The Changing World of Small and Medium-Sized Enterprise (SME) Lending

Narendra Kumar

04 Dec, 2020

Small and Medium Enterprises (SME) are classified based on investment capital entity. It understood in India as an entity where the investment in plant & machinery is between Rs. 25 lakhs to Rs. 10 crores in case of manufacturing industry and between Rs. 10 lakhs to Rs. 5 crores in case of service sector enterprises. As per Section 7 of Micro, Small & Medium Enterprise Development Act, 2006 notified in September 2006 provides a classification of enterprise based on their investment size and nature of activity undertaken by that enterprise. The lending structure and its overall trend in India are elaborated below on brief.

• SME finance is the funding of small and medium-sized enterprises and represents a major function of the general business finance market – in which capital for different types of firms are supplied, acquired, and priced.
• The number of small business owners expected to take an online loan could double in the coming years. While there is a broad range of business loan options available today, the trade-offs and costs associated with those options vary from lender to lender. Evaluating the differences between lenders and can be confusing – the wrong financing choice can hurt your client’s business in the long run.
• The big high street banks needed to shore up their capital and had to block-off some of their lending pipes. They needed to get their risk levels down.
• But politicians knew that the credit crunch could choke-off the small and medium-sized businesses (SMEs) that were powering the recovery. For almost a decade, banks have been given the ultimate mixed-message: “lend” and “don’t lend”.
• Regulators want them to be less risky, but politicians don’t want to see small businesses starved of funding. And the Government has also declared some of the new plans to encourage banks to lend to SMEs, so they can more easily export their goods and services like Newspaper plus Premium Digital, Premium Digital, Standard Digital & Digital Trial.
• But, with all this focus on the banks, some have missed significant wider changes in the world of SME lending, driven by technology, which might make 2018 the year that the small business lending taps are turned on in full.
• Deciding whether to approve an SME loan was previously a job for a bank manager or committee. They would meet the owners. Comb the business plans. Kick the tires. This was a huge time and labor-intensive process that made borrowing expensive.
• But technology and hard data are starting to rewire the model. For now, banks retain a significant advantage in the SME lending market. The data banks hold on their customers’ financials enables better credit risk modeling than the competition – which is reliant on filings at Companies House and bank statement printouts.

Global Trends – Shifting the Financial Inclusion frontier forward

Increasing Role of Technology 

• Mobile banking
• Branchless banking
• Use of non-financial retail outlets
• Expand credit information systems
• Create online movable asset registries

Product Diversification 

• Beyond-credit only approach
• Importance of cost-effective payments, savings, insurance
• Customer relationship management the key

Increasing Competition 

• Commercialization of traditional NGO MFIs and move up-market
• Importance of other commercial players (telecoms, supply chains, distribution chains, etc.)

Diversity of Investors 

• Proliferation and diversification of investors (e.g. private equity funds, peer-to-peer)

Increasing Importance of National policy 

• Importance of the regulatory environment for fostering innovation, sharing information, while ensuring stability/security, consumer protection

Advising your clients

A bank is a good option in some circumstances, but it’s not the only option. Nor is it the one size fits all solution it might have been decades ago. There are many situations where traditional financing options are just not viable. With that in mind, here are three questions to help you and your clients determine the best fit for their situation.

What is the purpose of the loan?

If your client has an opportunity to purchase inventory at a discount but needs to borrow funds to do it, the total interest cost of the loan might be the key metric to help determine whether or not the financing makes sense.

The loan purpose should influence the term. In the above example, it might not make sense to borrow a term of four or five years to purchase inventory that will turn over within a few months. A short-term business loan might make more sense and have a lower total cost than a long-term loan.

How much does your client need to borrow?

The loan amount may help identify where to look for finance.

It’s just too expensive for them to accommodate the lower loan amounts. However, with the streamlined application and approval processes, online lenders may be better positioned to offer those types of loans.

What does your client’s credit profile look like?

Many SMEs have never checked their business credit scoring, and this is an important step.

Knowing the health of their business will enable SMEs to make informed financial decisions and understand their eligibility for a business loan.

The Rise of the Digital SME Bank/Lender

• New banks/NBFIs have built a “banking-as-a-platform” (BaaP) model which permits for improved cooperation with alternative and third-party fintech
• Open APIs and support for integrating bank data with online accounting platforms are also strengthening the use of digital data to better enable banks to address SME lending.
• Success for those in SME lending who embrace a digital-first strategy.

Conclusion

• Open banking regulations brought in by the Competition and Markets Authority next year will force banks to share this data with any third party authorized by an account holder.

• All of a sudden, non-bank lenders will be able to combine their own data sets with those held by the bank. Not only will this help lenders decide if a business is creditworthy, but it will also help lenders monitor the ongoing affordability of repayments through the life of the loan, meaning the lender can step-in before problems become too serious.

• Collections and recoveries in small business lending will change, giving lenders more confidence to make positive decisions in the first place.

• But just as the banks will lose a competitive advantage in one area, they might level the playing field in another. The General Data Protection Regulation will come into force just a few months after open banking, and will require companies to make certain data points ‘portable’. This means enabling authorized third parties to access the data.

• A bank could ask an e-Commerce company for data on a small business that uses its marketplace. Assuming the business is happy to share the data with the bank in the hope of securing a better deal on credit, this extra information could help banks improve their own credit modeling.

• 2018 will bring about dramatic changes in small business lending. The transfer of data control from institutions to small businesses will mean more lenders, better credit decisions, and fewer bad loans. A boom in the competition will emerge. Small businesses and the broader economy stand to benefit from the boom.