Covid-19 has brought to the fore once again the critical role played by small businesses in economies – developed and developing alike. According to a World Bank publication, small and medium enterprises represent 95% of registered firms in the world and account for more than 50% of jobs. Over the years, many research reports have clearly brought out the importance of this segment and have also highlighted various impediments to effective growth. Among the key impediments, the availability of adequate credit on conducive terms tops the charts.
Credit Flow Before Covid-19
While the current public health-led global financial crisis has left the small business segment reeling, the reality is that there was never enough financing available for this sector despite wide recognition of its significance in terms of job creation, innovation and overall economic development. According to IFC, in developing economies alone, the financing gap in formal MSME credit is estimated to be $5.2 trillion, with an additional $2.9 trillion deficit in the informal sector. To put this in perspective, it amounts to about 29% of the GDP of developing economies. Similar studies in advanced economies have also brought out the significant credit gap in this segment.
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Factors Influencing Credit Availability
Credit rating, business life cycle stage, repayment capacity and collateral availability are some of the key factors influencing credit decisions. The laxity or strictness of these influencers in the credit policies of banks and financial institutions directly reflect on their risk versus return equation. On the other hand, lack of credit history or structured financial information, cash flow unpredictability, unavailability or under-availability of collateral and volatile business conditions are characteristics of a majority of small enterprises. Despite the dichotomy, this segment remains important on various counts and continues to present a sizeable opportunity, provided financial institutions are able to strike the right balance in their lending outlook and credit policy.
Missing Middle Conundrum
Business banking customers fall into three segments - micro enterprises, small and medium enterprises, and corporate. Each has distinct characteristics, and different credit requirements and sources.
At one end of the spectrum, corporate customers enjoy high traction from lenders, are able to negotiate terms of credit, and obtain large committed credit lines they can utilize as and when required. This is a market where the customer tends to dominate. Microcredit customers, on the other end of the spectrum, rarely have a credit history and have very small credit requirements that only microfinance companies are willing to meet. Small businesses fall somewhere in between, with credit requirements that tend to exceed the capacity of microfinance companies and a risk profile that tends to exceed the appetite of mainstream lenders.
Despite many policy measures and initiatives over the years, such as instituting specialized organizations promoting SME credit availability and the emergence of alternative / Fintech lenders focused on such firms, the credit gap in this segment continues to stagger. Organized flow of credit, structured credit information and strong institutional infrastructure are largely missing for this middle segment in the commercial borrower continuum.
Covid-19 And SME Credit:
The destruction of small businesses worldwide is among the worst economic outcomes of Covid-19. Governments everywhere are trying to come to the rescue of this community by announcing a variety of programs and stimulus packages, ranging from simple payment deferral measures to guaranteed lending programs such as the Paycheck Protection Program in the US, CBILS in the UK and similar programs in other parts of the world.
While the government-initiated programs are running into hundreds of billions of dollars, or as much as 15-20% of the GDP in some countries, commercial lenders, alternative lenders and other credit providers have become even more risk averse during the pandemic, suspending many ongoing credit programs or reducing approved credit limits. In many cases, they have become mere conduits for the government-sponsored credit programs.
Many small business enterprises have had to embrace payment deferral programs; those in need of additional funds are finding it difficult to raise fresh credit owing to unpredictable cash flows. Even getting credit through government stimulus programs has become significantly challenging.
Marching Ahead: Beyond Covid-19
The missing middle conundrum is likely to continue beyond Covid-19. However, as with every major event in the world economy, the current public health-led financial crisis will bring a multitude of changes in areas such as structure, policy, credit assessment methods, product mix and sources of finance.
Structural changes: A significant feature of SMEs in most countries, especially the developing economies, is an informal business structure. In future, many business entities will make a conscious effort to establish credit history and verifiable financial information to enhance their access to formal lenders.
Credit assessment: Reliance on alternative sources of information is expected to grow significantly at the expense of traditional credit assessment techniques. Along with AI-based underwriting models, lenders could lean more towards ‘Viability Based Credit Assessment’ approaches, which would help channel credit to even businesses with thin credit files but strong business fundamentals and repayment capacities. Alternative data and AI-based models would also play a bigger role in identifying risks posed by unforeseen circumstances and help fine-tune credit policies and decisions.
Product innovations: Traditional lending products such as term loans, payday loans, lines of credit and merchant cash advance would mutate into more innovative variants to suit individual business needs. Product bundling to deliver a unified solution for multiple banking requirements, such as lending products combined with, for example, credit protection or business insurance options, could gain further traction.
Sources of funding: Credit outflow through government sponsored lending programs and agencies would continue to rise. Although traditional lenders have scaled back, largely because of a higher perceived risk, they cannot ignore this segment for long. Reliance on non-conventional sources of funding, such as Fintech lenders, institutional funding, startup initiatives of HNIs or corporates, angel networks, crowdfunding etc., would also see a considerable increase as the economies start to rebound.
Digitization: Of the many potential changes in post-Covid SME lending, increased digitization is by far the most significant. Many banks and financial players have already started putting together digital- first strategies. High tech - low touch would be the new norm. Banking operations would be reimagined in a significant way with emphasis on analytics and automation.
Given the existing credit gap and disproportionate increase in credit requirements versus credit supply in the future, the missing middle conundrum is here to stay at least for some time. However, measures like the above would help improve the situation and enable banks and financial institutions to better support this critical customer segment worldwide.