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Risk mitigation strategies in SMEs (small and medium business)
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Risk mitigation strategies in SMEs (small and medium business)


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  • 1. THEME Risk Management in SMEs R isk is omnipresent and achieve performance targets, many aspects pertaining to all pervasive in any improve financial stability and risk. All risk taking units must walk of life. It is more ultimately, prevent loss/dam- operate within approved pro- so in the business sectors, par- age to the entity. cedures, limits and controls. ticularly in Small and Medi- Business, more so in the There is no specific definition um Enterprises (SMEs). The context of SMEs, is the art of for SMEs, which normally etymology of the word “Risk” extracting money from other’s cover closely held or unlisted may be traced to the Latin pocket, sans resorting to vio- companies, partnership firms, word Rescum, which means lence and unethical means. But proprietor concerns, etc. Risk at Sea. In business, risk is profiting in business without There exists fundamental always measured against capi- taking risk is like trying to live difference between the way tal and therefore the Capital without being born. Risk tak- they function and the way they will be served in the financial R.S. Raghavan Risk management highlights the fact that the survival of market, as the character andThe author is a member a business entity depends heavily on its capabilities to antici- integrity of the promoter/ of the Institute and working as Sr. Man- pate and prepare for the change rather than waiting for the owner are the key and criti- ager, Vijaya Bank (Risk change and then react to it. It should be clearly understood cal credit indicator and hence Management Dept). He can be reached at that the objective of risk management is not to prevent or play a large role. In SME busi-rsraghavan007@yahoo. prohibit taking risk, but to ensure that the risks are conscious- ness, the ‘gut feeling’, which is ly taken with complete knowledge and clear understanding so subjective, is more relied upon that it can be measured to help in mitigation. It is more so in than the ‘pure analysis’ that the case of SMEs. are more objective-oriented. Hence, both the business and professional relationships are to Risk-weighted Assets Ratio ing, as all of us know, is failure- rolled into one. Therefore (CRAR) is much in vogue. prone as otherwise it would credit rating or for that mat- Risk is the potentiality have been termed as sure tak- ter risk rating may not make that both expected and un- ing. Every enterprise, be it a material difference to SME expected events may have an small or medium, has its own sectors. Certain misconcep- adverse impact on the capital objectives and mission. Risk tions such as SMEs may get and earnings. When we use Management plays a key role low rating, provide unreliable the term “Risk”, we all mean in protecting its assets and re- information, may not afford financial risk or uncertainty of sources and ensuring that risks the fees for getting them rated, financial loss. If we consider are reduced to an acceptable etc. will have to be dispelled risk in terms of occurrence level. The essence of risk man- first. However, rating agencies frequency, we measure risk on agement is to reduce the risks with specialised teams with a scale, with certainty of oc- to a reasonable and manageable analytical tools customised currence at one and certainty level, on an on-going basis. to SME sector will go a long of non-occurrence at the other way in putting in place proper end. When the probability of Risks Specific To SMEs mechanism in this regard. occurrence or non-occurrence No doubt any business en- The SME sectors are ex- is equal, risk is the greatest. tity needs robust risk manage- posed to some specific risks, Risk can be broadly de- ment systems but the SMEs some of which are discussed fined as any issue that can need much more than that below: impact the objectives of a as they may not have where- business entity, be it financial withal to manage and control (a) Constitution of business service or commercial. Risk risks due to their very size and entity Management is an ongoing several limitations. This is not The business entities un- process that can help improve true in the case of large cor- der SME sectors are mostly operations, prioritise resources, porate entities where profes- proprietorship and partner- ensure regulatory compliance, sional personnel take care of ship concerns. Few in the joint 528 The Chartered Accountant October 2005
  • 2. stock companies are private (e) Incapacity to go for erty and standard home loanlimited or closely held public technological advancement margins apply. Where SMEslimited companies. Thus, the With very little financial are backed by other forms ofvery constitution itself may resources and poor ability for collateral the margins do notprove to be risky due to lack leveraging the financial struc- appear to be excessively aboveof professionalism and over- ture, the SME sectors may not those available for large busi-dependence on one or two key have the wherewithal to go ness. It may be noted that the By virtuepersons for running the show. for highly sophisticated tech- two biggest problems faced by of the factLenders and other stakehold- nological advancement which the SMEs are relating to Reg- that mosters in SME sector cannot af- would help them optimise ulatory issues and unskilled of the enti-ford to forget this fact. their available resources in