Vol.7 (2009)
DHIKARY

© Institute of International Relations and Area Studies, Ritsumeikan University
DHIKARY
*
The paper delineates deficiencies of the existing financial system in Bangladesh in order to cater the financing needs of SMEs specially those requiring finance in the range of US$15000 to
US$30000 and are regarded as ‘missing middle’ in the country.
The paper unearths that the banking system in Bangladesh requires collaterals almost double the size of requested loans, which most SMEs are unable to offer. Further, submerged in high amounts of non-performing loans (NPLs) with very low return on assets (ROA), the banking system does not prefer to bank on uncertainties. The paper argues that non-government organizations
(NGOs) and the ‘capital markets’ in Bangladesh also face systematic problems in catering to the financing needs of SMEs. The paper suggests that venture capital financing tool might be a suitable option to supply both the financing and non-financing requirements of SMEs as they practice a ‘participative management’ approach and exercise ‘due diligence’ technique in disbursement of credits.
JEL Classification: G21, G24
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Vol.7, pp.91-124 (2009).
* Assistant Professor, Ritsumeikan Asia Pacific University
1-1 Jumonjibaru, Beppu, Oita 874-8577

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Financial System, Bank, NGOs, Capital Market, SMEs and
Venture Capital.
Despite the fact that small and medium enterprises (“SMEs”) 1) constitute a vital sector of the economy of Bangladesh in terms of creation of industrial output and generation of employment (SMEs of Bangladesh account for almost 82% of the total industrial labor force and share nearly
35% of the gross output of the entire manufacturing sector) 2) , they face a severe crisis of capital for their growth and development. A most recent private enterprise survey reveals that 58% of the SMEs suffer from a lack of investment funds and 35% suffer from a lack of operating funds in
Bangladesh (Daniels, 2003). Another recent survey conducted by the
Bangladesh Garment Manufacturers and Exporters Association (BGMEA) in Dhaka city in 2003 reveals that 53% of the Readymade Garment (RMG) 3) businesses, which is a vital part of SME sector, receives only working capital from banks whereas 28% of them do not receive any financial supports.
SMEs relating to the export sector also have the problem of accessing working capital and there is no credit insurance policy for them 4) . These situations have created an interest in identifying available sources of
1) The Industrial Policy, 2005 defines small scale enterprise as an industrial undertaking engaged either in manufacturing or trading or in service activity with a total investment of less than Taka 1.5 crore in fixed capital excluding the value of land and factory building and having less than 25 workers. Similarly, a medium enterprise is defined as an industrial undertaking involved either in manufacturing or trading or in service activity with a total investment within the range of Taka 1.5 crore to Taka 10 crore excluding the value of land and factory building and having 25 to 100 workers. Again, Bangladesh Bank defines small and medium enterprise as an undertaking having not more than 60 workers with total assets between Taka 50,000 and Taka 1,00,00,000 for manufacturing, 20 workers having total assets between Taka 50,000 and Taka 50,00,000 for trading and 30 workers having total assets between Taka 50,000 and Taka 30,00,000 for service sector.
2) The data is obtained from the fifth five year plan, 1997-2002.
3) We are referring to the RMG sector because this sector alone accounts for more than 75% of total export earnings of the country, and provide employment directly to 1.5 million women and indirectly support employment up to 15 million. (Fifth five year plan, 1997-
2002).
4) Credit insurance is the insurance against the risk of non-payment by the buyers of importing countries.

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DHIKARY ） 93 finance for SMEs in Bangladesh as well as examining any alternative options for catering their financing and non-financing needs.
Broadly, sources of finance for SMEs in Bangladesh can be categorized into three major groups. They are the ‘banking sector’, the ‘non government organizations’ (“NGOs”) and informal players like money lenders, friends, relatives, “samity”, unregistered cooperatives and so on, and the
‘capital market’ of Bangladesh. As it is elaborated in the following section, these players (banking system, capital market and NGOs along with informal players) point to the gap within the existing financial system of
Bangladesh for catering to the financing needs of the SMEs, specially those that are not backed by collaterals and do not have a minimum asset base as well as a history of operation.
It is generally observed that NGOs basically provide finance in the range of US$100 to US$3500 and institutionally speaking, are unable to provide large loans. Besides, the capital market requires a minimum asset base, which the entrepreneurs of SMEs cannot offer. Finally, the banking system is burdened with high NPLs, moral hazards and incentive problems and prefers to provide credit under certainty and as such prefers collateralized lending. However, those entrepreneurs who graduated from the micro level to small and medium enterprises and require credit in the range of ‘US$15000 to US$30000’ 5) for their expansion and growth, generally lose out on the attention from all markets. They are popularly known as ‘missing middle’ in the country.
The basic purpose of this paper is to explore avenues to fill this gap of financing.
Figure 1 illustrates this gap.
5) This figure is obtained through personal discussions with bank officials.

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Minimum asset base, history
【 Vol. 7
Size of credit
(US$ 100
3500)
Collateral ,
High NPL, moral hazards
No access to f inancing (US
$ 15000 to 30000)
The research question is - how do we fill this gap of financing?
Can we rely on the banking system of Bangladesh to fill this gap? In fact, the banking system of Bangladesh accounts for 72% of public deposits
(Sayed, 2001) and is a pre-dominant player within the financial system and consequently they should take the responsibility. Or, can we ask the
NGOs to come forward? In fact, NGOs successfully disburse micro credit in the rural financial markets of Bangladesh with a high loan recovery performance (more than 90% on an average). Or, can we bank on the capital market of Bangladesh to take care of the SMEs? Or, should we develop an additional financial intermediary to fill this gap in financing?
These are the basic issues that have been dealt with in this paper.
The assumption is that in the present economic scenario of
Bangladesh, it might be difficult for these players (banking system, capital market and NGOs) to successfully cater to the financing and nonfinancing needs of SMEs. And, this paper proposes that the venture capitalist might be another alternative option to cater to the financing

