The Problem

SMEs: Powering Global Growth & Job Creation

Here at Sapling we love SMEs — a lot. SMEs drive growth, which helps everyone, including nearly half the world, that live on less than $5.50 a day.

Worldwide, SMEs represent over 90% of businesses and are responsible for 50–70% of employment globally. According to the World Bank, emerging economy SMEs contribute up to 40% of GDP and create 7 out of 10 jobs. SMEs not only generate employment but are also a driver of innovation and socio-economic change; women lead up to one-third of all businesses globally.

From a macro perspective, the IMF estimates that in geographies where SME financial inclusion lags the most, closing the gap could positively impact GDP (about one percentage point) and help increase employment by creating 16 million jobs by 2025.

Small and medium-sized enterprises are the world’s growth engine — helping SMEs grow means providing opportunities to a significant proportion of the world’s population. That’s our mission.

A $5.2 Trillion Problem

Like any business, SMEs need credit financing to grow, whether it’s hiring more employees, buying machinery, investing in new technology or providing working capital. However, unlike larger businesses, SMEs across the world struggle to get access to affordable capital. When they do manage to access capital, they face higher transaction fees and interest fees than larger businesses.

The International Finance Corporation (IFC) estimates that 65 million firms, or 40%-50% of micro, small and medium enterprises in developing countries, have an unmet financing need of $5.2 trillion every year.

So if most people recognise the importance of SMEs, the obvious question is, why does a financing gap exist?

Loss of Local Banks: The Evolution of Banking

One answer lies in the evolution of the banking industry. The history of banking is essentially the history of lending, with the origins of banking being traced back to the first recorded loans in the temples of ancient Mesopotamia.

From its inception, successful lending has been based on trust and proximity.

Lenders have always thrived more when they have deep knowledge of the borrowers’ ability to repay loans whilst borrowers have always achieved more affordable repayment terms when they have established a positive relationship and long-term credibility with the lender.

Banking scaled through relationships Until recent decades, the banking industry continued to scale based on relationships. A significant number of small community banks or credit unions and local branches of larger banks provided a wide distribution network for lending products to SMEs. As a result, SMEs never used to be far from a local bank manager who understood their business and happily provided affordable finance.

Banking mergers and consolidation However, in more recent times the evolution of the banking industry has meant that access to finance for SMEs has become much more challenging. As a result, the number of commercial banks has reduced in most countries. For example, the number of commercial banks in the US peaked at 14,496 in 1984, but by 2020 about 10,000 of these banks had disappeared, with bank closures and an increased number of mergers seeing a rapid decline in local financing options for SMEs.

Human vs algorithms The mergers and sector consolidation led to greater centralisation of operations. Lending decisions have gradually moved from local to central lending officers. These centralised, remote lending officers have limited knowledge of the businesses applying for loans and rely instead on computer algorithms.

The financial crisis of 2007–2008 only served to exacerbate the problem; increased capital requirements have made it harder for small and mid-sized banks to broaden their loan books and serve SMEs whilst overall lending by small and mid-sized banks seems to be in decline.

Large Consolidated Banks Find it Difficult To Service SMEs

As a consequence of this evolution, the average SME is faced with a banking system that has stacked the odds against them. The banks that have survived the industry’s transition and the financial crisis are predominantly global players searching for hefty fees whilst minimising their cost-income ratio through maximum centralisation. And who’s to blame them? It essentially costs a bank as much to process and underwrite a small loan as processing and underwriting a large loan, and given large loans are more profitable the clear incentive for modern banks is to lend to large institutions. In a lot of cases, it simply does not make sense for large banks to lend to SMEs, these SMEs are starved of financing and the countries those SMEs reside in miss out on SME-driven growth opportunities.

So Where Does This Leave SMEs?

SMEs have limited local financing options outside of family and friends, given the centralisation of banking operations and a lack of local banking relationships. Instead, SMEs are funnelled into a “one-size-fits-all” loan application process by banks and shadow banks, which can be arduous, intimidating, and take an excessive amount of time.

Banks will look for SMEs to provide their credit history, a cash flow history, and cash flow projections (usually in the form of a business plan), and a raft of other documentation ranging from personal financial statements to income tax returns. Suppose the SME has managed to surmount those obstacles, judged by someone from the bank’s central operations who they have never met. In that case, they are then invariably asked for collateral to secure the loan — something they may or may not have readily available.

At the end of this painful test of stamina, with collateral committed, the SME is then faced with higher interest rates and transaction fees than a larger business would experience — even if the SME has secured finance, it is rarely at an affordable rate or without onerous terms.

In developing countries, SMEs face even more challenges In developing countries there is even less choice, as the banking system is in its infancy. For example, in Africa 57% of people do not have a bank account. The IFC estimates SMEs in developing countries have an unmet financing need of $5.2 trillion every year. SMEs that can borrow are often subjected to extremely high interest rates. Self perception is also a problem. Women entrepreneurs in Africa are more likely to self-select out of the credit market because of perceived low creditworthiness.