DOCUMENT OF THE EUROPEAN BANK

FOR RECONSTRUCTION AND DEVELOPMENT

MICRO, SMALL AND MEDIUM-SIZED

ENTERPRISES STRATEGY
As approved by the Board of Directors at its meeting on 7 February 2006.
 TABLE OF CONTENTS

1. INTRODUCTION .....................................................Error! Bookmark not defined.

2. PILLARS AND PRINCIPLES .................................................................................. 4

2.1 FINANCE .............................................................................................................. 5
2.1.2 Additionality ............................................................................................ 6
2.1.3 Sound Banking Principles ....................................................................... 6
2.2 POLICY DIALOGUE .............................................................................................. 7
2.3 BUSINESS SUPPORT ............................................................................................. 8

3. CORE PRODUCTS AND COUNTRY SPECIFIC APPROACH ....................... 10

3.1 MSE PROGRAMMES THROUGH ESTABLISHED COMMERCIAL BANKS ............ 12
3.2 MICROFINANCE BANKS .................................................................................... 13
3.3 SME PROGRAMMES WITH PARTNER BANKS AND LEASING COMPANIES ....... 14
3.4 EXISTING PORTFOLIO AND INDICATIVE PROJECTION FOR MSME BUSINESS 16
3.5 CO-ORDINATION WITH OTHER IFIS AND DONORS ........................................... 16

4. NEW PRODUCTS AND CHALLENGES ............................................................. 17

4.1 NEW PRODUCTS ................................................................................................ 17
4.2 CHALLENGES..................................................................................................... 19

5. CONCLUSIONS....................................................................................................... 20

Annex 1: MSME Definitions...................................................................... 21

Annex 2: Assessment of Transition Challenges for MSMEs .................. 22
Annex 3: Group for Small Business – Historical Performance................ 24
1. INTRODUCTION

The Micro, Small and Medium-sized Enterprises (MSME) strategy focuses on the core
elements of the Bank’s approach towards supporting the development of MSMEs in its
countries of operation. Support for MSMEs is central to the Bank’s transition mandate,
and the document sets out the underlying principles of EBRD’s activities in the sector
going forward.

The strategy further aims to outline how the Bank can best support MSMEs across all of
the Bank’s countries of operations, strengthen the financial sector infrastructure
dedicated to financing growth of MSMEs of all sizes, improve the business environment
for MSMEs, and develop the skill sets of small entrepreneurs.

The Bank has been active in supporting the growing small business sector in its countries
of operation over the last thirteen years through a variety of instruments and activities.
This strategy paper will focus on the core elements of the Bank’s approach towards
supporting the development of micro, small and medium sized enterprises (MSMEs) in
its countries of operation.

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2. PILLARS AND PRINCIPLES

Long-term sustainable economic growth and job creation will only be achieved through
the development of a vibrant entrepreneurial sector. Active promotion of this sector is
both a means and an end to the transition to the market economy and the creation of an
entrepreneurial class will both mitigate the social costs associated with restructuring
enterprises and enhance the likelihood of a durable commitment to democratic societies
and the rule of law. The promotion of MSMEs is therefore at the heart of EBRD's
transition mandate.

The EBRD targets MSME support because it regards the participation of MSME in the
formal financial sector in the respective countries of operation as inadequate and believes
that instruments beyond foreign bank entry and bank privatisation are needed to
accelerate their development. This intervention by the Bank is designed to bring benefits
both to MSMEs and to the financial institutions that engage in MSME financing. The
support is designed with a view to ultimately making these activities financially
sustainable.

Providing sustainable lending and universal financial services to the MSME sector is a
key element of financial sector development. Financial institutions and markets are
underdeveloped in each of the EBRD’s countries of operations – even the most
advanced. The degree of underdevelopment is higher the poorer the country and the less
advanced it is in the transition towards an efficient market economy and a pluralistic,
open society and political system. Finance for MSMEs is an area where the gap between
what ought to be available and what actually is available is relatively large (see also
Annex 2).

Available evidence on the financing of MSMEs in the Bank’s countries of operations

shows that these firms rely more heavily on informal sources of finance and on retained
profits to meet their working capital and investment finance needs than larger firms do.
This is true even in the most advanced countries. These enterprises also perceive that
difficulties in accessing finance are a major obstacle to the operation and growth of their
businesses. 1 In addition, the voice of entrepreneurs and MSMEs is weak in the political
arena where legislative and regulatory decisions that will determine the future
opportunities for MSMEs are taken. The result is that MSMEs are fewer in number and
have less economic weight and political clout than is desirable from the perspective of
transition and economic development.

There are several reasons for this under-representation and provision of finance to
MSMEs and some of them relate directly to the post-communist transition. MSMEs
were largely absent from the previous economic system, which concentrated production
and investment in large, state-owned enterprises. State banks, which specialised by
economic sector, provided the financial resources for investment and working capital for
these enterprises. MSMEs were not significant clients for the state banks and, as a result,
this segment of the banking market has had to be developed from scratch.

1
See, for example, EBRD (2002), Transition Report 2002, London: EBRD, Chapter 2, and EBRD (2004),
Spotlight on South-Eastern Europe, London: EBRD, Chapter 3.
4
Though the Bank can point to some significant achievements in this field, there remains
much more progress to be made, and the Bank remains strategically committed to
expanding its activities with MSMEs.

Technical assistance, which supports the intermediaries’ ability to provide efficient and
quality financing on a sustainable basis, has been central to the Bank’s support to the
MSME sector and made possible the broad reach of the programme across international
and local commercial banks, as well through the establishment of greenfield
microfinance banks, and through non-bank financial institutions. Through technical
assistance, the Bank has been able to accompany its capital resources with significant
institution building support, addressing all aspects of banking to the MSME sector
including inter alia; credit methodology; information technology, universal banking
services; rural and agricultural lending; and corporate governance.

As well as providing technical assistance for intermediaries, the Bank strengthens

individual MSMEs, pre- and post- financing through the TAM/BAS Programme.
TAM/BAS both develops pipelines for financing and helps protect financing already in
place, by improving management and business skills.

