5 Steps to Closing the $2 Trillion Credit Gap
Everyone needs financial services – the poor, the middle class, and the wealthy. But if you are poor, access to quality finance is harder to come by, and much more expensive. Unfortunately, the same is still true for small businesses around the world.
Compared to large companies, small and medium-sized enterprises (SMEs) face severe credit constraints. Two-hundred million businesses globally are unable to get the credit they need, both for working capital and for investments. The estimated global credit gap exceeds $2 trillion. These credit constraints are most acute in low-income countries, where nearly half of small businesses cite lack of access to finance as a major barrier to growth.
This SME finance gap is often described as the “Missing Middle”: microfinance institutions provide capital for microenterprises with fewer than five employees and commercial banks or private equity firms serve large corporations and multinationals. Small and medium-sized companies, usually defined as companies with up to 250 employees, are stuck in the middle. This is an enormous problem, because the vast majority of all firms world-wide are SMEs – up to 95%, according to some definitions.
The good news is that closing the SME credit gap should be a win-win for everyone. A recent IMF paper suggests that lifting credit constraints for SMEs is associated with an up to 4 percentage points higher economic growth. Management consulting firm McKinsey & Company estimates the revenue potential of SME finance in emerging markets to be about $360 billion in 2015.
If SME finance drives economic growth while also creating billions in private sector revenue opportunities, then why does the credit gap still exist? Economic surveys show that the credit constraint is almost entirely a supply-side problem, as the demand for SME finance is overwhelming. The key obstacles for financial institutions are that small-scale lending in developing countries leads to high loss rates in case of default and has high operating costs.
Therefore, the central challenge in closing the SME credit gap is to find ways of bringing down the costs of providing credit to small businesses in the developing world. To illustrate, the median operating cost of lending for micro and small loans in developing countries is 18 cents per dollar lent, two to three times as high as one could expect this business to cost in advanced markets.
There are two main factors that will determine the success of narrowing, and eventually closing, the credit gap. Both factors depend heavily on the interplay of targeted public and private sector interventions:
- The quality of a country’s financial infrastructure, particularly the availability of data, including credit information and ways to secure, register and enforce pledges over movable and immovable assets.
- the ability of banks and non-bank financial institutions, including Fintech SME lenders, to innovate in servicing their clients and better leverage digital transactions and data to create convenient and affordable financial solutions.
Here is a 5-step action plan for how policy makers can address this critical challenge in collaboration with the private sector, and work towards closing the credit gap for small and medium-sized businesses:
- Build out credit infrastructures, especially credit information and movable collateral systems. Improved credit reporting benefits both lenders – banks, non-bank financial institutions, and fintech companies – and creditors. For example, after China introduced legal reforms and a fully electronic registry for receivables, receivables-based financing increased to 20% of banks’ balance sheets. Improved credit infrastructures also help non-bank financial institutions, like leasing and factoring companies, and they are a foundation for the fintech industry.
- Sharpen policy interventions by applying industry-wide best practice principles. Guarantee funds are a typical policy instrument in many countries to help SMEs get access to credit, and can play an important counter-cyclical role in times of crisis. The ‘Principles for Guarantee Funds’ were developed by a World Bank Group-led international task force to help improve the performance of guarantee funds.
- Digitize all government payments. Moving from cash payments to digital payments by shifting all government payouts to digital platforms will lead to an uptake in digital business transaction accounts and encourage the digitization of supply chains. Digitization creates an accessible data trail, which improves credit information, facilitates on-the-spot credit decisions, and provides means to secure loans against digital payment receivables.
- Lower barriers to entry for alternative lenders and fintech companies. Policymakers should aim to create a level playing field for non-bank lenders to compete with banks in the SME finance market. Fintech payment services providers and lenders, such as Square, Alibaba’s Alipay, and Amazon Marketplace Lending, hold great potential to reduce cash handling costs and increase efficiency for small businesses. More ‘traditional’ non-bank lenders, such as leasing and factoring firms, and marketplace/peer-to-peer lenders also play an important role in closing the credit gap and should be allowed, and encouraged, to compete in the SME finance space.
- Strengthen prudential oversight of the financial sector. Without proper oversight, an expansion of credit to SMEs could imperil financial stability and destroy – rather than create – economic growth. In contrast to simple expansions in household basic banking accounts, which pose no threat to stability, technological innovations in payments and credit markets call for better financial supervision. Without accompanying prudential oversight, any gains from expanding finance to small businesses could be outweighed by a loss in stability.
The current fintech explosion is already causing major disruptions across the entire financial services industry. For SME finance, this means that the timing has never been more opportune to finally reduce inequities in the credit market and close the credit gap.
It won’t be a walk in the park but, together, policymakers and the private sector can create the conditions necessary for the market to offer affordable and convenient financial services for small businesses.