These are just a couple of facts to state why the SMEs are very important to the nation’s economy and if one has to really prove it, he can go on to write pages about it. Despite all these positive growth factors, the Indian SMEs face a host of issues in securing adequate financial backing, both from government and private financial institutions.
Although the government/industry associations have initiated various programs to power SMEs with easy access to adequate financing, banks are still averse to fund small business for many reasons. Some of the major ones are:
Information Asymmetry: The irregularities in financial information and their unreliability are the major forces that stop financial institutions from lending to the MSMEs. The financial statements from small businesses often lack timeliness, completeness and accuracy which apparently make it difficult for banks to take decisions. Lack of appropriate accounting practices, inadequate skill sets to assess, high transaction cost, management constraints, complex financial infrastructure etc. add woes to the existing asymmetry in the system.
Higher Risks: The theory here is simple. The financial firms do not have the necessary tools to assess the good and bad risks in lending to the SMEs. Resultantly, the banks will tighten credit terms and hike the prices. In short, most of the banks in the India do not have the necessary expertise in SME lending risk assessment which makes them think twice or more about lending to the SMEs.
Pecking Order Theory: Here, the cost of financing increases with asymmetric information. The SMEs often tend to look out for alternative sources of funding as the cost of lending is above the true risk-adjusted cost. They are more likely to utilize retained earnings rather than look for options to raise loans from financial institutions.
Over Investing: This is a situation when the SME owners take higher risks when provided financial support by banks. The major reason behind this is that the business owners are likely to benefit completely from all the additional returns while still being in a safe ground as their businesses are less likely to suffer excessively if the company is liquidated. This situation, a moral hazard for banks, is quite widely present in the small business world and no bank would like to meet that over-investment sort of a situation.
Lack of Feedbacks: Lending institutions often fail to carve out an appropriate financial strategy for the SMEs due to the lack of feedback or organizational approach from small business houses.
However, a lot of these problems can be resolved though the induction of a common accounting standard for the SMEs, which will ensure smooth flow of credit and ease up financial regulations for SME lending.