According to data from the World Bank, Small and Medium Enterprises (SMEs) account for about 90% of businesses in the world. Not only do they employ about half of the workforce, but just SMEs in the formal sector also contribute up to 40% to the GDP in emerging economies. Their contribution becomes even more significant when large global events such as a financial crisis or the recent pandemic occur.
While SMEs as a group have a significant impact in terms of GDP contribution and job creation, individual SMEs businesses often struggle to raise the capital that they need to build and grow their businesses. This often hinders their growth prospects. Data from the International Finance Corporation (IFC) shows that about 65 million firms in developing countries struggle to get finance. This amounts to about 40% of formal micro, small and medium enterprises (MSMEs) in their geographies. The unmet credit need for just formal SMEs is to the tune of $5.2 trillion every year. This amount is about 1.4 times the current level of the global MSME lending.
Ad-hoc SMEs Operations Foster Lack of Confidence from Banks
Despite considerable discussion around the need to make finance accessible to SMEs, the credit gap continues to persist for several reasons. For instance, banks’ reluctance to finance SMEs often stems from the fact that their operations are mostly highly unorganized. Not only do these small enterprises not fall under the formal tax brackets, but they are often not even required to register themselves or maintain stringent employees to provide provident funds etc.
Drawing parallels with Maslow’s hierarchy of needs, the primary stages in the life of a business are existence, survival, success, take-off, and resource maturity. An overwhelming majority of businesses fail to make it beyond the existence and survival stages. The restaurant business, for instance, is known to have a mortality rate of about 90% within the first six months of existence. Several other industry sectors too have similar success statistics.
For companies that manage to achieve a certain degree of success, access to finance becomes very crucial to manage day-to-day expenses and manage working capital to keep operations going. Next, expansion and long-term growth also require considerable capital infusion. The lack of access to credit as well as their inability to raise funds via tools such as FDI, bonds or debentures, or IPOs presents several challenges. To meet their credit needs, these small enterprises must rely on Non-Banking Financial Companies (NBFCs) and take loans at higher interest rates, which put greater strain on their resources.
Small businesses are often subject to a greater number of perceived risk factors. For instance, they often lack clear policies, planning, and strategy since owners often do not possess the right skills design these. Also, small businesses do not have the money, time, and resources to work with third parties such as valuers or analysts receive endorsements or approval on their strategic direction.
In addition, many small family-owned businesses fail to make the distinction between personal and business accounts. They also often reward family members far more generously for their contributions, compared with standard industry practices. Also, most small businesses do not have robust succession plans in place.
Bridging the Credit Gap for SMEs
In some countries, government-owned banks such as Small Industries Development Bank of India (SIDBI) or IDBI in India take on the mantle of providing finance to SMEs at smaller interest rates to enable them to overcome their initial obstacles and achieve success.
In 2021, NITI Aayog, the Government of India’s planning body, released a discussion paper that proposed the launch a digital-only bank designed to service small and medium businesses. These banks would potentially have a lower capital requirement compared to traditional banks and could be floated even by individuals. The idea is that these banks will not be constrained by regular policy regulations which mandate certain requirements such as a certain number of physical branches in rural areas, extensive reporting etc.
Open Network for Digital Commerce (ONDC) is another government initiative envisioned as a non-profit company aimed at levelling the playing field for ecommerce platforms and thereby boosting SME growth. ONDC can boost lending to unbanked and underbanked enterprises, encouraging them to invest in digital tools and build technology capabilities.
Traditional banks have an opportunity to step in and work on their approach when it comes to providing credit to SMEs. Not only does it present an important way to truly participate in enabling economic development, it is also a way to meet the banks’ ESG goals. By studying the SME ecosystem, and identifying promising areas, banks can build a profitable and sustainable way to boost SME growth. They can also explore deeper relationships with SME customers by moving from transactional lending relationships, and becoming real partners who are invested in their growth and handholding them on the path to success.
While SMEs have a crucial role to play in boosting overall economic growth, it is important that the ecosystem of banks, governments, and other institutions work together to set them up for success by creating a favorable and supportive environment and conducive policies.
Rajashekhara Maiya is the Vice President and Head, Business Consulting Group at Infosys Finacle.