By Mindaugas Mikalajūnas, CEO of SME Finance
Micro businesses and SMEs represent around 90% of all firms globally, provide roughly 70% of all employment and, by some estimates, contribute to up to 70% of global GDP. That’s a $66 trillion annual opportunity for the world’s banking community.
And yet, a mix of outdated culture, processes and technology mean that the established banks seem reluctant to focus on SMEs' needs and accept them as a core revenue stream. That’s a big problem for SMEs because the biggest banks still control from 70% to 90% of the market in most developed economies.
Banks were not designed to serve small businesses
The big banks look at SMEs and see more risk, due to a lack of equity and formal business qualifications. Smaller businesses’ finances are often not very clear and they are very sensitive to turbulence in the market. That's why banks cherry pick and the result is a substantial SME loan rejection rate.
The first of these challenges — lack of visibility — shouldn’t be an issue in this day and age. One of the big promises of PSD2 and open banking, was that permissioned access would make data about clients and potential clients easier to access and share.
Logically, this should also make it easier for smaller businesses and startups to obtain loans. Banks can now get a clear picture of what’s really happening inside the account of a prospective loan client, even if that bank does not currently hold the account on its books.
New business models, where subscriptions are increasingly common, also should make it much easier for banks to lend to startups, using recent innovations such as revenue-based finance (RBF).
And with AI-based tools, you would think that understanding the data from open banking and making quick loan decisions would be standard practice. But that still seems to be the exception — usually limited to new fintech startup lenders and banks who come at SME lending from a new place, uncluttered by conventional thinking and manual processes.
Inequality of access to loans is recognized as a serious policy challenge by regulators. In the European Union (EU), the European Central Bank (ECB) produces a twice-yearly report about the availability of business financing: The ECB survey on the access to finance of enterprises (SAFE). The latest edition of the report, September 2021, shows that despite a general improvement in finance availability driven by macroeconomic recovery after the pandemic, the core issue remains unchanged: The smaller the business, the more difficult it is to obtain adequate working capital.
As a policy response, many governments provide credit guarantee schemes for the SME sector, already widespread well before the COVID emergency required emergency measures in this regard. For example, a European Investment Bank (EIB) report in 2017 concluded that “In many Western European countries credit guarantees play a key role in supporting SMEs’ access to finance… In absolute terms, the guarantee sector is largest in Italy (outstanding volume: EUR 33.6bn), France (EUR 16.7bn), Germany (EUR 5.6bn) and Spain (EUR 4.1bn).” These are national figures and exclude the EIB’s own multinational response, the European Investment Fund (EIF),
Regulation is failing to address inequality of access
With so much available in the way of loan guarantees, conventional banks could easily ramp up unsecured lending to SMEs. But that’s not happening at the required rate. The big banks don’t seem to understand, or want to make the effort to understand, the financials of smaller businesses.
Again, we should try and see this from the perspective of legacy banks. They have tended to be relatively few in number and very big: SMEs, of course, are much smaller and more numerous. It has been simply easier and more profitable for banks to focus on a smaller number of larger-enterprise business clients.
While competition in banking was low, as a result of barriers to entry such as regulation and the cost of technology, there was little motivation to shift from this status quo. But that’s all changing with the rise of open banking, fintech-driven challenger neobanks, and the encouragement of new, start-up regulated banks in newer EU countries, such as the Baltics.
While conventional banks do not have the agility to service SMEs profitability — nor the motivation to create that agility — neobanks and fintechs do have this agility and are solving the challenges through a combination of hard work, automation, and AI.
AI can focus on client behavior as the top priority to understand risk. This is how it can “look through” the short trading histories of many SMEs and recognise their true ability to repay loans. Client behavior, in this context, is about inbound and outbound money flows through the account. The AI calculates the flows and categorizes expenses to generate a fully manageable risk profile.
AI also addresses other issues holding SMEs back, such as unconscious gender and age biases that sometimes mean great business opportunities often get nipped in the bud because of discrimination. Possible AI bias is a regular topic, but the other side of the coin is the potential of AI to eliminate subconscious biases based on appearances and outmoded thinking.
Making SMEs attractive and accessible to institutional investors
Institutional investors understand all this. They are looking for high growth, high yield opportunities and are culturally more open to innovation and working with the entrepreneurs capable of delivering these goals. However, due to scale they are not geared up to manage a large number of smaller opportunities on their own books. They prefer to work with specialist SME financing banks who understand and can manage the risk profiling, and have the automation in place to handle the work efficiently and profitably. They also expect a high-visibility digital portal where they can see, understand and manage their portfolio risk.
Now offered this service by specialist SME financers, there is a clear trend for institutional investors to allocate a larger proportion of their portfolios to SME positions. My own company witnessed inflows of a quarter of a billion Euros in just two deals in 2021, for example.
There are good reasons for believing that the long-term neglect of small business financing is changing. The ECB’s data shows an improving macroeconomic picture at the end of 2021 and easier access to financing in general. I do not believe, however, that this is helping smaller businesses make up ground on larger firms. Instead the improvement in this direction is coming from a shift to more agile, specialist lenders, assisted by automated processes and AI-based risk evaluation. After decades of failed government policies to improve SMEs’ ability to raise the money they need, these new digital-first banks are what will make a real difference and enable smaller businesses to reach their full potential.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.