The strategy aims to provide support for MSMEs across all of the Bank’s countries of
operations, strengthen the financial sector infrastructure dedicated to financing growth of
MSMEs of all sizes, improve the business environment for MSMEs, and develop the
skill sets of entrepreneurs. In this context, the strategy will continue to be structured
around the three pillars established in its 2000 Strategy “Promoting SMEs in the
Transition”, namely, Finance, Policy Dialogue and Business Support.

2.1 FINANCE

The Bank’s primary strength and comparative advantage within the general framework
for MSME support undoubtedly lies in its work with financial intermediaries, leveraging
on its very broad network of relationships and reaching out to new institutions
throughout the region. In general terms a successful transition requires the development
of a sound financial sector which commands the confidence of the population, facilitates
transactions, and intermediates effectively and efficiently between savers and investors.
In the long-term, a financial sector with the necessary technical ability, strategic
commitment and long-term financial resources to address the requirements of MSMEs is
the cornerstone of healthy MSME development. One of the key instruments of the
Bank’s MSME strategy is therefore the sustainable provision of finance and financial
services to local small enterprises through financial institutions.

The full development of the MSME sector requires a long-term commitment from the
financial institutions to ensure that this specialised lending business will remain
sustainable without the support of donor and IFI funds. Further, the varying financial
needs of the diverse enterprises making up the MSME sector require intermediation
through a variety of financial institutions. For this reason the Bank and its partner donor
organisations are committed to continue financing and technical assistance programmes
until this sustainability is secured, which can be a lengthy process.

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All of the Bank’s initiatives in the MSME field will continue to be guided by adherence
to EBRD’s core principles – achieving transition impact, additionality, and applying
sound banking principles in all cases.

2.1.1 Transition Impact

In general, the EBRD designs its MSME lending programmes to achieve potential
transition impacts by capacity building at the MSME lending institution and by fostering
a culture of credit in the MSME segment of the banking market among both borrowers
and lenders. The Bank focuses on these impacts because the market and private banks on
their own are unlikely to adequately meet these needs. If, in addition, there are other
market failures the transition impact potential of MSME financing operations would be
further enhanced. However, the two market failures on which the Bank focuses appear to
be the most significant.

The first type of transition impact is achieved both through the use of technical co-
operation (TC) funds to invest in capacity (such as skills and information technology)
and through the experience gained by the MSME lending institution in using the funds
successfully to finance MSMEs (i.e. learning by doing).

The second type of transition impact component is broadly measured by the number and
value of loans and the proportion of new clients to the institutions that benefit from
programme financing. The greater the scale of the EBRD’s MSME financing operations
and the extent to which these programmes reach new clients, the more widely developed
the culture of credit becomes. These impacts are both direct and through the
demonstration effects created by MSMEs that grow and prosper. In addition, the
transition impact potential of MSME financing can arise from the increased financing of
MSMEs it permits, regardless of whether it contributes to building a culture of credit, if
there are other reasons for market failure in the credit market for MSMEs.

2.1.2 Additionality

The Bank supports MSME programmes which identify and fill a gap in the existing
financing market. The EBRD fills this gap not only by providing finance for MSMEs,
but also by mobilising support for capacity building for MSME financing operations in
partner institutions and fostering a culture of credit in its countries of operations.
Importantly, donor support is used to leverage the Bank’s resources and to achieve the
broader impacts associated with these activities. The programmes also catalyse private
sources of funding for MSMEs with the aim of increasing the share of private financing
over time. As the participating financial intermediaries develop and mature, an
increasing emphasis is placed on assisting them in attracting and mobilising non-IFI
funding and ultimately achieving financially sustainable activities. This aspect is
particularly true for the non-bank microfinance institutions with which the Bank has
started to work, which have in large part been dependent on donor grants and are new to
commercial financing.

2.1.3 Sound Banking Principles

Loans to financial intermediaries, including to non-bank microfinance institutions, are

priced commercially and funds are on-lent to MSMEs at prices which cover costs and
generate profits for the partner institutions.

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OCE is currently carrying out a survey of firms which benefited from EBRD finance and
comparing their performance and perception of the business environment to those of
enterprises which did not manage to access Bank finance. This will help better tailor the
Bank’s financial instruments to the needs of the local MSMEs.

2.2 POLICY DIALOGUE

Policy Dialogue work is intended to focus on improving the business climate for MSMEs
generally, with a priority on addressing policies and regulations which create
impediments to accessing and providing financing for MSMEs. This can take many
forms, ranging from ad hoc interaction with local government bodies to speed up the
processing time of a regional collateral registry, to long-term policy dialogue with the
respective Central Bank, in co-ordination with other IFIs, to adopt provisioning
requirements appropriate to micro and small lending. The bank’s policy dialogue work
related to MSMEs has been carried out by the Legal Transition Team of OGC, the Office
of the Chief Economist, the relevant Banking teams: Group for Small Business, Financial
Institutions, Country Teams and Resident Offices. The Bank also ensures that its work is
closely co-ordinated (and where possible, closely implemented) with that of other IFIs
and bilateral or multilateral donors.

The Bank is carrying out specific policy initiatives to improve both the regulatory and
business environments in the areas of corporate governance and remittances. The former
is based on dialogue at the government level accompanied by specific capacity building
at the bank level; the latter, initiated this year, involves intra and inter-regional discussion
on capital flows and ways to incorporate such flows in the formal financial sector for the
benefit of both the MSME and the respective countries.

The focus on policy dialogue has been a valuable supplement to the MSME finance work
of the Bank, and it is indeed a unique strength of the EBRD compared with other MSME
financiers. Proximity to the market in the shape of the relationships with the partner
banks and specialised microfinance banks and, through them, to the entrepreneurs they
serve, provides a unique perspective on the impediments encountered by both credit
providers and borrowers. By bringing these impediments to the attention of the relevant
authorities, targeted policy dialogue efforts contribute to an improvement in the
environment both for individual MSMEs and the institutions which lend to them. In
certain cases, the Bank can also directly assist in the changes it advocates in the form of
TC projects undertaken, for example, by the Legal Transition Team (LTT) in the area of
collateral laws and registries. For example, in 2001, LTT provided technical assistance
to the Serbian government for the development of a secured transactions law, which was
adopted in 2003 – ProCredit Bank Serbia actively participated to the drafting of this law.
In 2003 and 2004, GSB and LTT worked very closely on the development of Guiding
Principles for the Development of a Charges Registry, providing, for the first time,
standards for the development of a key institution for MSMEs. Current plans are to use
these principles in countries where the lack of proper collateral registration hampers the
development of MSME lending, such as Tajikistan.

