MSMEs: Big Opportunity In Small Lending

There is significant evidence that Micro,Small and Medium sized Enterprises (MSMEs) in emerging markets have insufficient access to finance. In the World Bank enterprise surveys, access to finance is rated as the most significant obstacle to business growth globally (16.2%) and Stein, Goland & Schiff (2010) estimate that there are 310 to 380 million enterprises that need more credit but can’t access it, with collective needs totaling $2.1 to $2.5 trillion. Studies of the business enterprises themselves demonstrate that if they had more access to capital, they could do very productive things with it and earn rates of return far higher than the interest rates banks typically charge.

On the other side of the potential lending transactions are the commercial banks. Despite the recent credit crunch, banks remain well capitalized in most emerging markets. Moreover, there is increased competition in traditional segments such as consumer and corporate lending that is forcing banks to look for new sources of growth. Why then aren't banks taking advantage of the big opportunity in small business lending?

A lady is selling vegetables in a market

If you speak with the banks, it is clear that it's not because of a lack of awareness of or interest in the sector. For example, in a 2011 survey by FOMIN 93% of banks in Latin America & the Caribbean considered small and medium-sized enterprises as 'strategic to their business'  and 89% of them had a specialized unit focused exclusively on this segment. Banks want to lend more to MSEs; it’s just that it’s difficult to do.

When lending to consumers, banks assess risk by verifying the monthly income of the applicant--do they have a job with a regular income and is that income sufficient to meet the consumer’s other obligations plus the amount of the loan? Verifying this income can be done rather easily as long as the individual has formal employment, which has the benefit of formal and verifiable evidence such as pay stubs and employment tax records. Moreover, such wage income is relatively stable.

Small business owners, on the other hand, often lack a stable or verifiable paycheck. Their income can change significantly from month to month and, even more importantly, it is extremely difficult to verify. In emerging markets many transactions are done in cash and generally MSEs do not have up-to-date audited financial statements.

Larger corporations can also have unstable income, but for larger businesses sales transactions and financials are more easily projected. Added to this is the issue of transaction costs. Large companies take out large loans, and a bank earns its money on the ‘spread’ (difference between the interest paid on the loan and the cost of capital). So even though interest rates and spreads are typically smaller for lending to large corporations compared to MSEs, the large loan size to which the spread is applied can support relatively high costs of loan origination.

Moreover, sending skilled loan officers to examine a large business’s financial records and business plan is worthwhile for a $500,000 loan to a large corporate borrower. However, the smaller loan amounts sought by small- and medium-sized enterprises cannot support very large transaction costs: the loan size is simply too small.

As a result, a bank has less information to evaluate risk for MSEs compared to consumers and corporations; and compared to corporations it can spend less money to gather and analyze information. Typically, they rely on rules like guarantors and collateral, which results in creating the above-mentioned $2.5 trillion dollar MSE financing gap as well as harming economic growth and poverty reduction.

New tools are needed to solve this problem--one of which will be proposed in the next post in this series.