BANK LENDING CRITERIA FOR SMEs: A COMPARATIVE STUDY BETWEEN THE SME BANK

AND NON-SME BANKS IN MALAYSIA

BY

AJETUNMOBI AMINAT TITILAYO

A Research Paper Submitted in partial fulfilment of the requirement for the degree of Master of Islamic Banking and

Finance

Institute oflslamic Banking and Finance

International Islamic University Malaysia

AUGUST 2013

ABSTRACT

Small and Medium Enterprises (SMEs) are largely considered an engine of economic growth with finance the fuel upon which to run the engine. Therefore, the role of finance has been viewed as a critical element for the development of small and medium enterprises. However, the majority of SMEs regard financial resources as a major obstacle due to their inability to meet the lending criteria set by the banks. In order to overcome this problem, this research studies the lending criteria used by the SME bank and Non-SME banks (Conventional and Islamic banks) in order to ascertain the important criteria required by banks from SMEs before approving financing in Malaysia. Upon having ascertained the necessary criteria for financing, the study then endeavours a comparison between the lending criteria for government owned banks, namely the SME banks, and non-SME banks, namely conventional and Islamic banks. The result shows a number of similarities in the criteria requirements of the two banking groups. However, as the SME bank is a government owned bank, it is very much influenced by country specific factors such as the country's economic condition and government policy. The limitation of this research is that it focuses solely on bank lending criteria for SMEs. There remains the need for future research to ascertain how the SME financing application is processed by the banks.

11

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APPROVAL PAGE

I certify that I have supervised and read this study and that in my opinion it conforms to acceptable standards of scholarly presentation and is fully adequate, in scope and quality, as a research paper for the degree of Master in Islamic Banking and Finance

Supervisor

This research was submitted to the IIUM Institute of Islamic Banking and Finance and is accepted as a fulfilment of the requirement for the degree of Master of Science in Islamic Banking and Finance

IV

Ahamed Kameel Mydin Meera Dean, IIUM Institute of Islamic Banking and Finance (IliBF)

DECLARATION

I hereby declare that this research paper is the result of my own investigations, except

where otherwise stated. I also declared that it has not been previously or concurrently

submitted as a whole for any other degrees at IIUM or other institutions.

Ajetunmobi Aminat Titilayo

.... ~ ............... .. .... .?.: 1.l? .1..1 .~ .1.5 .... Signature Date

v

INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA

DECLARATION OF COPYRIGHT AND AFFIRMATION OF FAIR USE OF UNPUBLISHED

RESEARCH

Copyright©20 13 by Ajetunmobi Aminat Titilayo. All rights reserved.

BANK LENDING CRITERIA FOR SMES: A COMPARATIVE STUDY BETWEEN THE SME BANK AND NON-SME BANKS IN

MALAYSIA No part of unpublished research may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without prior written permission of the copyright holder except as provided below.

I. Any material contained in or derived from this unpublished research may only be used by others in their writing with due acknowledgement.

2. HUM or its library will have the right to make and transmit copies (print or electronic) for institutional or academic purposes.

3. The HUM library will have the right to make, store in a retrieval system and supply copies of this unpublished research if requested by other universities and research libraries.

Affirmed by Ajetunmobi Aminat Titilayo

..... Jb0 ..................... . ..... ~!.I.~ .. 7. .. !. .~Q.! .~ Signature Date

VI

This research is dedicated to my beloved husband and my children

VII

ACKNOWLEDGEMENTS

First of all, Praise be to Allah Subhanahu Wataala for giving me strength and perseverance in undergoing this arduous academic journey, without which I may not be able to complete this humble work to fulfil the requirement for my Master degree. His All Merciful provided me, here at IIUM, with supervisors, lecturers and friends who assisted me and lightened the burden of my works.

Among them, my heartiest gratitude goes to my dedicated supervisor, Dr Sheila Nu Nu Htay for her relentless guidance and assistance through which I persevered through many difficulties. I am indebted to her for all the wisdom and experience she shared with me throughout the course of my studies at IIUM.

My utmost gratitude goes to my beloved husband and children for their continuous support and understanding. They were always there when I needed them the most and their unconditional love and support always put me in high spirits and encouraged me to move on till I managed to reach the end of this challenging academic journey.

My gratitude also goes to my friends Mrs Zakariyah Muibat, Hajia Ogunbado Halima and Mrs Olagunju Taye for their support in taking care of my children for me whenever I am not around. May Almighty Allah reward them abundantly. Last but not the least, my thanks go to those who have contributed directly or indirectly in the completion of this work. May Allah reward them all (Jazakum 'l/ahu Khairah).

