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?
Photo Credit: Anjali Banthia
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.
--------- The author is the CEO & co-founder of the Entrepreneurial Finance Lab.
In Small Business Corporation, the company I worked with, we use a risk based credit technology for lending to MSMEs. It has scoring and credit risk rating outcome and is quite effective and reliable. We have experienced abvout 2% to 3% default rate on our loan portfolio.
Great job, Bailey !
Keep pushing !
To reach MSME` segments efficently, we need to develop new and innovative tools. I truly believe that one of them is what EFL is doing.
Our industry no longer resist traditional methods (tremendously expensive and unefficient) that waste money, time and precious resources (what at the end comes to abort tons of projects)
I strongly believe in psycometrics, as it was succesfully used for years in other fields.
Lending to SME has many advantages than could do commercial banks, when thinking about improving on the living standards of the masses, which is of great interest and concern to every development practitioner. outreach and impacts are very wide and tangible. my case is a small lending initiative put in place under a common initiative group. This work mostly within urban markets where vendors are identified on daily basis on the same spot, they are sensitized on services offered and they make their choices. Choices range from house rents, njangui, loans repay, plot and building financing, school resumption preparation, normal savings etc Everyday they make contributions (savings) so as to meet up with their monthly demands. sometimes they request for very small loans raging from FCFA 10000 to 200000, which reflect their business size. securities here include, the savings choice, the spot they occupy in the market which the market master and the the suppliers recognize very well (suppliers in meat, tomatoes, fresh and dry fish, palm oil)etc.
Cash contribution by these very SMEs for just a sinle group in one market per monthly basis is estimated at USD 28000. In a market, about ten different groups execute such activities including some formal MFIs. These MFIs use this to improve on their running capital, while the others use the funds collected to generate interest as deposits in banks. since they are mostly school graduates with no job, they earn income raging from USD250 upwards which help improve on their living standards. many female collectors and men as well have received marriage blessings with some of the vendors in the markets and as this provides interest free cash to the business and a share in household expenses. Default rates here are very low, raging from 1 to 2 % per month, for those who failed to honour all their monthly payment.Very often, over USD 50000 is given out as loans per month to these very small vendors. Are the multiplier effects not seeming encouraging or the impacts not very great. All i intend to say is that, micro lending to SMEs has wide impacts not only to those that benefit, but also to those that offer. it is best for governments to promote this initiative so as to assure a participatory and sustainable growth in every nation economy. Confidence remains here the key to lending, not collateral and good financial statements. 'small lending is a promising future for development'