SME POLICY FACED WITH DEVELOPMENT OFFINANCIAL TECHNOLOGY

Digital Innovation Can
Improve Financial Access for
SMEs
Lead author

Naoko Nemoto (Asian Development Bank Institute)
Miriam Koreen (OECD)
Submitted on March 14, 2019
Revised on March 27, 2019

Abstract
This Policy Brief summarizes the small and medium-sized enterprise(SME) credit and equity gap and proposes ways that emerging
technologies and innovative business models can improve SMEs’ accessto financial services and boost long-term economic growth. The
measures described are intended to: (1) improve traditional lending
using new technology and big data; (2) broaden funding tools, including
capital market finance; (3) enhance the consultation function of financial
institutions; and (4) design an appropriate regulatory environment for
fintech.

SME Policy faced with Developmentof Financial Technology
Challenge
Small and medium-sized enterprises (SMEs) go through several phases in theirlife cycles—start-up, growth, maturity, and renewal/rebirth or decline—and
their financing needs vary depending on those phases. This Policy Brief
primarily focuses on the “growth” and “renewal” phases, although our proposal
to utilize new fintech technology is also useful for “start-up” firms.
Access to bank lending is more challenging for SMEs than for large businesses

Ø SMEs are key contributors to economic activity as an important source of
employment, growth, and innovation. Despite their essential role, SMEs
receive a disproportionately small share of credit from the financial system,a trend that persists across developed and developing countries (ADBOECD 2014). There appear to be structural barriers that impede banklending to SMEs, including information asymmetries, high transaction costs,
the possible decline of traditional-relationship lending, and the insufficientfinancial capabilities of SME owners and entrepreneurs.
1. Financial institutions may find loans to SMEs less profitable, even if theycharge higher interest rates to account for greater credit risk 1 . With
tightened capital and liquidity regulations after the global financial crisis,banks have the incentive to scrutinize and charge higher interest rates forloans to SMEs (Griggs 2012; Bucă and Vermeulen 2017).
2. Lack of public information and the sometimes-inadequate quality and lower
frequency of financial statements compared to large enterprises makes it
difficult for banks to assess and monitor the credit risks posed by SMEs
(Yoshino and Yamagami 2017).

Intensifying competition from other industries, including fintech firms, andpressure on profitability have led to reductions in staff and branches for many banks.
According to the European Banking Federation Report (2018), the number of domestic
banks branches in Europe fell by 21%, and the number of bank employees declined by 12%
during 2009–2016. Japan’s second largest bank has announced that they will slim down by
one-fourth of their total employees and decrease the number of branches by 20% by 2027.
1

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SME Policy faced with Developmentof Financial Technology
SMEs are over-reliant on straight debt

1. Bank credit is not always the most appropriate form of financing for new,innovative, and high-growth SMEs. Alternative financing tools, such as
equity finance, corporate bonds issuance, and mezzanine finance are
generally underutilized by SMEs. In particular, alternative finance is needed
for companies seeking to transform their activities, such as a change inownership or expansion into new markets.
2. This problem is compounded for start-up firms with limited credit histories
and untested business models.
Fintech solutions could help fill the credit and equity gap, but many issues
remainØ Despite the potential social and economic benefits of fintech in increasing
access to financial services and financial inclusion for the underserved andallowing easier and cheaper cross-border payments and transfers (e.g.,
remittances), the use of these innovative options remains limited compared
to traditional debt finance for several reasons.
1. These instruments are likely accessible only to SMEs with financial anddigital literacy and access to reliable information and infrastructure.
2. Alternative finance (such as equity crowdfunding and P2P lending) carries
inherent risks. Investors risk losing invested funds. Fraud risk, information
leaks, and cyberattacks are additional concerns (Federal Reserve Bank of
New York 2017). Most of these challenges extend to blockchain-based
financing (e.g., Initial Coin Offerings and syndicated lending).
The design of regulatory regimes is critical, but incomplete andinconsistent.

Proposal
Improve Traditional Lending using New Technology and Big Data

Ø Emerging financial technology and innovations in traditional business3

SME Policy faced with Developmentof Financial Technology
models can take advantage of the rapidly digitizing economy to expand
SMEs’ access to credit.

