymmetry are the reason
characterised by small loans, short maturity periods why SMEs have constrained access to credit.
and high interest rates which are not favourable for Information asymmetry assumes that SMEs have
long-term enterprise development (Okurut and superior private information pertaining to their real
Botlhe, 2006). financial structure, financial strength of the
While a series of previous studies have investment project and the effective intention to repay
investigated SME funding and contributions to their debt.
economic growth, there is little evidence of Since the funding institutions do not have full
documented study that critically examines the specific information about the SMEs, they cannot make
roles of credit rationing and risk management as informed decisions on their loan applications
determinants of the lending behaviour of commercial (Hutchinson and Xavier, 2006). The SMES usually
banks to SMEs in South Africa; hence the need for hoard away the unfavourable information from the
this research. The main focus of this paper is on lender, when they are applying for the loan. There is
access to SME finance with specific reference to the therefore decision risk on the part of the lender, and to
supply side, mainly commercial banks. In this paper, avoid or reduce the perceived risk, the lender would
the main criteria for accessing bank loans are reject the loan application or ration the credit value.
subsumed under two main aspects, namely credit This scenario is referred to as adverse selection (De

154
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

Meza & Webb, 1987; Broadway & Ken, 2005). After 2.2 Factors determining the credit
the loan is approved, there is a possibility that the loan rationing behaviour of banks
beneficiary may utilise the fund in activities not
expected or known to the lender, leading to failure to According to Coleman and Cohn (2000) commercial
repay the loan as per loan contract. This banks are the principal source of debt finance for
misappropriation of the loan is referred to as a moral SMEs, offering a wide range of services including
hazard, which has been documented as being the main overdraft facilities, term loans, trade bill financing,
reason why the lenders ration the loan values factoring, leasing, export and import finance, and
(Durham, 2003; Baas and Schrooten, 2006). even government loan guarantee schemes. Products
Under conditions of adverse selection and moral offered by banks to SMES include credit cards, hire
hazard, there is a tendency of high-risk individuals to purchase, current and savings accounts. However, all
willingly pay higher rates for credit and the risk that a these services and products require hard information
party to a contract can subsequently change its from SMEs, but because of information asymmetry
behaviour to the detriment of the other party (Alam & the majority of SMEs in South Africa fail to satisfy
Walton, 1995; Hall, 2002). Adverse selection can the criteria used by banks for screening their clients.
therefore change with lender beliefs and even with the The credit rationing behaviour of banks may be
cost of applying for funding. According to Calem and influenced by a number of factors which include the
Stutzer (1995), adverse selection can lead to credit borrower’s observable characteristics (age, gender,
rationing. Reducing this information asymmetry has wealth, experience, credit history), firm
been suggested to be one of the probable methods to characteristics, (business experience, risk profile,
reduce the impasse of credit rationing (DeGennaro, income), and loan characteristics (loan size, loan
2005). maturity, collateral offered, interest rate). According
According to Zambaldi, Aranha, Lopes and to Lapar and Graham (1988) the bank’s credit
Politi (2009), adverse selection and moral hazard rationing behaviour against the firm’s loan demand
relate inversely to the age and size of the firm. can be categorised into three stages namely: the
Availability of public information about SMEs is screening stage, the evaluation stage, and the quantity
limited due to the poor quality of their legal rationing stage. At the screening stage, the eligibility
accounting records and low incentives to operate of the borrower for credit is determined in terms of
formally. Thus, according to Baas and Schrooten credit worthiness, loan requirements and the terms
(2006), this becomes a specific reason why small desired. At this point, the decision whether the
businesses are confronted by challenges of applicant qualifies to apply for a loan or not is made.
constrained access to funding. Thus, small and At the evaluation stage, a detailed analysis of the
medium- sized businesses are more informational viability of the proposed investment is done. This
obscure and, therefore have less access to external includes an investigation of the credit record, the type
funding than larger businesses. Financiers are largely and value of the collateral, management of the firm
unable to solve the problems of information and probability of repayment. Details of the
asymmetry, thereby, inhibiting the possibility to requirements of SMEs by the bank at the screening
adequately fund small business expansion projects and evaluation stages are shown in the diagram
(Hartarska and Gonzalez-Vega, 2006). below.

Figure 1. Adapted from the McKinsey Report, 2010

155
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

As shown in the diagram above, it is mandatory As an instrument of risk management, collateral

