Modern Small and Medium Enterprises (SMEs) represent a significant part of the global economy, accounting for nearly 90% of all modern businesses. Modern SMEs are large contributors to the creation of workplaces and economic growth, especially in developing countries.
Although they’ve become a vital part of the financial ecosystem, these businesses are facing extreme difficulties in accessing finances. SMEs are often associated with higher risks, sizeable transaction costs, and a lack of collateral—about 50% of small business loans get rejected.
Many business owners cite this financial exclusion as a key obstacle to the growth of their venture. The common hurdles in obtaining a loan include burdensome processes, low level of transparency, and the high costs associated with searching for a loan. For instance, the research by the Federal Reserve indicates that small business borrowers spend nearly 24 hours on paperwork alone during the loan application process at a bank.
The problem is global: businesses from East Asia and Pacific regions represent the largest share (46%) of the total number of underbanked SMEs worldwide, followed by Latin America and the Caribbean (23%) and Europe and Central Asia (15%). In 2018, the finance gap between the needs of global SMEs and available funds reached $5.2 trillion, according to SME Finance Forum.
Following the financial crisis of 2008, with the idea of de-risking their balance sheets, large banks started to avoid lending to SMEs by introducing stricter requirements to receive funds. For instance, in the UK, where SMEs represent a tremendous 99.9% share of the 5.7 million businesses, the value of issued bank loans fell to £55.6 million in Q4 of 2018, a 78% drop from its maximum of £255 million in 2009.
The other reasons include the variety of regulations banks have to cope with, insufficient credit history, and the high transaction costs of underwriting and onboarding customers. All in all, providing loans to small businesses has become less of a priority for banks. “If you look at the great recession, what you’ve seen is a bounce-back of commercial lending, but lending to small businesses really hasn’t come back,” sums up Darrell Esch, Vice President of global credit at PayPal. The majority of banks are not interested in lending relatively small amounts of money on a frequent basis. Some banks have introduced a sort of a loan threshold (commonly around $100,000 to $250,000), and won’t engage in loans below this level. The others will not address requests from SMBs with less than $2 million in revenue.
But technology changed the scenery for many small and medium-sized enterprises. In comparison to traditional financial institutions, digital lending companies provide favorable terms on credits. With low-interest margins, faster approval, and without initial fees, they are scaling up quickly and already capitalizing on new scoring methods.
On the Path to Digitalization
Top decision-makers in the banking sphere are aware of the success of alternative lending companies. However, still slowed down by legacy systems, banks are only dipping their toes in digital lending. The outdated technology at banks isn’t the sole issue. At the recent Lending Fintech Europe in London, lga Zoutendijk, a career banker with several decades of experience, said that “legacy culture is a bigger problem at large banks than legacy tech and a much more difficult challenge to overcome.”
For traditional lenders, fintech is an opportunity to innovate and modernize. However, one can’t fight legacy culture alone: on their path to embrace digitalization, bank institutions need a fintech partner to bring technology, speed, and flexibility to the table.
Fintechs are looking for such partnerships as well. With all the improvements in customer experience, they predictably lack the expertise in areas such as risk management, loan monitoring, and servicing that banks have in spades. This mutual knowledge gap creates partnership opportunities. Denise Leonhard from Paypal is sure that “nobody is going to be able to do it alone. To get to the next evolution of payments, it’s going to be really partnership-driven.”
Addressing the Challenge
But what is the biggest challenge in initiating the loan process for banks? Moody’s Analytics, a financial intelligence provider, conducted a poll among bank institutions. The results revealed that 56% of bankers consider manual collection and data processing to be the greatest obstacle in the process of underwriting.
These outdated methods lack consistency, accuracy, and auditability, not to mention, they are time-consuming. This results in additional work for risk officers at a bank, and assessing an SME’s creditworthiness becomes a challenging and unprofitable task. Traditional players just can’t compete with agile, fast-moving alternative lenders and their “time-to-money” credit decisions which take less than a day.
Lending to SMEs is not profitable for banks unless they change their operational approach. The solution lies in the automation of manual processes. Banks have to adopt such solutions for enhanced data collection, scoring, and further rule-based decisions, and solve the problem of the data’s inconsistency and delay. Igor Pejic, the renowned author of Blockchain Babel, sums it up: “It is simply not possible to offer the customers the speed they need in today’s economy with manual processes.”
But what’s more important for banks, those changes mean investing in the future: alternative lending options make customer experience of SMEs convenient, transparent, and adapted to the way those businesses operate.
The Future of SME lending
Partnerships between banks and fintechs are one of the most-discussed topics in the industry as they have the immense potential to impact long-term growth, customer experience and client retention for both parties. Industry professionals agree that bank-fintech collaboration is evolving as a common industry practice that will shape the future of the lending domain.
By partnering with alternative lenders, traditional players fight the challenges associated with the process of credit risk assessment, increase the quality of the loan portfolio, and stay competitive in the SME lending sector. More importantly, they have the opportunity to offer small businesses a shortcut to finance with fast access to cash, less paperwork, and fewer rejected applications.
In return, alternative lenders benefit from partnerships by getting experience in handling a complex regulatory environment, reaching new markets, and scaling quickly. In regards to this, old-fashioned “collaboration” is the new industry trend, while “disruption” is regarded somewhat as a thing of the past. Effectively, change is almost impossible without industry-wide cooperation and consensus.
The question: is how will banks and fintechs manage their respective strengths to proceed with deeper integration in a newly-formed system? It’s important to note that these integrations shouldn’t be regarded as acquisitions by any means. In other words, the technological vision of fintechs shouldn’t be at odds with the slow processes within banking institutions: one needs to convince multiple stakeholders and departments that the partnership makes sense. Here’s Chris Skinner on the partnerships: “Banks are slow to move, particularly at the beginning. Realistically, you should consider allowing at least 12-months from the moment you engage to the moment you have a partnership agreement signed.”
However, the financial industry holds little pessimism about collaborations: 82% of top executives at banking institutions have plans to partner with a fintech within the next 5 years. That’s only a matter of time before both parties streamline their processes to completely change the dynamics of SME lending.
All in all, given the competitive advantages that come with strategic partnerships, banks and fintechs have better chances to achieve their scale ambitions and reinvent their business models.
According to the CGAP report, the global opportunity for SME credit is estimated to be around $8 trillion. At the same time, more than 50% of overall applications are being rejected regularly. If banks want to take their share of the lucrative market, they need to modernize, and that’s totally good news for small businesses, technological partners, and the whole fintech ecosystem.
Dmitri Koteshov is the digital content marketer at HES (HES FinTech), a fintech company behind comprehensive lending and credit scoring solutions. As a seasoned professional, Dmitri maintains a longstanding interest in providing insights on fintech software development and analyzing current technology trends.