1. Process automation
The traditional lending process may benefit from the use of online applications
and the automation of underwriting, due diligence, loan servicing, andregulatory compliance tasks. Financial institutions will enhance theirproductivity and lower their operating costs. As for borrowers, the use oftechnology (such as cloud-based accounting, digital payments, and theautomation of invoicing and settlement processes) could enable them tosubstantiate their business activities and become eligible for finance. Recent
research shows that blockchains can significantly improve the efficiency of
trade finance, which involves extensive paperwork across multiple ledgers(Creehan 2018).

2. Encourage innovative use of technology and data sharing
Data on SMEs could be integrated, generalized, and shared among financial
institutions and other players, such as fintech firms. The accuracy of credit risk
models tends to increase as the data pool becomes larger. In Japan, the Japan
Risk Data Bank (RDB) and Credit Risk Database (CRD)2 cover most financial
institutions, including credit unions. In France, the FIBEN (Fichier bancaire desenterprises) database collects a relatively comprehensive set of data on SMEs
(Boschmans and Pissareva 2018). Such data has been utilized for loan reviews,
interest rate setting, and portfolio management. They have also contributed tothe advancement of credit risk analyses by banks. In emerging countries, credit
scoring methods and the development of common databases are still in thedevelopmental stage (ADB 2014).
Several innovative banks and nonbanks are leveraging alternative data(including data on bank account information, e-commerce transactions, invoice
2 The Japan RDB anonymously covers credit information on 910, 000 companies, and the

CRD covers 2.4 million companies. In addition to financial data, data on transactions throughcompanies’ bank account information is collected and constantly updated. It is still rare evenin developed markets for most private banks, including credit unions, to have a shared
database on SMEs.
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SME Policy faced with Developmentof Financial Technology
data, and customer surveys) generated by the growing social and economic
activities taking place online to support credit scoring. According to researchby the Asian Development Bank Institute, bank account information (such as
information on deposits and cash flows) are not fully accounted for in
traditional scoring systems. If such alternative data is utilized, banks canenhance their credit risk scoring accuracy and reduce their credit costs andloan review time and costs, making SME financing smoother and more efficient(Nemoto et al. 2018).
In addition, banks could take more account of the value of intangible assets suchas patents, software, and contractual agreements when making lending
decisions. Even though these assets make up an increasing share of SMEs’
overall assets, they are often of limited relevance when securing credit(Brassell and Boschmans 2019).
The Chinese government sees clear potential for the use of alternative data. Ant
Financial Services Group, which is associated with Alibaba, has succeeded inproviding loan services to SMEs promptly and efficiently, leveraging data on ecommerce and artificial intelligence3.

3. Enhance credit guarantee programs
The public credit guarantee scheme is a tool to reduce the supply-demand gap
in SME finance. The clear majority of the Organization for Economic Cooperation and Development (OECD) countries have adopted public guarantee
schemes, as have an increasing number of governments in emerging countries(OECD 2018a). On the other hand, credit guarantee systems may be subject tomoral hazard problems, keeping unviable enterprises in business and causing
deadweight losses (Ono et al. 2014). To tackle these issues, the following points
should be considered: (1) the business sustainability of SMEs; (2) proper risk
sharing; and (3) credit infrastructure to enhance borrower performance (ADBOECD 2014; OECD 2018b).

3 This model has been pursued by Amazon and other companies in Western countries.

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Broaden the Range of Financing

