Fueling the Economic Engine: Global Experiments in Small Enterprise Lending

> Posted by Rishabh Khosla, Tahira Dosani, and Vikas Raj, Accion Venture Lab

Small businesses are the engine of employment, contributing up to 85 percent of new full-time jobs in low-income countries, and two out of three new jobs in countries like the U.S. The IFC finds a strong correlation between the health of the small business community, economic growth, and poverty alleviation.

Despite these Herculean responsibilities, micro, small, and medium enterprises (MSMEs) the world over struggle to access the financing they need to maintain cash flow, hire new employees, purchase new inventory or equipment, and grow their businesses. The IFC estimates that the unmet demand for MSME finance in emerging markets is $2.1-2.6 trillion (around 1/3 of outstanding loan balances to this segment). Unlike larger firms that can access capital markets, MSMEs must seek financing from banks or non-bank finance companies (NBFCs). Yet traditional lending approaches often fail to address this “missing middle” because the cost of diligence and underwriting is too high relative to the potential revenues from the smaller loans that MSMEs need. This situation is worse in emerging markets because of a lack of reliable financial data and high levels of informality. According to the Harvard Business Review, the financial crisis only exacerbated the situation: borrower balance sheets are still recovering, and banks, faced with new regulatory requirements, have reduced the share of lending to MSMEs in 9 out of 13 OECD countries.

Yet paradoxically, this retrenchment has opened the door to innovators. Non-bank finance companies, technology startups, and other players are finding ways to bring financial services to underserved consumers and businesses faster, cheaper, and maybe even better than ever before. We believe that there are tremendous opportunities for new, tech-enabled models to close the capital gap for MSMEs around the world. As early-stage financial inclusion investors, we at Venture Lab have a front-row seat to innovation across three dimensions in the lending process.

Partnerships enabling low-cost customer acquisition: Most marketplace lenders in developed markets (e.g. Prosper and LendingClub) rely on online ads to attract borrowers, bidding up the price of key search terms to unsustainable levels. This is why we’re excited by StreetShares’ model where they work through affinity groups (veterans organizations initially) to source quality borrowers at a lower cost. In emerging markets, companies have to be more creative, building partnerships to gain access to a steady stream of potential customers. Lendingkart (Ahmedabad) and Mr. Presta (Mexico, Brazil, Argentina) are following in the footsteps of proven models like AliPay (China), Paypal (USA), and Kabbage (USA) to partner with eCommerce marketplaces to access relevant predictive data and customers. Indeed, SnapDeal, one of India’s leading eCommerce platforms, recently announced a CapitalAssist program which invites a range of finance companies to lend through its platform. In Africa, companies like GoFinance and Umati Capital are working with value-chain partners (e.g. agricultural processors, major multi-nationals) to identify and extend working capital loans to small-holder producers, retailers, distributors, and suppliers in their networks. As a bonus, by routing re-payments through the partner, these finance companies can reduce default risk.

New data sources enabling faster and more effective credit decisions: In addition to the eCommerce examples described above (where lenders are using a merchant’s transaction history and seller ratings in the decision making process), non-bank lenders are beginning to leverage a range of other alternative data sources from mobile phone to social media data, provided by companies like DemystData and First Access. Separately, RevolutionCredit is taking an entirely different tack – inviting end-users to view short and entertaining videos that improve financial capability – and using data from a short quiz as an input to the credit decision. In Mexico, Konfío aspires towards a “blended” underwriting model that incorporates information from traditional credit bureaus and cash flow analysis, but also draws from these kinds of alternative sources. Existing providers of payment processing for small merchants like Kopo Kopo (Kenya) and Zoona (Zambia) have begun to offer cash advance services on the basis of the merchant’s historical payment volume and frequency. Borrowings on these platforms can be routed directly to suppliers and re-payments can be taken out of other payments processed for the merchant. In India, innovative lenders are focusing on developing expertise in specific niche sectors of borrowers.

Participation of a variety of investors enabled through marketplace platforms: By providing investors the opportunity to back specific types of borrowers (usually online), innovative lenders have attracted new forms of capital, from socially-oriented retail investors to return-seeking hedge funds, to help fill the MSME finance gap. Bolstr allows its prospective borrowers to create a personalized campaign to fund their business growth. Investors get to know the business, make a decision to lend money, and receive their returns in the form of revenue sharing. DealStruck is another marketplace lender providing working capital and term loans, funded off their own balance sheet as well as retail and institutional investors. Intoo (Brazil) is aiming to create a marketplace where existing buyers of small enterprise invoices (funds known as FIDCs) can aggregate their demand and build a custom portfolio of investments.

Despite our excitement at these new ideas—and the tremendous potential they represent—we think banks and mainstream financial institutions have a crucial role to play as partners, funders, competitors, and advocates to bring these ideas to scale and build new markets:

  • As partners: banks can help knit together a service offering for which a non-bank may not have the requisite capabilities or authority. For example, WebBank’s partnership with marketplace lender LendingClub in the U.S. enables the website to originate loans for consumers through a syndication partnership.
  • As funders: One of the biggest pain-points for innovative and early-stage finance companies is access to wholesale debt for onlending. Banks could find ways to set up new vehicles to support innovative non-banks as RBL Bank in India did when lending to one of our portfolio companies in India, Varthana, which in turn lends to affordable private schools for the poor. On the equity side, banks like BBVA, Barclays, and Itau (Brazil) have set up venture funds to gain an option on this rapidly evolving space.
  • As competitors: In a five-country study of Sub-Saharan Africa, the World Bank singled out Equity Bank in Kenya as a leading innovator and provider of financial services for MSMEs. The report argues that a broader environment of competition, innovation, and entrepreneurship has pushed banks to develop relevant offerings for this segment.
  • As advocates: Finally, banks have the ear of regulators and other ecosystem actors (like credit bureaus and payments providers). Advocating for a more liberal environment that encourages innovation and a variety of models is a key role that banks can play. Pushing for new clarity on regulation around the use of alternative and behavioral data in credit reports to broaden access is just one example of what banks can do.

There is a tremendous opportunity for banks to engage with innovators in MSME finance to help scale and mainstream promising ideas. With their greater resources and networks, banks can help tackle some of the biggest challenges these startups face. This includes moving even more “down-market” to smaller customers, smoothing barriers for end-users that may be less tech savvy, and strengthening the value proposition for various partners in the value-chain. Further, at the ecosystem level, banks can help to build out communications, distribution, and data infrastructure, speed access to wholesale finance for experimentation, and push for an evolution of standards and regulation with governments. The time is ripe for banks to take on more diverse roles in the value chain, unlocking new avenues for growth and progress.

Paul Breloff, the Managing Director of Venture Lab, will be discussing how some of these actors and trends can help MSMEs develop at Money 2020, during the “Mobile Driving Financial Inclusion” panel on Sunday, November 2nd at 1:50 pm-2:35 pm.

Image credit: Zoona

Have you read?

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The Implications of India’s 2014 Budget for Financial Inclusion

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