for SMEs to have documentary evidence of cash flow is also regarded as very relevant to credit granting
such as financial statements or payslip; and personal decisions (Laper and Graham, 1988). Collateral
capital to put down as deposit. In addition, SMEs serves as the last resort for recovery of the loan in
should have a verifiable credit history such as a credit case of default, where the bank can sell the collateral
rating from the credit bureau or collateral. If collateral obtained to recover the balance (or part) of the loan.
is not available, a guarantor can be used instead. It can In reality the bank has limited information (imperfect
thus be deduced that the likelihood of SMEs meeting information), and limited control over the borrowers
these requirements is very low and this explains why actions (incentive effect), leading to what is known as
the majority of small businesses are credit rationed. ‘Collateral and Limited Liability Theory’ in which
Owner information is personal information data financial institutions, especially banks, use collaterals
obtained from consumer credit bureaus. as a way to reduce the risk of default and,
A decision to determine whether it will be concurrently increasing their return on invested
profitable for the bank to grant the loan or not is done capital (Arroyo, 2007). This mechanism (with
based on the evaluation result. Therefore, those SMEs enormous implication in SME financing) by which
found not to be credit worthy are denied loans the bank increases the liability of the borrower should
completely (credit rationed). At the final stage of the project fail, leads to different perceptions of the
quantity rationing the bank determines the optimal risk and return of the project from both parties
loan size for a borrower at a given interest rate based (Arroyo, 2007). Collateral helps to reduce information
on firm’s probability of repayment, the marginal cost asymmetry and moral hazard problems that could
of granting the loan, and the collateral offered (Freel, arise between banks and small business owners
2007; Baas and Schrotten, 2006). Thus some (Coco, 2000. Due to the fact that most SMEs are not
borrowers are granted loan amounts less than they formally registered and therefore lack a credit record,
applied for. According to Lapar and Graham (1988), banks consider collateral as attractive security. The
the bank fine tunes the loan contract to reflect the willingness to offer collateral thus signifies the
bank’s subjective evaluation of the riskiness of the confidence of the small business owner’s commitment
loan and the impact of these risks on expected profit. in the business. Thus according to Smit and Fatoki
Thus credit rationing in some way is a form of risk (2012), collateral positively impacts on the risk
management on the part of the banks where they seek perception of the entrepreneur and the business.
to minimise the costs of production and create value The loan size and length of the loan’s maturity
for their shareholders. period required by the borrower may also influence a
The risk profile of a firm is an important factor bank’s credit rationing behaviour. The longer the
that determines whether a bank extends credit or not maturity period the greater the risk of loan recovery
(Hoff and Stiglitz, 1990). Firms for which the due to the riskier nature of long-term investments,
repayment of loans is uncertain are more risky for the hence the chances are higher that the firm will be
bank and hence are more likely to be credit rationed. credit rationed. The loan size affects credit risk, since
In this instance the bank is threatened by default risk, a loan tends to become riskier as its size becomes
being the risk that the SME cannot fulfil its larger (Stiglitz and Weiss, 1981; Hashi and Toçi,
obligations to the bank. The degree of risk of the firm 2010). According to Lapar and Graham (1988), the
may be inferred from its credit history, the expected observable characteristics of the borrower (level of
returns of the project and business experience of the education, income, wealth and asset values) are
firm. In the case of South African SMEs, most small argued to reduce the borrower’s probability of being
businesses fail to satisfy these requirements due to credit rationed. These factors tend to raise the
information asymmetries and are thus credit rationed. borrower’s credit rating and thus reduce the
Banks perceive SMEs as risky because they face a probability of loan default.
more uncertain competitive environment than larger Studies suggest that lending decision-making is
firms. As such SMEs experience more variable rates central to the operation of SME banking services and
of return and higher rates of failure. In South Africa, relies on type and suitability the lending technology
the risk perception on SMEs is endorsed by the high used (Ashton and Keasey, 2005). A transactional
failure rate of about 75% (Finscope, 2006) and it is lending technology refers to a bank-firm relationship
therefore reasonable for banks to ration credit to in which the bank obtains “hard” type information
SMEs. The environment in which SMEs operate is from the borrower that is quantitative in nature and
perceived to be risky for example; crime and labour so, easily transferable. The principal lending
unrest in South Africa may have a negative impact on technologies that can be employed for lending
the security of transactions. It may also be argued that decision-making include financial statement lending,
credit rationing may also originate from a lender’s asset-based lending and small business credit scoring,
inability to classify loan applicants into proper risk factoring and leasing. Financial statement lending is
categories due to information opacity (Zambaldi et al, focused on transparent borrowers (established firms)
2009). while the other technologies are all targeted towards
opaque borrowers. Relationship lending on the other