Project-related policy dialogue is also undertaken by the Group for Small Business to
support several partner bank programmes where a local legal adviser participates in the
consultants’ team and closely liaises with the Ministry of Justice and with all relevant
authorities involved in drafting and implementing laws (e.g. microfinance law, and

7
pledge law). Establishment of new microfinance banks, transformation of non-bank
microfinance institutions to banks where it is appropriate and bank privatisations provide
specific platforms to forward best practice initiatives.

The Financial Institutions group is engaged in a range of policy dialogue issues in the
countries of operation (as described in the annual Financial Intermediaries report) and is
co-operating with the “Convergence” initiative, a programme supported by the
Government of Italy and aimed at promoting dialogue between private financial sector
institutions and the respective regulatory authorities in the countries of South-East
Europe.

In addition to the ongoing policy dialogue carried out by banking teams in the context of
project development, OCE has recently carried out a number of additional initiatives.
OCE has been co-ordinating policy dialogue in the area of business environment for
MSMEs in the Stability Pact Region for the past three years, jointly with OECD and the
European Commission (DG Enterprises), under the aegis of the Investment Compact 2 .
During spring 2004 OCE and Banking initiated policy dialogue efforts to improve the
business environment for SMEs in Georgia, as a pilot for future policy dialogue in the
other ETC countries. OCE has recently conducted a survey (BEEPS III) and in
consultation with Banking will conduct structured interviews to investigate further these
survey results and inform policy dialogue on the business environment in ETCs, focusing
in particular on conditions for MSMEs.

2.3 BUSINESS SUPPORT

The EBRD TurnAround Management and Business Advisory Services (TAM/BAS)

Programme for non-financial enterprise support focuses on assisting and improving the
management skills of enterprises, leading to greatly improved business performance and
increased job opportunities.

The TAM/BAS strategy is to foster transition through a two-pronged, inter-linked

support Programme. TAM restructures and introduces a new management culture in
Early Transition Countries, for communities as well as individual enterprises, by utilising
the skills of industry-specific, senior managers from developed countries. BAS teaches
MSME managers to use external business services, and, at the same time, develops local
business consultancy sectors.

TAM/BAS is an essential pillar in the MSME strategy, since financial investment alone
cannot answer all the economic development needs of the Bank’s countries of operation.
Individual MSMEs require urgent assistance in order, for example, to develop strategic
business and marketing plans, to improve management skills, to develop new products
and to raise quality standards to those demanded by their actual and potential export
markets. These goals can only be reached quickly through the provision of customised
and focused assistance to individual companies with the explicit objective of achieving
such results.

2
Annual reports of these policy dialogue initiatives can be accessed at
http://www.investmentcompact.org/general/library.htm

8
The TAM/BAS Programme has a long and successful record in assisting the
development and growth of MSMEs, and the linking of banking projects with TAM/BAS
activities is now and will remain a high priority for banking teams. TAM and BAS are
able to produce strong pipelines of potential candidates for external financing by the
Bank’s instruments or those of its partner banks, because working with enterprises on
advisory projects is a very effective screening procedure. Moreover, TAM/BAS
expertise can also be applied to strengthening the performance of enterprises in the post-
investment phase.

An immediate productive feature of closer Bank/TAM/BAS relationships could be direct

collaboration in MSME programmes in the Early Transition Countries. For example, in
those countries there is a demonstrably strong demand for micro and small loans which is
being met by the Bank’s MSE lending programs and microfinance banks. Based on
feedback from MSMEs in the Caucasus, the synergy of linking this type of financing
with TAM/BAS projects would be very beneficial and create an extremely high demand
for overall transition assistance.

9
3. CORE PRODUCTS AND COUNTRY SPECIFIC APPROACH
The structure and needs of the MSME sector vary among countries at different stages of
transition and are also influenced by the history and economic structure of the countries.
An assessment of these differences should inform each country approach and will be
reflected in the respective country strategies.

Over the last 13 years the Bank has utilised its core products through financial
intermediaries to cater for the financing and development needs of MSMEs. These
include credit lines to existing commercial banks (so called “partner banks”) focussed on
MSE and/or SME sub-borrowers, investments in and loans to specialised microfinance
banks, SME leasing operations, and loans to non-bank microfinance institutions. These
products have proved durable and successful and with the necessary evolution and
adaptation, they will remain at the heart of the strategy moving forward. In addition, the
Bank will explore the use of guarantees, capital markets and local currency instruments
to provide a diverse range of products to meet the need of the evolving regional markets.
The Bank will also encourage intermediaries in the provision of universal services in
addition to lending which are recognised as a need of the MSME market.

In addition, the Bank has provided non-financial support directly to enterprises through
the TAM/BAS programme. This Programme, the core of the Business Support Pillar of
the Bank’s SME strategy, operates throughout the Bank’s countries of operation.
TAM/BAS Programmes are developed in line with the priorities of the Bank and Donor
organisations and, at present, are increasing activities in the ETC countries and the
Western Balkans.

It is important to note that where different approaches co-exist in the same country, the
Bank ensures that these approaches are broadly complementary, and are aimed at
developing different market segments in response to the different strategic needs of
partner institutions.

Going forward, the core strategy will be to leverage on the Bank’s wide network of
relationships with established financial institutions (commercial banks and leasing
companies) and use them as the main channel of delivery of MSME products. Though
the market segments are different, many commercial banks are engaged across the whole
continuum of MSE and SME borrowers. While delivery mechanisms may vary, the
Bank’s approach is to have a set of tools available that enables it to address the whole
range of banks’ needs, wherever an individual bank determines its strategic focus lies.
Whether institutions choose to move up in target market from MSE to SME or
conversely move down from SME to MSE, the Bank should be able to address their
requirements.

