SMEs are looking for alternatives to meet their financing needs. Can data innovations help fill the gap?
Small and midsize enterprises (SMEs) play a critical in most economies, representing about 90% of businesses and more than 50% of employment worldwide according to the World Bank. But they operate at a disadvantage to their larger competitors, relying disproportionately on external sources of finance for operational and investment funding even as they are less likely than large businesses to obtain bank loans.
Figures from the International Finance Corporation suggest that some 65 million firms, or 40% of formal micro, small, and midsize enterprises in developing countries, have an unmet financing need of $5.2 trillion a year. East Asia and Pacific accounts for the largest share (46%) of the total global finance gap, the data shows, followed by Latin America and the Caribbean (23%) and Europe and Central Asia (15%).
The challenges SMEs faced during the pandemic have since been exacerbated by an increasingly pessimistic global economic outlook. In the UK, the Federation of Small Businesses warned in its December report, “Credit Where Credit’s Due,” that the financial markets may soon begin squeezing lending to small businesses—“reminiscent of the period following the 2008 financial crash.”
Further complicating the picture, SMEs’ priorities, concerns, and resources have changed in the 15 years since the financial crisis, and their conversations with their banking partners have changed focus accordingly. Despite the divison caused by the pandemic and political turmoil in many countries, SMEs seeking opportunities to reinvent themselves and pursue new opportunities with customers, says Augusto Paz-López, head of the SME segment of BBVA in Peru.
That in turn has changed SMEs’ demands on their banks. “After the pandemic, SMEs entered a digitalization stage,” says Paz-López. At BBVA, “the bank’s commitment is aimed at providing products and services aligned to optimize delivery times in both physical and digital channels, without generating extra associated costs.” However, “most countries have room for improvement when it comes to serving SMEs,” says Dennis Khoo, author of Driving Digital Transformation and The allDigitalFuture Playbook, who worked with Singapore-based United Overseas Bank to create TMRW, the first digital bank in the ASEAN region. “Especially in large parts of Asia-Pacific, the SME credit bureaus are not that strong on risk-ranking companies that banks should and should not lend to. But fixing this problem isn’t easy, as the data required is fragmented, disparate and not easy to obtain and verify for authenticity and integrity.”
This may also represent an opportunity, both for SMEs and financial innovators, says Khoo. For neo or challenger banks to “make a big bet on the coming-together of accounting and business banking” could represent a breakthrough, he argues, “in a similar way to the coming together of phones and computers over the past 20 years to yield smartphones.”
With economic pressures rising globally and Covid-era lending tapering off, banks are feeling the pressure to get credit decisions right, especially since many SMEs have lost market share over the last three years. Bringing accounting and banking closer could make this easier.“Japan has numerous fintech and crypto startups, but I don’t see newcomers in the banking market trying to solve problems at the smaller end of the corporate world,” says Tomohiko Shinohara, manager at FinCity Tokyo, an organization that promotes Tokyo as a financial hub. “Generally, SMEs are served by regional banks or other lending cooperatives. Where major banks fail to deliver sufficient funding, major companies can provide funding through a traditional structure called a keiretsu,” Japan’s networks of interlocking companies.
Shinohara anticipates greater utilization by SMEs of crowdfunding, an unregulated area that has become a source of development finance for nonprofit projects including ocean clean-up. “There are also a number of B2B and B2C direct trading businesses that may be able to help small businesses go national or global,” he adds. Makers of sake, which is growing in popularity outside Japan, could be among the beneficiaries. “Most of these breweries are very small SMEs and fit the model for this new kind of support.”
New sources of finance like these could loom larger as a weaker global economy further challenges SMEs, warns Hidekazu Ishida, EMP special advisor at FinCity Tokyo. “There are more and more bankruptcies on the horizon. I envisage buyout funds being called in to modernize some of these businesses, where possible,” he says. “Some consultants, including Japan M&A Center, operate a little like an investment bank, mainly executing smaller succession M&A. Buyout funds also sponsor such M&A activities, often in joint ventures with regional banks. J WILL Partners is the most active player in setting up local buyouts, a trend that has spread across the regional banking sector in the last 10 to 20 years.”
Separately, several smaller accounting fintechs are beginning to compete with the larger banks serving the SME segment in Japan. “Money Forward is one such example, and while it has not reached the scale of what you might call a neobank, [fintechs] are one of the most powerful infrastructures for accounting data,” says Ishida.
Breakthrough Innovations
Data from accounting systems could be used to power new credit algorithms, says Khoo, and by combining account and banking systems, “reduce or even eliminate reconciliation by using unique account numbers for each invoice to pay into. This also has the benefit of eliminating double entries in separate accounting and payment systems.”
Khoo envisages SMEs carrying out all their banking on an accounting system rather than a business banking app. “This would be truly embedded financing for SMEs,” he says. “On the experiential side of things, most SME business banking apps are rudimentary and hard to use. If there isn’t a breakthrough in use of data for alternative credit assessment and underwriting, there isn’t a strong business case to improve transactional banking for SMEs.”
