SME finance

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 is supplied, acquired, and costed or priced. Capital is supplied through the business finance market in the form of bank loans and overdrafts; leasing and hire-purchase arrangements; equity/corporate bond issues; venture capital or private equity; asset-based finance such as factoring and invoice discounting,[1] and government funding in the form of grants or loans.

Importance

The economic and banking importance of the small and medium enterprise (SME) sector is well recognized in academic and policy literature.[2][3] It is also acknowledged that these actors in the economy may be under-served, especially in terms of finance.[4] This has led to significant debate on the best methods to serve this sector.

Although there have been numerous schemes and programmes in different economic environments, there are a number of distinctive recurring approaches to SME finance.[5] One such approach is collateral-based lending, which encompasses a combination of asset-based lending, contribution-based finance, invoice discounting, and factoring-based finance.[6] This approach relies on the collateral provided by reliable debtors or contractual agreements, serving as a cornerstone for SME financing.

Gap

A substantial portion of the SME sector may not have the security required for conventional collateral based bank lending, nor high enough returns to attract formal venture capitalists and other risk investors. In addition, markets may be characterized by deficient information (limiting the effectiveness of financial statement-based lending and credit scoring). This has led to claims of an "SME finance gap" or Nano gap[9]– particularly in emerging economies.[10] At a workshop hosted by The Network for Governance, Entrepreneurship & Development (GE&D) in Geneva in July 2008, SMEs that fall into this category have been defined as Small Growing Businesses (SGBs).[11]

There have been at least two distinctive approaches to try to overcome the so-called SME finance gap.

The first has been to broaden the collateral based approach by encouraging bank lenders to finance SMEs with insufficient collateral. This might be done through an external party providing the collateral or guarantees required. Unfortunately, such schemes are counter to basic free market principles, and they tend to be unsustainable. This sector is increasingly called the Meso-finance sector.[12]

The management of business lending

The effective management of lending to SMEs can contribute significantly to the overall growth and profitability of banks. There has been considerable research and analysis into the methods by which banks assess and monitor business loans, manage business financing risks, and price their products – and how these methods might be further developed and improved.[18] There has been particularly intensive scrutiny of the kinds of business financial information that banks use in making lending decisions, and how reliable that information actually is.

Banks have traditionally relied on a combination of documentary sources of information, interviews and visits, and the personal knowledge and expertise of managers in assessing and monitoring business loans. However, when assessing comparatively small and straightforward business credit applications, banks may largely rely on standardized credit scoring techniques (quantifying such things as the characteristics, assets, and cash flows of businesses/owners). Using such techniques – and also centralizing or rationalizing business-banking operations generally – can significantly reduce processing costs. Standardized computer-based assessment may also be more accurate and fairer than reliance on the personal judgments of local bank managers. As a result, banks may now be able to offer more loans, faster and in larger amounts, and reduce previously high security requirements.[19]

However, business lending as a whole is substantially more diverse and complex than personal and residential mortgage lending. This, coupled with the large size and inherently risky nature of many business loans, tend to limit the scope and desirability of computerized credit scoring in assessment and monitoring.