Should There Be Another CGAP, This Time for SME?

I’m sensing an upsurge of interest in small and medium (as distinct from micro) enterprise. There’s talk of a “missing middle”—the underserved hole between conventional finance for big-business fat cats and microfinance for tiny low-income entrepreneurs. The list of reasons to support SME starts with the well-documented role of such enterprises in job creation, and goes on from there. Certain folks over at the World Bank and elsewhere are asking whether development funders ought to organize some sort of consultative group, á la CGAP, for SME. I don’t have a view on that question, but I do have some observations and impressions.

First, in earlier days of microfinance there was some vagueness, and consequent heat loss, about whether the focus was about microenterprise support (including non-financial forms thereof), or more narrowly about financial services for microentrepreneurs. There were reasonable arguments for a broader focus, but the founding members of CGAP decided that their group would focus on financial services only. There’s a similar vagueness in some of the new discussion of SME and a possible consultative group for it. Is the focus going to be SME finance, or SME support more generally? Either way, it will help to be clear.

Second, boundaries. There’s obviously no sharp dividing line between microenterprise and small enterprise. If the focus is going to be on finance, then I think it’s most useful to draw the dividing line, not so much in terms of business size, but more in terms the lending methodology being used. (In the arena of microfinance, savings services are hugely important, not just credit. My guess is that when we turn to small and medium enterprises that are larger, and less integrated with the household finance of the owner, the relative importance of savings compared with credit will lower.)

Microcredit is mainly about uncollateralized lending to unsalaried entrepreneurs where credit is assessed not by collateral valuation, financial statements, and formal project budgets but rather through some mechanism where a loan officer or a borrower group judges household cash flow. The essential repayment incentive is not collateral or legal sanction (both of which are impractical), but rather desire to keep continued access to a valued credit facility. To lend in the micro arena, MFIs use some techniques that are quite different from normal bank loan techniques, including group lending, graduated loan amounts, frequent repayment, etc. These “magic tricks,” discovered and fine-tuned over the past 30 years, allowed for substantial reductions in cost and increases in collection for very small loans.

While there is overlap at the margins, SME lending tends to have different customers and therefore different methods. The borrowers are more likely to be formal enterprises with accounting systems and financial statements that track enterprise finance separately from the owner’s household finance. The appropriate methods for loan assessment are more like conventional banking methods. SME loans are smaller than “regular” commercial loans, and therefore more expensive to process. Unlike the case of microfinance, there don’t seem to be many new magic tricks available to reduce these costs. (I think this is generally true, but it’s interesting to see a group like ProCredit moving some microcredit techniques upscale into SME lending.)

The third point is that the above considerations, if correct, may have some consequences for our expectations about SME finance. There is a long history of governments and development funders trying to support SME finance. My impression—certainly not a thoroughly researched one—is that the success rate has been low. It is clearly possible to do SME lending sustainably (i.e., profitably), but might it be that because of the shortage of new magic tricks, you need exceptionally competent management (like ProCredit) to make it work, which could be why it may never mushroom like microfinance did?