Risk mitigation strategies in SMEs (small and medium business)

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 and
The 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
co.in
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

stock companies are private (e) Incapacity to go for erty and standard home loan
limited or closely held public technological advancement margins apply. Where SMEs
limited companies. Thus, the With very little financial are backed by other forms of
very constitution itself may resources and poor ability for collateral the margins do not
prove to be risky due to lack leveraging the financial struc- appear to be excessively above
of 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 virtue
persons for running the show. for highly sophisticated tech- two biggest problems faced by of the fact
Lenders and other stakehold- nological advancement which the SMEs are relating to Reg- that most
ers 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, they
of the business entity limits very limited in SME sector, the problem list. may have to
the funds mobilisation ef- it is prone to high degree of encounter
forts 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 from
a small and medium business manpower and additional cost defined as providing credit, the bigger
enterprise can raise capital and in the form of training and thrift and financial related players
borrow. This naturally affects knowledge updation, affecting services and products of very
their 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 be
most 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 to
encounter tough competition
Lamiya Lokhandwala

from the bigger players. They
face the pressure on their mar-
gin as they can’t raise their
price but have to absorb the
high input cost.

(d) Low collection in Account
Receivables
As is evidenced in the
increasing trend of outstand-
ing receivables in the SSI sec-
tors, there exists collection risk
in the receivable portfolio of
SME sectors for the reason that
SMEs cannot dictate terms to
their customers. As SME sec-
tor business entity is at the re-
ceiving end, this may put strain
on the liquidity position of the
business entity. However, the
track record of SMEs as bor-
rowers reveals that the default
rate is low. Very low rates of
bad debts may be the result of
banks restricting their exposure
to this sector.


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 important
SMEs are istration and market based family home is used to obtain part of economic growth in the
an impor- pricing adopting profit center business finance. country and bank lending is
tant part of approach is sustainable. This Collateral is more impor- the primary source of external
economic approach leads to profound tant in the following circum- finance to them. Therefore, it
growth in the changes in a cumulative causa- stances. is essential that banking sector
country and tion triggered by credit to rural a. The business is small, responds not only effectively
bank lending mass, as well as SMEs. as larger firms gener- but also efficiently to the just
is 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 more
finance to eral means that banks do not that reduce the need for about prospects of venture and
them 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

may also curtail the extent of of risks viz Credit Risk, Mar- the limitations associated with
lending and resort to what is ket Risk and Operational Risk. a simplistic and broad-brush
known as Credit Rationing, While the credit risk is associ- approach of classification of
notwithstanding the fact that ated with the default of coun- exposures into a good or bad
SMEs would be willing to pay ter party, market risk relates category. The rating models
a fair Risk Adjusted Cost of to changes in the earnings as must be fully documented and
Capital. 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 Risk
analysing information will ables and the operational risk models must be duly validated is measured
be made only up to the point is the residual risk which does so as to ensure acceptability through
where the benefits just offset not directly relate to credit or among the users of the models. Probability of
the 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 Loss
ary rather than a financial in- through Probability of Default representing acceptable credit Given Default
termediary. Business grows (PD) and Loss Given Default risk and the rest 4 or 3 grades (LGD). Bank
mainly 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 PD
hence the business unit must rowers in each of the risk rating whole purpose of risk rating is associated
strike 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 rating
risk management are to iden- the large corporate or entity, exposure. grades
tify, measure and more im- though in absolute terms, it When the risk grading
portantly monitor the risk. may relatively be smaller. How- system does not show desired
Risk 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 the
change, before the risk man- the quality of the loan book relationship between Risk
ages the persons concerned. rather than outright default. Rate and Pricing losing its
As per the RBI guidelines, Credit Risk Rating Frame- predictive capability, thereby
there are basically three types work is essential to overcome causing losses to lender larger


than the predicted/predict- not regard it as its role to foundation for identifying risks
able 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 of
terms 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 risk
to 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 to
may ultimately end up in the ception among the evolve an exclusive/separate
bank building up poorer qual- banks that a high model for SME sector, duly
ity loans on its books as better proportion of small capturing their peculiarities in
quality borrower may seek al- businesses fail within the major parameters such as
ternative lending arrangement a few years of start- Industry Risk, Business Risk,
elsewhere. Such a situation is ing operations and it Financial Risk, Management
known 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 one
for business activities, the rower may not be suitable for
than to run the risk
owners of the business may rating the risk in a business
of lending to new
have incentives to take high- entity in the SME sector.
er risks than they otherwise ventures.
The rating model should
would. This is because the b. It is often seen as
capture both systemic risk and
owner of the business entity difficult for start-ups
unsystemic risk. The systemic
benefits fully from any addi- to satisfy bank re- risk means the risk emanating
tional 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- Identification
moral hazard. When a busi- policies, fiscal policies of the of risk should
ness entity is a proprietorship try, meeting mini- government and infrastructur- occur with
or partnership concern and mum equity stake al changes whereas unsystemic the people
the liability of the owner is and having in place risk arises out of mainly inter- and experts
unlimited, owners may be less contracts for sale to nal factors such as machinery where the
prone to moral hazard because support the business breakdown, labour strike, new domain
the owner may suffer loss in plans. competitors, etc. knowledge
the event of liquidation. c. Personnel with spe- resides
Where information asym- cialised skill sets are Enterprise Wide Risk
metry and moral hazards are some times neces- Management
prevalent, business entities sary to understand Enterprise Wide Risk
are likely to fund themselves the risks inherent Management is the latest trend
primarily from retained earn- with particular new and buzzword for an overall
ings and then only through ventures. The banks, approach of the management
bank 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 of
SMEs 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 management
of 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


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 years
Every busi- of the incident, despite many work backlog, critical func-
and sophistication of risk tions, work prioritisation and
ness entity, analysis on interest rate, mar- of them having had business
particularly 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 management
tinuity and framework has become more a ity and Business Contin- agement should actually be
Business necessity than a luxury for all gency Plan (BCBCP). It is the entity specific, dictated
Contingency the business enterprises. a complex exercise involving by the size and quality of the
balance sheet, complexity of
Plan (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 the
complex 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. Any
ing a number consisting of senior manage-
is more closely associated with risk management model is as
of 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

Risk mitigation strategies in SMEs (small and medium business)

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