Bridging the SME Finance Gap
Achieving Economic Growth By Unlocking Access To Finance For SMEs
Small and Medium Enterprises (SMEs) are critical to the global economy, providing 40-50% of global GDP and about 65% of global employment. Despite this, SMEs are heavily under-represented in terms of bank lending, constituting only 5-10%. This leads to what is known as the SME Finance Gap, which is defined as the difference between the financing needs of SMEs and the actual credit available to them. In this thought piece, we aim to explain the main reasons for the SME Finance Gap, put our own estimate on the size of it, and look at the solutions being employed globally to try to reduce it.
Factors Exacerbating the SMME Finance Gap
Firstly, it is important to understand the main drivers of the SME Finance Gap, which are essentially the most common factors causing SMEs to have reduced access to bank lending:
- Limited Collateral: SMEs often lack sufficient collateral or assets to secure traditional loans. Financial institutions typically require collateral as a form of security, making it difficult for SMEs to meet such requirements.
- Lack of Financial Track Record: Many SMEs are relatively new ventures or operate in sectors where financial information and track records may be limited. This lack of financial history makes it challenging for lenders to assess creditworthiness, resulting in reduced access to credit.
- High Risk Perception: SMEs are often perceived as higher-risk borrowers due to their smaller size, limited resources, and market uncertainties. Financial institutions may be more cautious in lending to SMEs, leading to stricter lending criteria and higher interest rates.
- Regulatory and Legal Barriers: Complex licensing procedures, bureaucratic processes, and stringent compliance requirements can deter financial institutions from extending credit to SMEs.
- Information Asymmetry: This occurs when lenders have less information about the creditworthiness of SMEs compared to larger, more established businesses. This makes it challenging for lenders to assess the risk accurately and offer suitable credit terms.
Methodology To Work Out The Size of The Finance Gap
Determining the exact size of the global SME Finance Gap is challenging and can vary across different studies, based on the methodology used, the definition of SMEs, and the specific geographic and economic contexts. The most updated and in-depth research comes from the International Finance Corporation (IFC), part of the World Bank Group, which estimated that the global SME Finance Gap across 128 developing countries was around $5.2 trillion per year in 2017 for formal SMEs, an average of 19% of the GDP of those countries. This gap alone is equivalent to 1.4x the current level of SME lending in those countries. Additionally, the IFC estimated this figure swells by another $2.9 trillion (10% more of GDP) when including informal SMEs. This is an eye-watering 29% of total GDP and 2.2x the total SME lending in these developing countries.
The methodology employed by the IFC is to use the Debt-to-Sales data per industry from a representative set of 10 developed and financially sophisticated countries to calculate the demand for credit across various industries. This is then multiplied across the number of SMEs in the developing countries (segmented by industry), and compared to the supply of credit to SMEs. The conceptual argument using this methodology is that if these developing countries had more developed regulatory and lending infrastructure as in the sub-set of developed countries, the availability of credit for the SMEs would be higher.
Research of this nature requires simplifying assumptions and estimations to come up with the final outcome. We have attempted to update the figure with our own estimate based on subsequent GDP growth. The main challenge is that an economic shock like COVID would likely have had a disproportionately higher impact on the SME sector than on larger companies. This is because SMEs have smaller amounts of capital to act as a buffer against such disasters, and the banks tend to become more risk averse in downturns. This is counter-balanced somewhat by government interventions globally to support SME lending during COVID, including low-interest loans. Without further data, it is difficult to challenge the findings of the IFC research, so the key tenets have been carried over into our estimate.
We have updated the GDP of the 128 countries used in the IFC study, which has grown to $42.1 trillion at the end of 2022. If the Finance Gap in the formal SME sector has remained 19% of GDP and 1.4x higher than formal lending supply, then this translates into a Finance Gap of $8.1 trillion in the formal sector, against total lending of $5.7 trillion. Assuming the informal sector Finance Gap has remained 10% of GDP, this would add another $4.2 trillion to the total Finance Gap, giving an overall total of $12.2 trillion. To put this in perspective, this equates to 12% of total global GDP.
Measures to Reduce the SMME Finance Gap
Reducing the SME Finance Gap is clearly an extensive global problem and requires efforts from various stakeholders, including governments, financial institutions, and the broader business ecosystem. Independent governments, the World Bank and other organisations are trying to assist via implementing measures that can include:
- Financial inclusion initiatives: Governments and financial institutions can implement policies and programs to promote financial inclusion, such as establishing specialized lending programs, microfinance institutions, or guarantee schemes targeted at SMEs.
- Credit scoring and alternative data: Developing credit scoring models that incorporate alternative data sources and metrics beyond traditional financial records can help assess the creditworthiness of SMEs more accurately.
- Capacity building and financial education: Providing support and training to SMEs on financial management, record-keeping, and business planning can enhance their creditworthiness and make them more attractive to lenders.
- Direct interventions from government: Measures can include credit guarantee facilities, low-interest loans, trade finance incentives for exporters, and an SME-friendly regulatory environment. An example of this in the United Arab Emirates saw the government pass a law allowing the SMEs to use movable assets as collateral.
- Adoption of technology: Fintech companies can assist in reducing some of the key barriers to financing for SMEs by disrupting traditional banking strongholds. This includes alternative credit scoring, innovative collateral solutions, and access to cheaper and more efficient financial services.
What This Means for Kingson
At Kingson, we have an investment philosophy that leads us to invest in themes that we believe have enormous longevity and will outlast us. This means we look beyond current popular trends, because these will likely disappear as economic cycles and access to venture capital funding worsen. We see the SME Finance Gap as a massive driver of the future and see the value of investing in companies that play a role in solving elements of this problem through their innovative technology and business models.
