An Unmet Need
The International Finance Corporation (IFC), the SME Finance Forum and the World Bank Group estimate the entire MSME finance gap to lie close to US$ 5 trillion, hindering the ability of MSMEs to grow. This gap, however, is not due to a lack of available funds. A report by the International Trade Center indicates that “in 2018 global funds held US$ 1 trillion of cash-in-hand equity capital that was seeking investment opportunities”. Of particular concern is the well-known trade finance gap, which disproportionately affects MSMEs. Despite the low-risk nature of short-term trade finance, the trade finance gap alone is estimated at upwards of US$ 1.5 trillion. The rejection rate of MSME proposals for trade finance is 45 per cent. According to the ADB, “among MSMEs initially rejected that sought alternative financing, 47 per cent were unable to find anything appropriate,” and this doesn’t include those firms that do not even apply for financing in the first place.
Several key reasons are commonly put forward to explain why MSMEs, particularly those in developing nations, struggle to obtain financing. These reasons include, among others, a greater risk profile combined with MSMEs’ lack of additional collateral and formal documentation required for financing, increased complexities for financing cross-border activities, a lack of awareness among MSMEs, and high costs to service due, in part, to lack of digitalization. When it comes to trade finance, some issues are related to working capital issues, others to trade finance products, each creating different challenges.
Assessing MSME Risk Profiles: a complex task
Many of the challenges facing MSMEs in their quest for financing stem from their general position in the market. There is a lack of appetite among banks to provide funding and support MSMEs businesses in part due to the perception held by banks that the rate of default in loans awarded to MSMEs is much higher than large scale businesses and that MSMEs are often not known to banks and lack a credit history. Lack of collateral may be a problem as well. Banks often require additional collateral to mitigate risks against MSME borrowers that they do not have strong existing relations with, but this requirement is difficult for many MSMEs to fulfill, leading to increased rejections. MSMEs often lack the extensive documentation that helps funders understand the risk profile of their business. This means that the little money banks are willing to provide often goes to larger businesses whose risk is easier to calculate. Assessment of MSMEs’ creditworthiness, i.e. risk assessment, is clearly a central issue for MSME financing. It is important to note, however, the difference between good and bad risk. Some of the US$ 1.5 trillion trade finance gap is good risk, but some of it is bad risk. We need to focus on the good risk. What we need is to improve our understanding of the good risk within that gap. This is also relevant in the context of domestic financing.
In addition to this, most MSMEs do not have an effective marketing strategy and so have not been able to successfully sell their ideas to funders. Ultimately, this suggests that because of an inability to successfully communicate with potential funders through actual documentation or comprehensive marketing, MSMEs are inadvertently withholding information from these funders, negatively affecting their ability to acquire the funding. To successfully acquire funding, MSMEs need to articulate their unique benefits while simultaneously providing necessary KYC compliance documentation.
One tool that may help in this realm is a digital identification system for companies that permits them to identify a legal entity quickly and unambiguously and would underpin a global digital identity system. Without a global digital identification system, finding information about an MSME in a sea of metadata is difficult, if not impossible. Such a system can drive more transparency and underpin the promise of fintech to deliver greater inclusion of MSMEs in the global economy by facilitating customer onboarding, credit approval processes, and identity validation of potential clients; increasing access to finance for MSMEs in emerging markets by easing the flow of reliable information about small companies; and promoting the development of emergent technologies such as blockchain, thereby reducing costs. Recognizing the value of a global identification system for companies, the G20 spearheaded work on a global legal entity identifier (LEI) in 2011. Launched in 2014, the LEI has, however, seen limited adoption. At the end of 2020, 1.8 million companies in over 250 jurisdictions had acquired an LEI. Other initiatives in this space include the Data Universal Numbering System (DUNS), a proprietary system developed and managed by Dun & Bradstreet that assigns a unique numeric identifier (a DUNS number) to a single business entity, and the Trade Identification Number (TIN) developed by the World Customs Organization (WCO) – not to mention the various DLT-based initiatives that have flourished in recent years. More recently, the B20 Saudi Arabia, together with Business at OECD, proposed to investigate the feasibility of a Global Value Chain (GVC) Passport allowing firms to be accredited throughout the relevant GVC as a credible partner, and proving compliance with relevant financial regulations and requirements, thereby avoiding the burden of having to re-apply multiple times across borders.
Complexities for Financing Cross-Border Activities
Cross-border activities entail complex risks, particularly linked to foreign transactions and legal procedures. The ADB Trade Finance Gap Survey indicates, for example, that know your customer (KYC) and anti-money laundering (AML) concerns, which become amplified when transacting in multiple jurisdictions, were the eminent reason for MSME financing rejection and that 20 per cent of trade finance applications were rejected due to a lack of additional collateral. Some of these risks are not present in a domestic environment, such as fluctuating foreign exchange rates, higher local interest rates, unfamiliar legal environments, prudential regulatory and financial transparency risk. Add to this a backdrop of constant geopolitical instability and a hotbed of economic uncertainty, it’s a challenging environment at best for most MSMEs to operate in. According to a WTO report, “many local banks may lack the capacity, knowledge, regulatory environment, international network, or foreign currency to support import-export related finance.” As local banks most often serve MSME clients, particularly in developing nations, this may explain why few banks are focusing on MSME trade finance needs. This may stem from the complexities associated with financing cross-border activities. While this is the case, cross-border activities cannot be considered in isolation; domestic activities, such as financing domestic trades and transactions, are also important for MSME to achieve success in international markets.