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
DHIKARY ） 95 and non-financing needs of SMEs.
We are aware about the fact that the venture capital as a financing tool is mainly operative in industrialized countries to finance new technologies and innovations and deems more suitable to the Anglo -
American type of financial system. However, it is to be noted that entrepreneurship and innovation have quite different meanings in developing countries as compared to their industrialized counterparts. Entrepreneurs of industrialized countries initiate unique products, services and processes, whereas entrepreneurs in developing countries just imitate existing products, services and processes of the industrialized countries that are considered new for their own local markets and usually, this sort of imitative innovation is undertaken by entrepreneurs of SMEs. This paper is concerned with financing of the imitative innovation, not the radical one.
1.2: Research Methodology
The paper mainly uses secondary information and the philosophy of new institutional economics, financial economics and transaction cost economics to construct opinions logically. In order to obtain secondary information relating to the financial system of Bangladesh, the Annual Report of Bangladesh Bank, Economic Trends, the SAPRI SME Survey Report,
Bangladesh Economic Survey, Reports from the Planning Commission of
Bangladesh, ADP outlook, Reports from Bangladesh Enterprise Institute, the BGMEA Survey Reports and different scholarly articles have been referred to. In order to obtain secondary information on venture capital organizations as well as the growth and dimensions of venture capital industry round the globe, a combination of databases, directories and journals has been used in this paper. These include, LEXIS- NEXIS
( www.lexis-nexis.com), Venture Economics (www.ventureeconomics.com),
Asian Venture Capital Journal ( www.asiaventure.com), Money Tree
Survey Report, Pratt’s Guide to Venture Capital Sources, European
Venture Capital Journal (www.eva.com), Private Equity Week, Venture
Capital Year Book, Guide to Venture Capital in Asia, National Venture
Capital Association Year Book ( www.nvca.org), National Venture Capital
Association, Venture One Database ( www.ventureone.com), Directory of
Operating Small Business Investment Companies (www.sba.gov), Venture
Capital Report, MIT Press (www-mitpress.mit.edu), Equity Finance

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(www.willey.com), Asset Alternatives (www.aspenpub.com) and so on.
Necessary statistical tools have also been applied, to analyze relevant data.
1.3: Outline of the Paper
The paper is organized as follows: section 2 provides the theoretical foundation as well as a brief literature review of the study. Section 3 evaluates in details the existing problems and constraints of the major players within the financial system of Bangladesh. This section covers the banking system of Bangladesh, capital markets and NGOs - the three main players that oversee the credit needs of the country. This evaluation is quite essential for understanding whether Bangladesh needs an additional financial intermediary or not to cater to the financing requirements of SMEs. Section 4 examines the potential of the venture capital financial tool in comparison to banks in supplying financial and non-financial requirements of SMEs. This section also provides evidences of venture capital financing in UK and the USA. Section 5 discusses how to construct the venture capital industry in Bangladesh. Finally , section 6 presents summary and concluding remarks.
Section 2: Theoretical Foundation
Banking systems of developing countries mainly channel funds to deficit sectors as stock market usually suffers from solid base of private investors followed by questionable transparency and accountability.
However, the banking system in the developing countries does not practice a deposit insurance system and depositors deposit their money in a particular bank solely on the basis of ‘trust’. Therefore, it is the basic philosophy of the banking business to protect this trust by not allocating the depositor’s money to risky ventures. This implies that bankers by nature cannot afford risky ventures thereby preferring collateralized lending. On the other hand, SME financing is incompatible with the philosophy of the banks as it increases transaction costs and moral hazards. Figure 2, shown below, presents characteristics of SMEs and Banks and exhibits a
‘strategic mismatch’ situation in terms of their inherent characteristics.
The strategic mismatch situation arises because banks are regarded as passive investors, as opposed to active investors, which is an essential prerequisite for SME financing. Therefore, theoretically, we can pre-suppose

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
DHIKARY ） 97 that that bankers’ cannot extend credit to enterprises which have uncertain futures - (SMEs), as this might destroy important yardsticks like confidence, trust, reputation and robustness within the sphere of banking operations.
Characteristics of Banks
Deals with depositors money
Trust is the foundation (no deposit insurance)
Reputation is success
High viral fever (contagious effect)
Characteristics of SMEs
- Lack of capital base
Owner manages firm
Lack of standard product
Lack of marketing network and intelligence
Poor accounting records
PASSIVE INVESTOR
Avoids risky transactions
Prefers securitized transactions
Strategic
Mismatch
ABOVE AVERAGE RISK
Risk and uncertainty dominates
The present lending behavior of the banking system in Bangladesh is based on collateral. Bankers want to avoid ‘uncertainties’ 6) as well as
‘credit crunch’ 7) . Among many reasons, the huge amount of non-performing loans (13.56% in 2005; Annual Report 2005-2006, Bangladesh Bank) 8) with a very low percentage of return on assets (0.6% in 2005; Annual
Report 2005-2006, Bangladesh Bank) make it mandatory for policy makers to direct all their efforts to curbing non-performing loans (“NPLs”) by
6) Suzuki (2004) states that the credit risk and uncertainties of banks (as an agent) are increased when the economy graduates from the ‘catching-up stage’ to the ‘frontier stage’, which restricts agents from undertaking risky projects and demands ‘socialization of credit risk and uncertainties’ to prevent contagious bank runs.
7) Banks are not interested to invest in uncertain SMEs, as this leads to the accumulation of non-performing loans. High amounts of non-performing loans usually shrinks operating margin of the banks and erode the capital base of the banks to advance new loans which is sometimes referred to as credit crunch.
8) In 1999, banking system of Bangladesh recorded NPLs as 41.11% of total disbursed loans.

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FFAIRS 【 Vol. 7 way of transferring risks to bank officials. This situation, in fact, has compelled bank officials to extend credit only under ‘secured circumstances’ ensuring enough tangible securities to be held as collateral. Since most
SMEs are characterized by uncertainties and lack tangible assets (that they pledge to banks as collaterals), they are usually deprived of receiving finance from banks in Bangladesh. This fact is observed from various studies and micro surveys relating to SMEs in Bangladesh. For instance,
Hossain (1998), Qureshi (2000), Bhattacharya (2000) and Akhtaruddin
(2000) mention that in most cases banks and non-bank financial institutions of Bangladesh require collateral, almost twice the amount of requested loans, in the form of land and buildings in lieu of getting loans by large enterprises as well as SMEs. SMEs are also regarded as high risk borrowers by bank officials because of their low capitalization, insufficient asset base and high mortality rates and consequently, they are not offered any attractive deals in terms of loans and interest rates (Sia, 2003). Banks are further seen to be conservative in nature in lending to SMEs, as they do not consider them as attractive and profitable undertakings
(Bhattacharya, 2000; Sia, 2003).
Importantly, the SAPRI SME survey (1999) 9) has revealed a bunch of factors (barriers) both on the demand side (borrowers’ perception) and supply side (bankers’ perception) that hinder the growth and development of SMEs in Bangladesh. On the demand side, the report (SAPRI SME survey, 1999) mentions that 79.4% of SME borrowers face collateral problems in obtaining credits from different commercial banks. The second most problem they face is bribe (66%), which actually increases their cost of funds. They also face problems in certain other factors like delay in getting loans (54.6%), high interest rate (39.2%) disinterest from the part of banks (27.8%), requirement of guarantees (27.80%) and harassment
(11.3%). Besides, the SAPRI report also mentions that 55% of the borrowers had to visit the bank for 8-15 times, while 20% required to visit for 16-
30 times as compared to one time in the case of money lenders, Samity and friends in order to get funds. This entire situation, in fact, has increased the cost of funds in doing businesses and created frustration in the minds of the entrepreneurs of the SMEs.
On the supply side barriers, the report (SAPRI) mentions a bundle of
9) SAPRI SME survey was conducted on 500 SMEs in Bangladesh (these include RMG, leather and agro-based industries).

