Solving the SME Credit Gap — what needs to change to drive growth

Fintechs, banks, lending platforms, governments, development banks and the private sector do not understand SME lending

14 min readSep 23, 2023

Midjourney prompts: small business lending, credit, securitization

Executive Summary

For decades, commercial and community banks, policy makers, politicians, central banks, ministries of finance, and fintechs have tried to solve the persistent credit gap for Small and Medium Size Businesses (SME). Despite massive liquidity infusions into economies in times of crises, the credit gap for SMEs continues to exist.

Why? Because digitization and innovation has only addressed two of the four critical elements in SME lending: Digital onboarding and innovation in underwriting. However, two equally critical elements persist and have yet to be addressed: Standardized financial contracts and credit enhancements, both significantly vital to a healthy, efficient economic marketplace. Absent these, even marginal improvement in the sector remains illusory.

The key to success is technology-enabled, near real-time credit risk adjusted portfolio management with highly automated securitization, paving the way for massive scale and significantly increased portfolio returns, all to the benefit of the bedrock of every economy — SMEs.

Unfortunately, it seems that the finance industry fails to understand the centrality of the financial contract to its business. A standardized algorithmic definition of the cash flows of financial contracts, combined with consistently integrated credit enhancements, must form the technological and policy underpinning for transforming SME lending at scale.

On a more existential level, it is difficult to understand why SMEs are not afforded the same luxury as most investment grade borrowers: As long as interest is paid, debt can be rolled over in perpetuity.

Introduction

In 2015, I had the opportunity to see the dark underbelly of the U.S. financial system. As an early Angel investor in a small software startup providing digital onboarding solutions for sales organizations & balance sheet lenders which were active in then burgeoning MCA (Merchant Cash Advance) space. After the liquidity spiral of 2008, funding organizations were formed by private capital. To avoid usury lending regulations, these private funders deployed factoring-type arrangements in order to buy future cash flows from small businesses, charging upwards to 1000% per annum. Meanwhile, victims of these predatory arrangements received zero benefit to their creditworthiness.

In essence, these lenders were exclusively reviewing cash inflows of businesses to make credit underwriting decisions. With just a few more data points, such as verification of business licenses, address and KYC/KYB, these MCA lenders were providing credit to small businesses for amounts typically ranging from $5,000 to $15,000 at effective interest rates of 25% to 35% over 60 and 90 days (sic!). Payments were collected in daily installments via ACH (a kind of direct debit in the U.S.), after the small businesses’ credit cards and checks had cleared in the bank account at 0300 each day. Pure and simple, this is classic revenue based lending, essentially forward purchasing of receivables.

Many aspects of this industry were shocking. Clearly, this was B2B payday lending. Borrowers were directed from landing pages on Facebook campaigns and websites to call centers which operated like boiler rooms. Effectively, the pink sheet boys of the 80s and 90s who migrated to mortgage origination among other things had moved onto prey on the very large, working capital starved SME market. Confusing forward purchase of cash flows and undisclosed borrowing costs created an environment where interest rates were not disclosed, instead agents spoke of “factors” when discussing daily amounts to be collected from their bank accounts (“I can give you a factor of 1.28 for 80 days”), default rates on the portfolio reached 8% and in some cases 10% or more as amateur lenders entered the market in droves.

Still the number of desperate borrowers did not stop growing, and the flow of profits on these loans to the MCA lenders seemed to produce many sports cars outside the call centers housing these makeshift brokerage & lending enterprises that blossomed in this cottage industry. Hedge funds the likes of Angelo Gordon even came to play.

In the meantime, governments around the world pumped massive amounts of liquidity into their economies, very little to none of it reaching its primary target, the small business. Once again, the interest environment has dramatically shifted, and it’s looking as though access to capital for SMEs will be even more constrained, and therefore dramatically impacting the growth prospects of the global economy.

Why is SME Lending important?

