Enhancing Funding Sources for MSME’s

By: Senen Matoto

June 12, 2022

1. The prospects for the recovery of the Philippines rests largely on the strength of the bounceback of businesses, large and small, from the ravages of the covid pandemic which forced the closures or slowdown of practically all of the approximately one million establishments in the country. Small businesses (MSMEs) in particular which comprise 99.5% of all enterprises and account for about 62% of total employment have been particularly hard hit. According to a 2021 ADB report, as much as 73% of MSMEs closed down barely a few weeks into the pandemic. To survive the ensuing liquidity crunch, MSMEs have either had to dip into their savings, borrow from informal 5/6 lenders or, for the fortunate few that had bank support, seek restructuring of their loans courtesy of the government mandated Barangay 1 & 2 economic relief legislation. The majority however had no savings or bank loans to lean on as even prior to the pandemic, the lack of financing has been cited as the major concern of MSMEs in the same ADB study

2. So why is this the case? Undoubtedly, it is already a given that banks are naturally risk averse because of their fiduciary responsibility to their depositors and would typically require hard collaterals like a real estate mortgage for a prospective borrower with no credit history particularly for a small business owner. Unsecured loans based primarily on established cash flows arising out of trade transactions is not a reality as far as MSMEs are concerned. Banks will always gravitate to safer risk assets such as big business lending, collateralized loans or government securities. Part of the problem rests with the entrepreneurs who likely run their businesses typical of most family owned enterprises with scant regard for proper governance and transparent financial reporting.

3. The government has long recognized this dilemma and has in fact instituted various measures in an attempt to provide support to MSMEs. The Department of Trade and Industry (DTI) has various programs such as Go Negosyo for MSME training in product development and management and the MSME lending window of the Small Business Corporation. The Bangko Sentral ng Pilipinas (BSP) in turn has issued circulars to encourage banks to lend to MSMEs by allowing these loans to be used as an alternative compliance to reserve requirements and has even mandated that at least 10% of the industry’s loan portfolio should be allocated to MSME borrowers failure of which will result in monetary penalties for the erring banks. Government’s primary credit institutions (DBP, Landbank and PhilGuarantee) also have their respective MSME programs. But unfortunately the banking industry has still fallen short of the apparent needs of the MSMEs. Of the total banking industry’s loan portfolio of P8.7 Trillion as of end 2021 only P463 Billion was lent out to MSMEs way below what should be at P857 Billion. This number however is of course much lower than the MSMEs actual funding needs. Not finding any data on this number, but to have a ballpark estimate of this segment’s total requirements, by inference, if MSMEs contribute about 35% (DTI 2020 data) of the country’s GDP then it probably should be reasonable to assume that their share of the country’s total funding needs is about the same. This comes out to about P4.7 trillion or about 10x more than actual loans extended by the banking industry to MSMEs.

4. But until such time that the MSMEs can demonstrate their adherence to good governance practices and proper financial reporting to provide comfort to prospective creditors, the banking industry will always be guarded as far as MSME loans are concerned. Private sector industry associations such as FINEX, MAP and ICD stand ready to provide support to improve governance through seminars, periodicals and coaching. Banks on the other hand must resort more aggressively to be comfortable with the use of technology to have a better grip on the merits of algorithmic digitally based micro lending. Apart from significant investments in technology, this suggests a high degree of systems interoperability among the market players to enable tracking and monitoring of retail and MSME commercial transactions. This kind of cooperation will probably be a challenging proposition as banks will be loath to share valuable client data to competitors. But certainly the BSP might be able to pry loose this self-serving industry constraint with properly timed circulars mandating gradual interoperability among the players.

5. However, a hopeful development that could accelerate MSME financing is the use of financial technology (fintech). Judging from the slew of digital banks and fintech companies (about 220 fintechs and six digital banks) which have recently opened up shop and have openly advocated financial inclusiveness, the only way their bricks-and-mortarless but technology powered (cloud data and big data analytics) business model could be competitive to the bigger banks and thrive is to focus on unsecured small ticket lending based on algorithmically established cash flows. This translates to MSME financing. Small business owners who buy and sell and transfer payments via the digital portals of these digital banks and fintechs will be able to build a history of their transactions that could give confidence to lenders in possession of such data. We need not look too far to see clear examples that attest to the viability of microlending via this mode. Our regional neighbor, Indonesia, whose demographics (significant underbanked population), widespread geographical features (17,508 islands), internet penetration (74% of population) and social aspirations for greater financial inclusion are very similar to ours. The fintech industry of Indonesia has been growing in leaps and bounds according to a 2021 ADB report which noted that as of end 2nd quarter 2020 there were already about 362 fintechs of which a handful have already reached unicorn status, i,e, $1Billion in market capitalization.

6. This business model could very well prosper in the Philippines. But to scale up, apart from investing in technology driven risk management systems, a major impediment will be funding for these digital banks and fintechs. Other than securing loans from the big banks which are likely eventually to be their competitors, as this source dries up, the capital markets could very much be a viable alternate source for the digital banks and fintechs. The capital market continues to be liquid with both retail and institutional investors eager to invest in safe but more attractively priced instruments other than just bank deposits.

7. Just how big is the capital market? As of second quarter 2021, the bond market reached P9.35 Trillion which is much larger than the entire banking industry loan portfolio of P8.7 Trillion as of end 2021. This means a liquidity of invested and loanable funds of about P18 Trillion.Total assets of the banking industry however for the same period was at P20.83 Trillion which suggests that another P2.8 Trillion are just in deposits. On the other hand, the outstanding MSME loans of P463 Billion end 2021 implies that access of small business borrowers is approximately only about 2% of the total financial system’s available liquidity.