156
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

hand, is the lending decision-making technology, factors. Banks do not have control over external
which relies upon a “relationship” between the bank factors and it thus it would be in their best interest for
and the SME (Berger and Udell, 2002). Relationship them to work closely with the government.
lending assigns a key role to “soft” information and is Research on the determinants of bank lending to
therefore regarded to be more appropriate to opaque SMEs has been carried out in various parts of the
borrowers such the SMEs (Burger and Udell, 2006). globe and there seems to be a general consensus that
The main lending technology used for SME banks ration credit to SMEs mainly due to
lending in South Africa is the traditional scoring information asymmetries and risk management in
model. However, SMEs rarely posses the information general with the ultimate objective of reducing
required for traditional credit scoring due to lending cost while increasing the profit margin at the
information asymmetries. This lending technology is same time. The empirical evidence on the importance
based primarily on hard information about the SME’s of firm and business owner’s characteristics and
owner as well as the firm. The firm/owner should factors affecting determining the credit rationing
have documentary evidence of cash flow such as behavior of banks is discussed in the following
financial statements and salary slip; some form of section.
personal capital to put down as deposit; verifiable
credit history such as a credit bureau report and assets 2.3 Empirical literature on credit
for collateral or guarantor. rationing for SMEs
However, in the case of South Africa the
majority of people do not have a good credit record Pisarovic, Tisma and Czraky (2005) carried out a
and rating because they have been blacklisted and it is study on the determinants of the low SME approval
difficult and costly for them to clear their record rate in Croatia. They focused on a governmental SME
(Mazanai and Fatoki, 2012). The data is pooled loan programme in Croatia and investigated possible
together with information on the SME that has been reasons for low level of loan approval that was
collected by the lender and entered into a loan recorded despite interest rate subsidisation and
performance prediction model which yields a score, sufficient supply of the loan funds. The aim of the
or summary statistic for the loan. Like financial study was to evaluate the consistency of the applied
statement lending, this technique is appropriate for decision criteria in the loan application procedure
firms with long histories, which may reduce its carried out by commercial banks. The main question
importance as a tool for SME lending in developing being addressed here is “do banks indeed have
economies. The process of credit scoring is very negative attitudes towards small lending and thus
important for banks as they need to discriminate credit ration small loan applicants, or do they have
“good SMEs” from “bad SMEs” in terms of their excessively high standards and optimal lending
creditworthiness. This is a classical example of policies”? The paper proposes a new methodological
asymmetric information, where a bank has to reveal framework for investigating consistency in loan
hidden data about its customer (Fantazzini and Figini, assessment decisions and determinants of loan
2009). Credit scoring, on the other hand, is able to approval based on structural equation modelling and
provide automated accept/reject decisions in high covariance structure analysis. The empirical findings
volume environments and therefore makes it a reject overall consistency of criteria but indicate a
suitable lending technique for commercial banks. preference toward smaller loans by SMEs. The results
Indirectly this is a form of risk management as banks indicate that individual banks differ in their criteria
endeavor to minimize losses resulting from SME in and in their loan size preferences and that there is no
lending. positive correlation between the bank’s size and its
Credit assessment or analysis of is the loan preference.
measurement of credit risks. The borrower’s credit Steijvers (2008) studied the empirical
assessment is done using the five Cs of lending; significance of credit rationing for SMEs in a Belgian
character (willingness of the customer), capacity (bank based) context for the period 1993-2001. They
(ability to pay), capital, collateral (pledged assets) and calculated the proportion of credit rationed SMEs
general economic conditions. It is interesting to note using an extensive panel data consisting of 2698
that two factors (capacity and capital) are based on SMEs reporting data for the period 1993-2001. Their
hard information, character refers to soft information results suggest that, over the entire period, more than
and economic conditions refer to the external 50% of the Belgian SMEs are credit-rationed for long
environment while collateral is needed when and short term bank credit. Their results also reveal
insufficient hard and soft information to grant credit that firms that are credit-rationed for short-term credit
are available (Smit and Fatoki, 2012). However, it has are smaller in proportion as compared to those that are
been argued that the credit lending behavior is not denied long-term credit facilities. Also, the short-term
only determined by internal factors alone, but by rationed firms are more susceptible to faster growth,
external factors as well. These determinants include but with lower returns on assets. Although the
demand, competition, and macroeconomic research confirms that this set of firms exhibit some
environment, regulatory, social and institutional significant levels of value-adding, their account