Specifically concerning the smallest “micro” borrowers, the central plank of the strategy
will be to work with existing commercial banks to provide intensive institution building
support which will allow them to lend profitably and sustainably to this category of
borrower. This “downscaling” approach has already proved successful in many EBRD
countries of operation, most notably across Central Asia where commercial banks have
recognised the market potential of micro borrowers and engaged dynamically in
capturing this customer segment. In other countries, such as Ukraine and Georgia, the
demonstration effect of the EBRD funded specialist microfinance banks has prompted
local commercial banks to compete for MSE market share. The Bank’s recent loans to

10
 non-bank MFIs under the ETC Framework have enabled EBRD to reach even smaller
borrowers; in Tajikistan the average loan size is under USD 500.

The table below provides a snapshot of which of these products is currently active in
which of the Bank’s countries of operation:

MSE Specialised Non-bank SME SME TAM/ Policy

programmes Microfinance Microfinance financing leasing BAS Dialogue
through Banks Institutions through through
established established established
commercial commercial leasing
banks banks companies

CEB
Croatia X X X X
Czech
X X P
Republic
Estonia X X X
Hungary X X X
Latvia X X X
Lithuania X X X
Poland P X X P X
Slovakia X X P
Slovenia X X X
SEE
Albania X X X
Bosnia &
X P X X X
Herzegovina
Bulgaria X X X X X
Macedonia X X X X
Romania X X P X X X X
Serbia and
X X X X X X X
Montenegro
ETC
Armenia X P X X P
Azerbaijan P X P X X P
Georgia X X P X X X
Moldova X P X X X
Kyrgyzstan X X X X
Tajikistan X X X P
Uzbekistan X P P X X X X
CIS non-ETC
Belarus X P X P X
Kazakhstan X X X X
Russia X X P X X X X
Turkmenistan P P P
Ukraine X X X P X X

X denotes existing programmes, P denotes pipeline

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3.1 MSE PROGRAMMES THROUGH ESTABLISHED COMMERCIAL BANKS

The provision of long-term credit lines coupled with intensive specialised technical
assistance has been a central part of the Bank’s MSME strategy since the Russia Small
Business Fund was established in 1994. MSE programmes through existing commercial
banks generally target an average loan size of under USD 10,000 and have proved a
particularly effective way of delivering funding to clients which have previously had
little or no access to formal sector finance. In Central Asia particularly, commercial
banks have been enthusiastic in embracing this new and dynamic target customer group.

Even in the larger countries with relatively more developed financial sectors such as
Kazakhstan and Ukraine, banks have seen the potential in extending their reach down to
smaller borrowers. The following table shows the extent to which this has been
occurring in selected countries and is indicative of the basis on which the future activity
can be built:

End October Project start No. of No. of loans US$ volume of US$ average
2005 date banks granted loans granted loan amount
Kazakhstan May 1998 7 168,608 1,113,743,494 6,606
Kyrgyz
April 2002 5 31,659 57,845,150 1,827
Republic
Russia August 1994 7 278,068 2,486,297,399 8,941
Tajikistan October 2003 4 7,822 20,973,455 2,681
Ukraine September 1998 6 202,744 1,155,759,432 5,701

Going forward, working with an expanded range of established commercial banks will be
a key priority in expanding the scope of MSE lending programmes. The existing model
is based on providing intensive technical assistance with an institution-building
approach. It involves strengthening banks’ staff capabilities and technical capacity to
enable them to lend efficiently and sustainably to MSEs. Often this can entail root and
branch restructuring of credit departments and internal procedures in order to put in place
the necessary conditions for this very specific lending business to operate profitably.

Within this framework, the Bank’s future strategy as regards these programmes has a
number of key emphases and potential new directions:

¾ Programmes will be put in place in countries where there are currently no MSE
credit lines, such as most of the Western Balkans, Azerbaijan and Moldova. With
smaller commercial banks in the ETC countries or in the Western Balkans, the aim
will be to provide combined MSE/SME support, managed as a single product and
client relationship. Depending on the participating banks’ needs and capacity,
MSE and SME lending could be combined in a single credit facility managed and
supervised by the same team of consultants.

¾ In Central and South-Eastern Europe, the focus will be on co-operating via credit
lines and TC with the larger established mainstream commercial banks (often
foreign owned) already active in the SME market, which are strategically looking
at reaching to the MSE market as a new business opportunity. The bank will also
particularly seek to mobilise private capital alongside its own interventions in order

12
 to leverage donor and IFI finance, through syndicated loans or other leveraged fund
structures such as the envisaged European Fund for Southeast Europe.

¾ In the countries covered by existing programmes, efforts will be intensified to bring

in more partner institutions to deepen the impact on the banking sectors, while at
the same time encouraging continued regional outreach to broaden the impact in
the respective countries. In parallel with this, much more emphasis will be placed
on creating and tailoring products for rural and agricultural lending. In
Kazakhstan, Kyrgyz Republic, Ukraine, the EU Accession countries (EU/SME
rural finance) and in the New Member states (Preparatory Action) for example,
specific technical assistance has been sourced to develop these initiatives.

¾ The Bank will continue to interest other potential funding sources in participating
in these programmes. Co-financing and risk-sharing initiatives such as those
currently in place via the US/EBRD SME Finance Facility, and with SECO and the
IFC in Central Asia will be explored with other partners in order to leverage EBRD
funding and increase overall volumes being made available to partner institutions
and MSE borrowers. In addition, the Bank will look to extend the Syndications’
initiatives which have so far been used only with the ProCredit network to local
partner banks in MSE programmes.

¾ In existing institutions ongoing efforts will continue to enhance the efficiency of

MSE operations. In particular, this entails making continuous improvements to
loan officer productivity in order to ensure TA efficiency ratios remain at
acceptable levels.

¾ In the mature MSE lending programmes attention will increasingly turn to

managing “graduation” strategy in the optimal way, putting in place systems to
monitor partner banks’ continued commitment to the MSE target group once the
technical input has withered away. In Kazakhstan, a Graduation Agreement was
recently signed with one of the participating banks in the Kazak Small Business
Programme to address such issues. The agreement states the obligation of the
participating bank to keep a portion of the overall MSE portfolio in micro loans
(below USD 10,000), to continue to use the EBRD’s credit technology, to maintain
the same incentive structure for loan officers, to establish an internal audit position
responsible for auditing the MSE portfolio on a regular basis, and to maintain
monthly reporting on the MSE portfolio to the Bank.

