During the wait for a regulation to apply the law, a lot of questions appear
Since May 2020, “The Special Law to Facilitate Acess to Credit» has been in force. With the application of this law, the Government is seeking to modify regulations in order to facilitate the access to credit coming from all financial institutions for all companies that require short-term liquidity due to the impact of the Pandemic.
The law is applicable to both regulated and non-regulated financial institutions. Also, it is determined that these institutions can utilize the methodologies that they consider pertinent in each case to evaluate the credits destined for the productive activities of entrepreneurs, as well as the credits addressed to micro and small entrepreneurs. According to Legislators, this is the sector with more difficulties in accessing credit and it represents approximately 70% of the population.
In the table below, a summary of the most essential content of this Law is presented.
One of the Law’s objectives is to incentivize that Banking Institutions support the MSE sector more effectively. However, the difficulties of Commercial Banking to attend the sector aren’t uniquely related to the asked requirements. The issue is much more complex and several aspects have to be considered: the type of policies and operational processes, the culture and approach to risk management, and the methodologies needed to evaluate the requests from a sector that is informal for the most part.
The real problem lies in the fact that most of the banking sector is not designed to attend the demand for credit from this largely informal sector. According to our estimates, the sector is made up of one million economic units of totally dissimilar sizes and economic activities.
Precisely to serve this informal sector that can’t be covered by traditional banking, cooperatives and microcredit organizations have been developed for the last 30 years. Most of them are grouped under the group Asomi, and they serve this sector with ad-hoc credit methodologies. What stands out and is very specific from their methodologies is that they use the information of the clients’ historic payment paths and they also conduct field visits made by on-site advisors as an alternative method to cover the gap in documentation and requirements, which these clients cannot meet due to their informal status.
Banking institutions will probably be able to partially cover, and with many limitations, the part of this sector that is sufficiently banked. However, very doubtfully will they be able to close the gap and curve the limitations that they intrinsically have to support a sector which by definition lacks for validated documentation to support its income and expenses statements.
The Clients That Will Be Most Affected
After Reading the Decree, it can be deduced that the clients that will have the most problems are those who demand loans greater than US $30.000 and who already have credit references in the financial system or credit bureaus. These clients, a big part of which are already clients of microcredit institutions, will be faced with new requirements as a result of the application of this new Law. They will have to present municipal and tax solvencies, and deposit certificates of their financial statements in the Registers of Commerce.
The implications that this Law has on this type of clients seem very clear: if they want to have access to credit they must report their financial statements and get registered, otherwise, they must go to informal or unregulated institutions that have weak supervision and that operate with much higher loan rates which poses a big risk to them.
Although it seems that a non-explicit objective is to build a base of potential taxpayers for the treasury, the truth is that short term many of these clients won’t be able to fulfill these requirements, since it will be very difficult for them to make and register retroactive statements without the necessary documentation. On the other hand, if some clients do have these financial statements, they will probably be the statements prior to the Pandemic, and probably won’t reflect their real expected sales and profits during this new context caused by the crisis.
To summarize and as a result, many institutions will not be able to approve credits over US $ 30,000 to many of their clients, which according to our estimates, correspond to one of the MSEs segments that generate the most employment. Thus, the results could end up being the opposite of what is expected: preventing the reactivation of one of the most dynamic MSE segments due to the inability to access credit. It is estimated that this segment of small entrepreneurs is composed of approximately 400,000 economic units.
The aim of accomplishing the formalization of this sector is legitimate and very necessary, since a big part of the sector has the capacity to pay taxes. However, the experience from the region and other countries has shown that if there are no real incentives or benefits, and only new costs are represented, the results of such a policy are doubtful. Especially if one considers that the reduction in sales and demand caused by the Pandemic has put more pressure on the profit margins, which also has led many MSE entrepreneurs to operate with a logic of subsistence.
The following questions remain unanswered:
Will a Law that aims to formalize a big part of the sector so that formal banking Institutions support it be successful? Even when the processes, approach, and operations of the financial system are custom designed to attend formal and not informal sectors?
Is it a convenient Law, given the extraordinary crisis conditions that these businesses are facing?
Will this Law end up provoking that these clients get deviated and start to approach non-regulated and non-supervised organizations, with the consequent credit rate increment that it entails? Could this put a financial burden on these businesses?
Even though the proposal simplifies the requirements for information, at least for the first two segments of stipulated loans, many doubts about the way in which financial institutions will apply the Law arise. Also, there are doubts on whether the microenterprise sector will effectively obtain greater access to credit with the application of the Law.
As for now, financial institutions are on the wait for the Central Reserve Bank to issue the regulation under which the new law will be applied. Hopefully, the regulation gives more flexibility and fixes some of the inaccuracies of the main Law, otherwise, its results could be counterproductive midterm and they could lengthen the reactivation of this very important sector.
The new regulation from the Special Law to Facilitate Access to Credit (LEFAC)
…Problems foreseeable in the near future
Recently the Legislature enacted the “Special Law to Facilitate Access to Credit” -LEFAC-, which basically seeks to facilitate access to credit by simplifying documentation requirements for credits below US $ 30,000.
For its third edition, the SMEs Newsletter made a summary of the Law, which at the time was still waiting for the regulation that the Central Reserve Bank (BCR) has now issued.
Analyzing the Provisions of the Law
The regulation was incorporated in August of this year and it modified the regulation for Classifying Credit Risk Assets and for Establishing Sanitation Reserves (NCB-022). The BCR has granted financial institutions a 90 days term that expires on December 2 of this year, so that they can adapt their Policies to the changes required by the new regulation.
