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views or policies of the Asian

Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they
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Improving MSME financing:

the role of Digital Finance
Feng ZHU
Luohan Academy

Disclaimer: the views expressed here are those of the author and do not necessarily
reflect those of Luohan Academy, Ant Financial or the Alibaba Group.

1
Outline

Difficulties with Micro, Small and Medium-Sized

Enterprises (MSME) financing

Core problem in MSME financing: information asymmetry

Digital finance: how it may change MSME financing

Micro, Small and Medium-Sized Enterprises
Defining MSMEs and SMEs
 Number of employees (eg 250), annual sales (eg €50
million), size of assets or amount of loans
 World Bank classifies firms employing less than 10
permanent workers as microenterprises
MSMEs are among the most important drivers of real GDP
growth, employment, productivity growth and innovations
 A survey (firms in 99 countries, 2006-2010) estimated that
SMEs employed 66% of total workers
 In China, over 90% of firms are MSMEs, they provide over
50% of fiscal revenues, over 60% of GDP, over 70% of
technological innovations, over 80% of urban employment
Difficulties in MSME financing

MSME financing sources are diverse across economies

 Differences in financial systems
 Firm structures and characteristics
 Macroeconomic conditions

Despite differences, MSME financing tough in all

economies
 Greater credit constraints, more limited credit access
 MSMEs rely more on trade credit and informal
financing
Distribution of financially constrained MSMEs
 IFC (2017)
 On average, 30% of
SMEs in all developing
countries are fully
constrained, 14% are
partially constrained
and 56% unconstrained
 21% of microenterprises
in developing countries
fully constrained, 19%
partially constrained,
60% unconstrained
 South Asia has largest
proportion of
financially constrained
microenterprises (54%)
Distribution of formal MSME financing gaps
 Potential MSME
demand highest in
East Asia-Pacific
(58%), mainly driven
by China
 Financing gap second
largest in Latin
America and the
Caribbean, driven by
Brazil
 India is a big
contributor (68% of
South Asia)
Distribution of potential formal Micro & SME demand
 Potential demand of
microenterprises totals
USD 882 bn; SMEs USD
8.1 trn
 Microenterprise
financing gap USD
718.8 bn, SME gap
USD 4.5 trn
 96% of MSME financing
goes to SMEs, only 4%
to microenterprises
 Microenterprises (14%)
have higher unmet
needs from formal
sources
Distribution of female formal MSME financing gaps
 Women-owned
businesses comprise
28% of MSMEs but
account for 32% of
MSME finance gap.
 Generally smaller than
male-owned MSMEs,
employ fewer workers
 Gap for women about
USD 1.7 trn, over 6% of
GDP, about 24% of
total microenterprise
finance gap (USD 173
bn) and 33% of total
SME finance gap ($1.5
trillion)
Distribution of potential informal MSME demand
 Potential demand for
MSME finance in the
informal sector or
shadow economy
totals USD 2.9 trn in
developing countries,
about 11% of their GDP
 Demand is largest in
East-Asia-Pacific (USD
995 bn), smallest in
MENA (USD 69 bn)
 Average demand is
also largest in East-
Asia-Pacific (USD 55.3
bn) and smallest in
MENA (USD 7.7 bn)
SMEs typically face higher financing costs
 Interest rate spread
between loans to
SMEs and loans to
large corporates is
generally around
0-5%
 It has remained
relatively flat for
most economies in
recent years, but
has been affected
by a generalized
compression of
corporate risk
premia
SMEs hardest hit by tighter macro-financial conditions
 SMEs particularly
affected by tighter
financial conditions,
as smaller banks
serve SMEs
 In China, fall in
profits in smallest-
cap firms about 0.2
ppts of GDP growth
in 2018
 Near 40% fall in
market cap, 1.5
times that of the
market as a whole
Differences in SME lending reflects banking structure
 SMEs tend to rely on
relationship lending,
requiring soft
information and
thorough understanding
of local markets, where
smaller banks have a
comparative advantage
 Larger banks overcome
informational obstacles
via contract design etc
 Market share of SME
lending has not changed
much in recent years,
except for China
Banks primary providers of external MSME financing
Bank lending remains the prevalent form of external SME
financing
 Significant heterogeneity across economies in the types
of banks that provide SME financing, largely reflecting
the structure of the banking sector
Access to public capital markets for SMEs is not common
Internal financing typically is important especially for micro
and small firms
SME lending growth has resumed after the global financial
crisis in some economies, but the volume remains below the
pre-crisis level in some places
Main difficulties with MSME financing
MSMEs have little access to alternative financing sources
High-credit-risk entities, hard for banks to assess their
credit worthiness: small, uncertain income streams, lack
of collaterals, difficulties in pledging personal and
public guarantees, and absence of verified financial
statements and bank credit histories
Generally too small to tap on capital markets
Many MSMEs located in rural and remote areas with
little presence of formal financial institutions
Elevated transaction costs for services provided by
traditional financial institutions (often reluctantly)
Why is MSME lending so difficult? Information
Information asymmetry
Adverse selection (pre-transaction) and moral hazard
Free-riding problem, costly monitoring and costly state
verification
Solving the information problem
 Financial intermediation with (long-term) relationship
banking and loan commitment, credit lines
 Credit scoring, increasing net worth and collaterals, and
