More than Just Loans: A Comprehensive Policy for SMEs

Interview with Ramón Lecuona, former Director of the School of Business and Economics at Universidad Anáhuac

By: Karina Almaraz

More than Just Loans: A Comprehensive Policy for SMEs
Providing financing to micro, small, and medium-sized enterprises is one of the great challenges of the country’s banking system. There is very little of this type of financing in the bank loan portfolio, with the damage it entails in the strengthening of the country’s production capacities. In this interview, economist Ramón Lecuona offers a thought-provoking diagnosis of the country’s banking system, of the condition of smaller companies, and of the actions that banks—public and private—should implement to support the operation of these companies. More than just loans, he concludes, a comprehensive support package is needed.

From the banking perspective, what distinguishes this crisis from other similar episodes in the country’s recent history?

The current crisis is totally different. The ones in 1994 and 2008 were financial. The former was triggered by internal errors in Mexico’s economic policy, and the latter by a financial problem that started in the United States and later spread all over the world. The origin of today’s crisis is health related, and the difference is such that we cannot compare them. The previous crises were faced with public policies that resolved financial imbalances and reactivated the economy. This time, the crisis has been handled completely differently, and the great uncertainty that has prevailed in these months is due to not knowing how the pandemic will evolve. The current dilemma is that as long as the health crisis is not resolved, there is no way of solving the economic problem.

 

What risks do you foresee for the country’s banking institutions in the face of this uncertainty?

The bank situation will depend on the present and future condition of borrowers. If a company drastically reduces or outright stops activity—as has happened in some extreme cases during this health emergency—its cash flow is paralyzed; but, at the same time, it still has a series of spending commitments with its employees, with the premises that it rents, and more. If it has some emergency funds, it can hold out for a few weeks or months, but problems will only increase as the emergency drags on. Cases exist of very well positioned companies that have managed to partially operate and generate between 30 and 40 percent of their usual revenue. They breakeven and survive, even a few have made a profit. The country’s business fabric situation is very heterogeneous.

Although we often complain about the limited bankarization of SMEs, in a time like the present, it seems to be positive: its weight in bank portfolios is limited and generally only the healthiest and best organized are there. To a large extent, this low participation of SMEs in the banking portfolio is due to deficiencies in their structure. However, no matter how well constituted they are, it has been a hard blow for SMEs; we will start 2021 with a semi-paralyzed economy, trying to have a balance between economic reactivation and the prevention of cases and deaths, just like in the whole world.

It is still very difficult to determine the impact this crisis will have on banks. The four-month period granted to companies to postpone their payments without falling into overdue portfolio ended, and a wave of restructuring has followed. Only over time will we really know how many companies who benefited from this will be in conditions to continue. So far, there is no lack of liquidity problem and, generally speaking, banks are capitalized. The largest ones created special reserves, and Banco de México has a liquidity program for SMEs that supports these efforts. We will find out throughout the year how many companies will overcome the crisis and how many will have lost viability and have solvency problems.

 

What other measures should bank institutions take to maintain the quality of their portfolio, jobs, and the country’s business fabric?

We would need to analyze case by case. We will see what capacity banks have to choose the type of support they give each company. They face the same uncertainty as everyone: we don’t know how long the health emergency will last. What they should not do is lend indiscriminately to companies that will not succeed later, because it’s taxpayer money. There is a big discussion worldwide, especially in countries where very aggressive fiscal programs were implemented, about how much of that money was channeled to companies that were already staggering and that will not be recovered. That’s why it should be reviewed on a case-by-case basis.

 

What is the main purpose of loans granted by development banks to companies?

A few years ago I worked with the Economic Commission for Latin America and the Caribbean (ECLAC) and some of the studies in which I participated specifically addressed the trajectory of development banking in Mexico and other Latin American countries. In Mexico, this path has been very unstable and it has been immersed in multiple financial crises; on top of 1994 and 2008, we also had crises in 1976 and 1982. Development banks have been very involved in these episodes of major financial crises and this has caused great institutional instability.

