Home > Op-Ed > Financial Inclusion: Is SME lending the Goldilocks of digital banking?
The Future

Can digital plug the SME credit funding gap and support financial inclusion? Lack of financing for small business has vexed policy makers around the globe for years but, by working together, banks, governments and technology companies have it within their power to solve the problem today.

More than 200 million small and medium enterprises (SMEs) in emerging markets lack access to finance. This inability to raise working capital is particularly a problem for small businesses, including technology start-ups and professionals branching out into entrepreneurship.

SMEs are a major driver of economic growth and job creation, accounting for more than half of the world’s GDP and two-thirds of its work force. Yet, they have difficulty securing financing, limiting their ability to grow and thrive.

Financial inclusion refers to universal access to reasonably priced financial services, provided by sound and sustainable institutions. It includes saving, investing and borrowing. In recent years, a lot of progress has been made in promoting financial inclusion for individuals for their saving needs, through new mobile payment systems and increased access to bank accounts. In the three years to 2014, the number of unbanked adults globally dropped 20 per cent to 2 billion.

The bottom of the small business pyramid is enticing

Meanwhile, limited progress has been made in addressing the credit needs of small businesses.

The International Finance Corporation estimates that financially excluded micro businesses and SMEs (MSMEs) account for a significant credit gap of USD2.1 to 2.6 trillion in developing economies. This represents a major constraint for MSMEs, and a massive missed revenue opportunity for the financial sector.

What under-banked small businesses need

Widening access to financing for small businesses is top of almost every government’s agenda, given the sector’s importance for jobs and economic growth. While the revenue opportunities for banks are huge, the financing needs of MSMEs are so far met largely by informal service providers, governments, state agencies, development organisations and non-governmental organisations.

MSMEs need financial products and services that are appropriate for them, at the right price and design, with ease of access and fast processing. Their credit needs can be summarised as high in complexity and low in scale, leading to the traditional banking view that MSME financing is low-end and unprofitable. The credit underwriting process is time-consuming and expensive for a variety of reasons, such as a lack of SME credit bureaus, lack of official identity documents, stringent regulatory know-your-customer requirements, and the fact that many MSMEs lack an audited financial history.

Small businesses are the Goldilocks of digital banking: corporate applications are too complex for them, but retail ones are way too simple. They often end up being offered retail credit products, though their diverse needs call for a more customised service. Lending in this area by banks is often pursued under regulatory pressures or as part of philanthropic ambitions.

Many governments have introduced specific programmes to improve availability of finance to MSMEs by encouraging the alternative finance sector to flourish.

The US JOBS (Jumpstart Our Startups) Act of 2012 has had significant positive impact for meeting the credit needs of individuals and small businesses. The UK government has introduced challenger bank licences and created the British Business Bank, while proposing legislation to mandate banks to refer to other providers when they decline MSMEs for finance. China has issued new banking licences to technology companies to promote financial inclusion while Indian regulators have issued Small Finance Bank licenses.

However, while the efforts have shown some positive results, and momentum is building, a vast funding gap still remains.

Fintech as a game changer: big data, small credit

Changing market drivers are giving banks a good reason to rethink the traditional position that banking MSMEs requires a trade-off between financial and social returns.

A consumer financial services revolution is taking place around the globe, powered by mobile phones, technological innovation and changing consumer mindsets. Already, over 1.7 billion adults who are unknown to formal credit bureaus, are becoming ‘digitally discoverable’ through their mobile footprint. This is enabling new business models for servicing MSMEs profitably, and meeting their diverse financing needs using digital solutions, advanced analytics, a network of agents and correspondents, and partnerships with the development sector.

Several innovative fintech firms have begun to use predictive credit models, based on unconventional data sources and machine-learning algorithms, to assess the credit risk associated with MSMEs. These marketplace lending platforms are also using technology to reach segments historically underserved by banks. They have a lower cost structure than banks, and lighter regulatory scrutiny. However, they primarily offer unsecured term loans and only a handful are targeting the specific business needs of SMEs, such as Kabbage and OnDeck in the US, Funding Circle in the UK, and Sino-Lending and Ant Micro Loans in China.

A study released in April 2016 by Cambridge University’s Center for Alternative Finance highlights that between 2013 and 2015, online alternative finance platforms in the US facilitated nearly USD11 billion worth of growth, expansion, working and venture capital to over 260,000 SMEs.

The path ahead: Creative collaboration between policymakers, banks and technology firms

New technologies could become a game changer for MSMEs, as new solutions can be customised, effective and profitable at lower scale. This includes tailored products that are normally out of bounds for small business, such as working-capital lines, merchant and e-commerce finance, invoice discounting, supply-chain finance and trade finance.

Banks have a critical role to play in this digital future. They know the financial products, possess the required scale, capital and consumer trust, and have the key competitive advantage of risk management. Technology firms bring innovation, new customer segments and new distribution channels.

Governments and regulators have been supportive of financing needs for this sector and are doing more through further regulatory reforms and co-funding schemes. The linkages between economic growth, financial stability and innovation are clear.

Policymakers, banks and technology companies together can solve the industry’s one-size-fits-all problem for small business needs and create commercially viable, technology-driven business models for MSMEs, thereby supporting the financial inclusion agenda at a time when it is needed more than ever.

Anju Patwardhan is a Fulbright Scholar at Stanford University and her research is focused on use of innovation and technology to support financial inclusion. She is the ex-Global Chief Innovation Officer of Standard Chartered Bank. She is a Fintech Industry Expert at UC Berkeley and Innovation Fellow at National University of Singapore.