strengthening regulation (eg accounting standards)
 Strengthening screening, monitoring and (contact)
enforcement of restrictive covenants
 Venture capital firms funding startups
SME fintech financing rising but still small
 Rise of fintech
 New approaches to
MSME financing
 BigTech
lending
 P2P lending
 Crowdfunding
 ICO funding
 BigTech-Bank
cooperation
 A better
solution?
 New
“syndicated
loans” in China
Rise of the platform economy and finance
Digital technology has radically transformed the classic
firm-versus-market tradeoff
 This leads to two-sided digital platforms, a third
institutional form (Tirole, 2014)
 Digital platforms are much more scalable, as digital
information has low marginal costs, low skill threshold,
and is characterized by non-rivalry
Digital information helps build affordable and efficient
digital identities, essentially an unlimited number of
consumers and suppliers can coordinate and transact with
no geographic constraints
BigTech platforms: economies of scale and scope
BigTech business model favors MSMEs
1. Build network of
users, collect and
analyze user data,
especially payment
information
2. Expand functionalities
into other life
scenarios - Finlife
3. Build more complete
ecosystems
enhanced with big
data analysis
4. Cross over into other
major financial
services
BigTechs venturing into financial services
 BigTechs providing
financial services now
comparable to
largest banks in size
 BigTechs provide
financial services to
MSMEs ignored by
big banks
 Data collected from
different life
scenarios enable
BigTech lending by
reducing information
asymmetry
BigTech finance serving Chinese MSMEs
 In China, banks
still handle 95% of
all payments
 But non-bank
mobile payments
grew
exponentially,
from USD 15 bn
in 2011 to over
USD 22 trn in
2017
 Payment is linked
to all sorts of life
scenarios and
ecosystems
A new BigTech lending model emerging
 In the inclusive digital
platform model,
credit lines are
extended based on
information derived
from the platform
 Information
intermediation is
crucial (“syndicated
loans”)
 Lenders have much
more knowledge
about the borrowers,
real collaterals might
not be needed
Fintech credit assessment and big data analytics
 Data collection, processing
and analysis at the core of
BigTech lending model
 Use of more granular data
with machine learning help
improve predictive power of
prepayment prospects,
especially for small
merchants
 BigTech credit scoring
applied to small vendors
outperforms models based
on credit bureau ratings and
borrower characteristics in
predicting defaults
Credit access fosters sales growth
 Ability to obtain financing has
had a significant, positive
impact on growth of sales for
small firms
 Hau et al. (2018) conclude
that the average sales growth
rate after obtaining credit
access jumped by
approximately 9.5% in just one
month and persisted at this
level even after half a year
... and reduced sales volatility
 Chen et al. (2018) find
that credit access
leads to reduced
volatility in firm sales,
and the effect is
strongly
countercyclical
 Volatility reduction is
concentrated in firms
within more
competitive industries
and in regions with
slower growth, weaker
legal environment and
contract enforcement
Collateralized SME loans
 Collaterals raise
recovery rates in the
case of default
 Share of collateralized
loans to SMEs has risen
in many economies
since the crisis
 Significant variations in
the use and type of
collaterals for SME
loans in different
economies, with a
prevalence of
immovable assets such
as real estate
BigTech credit less responsive to house prices
 BigTech credit stronger
in less-banked areas
 Massive data and
network effects may
allow BigTechs to
reduce information
asymmetry traditionally
addressed through use
of collaterals
 Contrary to banks,
BigTechs’ supply of
corporate loans does
not closely correlate
with real estate prices
Fintech/BigTech credit important for MSMEs
 Fintech/BigTech
credit expanded
most in China
 They mainly
serve MSMEs
and consumers
in China
 Loans are
typically credit
lines, or small
loans of short
maturity (up to
one year)
BigTechs still have much room to grow
 Core IT businesses (cloud
computing, data analysis)
about 46% of revenues;
Financial services about 11%
 BigTechs serve users mainly in
Asia-Pacific and North America
 BigTech financial services most
extensive in China, expanding
rapidly in other EMEs
 Fintech credit still a very small
part of overall credit. In China,
total flow of fintech credit less
than 3% of total credit
outstanding to the non-bank
sector in 2017
Digital platforms foster inclusive growth

 Online entrepreneurship
grew much faster in
Western China (eg Tibet,
Xinjiang) than in more
developed regions (eg
Shanghai, Beijing)
 Strong negative correlation
between rate of growth of
new online entrepreneurs
and level of economic
development
Micro credit grew faster in less banked areas
 Less-developed
regions have
witnessed faster
growth in SME
lending
 Growth in micro-
lending powered
by digital
technology bears a
strong negative
correlation with
the presence of
traditional financial
institutions
Conclusion
MSME financing has always faced much difficulties and
significant challenges, with unmet demand in both formal
and informal sectors in the global economy
The problem at the core of MSME financing is information
asymmetry, while large banks are reluctant to lend to MSMEs
Digital finance provide different external funding alternatives
to bank lending for MSME financing, yet not all alternatives
are valid
Platform finance, in particular the new BigTech business
model has so far proved useful and promising in tackling the
information asymmetry problem, based on integrated
businesses, digital ecosystems and big data analysis