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.
Thank you for the article. I found Myth #2 surprising since in order to debunk it a large number of people would have to think it is true; runs counter to my experience as the reason the SME discussion exists (and the consultants who work in the sector!) is because local banks, in general, do not know how to finance small businesses.
Mainstream banks are not in the business of providing risk capital, and even those that believe the SME story are not incentivized to risk their lending portfolios (and ultimately their job security) by taking a chance on a potentially questionable credit. It is highly likely that they misprice this risk, but since very few banks that service this space will lend against streams of future cash flows, as opposed to hard collateral, even if they could get comfortable with the diligence the example you gave of Mr. Andrade transferring ownership of the store (in order to effectively dodge taxes) would lend an additional level of discomfort to a lender.
The above example highlights (as does the bar graph) that there are wide discrepancies in business practices which increase the costs of diligence. Efforts that help to lessen information asymmetries through better technology will help, it’s difficult seeing a one-sized-fits-all template working given the idiosyncrasies.
Dear Dorte Weidig
Three Myths of SME are useful but they are more concerned with supply side by and large related to financial input . There is therefore a need to focus on 4th Myth in the demand side which may probably demystify all these three myths.
Myth # 4 : Mere provision of finance to SMEs is important to foster economic growth , no matter other non financial inputs.
4th Myth assumes more importance as it concerns with more on demand side complexities of SMEs pertaining to non financial inputs such as, labor, land, raw materials, power, store/warehousing ,technical knowhow, marketing, pricing, transport, road , bridges, local licensing formalities related to sanitation, drainage, pollution etcetera. Logically in the absence of these non financial inputs in terms of availability, (uncorrupted) accessibility, adequacy, timeliness, quality, etc required for the concerned SME in the given region/area , financial access may also become difficult no matter the type of financial institutions.
Among others, the moot question to be researched is
Whether difficulty in financial access for SMEs is due to absence of these non financial inputs or in spite of presence of these inputs in the target area?
Thank you for sharing my views
Great article to feed a very important and timely discussion indeed. I find the graph illustrating diversity amongst SMEs quite compelling, as well as the concrete examples you picked.
I don’t believe, though, that the 3 myths you highlight are actually real myths. The size of the SME Finance gap (Myth #1) is increasingly documented (see WB-IFC-McKinsey-G20 recent work); a large part of the gap is due to commercial banks not being able to effectively and efficiently finance SMEs (Myth #2), but they can be taught how to do so and learn quite fast, with the right incentives; and yes, providing finance to SMEs would have a strong impact for economic growth, but I don’t recall anybody suggesting that this can be done “no matter the method” (Myth #3)
This said, we seem to be reaching the same conclusions: (1) best practicies in SME Banking are increasingly known and can be taught, with capacity-building to banks. (2)They highly leverage on client segmentation according to financial needs and behaviors, not just size and basic demographics.
The example of M. Andrade also calls for SMEs having to upgrade their accounting and financial management practices, and this would hopefully go in parallel with commercial banks increasingly being able and willing to provide financing to well managed SMEs.
Finally, allow me to share two hard myths that I have also regularly come across when dealaing with SME Financing, and that one have to be careful with before engaging in capacity-building to banks:
Myth 1: commercial banks should fill the whole SME Financing gap. This is specially untrue for start-up SMEs, who are often a key target for policy-makers. Start-ups are generally not, and will most likely never be, a risk that commercial banks can take with lending products.
Myth 2: banks that learn how to deal with SMEs will enter this market segment. This ties into the questions of what you call “genuinely interested banks” in your article. I consistently found that for banks to be willing to enter the somehow complex SME market, the right incentives have to exist, and are greatly dependent on the other options commercial banks have to allocate their capital. Two examples: (1) in countries where the government borrows locally at high rates, I generally found it quite hopeless to help banks find an incentive to target SMEs. (2) in countries where the capital market is fairly developped and large firms have access to equity and bond financing on their local market, banks have no other choice but targetting SMEs to offset the loss of lending business they experience on the corporate segment.
Ayr Naïm, IFC
Thanks for the article. Coming from a banking and entreprenuer background, I couldn't agree more that finance is not the only and the most important driver for SMEs' success, Here in Malaysia we are blessed with financing assistance but experience among SMEs revealed that successful SMEs are those that do not rely on government subsidized schemes. Its their ability to generate internal financial capabilities that drives and sustain their performance. Creativity in financing the business that exist within SME's business model are far more important.