Which sounds like the better investment: a one-man flower stand that resells roses or a local vitamin company looking to expand to new markets? In the developing world, this is a no-brainer. Tiny, unproductive firms are stuffed with credit while small- and medium-sized enterprises (SMEs) struggle to borrow money. This credit gap is not a byproduct of market logic but rather an overlooked and potentially lucrative market – and one that can be tapped through digitization and analytics.
Increasingly, banks and economic development firms are using data to reduce barriers for SME lending. Channels through which this may occur include:
- Digitization to help businesses with record keeping and allow banks to monitor transactions
- Psychometric testing to assess credit risk for would-be borrowers with no credit history
- Industrial policy such as collateral registries and commercial courts to build a financial ecosystem
In this post, we examine the reasons behind the credit gap for SMEs, identify the barriers preventing SMEs from acquiring loans, and explore the steps being taken to increase financial access.
Why does the credit gap exist?
Banks provide credit for the very poor and the very rich. Since the founding of the Nobel Peace Prize-winning Grameen Bank in 1976, both philanthropic organizations and commercial banks have flooded the microfinance space. On the other end, banks also lend to massive clients like global corporations and governments. SMEs, which lack the volume and philanthropic pull of microfinance as well as the low risk of established borrowers, fall into an uncertain middle category. As a result, they are underserved by both the private and development sectors.
Neglect does not necessarily indicate that SMEs are a bad investment. After all, the developed-world analogue to such a loan would likely be venture capital or private equity – both highly profitable industries. If investors can generate significant returns through startups in an established economy, they can likely profit from similar investments in a less picked-over market.
What prevents SMEs from gaining funding?
In order to scale up access to credit for SMEs, lenders must address the barriers to growing a business in an emerging economy. While macro-level concerns such as political instability, corruption, and low human capital are hard to mitigate, many micro-level obstacles are surmountable. A recent article in the Economist lists the following hurdles:
- Possessing insufficient collateral
- Keeping patchy, incomplete records
- Lacking a credit history
- Requiring a longer time horizon for repayment
By using data to supplement the lack of records and increased uncertainty, banks can reduce the risk of lending to small businesses with growth potential.
How can data increase lending to SMEs?
In the past decade, financial technology (or fintech) firms, researchers, and policymakers have made strides towards bridging credit gaps around the world.
On the private sector side, both large companies and small startups have entered the fintech industry. In 2014, MasterCard launched an innovation hub in Nairobi, Kenya, to expand digital financial services. Traditional banks such as Citi Group, HSBC, and Deutsche Bank have also introduced new payment technology initiatives. Other firms such as Numida, a Uganda-based startup, offer platforms for entrepreneurs to record transactions on their phones. Both payment technologies and tracking services boost SMEs’ appeal as loan candidates by reducing uncertainty.
Other researchers are studying unorthodox methods of assessing credit risk. The Entrepreneurial Finance Lab, an initiative based at Harvard, is pioneering psychometric testing that quantifies a borrower’s innate tendency to default. This approach may help banks winnow risky clients.
Public policy can also contribute to a better lending climate. Collateral registries, publicly available databases that track asset ownership, prove creditworthiness of potential borrowers. The provision of commercial courts can also lessen fears of default.
The credit gap for SMEs is an underserved market, and data can help. As financial technologies and policies streamline the loan process, firms will be better able to access the capital they need to grow.
You can access the original Economist article here, and an article about big banks and business lending in the Wall Street Journal here.
Contributed by Marisa Barghava.
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