3.2 MICROFINANCE BANKS

The Bank has made equity investments in and provided credit lines to 12 specialised
microfinance banks. This has proved an excellent way of kick-starting the market for
MSE finance in these countries, and creating a demonstration effect and a significant
competitive stimulus for other commercial banks. The primary focus will now be on
continuing activities in these countries through commercial banks which will be at the
heart of a sustainable MSE finance sector. While the creation of new microfinance
institutions is not envisaged to be a mainstream delivery mechanism going forward, it
will remain a possibility in order to stimulate the MSE finance market in countries where
there is no alternative. This might concern countries where the financial sector remains
unreformed or under government control and where existing banks are structurally

13
unsuited to become MSME partners, such as Uzbekistan. The Bank will also consider
making equity investments in existing specialised microfinance banks, or in financial
institutions which demonstrate a strong strategic commitment to MSME lending. The
Bank will also work with selected non-bank microfinance institutions in their
transformation to fully licensed banks where appropriate.

Ten of the microfinance banks where EBRD has investments are part of the ProCredit
network, and a recent paper submitted to the Board addressed the issue of the Bank’s
staggered exit strategy for these institutions. It is important to re-emphasise that the
Bank will continue to be a significant creditor of the network and will consider making
additional senior loans on a case-by-case basis. The purchase by Banca Intesa of a
majority stake in KMB Bank Russia is an excellent example of how mainstream
commercial banks are increasingly coming to view MSME lending as a profitable and
sustainable business which warrants the investment of significant capital. As one of the
conditions to the purchase of part of EBRD’s shareholding in KMB, Banca Intesa has
undertaken to significantly grow KMB Bank’s MSME portfolio, and EBRD will
maintain a holding of 25% plus one share in order to monitor and assist Banca Intesa in
this task.

The Bank will also maintain its existing Board representation and will participate in
capital increases in order to maintain current shareholding levels and the rights associated
with them, except in circumstances where the proximity to our final exit would make
such an investment a sub-optimal use of the Bank’s resources.

In addition the Bank will continue to explore possibilities for syndicated loans using the
A/B loan structure, building on the successful experience with such facilities in the cases
of ProCredit Ukraine, ProCredit Bulgaria, ProCredit Romania and ProCredit Serbia.

3.3 SME PROGRAMMES WITH PARTNER BANKS AND LEASING COMPANIES

The EU/EBRD SME Finance Facility (EU SME Facility), initiated in 1999, is the Bank’s
main instrument for financing small businesses in the EU Accession countries. Under
the programme, the EBRD is making EUR 1,100 million funding available for lending
and lease financing to SMEs with an EU contribution of EUR 156.75 million for
technical assistance and financial incentives. Close to 90% of these amounts will be
committed as of 31 December 2005. With an average transaction size of EUR 22,000 in
the more advanced countries, the programme has proved to be an effective instrument to
catalyse banks and leasing companies to provide financing to SMEs and reach the lower
end of the market. However, average size of sub-loan and lease financing are higher in
the less advanced countries.

Going forward, working with increased number of financial intermediaries will be a key
priority in expanding the scope of SME lending programmes. Within the framework of
the existing model, the Bank’s future strategy for the programme has a number of key
emphases and potential new directions:

¾ Although the Bank works through different financial intermediaries, banks will
remain the main vehicle for SME finance. The Bank will continue to focus on
providing long term funds to established commercial partner banks for SME lending.

14
¾ In the Accession states, the Bank will continue to implement the EU SME Facility.
As experience shows that this capacity-building programme for the financial sector
has been particularly successful in reaching its objectives, it is expected that the EU
SME Facility may be enlarged to the pre-candidate countries of South Eastern Europe
as part of the Instrument for Pre-Accession Assistance (IPA) initiatives from 2007
onwards. In the EU candidate and pre-candidate countries, a combination of
performance fees and technical assistance will continue to be used to achieve the
potential transition impacts.

¾ In the new Member States, the Bank will implement the EU/EBRD Preparatory
Action programme, which is an evolution of the SME Facility with the aim of
encouraging microfinance in particular. Since the EU SME Facility has widely
demonstrated the potential for banks and leasing companies to serve the SME market
segment in the new Member States, technical assistance for institutional building will
focus on expanding further into the MSE segment. Under this programme, no
performance fee support will be provided.

¾ To support improved access to finance for the development of SMEs and

development of micro-credit, the Bank will co-operate with the European Investment
Fund in the implementation of a new EU initiative, JEREMIE (Joint European
Resources for Micro to Medium Enterprises) which will be available from 2007
onwards in the Member States. In particular, the programme will address the need to
enhance support for start-ups and micro-enterprises through technical assistance,
grants, as well as non-grant instruments such as loans, equity, venture capital or
guarantees. In line with its mandate, the EBRD will engage selectively with
countries and instruments where the transition gaps have been identified.

¾ The Bank will mobilise donor funding to implement programmes similar to the
EU/EBRD SME Finance Facility in countries that have not yet been covered or are in
an immature stage of development. Examples are the Western Balkans SME Finance
Facility, and Ukraine.

¾ Leasing may in some cases be the only funding source available to SMEs as SMEs in
many instances cannot afford other ‘traditional’ bank financing. On the other hand,
leasing is a key part of more developed financial markets and it generally follows the
development of the banking system as financial sectors become more advanced and
adequate legislation is in place. The Bank’s goal is to continue to work with leasing
companies to improve their lease underwriting to reduce losses and ensure their long-
term viability.

¾ Risk-sharing is one way to alleviate bank balance sheet and equity requirements
under Basle II, which should be fully implemented by the end of 2006. The Bank is
planning to introduce risk-sharing products for banks’ SME portfolios in the more
advanced markets. This will be a key product with which the Bank will remain
additional including in the advanced countries.

15
3.4 EXISTING PORTFOLIO AND INDICATIVE PROJECTION FOR MSME BUSINESS

The table below shows both the Bank’s current exposure and the indicative volume of
new commitments to the MSME business by the end of 2008.