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
DHIKARY ） 99 factors like the requirement of collateral, equity margin, high transaction costs, shortage of skilled manpower, high risk premium, lack of profitability, lack of standard product, lack of market access and so on that prevent the banks not to disburse credit to the SMEs and start-ups. Finally, financing of SMEs has become very difficult proposition for the bankers’ because of the prudential and supervisory regulations adopted by
Financial Sector Reforms Project (FSRP) 10) in 1990, which have impacted all categories of borrowers. In fact, the banking system at present requires receiving detailed financial statements from the borrowers including projected cash-flow statements, solvency and liquidity ratios, equity declarations and income tax declarations, which have hindered easy access to credit by SMEs in general.
Beside these problems on the supply and demand sides, it would be worthwhile to note that most SMEs in Bangladesh are family owned and they lack knowledge of strategic planning, and marketing, have no commitment to quality, show little or no knowledge of quality systems, are unable to communicate in foreign languages, and have no experience in cash-flow management or application of information technologies to business – factors which are considered essential to survive in an internationally competitive market environment (SAPRI, 1999). It is important to note that Bangladesh has been following the system of an open market economy since the 1990s and Ahmed (1999) states that in a liberalized developing economy like Bangladesh, SMEs are exposed to tougher competitive conditions both from domestic and international markets and might end in prematurely termination of their operations, if adequate financial and non-financial support is not provided to them timely.
Section 3: Analysis of the Structure of the Financial System of
Bangladesh
The financial system of Bangladesh encompasses Bangladesh Bank
(BB) as its central bank, four (4) nationalized commercial banks (“NCBs”), thirty (30) private commercial banks (“PCBs”), ten (10) foreign commercial
10) Before adopting FSRP, the banking system of Bangladesh lacked prudential laws and regulations and it was easier to obtain credit. There was no provision for classifying non performing loans and bank officials practiced the accrual principal of accounting to book interest on loans. So, they did not feel the need to assess the credit risk of the borrowers.

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NBFIs include specialized institutions (“SIs”) like house building finance corporations, the investment corporation of Bangladesh, leasing and finance companies, government cooperatives and ‘specialized public institutions (“SPIs”) like the post office savings scheme (figure 3).
Ministry of Finance
Controlled market
Formal Financial Market
Bangladesh Bank
Semi formal Financial
Market
Non controlled
Market
Insurance
Company
Informal Financial
Market
NGOs, Grameen Money lenders, friend s/relatives
Unregistered Co-ops.
Banking FIs Non-banking Fls Stock Exchanges
NCBs SIs
COBs
DSC
CSC PCBs
FCBs SPIs
SBs Figure 3 : Financial System of Bangladesh.
Source : Constructed by author.
All these institutions mainly play in the ‘formal financial market’ 12) and are controlled by Bangladesh Bank. The financial System also embraces 49 insurance companies and 2 stock exchanges (figure 3). There are also more than 3000 NGOs and a large number of registered cooperatives that play a significant role in the semi-urban and rural financial markets of Bangladesh. They are popularly known as ‘semi-formal’ as they have their own rules and regulations and are not controlled by
Bangladesh Bank or by the Ministry of Finance. They are guided by the
11) SBs were earlier known as ‘Development Financing Institutions (DFIs) ’.
12) Formal financial market is controlled by Bangladesh Bank and the Ministry of Finance.

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Societies Act 1861, which does not permit them to conduct business activities. Besides, there is an informal market, which is mainly dominated by friends, relatives, moneylenders and non-registered cooperatives, and they do not have any formal rules and regulations. Obviously, they are outside the purview of any controlling body (figure 3).
In the formal market, Bangladesh Bank, as the central bank, performs the traditional central banking role of note issuer and act as a banker to the government and all commercial banks. It formulates and implements monetary policies, manages foreign exchange reserves and supervises all banks and non-bank financial institutions. Its prudential regulations include minimum capital requirements (Tk.1000 million for setting up a new bank), capital adequacy (9% of the risk weighted assets), limits on loan concentration and insider borrowing, CAMEL rating, guidelines for asset classification and income recognition etc. The transparency and accountability of the stock market is usually maintained by the
Security and Exchange Commission in collaboration with Ministry of
Finance and Bangladesh Bank.
In the banking sector of Bangladesh the four NCBs and the five SBs mainly cater to the credit needs of the SMEs of the country. Again, these
NCBs and SBs alone account for 45.8% of total deposits, 49.3% of total industrial assets and 73.81% of total bank branches and thus dominate the banking system (Annual Report 2005-06, Bangladesh Bank). The four
NCBs also supply finance to the state owned enterprises, although most of the state owned enterprises do not show profitability. Therefore, it is the prime responsibility of NCBs and SBs to ensure stability and robustness of the financial system by selecting appropriate borrowers who are not characterized by uncertainties.
But reality is that both nationalized commercial banks and SBs 13) are submerged in high amounts of non-performing loans (table A & B) and low
13) SBs are also state owned institutions and are responsible for catering to the funding needs of SMEs and other industries.