The regulation related to the LEFAC, as can be inferred logically, hasn’t gone beyond what the LEFAC had previously established. To summarize it comprises the following provisions:
- The financial institutions that are obliged to comply with the regulation must establish in their internal credit granting policies clear mechanisms to originate credits, based on simplified requirements and procedures, for all credits destined for the productive that the LEFAC mentions.
- Each entity will define in its internal policies their own concept of productive activities, taking into consideration the provisions of article 2, literal d) of the LEFAC.
- The credits that the LEFAC refers to are grouped within the credits for companies indicated in the regulation.
- The evaluation and classification of credits under the LEFAC will be carried out following the content of the Annexes from the NCB-022 Normative and the information requirements established in the LEFAC.
- The resulting files for each credit debtor of productive activities under the LEFAC, must contain all the documents related to the request, analysis, approval, and follow-up, taking into consideration the information requirements established by the LEFAC for such credits. Also, these credits must be properly identified.
- The information that financial institutions send to the SSF each month must contain the portfolio classification of all their credit assets and the respective provisioning reserves referred to the balances at the end of the month. Also, the entities must identify in their registry all the credits granted by the LEFAC.
The LEFAC was issued and based on an essential assumption: that the problem of access to credit is an issue of requirements. In such a way that its focus is based on simplifying the processing of loans under US $ 30,000, and it only increases them for businesses that demand loans above US $ 30,000. For these amounts, it is assumed that because they are businesses with higher sales, they will be able to comply with the new formalization requirements that the new Law demands from them.
However, the essential issue of why informal clients and businesses cannot meet these requirements is precisely a consequence of the informal nature of their operations. They cannot operate as a formal business that complies with the requirements of the Law, due to a series of factors, among which are the low levels of sales, the absence of working capital, the cultural and socio-educational level, the low-profit margins, the market they serve, among other aspects.
For this reason, traditional banks have problems when lending to the informal sector: they do not know how to evaluate businesses that lack documentation and formal billing and accounting processes. Access to credit through a regulated financial institution depends on the ability of their business model to identify and reward good payers, and not on the weight or simplification of the documentation or the existence or not of guarantees.
What truly opens up the access to credit to entrepreneurs is the achievement of a certain level of development of their businesses, which allows them to gradually comply with legal requirements, as he continues to get linked to more formal business chains.
In El Salvador the Law already recognizes the gradual approach of the regulation, which depends on the capacity and development of informal SMEs entrepreneurs.
The table below shows the existing regulation before the LEFAC
LEGAL REQUIREMENTS PRIOR TO LEFAC LAW
As can be seen, in El Salvador we already have a regulation in place that a micro-entrepreneur (individual trader) must comply with according to their level of development, which is measured through sales volume, amount of assets, and total income, among others.
The new requirements that the LEFAC establishes for credits above US $ 30,000, only add new ones, in a context where many microentrepreneurs already have trouble complying with the current Laws. In addition, the Pandemic has diminished the capacities of SMEs and had increased their informal operations’ modalities.
Analyzing a hypothetical case
If Mr. Pérez is an informal microentrepreneur and he requests a loan of US $ 32,000, showcases sales of US $ 40,000 per year, and has assets of US $ 35,000; with the application of the LEFAC he wouldn’t be able to access formal banking institutions without first:
Therefore, Mr. Perez who needs financing to develop his business, but doesn’t fulfill the requirements, will be left out with only three options:
- Initiating a process to formalize his business, ask for support, get consulting and check his business model. To reach this goal he will need more resources and a timeframe of a few months. If he can do this, he will finally be able to initiate his entrepreneurship venture, and once his business is formalized he will be able to ask for credit.
- Looking for a loan shark who will impose an annual interest rate of 80%, and will require a mortgage guarantee from the lender. After that, the loan shark will give him the US$32,000 immediately.
- Divide his credit application into two in order to submit two credit applications to two different institutions simultaneously, for an amount that is less than US $ 30,000.
Getting formalized to have access to credit
The LEFAC has an implicit objective which is the formalization of this sector of the economy, which asks for or requires credits that surpass the amount of US $ 30,000.
However, the objective of this analysis is not to discuss the apparent tax implications that are behind this legislation. Whilst it is true that adequating the regulation and promoting regulation can be very positive if it is modified to their level of development and skills, the problem is that the current regulation and the present law lacks flexibility and it is not gradual, because its requirements are something that the majority of SMEs entrepreneurs won’t be able to fulfill during that timeframe.
The result, as we were foreseeing in our previous newsletter, is that many entrepreneurs from informal SMEs, which is also the most dynamic segment and the one that generates the most employment in the country, will have problems to request access to credit.
The business of Mr. Perez, from our previous example, would face many difficulties. He would have to look for solutions “under the rocks”, putting it into “slang” language, in order to find ways to keep his operations going.
This quick analysis showcases the necessity to check the LEFAC and recognize that a a certain level of flexibility and graduality is required, because informal SMEs constitute a complex sector, with multiple size differences, profitability margins, and sociocultural characteristics that makes them unable to quickly adapt to this new regulation without making a continued effort and receiving training, consulting and support.
Depriving them of access to effective financing, after an almost apocalyptic pandemic, seems to be an inappropriate measure, to say the least, especially because of the extraordinary situation that the country is going through.
The need to rethink Laws such as the LEFAC seems the most reasonable path to take in the current context of the country, when the priority is to promote the generation of employment, no matter of what nature: formal, semi-formal, or informal. What Salvadorans need are quick means that can provide them with employment, and livelihood, through the most flexible ways possible.
If the law doesn’t follow such pragmatic logic, it runs the risk of being ineffective.
There is a basic principle that doesn’t cease to be true: the law has to be adapted to the reality of the country and not the other way around. Without question, it is a correct measure if it is to be considered on a mid-term or long-term basis, but it requires time so that the necessary conditions for its application can be created.