Question

Given the current economic issues associated with the pandemic situation in the world, developing economies such as of Pakistan is facing severe financing issues and credit crunch in financial markets. Suggest way(s) through which a new business can meet its financing obligations given the economic uncertainty and lack of credit availability from financial institutions.

Answer 1

Broadening the finance options available and accessible to SMEs is a key challenge for policy makers in the quest for fostering their development and sustaining the most dynamic enterprises, in a credit constrained environment. It also represents a long-term challenge to improving the SMEs’ capital structure
and investment capacity, and reducing their over-reliance – and vulnerability – to the traditional lending
channels.

The range of instruments
1. Asset-based finance is a widespread form of finance for SMEs, to monetise the value of specific
assets and access working capital under more flexible terms than they could from conventional lending
channels. As firms obtain funding based on the value of specific assets, including accounts receivables,
inventory, machinery, equipment and real estate, rather than on their own credit standing, asset-based
finance can serve the needs of young and small firms that have difficulties in accessing traditional lending,
because they are informationally opaque, lack credit history or face temporarily shortfalls or losses.

2. In its long-established forms of factoring and leasing, asset-based finance is widely used across
OECD economies. In Europe especially, the relevance of these instruments for SMEs is on par with conventional bank lending, and the specific financial segment has grown steadily over the last decade, in
spite of repercussions of the global financial crisis on the supply side. Factoring and leasing are also
broadly diffused across emerging economies, and increasingly so in supply chain arrangements and cross-
border activities. Their diffusion is favoured by less stringent requirements, in terms of an efficient legal
and judicial system, than traditional and asset-based lending.

3. Indeed, a weak legal environment can be an important constraint to the development of asset-
based lending, which has mainly taken place in economies characterised by a solid framework for the
protection of secured interests and efficient bankruptcy laws. In fact, in countries where this form of
financing had already developed, its demand by SMEs has significantly increased in the aftermath of the
2008-09 global financial crisis, as awareness rose and access to other financing channels have become
more difficult, and also as a consequence of regulatory changes.

4. Alternative debt differs from traditional lending, in that investors in the capital market, rather
than banks, provide the financing for SMEs. These include “direct” tools for raising funds from investors
in the capital market, such as corporate bonds, and “indirect” tools, such as securitised debt and covered
bonds, whereby banks can access lower-cost funding on capital markets and extend SME lending.

5. Across OECD countries, the corporate bond instrument, which can serve the needs of medium-
sized companies, providing an injection of liquidity to undertake investment and seize growth
opportunities, has had only limited diffusion in the SME sector. However, in the aftermath of the global
crisis, as other traditional financing sources dried up, the potential for a bond market for the larger segment
of the SME sector is starting to be recognised by entrepreneurs and investors. At the same time, this
remains an area in which lack of knowledge and awareness by entrepreneurs still represents a major barrier to development.

6. The regulatory framework allows private placements of corporate bonds by
unlisted companies, which are subject to less stringent reporting and credit rating requirements. However
lack of information on issuers, lack of standardised documentation, illiquid secondary markets and
differences in insolvency laws across industry players and jurisdictions currently limit the development of
these markets.

7. Debt securitisation and covered bonds are instruments for the refinancing of banks and for their
portfolio risk management, which have developed at a high pace in the past decade. However, in the wake
of the financial crisis, they have come under scrutiny and criticism, as one major driver of risk leveraging
and financial instability. Although it was not at the core of the financial turmoil, SME loan securitisation,
which had started to expand just before the crisis, came to a halt or decreased significantly, affected by
contagion in financial markets and in public perceptions. Over the last few years, however, it has attracted
renewed attention by policy makers and financial authorities, as an important instrument to foster SME
lending.

8. Crowdfunding has grown rapidly since the mid of the 2000s, and at an increasing rate over the
last few years, although it still represents a very minor share of business financing. While the pace of
technological developments has enabled a rapid diffusion of crowdfunding, the regulatory environment has
limited a broader adoption, especially for securities-based crowdfunding, which is still not legal in some
countries. Hence, in recent years, crowdfunding has been the object of important regulatory attention in
some OECD countries, which have aimed to ease the development of this financing channel, while
addressing concerns about transparency and protection of investors.

9. Hybrid instruments combine debt and equity features into a single financing vehicle. These
techniques represent an appealing form of finance for firms that are approaching a turning point in their life cycle, when the risks and opportunities of the business are increasing, a capital injection is needed, but they
have limited or no access to debt financing or equity, or the owners do not want the dilution of control that
would accompany equity finance. This can be the case of young high-growth companies, established firms
with emerging growth opportunities, companies undergoing transitions or restructuring, as well as
companies seeking to strengthen their capital structures.

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