Three Myths about SME Finance
Small and medium enterprises (SMEs) are again at the center of attention – and this is excellent news because in many countries these businesses are the backbone of the economy and they employ large numbers of people. I applaud the G-20 initiative, and more specifically the work of CGAP, to shed light on the topic of access to finance for SMEs.
Unfortunately, the environments in which SMEs operate are not always conducive for their growth and development. This is true across many commonly cited dimensions, such as the regulatory framework, fiscal treatment, worker qualification and, last but not least, access to finance.
Being the center of attention has meant that SMEs have, in the past years, received significant support in terms of business development services, policy dialogue, “political” empowerment and foremost provision of funds for the external financing of these businesses.
The results of several recent demand studies confirm what we, as consultants who have been working with SMEs for decades in many countries on four continents, have seen on the ground: access to finance is not always the main problem.
Our hands-on experience has revealed a number of mistaken assumptions about SME finance. I’ll highlight three core myths about SME finance:
- Myth #1: “There is a huge financing gap for SMEs – more funds are needed to close this gap”
- Myth #2: “Commercial banks know how to finance SMEs”
- Myth #3: “In order to foster economic growth it is important to provide finance to SMEs, no matter the method”
Despite the abundance of liquidity available to finance institutions in many parts of the world, too few SMEs have access to finance that allows for sustainable growth. Others are fortunate enough to operate in markets where liquidity flows in a way that enables them to obtain a share of it–-but at the risk of either having too little financing or becoming over-indebted due to irresponsible lending practices.
The underlying challenge that many financial institutions face when attempting to establish SME lending operations is that this segment consists of an extremely heterogeneous group of businesses. While it is fairly easy to identify common features in both micro enterprises and corporate businesses, it is far more difficult to classify SMEs.
Image credit: IPC GmbH
Hence, a far more sophisticated approach to customer service and risk assessment is needed to serve these businesses adequately and to keep credit risk under control. More than for any other client group, the “Know Your Customer” principle applies. However the lack of capacity or willingness of many financial institutions to invest in understanding the SME’s financial needs has caused and will continue to cause more harm than good with respect to both SMEs and the financial institutions issuing the loans.
To underline my arguments, I’ll zoom in on the financial situation of two SMEs that illustrate my posited “myths about SME finance.” Although every situation has its own unique features, the descriptions presented below are by no means isolated cases, and my colleagues and I often encounter similar examples. They reflect some of the negative consequences that can result if financial institutions do not understand the client’s business (potential) and financial needs:
Scenario 1 – Ukraine, Europe: Irresponsible Financing
This is an SME from Ukraine that produces plywood and wooden components for doors. The business was founded in 2001 by Vladimir and Nadja Kurkow and developed steadily until 2006. In 2007, driven by the economic upturn, production capacities were enhanced followed by a series of further investments due to optimistic business projections. The enterprise has 28 employees.
The tables below show the SME’s real financial statements as of January 2008 and June 2009.
Behind the Scenes
As of June 2009, the entrepreneurs had 14 outstanding loans received from five different banks and one leasing company. Although the main business income is generated in Ukrainian Hryvnia, the loans were disbursed solely in EUR and USD, which means that currency risk was completely ignored by the lending institutions. As a result, the client has become over-indebted, as the exclusively externally financed purchase of equipment has not been accompanied by an increase in business income. The impact of the financial and economic crisis on the business is just the tip of the iceberg.
This SME is facing many problems now, but clearly has no difficulty obtaining access to finance. Although SME lending is apparently booming in many markets worldwide, irresponsible financing practices, such as ignoring currency risks or over-indebting clients, may cause more harm than good for SMEs in transitional and developing economies. Therefore, financial institutions need to understand the client’s businesses and thus provide adequate financing to foster the growth of the SME segment.
Scenario 2 – Mexico, Latin America: Inadequate Financing
Pablo Andrade, a Mexican entrepreneur who imports and produces perfumes started his business 18 years ago in Guadalajara. He owns three shops, two in the centre of the city and one in a shopping mall. For tax reasons, he transferred the ownership of the shops to his niece and two nephews. One of the shops was purchased only recently. He has a university degree in business administration, is the sole manager of the business and has six employees.
The tables below show both the SME’s official and real financial statements from 2010.
Behind the Scenes
Mr. Andrade financed the purchase of the last shop as well as on-going working capital with credit cards and short-term loans. At the time of the analysis, the SME had eight credit card limits and five outstanding short-term loans with eight different financial institutions. The only long-term loan was disbursed by a bank where the entrepreneur has been a client since 1992. The purpose of this loan is working capital and carries a maturity of 2.5 years and a grace period of six months.
This SME also has no problem obtaining access to finance, but it is not receiving adequate finance. Credit cards are an acceptable instrument for making purchases abroad, but should certainly not be used for financing permanent working capital needs, as the maturities do not correspond to the business’s operating cycle and the cost of funding is unnecessarily high. A maturity mismatch in the financing structure causes high liquidity risks for all types of businesses.
What these examples show us is that many financial institutions do not understand the needs of enterprises and have not yet recognized the real potential of SMEs. This is the only conceivable explanation as to why so few have “invested” in developing their capacity to serve SMEs sustainably, responsibly and to the client’s satisfaction. Catering to real SME needs requires a substantial up-front effort and SME lending models developed for stable markets with reliable documentation cannot be applied to markets that are still largely informal.
Financial institutions that are genuinely interested in serving SMEs need more long-term support from donors and development finance institutions so that they can develop the capacities needed to serve SMEs on a sustainable basis. In other words, support that goes beyond funding and short-term advisory is necessary for real institution building.
Readers of this blog may note that I shaped my arguments to make a case for more consulting. Well, yes, this is partly true. Consultancy has proven to be an effective way to transfer knowledge and share experience. If anyone feels that I have crossed the line into marketing for the consulting industry, please take the time to engage in real discussions with some SMEs – and some of the above-mentioned popular beliefs will quickly be demystified.
A recent Financial Times article entitled, “Innovators don’t ignore customers” argued that the rapidly dropping share price of Netflix, a DVD rental and online film service could be explained by the fact that the company lost touch with what its customers wanted. Keeping a sharp eye on client demand is thus not only the responsible or developmental thing to do–it simply makes good business sense.