EUR mln. MSE Specialised Non-bank SME SME leasing Totals

local Microfinance Microfinance financing through
partner Banks Institutions through established
banks established leasing
partner banks companies
Existing
CEB - - - 433 232 665
SEE 3 55 1 265 39 363
ETC 20 14 - 89 1 124
CIS non-ETC 149 56 - 169 12 386
Totals 172 125 1 956 285 1,539
Planned 2005-8
CEB 0 0 5 100 100 205
SEE 10 30 40 200 150 430
ETC 60 15 20 65 10 170
CIS non-ETC 195 50 10 380 100 735
Totals 265 95 75 745 360 1,540

3.5 CO-ORDINATION WITH OTHER IFIS AND DONORS

The Bank co-ordinates with other IFIs and donors active in its countries of operation on a
regular basis in order to ensure the most effective focus of the Bank’s MSME
programmes, utilisation of donor technical assistance funds and platform for policy
dialog on specific MSME related issues. Tangibly the Bank has jointly established
twelve microfinance banks jointly with other IFIs and bilateral agencies. In other
instances, the Bank has been able to attract additional funding for its client financial
institutions from other international and bilateral financial institutions.

Going forward, the Bank will continue to closely co-operate with other agencies.
Specifically the Bank will seek to establish common benchmarks with other institutions
to better measure the breadth, depth and effectiveness of its MSME programs.

16
4. NEW PRODUCTS AND CHALLENGES

4.1 NEW PRODUCTS

A number of new products and areas will continue to be explored as the Bank seeks to
enhance the impact of its operations with MSMEs and to leverage its own resources. The
following concepts are early exploratory stage.

¾ Support to non-bank microfinance institutions (MFIs): ETC Framework & other

countries

A recent study of microfinance across Central and Eastern Europe and the CIS found that
nearly 6,000 microfinance institutions operated in the region – approximately a third of
all microfinance was undertaken by traditional financial intermediaries i.e. commercial
banks (including formalised microfinance banks). The remaining two thirds of all
microfinance was provided by non-bank MFIs (credit unions, finance companies,
NGOs).

Non-bank MFIs provide an important new delivery mechanism for the Bank and a first
framework facility for providing on-lending funds to such institutions in the ETCs was
approved this year and should be fully committed by early 2006. Technical assistance
will support these MFIs in their efforts to transform into sustainable institutions. The
Bank will also look at ways of delivering funding to successful non-bank MFIs across the
Bank’s countries of operation.

¾ Local Currency Financing

A significant part of the demand for microfinance is in local currency, whereas much of
SME finance can be provided in USD or EUR given that SMEs are more likely to be able
to match their loan service payments with export earnings. The Bank has already
successfully engaged in local currency financing through programmes in Hungary and
Russia. Going forward, Kazakhstan, Bulgaria and Romania may be considered as well.
However, providing local currency loans to partner organisations remains a key
challenge in other countries.

The Bank is exploring various ways to raise local currency, including standby credit lines
and the issuance of securities. The proceeds of such initiatives could be on-lent on a long
term basis to partner institutions. The feasibility of such attempts is of course dependent
on the level of development of local capital markets, and in the meantime foreign
currency based MSME programmes remain highly successful even in countries such as
Kyrgyzstan and Tajikistan.

17
¾ Microleasing

Entrepreneurs in the MSE sector requiring asset finance are frequently caught in a
“missing middle” between products available from MFIs (often short-maturity) and those
available from leasing companies (often too high value). Leasing provides a solution to
the problem of lack of collateral faced by smaller businesses mostly involved in the
production sector. The Bank could potentially play a role in downscaling existing leasing
operations to amounts that could benefit MSE clients, or assisting non-bank MFIs to
develop this product. Building on the experience of the EU/SME leasing programme
will be critical in this respect.

¾ Risk Sharing

In the most advanced countries of the Bank’s operation Basle II will need to be
implemented by the end of 2006. The Bank is developing risk-sharing products where
the Bank would share the risk of SME portfolios of partner banks. This product will be
highly additional as it is critical to alleviate bank balance sheet and equity requirements.

A further development would be the securitisation of loan portfolios. Though the legal
framework in the Bank’s countries of operation tends to make securitisation fraught with
difficulty, the quality and uniformity of MSME portfolios in our partner institutions
would suggest that securitisation could possibly become an innovative and useful
instrument, especially as loan portfolios are reaching a serious critical mass in a number
of partner institutions.

¾ Credit Scoring

Current lending methodologies in EBRD MSME programmes have proven to be able to

generate excellent quality loan portfolios yet it would be appropriate to explore the
possibility of shifting to credit scoring mechanisms where and when wage costs become
excessive for currently used methodologies, and begin to affect the
profitability/sustainability of programmes for partner institutions. Credit Scoring has
long been seen as the logical next step in terms of improving efficiency, profitability and
sustainability of operations with MSMEs. So far, most Bank MSME programmes have
focussed on achieving the maximum possible efficiency, while remaining within the
existing state-of-the art lending analysis techniques which involve case-by-case
assessment of the client’s ability to repay. Any new initiatives in this arena could
usefully build on the experience gained with a number of financial institutions under the
technical assistance programme of the EU/EBRD SME Finance Facility.

¾ MSME Focussed Equity and Loan Funds

Consideration will be given to investing in or alongside the increasing number of

regional funds which have been created to invest in financial institutions with a strategic
commitment to the MSME market in the Bank’s countries of operation. Clearly, in such
cases the Bank will need to be convinced of the capabilities of the Fund Manager,
especially in terms of the value-added they will bring. Shorecap, which is a global fund
with an MSME focus, is an interesting model in this respect, as it brings its technical
expertise to bear on its investee institutions. A regional fund for South East Europe is
presently under preparation.

18
¾ TAM/BAS Innovative Programmes

TAM/BAS has taken many initiatives in 2005 and the following will be broadened:

• “Cross-border” programmes;
• Women in Business projects;
• Tourism programmes;
• Utilisation of TAM/BAS methodology and expertise for environmental
programmes (in collaboration with the Environment Department) and for
development of business incubators;
• Support of privatization programmes in the Western Balkans

4.2 CHALLENGES

¾ Technical Assistance Requirements

There will remain a need for significant TC funding to support MSME lending initiatives
in the coming years, and the Bank will continue to rely on the generosity of many
interested donors to provide this funding. Recent years have seen the ratios of TC spend
relative to lending volume in constant decline as programmes and banks mature and
move away from the necessarily high levels of start-up TC funding. The Bank’s clear
intention is to leverage as far as possible the sunk cost of existing and spent TC, and
constantly strive to improve TC efficiency ratios in all programmes.