I believe that development banking is an extraordinary and indispensable instrument, but it must also be very well defined. We don’t need it to do what commercial banks do, its space lies in all segments of the economy where, for market reasons, commercial banking will not enter because it must conform to certain rules and a fiduciary concept, to a responsibility with its depositors and creditors. Activities that are too risky and costly in terms of operation are not attractive to commercial banks and there lies a good part of the space for development banks. That’s why I think it’s inherent to SMEs and entrepreneurship.

Normally, in the segment of smallest companies there’s a serious survival problem and the enterprises that manage to stay in the market are highly exposed to economic fluctuations. That’s why it’s important for development banks to make sure they support the emergence, operation, and development of SMEs. Although the space is huge, I must emphasize that loans are only one of the instruments that should be used to promote them. It’s not reasonable to lend in extraordinarily high-risk segments and, in our business environment, there are many aspects that make it very difficult for SMEs to operate.

The World Bank's ease of doing business index places Mexico in 160th place, out of 190 countries, in terms of how easy it is to start a business, and in 120th place in terms of tax burden and simplicity. With data from the Economic Census and the Productivity Survey, insecurity is shown to be the main problem faced by SMEs in Mexico. The big ones also suffer from it, but they will survive because they have the resources to work in adverse environments; it’s only an additional cost. On the other hand, for small companies, the difference is substantial, it’s life or death.

SMEs also face excessive regulatory burdens that often lead to pressure, corruption, closures, and more. There are great difficulties in complying with all tax and labor provisions, which encourages informality and leads to irregularities and contingent liabilities with the tax and labor authorities. Under these conditions, with the uncertainty created by these contingent liabilities, how can we lend?

SMEs need a comprehensive policy: they need a very significant regulatory simplification so they can be formalized. A basic security environment is necessary where they won’t disappear from the market because they were robbed. Financing is just one ingredient. In fact, according to economic census data, financing is the least of their problems. Providing financing under these conditions is like wasting resources: it’s not in company hands to be able to use them productively. It’s very important to keep that in mind. Development banks must cater to SMEs, but under the guidance of public policies that, together with the Ministry of Economy, provide a framework in which they can work so that financing becomes a virtuous instrument.

 

Are qualitative criteria enough to adequately evaluate development promoting banks? Would you add any other?

I think it’s been a public policy mistake not to address the SME issue from a comprehensive perspective. We want to be very aggressive on the financing and financial inclusion front, as if unilaterally that would solve all problems; then we focus everything on the development of emerging companies. In reality, the only way to create a favorable environment for SMEs to develop and contribute more to the generation of employment and income, is a regulatory environment of tax, labor, and financial security in which the basic conditions for entrepreneurship, development, and innovation are found. Opening their doors is not enough, they must consolidate, become increasingly innovative companies. It’s useless to open a small business which will continue to do the same thing 15 years down the line, barely allowing the entrepreneur to ‘survive’.

 

What indicators would be appropriate to evaluate development bank performance? 

It’s important to know how many loans are granted, but it’s even more important to determine if they really fulfilled the objective for which they were designed: if they were given to those they had to be given, if additionality was really achieved, if they were not assigned to ones that had already obtained them in commercial banks, etcetera. If there were serious studies on this, I would love to see what they say, but obviously a thorough evaluation of the impact of development banking on the SME sector has been needed.

The priorities of development banking in Mexico have significantly changed over time. First, we need to answer ‘what it is for?’. Is it to finance large government or private projects, or to develop some strategic sectors? In some stages it has participated, in general, in ‘development’ and, of course, anything could fit there. At other times, there have been attempts to direct it to sectors where commercial banking cannot get in, to work in a complementary and non-competitive way. Throughout time we have seen everything. For example, in 2008 and 2009, the impact of the global financial crisis in Mexico was enormous, and development banks had to capture international liquidity to transfer it to the domestic market, thus dissipating the desire to focus on SMEs again.

 

Why do SMEs face so many difficulties in fully qualifying for loans?