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FFAIRS 【 Vol. 7 profitability (table C) and they can no longer take the risks involved in the financing of SMEs. An investigative look at the NPL situation of NCBs and SBs from 1990 to 2005 unearths that while in 1990 NCBs accounted for 27.59% of their total loans as NPLs, the same increased to 45.62% in
1999 and then reduced to 21.35% in 2005 (table A). In case of SBs, the
NPL is still seen to be at 34.87% (2005), which was 42.8% in the preceding year (table A). Besides, NCBs and SBs are found to be the highest NPLs holders in case of term loans disbursed up to five years, which is 33.83% and 40.45% respectively (table B). The profitability of the NCBs and SBs is also seen as stagnant. For instance, return on assets (ROA) of both
NCBs and SBs is found to be at –0.1% in 2005, which was also negative in the year 2004 (table C). Also, NCBs maintained negative (-0.4%) capital adequacy ratio (CAR) as opposed to 9% in the year 2005.
Year NCBs PCBs FCBs SBs
1990 27.59 23.73 20.65 NA
1991 26.30 34.20 11.87 NA
1992 31.86 31.10 12.64 NA
1993 32.23 44.42 10.46 NA
1994 32.12 44.53 8.89 NA
1995 31.00 39.43 5.40 NA
1996 32.55 34.77 4.72 NA
1997 36.57 31.42 3.58 65.72
1998 40.38 32.72 4.14 66.70
1999 45.62 27.09 3.80 65.02
2000 38.56 22.01 3.38 62.56
2001 37.02 16.98 3.32 61.80
2002 33.73 16.38 2.61 56.19
2003 29.0 12.4 2.7 47.4
2004 25.3 8.5 1.3 42.8
2005 21.35 5.62 1.26 34.87 p g y yp
2005)
(
Table B : NPL percentage ratio by type of loans and bank clusters (December 2005)
Bank types Continuous loans
NCBs
PCB s
F CBs
SBs
Total
19.95
6.43
2.31
18.44
11.06
Demand loans
10.21
3.83
0.78
5.26
6.26
Term loans
Up to 5 years
33.83
5.91
0.9
40.45
13.20
Over 5 years
24.54
5.37
0.49
42.68
19.56
Micro and agriculture loans
47.09
2.03
0
39.20
41.80
Bangladesh Bank.

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Bank Types
NCBs
SBs
PCBs
FCBs
Total
Return on Assets (ROA) in percentage
1998 1999 2000 2001 2002 2003 2004
0.0
0.0
0.0
0.1
-2.8
-1.6
-3.7
-0.7
0.1
-0.3
0.1
0.0
-0.1
-0.2
1.2
0.8
0.8
1.1
0.8
4.7
3.5
2.7
2.8
2.4
0.3
0.2
0.0
0.7
0.5
0.7
2.6
0.5
-1.2
3.2
0.7
2005
-0.1
-0.1
1.1
3.1
0.6
Therefore, the present condition of NCBs and SBs does not allow them to take any additional risks that might increase their NPLs further.
Interestingly, the World Bank and IMF also create pressures on the policy makers of Bangladesh to curb the NPLs in order to receive loans and this situation has further influenced bankers’ to be conservative in disbursing loans to SMEs. Moreover, policies of prudential and supervisory regulations adopted by the Financial Sector Reforms Project (FSRP) in 1990 have made it mandatory for the banking system to insist on detailed financial statements from borrowers including projected cash-flow statements, solvency and liquidity ratios, equity declarations and income tax declarations for screening of loans. Regrettably, SMEs find it impossible to provide the same and this becomes an obstacle in their way of obtaining finance.
3.2: Additional Problems - NCBs and SBs
Beside the high amount of NPLs and low percentage of return on assets, nationalized commercial banks and SBs also suffer from some additional problems. For example, they mainly follow government instructions when disbursing credits and supply finance to the state owned enterprises despite knowing inefficiency of this sector. Also, the government instructs nationalized commercial banks to pay salaries of employees and conduct many transactions for other government services such as disbursement of monthly grants given to elderly people, disbursement of salaries and government scholarships, sales of government service application forms and taking of electricity, gas and water bills and so on in exchange for minimal or in most cases, no fees. This consumes significant time, costs and energy on the part of bank officials and adversely impacts the bank’s profitability. Further, the promotion system of nationalized

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3.3: Problems and Constraints of the Banking Sector of
Bangladesh - PCBs and FCBs
In order to provide finance to SMEs, however, one alternative might be to direct the domestic private commercial banks and foreign commercial banks. It is argued earlier in the introduction that they mainly practice branch banking in urban areas and do not feel any compulsion to open branches in rural or semi urban areas because of the presence of high transaction and monitoring costs. Although, at present, domestic private commercial banks book 5.62% (year 2005) of their total loans as non-performing, the same was booked as 12.4% in 2003 (table A). Interestingly, their ROA shows a declining trend, which was 1.2% in 1998, 0.07% in
2003 and –1.2% in the year 2004 (table C). Although, foreign commercial banks are found to be efficient in the management of NPLs (1.26% in
2005) and ROA (3.1%) when compared to PCBs, NCBs and SBs, they usually follow selective credit policies and are not in favor of disbursing loans to SMEs. Unfortunately, banking policies in Bangladesh also do not allow bankers to participate in the equity of the enterprises so that they can actively participate in the businesses of their clients thus reducing the transaction cost of monitoring 14) . In fact, the policy making institutions cannot direct the commercial banks to inject equities as this would create additional risks for the banks and might destroy the confidence of general depositors. Surprisingly, private commercial banks also lacked by skilled human resource to assess credit risks under uncertainties. Foreign com-
14) In SMEs, the transaction cost of monitoring is very high because of uncertainties. It can be reduced if lenders can participate in the management process. This would reduce information asymmetry and also transaction costs.

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
DHIKARY ） 105 mercial banks also behave in the same way as the domestic private commercial banks do, although they have low rates of NPLs. This implies that the entire banking system in Bangladesh faces institutional, financial and human resource problems in taking care of the financing needs of SMEs.
3.4: Sectoral Distribution of Advances by the ‘Scheduled Banks’ of Bangladesh
Sectoral distribution of advances by ‘scheduled banks’ 15) in
Bangladesh reveal the importance of small and cottage industries to have decreased over the years. While in 1987 ‘small and cottage industries’ received 3.32% of loans given by scheduled banks, the same decreased to
0.51% in 2005, except in some cases (table D). Even working capital financing to small and cottage industries is seen to be very minimal, only
0.93% of total loans in 2005, and this also shows a downward trend for the last several years. This implies that the banking system of Bangladesh has reduced the disbursement of loans to small and cottage industries over the years in order to reduce the risks of NPLs. Although, the share of large and medium scale industries has increased to the maximum in 1998
(27.99%), the same has reduced to 15.66% in 2005 and this exhibits the bankers’ current behavior of disbursing loans only under secured conditions. In fact, the banking system now does not want to take risks of financing large industries as loan default here is found to be very high
(the percentage of NPL in the case of term loan up to 5 years is 33.83% in
NCBs and 40.45% in SBs in 2005). Another trend is that the proportion of loans to the agriculture sector has declined over the years (24.94% in 1987 against 8.84% in 2005) and this has also created problems for agro based
SMEs in receiving finance. Agro based SMEs occupy a major share of
SMEs in Bangladesh. All these factors lead to the conclusion that at present, it has become very difficult for the banking system of Bangladesh to cater to the financing needs of the SMEs.
15) Schedule banks include NCBs, PCBs and SBs, which operate under supervision of the central bank of Bangladesh.