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TABLE OF CONTENTS

Abstract....................... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 11

Abstract in Arabic......................................................................... m Approval Page............................................................................... 1v Declaration Page....................... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v Copyright Page.............................................................................. v1 Dedication.................................................. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. v11 Acknowledgement........... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vm List ofT able.............................. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. x1

CHAPTER 1: INTRODUCTION 1.1 Background of the study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 1 1.2 Statement of the problem....................................... . . . . . . . . . 3 1.3 Purpose of the study............ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . 4 1.4 Scope of the study............................................................. 4 1.5 Limitation of the study..................................................... 5 1.6 Significance of the study.................................................. 6 1. 7 Organisation ofthe research proposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 6

CHAPTER 2: LITERATURE REVIEW 2.1 Overview of SME in Malaysia................................................... 7

2.1.1 Definition of SME .. ... . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . ... .. . . .. . ... . . . . . . . . 9 2.1.2 Government Policy .......................................................... 10

2.2. SMEs Financing Constraints .............................................. ..... 13 2.3 Sources of SME Financing . . . . . . . ... . . . . . . . . . . . . . . . . . . . . ... . . ................ .... 17 2.4 Bank Lending Criteria to SMEs ................................................. 23 2.5 Factors that Lead to the Rejection of Loan Applications.................. 34

CHAPTER 3: RESEARCH METHODOLOGY 3 .1 Introduction............... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . ... . 40 3.2 Data ........................................................................................ 40 3.3 Population and Sample ............................................................ 41 3.4 Data Analysis ...................................................................... .42 3.5 Conclusion .......................................................................... 43

CHAPTER 4: FINDINGS 4.1 Introduction ......................................................................... .44 4.2 Background of the Respondents............................................. 44 4.3 Banks' Involvement with SMEs .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . .. ...... .. . . 45 4.4 Findings ......................................................................... 48

IX

4.4.1 Firm Factors 000000000000000000 000000000000 ooOOooooooOOOOOOooo .......... .48 4.4.2 Country Factors 00 .................. oo ...... 00 00 00 00 0000 00 00 .......... 50 4.4.3 Factors that make Loan Applications Rejected .. 0000 ........ 50

4.5 Conclusion ooooooOOOOOOoooo 000 ................ oo, ... 000 oooooooooooooooooooooooo ....... 51

CHAPTER FIVE: CONCLUSION 5.1 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 5.2 Limitation of Study .............. oo, ... 00.00 ........... 00.00 ........ 00 ...... 0000 53 5.3 Significance of the study 000000 ooooooooOOOOooooooOOOO OOoooooooooooo .. oooo .... 54 5.4 Area of Future Research 000000 000000000000 ooooooOOOOOOoooo 000000 oooooo 0000000 54

RESULT TABLES ................................. oooo•oo·oo·oo········· .. ·oo············oo.55

REFERENCES. 00 •••••• 00 •• 00 00 •• 00 ............... 000 00 •• 00 000 000 00.00. 000000 ••••• 00 .......... 62

APPENDIX: Questionnaire ............................................... 00 ••• 00........ 68

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LIST OF TABLES

Table No. Page No.

2.1 Definition of SMEs by Small and Medium Industries 10

2.2 Profile of SMEs 2011 13

3.1 Respondent Banks 42

4.2 Profile of Respondents 45

4.3 Bank's involvement with SMEs 47

4.4.1 Firm Factors 49

4.4.2 Country Factors 50

4.3.3 Factors that make Loan Application Rejected 51

5.1 Bank involvement with SMEs result table 55

5.2 Level of Importance of Bank Lending Criteria 56

5.3 Country Factors and Government Programmes that 58

influence Bank Involvement with SMEs

5.4 Factors that make Loan Applications Rejected 59

5.5 Background of the Respondents 60

XI

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

SME refers to Small and Medium Sized Enterprises. Generally SMEs have the

biggest share in a country's economy. In addition, they are a vital component for

developed countries and developing countries in their development plans in which

often the most important roles and responsibilities are awarded to the SMEs. SMEs

constitute the dominant form of business organisation, accounting for over 95% and

up to 99% of enterprises depending on the country (OECD, 2006).

The SME sector is a major contributor to the country's gross domestic product

(GDP) and employment. Small businesses are particularly important for introducing

innovative products or techniques to the market. Microsoft may be a software giant

today, but it started off in typical SME fashion; as a dream developed by a young

student with the help of family and friends. Only when Bill Gates and his colleagues

had a saleable product were they able to take it to the marketplace and look for

investment from more traditional sources (OECD, 2006).

