November 16, 2016
While accessible consumer credit options have been widely expanded with financial technology startups to the extent of not being a major problem, accessible business credit is still a tough question. According to the World Bank, 200 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.
The problem wouldn't be so severe if it wasn't for the scale of SME industry – up to 95% of all firms globally are falling into that category, making them an integral and crucial part of every national ecosystem. SMEs drive economic growth and create millions of jobs.
Meanwhile, financial institutions are constrained by risk management requirements and are mostly unable to find a balance between favorable and enabling rates and failure risk mitigation. High operating costs of lending to small businesses and high complexity at a low scale of those businesses disable the financing option. Some estimates from WEF suggest that the median operating cost of lending for micro and small loans in developing countries is 18 cents per dollar lent, 2X–3X as high as one could expect this business to cost in advanced markets.
Advanced markets, however, are not a benchmark either. In the US, for example, SME loans as a percentage of all bank business loans fell from 35% in 2013 to 24% in 2014. In the Eurozone, borrowing costs for SMEs as spread over larger loans increased by 150%.
While $2-trillion-dollar gap seems vast, FinTech has a shot at reducing that gap and recovering the so-called ‘missing middle’. The Inter-American Investment Corporation (IIC) in collaboration with Oliver Wyman published a paper in September, outlining some of the ways FinTech is revitalizing financing opportunities for small businesses, which we will review further.
The use of alternative sources and types of data has been under our radar for some time now and the approach is believed to be highly beneficial both for consumers and for businesses in facilitating inclusion and prosperity.
As Paul Christensen, a clinical professor of finance at the Kellogg School, noted when sharing insights on alternative scoring, For companies, alternative credit rating is about reducing transaction costs, Christensen said. He also added that it is a way of addressing the problem of information asymmetry, which he calls one of ‘the definitional causes of market failure’ and one of the biggest threats to traditional microfinance.
Fortunately, digital technology has been adopted at a level enough for creating an immense amount of data that can be used to drive insights about the state of business and perform risk assessment. Alternative sources of data such as mobile phone usage patterns, social media impressions, and contractual details provide an opportunity to assess businesses and apply advanced analytics solutions to find the best financing option based on specific needs, repayment capacity and firm reliability.
Transactional data, for example, provides a complete picture of the credit capacity and health of small businesses, as most are dependent on cash flows rather than fixed assets or investment.
Financial technology companies have contributed greatly to the reduction of cumbersome manual paperwork related to business operation. They have also streamlined and automated underwriting processes for lenders and made it easier for small business owners to apply for a loan through online forms. The ability to cut overhead and offer a loan to small businesses online significantly reduces operating and servicing costs and allows more wiggle room for rate reduction.
Speaking of automation, financial institutions have never had a better opportunity to reach, educate and serve small businesses more efficiently than now because of client service automation tools and new interactional interfaces.
Education is one of the most powerful drivers of access to finance as an educated borrower is less likely to default on the loan and, hence, is able to prove its creditworthiness to unlock access to lines of credit. Providing virtual support can prepare prospective borrowers to receive credit by supporting the development of business plans and growth strategies, as well as the expectations for repayment.
In addition, virtual support tools open up opportunities for financial institutions to introduce small firms to additional services, which – according to ICC – can generate 30%–50% more bank revenue than lending alone.
FinTech was able to develop various business models for the alternative lending market, expanding financing options for small businesses. Regardless of the model, the core idea behind them is the democratization of financing and investment. In crowdfunding, it happens by letting the crowd decide which campaigns are worth funding and open digital channels to facilitate the flow of information used to make these decisions. Over 40 companies that we have mentioned as examples across 8 models are reducing financing tension for micro and small businesses, boosting their chances of survival.
Electronic payments are known to be major facilitators of inclusive economic growth and increased usage of electronic payments solutions have created opportunities for businesses to expand their reach and create meaningful data that can be used to secure financing.
As IIC notes, non-cash merchant transactions demonstrate records of sales volumes over time, which can provide banks with a means for verifying revenue streams and, correspondingly, contribute to the confidence needed to extend credit. The size of the opportunity in payments is significant; the global market for person-to-business retail payments was estimated at nearly $19 trillion in 2015. mPOS solutions deserve special attention as they are offering convenience for businesses and customers combining affordability for small firms with ease of setup and seamless service.
Both electronic payments solutions and mPOS products have a great deal of offering analytical tools to make sense of transactional data and provides higher visibility on business cash flow sustainability and daily operations. They contribute greatly to making businesses visible from creditworthiness point of view and establishing trust with financial institutions to secure financing.
Value chain finance is critical to small firms that depend on the immediate availability of funds for sustainable operations. ICC brings an example of electronic invoicing and other non-bank platforms that allow firms to streamline factoring solutions and sell accounts receivable to third-party financial institutions more efficiently.
Receivables are sold at a discount to generate often critical working capital for the business, allowing them to cover payroll expenses, pay suppliers, or invest in new inventory without having to wait for 30 to 90 days or more to receive payments for outstanding invoices, the report notes.
Supply chain finance options are critical for small firms as they optimize cash flow by allowing businesses to extend payment terms to suppliers while providing the option for suppliers to get paid early. The buyer thus optimizes working capital and the supplier boosts its cash flow, resulting in reduced risk throughout the supply chain.
The value of data has not only been delivered by FinTech to enhance profiling and assessment of the potential borrower, but also to allow small firms to have a better understanding of the market and opportunities. Financial and other types of data aggregators unlock insights and customer data from various sources to help businesses see how they compare to competitors in their industry and identify the best places to target publicity. Those solutions boost the competitiveness of businesses and facilitate a sophisticated approach to looking up the best financing options and defining businesses’ place in the market.
For financial institutions, those solutions allow a better understanding of the needs of businesses, their customers, clear vision of the needs of various segments and subsegments. As a result, banks can develop more attractive financial and non-financial offerings, enhance their ability to target these offerings and cross-sell complementary products and services over time.
However, without technological systems in place to efficiently collect and process relevant information, it remains excessively costly to convert the raw, often isolated data into useful, synthesized knowledge.