8. So how can MSMEs tap this huge liquidity? Lenders and capital market investors are primarily concerned with Credit Risk, Yields and Liquidity which any funding scheme for MSMEs will need to address. On credit risk: what is perhaps not generally known by the market players is that the government has a formidable credit guarantee capacity in PhilGuarantee due largely to the government’s economic recovery response to the pandemic by significantly boosting its capitalization. Furthermore what is probably equally not appreciated is that a credit guarantee extended by PhilGuarantee is considered a sovereign risk exposure which means a zero risk rating, a valuable commodity for regulated financial institutions. And finally, perhaps the various primary microlenders such as rural banks, cooperatives and now digital banks and fintechs are not too fully aware that PhilGuarantee has a special window for MSME loans and that availing of its guarantee facility will ease up capital risks reserve requirements.

9. Currently, the allowable mode of accessing PhilGuarantee is via a guarantee facility for lenders under the supervision of the BSP to cover its exposure in government’s priority programs such as housing, agri-modernization, tourism, infrastructure, telecommunications and, renewable power and energy distribution. The coverage is premised on credit risk sharing with the private bank loan originators. PhilGuarantee can cover anywhere from 50% to 80% of the credit exposure in exchange for the private banks assigning and sharing pro-rata any collections or any credit support for the loans. The private banks should also have satisfactory CAMELS ratings with the BSP and acceptable credit risk taking process in place.

10. Other than the direct bond issuances of digital banks and fintechs in the capital market as well as other lending entities traditionally focused on MSMEs such as thrift, rural banks, microfinance entities and cooperatives that do not have the funding base of the banking behemoths, securitization of their loans is another mode of raising funding from the capital market. I believe the Securitization Act of 2004 which was enacted into law primarily to support the housing sector can also be applied to any other form of receivables including MSME loans. Securitization is essentially the assignment and pooling of loans and other receivables without recourse to the assignor (the originating lenders) into a Special Purpose Entity (SPE) which could be either a Special Purpose Corporation or a Special Purpose Trust (trust entity supervised by BSP). The SPE in turn can issue Asset Backed Securities (ABS) which have ownership over the underlying pool of receivables. These ABS will have to be credit rated and can be enhanced with structures such as a Senior Tranche which enables market investors to receive initial cash flows from collections and Subordinated Tranche held by the originator which provides a buffer for the senior tranche ABS investors since subordinated tranche holders only receive the residual cash flows after the senior tranche holders are repaid.

11. Other parties involved are: a servicing agent which shall collect, manage and administer all collections from the pool on behalf of the investors; and a secondary mortgage institution (SMI) which essentially is the SPE which can be the pooling entity purchasing receivables from any originators and also serve to provide a secondary market for the ABS. The Securitization Act provides various benefits such as tax exemptions from VAT, DST, and capital gains tax for any asset transfers into the SPE. For ABS of low income and socialized housing receivables, the interest income of these receivables are tax exempt for the investors. It also entitles the SPE to issue ABS and its own notes for the purpose of pooling receivables and not be subject to quasi- banking regulations such as reserve requirements and GRT. The act provides room for a government entity to participate in its ownership which presently is limited to not more than 30% of the SPE. Perhaps the incoming administration can evaluate the possibility of using any of the government financial institutions such as DBP or the Small Business Corporation to consider investing in an SPE dedicated primarily to promote greater MSME funding access from the capital market.

12. Another mode of enhancing the credit is to cover the ABS with a PhilGuarantee guarantee which essentially converts the exposure into a sovereign risk. Currently the limitation is that the investors of such PhilGuarantee enhanced ABS will have to also be financial institutions under the supervision of the BSP and insurance companies supervised by the Insurance Commissioner. This coverage I believe will include the trust departments which of course manage Unit Investment Trust Funds (UITFs) under a full discretionary structure that cater to the retail market. The securitization of a PhilGuarantee enhanced MSME ABS which is a sovereign risk exposure should prove to be an acceptable credit risk to capital market investors.

13. And in so far as distribution and liquidity issues are concerned, there will be no need for bricks-and-mortars branches to reach investors as digital banks and fintechs could now digitally issue bonds and ABS which the Philippine Dealing System Holdings (PDS Group) has recently made possible. Furthermore the listing of such instruments in the bond exchange of PDS will facilitate the secondary trading for any investor seeking an exit.

14. Finally, the yield of an enhanced MSME ABS will likely be attractive as the underlying MSME loan receivables carry generally a much higher yield compared to corporate issuances. Current corporate bond issues are typically priced at anywhere from 50 bps to 200 bps over the BVAL rates whereas MSME loans are probably priced easily at low double digit rates, providing a comfortable leeway for the primary lenders to sell at a premium to an SPE. For the primary lenders assigning a portion of their receivables to an SPE, other than recognizing upfront a premium, this will provide additional liquidity to enable additional loans to be generated.

15. There are however other issues to contend with such as the interoperability challenge and disinclination of the banking industry to share access to client information limiting the information flow to the digital banks and fintechs. There is also the Data Privacy law which is surely a formidable hurdle to overcome as customers may generally be reluctant to authorize sharing of their transactions data. But on the other hand, we have the Credit Information Corporation (CIC) which is the country’s sole public credit registry and sole repository of credit information. The law actually mandates submission by BSP supervised lenders of credit data which is a valuable tool for any lender serious about MSME lending. Interestingly, based on CIC’s April 2022 press release, their database already contains credit data on 33 million unique individuals. Then there is the enhanced Personal Property Act which provides legal protection to creditors holding on to assignment of personal properties such as purchase orders, trade receivables and the like further strengthening the credibility of the ABS. Bottomline, stimulating greater credit access to MSMEs can be formidable but with a concerted multisectoral effort and a proactive executive and legislative support, any hurdle can be overcome.