Constituting up to 97.3% of total business establishments in Malaysia, it is

more than important to develop and support SMEs. In this regard, the role of finance

has been viewed as a critical element for the development of small and medium-sized

enterprises (Cook, 2001 ). The availability of external finance for SMEs is a topic of

significant research interest to academics and an issue of great importance to policy

makers around the globe. The majority of businesses regard financial resources as

their most pressing concern (Helms and Renfrow, 1994).

The biggest obstacle facing business owners in Malaysia today is the

difficulties of meeting the financing requirements. The main factors behind the

problem of financing requirements were the general economic and the firm-specific

outlook, which are discussed in the later chapter.

The main providers of SMEs financing are financial institutions. According to

the census of establishment 20 II, the access of financing by size revealed that

financial institutions were the main source of financing for medium-sized enterprises.

Although there are different types of financial institutions, this research focuses on

bank financing to SMEs by analysing how, and to what extent firm specific factors

and country factors affect bank lending to this segment, and the factors constraining

their ability to provide financing. This research focuses solely on banks for the reason

that banks as opposed to considering other financial providers (e.g. capital markets)

are by far the largest suppliers of external (formal) finance to SMEs and they tend to

dominate the domestic financial system in most countries. In Malaysia, SMEs rely

more on banks for financing than the multinational companies (MNCs) and bigger

corporation which can have access to the equity market and the bond market.

The issue of collateral requirement by financial institutions is a serious

problem facing SMEs. To some credit institutions, however, the outlook on collateral

vis-a-vis the small entrepreneur has been changing over time with more emphasis

given to credit worthiness in place of common collateral (Rweyemamu, 2003). The

new emphasis involves such factors as the history of loan repayments, trustworthiness

and the capacity to repay (Kashuliza and Kydd, 1996). The other criteria added by the

World Bank (2005) for assessing credit worthiness is the reputation of the individual

within the area, the technical feasibility of the proposed enterprise, and expected cash

flow generation.

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This study seeks to determine the bank lending criteria for SMEs among

Islamic banks, conventional banks and the SME bank in Malaysia. This research aims

to determine which firm-specific factors (such as type of set-up, turnover, character of

the owner/trustworthiness and the capacity to repay etc.) are criteria by the Islamic

banks, conventional banks and the SME bank in financing SMEs. Country specific

factors such as government policies, government programmes and the country's

economic condition are also studied from their influence on the banks involvement

with SMEs to overcome financing constraints.

1.2 STATEMENT OF PROBLEM

In so long as financing is part of a credit economy, it is difficult to invest capital in

something insecure. For this reason, in order to minimize the risk all banks have set

their criteria for SMEs which they must meet before being approved for financing. An

understanding of the lending criteria in finance has important implications on the

banks financing decisions, therefore, this study explores bank lending criteria to

SMEs for banks in Malaysia. Special focus is awarded to the extent or which these

criteria influence the banks financial decision making.

In spite of the importance of the topic, relatively little research exists on how

banks finance SMEs around the world. Nonetheless, existing studies such as Beck et

a!. (2008) show that contrary to the conventional perception that financial institutions

are not interested in dealing with SMEs, banks consider the SME segment

strategically important. Yet institutional constraints remain and the market is far from

saturated.

As far as Malaysian banks are concerned specific criteria have yet to be

produced for financing SMEs. Every individual bank has its own criteria. When banks

3

grant loans or credit, their decisions are mostly based on the availability of fixed

assets as collateral. Many SMEs cannot provide collateral as they cannot dispose of

equipment, machinery, or land. Therefore, banks have increased their criteria by

adding reputation, credit history of the firm etc. which can substitute collateral.

However, loans responding to financial requests from SMEs are often

considered high risk by the banks. The weak capacity inherent in SMEs for drawing

up business plans and developing business projections mean that banks find it difficult

to assess profitability and, at the same time, could face an increased financial risk as a

lender in case of default. This research addresses these problems by using firm

specific characteristics and country characteristics as lending criteria for banks in

Malaysia to finance SMEs.

1.3 PURPOSE OF THE STUDY

This thesis studies bank lending criteria for SMEs among conventional banks, Islamic

banks and the SME bank in Malaysia. This study hopes:

1. To know bank lending criteria in conventional banks, Islamic banks and

the SME bank for financing SMEs in Malaysia

11. To know the extent these criteria can influence the banks in their financial

decision.

111. To compare between the SME bank and Non-SME banks' lending criteria.

1.4 SCOPE OF THE STUDY

While it is clear that promoting a viable SME sector is essential in the nation's stride

towards broadening the sources of financing, the general aim of this study was to

understand bank lending criteria through evaluation methods applicable to financing

SMEs by banks in Malaysia and to test how these can influence their decision

4