Imagine this: you have an idea for a small business, have a robust business model in place, your partners have agreed to support you in principle, and all that remains now is for your loan to come through. Then you get a call from the bank and hear those heartbreaking words – Application denied.
The story is a common one – banks tend to reject three out of every four loan applications they receive from small businesses, highlighting a clear apprehension towards financing small-and-medium-scale enterprises (SMEs).
Banks have traditionally been a custodian of customer relationships in the SME lending space, but after the global financial crisis, there has been a significant reduction in their risk appetite. This reduction, in turn, led to banks being increasingly cautious (and often conservative) when it comes to SME lending, especially newer businesses which lack a strong credit history. With increased regulatory scrutiny, banks have further tightened their lending standards and reinforced their requirement for more internal approvals. Despite an almost decade-long endeavor to convince banks of the importance (risk notwithstanding) of SME financing, they seem to be generally inclined more towards larger corporate loans. This inclination is evident when considering that the share of SME loans (as part of their total business loans) has continued to demonstrate a downward trend in recent years.
That may be the case, but there’s no denying that SMEs remain vital to the economic growth of any country, especially developing ones. As of 2018, India had 51 million SMEs contributing 37% of the non-agricultural GDP and employing 40% of the workforce. SMEs are a significant contributor to the nation’s GDP and employment. Though they are heterogeneous in their organizational form and offerings, they share a common challenge – the availability of formal financing to the sector has not been commensurate with its importance for the economy. As per the Transunion–CIBIL MSME Pulse Report, only 5 million out of 51 million SMEs have access to formal finance. These numbers are due to several factors: fragmented/incomplete financial data that inform lending; the inability of formal lenders to lend below a ticket size, given the (fixed) costs of due diligence; incomplete credit infrastructure coverage as credit bureaus cover a minor fraction of MSMEs; and inflexible payment options. A study authored jointly by Omidyar Network and BCG (The MSME Study) in November 2018 suggests that 40% of the MSMEs are constrained to borrow from informal sources at interest rates that are on average 2.5 times what formal sources would charge.
The Trouble with SME Lending
- Most of the time, banks refuse to lend money to those whose revenue is less than $2 million.
- Banks view SME loans as a high-risk proposition and challenging customer segment.
- After approaching multiple banks, SMEs need to spend more than 24 hours on loan origination paperwork and have to wait weeks or months to get the loan approved.
- Many banks are still involved in a paper-intensive, manual, cumbersome process. Even maintaining Excel sheets could result in data loss unless integrated with systematized loan origination and other processes.
Consider the SME credit gap in India, for instance
Many gaps are emerging from genuine constraints that make banks and formal institutions averse to SME financing. FinTech comes into play here as a savior: advances in FinTech, coupled with formalization, offer the opportunity for a million NTC MSME borrowers annually and a 10-to-15-fold increase in disbursements to the MSME space through 2023, as studies suggest.
FinTech: Targeting SME Financing Gaps
Globally, access to finance remains one of the most significant constraints to the growth, productivity, and even survival of SMEs, as well as the critical jobs they create.
Small businesses account for more than half of the world’s GDP and two-thirds of all employment, says Peer Stein, Director of Finance & Markets Global Practice at the World Bank.
Moreover, the gap between demand and supply in SME funding is massive, especially in developing economies like India. As of 2017, this is what the demand-supply gap looked like:
That said, according to the World Economic Forum (WEF), FinTech startups in P2P lending and crowdfunding are well poised to play a key role in bridging the $2-trillion funding gap for millions of small businesses across the world.
Michael Koenitzer, Financial Inclusion Project Lead at WEF, claims, “FinTech disruptors are increasingly filling the gap (that) banks and investors leave.”
The increasing digitization of SME finance and the potential supply of alternative data it provides offers an opportunity and solution to both the demand and supply side of the credit gap. By 2020, the world digital data stock will double every two years. Rising mobile usage, cloud-based services, big data, electronic payments, and exponential use of social media will fuel this increase. By 2020, 60% of the global digital data stock is projected to be contributed by developing economies.
So what can this mean for emerging markets that currently face constraints in accessing finance? Unmet SME lending requirements present enormous opportunities for new-age alternative lending providers to intrude into the system, reshaping the way legacy banks have done lending so far. Unlike traditional lending, alternate lending requires the company’s bank statement for the previous 12 months and supporting documents such as invoice copy, receipts against payments, references, canceled checks, digital footprints of the borrowers, online transaction history, and more. Once again, consider India: a 2017 report showed that India had the fourth-highest number of FinTech startups focused on alternate lending for SMEs.
The greater digital footprint of SMEs also leads to a proliferation of technology-focused alternative SME lenders using this treasure trove of digital data. These alternative lenders focus on new data and analytics to decrease costs associated with loan origination & collection, demonstrating the profitability of the SME market. Further, they show banks that without innovation, they can lose this SME market.
Simultaneously, the world is beginning to witness an alternative to alternative disruption – new partnerships between banks and FinTechs. These partnerships allow banks a fast and convenient way to innovate their product offerings and better serve their SME customers. Banks can vastly improve their customers’ experience with lower capital expenditures if they learn how to plug in FinTechs into ongoing operations. The FinTechs also benefit as they gain access to the banks’ extensive customer base, existing infrastructure, and lower costs of capital.
Digitizing a bank’s processes through intelligent automation, combined with machine learning and artificial intelligence, will soon no longer be optional for banks to stay competitive in the future. Realizing the potential of addressing the existing credit gap among small businesses, banks have started reinventing the SME loan approval & disbursement process by leveraging the latest technologies such as data analytics, big data, and artificial intelligence. Automation allows for faster verification of documents & the loan application process, self-service interface (in both website and app), transparent communication, and meaningful engagement with banks. It also allows for centralized onboarding, taking a unified view of the customers’ data. This development will let banks offer customized product offerings while reducing the hassles & costs associated with the manual processes and adding numbers to their revenue. In addition, having a comprehensive credit assessment tool would enable easy due diligence of documentation. Further, the insights derived from the due diligence report will help provide customized loan packages based on the requirements of individual small-business owners. The ambit of automation could cover:
- Loan origination
- Loan approval
- Underwriting
- Auto-KYC verification
- Document capture automation
- Document management system
- Streamlined management of collateral
- Error-free data entry
- Decreased onboarding time
- Extension of personalized services beyond loan disbursement
Digitizing SMEs’ finances holds immense potential for SMEs and SME lenders. By leveraging the opportunities digitization offers, close to 250 million SMEs in developing markets (currently have unserved or underserved credit needs worth trillions of dollars) can be helped effectively.
Against this background, many FinTechs have taken advantage of this favorable environment. Considering the rate at which these startups receive funding and disbursing loans while offering other associated services to SMEs, they are set to hold a greater share of the SME lending market in the next few years. According to one study, based on the AUM projections of Indian FinTechs serving SMEs, these companies will manage assets worth INR 1,00,634 crores by 2020.
If at all further convincing is needed to establish the hugely critical role FinTechs around the world have been playing over the years in service of bridging the SME financing gap, here’s a timeline of the global FinTech SME lending landscape:
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