The role of digital financial services in bridging the SME financing gap
Ivor Istuk, Senior Financial Sector Specialist
Small and medium enterprises (SMEs) are often flattered by being called backbones of world economies. However, this seemingly important role and their potential is usually undermined with their lack of access to appropriate financial services. That creates a financing gap which acts as a hurdle for building SME resilience and potential growth.
There are many already well-established reasons behind this financing gap, some related to financiers and some related to the very nature of SMEs. From the perspective of financiers financing SMEs comes with higher cost to reach and service relative to the revenue potential. This drives their focus away from SMEs towards corporate and retail clients resulting in lack of SME finance skills and specialized financial products. Although the diversity among SMEs means that their financing needs and issues would not be homogeneous some of their common characteristics contribute to the financing gap too. They are small, relatively young, risky, lacking financial education (managers and owners) with questionable quality of financial reporting and lack of assets to be used as collateral.
Addressing these issues requires well-coordinated multifaceted policy actions targeting different frictions underlying this problem. Current rapid technological advancements in financial services industry beg the question of what role can digital financial services (DFS) play in bridging the financing gap? How are DFS developments being leveraged by all relevant stakeholders to improve access to finance for SMEs and what are the implications of these developments for designing future policies?
A recent World Bank report “Fintech and SME Finance: Expanding Responsible Access” discusses these and other related questions including the current level of the adoption of fintech solutions for SMEs, impact on the incumbents and the implications for market structure; challenges and risks these fintech solutions pose; and presents policy recommendations to address the challenges and risks.
The report argues that digital financial services can help close the financing gap for SMEs by providing access to alternative sources of funding and improving access to traditional players by enabling new digital products and process automation. Digitization and automation make the financing process more efficient, thereby lowering costs. The use of alternative data sources and big-data analytics provide additional information sources to the credit risk-assessment process, allowing SMEs that were once unable to obtain finances to gain access. New business models such as the sharing economy and e-commerce, digitization of SME business processes, and open banking provide rich data on SME activities and cash flows, enabling DFS, and can help SMEs obtain access to financial products.
Fintech solutions with promise for SMEs financing include digital loans, supply chain finance platforms, secured revolving lines of credit, merchant receivables finance, P2P/marketplace lending, as well as investment-based crowdfunding. In addition, the digitization of internal business processes and business-to-business (B2B) processes such as electronic invoicing (e-invoicing), and tokenized assets using blockchain/distributed ledger technology (DLT), can also help address the major barriers to SME access to finance. Competition for finance is also being developed by the introduction of innovative solutions by fintech and big tech firms and neo-banks or challenger banks disrupting traditional financial institutions.
At the same time there are obstacles and challenges that make it difficult for SMEs to fully adopt digital financial products. The main areas where challenges have been identified are digital financial literacy and awareness of DFS, digital infrastructure, financial supervision and regulation, identity, and data privacy and data protection. Some issues are more prevalent in emerging markets, which have less developed digital infrastructure, systems, and processes.
To overcome these challenges and enable realization of a Fintech promise for SMEs policymakers should focus on foundational elements such as creating enabling environment, empowering potential users and balancing risks and benefits of innovative financial products. The report presents and discusses specific policy and regulatory actions to be considered for this intent.
These include policy and regulatory recommendations that are specific to digital financial products for SME financing, digital financial education programs for SMEs highlighting DFS awareness, affordable digital infrastructure that fosters widespread internet access and use, along with robust cybersecurity frameworks.