Banks tend to leverage either retail or wholesale banking systems for small-business banking, neither of which are ideal, Khoo notes. Thus, working on a much better transactional banking app for SME banking would be in this quadrant. If you combine the customer experience and the operational gain, then you could have something truly transformational.
How close would this be to open banking? And would SMEs balk at putting all their eggs in one digital basket?
Reassuring clients about their privacy concerns will be the key to making a success of information sharing, says Paz-López. “Although open banking generates a series of opportunities based on the synergies that can occur through sharing information, communication and transparency toward customers will be the key words for the opportunities to become tangible benefits” without leaving clients feeling their privacy could be violated.
The UK is taking slow but steady steps toward open banking. Britain’s Federation of Small Businesses argues that while its members are often innovators, a framework that would make open banking appeal to them is not yet there.
“It is often small businesses that are early adopters of new technology,” FSB chair Martin McTague says. “We expect open banking will be explored by more small firms over time. The pace of change in technology means small firms’ relationships with banks, finance providers, and new entrants to the market are changing all the time, and we are keen to see regulation keep up with these developments, so that open banking works for businesses of all sizes.”
The FSB’s research has found that it is increasingly difficult for small businesses to apply for finance, with interest rates rising and acceptance rates at worryingly low levels. This is where open banking can play a role, McTague argues. “Codat’s [an Ireland-based API solution provider] proposal of an SME Funding Passport should be explored,” he says. “It represents an opportunity to support SME borrowing while minimizing the administrative burden for the businesses looking to borrow funds.” An SME Funding Passport would comprise a digital file containing company financial data necessary for underwriting. The file would be consented, standardized and easily shareable with lenders in real time.
Technology is not the whole game for SMEs, however. According to the FSB, they remain keen for cash to remain a viable option and for banking facilities to be available as widely as possible on high streets around the UK.
The need for continuing traditional support is a theme for businesses in Japan, too, where an older population is struggling to keep pace with digitalization.
“In Japan’s aging society, many SMEs have older management that arguably need to find successors,” says FinCity Tokyo’s Shinohara. “The challenge for these firms is that they are doing their books in analog, denying them access to fintechs and to funding from local banks. Some local institutions have tried to help them adapt to new technologies, but many still struggle. This is more the case in local prefectures and less so in urban conurbations such as Tokyo, where younger generations tend to flock.”
Finding Synergies
The future in financial services for SMEs, nevertheless, is all about the data, Khoo argues.
“The issue for SME business banking is finding the data that is necessary for underwriting, including being able to trace where loans have gone and what the customer has done with the funds,” he says. “Banks currently lend by securing the loan against an invoice for an order the SME is supplying, or a fixed unsecured loan based on the SME’s bank balances.”
Accounting systems hold information on SMEs’ accounts receivable and payable. If banks would extract this information and create algorithms to determine the integrity of a transaction, this data could be used to underwrite SME loans, Khoo suggests. The velocity of accounts receivable and payable is also an indication of the health of the business, and other accounting information could allow traceability of the funds loaned.
“This pool of data can help to ascertain whether a bank can underwrite a loan,” says Khoo, “but it also allows banks to throttle credit, so that when the business is doing well, they automatically lend more, and when they’re not doing so well, the bank can cut back.” Khoo finds a potential disruptive development in the coming together of these two trends, yielding benefits to both the customer and the bank. “It’s not a great leap to imagine that a provider that does this very well could threaten other existing banks,” he says.
One feasibility bottleneck is the pervasiveness of software-as-a-service (SaaS) accounting systems, which greatly simplify integration to banking systems. Another is the adoption of accounting systems by smaller SMEs that need working capital.
On the other hand, in addition to having more underwriting data, access to a growing customer base through supply chain information presents a compelling argument for adoption.
“If there was a strong enough proposition to convince a large local corporate to integrate their SaaS accounting systems in the breakthrough and synergies sections, the many suppliers of these large corporates could be persuaded to join, allowing for faster scale up,” Khoo argues. “The focus thus far has been on leveraging B2B portals in a similar fashion, but B2B portals tend to be more fragmented and difficult to implement than B2C portals. So, this could be an alternative way of building supply chain information. This could be one of the things that early SaaS banking adopters could achieve. This could be a breakthrough in the making.”
To benefit from these possibilities, SMEs will need banking partners that understand the advantages and are keen to pursue them. While there is nothing to stop larger banks from doing so, Khoo detects greater inertia in this group. SMEs need to look carefully at the capabilities of neo and challenger banks as well, Khoo adds. “Are their banking apps integrated to SaaS accounting software? How are they building their partnerships? Are they simply giving accounting software to SMEs as a lead generation activity, or do they plan to use this information to grant a loan? That would tell you whether they’re just skimming the surface, or if it’s the beginning of something very strategic.”
