# **1. Introduction**

The purpose of this policy paper is to shed light on current trends and policy challenges in the financing of small- and medium-sized enterprises (SMEs) by banks in Colombia. In particular, the paper, which forms part of a broader World Bank regional project on this topic, has the following two objectives:

- to describe the evolution and characteristics of bank financing to SMEs in Colombia in recent years

- to identify remaining constraints that impede further growth of this market, and to develop relevant policy implications.

The paper is motivated by the well-documented financing gap for SMEs in many countries, whose causes are complex and multi-dimensional. A number of other studies have highlighted the importance of SMEs in overall employment and economic growth, as well as their financial constraints and perceived lack of access to finance<sup>1</sup> . Conventional wisdom, exemplified by an apparent U-shape in financing patterns, is that lending is easier for retail customers and large corporations. By contrast, lending to SMEs is complicated by a variety of factors that are identified and discussed in the relevant literature. The nature and complexity of these factors have often left policymakers and practitioners with few guidelines on how best to address them in a market-friendly and sustainable fashion, or on what the priorities (binding constraints) should be.

The topic is particularly pertinent for Colombia, since the authorities have recently embarked on initiatives to promote SMEs and to expand financial access. As described in section 2 of the paper, access to credit has been cited as one of the most important constraints for Colombian firms. Given the importance of the micro and SME sectors to the economy, there have been several initiatives in recent years to promote their development using financial and non-financial policy instruments. In fact, the National Council for Economic and Social Policy ( _Consejo Nacional de Política Económica y Social_ or CONPES) has recently prepared a document on this topic, which includes strategies to expand access to financial services for SMEs as one of its components. In addition, and in response to the low level of financial penetration, the authorities are currently adopting regulatory reforms in order to stimulate financial access.

In terms of approach, the paper is primarily based on data collection and interviews with a representative sample of Colombian credit institutions and other relevant entities. The focus is on bank financing to SMEs by analyzing why, how, and to what extent banks lend to this segment, the business and risk management models they use, and the factors constraining their ability to provide more financing. The reason for focusing only on banks – as opposed to considering other financial providers (e.g. capital markets) – is that banks are by far the largest suppliers of external (formal) finance to SMEs and they tend to dominate the domestic financial system in most countries, including Colombia. A

> 1 See, for example, Angeli and Generale (2005), Cull, Davis, Lamoreaux, and Rosenthal (2005), Beck, Demirguc-Kunt, and Maksimovic (2005), Beck, Demirguc-Kunt, Laeven, and Maksimovic (2006), Beck and Demirguc-Kunt (2006), OECD (2006), and Aghion, Fally  and Scarpetta (2007).

7