How the times have changed. Barely five years ago, if one had asked a banker to advance a loan to a small and medium enterprise (SME), chances were that he would try and find some way to wriggle out of it. Ask him now and he'll jump at the opportunity of "building a new and mutually beneficial relationship". Yesterday's pariah is today's sought after princess. The post-reforms Indian economic landscape is filled with instances of ugly ducklings turning into beautiful swans and vice versa, but seldom has banking sentiment towards an entire segment-spanning almost the entire industrial spectrum-shown such a dramatic and broad-based turnaround.

The reason is simple: there's lots of money to be made from SMEs. Cherian Varghese, Chairman, Union Bank, says the SME portfolio of the banking sector as a whole gives 1-1.5 per cent higher returns than the more pampered large corporate segment. "The SME segment is seriously profitable; in absolute terms, it gives margins of 2-2.5 per cent," concurs Vijay Chandok, General Manager, Small and Medium Enterprises, ICICI Bank.

The country's largest bank, the State Bank of India (SBI), already has an SME portfolio of Rs 80,000 crore; and it's growing at an annual rate of 38 per cent. "Given the size of our exposure to the SME segment, that's massive. At this rate, we'll add another Rs 1,00,000-crore of SME assets over the next three years," says a top official of the bank. At the lower end of the profitability scale (2 per cent), that translates into an incremental Rs 4,000 crore being added to the SBI bottom line over the next three years; at the higher end, the figure rises to Rs 5,000 crore. No wonder bankers of all hues are falling over themselves to grab a larger slice of this pie. SMEs currently account for about 35 per cent of SBI's asset book.

But profitability and margins are only one side of the story. There are other operational reasons for the banking sector's renewed love affair with the SME sector. About three to four years ago, banks discovered that they were flush with funds but their preferred customers, the large corporate houses, weren't particularly keen to borrow. India Inc. found it easier and cheaper to raise money-both equity and debt-from the Indian and global capital markets. That was around the time when bankers started looking at the SME sector as an alternative destination for their funds.

It helped that small and medium companies had cleaned up their act over the previous decade. Many individual companies in this segment were not actually small any more; some of them boasted turnovers of Rs 100-500 crore. And the sector seemed set to benefit from a long-term trend-outsourcing of work both from within and outside India. "Large corporates want to keep their inventory levels and workforces thin and slim. So they resort to outsourcing, whether for their back office operations or for frontline production," says an SBI official. "This alone can keep several SMEs in fine fettle for years."

"A reasonably good quality company can get a loan in a month. Five years back, the entire process from application to disbursement would have taken around three months even for a Rs 200-crore company" Manish Kothari Kotak Mahindra Bank		"SME lending calls for a certain amount of specialisation. Banks need to develop an understanding of their clients' needs. But once you get the basics right, things fall into place" Arvind Jain IndusInd Bank

Today, the SME sector is the second largest employer (after agriculture) in the country and the biggest producer of consumer goods both for domestic consumption as well as for exports. Most of the big exporters of cotton yarn, textiles, clothing and gems and jewellery are SMEs. Says Chandok of ICICI Bank: "Broadly speaking, SMEs contribute 35-40 per cent of both exports and the country's gross domestic product. The sector is growing at more than 10 per cent per annum; and is likely to maintain this rate of growth in the foreseeable future."

Little wonder then, that in 2004-05, the SME sector accounted for a 12 per cent share of the total credit disbursed in the country; five years ago, in 1999-2000, the figure was still in single digits. It is also much more profitable than the much more high profile retail lending segment and not half as risky.

But it's also not the easiest business to handle. "SME lending calls for a certain amount of specialisation. Banks need to develop an understanding of their clients' needs. But once you get the basics right, things fall into place as these relationships are of a continuing nature and the margins are so much better," says Arvind Jain, Head, Credit, IndusInd Bank, where loans to SMEs account for nearly 60 per cent of its total Rs 5,500-crore corporate loan portfolio.

A vast range of financial products and services are now also available to this sector. SMEs can now deal in treasury products such as derivatives, which were previously available only to large corporates, and can also avail of new technology platforms with e-payment options, which till recently were prohibitively expensive, and, therefore, unaffordable. "Loan approvals have also become much easier too," says Manish Kothari, Senior Vice President and Business Head for SMEs, Kotak Mahindra Bank. "A reasonably good quality small or medium company can get a loan in a month. Five years back, the entire process from application to disbursement would have taken around three months even for a Rs 200-crore company," he informs.

TOP 10 SME VERTICALS
Auto Ancillaries & Engineering	ICE & ITES	Pharmaceuticals & Chemicals
Infrastructure	FMCG, Food & Agri-Business	Travel & Tourism
Gems & Jewellery	Retail Trade	Textiles & Apparel
	Commodity Trading & Others

Traditionally SMEs accounted for a very high incidence of banks' non-performing assets. Precise figures are not available, but bankers say it was unacceptably high even a decade back. This, in fact, explains the reluctance of bankers to deal with the sector earlier. Consequently, the government had to bring small scale industries (SSIs), which account for a fairly large majority in the SME universe, under the priority sector lending norms to force banks to lend to them. These norms still apply to SSIs. But the diffidence in dealing with them is clearly a thing of the past. A happy confluence of an uptick in the fortunes of the SME sector and the use of sophisticated credit appraisal tools-like scoring models which take into account financial as well as non-financial data to arrive at the creditworthiness of potential clients from the sector-has led to a win-win situation for both parties. "NPAs in the SME sector for most private banks are very low, and are currently in the range of 0.5-1 per cent only," informs Chandok.

"The SME segment is seriously profitable. It contributes 35 to 40 per cent of both exports and the country's gross domestic product. And this sector is growing at more than 10 per cent per annum." Vijay Chandok ICICI Bank		"Their cost of capital will go up, but businesses always factor these things into their plans. So, I don't see any scope for any disruption due to this" Brijesh Mehra ABN AMRO Bank

"Independent rating agencies such as NSIC (National Small Industries Corporation) and SMERA (SME Rating Agency of India) help SMEs with higher ratings access funds on better terms than others," says Munish Dayal, President, Business Banking, Yes Bank. For example, an SME with a grade of 1 (the highest rating for SMEs on a scale of 1-8) can get loans at PLR (prime lending rate) minus 2 per cent. An SME with a grade of 4 (the lowest creditworthy level), on the other hand, will be charged PLR plus 3 per cent. Union Bank goes a step further. "The customer with the highest CRISIL and SMERA ratings gets a half per cent discount on interest rates," says Varghese. The second highest rated company gets a quarter per cent discount.

But despite the improved record and the slew of incentives on offer, SMEs still suffer some discrimination. They pay an interest rate that's at least 2 per cent higher than what the large business houses pay (see Big Is Still Beautiful). "But this will change once the practice of rating SMEs is institutionalised. I expect AAA-rated SMEs to get loans at PLR," says M.A. Shah, General Manager, J&K Bank.

There are some other dark clouds on the horizon. Interest rates are hardening once more, and this is expected to hit SMEs, which don't have access to alternative sources of funds, harder than their bigger counterparts. "Their cost of capital will go up," accepts Brijesh Mehra, Head (Wholesale Clients), ABN AMRO Bank, "but businesses always factor these things into their plans. The managements of SMEs will obviously do the same. So, I don't see any scope for any disruption due to this."

SMEs today represent, arguably, the most important, albeit widely dispersed, segment of India's corporate value chain. And so long as the economy continues to canter along at 7-8 per cent per annum and more, bankers will follow in lock step to share in its prosperity. The beggar maid of yesterday has truly emerged as today's new royalty.

-additional reporting by Anand Adhikari