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Sectors
Agriculture
Fishing
Forestry
Large and Medium scale industry
Small cale and cottage industry
WC Financing
Large and Midium
WC Financing
Small scale and cottage
Construction
Electricity Gas water Sanitary
Transport and communication
Storage
Trade
Export
Import
Miscellaneous
1987
24.94
1.51
0.03
24.30
3.32
4.33
0.39
3.22
0.60
2.97
33.70
5.75
7.46
3.40
3.49
4.46
0.33
3.33
0.50
2.50
37.39
5.84
8.41
3.67
1988
22.93
1.58
0.03
19.56
1990
21.07
1.62
0.01
25.39
1.13
8.69
1.03
3.89
0.18
1.47
46.25
9.08
19.67
1.14
1991
16.62
1.62
0.01
26.48
1992
17.75
1.59
0.01
25.76
1993
16.70
1.51
0.01
26.22
1994
17.32
1.42
0.01
24.16
1995
16.31
1.29
0.03
26.71
1996
15.36
1.08
0.02
25.72
1997
14.09
1.08
26.56
1998
12.23
1.43
0.02
27.99
1.35
8.73
1.22
4.92
0.26
1.58
1.41
8.05
1.09
5.12
0.02
1.51
1.39
7.91
1.15
5.19
0.09
1.33
1.61
9.73
1.36
5.57
0.21
1.37
0.87
31.76
4.64
6.12
4.60
0.83
32.69
5.31
6.66
4.77
0.80
32.18
6.09
5.61
4.92
0.94
29.94
6.20
6.43
6.37
1.51
1.09
1.43
8.01
10.30
10.02
1.34
5.40
0.10
156
1.43
5.35
0.20
1.48
1.41
5.60
0.03
1.50
1.53
9.08
1.36
5.36
0.02
1.41
0.89
29.59
5.81
6.55
7.26
1.25
28.93
5.27
6.21
7.74
1.12
29.00
5.63
7.03
8.17
1.47
28.41
5.98
6.71
8.69
Sectors
Agriculture
Fishing
Forestry
Large and Medium scale industry
Small cale and cottage industry
WC Financing (Large and Midium)
WC Financing (Small scale and cottage)
Construction
Electricity Gas water Sanitary
Transport and communication
Storage
Trade
Export
Import
Miscellaneous
1.41
1.42
28.28
5.48
5.98
11.43
1999
13.22
1.24
0.01
26.17
1.42
8.58
1.08
5.68
0.07
1.42
1.59
30.66
7.07
7.23
11.10
2000
13.14
1.08
0.01
25.18
1.31
7.74
1.07
5.56
0.03
1.50
1.07
31.70
5.09
8.52
9.31
2002
11.27
0.51
0.00
19.00
1.16
16.28
0.96
6.78
0.00
1.55
1.34
30.55
6.48
7.03
14.61
2001
12.02
1.04
0.01
23.53
1.26
7.47
0.86
5.60
0.16
1.24
0.74
33.75
4.54
9.97
9.16
2004
9.65
0.58
0.01
17.36
0.65
18.11
1.24
6.78
.00
1.29
0.84
34.19
5.22
10.07
9.42
2003
10.12
0.41
0.02
18.39
0.57
15.88
0.97
7.21
0.01
1.24
0.59
35.23
4.25
12.42
9.16
2005
8.84
0.84
0.01
15.66
0.51
19.13
0.93
6.94
0.00
Different Issues, Bangladesh Bank.

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3.5: Problems of “NGOs” in Financing SMEs of Bangladesh.
Hoff and Stiglitz (1990) opine that rural credit markets of developing countries suffer from screening, incentive and enforcement problems which can be better resolved by the ‘group lending’ approach of informal institutions like NGOs and Grameen Bank of Bangladesh and also by mechanisms adopted by informal lenders and vis-à-vis those by formal financial institutions. The idea is that the group lending approach creates moral pressure among the members of the group in the screening of loan applicants and collection of installments spontaneously. Ultimately, it reduces transaction costs, risk premiums and moral hazards of the institutions giving credit. But the formation of these peer groups and their effective supervision are only possible by social development workers who are working at the rural level and not by formal financial institutions like banks. According to the above logic given by Stiglitz and Hoff, one might argue that, as a large number of NGOs working in Bangladesh, NGOs would be better in taking care of the needs of SMEs and in fact, the government should encourage them.
However, NGOs operate under the Societies Act 1861 that prohibits them to earn profits through business activities. Also, most NGOs receive funds from donor organizations /countries which impose restrictions on them with regard to disbursement of large amounts of credits. Therefore, in practice, it is observed that NGOs basically practice ‘income generating activities’ 16) and their loan size varies from US$ 100 to US$ 3500. They also charge very high effective rate of interest (45% to 120%) 17) as their installment is mostly based on weekly payments. Thus, it is not financially logical for SMEs to loan funds from NGOs that charge very high effective rates of interest as this increases the cost of operations of SMEs and
16) Although more than 3000 NGOs are working in Bangladesh, four main NGOs namely
BRAC, ASA, Proshika and Grameen Bank cater to the needs of the rural and semi-urban financial market in Bangladesh. Besides, PKSF and BRDB are government institutions that are working alongside the NGOs. However, they are popularly known as players of
‘micro credit’ that disburse money to generate income only for very small concerns.
Interestingly, some of these people graduate from small to medium and demand higher amounts of capital, which NGOs cannot provide because of their operational guidelines.
17) Most NGOs charge interest rates of 20% to 25% and their payment is based on a weekly basis. Some NGOs require depositing some money to them before getting credits. Taking all these into account, Ahmed (1999) calculates that the effective rate of interest of NGOs varies from 45% to 120%.

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FFAIRS 【 Vol. 7 jeopardizes their future growth due to high interest payments in the initial stage. It is to be noted here that loan disbursement record and recovery performance of NGOs are found to be very good but their operating guidelines do not allow them to extend credits to SMEs. In fact, it would not be logical to say that NGOs would cater to the needs of all markets in any economy rather different mechanisms need to be adopted for fulfilling different types of needs.
The important point here is that tiny enterprises that receive funds from NGOs and graduate to small and medium size enterprises later, face financial and non-financial crises as neither commercial banks nor NGOs fund them. On the whole, it is found that the entrepreneurs of SMEs who require US$15000 to US$30000 do not get support from traditional banks and NGOs and is known as the ‘missing middle’ that needs to be taken care of properly by developing a separate financial mechanism for them to increase the economic benefits of the country.
3.6: Problems of the “Capital Market” in Financing the SMEs of
Bangladesh.
The stock market in Bangladesh is not well developed because of several reasons. Firstly, Bangladeshis by nature are usually averse to taking risks (72% of private deposits go to the bank. If we include saving certificates here, the figure becomes more than 90%; Annual Report 2005,
Bangladesh Bank ) and prefer to invest money in the banking sector rather than in the stock market. Secondly, the majority of the population is uneducated (the literacy rate is 64% as per UNDP report 2004) and people in general have doubts about the credibility of the stock market especially after the stock market crash in 1997. Thirdly, the country has only two rating houses, and few investment bankers who are yet to earn the trust of the average Bangladeshi household. Most importantly, when raising funds, the stock market requires compliance to certain rules and regulations which the SMEs cannot comply with because of their low base of capital. As a result, it is found that the number of companies that seek capital from the stock market is minimal (not more than ten in a year, except in few cases) and surprisingly, eight companies are seen delisted in their status from the stock market in year 2004-05 (graph 1).