theemployees, which collectively ties in SME best way. constitute nearly 45 to 50 per sector are(b) Leverage on financial cent of the problems encoun- small play-structure (f ) High employee turnover tered by them. Access to fi- ers in their The nature of constitution As growth prospects are nance is at the bottom end of field, theyof the business entity limits very limited in SME sector, the problem list. may have tothe funds mobilisation ef- it is prone to high degree of encounterforts and leveraging capacity. employee turnover and this (g) Micro Finance tough com-There is a limit up to which may involve lot of wastage of Micro Finance can be petition froma small and medium business manpower and additional cost defined as providing credit, the biggerenterprise can raise capital and in the form of training and thrift and financial related playersborrow. This naturally affects knowledge updation, affecting services and products of verytheir capacity to leverage on continuity besides lowering small amount so as to im-the financial structure. the productivity. Qualified and prove the standard of living. experienced personnel may In Indian context, loans up to(c) Tough competition and not stay long as they may gain Rs. 25,000/- are covered un-Inadequate margin some experience and change der Micro Finance. Number By virtue of the fact that employment. of small enterprises could bemost of the entities in SME Majority of SME loans covered under these social-sector are small players in are backed by residential prop- oriented entrepreneurial ac-their field, they may have toencounter tough competition Lamiya Lokhandwalafrom the bigger players. Theyface the pressure on their mar-gin as they can’t raise theirprice but have to absorb thehigh input cost.(d) Low collection in AccountReceivables As is evidenced in theincreasing trend of outstand-ing receivables in the SSI sec-tors, there exists collection riskin the receivable portfolio ofSME sectors for the reason thatSMEs cannot dictate terms totheir customers. As SME sec-tor business entity is at the re-ceiving end, this may put strainon the liquidity position of thebusiness entity. However, thetrack record of SMEs as bor-rowers reveals that the defaultrate is low. Very low rates ofbad debts may be the result ofbanks restricting their exposureto this sector. 530 The Chartered Accountant October 2005
  • 3. tivities. There can be no doubt where the promoter of SME ship with the bank as that lenders spread their risk is willing to offer the family reputation, character and when they lend to this par- home as security against the first-hand opinion is very ticular sector. It is under the amount borrowed, it serves important in lending de- premise that poor are bankable as a catalyst to avoid default. cision. and micro enterprise finance That is to say the incentive through repayment incentive to avoid the risk of default is (i) Bank Lending To SMEs structure, streamlined admin- likely to be stronger where the SMEs are an importantSMEs are istration and market based family home is used to obtain part of economic growth in thean impor- pricing adopting profit center business finance. country and bank lending istant part of approach is sustainable. This Collateral is more impor- the primary source of externaleconomic approach leads to profound tant in the following circum- finance to them. Therefore, itgrowth in the changes in a cumulative causa- stances. is essential that banking sectorcountry and tion triggered by credit to rural a. The business is small, responds not only effectivelybank lending mass, as well as SMEs. as larger firms gener- but also efficiently to the justis the pri- ally have other attributes needs of SMEs.mary source (h) Collateral Security such as credit rating, cash When the business own-of external The existence of collat- flows, track record, etc. ers or managers know morefinance to eral means that banks do not that reduce the need for about prospects of venture andthem have to rely as much as they collateral. risks facing their business than otherwise would on detailed b. The business entity has lenders, information asymme- investigation and analysis of come into existence re- try sets in. Where information borrower’s business. It serves cently and the lenders asymmetry exists, lenders may as insurance to lenders and for have no track record to respond by increasing lending the borrowers. It is a reflection call upon for analysis. margins to levels in excess of of credit-worthiness to lenders. c. The borrower is yet to that which the inherent risks Extending the logic further, establish strong relation- would require. Besides, banks October 2005 The Chartered Accountant 531
  • 4. may also curtail the extent of of risks viz Credit Risk, Mar- the limitations associated withlending and resort to what is ket Risk and Operational Risk. a simplistic and broad-brushknown as Credit Rationing, While the credit risk is associ- approach of classification ofnotwithstanding the fact that ated with the default of coun- exposures into a good or badSMEs would be willing to pay ter party, market risk relates category. The rating modelsa fair Risk Adjusted Cost of to changes in the earnings as must be fully documented andCapital. well as capital on account of minimum standards must be Investing in gathering and changes in the market vari- specified as hurdle points. The Credit Riskanalysing information will ables and the operational risk models must be duly validated is measuredbe made only up to the point is the residual risk which does so as to ensure acceptability throughwhere the benefits just offset not directly