Lack of Awareness Among MSMEs
MSMEs do not possess the magnitude of knowledge that funders hold. This affects both their ability to identify potential sources of funding and their level of comfort pursuing innovative financing methods. In most cases, MSMEs are not fully aware of the various government grants and other initiatives to support their type of business and they are not taking advantage of various innovative solutions geared towards supporting MSME business. Beyond this, even when MSMEs are aware of the options available to them, many still struggle with a lack of understanding of the processes and criteria for acquisition. Many experts in the space can recount conversations they have had where an MSME draws attention to the fact that, had they known the process upfront in terms of what would impact the decision-making process, they could have addressed these requirements and secured the funding. Not only do MSMEs often lack knowledge of the potential funding available to them, including alternative financing options, but they can also lack knowledge of what is necessary to acquire the funding. While MSMEs talk about access to long-term capital, financial institutions talk about debt. The right conversation is not happening. MSMEs are asking for the right thing but from the wrong institutions.
To overcome this, there is a need to educate and advertise more and also to simplify and standardize the application process. In light of the COVID-19 pandemic, however, many financial institutions are providing customers with resources to improve their business plans and financing applications with the aim of improving acceptance rates for pandemic-related financial aid. This is a promising step in the right direction.
High Costs of Service from a Lack of Digitalization
Another factor affecting MSMEs’ ability to acquire finance is the high cost of service often associated with MSME financing, in particular trade finance, due, in large part, to a lack of automation due to a non-digitized environment. Without automation, manual handling costs will stay too high to serve a big portion of the MSME market. This is because the processing costs of trade finance transactions are far too high in relation to low-value or single transactions, the predominant transaction type for MSMEs. This creates an unfavourable situation for MSMEs as they seek out financing, as finance providers are incentivized to allocate their resources elsewhere. A lack of digitalization of MSMEs together with small loan sizes, can lead to a high cost of service and subsequently, a low appetite for providing funds. This same paradigm also applies for access to credit insurance if the portfolio of debtors is not optimal, for instance too small or too concentrated. Most clients of credit insurance companies in short-term trade are MSMEs. Increased digitization can lower costs and create capacity for servicing lower ticket firms. From an MSME perspective, striking the balance between complying with new trade agreements and investing in new technologies is a key challenge and distraction when one considers their limited resources and investment.
Results from the ICC Global Survey on Trade Finance also suggest that a portion of the difficulties experienced by MSMEs may be a result of the banks that serve these firms. MSMEs tend to be more often served by smaller local or regional banks as opposed to larger global banks. Smaller local or regional banks tend to be better able to form close relationships with MSMEs, fostering a greater sense of trust between the two parties. The ICC study, however, indicates that it is the local banks that lag the most in terms of digitalization. Only 25 per cent of local banks think that digitalization will provide benefit to their operations and only 55 per cent project any cost savings, due mainly to the perceived cost of change weighed against the potential benefits. This is compared to 59 per cent and 90 per cent respectively for global banks. On top of this, less than half of local banks have a digital strategy. This lack of digital appetite for the banks servicing the most disproportionately underfinanced companies comes despite the belief held by 55 per cent of local banks that they would be better positioned to service MSMEs with digitalization.
From these studies, it seems evident that although digitalization efforts could help improve the service delivery for MSMEs, the challenges that persist have all but eliminated the incentives for local banks to pursue digitalization. As the ICC Digitalization Working Group articulated, digitization and “Electronic documents sit at the uncomfortable intersection of 19th-century legislation and unsophisticated 21st-century operators”. This leads to too few cost-effective choices of new technology provision for smaller banks. Technology is often seen as too costly and too futuristic with insufficient business cases, clearly articulated a luxury for large banks or an opportunity for new digital banks, but not for local banks in developing countries.
Cost of Capital and Basel Requirements: an additional challenge?
There has been debate surrounding the possible unintended consequences of Basel III requirements. These debates led the Basel Committee on Banking Supervision to make several revisions reflecting the low risk of trade finance and improving its regulatory treatment. It is important to note, in this regard, that studies conducted by the Financial Stability Board and the World Bank do “not identify material and persistent negative effects on SME financing in general, although there is some differentiation across jurisdictions. There is some evidence that the more stringent risk-based capital (RBC) requirements under Basel III slowed the pace of SME lending growth at the most “affected” banks (i.e. those least capitalized ex-ante) relative to other banks”, but “these effects are not homogeneous across jurisdictions and they are generally found to be temporary. […] Stakeholder feedback suggests that SME financing trends are largely driven by factors other than financial regulation, such as public policies and macroeconomic conditions”, a conclusion which is consistent with the literature on the effects of bank capital regulations and with stakeholder feedback that SME financing is largely driven by factors other than financial regulation. In spite of this, questions are being raised about how to provide a more favourable framework for assessing MSME credit risk through digital innovations and taking into account new analytics provided by fintechs, in a Basel environment.
Other concerns have arisen from the termination by many international banks of correspondent banking relationships after the financial crisis and their reduction of overall exposure towards developing countries and SMEs (de-risking). While some practitioners have become increasingly concerned about de-risking as a possible result of these requirements, where financial institutions have terminated or restricted business and correspondent banking relationships in order to avoid, rather than manage, a risk-based approach, analysis by international financial institutions, trade institutions, multilateral development banks and academics provides a nuanced picture. De-risking can also be the outcome of commercial decisions by private financial institutions, and of changing market shares in a post-financial crisis environment. Nevertheless, the boost that beneficial capital weightings could have on MSME lending should not be completely discounted, as some practitioners noted. At the very least, it could form one part of an overall support strategy at local, regional or international levels and could encourage banks to re-examine their approach.