SME lending is important as it drives economic growth, employs the most people in economies and provides resiliency for national economies when large industries are impacted by global economic shifts. The key facts are known and elaborated in many studies from the World Bank, IMF, countless finance ministries and government treasuries.

What is the current state of SME lending?

Not good.

None of the innovations in payments by electronic platforms have managed to close the persistent credit gap chronically experienced by small businesses. This is not only a problem in developing countries, developed economies also have very large gaps. For example, the Bank of England estimated the SME credit gap prior to Covid at GPB19B, post Covid at GBP22B.

An additional problem are Venture Capitalists who have been desperately trying to find more capital and drive up valuations of Neo-Banks and Fintech Lenders backed during the heyday of the Fintech cycle, which have been largely loss generating for years, with no viable business model or “breakthrough” moment in sight.

Innovation in payments has been mistaken as innovation in finance. NOT the same. Shiny apps for the exchange of foreign currency on vacation and colorful mobile banking interfaces may be nice for retail payments, but they do not constitute innovation in finance. Finance is the function of exchange of sequences of cash flows over time, whereas payments are a subset of finance — the exchange of cash now. It’s the financial contracts that express these cash flow patterns which represent the molecular building blocks of finance, each pattern represented and defined by the expression its nucleus dictates.

Why are SME financing problems persisting?

The fundamental issues in SME lending persist simply because none of the novel approaches to SME lending have had much discernable impact on the credit gap. In fact, some manifestations such as MCA lending described earlier are destructive in nature. Peer to peer lending platforms, and other crowdfunding platforms continue to face difficulties raising initial capital, and more importantly, are unable to securitize their balance sheets. In some cases, despite long running success at a certain scale. In the absence of a portfolio approach with risk adjusted returns these solutions will continue to fall short

The key problems are rooted in the inability for large capital providers to conduct due diligence and risk management on portfolios of SME debt, resulting in the lack of securitization options, despite highly attractive portfolio returns.

Lending platforms, banks and service providers focus on the highest quality borrowers and do not want to attack the lower quality borrowers, even if they could charge much higher interest to lower quality borrowers and realize much higher risk adjusted returns on a portfolio basis. Why?

Because most regulators and capital providers are looking at individual Non-Performing Loans (NPL), not total portfolio risks and returns. This results in a catch-22 situation: In order to expand the loan book and provide opportunities for securitization on larger scale, lenders would need to extend credit to higher risk borrowers, resulting in higher default rates (in absolute and relative numbers) which are unacceptable to capital providers, and thus the volume of credit available for securitization remains small with very unexciting returns for large capital pools.

Escaping this situation, will require a comprehensive rethinking of SME lending around four essential elements.

What are the key elements for successful SME lending?

If we want to successfully close the persistent credit gap, we must find ways to significantly increase transparency on any given portfolio down to each obligation, provide real time risk management, and enable nearly automated securitization at scale. Only then will loan volumes, risk-adjusted portfolio returns, and ultimate health in the SME ecosystem increase. This must and will be driven by novel technology and data models,

Without fundamentally rethinking the real technological hurdles in the way that SME Loans are life-cycle managed and securitized, the SME credit gap will never be closed.

A review of the four key elements of SME lending will prove helpful to outlining and unpacking the remainder of our discussion:

The Four Elements for Successful SME Lending

Let’s review each of the four key elements.

Digital Onboarding and Processing

Digitalization of onboarding and stakeholder processing has been well addressed by fintechs, e-money platforms and is ubiquitous in both developed and developing economies.

Digital onboarding is further enabled by regulatory innovation, such as digital identities, certified electronic signatures for legal documents, electronic filing of corporate actions, electronic registries of business licenses, professional certifications and qualifications, etc.

Underwriting Data and Models

Large numbers of micro enterprises and SMEs do and will not meet traditional underwriting standards, which is why banks and traditional lenders struggle to extend credit to SMEs. It is a fact of life that bookkeeping and accounting are not the primary concerns of most entrepreneurs, who like their larger corporate counterparts are cash-flow focused, provided cash revenue exceeds cash expenses.