relate to credit or among the users of the models. Probability ofthe costs involved. Lenders are market risk. The rating scale could consist Default (PD)now becoming risk intermedi- Credit Risk is measured of 9 strata with the first 5 or 6 and Lossary rather than a financial in- through Probability of Default representing acceptable credit Given Defaulttermediary. Business grows (PD) and Loss Given Default risk and the rest 4 or 3 grades (LGD). Bankmainly by taking risks. Greater (LGD). Bank would estimate of unacceptable credit risk as- would esti-the risk, higher the profit and the PD associated with bor- sociated with an exposure. The mate the PDhence the business unit must rowers in each of the risk rating whole purpose of risk rating is associatedstrike a tradeoff between the grades. Historically speaking, that the exercise should ulti- with borrow-two. the default percentage is quite mately reflect the underlying ers in each of The prime functions of high in SME sectors than in credit risk for a prospective the risk ratingrisk management are to iden- the large corporate or entity, exposure. gradestify, measure and more im- though in absolute terms, it When the risk gradingportantly monitor the risk. may relatively be smaller. How- system does not show desiredRisk management activity is a ever, default probabilities do ability to discriminate be-pro-active action in present for not capture the risk that a bank tween good and bad risks—securing the future. Managing might experience an economic implying lack of granularity,risk is nothing but managing loss through deterioration in the outcome may lead to thechange, before the risk man- the quality of the loan book relationship between Riskages the persons concerned. rather than outright default. Rate and Pricing losing its As per the RBI guidelines, Credit Risk Rating Frame- predictive capability, therebythere are basically three types work is essential to overcome causing losses to lender larger 532 The Chartered Accountant October 2005
  • 5. than the predicted/predict- not regard it as its role to foundation for identifying risksable parameters. This may fund start up ventures, for as it would provide the frame-result in tightening the credit which venture capitalists work to help identification ofterms or increase in price or are expected to finance. risk in the organisation.both. The situation may lead Banks may consider it to There should be a riskto overpricing good risk or be a risky venture. rating model for identifica-under pricing bad risk. This a. There is a miscon- tion of risk and it is better tomay ultimately end up in the ception among the evolve an exclusive/separatebank building up poorer qual- banks that a high model for SME sector, dulyity loans on its books as better proportion of small capturing their peculiarities inquality borrower may seek al- businesses fail within the major parameters such asternative lending arrangement a few years of start- Industry Risk, Business Risk,elsewhere. Such a situation is ing operations and it Financial Risk, Managementknown as adverse selection of may be safe to lend Risk, Compliance Risk, etc.borrower in banking parlance. to already working The rating model used for Once loans are sanctioned large corporate or large bor- and established onefor business activities, the rower may not be suitable for than to run the riskowners of the business may rating the risk in a business of lending to newhave incentives to take high- entity in the SME risks than they otherwise ventures. The rating model shouldwould. This is because the b. It is often seen as capture both systemic risk andowner of the business entity difficult for start-ups unsystemic risk. The systemicbenefits fully from any addi- to satisfy bank re- risk means the risk emanatingtional returns when the firm quirements, in terms from general political envi-is liquidated. This is known as of demonstrating ronment, change in economic experience in indus- Identificationmoral hazard. When a busi- policies, fiscal policies of the of risk shouldness entity is a proprietorship try, meeting mini- government and infrastructur- occur withor partnership concern and mum equity stake al changes whereas unsystemic the peoplethe liability of the owner is and having in place risk arises out of mainly inter- and expertsunlimited, owners may be less contracts for sale to nal factors such as machinery where theprone to moral hazard because support the business breakdown, labour strike, new domainthe owner may suffer loss in plans. competitors, etc. knowledgethe event of liquidation. c. Personnel with spe- resides Where information asym- cialised skill sets are Enterprise Wide Riskmetry and moral hazards are some times neces- Managementprevalent, business entities sary to understand Enterprise Wide Riskare likely to fund themselves the risks inherent Management is the latest trendprimarily from retained earn- with particular new and buzzword for an overallings and then only through ventures. The banks, approach of the managementbank debt rather than through particularly the PSU of risk as a whole in the busi-public equity. Nevertheless, banks, do not neces- ness. All business entities accu-among the SMEs switching sarily have such staff mulate resources viz. men, ma-between banks is not a wide- strength. terial, money, technology, etc.spread phenomenon. Consequently there is a and invest them in activities distinct reluctance by banks to which are uncertain and hence(j) Reluctance of Lending To lend to ventures not compre- fraught with various kinds ofSMEs hended completely on tech- risks. As whole is always big- The reluctance of lending nical aspects and the exposed ger than sum of its parts, en-to SMEs may be on account risks not fully understood by terprise wide risk managementof the following. the bank employees. should be attempted instead(i) Stemming from concerns of adopting silo-approach and about risk and in turn, the Risk Identification handling risk of one issue, in responsibilities of banks Identification of risk isolation and exclusion of other towards its stakehold- should occur with the people functions. ers such as sharehold- and experts where the domain EWRM is a process ers, deposit holders and knowledge resides. Identifica- through which a business en- regulators, the banks do tion of business process is the tity optimises the manner in 534 The Chartered Accountant October 2005
