- Small and medium-sized enterprises (SMEs) are businesses whose personnel numbers typically fall below 250 employees.
- SMEs account for 90% of global businesses and are responsible for 7 out of 10 job opportunities in developing countries.
- However, 44% of SMEs are financially constrained and underserved by traditional finance institutions.
- Public and private sectors must work together to develop solutions to meet the growing demand for finance.
- While governments have the responsibility to improve market-enabling policies, the unmet demand presents an opportunity for financial institutions to engage.
What Are SME’s?
Small and medium-sized enterprises (commonly abbreviated SMEs) are businesses whose personnel numbers fall below certain limits. While this number varies across countries, the most frequent upper limit designating an SME is 250 employees (source).
Small-to-medium sized businesses are vital to global economies, accounting for 90% of businesses and more than 50% of job opportunities. Their importance is magnified in developing economies, where SMEs are responsible for creating 7 out of 10 job opportunities. That job creation translates into 50-70% of global gross domestic product (GDP) (source).
SME growth will play an important role in absorbing the growing global workforce that requires an additional 600 million jobs by 2030. However, a large percentage of SMEs remain financially constrained and underserved by traditional finance institutions. Less access to finance translates into less opportunities for growth. Instead, SMEs must rely on internal funds, or cash from friends and family, to launch and initially run their enterprises.
Quantifying the SME Financing Gap
The International Finance Corporation (IFC) estimates that 65 million businesses, or 40% of formal micro, small and medium enterprises (MSMEs) in developing countries, have an unmet financing need of $5.2 trillion every year. That is equivalent to 1.4 times the current level of the global MSME lending (source). While the microenterprise finance gap is estimated at $718.8 billion, the SME finance gap makes up a larger percentage with $4.5 trillion in unmet demand. The combined gap is equivalent to 19% of the GDP of the IFC’s 128 surveyed countries.
Microenterprises outnumber SME’s 7-to-1, yet SMEs account for a larger percentage of the finance gap due to larger transaction volumes. Despite the distribution of volume between microenterprises and SMEs, the percentage of constrained enterprises within each segment is nearly identical. It is estimated that in developing countries, 21% (29.6 million) of microenterprises are fully-constrained, and 19% (26.6 million) are partially constrained. For SMEs, 30% (6.2 million) are fully constrained, while 14% (2.8 million) are partially constrained (source).
In terms of concentration, a majority of MSMEs are located in upper-middle-income countries (includes Brazil and China – the two largest contributors). Lower-middle-income countries make up the second largest category, which includes Nigeria – the third largest contributor. East Asia has the largest concentration of enterprises (64 million), followed by SubSaharan Africa (44 million) and Latin America and the Caribbean (28 million). When looking at SMEs specifically, Sub-Saharan Africa has the largest proportion of financially constrained enterprises – both fully and partially constrained (54 percent), followed by South Asia (50 percent).
Closing the SME Finance Gap
In order to close the finance gap, the public and private sectors must work together to develop solutions to meet the growing demand for finance. On the public side, governments have a responsibility to improve institutional environments, provide regulatory frameworks, and foster competition and other market-oriented policy actions. Broader regulatory environments, and in particular tax administration and governance, can improve access to finance. In particular, MSMEs often lack the necessary technical knowledge for preparing financial statements needed for loan applications. Business development services can help build capacity in this area. Regulatory reforms that encourage businesses to formally register with authorities may also lead to better information and documentation.
The private sector can benefit from market-enabling policies set by the public sector. Private sector initiatives focusing on the capacity of traditional financial institutions can help better serve the MSME segment. However, the current environment often makes it difficult to enter and operate in the MSME market. Without adaptation and customization, traditional corporate banking or consumer banking models have not proven to work well in targeting MSMEs. Typical challenges include: having high levels of informal businesses; a lack of reliable data; and lack of collateral coverage to hedge the perceived high risks.
That is not to say the the unmet demand – that is, the finance gap – doesn’t present a significant opportunity for capable financial institutions. According to the IFC, significant Return on Equity (RoE) can be achieved with a structured approach to servicing the SME segment. However, since this segment is drastically different from both retail and corporate banking, financial institutions need to utilize the appropriate models and approaches to effectively tap into the revenue opportunity, while at the same time mitigating the potential risks.