Usually, it’s because these are poorly structured companies. In the latest SME competitiveness and productivity survey, which was published in 2018, more than 70% of the sample mentioned they would not accept a loan. They didn’t say they wouldn’t look for one, but that they would not accept a loan, nor would they approach banks. My conclusion is that many of these companies have a mix of formal and informal operation that prevents them from considering having access to the financial system. They don’t go down the formalized route because their business would no longer be profitable. My diagnosis is that SMEs prefer to stay out of the financial system in order to stay below the tax authority radar, even if for that they have to renounce to bank loans. I believe that the only way to lead them to the financial system would be a sufficiently accessible and simple regulatory and fiscal framework, an issue that we’ve been discussing for the last forty years without finding a satisfactory solution.

 

What measures would you recommend to improve SME loan profiles?

Policy makers should promote a realistic framework within which SMEs can be formalized. The reality has been detrimental; with the fiscal regulatory framework in force in recent decades, SMEs have preferred to stay out of the financial system. The first thing would be to simplify the regulatory framework to keep an adequate record of the SME sector. Once an adequate information system is in place, things can start to be reorganized. The problem is that we don't even have a good record system.

When reviewing the most recent quarterly Banco de México survey on how companies are financed, I discovered that we’re still where we were when I consulted it for the first time: two-thirds of companies with less than 100 employees in Mexico have financing, not from banks, but from their suppliers. There is a functional arrangement that allows this to happen: the supplier knows the company, leaves the merchandise, and includes the financial cost in the price, the credit is not free, but its cost is not very transparent. Yes, there may be financing, but it’s not from banks. Institutional financing, whether from commercial or development banks, requires various financial statements and tax information, which the vast majority of companies neither want nor can provide.

Guarantee schemes have worked for development banks. Also, reverse factoring schemes that Nafin has implemented with great success for many years. There are very good experiences in this regard, they promote good interaction between development banking, commercial banking, and large companies, to support SMEs. The issue is how to reinforce what has been done well. Technical assistance, which helped development banks organize producers to convert them into loan candidates, disappeared long ago. Some of these activities would have to be recovered, either in development banking or the Ministry of Economy or, even better, through a coordinated scheme of various public institutions.

This obviously has to be designed with very clear sector and regional criteria, general schemes cannot be used because technical assistance is very expensive. Well-defined criteria are needed to find companies with the best growth prospects. Commercial banks that have worked hard to find companies to lend to have made real efforts to reach SMEs, not to mention development banks. The point is that current conditions don’t make them qualify, this goes far beyond the interest in lending.

 

Can more resources be channeled without jeopardizing the financial viability of institutions? Could emerging forms of digital banking contribute?

At the beginning of the health crisis, one of Banco de México’s concerns was the risk that the capitalization plan would fall short. But I believe the real risk was that the plan would not work. Banks have restructured SME loans with their own resources and have created additional reserves to face contingencies resulting from the financial crisis. The vast majority of SMEs, which before the pandemic were outside the financial system, have continued to finance themselves with their own resources and their suppliers’. Companies haven’t complained that banks don’t lend them, that’s not the case yet. For now, the SME sector doesn’t seem to be a threat to the viability of financial institutions.

 

Where should the country's development banking head to contribute more effectively to the harmonious and inclusive growth of Mexico?

In addition to doing what’s already done well and working, such as reverse factoring, I would like to see a serious push from development banking to promote the flourishing of SMEs in Mexico. This under the understanding that it’s not only about giving out loans, but to accompany company growth. Development banks should be the advocate for SMEs in designing public policies, and should promote the establishment of the necessary conditions to channel loans, their productive use and recovery. I would love for them to say, “Let’s even out the field, together with the Ministry of Economy, let’s solve critical SME problems. Given that I will provide the financing, let’s add technical assistance programs to make loan candidates we can lend to.”

 

Which institutional structure do you think is best for development banks aimed at companies to fulfill their mission?

Every institution must establish an objective. If there is no specific objective to evaluate, if the objective is vague, so will be the evaluation. One of Banco de México’s strengths is that it has a clear objective, and the autonomy to follow through; they know what needs to be done. I would love to see that in development banking, for one of our development banks to know that it exists to develop micro, small and medium-sized companies in the country.

It all starts with setting objectives to then focus on meeting them.