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Number of companies listed in DSE
Year
Graph 1 : Number of companies listed in Dhaka Stock Exchange and newly listed companies per year.
companies per year. Source: Constructed by author from Economic Trend,
October 2005, Bangladesh Bank.
To sum up, it is found that the banking system of Bangladesh mainly practices collateral based financing and they have huge amounts of nonperforming loans followed by low rates of return on assets. Bank officials also show a marked lack of initiative in increasing their skill sets as promotion system is mainly based on seniority. The banking system does not participate in equities, which is required not only for proper monitoring of
SMEs but also to provide non-financial support to them. The banking system also faces constant pressure created by the World Banks and IMF to maintain capital adequacy, which discourages it to finance risky projects.
On the other hand, the stock market has not been effective enough to create opportunities for SMEs and finally, NGOs face institutional problems in extending large finance to SMEs.
Section 4: Potential of Venture Capitalists to Cater to the
Financing and Non-financing Needs of SMEs.
It is stated earlier that a systematic problem exists within the major segments of the financial system in Bangladesh in catering to the financing needs of SMEs. Therefore, it is argued that the venture capital industry may be developed as an additional financial intermediary for catering to the financing and non-financing needs of the SMEs, as it can participate in the management of the investee firms actively and exercise the

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‘due diligence process’ 18) when disbursing credits. Importantly, a unique feature of venture capital financing is that it addresses the funding needs of entrepreneurial companies that generally do not have the size, assets, and operating histories necessary to obtain capital from more traditional sources, such as public markets and banks (Venture Impact, 2004). While traditional bankers usually shy away from equity financing and provision of loans to SMEs, venture capitalists bridge this gap by way of provision of equities or loans or both and practice of the ‘participative management approach’ 19) . Venture capitalists can also reduce ‘information asymmetry and transactions costs 20) (Gladstone, 1998; Jensen, 1993) of lending SMEs which are basically characterized by uncertainties. The point is that banks cannot undertake uncertainties in their lending, as they are required to ensure the security of their depositors’ funds. Another point is that investments to risky projects or uncertain SMEs might generate huge
NPLs for the banks, which in turn destroys their profitability, and creates a panic in the depositor’s mind which might further lead to contagious bank runs. This means that bankers are required to ensure the security of their lending for maintaining the credibility of the financial discipline and obviously, this becomes a crucial issue when the financial system is dominated by banks. Unfortunately, this situation creates a problem for SMEs who are basically characterized by uncertainties. Importantly, uncertainties make the decision process of the financial agents (banks) complex and volatile and lead them to be ‘bounded rational’ 21) which results in ‘contrac-
18) Due diligence’ is a detailed investigation of the affairs of a company. It is the phrase, which is used to describe the investigative analysis of the financial and operating activities of an entity in connection with a proposed transaction that would result in a significant change in the ownership or the capital structure of the entity. This should make one appreciate, at the outset, that a due diligence exercise is an interactive process requiring inquiry, analysis and interpretation.
19) Venture capital financing is basically a partnership business. Venture capitalists usually participate in the management of the investee firm and design all business and marketing plans together which is known as the participative management approach.
20) Simply, transactions costs are all costs associated with generating a particular transaction and closing the same. One important component of the total transaction cost is the cost of monitoring and controlling the behavior of the agents. It is argued here that since venture capitalists usually participate in the management and design plans together, the cost of monitoring and controlling reduce significantly ( to almost zero) which reduces total transaction costs.
21) Herbert Simon described bounded rationality as a “behavioral model in which human rationality is very limited, very much bounded by the situation and by human computational powers” (Reason in Human Affairs, 1983, page 34).

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
DHIKARY ） 111 tion of credits’ or ‘credit rationing’ (Suzuki, 2005). However, venture capitalists in this respect deem suitable to intermediate funds in the midst of uncertainties as they use an extensive ‘due diligence process’ As well as the ‘participative management approach’ in their lending. It would be worthwhile to note here that the venture capitalists are professional and skilled in different lines of business and they put in their best efforts to run the applicant’s business effectively, as they also own the investee firm.
Usually, this skill is developed through practical exposure and training and cannot be created. Such a pool of diverse talents cannot be created in a traditional bank because of institutional limitations which results in accumulation of knowledge only in selected and mature companies.
Therefore, in uncertain businesses like SMEs banks usually face problems in intermediating funds whereas venture capitalists do not feel so.
Another important point is that banks usually prefer to give loans, which is not always considered to be a suitable financing technique for SMEs from the perspective of cash management, as it severely shrinks the cash flows of those companies that are willing to finance their (SMEs) growth in the early stage. Bankers also have the right to file a suit against the client if the loans are not repaid timely. This usually creates tension in the minds of entrepreneurs of SMEs and prevents them from taking any decision, which is considered risky but profitable. This also places them on a less competitive platform when compared to other firms who have equities. Therefore, from the perspective of cash management, venture capital financing option is usually viewed as the better form of financing for
SMEs. It is to be mentioned here that venture capitalists not only supply finance to investee firms but also provide non-financial services, which a traditional bank can never offer. Institutionally, banks are in the lending business whereas venture capitalists are in a partnership business. So, venture capitalists have the opportunity to offer different non-financial services like strategic decision making, marketing, management, contracts and so on for the betterment of the firm. A survey conduced by the
British Venture Capital Association