1. Form special investment funds for SMEs
Many studies have indicated that funding diversification has had a positive
impact on corporate performance (Guo et al. 2011). But for most SMEs, the useof equity finance is still quite limited (Department of Business Innovation and
Skills of the UK 2012). This is attributable to the difficulties of SMEs inproviding enough qualified information to investors (OECD 2018b). In addition,
financial intermediaries (such as brokerage firms) have few incentives tosupport SMEs in tapping the capital market, considering the costs and returns.
In light of these constraints, the G20/OECD High-level Principles on SME
Financing, welcomed by G20 Leaders in 2015, call for a two-pronged policy
approach to stimulate the development of a broad range of finance instruments
and to strengthen SME access to traditional bank financing (G20/OECD 2015).
Many countries have taken actions to enable SMEs to diversify sources andinstruments to meet their financing needs (G20/OECD 2018).
For example, the formation of special funds initiated by the public sector has
contributed to filling the gap in equity needs in the United Kingdom (UK) andother countries.
In Kenya, the government has set up the Kenya Micro, Small, and Medium
Enterprise Competitiveness Project in collaboration with the World Bank,
which has led to the diversification of SME funding (Hua 2013). The fund has
deep knowledge on local investees and has provided advisory services coupledwith financial investment to SMEs, which are a key success factor for the project.

2. Improve SME access to capital markets
Capital markets could contribute to mitigating the SME financing gap, especiallyfor segments in the SME population for which bank credit is not particularly
appropriate or may be difficult to obtain (Thompson et al. 2018). Cross-bordertransactions and listings on foreign exchanges should be considered, as SMEs
would benefit from high liquidity and diversified investors. Some studies haveindicated the adoption of network cooperation among major European
exchanges are associated with higher market capitalization, lower transaction
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SME Policy faced with Developmentof Financial Technology
costs, and higher growth of companies (Hasan and Schmiedel 2004). Exchanges
in Asia trail their global peers in terms of the presence of foreign firms (apartfrom Singapore). The Japan Exchange Group and other exchanges are working
toward standardizing IPO guidelines and opening markets for high-growth
emerging companies, which is a positive step for market integration.

Enhance the Consultative Functions of Financial Institutions

1. Alternative data can be an effective tool for financial institutions foranalyzing the business and financial conditions of their customers andproviding effective consulting services. Several innovative banks andnonbanks provide comprehensive services to SMEs for marketing, staff
recruitment, and business restructuring. The consultation function offinancial institutions could be further augmented by developing an effective
community or ecosystem among public entities, universities, and theprivate sector (Acs et al. 2018).
2. Demographic change and the increasing needs for business transfer are
areas of concern. In Japan, 2.5 million SME owners will be over 70 years ofage between now and 2027. Around half of them do not have clear
succession plans for their businesses. According to the Japan Ministry of
Economy, Trade and Industry, this trend will result in 6.5 million or 9.7%
fewer workers and $200 billion in gross domestic product. In response,
financial institutions and local governments are taking proactive steps to
support business succession (for further information and proposals, pleaserefer to the Policy Brief, “Business Transfer as an Engine for SME Growth”).

Design an Appropriate Regulatory Environment for Fintech

The design of regulatory regimes is critical. The challenges for regulators are toprotect against systemic risks, ensure compliance with regulations on personaldata, and maintain a fair, safe, and competitive market.
Policymakers should remember the following points to capitalize on the7SME Policy faced with Developmentof Financial Technology
benefits to users and investors.
1. Financial literacy and education for borrowers and investors
2. The detection of fraud, data leaks, and cyber criminality
3. Fair competition and transparency
4. Financial stability concerns
5. Enabling a legal framework to accommodate technological changes (e.g.,contracts, data ownership, and digital payments)
The UK is an effective model for the regulation of alternative finance, including
crowd finance and P2P lending. Authorities in the UK provide feedback tocompanies on the regulatory implications of their plans and run a regulatory
sandbox to allow selected firms to test new models on the market4. Regulatory
action to date suggests that it has helped to build an understanding of the issues
and responsiveness to evolving industry dynamics (Nemoto et al. 2019).
The Payment Service Directive Revised (PSD2, issued in the European Union in2016 and became effective in 2018) is a new regulation affecting most banks in
European markets. One of the main consequences of PSD2 is the appearance of
Account Information Service Providers.
This will allow individual account owners holding accounts in several banks toshare their information with an account aggregator. It remains to be seen how
this will affect the business models of banks and nonbanks and the quality ofservices (Neyer 2017).

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4 The sandbox approach has been adopted by many other jurisdictions (BIS 2017).

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