157
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

receivables are lower and as such, have very little to factoring. However, the study concluded that there are
offer as collateral. The main reason for firms being significant differences across banks and countries
credit rationed included regarding the use of particular techniques, but these
In a study of 45 developed and developing technologies allow banks to compensate for
countries, Beck, Demirguc-Kunt and Martinez Peria weaknesses in the enabling environment (Rocha et al.,
(2008) report that the average share of SME lending is 2011)
smaller in developing countries by comparison with Using the Heckman Probit Model with sample
the average share in developed countries. The authors selection, Okurut, Olalekan and Mangadi (2011)
found out those banks in developing countries report investigate the factors that influence the credit
that macroeconomic instability is the main obstacle to rationing behaviour of banks towards SMEs using
SME lending, rather than flaws in the legal and 2007 Informal Sector Survey data and interviews with
institutional framework. However, the second study banks in Botswana. The findings suggest that the
by the same authors in 2009 based on statistical experience of SMEs reduces their probability of being
analysis of the data set concludes that the enabling rationed by banks. From the bank’s perspective the
environment is more important than firm size or bank experience of SMEs is determined by their ability to
ownership in shaping the bank financing to SMEs. keep proper financial statements, the performance of
Zambaldi et al (2009) investigate the their bank accounts, and their ability to make profits.
significance of transaction costs in the supply of This meant that capacity building of SMEs in areas of
credit to small and medium-sized firms in Brazil. business management is necessary if they are to be
From a sample of 65,535 SME credit proposals rated as credit worthy borrowers by banks. The
submitted to a large Brazilian bank between January findings suggest that firms with clearer financial
2004 and September 2006, the research analyses records were able to rely more on banks to finance
credit granting decisions. Results suggest that small their investment. The authors also found that banks
firms face credit rationing and that low risk credit need to improve on their efficiency by reducing the
contracts with liquid collateral are their principal loan processing time and the cost of borrowing
source of credit. Variables used in the analysis include (interest rate).
firm’s age, loan-size, type of collateral (liquid or
illiquid), and probability of approval of loan 3. Lending risks associated with credit
applications. Also, private information is captured by rationing to SMEs
the banks through lending relationships with
borrowers, which ultimately affects its lending Definitions of risk typically refer to the possibility of
decisions. The study reveals that the bank under a loss or injury created by an activity or person. Risk
investigation faces difficulties in expanding the management seeks to identify, assess, and measure
supply of credit to small firms mainly due to cost, risk and then develop counter measures to handle it.
collateral-dependency and constraints due to This typically does not mean eliminating risk but
information asymmetry. rather seeking to mitigate and minimise its impact.
Hashi and Toçi (2010) investigate the impact of Risk should not be viewed as intrinsically bad. All
financing constraints, credit rationing and financing opportunities for the banks come with some degree of
obstacles on firms in South Eastern Europe using risk. An organisation that is totally risk-averse is not
firm-level survey data and extensive economic likely to be very attractive to investors and may be
modelling. The findings suggest that these phenomena doomed ultimately to fail. Other risks that impact on
are prevalent in the small business sector, a driving banks include operational risk, liquidity, currency,
force of economic development in these countries. interest rate, and compliance risk. Risk management
In a study of 37 banks in Argentina, Chile, is an ongoing process that can help improve
Colombia and Serbia, De la Torre, Peria and operations, prioritise resources, ensure regulatory
Schmukler, (2010) examined the strategic approach to compliance, achieve performance targets, improve
SME lending, business models, and risk management financial stability and ultimately, prevent loss/damage
techniques used by the banks under investigation. The to the entity (Raghavan, 2005).
study investigates to what extent the conventional One risk type reigns supreme in the credit
wisdom on SME lending holds in practice – that large provider universe, credit risk is also known as default
banks are not attracted to SME lending and that the risk. It is recognised that the intelligent and
SME business in dominated by small banks and based responsible management of credit risk makes it the
on relationship lending. Their results support those of bank’s largest profit driver and hence the management
Beck, Demirguc-Kunt and Martinez Peria (2008) that of credit risk associated with lending to SMEs is
the SME segment is perceived to be profitable and central in banks’ consumer credit management
that most banks are now interested in serving the process. According to (Colquitt, 2007) credit risk is
SMEs irrespective of the size or ownership. In the potential that a bank borrower/counter party fails
addition to relationship lending, banks apply different to meet the obligations on agreed terms. There is
lending technologies such as credit scoring, risk- always possibility for a borrower to default from his
rating tools, and special products such as leasing and commitments (moral hazard) for one or the other

158
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

reason resulting in crystallisation of credit risk to the legal frameworks which make the enforcement of
bank. The inability of the SME to pay interest contracts difficult for financial institutions.
payments (or repay the principal) will result in a According to Mazanai and Fatoki (2012) risk
default that might lead to bankruptcy. The default risk factor explains the credit rationing behavior of
increases with the size of the loan due to more financial institutions. Total risk (both business and
constraints on the firm’s cash flow as a result of the financial risk) may be a dimension across which a
interest payments. This explains why banks credit- financing gap may exist. According to Correia et al.,
ration SME loans by giving them small loans. Various (2008) a firm’s business risk focuses on a firm’s
credit risk management approaches are utilized when operations, represents the uncertainty of the firm’s
extending credit to SME clients, depending on the return on assets. Financial risks on the other hand,
volume of transactions and facility or loan size. occur in the form of credit risk, capital risk,
It is well documented that the drive to minimise investment risk, interest rate risk, market risk and
risks informs the decision of banks to minimise loan currency risk. Further to this, the firm exposes itself to
approval for SMEs (Pretorius and Shaw, 2004; default risk which arises as a result of its inability to
Cassar, 2005; Malhotra et al, 2007). As a result, make its loan repayments on time leading to the
SMEs are less accessible to the required funds they possibility of bankruptcy (Green, 2003).
need to execute operational strategies, especially The difficulties faced by SMEs in accessing
those that relate to growth and expansion. This finance are attributed to their perceived higher risk
problem is further compounded in the developing profile. Lending institutions regard SMEs as riskier
economies where venture capitalism is largely enterprises for a number of reasons which include the
unpopular (Ojah and Pillay, 2009). Basel II defines following:
operational risk as the risk of losses resulting from  SMEs face a more uncertain competitive
inadequate or failed internal processes, people, and environment than larger firms – they
systems or from external events. A significant experience more variable rate of return and
reduction in operational risk, as suggested by higher rates of failure. Therefore lenders are
literature, is seen as a possible antidote to credit left with no option but to ration the credit to
rationing and therefore, a better form of financial SMEs who have little or no credit history.
deepening that is capable of improving investor’s  SMEs are usually less equipped in terms of
access to growth-incline credit (Alfaro, Chanda, both human and financial resources to
Kalemi-Ozcan and Sayek, 2004; Ojah and Pillay, withstand economic resources (Van Aardt
2009). and Fatoki, 2012).
Commercial banks tend to ascribe a high risk to  There is the problem of inadequate
small enterprises and are therefore reluctant to extend accounting systems, which undermines the
credit to them. Banks follow certain principles in accessibility and reliability of information
evaluating credit applications and making credit concerning profitability and repayment
decisions. The purpose of any credit assessment or capacity
analysis is the measurement of credit risk. Brierley  More volatile operating environment in the
(2001) argues that the willingness of financial developing and emerging markets. For
institutions to provide finance to small business example crime and labour unrests in South
ventures depends ultimately on the risk-reward Africa. This has a negative impact on the
relationship. This implies the extent to which such security of transactions.
investments are likely to provide returns proportionate  There is also a greater risk that lenders will
to the risk involved. not get paid or that assets are not properly
Due to their small size and intrinsic exposure to registered. SMEs on the other hand may not
market fluctuations, the mortality rates of small firms be paid in time for the products and services
are relatively high in South Africa. The majority of they render to the government through tender
SMEs is young and therefore lacks financial history contracts (Sunday Times: March 2012).
and a track-record of profitable projects. In addition  Dispersed market – SMEs are geographically
these firms are characterized by organizational and unevenly distributed in South Africa, making
administrative deficiencies, low quality management it costly for banks to reach their clients. The
and a lack of appropriate accounting systems which share of people living in towns and cities
may compromise the accessibility and reliability of (40% in Africa) is far less than in developed
information from small firms on their repayment regions like Europe (80%). In South Africa,
capacity (Green, 2003). The relative labour-intensity SMES are scattered throughout the country
of the SMEs implies a high debt-to-asset ratio if loans making it costly for banks to penetrate the
are made. Lack of sufficient and adequate collateral unserved and underserved
further limits the amount of finance that banks are
 High lending costs – With less data available
willing to grant SMEs. Collateral thus acts as a
and an inherently higher risk than consumer
screening device and reduces the risk of lending for
lending, the operational cost generated by
commercial banks. This is exacerbated by inadequate determining whether to accept an SME credit

