Why banks are wary of lending to startups?

Transaction between banks and startups

Banks are an extremely important source of finance for businesses, for short-term as well as long-term funding needs. But why banks are often cautious while lending to startups?

The risk factor

Banks have been reluctant to lend aggressively to this sector due to a variety of factors. The biggest problem seems to be the lack of transparency in financial and accounting information. Improper business plans and financial statements make it difficult for banks to assess risk and creditworthiness of the SME. Transaction costs also are high for banks as the ticket size of such loans is small. Many of these problems exist even today and are almost synonymous with startups.

How things have changed?

The issues which plague the SME sector and lending to SMEs are by enlarge still existent. However, banks have matured in their reach and approach to this segment.

SMEs, the priority segment: The Government and RBI, with a view to increasing lending to the SME sector bring about various regulations from time to time. Lending to micro and small enterprises is today reckoned under priority sector target for banks. Banks, as a result will be encouraged to lend more to this sector to achieve their priority sector targets.

More branches and products:

Over the past decade, banks have widened their reach by opening more branches. This by itself makes it easier for an SME to approach a bank for funding. Banks have also recognized that lending to the SME segment is more profitable compared to lending to large companies. This is because SMEs usually have a lower credit rating. This means that the interest rate charged on the loans will be higher for this segment when compared to a loan given to a large corporate which enjoys a better rating.

Further, banks are nowadays stressing on relationship banking. Improving and customizing the products depending on the SME’s needs can help in building strong relationships. Most banks have dedicated SME centres which cater to specific needs of this segment. These steps signify that banks’ attitude towards this potential segment has changed over the past decade.

How would it be going forward?

There is an increased risk of default and chance of the asset becoming a non-performing asset for banks when dealing with startups. As the size of the loan is relatively smaller in size, banks are reluctant to invest in detailed credit appraisal mechanisms. However, it is important that banks do not neglect this aspect.

Credit scoring models can be used to assess the proposal before the loan is granted. Credit behaviour of the entrepreneur and the business needs to be considered while evaluating the loan proposal.

Another problem while lending to startups is the high transaction cost. Using technology can reduce transaction costs to a large extent. Almost all banks have moved to core banking solutions which has resulted in a fall in costs. Tapping the client for other products of the bank such as credit cards, deposit accounts and other SME products can also help in making the relationship more profitable for the bank.

The landscape of bank funding for SMEs has definitely changed over the past decade or two. However, availability of adequate and timely credit still remains an issue for this sector. It is critical to step up measures which provide reliable funding to SMEs, while at the same time reduces cost and risks to banks. A friendly regulatory framework along with proactive measures from the banking sector can help both lenders and the SME borrowers in the long run.

What has been your experience with approaching banks for startup funding? Please share your views.