  • 6. which it takes risks. It is not the perspective of SME sec- The Business Contingen- seeking or avoiding risk, but tors, Basel II should be viewed cy Plan and procedures should optimising the risk. Hence as a positive development, as it be properly documented, cov- putting in place an EWRM promotes alignment of interest ering the critical business pro- makes good business sense. rates with true economic cost. cess, functions and procedures Any successful implementa- to be followed and the related tion of EWRM framework Business Contingency database should be duly pro- needs to take into consider- Plan tected with a back up facility ation the integration of En- A study reveals that dur- and kept in an offsite storage terprise Resource Planning ing the past two decades, location. The LCMT shall system (ERP) so as to effec- nearly 80 per cent of the or- evolve Resumption Strategy tively manage the risk across by which the resumption pro- ganisations that lacked busi- the organisation facilitating cess either at the company’s ness contingency plan and the integration of the various premises or at an alternative roles to manage the same ef- suffered catastrophic loss of property, records, customer location is ensured so that ficiently. normal business operations In the light of advance- loyalty, skilled and trained workforce, cash flow, etc. were are carried out. The Resump- ment in information technol- tion Strategy may include ogy, power of computation gone within a couple of yearsEvery busi- of the incident, despite many work backlog, critical func- and sophistication of risk tions, work prioritisation andness entity, analysis on interest rate, mar- of them having had businessparticularly interruption coverage insur- formation of communication ket fluctuations, availability center.the SMEs, of extensive database as well ance policy.needs to as information flow, the scope Every business entity,have Busi- particularly the SMEs, needs Conclusion for putting in place an enter-ness Con- to have Business Continu- Functions of risk man- prise wide risk managementtinuity and framework has become more a ity and Business Contin- agement should actually beBusiness necessity than a luxury for all gency Plan (BCBCP). It is the entity specific, dictatedContingency the business enterprises. a complex exercise involving by the size and quality of the balance sheet, complexity ofPlan (BCB- a number of stages and dis- functions, technical/profes-CP). It is a Basel II and SME Sector crete activities. In this regard, sional manpower and thecomplex ex- Under the new Capital a Local Crises Management Accord, popularly known as status of Management Infor-ercise involv- Team (LCMT), a core group Basel II, the regulatory capital mation System in place. Anying a number consisting of senior manage- is more closely associated with risk management model is asof stages ment personnel shall be con- risk implying that lending to good as the data input.and discrete stituted to formulate strate- lower risk borrowers will at- In the present scenario,activities gies and take decisions in the where profits are derived tract lower capital require- event of business interrup- ments. Those banks which mainly from trading in the tion. Further, a second line market, one can no longer af- are likely to employ IRB ap- Departmental Representative proach should be better placed ford to avoid measuring risk Group (DRG), comprising and managing its implica- to avoid over-pricing good senior line management from risks and under pricing bad tions thereof. To the extent across the business organi- the SME entity takes risk risks. By deduction, it means sation, shall be constituted. that there may be some mi- consciously, anticipates ad- Its role, besides assisting the verse change and hedges ac- gration of higher risk SME Local Crises Management cordingly, it becomes a source loans to those banks which do not adopt IRB approach and Team, is to assess the busi- of competitive advantage as which the banks, by implica- ness impact of the interrup- it can offer its products at a tion, rely on less sophisticated tion on their client base and better price than its com- and more standardised mea- business areas. In addition, petitors. What can be mea- sures of risk. a Contingency Plan Co-or- sured can also be managed. It Any enhanced sensitivity dinator shall be appointed should be clearly understood of regulatory capital require- with certain responsibilities that risk mitigation efforts ments to risk may be doing and rights so that both the are more important and vital nothing more than aligning LCMT & DRG meets regu- than capital allocation against the regulatory environment larly and initiate the requisite inadequate risk management with current practice. From action plan. system. October 2005 The Chartered Accountant 535