159
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

application can often be higher than the achieved through the provision of low cost branches
potential return, and it is thus not uncommon and the extensive use of correspondent banking. With
to find that many banks do not encourage correspondent banking, banks use retailers to expand
lower value SME lending because the time their distribution reach. A good example in South
and effort is not worth the revenue received Africa is the accessibility of Capitec services in all
(Gildert, 2009). Pick ‘n Pay outlets throughout the country.
Demand for credit continues to come from Psychometric testing uses test score to separate
businesses where the assessment of risk is less easy good risks from bad ones and are capable of lowering
using traditional lending methods: unproven start-ups, default rates by 25-40%. This is self-administered test
unregistered small businesses, sole traders and done in thirty to forty minutes and measures attributes
partnerships that do not file any accounts other than such as entrepreneur’s psychological profile, ethics
for tax purposes. Thus the efficiency and success of and integrity, intelligence and business skills.
traditional lending technologies is hindered by According to the Mckinsey Report (2010) the cost of
information asymmetries. assessment is 45% less than the traditional credit
assessment measures. Being computerized, simple
4. New strategies and innovations in SME and low cost, it is ideal for use by small-scale
financing enterprises lacking traditional credit scoring inputs.
Psychometric testing has been successfully used by
The banking industry is currently undergoing changes banks in Chile and Argentina, while in South Africa
in response to swift changing customer behavior, one big bank has successfully used it in a pilot study.
technological and regulatory realities. Thus banks Other banks are using approaches which
have to keep pace with changes in technology such as combine quantitative and qualitative assessment such
internet and cell phone banking, as more and more as Qualitative Credit Assessment (QCA) by
SME clients have access to mobile phones and McKinsey. QCA is a 15-25 question assessment for
laptops. For example, in Kenya 60% of the micro, SME clients that can be completed in less than an
small and medium enterprises (MSMEs) use M-Pesa, hour. Areas covered by the QCA include SME
a mobile phone-based product, offering clients, competitiveness identifying the strength and integrity
payments and deposits or savings functionality. The of the entrepreneur); SME management (ownership
physical infrastructure is minimal, with account structure, relationship with the bank), and SME firm
opening, cash transactions and customer support operation (including relationship with suppliers and
facilitated by more than 28000 merchants acting as customers). Each of the questions is then aggregated
agents. According to the McKinsey report, a to provide a score, with the weight of each question in
significant number of MSMEs with traditional bank the score being determined by the question’s
accounts in Kenya and Tanzania prefer M-Pesa for predictive power. The QCA has been successfully
flexible, acceptable, safe and reliable transactions. It used by more than 20 countries in the emerging
is believed that with new technology, banks are most markets including South Africa. The strength of QCA
likely to pursue channel innovation in order to reach questionnaires can be tailored to reflect factors
SMEs even in remote rural areas. Thus internet is relevant to a bank’s country and target client
most likely to reduce operating costs and the segments.
turnaround times (1 to 4 days) for the processing of The third approach is for banks to advance
loan applications. The new consumer preferences unsecured credit to SMEs in an effort to do away with
pose a challenge to the traditional lending the collateral altogether. Banks can use insurance of
technologies. loans instead of collateral and if priced correctly, this
The cost of risk for banks can be drastically can deliver exciting returns from loans which can
reduced by creating products anchored in lean, improve the profit for banks. In South Africa,
automated processes. For example, according to the unsecured credit is gaining popularity amongst all the
McKinsey Report (2010), a large African Bank made leading commercial banks. Instead of relying on
savings of around $15 million by reducing its financial statements, other banks now rely on the
application form from twenty to two pages. At the lender’s estimate of cash flow through observation of
same time, banks can issue more products other than the business or analysis of payments into a
loans to their SME clients such as the cheque account, transactional account. However, credit scoring is only
foreign exchange, savings and use of derivative one element of the of the credit risk management
instruments such as swaps and options. Lending process. Therefore, banks must review all parts of the
institutions should strike a balance between credit process which include credit origination,
maximizing profits and adding value to SME clients underwriting, monitoring and collections as shown in
at affordable prices. Therefore banks must meet their the diagram below.
client needs at the lowest possible costs in terms of
distribution and products. Distribution can be