To support the level of new business foreseen from 2006-2008, the approximate level of
TC funding required would total up to EUR 100 million across all products and
countries.

¾ Staffing

The planned increase in exposure for MSME lending initiatives will lead to heightened
monitoring requirements as regards the implementation of the programmes and the
utilisation of the Bank’s funds. It is anticipated that these needs will be addressed in
team business plans primarily by increasing staffing in Resident Offices, since
monitoring activities need to be undertaken through close contact and co-operation with
those involved in project implementation.

19
5. CONCLUSIONS
Providing support for the development of MSMEs is and will remain one of the Bank’s
core businesses going forward. Each of the Bank’s countries of operation has specific
needs which reflect the varying stages of transition and development of their MSME
sectors. In response, the Bank has to have at its disposal a wide range of different
instruments to address these requirements effectively, and must be prepared to adapt the
use of these instruments over time in order to reach the different sub-segments within the
overall MSME sector, and to push outward the frontiers of private sector development.
Established commercial financial institutions will be the main channel to deliver these
products.

Established commercial financial institutions will be the main channel to deliver these
financial products, while TAM/BAS will add value by strengthening competitiveness and
all business aspects, including management skills of individual MSMEs.

The need for the Bank to support the MSME sector in Central Europe is expected to
decline gradually and to move towards more difficult segments and regions. In all other
countries of operation, it is likely to remain a core business for the foreseeable future,
especially the ETCs.

The measure of the success of the Bank’s MSME strategy will be seen in evidence that
partner institutions across countries of operation are sourcing increasing proportions of
funding for MSME lending from the private sector, either via commercial banks or
private depositors, and sustaining increased levels of activity that have been associated
with the Bank’s operations. The allocation of non-IFI, non-directed funding to MSME
lending will indicate that the business has developed sufficiently to be incorporated by
partner banks as a regular core profitable business line. At the same time, the ability of
specialised microfinance banks to attract private sources of equity will indicate the extent
to which these institutions have progressed towards financial sustainability. When these
benchmarks for success are attained, the Bank can be reasonably assured that MSMEs
will have increased and sustainable access to finance from the formal financial sector,
which is the ultimate goal of these operations.

20
Annex 1: MSME Definitions

The Bank has traditionally defined its target group of the smallest borrowers by using a
definition based on sub-loan size. In some programmes the Bank has tried to specify its
target further by including a definition based on the number of employees of the sub-
borrower.

Loan Size – In the EU/EBRD SME Facility a micro loan/lease is a loan up to a maximum
of €30,000, and a small loan/lease between €30,000 and €125,000. In the MSE lending
programmes a micro loan is a loan up to US$ 10,000 and a small loan can go up to
$200,000. Other credit lines targeting SMEs have traditionally exceeded the loan size
targets of the two types of programmes mentioned above.

Sub-Borrower - MSMEs are often defined in terms of the size of the sub-borrower, either
by the number of employees, value of assets or the company’s turnover. If one used the
EU SME definition then microenterprises are companies with up to 9 employees
(including sole proprietors), small enterprises have between 10 and 49 employees and
medium companies have between 50 and 249 employees. This definition has been
adopted in all new EU member countries, in countries currently negotiating for
accession, and in countries aspiring to begin negotiating for accession. It has to be noted
however that in some of the EBRD countries including those from SEE aspiring for
accession, adopting the EU definition would de facto include all enterprises in the
country. In this respect talking about targeting SMEs would be equivalent to targeting
any enterprise in the country, in other words invalidating the effort of targeting only the
smaller borrowers (this is relevant if smaller size of the company is indeed associated
with higher risk perception and information asymmetries). Therefore there might be a
case to adopt tighter definitions for SMEs than the EU definition in countries at earlier
stages of development.

Maturity - Microloans tend to be for shorter maturities than small or medium sized loans
and for short-term working capital needs. Longer maturities are needed for the purchase
of productive assets and these tend to be for larger loan amounts.

Price - Shorter maturities and smaller loan sizes tend to command a higher price,
reflecting the higher transaction costs.

Delivery Mechanisms - Each of the EBRD MSME programmes specialise in different

sub-segments within the full range of MSME clients. The programmes with
microfinance banks and MSME participating banks tend to focus on smaller clients with
smaller average loan amounts at shorter maturities than do the EU/EBRD-SME
programmes with participating banks and leasing companies. Other SME credit lines
target even larger clients at longer maturities.

21
Annex 2: Assessment of Transition Challenges for MSMEs

Two impediments to MSME growth at the start of transition resulted from vested
interests against market entry and competition and from rigidities in the labour and
property markets (lack of skilled labour and business premises). In addition, the SME
sector was highly credit constrained due to the banking sector’s focus on lending to large
and/or foreign owned enterprises. Finally, administrative and fiscal measures appropriate
for the MSME sector were not in place. These four challenges define the elements of the
MSME transition process:

Structure and extent of markets

• Development of simple and transparent entry procedures (removal of laws and
regulations preventing MSMEs entry and creation of clear and transparent
administrative channels in which all formal requirements, including tax payments,
can be dealt with). Best practice includes creation of one-stop shops for company
registration; possibility to register on-line, short time needed to register a business,
adoption of principle of “silence equals consent” on the part of the authorities.

Market institutions and policies

• Development of a legal and regulatory framework conducive to MSME development,
including simplification of the tax system for MSMEs. Specific measures may
include: the creation of a flat rate structure for enterprises below a certain size
(presumptive taxation), dispensation from detailed reporting / accounting
requirements, limits on the discretion of inspecting officials and the improvement of
systems for dispute settlement and contract enforcement. In order to promote tax
compliance one important measure is to encourage and support MSMEs
representative organisations to actively participate in the government’s consultative
process on tax legislation and regulation.
• Introduction of an institutional, legal and regulatory framework supportive of the
development of MSME commercial finance, targeting broader sharing of credit
information and stronger legal rights in and out of bankruptcy. Best practice would
include the creation of public credit registry (a database managed by the public
sector) and/or of private credit bureaus (private firms or a non-profit organisations)
that maintain a database on the standing of borrowers in the financial system and
facilitates exchange of credit information among banks and financial institutions.
• Improved access to skilled labour through measures to increase labour mobility, such
as the expansion of job centres in order to reduce search costs, and improved access
to business premises through development of property markets and underpinned by
necessary privatisation legislation.