Sophisticated underwriting models and data analysis have been developed in the past decades, with much more data and identification possibilities available. Risk modeling on payment behaviors of large scale customer data sets allow a level of abstraction and enable novel decision making processes.

While there are highly sophisticated data collection methods and modeling employed by firms in the space, without the following two elements expanded on below, such underwriting models alone cannot increase lending volumes and per se, and do not enable securitization. Among the most important factors for underwriting is the ability to track and verify the revenue from which interest and amortization (if any) are paid from by the small business.

Standardized Digital Smart Financial Asset

The key to understanding finance is to start by developing the understanding that financial contracts are the building blocks, and therefore, at the heart of finance. Since credit markets dictate survival, it’s innovation in this area that offers a beacon of hope in SME lending. A financial contract in simple terms is the agreement of two parties on the exchange of cash flows, i.e. it defines the payment obligations of the parties. Financial contract terms can be standardized on both the data model side and the algorithmic definition of the cash flow patterns. This approach results in consistency between financial contracts, from a simple loan to complex, multi-leg swaps, structured instruments and credit enhancements. Machine-readable and machine-executable term sheets based on the ACTUS standard, produce a standardized digital financial asset, which defines cash flow obligations of the parties based on the underlying financial contract. This enables a completely new efficiency in transaction processing and portfolio analysis. It results in integrated, real time risk management on any level of analysis from an individual obligation to any aggregation of the portfolio.

The natively digital financial asset based on the ACTUS standard enables the kind of transparency required to securitize assets with durations and granularity currently impossible to achieve. Investment banking-grade services and decision-making capabilities are available at any level, and at scale, throughout the economy

This technological innovation is made possible by deploying a consistent and expandable Life-Cycle Management (aka core banking system) based on the open source algorithmic financial standard ACTUS. The result is a fast and simple configuration of any financial instrument, as well as consistent management of any securitization, structured instruments, and credit enhancements which are based on the underlying loan obligations.

Integrated financial and risk analytics power and support all kinds of risk models from simple accounting to the most sophisticated rocket science analytics. Integrated risk assessment and monitoring are key to success in SME lending in order to meet the internal and external requirements for reporting and modeling to enable refinancing on a granular level and at scale.

Without truly digital native financial assets based on the ACTUS standard, which are issued with consistency and analyzed on a real time basis, SME lending will not scale. The time to rally around sensible, cogent standards is now.

Next, let’s look at an illustration to get a better understanding of the challenges currently present in growing an SME loan portfolio. Initial growth and efficiencies can be achieved by introducing digital onboarding solutions. Once a certain size of book and level of efficiency is achieved, most fintech enabled SME lenders are can not grow their portfolios due to their inability to securitize their portfolio efficiently, if at all. In addition, current fintech lending solutions offer limited returns, as they are unable to lend to higher risk borrowers on scale thus are unable to increase portfolio returns. In plain terms, current fintech models do not scale, and will continue to face insurmountable blockers.

In order to increase access to higher risk borrowers and increase total portfolio return, the fourth critical element of SME lending must be integrated and equally technology enabled.

Credit Enhancements

The combination of the standardized digital financial asset and credit enhancements form the basis on which significant growth in lending volume can be achieved.

In the world of ACTUS, credit enhancements are defined as collateral, guarantees, repo and margin calls.

Thanks to the consistency and the algorithmic definitions of the underlying financial contracts, automated integration of credit enhancements at all levels of lending, enables a dramatic expansion of portfolio size and an increase of risk adjusted returns. Together with the pooling of multiple lender’s assets, near real-time risk management and nearly automated securitization enabling granular tranching based on the risk appetite of the capital providers.