160
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

Figure 2. The credit risk management process for SMEs

Source: Adapted from the McKinsey Report, 2010

By so doing, the problems of information electricity as these factors increase the cost of bank
asymmetry, lack of collateral are taken care of thereby operations. These strategies have been successfully
allowing more SMEs which are considered to be implemented in Colombia and Brazil (Stephanou and
informationally opaque to access credit. If more Rodriguez, 2008).
SMEs are able to access credit, there will be
sustainable growth in the SME sector while at the 5. The way forward for South Africa
same time banks realize increased shareholder value.
From the lender’s perspective poor financial Economic growth is a key policy drive for the South
literacy increase transaction costs, notably the African Government and one key area of policy
investment in the time required to explain products, concern is the enhancement of the performance of
services, interest rates and other issues to bank clients. SMEs. Therefore, the government should engage with
In a survey of the commercial banks in emerging banks in the drive to improve SME access to credit by
markets including South Africa, the McKinsey Report providing the infrastructure such as roads, electricity
(2010) indicates that poor business plans (a and internet services to all geographic regions of
consequence of poor financial literacy) is the number South Africa; and an enabling regulatory and legal
one reason why banks decline credit applications for environment. In so doing banks will be able to reduce
SMEs. In addition to that, SMEs often have limited the cost of bank lending to SMEs. Banks can also the
knowledge of bookkeeping, supply chain increase the number and quality of products offered to
management, sourcing and pricing. Therefore banks SMEs thereby diversifying their portfolios and
need to empower their clients by developing their consequently reducing their risk exposure. SMEs in
clients’ financial literacy and business skills. For South Africa do not require large loans but need small
example, Standard Bank and Nedbank South Africa loans which can be accessed in the shortest possible
run business seminars to their SME clients in an effort time. Therefore the administrative processes of credit
to introduce them to business skills such as financial granting should be made easy by reducing the loan
reporting, supply chain management and inventory processing period through measures such as
management. Empowering clients with financial simplification of the loan application forms, and the
literacy and business skills helps existing SME clients employment of more qualified persons to handle the
survive where they might not have done so, and new assessments of clients (Stephanou and Rodriguez,
clients thrive, thereby increasing the bank’s profits. 2008). Traditional loan products cannot continue to be
To improve the overall business environment, utilized for SMEs due to information asymmetries and
banks need to engage much more actively with therefore, banks should develop loan products that are
government by encouraging the setting up of credit suitable for SMEs according to their operations, needs
bureaus. This can drastically reduce the probability of and challenges and the economic sector. Technology
SMEs reporting financing constraints, thereby can be leveraged to meet the client’s needs more
significantly increasing the chance of loans being effectively and keep credit affordable. Therefore, the
granted and reducing default rates considerably. Poor use of smart phones and laptops can significantly
infrastructure can be another factor indirectly speed up the credit application process and eliminate
affecting crediting granting to SMEs in rural and paper (satisfying the sustainability objective of the
geographically remote areas of South Africa. Banks banks at the same time). Banks should also come up
can also work with the government to penetrate areas with packages for start-up firms that do not satisfy the
with limited access to internet, transport and requirements of the traditional lending technologies.