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Startegic Direction
Financial Advice
Contacts
Mangement
Marketing
0
50%
50%
50%
32%
10%
0. 1 0. 2 0. 3 0. 4
% of respondents rating contributions
0. 5
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(BVCA) over 500 venture capital backed companies in 2003 revels that 50% of venture capital backed companies receive strategic directions, financial advice and contract advice/services from the venture capitalist followed by 32% that received management services (graph 2). It is argued in the introduction that most of the SMEs in Bangladesh also suffer from shortage of managerial skills, marketing skills, lack of standard products, communication skills and so on besides being overloaded with financial problems. Thus it can be concluded that developing the venture capital financing technique would definitely be a better option for them.
4.1: Venture Capitalists between Capital Market and Bank Based
Financing
It has been argued earlier that the capital market requires a minimum size, history and capital in order to procure funds. Also, most SMEs are run by single owners and they require active investors, as they lack in planning, management quality and marketing strategies, beside the financial requirements which cannot be catered to by the banks. Figure 4 shows that SMEs do not have a good reputation, have minimum assets and lack profitability which act as constraints in securing finance from the capital market. Figure 4 also shows that banks require collateral when providing finance because they need to guard depositors’ funds.
Fortunately, venture capitalists can act as active investors and they do require neither collateral nor reputation. Therefore, they can perform the important task of financial intermediation to ease financial and non-finan-

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
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Minimum assets
Reputation
T
E
M
S
Y
S
A
N
C
I
F
I
N
A
L
Capital market
Venture capital
Records of profitability
Reputation and collateral
Active Investors
Collateral require ments
No yes yes
Constraints to start-ups and SMEs
Relationship based
Passive investor
Figure 4 : Venture capital between capital market and relationship based financing.
Source : Constructed by author.
Source : Constructed by author.
4.2: Evidence from Real Life
Venture impact (2004) reports that venture capitalists have boosted
America’s economic strength by way of creating 10.1 million jobs which is an additional 600000 jobs in 2003 as compared to 9.5 million jobs in 2002.
A comparison of the growth rate of jobs created in venture capital backed companies against all private sector companies during the years 2003 and
2004 reveals that VC backed companies’ account for 6.32% as against
–2.3% of the private sector companies (table E). Not only this, the sales growth rate of the venture capital backed companies in 2003 also

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Year 2002
Job creation and sales growth
Year 2003 Growth All PS Growth
Job creation 9.5million 10.1million 6.32%
Sales $1.6 Trillion $1.8 Trillion 12.50%
-2.30%
6.50%
Moreover, in the USA , VC backed companies represented 9.4% of the total work force and 9.6% of the total sales in 2003 (Venture Impact,
2004). Again, it is found that the employment growth rate of VC backed companies in terms of being in the industrial sector is also quite impressive (table F). For instance, while total employment growth rate in the biotechnology sector is seen as 5%, the growth rate of venture backed companies in this sector is 23%. Although, the semiconductor sector and computer hardware sector show negative growth (-10% and -1%) rates, they, however, are in a better position vis-à-vis the total employment growth rate (-26% and -14% respectively) manifested by these industries.
Similarly, an impressive record is observed in the UK venture capital industry. For instance, the British Venture Capital Association (BVCA) reports that in 2003, VC backed companies in the UK accounted for 19% employment growth as against growth rates of 9% and 6% of FTSEMd-250 and FTSE100 companies respectively. During the same time, the National level employment growth rate was recorded at 0.50% only. In terms of sales growth, VC backed companies represented 21% in 2003, which was
33.3%, and 52% higher than that of FTSE Mid-250 and FTSE 100 companies respectively (BVCA, 2003).

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Companies given in the industry
VC backed companies employment growth
Total employment growth
Another important observation is that even in the USA, venture capitalists mainly disburse funds in the early stage and in the expansion stage, not in start-up or in seed corn financing (graph 3). Also, in the UK venture capitalists primarily focus on management buyouts and buy-ins, not in seed corns (graph 4).
Year
Graph 3 : Number of deals made in different stages of finance from 1995-2004 in the USA.
Source : Constructed by the author from the data on NVCA Report, 2004.
Source: Constructed by the author from the data on NVCA Report, 2004.

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Early Expansion MBO/MBI
7000
6000
5000
4000
3000
2000
1000
0
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Year ph 4 : Amount of funds invested at different stages of financing in the UK (1984 -20 rce : constructed by author from the report on British Venture Capital Association, 2
Source : constructed by author from the report on British Venture Capital
Association, 2003.
The important point here is that although, traditionally venture capital financing is used to provide finance to newly untested technologies or high risky businesses, this mode of financing is not largely practiced even in the USA, the country that pioneered the concept. It is argued earlier that developing countries imitate innovations and their industrial base is based on imitated technologies and hence venture capitalists can launch their products to meet the requirements of this imitated industrialization.
As SMEs in Bangladesh are in an expansion stage, venture capital techniques can be introduced to meet their (SMEs) financing and non-financing requirements.
Section 5: How to Construct the Venture Capital Industry in
Bangladesh
It can be proposed that the government should fund the venture capitalists as a first step to set up the venture capital industry independently and provide guarantees to the funding authorities about the safety of their funds so as to reduce moral hazards. The reason for setting up an independent venture capital institution is to give them full authority in making their decisions. It needs to be mentioned here that if a venture capital institution is set up to function as a subsidiary of the banks then it might lose autonomy in working and the bank might enforce on them some of

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
DHIKARY ） 117 their own assessment and selection criteria which might not be suitable for assessing the risks and potentials of all types of SMEs. Again, this might generate employee dissatisfaction and moral hazards between parent banks and subsidiaries, as employees in the venture capital institution usually deserve high salaries. Regarding sources of finance, the government might take funds and guidance from the World Bank or IMF initially for the successful running of this industry. Besides, the government should encourage Non Resident Bangladeshis (NRBs), who supply large amounts of remittance each year, to contribute funds to this industry. Side by side, the government should emphasize on the creation of quality manpower, prudential regulations and necessary policies to attract foreign investment for this industry. Most importantly, the government should provide guarantees at the initial stage to minimize moral hazard problems of fund suppliers.
Regarding exit strategies for venture capitalists, obviously, stock markets offer the best opportunities, but in Bangladesh this might create an exit barrier for the venture capitalists, as the stock market is not developed enough to address information asymmetry. There is also a marked lack of business acquisitions and mergers. However, it is to be noted here that the reasons for the poor development of the stock market in
Bangladesh is the lack of trust and transparency followed by the attitude of average households which are generally averse to risk. It can be argued that when venture capitalists finance companies and manage them effectively, they would give a signal to the stock market that their companies are well managed as well as profitable. In fact, this signal would help them to sell their businesses. Also, it would not be fair to say that there are no investors in the stock market of Bangladesh. There are investors, although not a big size, but there is a noticeable dearth of good companies.
For instance, when Square Pharmaceuticals – a well managed profitable company- issued shares at 800% premium, they received subscriptions over 5 times higher than their issued shares. Therefore, it can be said that the venture capitalist might in turn develop the stock market of
Bangladesh and would be able to exit from the ambit of operations of the investee firms.
However, one might argue here that instead of establishing a venture capital firm the government can nurture quality bank officials and inspir-