Market-based conduct, skills and innovation

• Transfer of commercial skills to MSMEs, for example, business strategy and
planning. Establishment of business support environment (establishment of
commercial associations and provision of suitable locations with appropriate utilities,
e.g. business parks). Business advisory services are best managed and operated like
commercial entities, even though they might initially have been set up by IFIs,
donors and/or governments with subsidies.
• The transfer of MSME financing skills in order to increase access to external finance.
Best practice includes the existence of banks that have regional branch networks and
specialised SME departments (credit officers trained in SME lending and rural
lending), and/or dedicated micro-finance banks, and NGOs targeting the start-up
22
 segment of the market on commercial and sustainable basis. In these contexts,
targeted and time-bound subsidies can support training and fostering a culture of
credit within existing providers of finance to the MSME sector.

Remaining transition challenges were assessed against these transition milestones and
rated on a scale from negligible (smallest remaining challenge), small, medium to large
(largest remaining challenge). The following table summarises the assessment.
Structure and extent of Market institutions Market-based
Country markets and policies behaviour
Albania Large Medium Medium
Armenia Small Large Large
Azerbaijan Large Large Large
Belarus Large Large Large
Bosnia Large Large Small
Bulgaria Medium Medium Small
Croatia Small Small Large
Czech Republic Medium Small Medium
Estonia Small Small Medium
FYR Macedonia Medium Medium Medium
Georgia Medium Large Small
Hungary Medium Small Medium
Kazakhstan Medium Large Small
Kyrgyz Republic Medium Large Medium
Latvia Medium Small Medium
Lithuania Medium Medium Medium
Moldova Medium Medium Medium
Poland Medium Medium Medium
Romania Medium Medium Medium
Russia Medium Large Large
Serbia Medium Medium Medium
Slovak Republic Small Medium Medium
Slovenia Medium Small Medium
Tajikistan Large Large Medium
Turkmenistan Large Large Large
Ukraine Medium Large Medium
Uzbekistan Large Large Large

23
Annex 3: Group for Small Business – Historical Performance

(i) GSB commitment volumes

GSB has executed 139 projects since 1994 for a cumulative signed volume of EUR
541.9m (USD 650m). To the end of 2005 EUR 448.3m (USD 538m) has been disbursed
and the current outstanding committed portfolio is EUR 354.2m (USD 425m).

See the table below for details of how GSB’s business volume has developed over the
years:

Year Total Project Value EBRD Share Number of

(EUR m) (EUR m) Projects*
1994 23 12.2 15
1995 13.9 8 8
1996 65.8 30.8 15
1997 24.5 11.2 7
1998 130.6 116.7 7
1999 11.1 1.8 3
2000 166.8 84 10
2001 105.1 46.4 7
2002 59.9 23 9
2003 111.2 83.4 17
2004 97.5 68.1 18
2005 85.3 56.4 23
Totals 894.8 541.9 139

* The figures represent the number of projects shown as signed for each year in DTM at the operation
level. Some of these operations include both debt and equity facilities which are not counted separately.

24
(ii) MSE sub-loan statistics as at December 2005

Country Start Date No. of loans US$ amount of loans US$ average Arrears % > No.of Active
granted granted loan amount 30 days Loan Officers

Albania Feb-99 39,846 257,560,547 6,464 2.11% 101

Armenia Oct-02 15,991 37,722,721 2,359 0.05% 33
Azerbaijan Nov-02 13,713 46,737,594 3,408 0.36% 79
Belarus Apr-01 2,896 39,396,747 13,604 0.00% 10
Bosnia Nov-97 58,685 267,872,771 4,565 0.48% 154
Bulgaria Oct-01 64,794 577,930,286 8,920 0.31% 150
Georgia May-99 99,080 463,178,890 4,675 1.47% 299
Kazakhstan May-98 177,048 1,195,979,897 6,755 0.77% 666
Kosovo Feb-00 39,184 361,567,711 9,227 0.69% 140
Kyrgyz Republic Apr-02 37,777 71,488,675 1,892 0.73% 247
Macedonia Jul-03 23,868 123,165,628 5,160 1.50% 103
Moldova Dec-99 26,657 67,135,156 2,518 1.14% 76
Romania May-01 34,672 228,232,961 6,583 1.46% 100
Russia Aug-94 291,474 2,644,438,213 9,073 1.00% 662
Serbia & Montenegro Apr-01 81,250 536,094,848 6,598 0.72% 420
Tajikistan Oct-03 24,982 31,538,137 1,262 0.25% 122
Ukraine Sep-98 224,001 1,288,622,528 5,753 0.60% 1468
Uzbekistan Apr-01 21,783 53,360,280 2,450 0.27% 140

TOTAL 1,277,701 8,292,023,589 6,490 0.84% 4,970

Number of Loans Disbursed to end December 2005

600,000

500,000
492,796

400,000

330,254
300,000

200,000
198,786

100,000 119,746
64,380

0
2001 2002 2003 2004 2005

25
 USD Volume of Loans Disbursed to end December 2005

3,192,598,591
3,500,000,000

3,000,000,000

2,500,000,000 1,962,377,080

2,000,000,000

1,212,151,638
1,500,000,000

738,956,594
1,000,000,000 478,395,481

500,000,000

-
2001 2002 2003 2004 2005

(iii) Year by year TC Committed and Disbursed by GSB

The total amount of TC committed by GSB comes to USD 187.9 million, and the
year-by-year breakdown is as follows:

Technical Cooperation Funds Committed to 2005

30,000,000

25,000,000

20,000,000
USD

15,000,000

10,000,000

5,000,000

0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

26
 Technical Cooperation Funds Disbursed to September 2005

25,000,000

20,000,000

15,000,000
USD

10,000,000

5,000,000

0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

27