161
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

6. Conclusion 10. Chironga, M., Dahl, J., Goland, T., Pinshaw, G.,
Marnus, S. (2010), “Micro-, small and medium-sized
With the use of the new innovative strategies in SME enterprises in emerging markets: how banks can grasp
bank lending, the traditionally inherent challenges of a $350 billion opportunity”, McKinsey & Company.
11. Coco, G. (2000), “On the use of collateral”, Journal of
serving SME bank clients such as low revenue per
Economic Surveys, Vol. 14 No. 2, pp. 191-214.
client, high risk of credit losses and the need for 12. Coleman, S. and Cohn, R. (2000), “The role of debt in
physical presence to lend to SMEs are no longer small business finance: A comparison of men- and
obstacles they used to be. With increased penetration women-owned firms”, Academy of Entrepreneurship
of the large number of unserved and underserved Journal, Vol. 6 No. 2, pp. 87-103.
SMEs, and an increased take-up of more advanced 13. Colquitt, J. (2007), Credit Risk Management, First
business models and higher revenue banking edition, McGraw-Hill, New York.
products, credit rationing by commercial banks in 14. De la Torre, A., Peria, M.S.M., and Schmuckler, S.L.
South Africa may soon be a thing of the past. Credit (2008), “Bank involvement with SMEs: Beyond
Relationship Lending”,
risk is inherent to any bank. Actually, credit allocation
15. DeGennaro, R. P. (2005), “Market imperfections”,
is one of the main activities of banks and the one Journal of Financial Transformation, Capco Institute,
which brings much of its turnover. But the greater the Vol. 14, pp. 107-117.
incomes brought by the credit activity, the greater are 16. Economic Intelligence Unit (EIU), (2011), Country
the risks assumed by the banks. Therefore, one of the Report – South Africa. London, the Economic
greatest challenges of all financial institutions, Intelligence Unit Limited.
including the South African commercial banks, is to 17. Gitman, L. (2009), Principles of Managerial Finance,
find an efficient balance between the risks incurred by Addison Wesley, New York.
their financing activity and maximizing shareholder 18. Fantazzini, D., and Figini, S. (2009). “Random
Survival Forests Models for SME Credit Risk
value on the form of profits. The capacity to reduce
Measurement”,
information and transaction costs are the hallmark of 19. Fatoki, O.O. (2011), “The impact of Human, Social
successful banks engaged in SME lending endeavors. and Financial Capital on the Performance of Small and
Medium-Sized Enterprises (SMEs) in South Africa”,
References Journal of Social Sciences, Vol. 29 No. 3, pp. 193-204.
20. Fatoki, O and Odeyemi, A. (2010). The determinants
1. Alfaro, L., Chanda, A., Kalemi-Ozcan, S., and Sayek, of access to trade credit by new SMEs in South Africa.
S. (2004), “FDI and Economic Growth: The Role of African Journal of Business Management, Vol. 4 No.
Local Financial Markets”, Journal of International 13, pp. 2763-2770.
Economics, Vol. 64 No 1, pp. 89-112. 21. Fatoki, O. and Smit, A. (2012), “Debt financing to new
2. Arroyo, M.R. (2007). “Information asymmetries, credit small ventures in South Africa: The impact of
rationing and banking concentration: The Argentinean collateral, ethics and the legal system”, African Journal
case”, Centro Internacional de Formación Financiera. of Business Management, Vol. 6 No. 3, pp. 1136-1146.
Madrid. 22. Mazanai and Fatoki (2012), “The Impact of Ethics on
3. Ashton, J. and Keasey, K. (2005), “Competition and the Availability of Trade Credit to New Small and
the Provision of Banking Services to SMEs in the Medium Sized Enterprises (SMEs) in South Africa”
U.K.”, Small Business Economics, Vol. 24, pp. 477- 23. Fin Mark Trust. (2006), “Fin Scope small business
485. survey”, [Online], Available:
4. Baas, T. and Schrooten, M. (2006), “Relationship http://www.finmarktrust.org.za [Accessed: 25 April
banking and SMEs: a theoretical analysis”, Small 2012]
Business Economics, Vol. 27 No. 2-3., pp. 127-37. 24. Foxcroft, M. Wood, E., Kew J., Herrington, M. &
5. Beck, T., Demirguc-Kunt, A. and Martinez, P.M.S. Segal, N. (2002), “Global Entrepreneurship Monitor”,
(2008), “Bank Financing for SMEs around the World: Graduate School of Business, Cape Town, University
Drivers, Obstacles, Business Models and Lending of Cape Town.
Practices”, World Bank Policy Research Working 25. Freel, M. (2007), “Are Small Innovators Credit
Paper, 4785. Rationed?” Small Business Economics, Vol. 28 No 1,
6. Berger, A.N. and Udell, G.F. (2002) “Small business pp. 23-35.
Credit Availability and Relationship Lending: The 26. Gildert, S. (2009), “Risk-reward and the SME-lending
Importance of Bank Organisational Structure”, The imperative: An Experian briefing paper “.
Economic Journal, 112: F32-53. 27. Green, A. (2003), “Credit Guarantee Schemes for
7. Berger, A.N. and Udell, G.F. (2006), “A more Small Enterprises: An Effective Instrument to Promote
Conceptual Framework for SME Financing”, Journal Private Sector-Led Growth?” The United Nations
of Banking and Finance, Vol. 25 No. 2, pp. 2127-2167. Industrial Development Organization (UNIDO)
8. Brierley, N. (2001), “The financing of technology- Working Paper No. 10.
based small firms: A review of the literature”, Bank of 28. Hartarska, V. and Gonzalez-Vega, C. (2006), “What
England Quarterly Bulletin, London, Vol. 41 No. 1, pp. affects new and established firms’ expansion?
64-78. Evidence from small firms in Russia.” Small Business
9. Brink, A., Cant, M. and Ligthelm, A. (2003), Economics, Vol. 27 No 2, pp. 195-206.
“Problems experienced by Small Businesses in South 29. Hashi, I. and Toci, V.Z. (2010), “Financing constraints,
Africa”, Available: http://www.cecc.com.au/programs/ credit rationing and financing obstacles: Evidence from
resource-manager/accounts/seaanz-papers/ firm-level data in South Eastern Europe”, Economic
newdocant.pdf. (Retrieved May 15 2012). and Business Review, Vol. 12 No. 1, pp. 29-60.