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FFAIRS 【 Vol. 7 ing them to finance SMEs. Regarding this aspect, it is mentioned in section 3 that the banking system at present is submerged in high amounts of non performing loans and yields very low percentages of return on assets and the government is mainly concerned with reduction of costs and improvement of performance by transferring financing risks to bank officials. Also, the bank officials do not find the motivation for taking additional risks as the promotion system is mainly based on seniorities.
Institutionally, bank officials also cannot meet non-financial requirements of SMEs, which are quintessential to their success. It is to be noted here that it becomes the prime responsibility of banks to ensure stability within the banking system and in the present scenario, if the banks face uncertainties; this might further aggravate the banking crisis. Also, it is not logical to say that banking system is a panacea for all problems of the
SMEs and therefore responsible for all sorts of finance. Therefore, it is argued that the government of Bangladesh can cultivate venture capital financing as an additional tool by recruiting experienced bank officials, investment bankers and NGO officials who are capable of providing both financial and non-financial support to SMEs.
Section 6: Summary and Concluding Remarks
In this paper, an attempt is made to delineate the deficiencies of the existing financial system in Bangladesh to cater to financing needs of
SMEs specially those requiring finance in the range of US$ 15000 to US$
30000 and a proposal has been given to develop the venture capital industry to meet financing and non-financing needs of SMEs. This paper notes that SMEs employ almost 82% of the total industrial labor force and share nearly 35% of the gross output of the entire manufacturing sector and thus occupies a vital position within Bangladesh’s economy in terms of creation of industrial outputs and generation of employment. However, the paper reports that 58% of SMEs face problems in securing investment funds and 35% face problems in allocating the funds to a profitable operation. The paper argues that without catering to the financing needs of
SMEs, it is virtually impossible for Bangladesh to accelerate the economic growth rate of the country. Thus, the paper proposes the development of the venture capital industry as an additional financial intermediary to cater to financing and non-financing needs of SMEs.

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The paper discusses available sources of finance for SMEs and the constraints of these sources. There are basically three sources from which
SMEs may receive finance. These are banks, non-government organizations (NGOs) and the capital market. Within the banking system, it is found that nationalized commercial banks (NCBs) and Specialized Banks
(SBs) mainly cater to the financing needs of SMEs in the country.
However, the paper reveals that both NCBs and SBs are submerged in alarming amounts of non-performing loans (NCBs and SBs account for
21.35% and 34.87% of their loans as NPL respectively in 2005) and have a very low rate of Return on Assets (NCBs and SBs both have recorded -
0.1% ROA). It is argued that this high amount of NPLs and low rate of
Return on Assets have compelled bank officials to extend credit under sufficient collaterals and only under secured circumstances. The paper also argues that as most SMEs do not have sufficient quality collateral and are characterized by uncertainties, they lose out on the attention of NCBs and
SBs. They are popularly known as the ‘missing middle’ in the country. It is also argued that after the adoption of FSRP, banking system has made it mandatory for all borrowers to give their detailed financial statements including projected cash-flow statements, solvency and liquidity ratios, equity declarations as well as income tax declarations, which most SMEs are unable to supply and this has created hindrances for SMEs in accessing credits in general. Further, it is observed that bank officials do not have the skills required to assess risks of diverse SMEs. Moreover, they require shouldering the risks of lending without any incentives. The paper argues that such a situation is responsible for the passivity on the part of bank officials in giving loans to SMEs, as banks require protecting depositors’ funds and contagious bank runs as well.
Beside NCBs and SBs, it is observed that Private Commercial Banks
(PCBs) and Foreign Commercial banks (FCBs) are not interested to lend to SMEs because of low ROA (1.1% in 2005 and negative in 2004). This low ROA also encourages them to practice branch banking to improve their situation. Although, the profitability of FCB’s is seen to be comparatively higher than that of PCBs, the present legal status does not compel them to lend SMEs.
This paper also examines the role of NGOs in catering to the financ-

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Societies Act 1861. This paper has also discussed the effectiveness of the capital market in catering to the financing needs of SMEs. It is found that the capital market requires a minimum capital base and a history of successful operation that SMEs do not have. Also, capital market itself suffers from the lack of trust and confidence on the part of investors especially after the stock market crash of 1997. It is further argued that the stock market lacks a large base of private investors who can take the risks associated with the SMEs.
Then, the paper discusses the advantages that venture capitalists have over banks in catering to the funding needs of SMEs. It is argued that venture capitalists perform the role of ‘active investors’ by way of offering both financial and non-financial commitment to the investee company, which is essential in a market characterized by a high level of uncertainties. Also, it is argued that venture capitalists can reduce the transaction costs associated with monitoring as they launch the extensive process of ‘initial due diligence’ and practice the ‘participative management’ approach. This paper reveals that that venture capital backed companies grow faster and show better employment rates in comparison to non- venture capital backed private companies both in the USA and in the
UK. This paper reveals further that most venture capitalists in the USA and UK prefer expansion stage financing than seed corn financing. This behavior is logical from the optimal portfolio point of view. It is argued that the venture capital financing tool is to be used to finance SMEs in
Bangladesh, whose operations are in the expansion stage.
The paper argues that Bangladesh has a large number of SME entrepreneurs and does not need new entrepreneurships to be set up as venture capitalists do in the Western countries. It is argued that policy makers should focus on how venture capitalists might receive finance that would in turn reduce moral hazard problems between fund suppliers and them.
It is argued that the Government of Bangladesh might take the first initiative along with IMF or World Bank to develop the venture capital

2009 】 Can Venture Capitalists Cater the Financing Needs of the Small and Medium Enterprises (“SMEs”)? A Study of Bangladesh （ A
DHIKARY ） 121 industry by formulating necessary policies and regulations. It is argued that seeking help from the World Bank and/or IMF at an early stage is essential for acquiring the necessary skills for the venture capitalists so that they can start this business locally at a later stage. Regarding sources of funds for venture capitalists, the paper focuses on approaching wealthy non-resident Bangladeshis and foreign investors besides
IMF/World Bank and stresses on a guarantee to be given by the government at an initial stage so as to reduce moral hazard problems between venture capitalists and fund suppliers. It is further argued that the development of venture capital industry should not be made subservient to the operation of banks as this would create internal conflicts within the banks.
To conclude, it is important to say that the economic growth rate of
Bangladesh is related to the development of its SMEs. As the present players within the financial system of Bangladesh are found to be incapable of meeting the credit requirements of the SMEs, especially those who require funds in the range of US$ 15000 to US$ 30000 for their expansion and growth, the policy making institutions might consider the development of the venture capital industry as an additional financial intermediary for the economic betterment of the country.
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