Let’s look further into the universe of borrowers, and consider how lenders can build higher return portfolios with acceptable risk. In addition to the advantages of standardized digital financial assets which allow securitization at lower costs with more granularity, increasing portfolio returns requires lending to more risky borrowers. Risk/return adjusted tranching of portfolios can be achieved by introducing credit enhancements allowing for capital providers to pick and choose the risk exposure they consider acceptable. Conservative, large capital providers do look for increased yields, but they must be able to understand the risk associated with each obligation, and the nature of the credit enhancement (if any), associated with each obligation.

Securitization at scale, thanks to a granular understanding of each obligation, is a precondition for loan volume increase while achieving attractive risk-adjusted returns. Credit enhancements are essential to support market volatility and increase portfolio returns while allowing capital providers to granularly select risk exposure aligned with their mandates.

The following illustrates the potential impact of digitally empowered, credit enhancement solutions compared to what’s out there today.

Now imagine building diversified portfolios of small business loans from multiple originators and across many platforms, while being able to monitor your portfolio at a granular level, in real time, having a full understanding of all the cash flows and risk factors associated with each loan, regardless of originator or servicer. Securitization vehicles, powered by credit enhancement instruments equipped with granular obligation level detail and real-time monitoring, as well as on a tranche or portfolio level, are the logical progression.

Credit enhancements in the world of small business lending come in many forms. In some markets, cooperatives provide mechanisms to absorb losses of its members by guaranteeing, and thereby subsidizing and making credit accessible. Regional development banks backstop certain types of loans, government entities subsidize businesses, de-facto covering high risk activities, and even private captive insurance vehicles may cease on the opportunity in certain industry segments. Unfortunately, these instruments are deficient, and are significantly constrained due to the brute force reconciliation effort across an eclectic set of heterogeneous systems, various data and calculation methodologies, not to mention the differences in documentation and underwriting standards.

The key ingredient for success remains the standardization of the loans with machine readable and machine executable term sheets, the integrated real time risk management enabled by the standardized financial contract, and a core banking system which can securitize on a near automated basis.

How will the SME lending world look with all four key elements in place?

By using the concept of a native digital financial asset, which standardizes the representation of SME loans from any issuer, it will be possible to create large portfolios of loans and securitize those at extremely low costs and nearly automated. This innovation in and by itself will provide lenders the ability to securitize more loans and will enable capital providers to acquire higher volumes of SME loans including the ability to have true diversification on any level desired (geography, sector, size, risk, etc.). .

Integrated financial analytics and sophisticated risk management based on a granular understanding of each obligation in any given portfolio, will enable everything from simple cash flow risk analysis to much more sophisticated domains such as rocket science analytics, supporting lending as well as securitization.

A dramatic expansion of SME lending will occur with the integration credit enhancements which are equally digitally native and can be individually tracked on each obligation level, allowing lenders to increase portfolio returns and securitize risk/return adjusted portfolio tranches.

In the future, investors will be able to purchase instruments with interest payments for 30 days or any duration backed by a revolving set of SME loans. For example, there will be instruments which enable working capital financing for hospitality or retail businesses during holiday peaks, and investors will be able to access such instruments with tokenized securities on DLT exchanges with attractive returns otherwise only accessible to specialized private equity investors.

Regional governments, development banks and ministries of finance, will be able to provide working capital financing to SMEs with higher risk profiles, thus enabling sustainable economic growth of unprecedented magnitude.

Why should SMEs not be afforded the same “luxury” of other borrowers?

No one seriously expects that large investment grade corporate borrowers, or for that matter, most sovereign borrowers ever pay back their principal without refinancing, i.e. rolling over their debt. In a revenue based lending model, the key for the borrower is to pay back the principal that one time or those few times, when it is really necessary to establish credibility as a borrower.

Alexander Hamilton, the father of modern sovereign finance, knew very well what it takes to become a trustworthy borrower. Pay back your debt, when it really counts — and then live off the promise of ever occurring interest payments…