162
 Corporate Ownership & Control / Volume 10, Issue 2, 2013, Continued - 1

30. Hawkins, P. (2002), “Banks and small business”. South 42. Petersen, M.A. and Rajan, R.G. (1994), “The effect of
African Journal of Economics, Vol. 70 No. 3, pp.519- Credit Market Competition on Lending relationships”,
542. National Bureau of National Research, Inc. NBER
31. Herrington, M., Kew, J. and Kew, P. (2009), “Global WorkingPapers.
Entrepreneurship Monitor; South African Report”, 43. Pisarovic, A., Tisma, S. and Czraky, D. (2005),
[Online] Available: “Determinants of the Low SME Loan Approval Rate in
32. Higgins, D., Kendall, J. and Lyon, B. (2012), “Mobile Croatia”, Small Business Economics, Vol. 25 No. 4, pp
Money Usage Patterns of Kenyan Small and Medium 347-372.
Enterprises”, Innovations: Technology, Governance, 44. Pretorius, M. and Shaw, G. (2004), “Business plan in
Globalization, Vol. 7, No. 2, pp. 67-81. bank-decision making when financing new ventures in
33. Hoff, K. and Stiglitz, J.E. (1990), “Imperfect South Africa”, South African Journal of Economic and
Information and Rural Credit Markets: Puzzles and Management Sciences, Vol. 7 No. 2, pp. 221-242.
Policy Perspectives”. The World Bank Economic 45. Raghavan, R.S. (2005), “Risk Management in SMEs”,
Review, Vol. 4 No. 3, pp. 235 – 250. The Chartered Accountant
34. Holmes S, and Cassar, G. (2003), “Capital Structure 46. Rauch, J.H. and Hendrichson, J.M. (2004), “Does bank
and Financing of SMEs: Australian Evidence”. Journal consolidation hurt the small business borrower?” Small
of Accounting Finance, 4(3): 123-147. Business Economics, Vol. 23 No. 3, pp 219-26.
35. Hutchinson, J. and Xavier, A. (2006), “Comparing the 47. Roberson, C.M. (2008), “Tracking SMME
impact of credit constraints on the growth of SMEs in a Development in South Africa: Issues of Finance,
transition country with an established market Training and the Regulatory Environment”, Urban
economy”, Small Business Economics, Vol. 27 No. 1, Forum, Vol. 19, pp. 61-81.
pp. 169-79. 48. Stephanou, C. and Rodriguez, C. (2008), “Bank
36. Lapar, M.L.A and Graham, D.H. (1988), “Credit Financing to Small and Medium-Sized Enterprises
Rationing under a deregulated Financial System”, (SMEs) in Colombia”. Policy Research Working
Working Paper Series No. 88-19, Paper, 4481, World Bank.
http://3.pids.gov.ph/ris/wp/pidswp8819.pdf 49. Stiglitz, J.E. and Weiss, A. (1981), “Credit rationing in
37. Malhotra, M., Chen, Y., Criscuolo, A., Fan, Q., Hamel, Markets with Imperfect Information,” American
I.I and Savchenko, Y. (2007), “Expanding Access to Economic Review, Vol. 71, pp. 343-410.
Finance: Good Practices and Policies for Micro, Small 50. Uchida, H. (2011), “What do banks evaluate when they
and Medium Enterprises”. Washington DC. World screen borrowers? Soft Information, Hard Information
Bank Press. and Collateral,” Journal of Financial Services, Vol. 40,
38. Mazanai, M. & Fatoki, O. (2012), “Access to Finance pp. 29-48.
in the SME sector: A South African Perspective”, 51. Van Aardt Smit, A. and Fatoki, O. (2012), “Debt
Asian Journal of Business Management, Vol. 1, pp 58- financing to new small ventures in South Africa: The
67. impact of collateral, ethics and the legal system”,
39. Oja, K. and Pillay, K. (2009), “Debt markets and African Journal of Business Management, Vol. 6 No.
corporate debt structure in an emerging market: The 3, pp. 1136-1146.
South African example”, Economic Modelling, Vol. 52. Von Broembsen, M., Wood, E. and Herrington, E.
26, pp. 1215-1227. (2008), Global Entrepreneurship Monitor, the South
40. Okurut, F.N., Olalekan, Y. and Mangadi, K. 2011. African Report. GEM, Cape Town.
Credit Rationing and SME Development in Botswana: 53. Zambaldi, F., Aranha, F., Lopes, H and Politi, R. 2009.
Implications for Economic Diversification. Botswana Credit granting to small firms: A Brazilian case, J Bus
Journal of Economics, Vol. 8 No. 12, pp. 62-85. Res (2009), doi:10.1016/j.jbusres.2009.11.018
41. Peria, M.S.M. (2009), “Bank financing to SMEs: What
are Africa’s specificities? SME financing in sub-
Saharan Africa”,

163