Headwinds and Tailwinds in Banking Small Businesses
Micro, small, and medium enterprises (MSMEs) are particularly important for developing economies, as they are often the largest employers in these economies and the source of most innovation. Yet limited access to financial services for these firms is holding them back. As World Bank Enterprise Surveys frequently show, it prevents them from achieving their potential as drivers of economic growth and innovation.
One of the Sustainable Development Goals adopted by the United Nations last year deals with infrastructure and financing for firms – as an important underlying investment that fuels economic growth and sustainable development. Fortunately, today, bank financing for MSMEs has the potential to be more affordable and scalable than ever.
The rapid “digitization” of business and unprecedented investment in financial technology are creating these headwinds – and have the potential to significantly improve access to finance for the 360 million to 440 million formal and informal MSMEs worldwide.
Historically, MSMEs never meshed well with old-style branch banking; banks found MSMEs too expensive to acquire or serve as customers. MSMEs aren’t like consumers, which banks serve through automated, standardized procedures. They also aren’t like corporate customers, whose value-add makes custom-tailored, “high touch” services affordable.
Making the banking of MSMEs viable requires tapping into financial technology, or FinTech, and the valuable range of data it can provide in assessing a firm’s risk profile. However, there are still many challenges in leveraging data for this purpose. MSMEs don’t provide the kind of rich, affordable data consumers provide. MSMEs also want that high-touch experience, putting limits on a purely technology-based solution.
A small group of financial institutions, both banks and nonbanks, has overcome some of the obstacles and built strong MSME finance businesses through a labor-intensive approach that uses a cadre of specialist credit officers operating outside branches. With some notable exceptions, however, these institutions are small and this model has not yet reached scale. Consequently, MSMEs remain “ghosts,” and large banks remain uncomfortable with the market – even where credit bureaus provide positive and negative information.
There are both headwinds and tailwinds that are influencing whether FinTech will solve the access to finance problem for MSMEs in practice.
Tailwinds helping banks better serve MSMEs:
- MSMEs are doing more business electronically. Cards and point-of-sale devices are far more affordable than 10 to 20 years ago. But the game changer is the mobile phone, which has ushered in a lower cost option into the payments system. Critical transactional information can flow to a banker sitting behind a computer – or a “super credit officer” in the field.
- Significant growth in FinTech firms. From 2013 to 2014, funding for FinTech firms quadrupled. The World Economic Forum reckons it could now top $30 billion.
- Many FinTech firms are focusing on data mining technologies, which can be leveraged by banks serving MSMEs. Wells Fargo has demonstrated the potential of such a data-driven approach for over 25 years, having mined its own transactional data as it morphed from a regional institution into a national one. The MSME segment consistently ranks among the bank’s highest margin client segments. Today we see many examples of other banks profitably exploiting this alternative data source, including Türk Ekonomi Bankasi (TEB) and Garanti Bank in Turkey, and Commercial Bank of Africa (CBA) in eastern and southern Africa, which has been building new business from prepaid cellphone transactions data.
- Banks are also using FinTech to help MSMEs manage their operations. Banks are partnering with FinTech firms to use data as a tool to help MSMEs run their businesses more efficiently. FinTech companies like U.K.-based Strands and Barcelona-based BCSG provide “white label” (unbranded) services through large bank partners.
Yet, countervailing headwinds are strong:
- Regulation lags behind. The Basel Committee has backed away from the larger risk capital set-aside levels it considered in guidance for lending to smaller, less formally organized firms (without audited accounts, fixed assets or strong financial statements). But it hasn’t recognized the potential merits of alternative risk-management options. That’s despite growing evidence real-time electronic transactional data help predict credit behavior. This discourages more heavily regulated institutions, like banks, from investing in alternative risk management technology that might make small firm lending less risky.
- Lack of regulatory clarity for nonbank lenders. Nonbank lenders generally are not required to abide by risk-weighted capital requirements, meaning their costs of lending to SMEs are the same as for any other loans. This is not the case for banks, who today must carefully consider how to manage increasingly scarce capital. This is why many regulated banks are exploring partnerships with such “alternatives” to find capital-efficient ways to explore the MSME market. Witness the recent partnerships between Banco Santander and Funding Circle, or JP Morgan/Chase and OnDeck Capital. How will regulators treat bank capital invested in such partnerships?
- Know-your-customer rules dissuade investment in long supply chains. While the official guidance from the cross-border money transfer standards setter Financial Action Task Force (FATF) doesn’t require it, in practice, it’s becoming necessary to know not only your customer, but your customer’s customers. With supply chains getting longer and more complex, involving smaller and smaller firms, this is becoming more difficult to do – particularly for older, larger banks who also make local banks or money transfer operators from their correspondent networks, rather than risk large fines for noncompliance.
- Underlying payments systems for cross-border transactions are outdated. Despite much tinkering around the edges, its core remains based on early 1970s messaging protocols that require too many hands and not enough automation. The system works for larger firms and transactions. But it’s not conducive for small transactions involving MSMEs. Alternative technologies exist to support direct, more transparent, more cost-effective and more scale-neutral global payments systems. But moving to an alternative institutional structure that supports this is proving difficult.
Overall, the growing electronic “footprint” of MSMEs is opening many doors to innovative financing. The biggest banks, which have struggled to make this market profitable, could turn their scale to a comparative advantage by partnering with the right organizations to find the right ways to access and analyze the new data streams.