International Network for Economics and Conflict

Lending is severely biased towards larger firms in developing countries.  The World Bank’s International Finance Corporation and McKinsey estimate $750 to $850 billion of unmet SME demand for credit in emerging markets[1].   Traditional financial institutions have operating models that yield very small profits for small and medium enterprises. Assuming fixed evaluation costs and a percent based revenue that depends on the loan size, the finance of small and medium enterprises presents a less attractive option than the finance of larger firms. Microfinance now enjoys a greater access to finance due to innovations that standardize processes and lower the cost of evaluation, but such innovations are only starting to be applied to the small and medium firm sector.

This “missing middle” is even more starkly apparent in countries recovering from strife where
the small and medium enterprises (SMEs) benefit from hardly any access to finance. In South Sudan for instance, “access to finance remains a major constraint for businesses and individuals” where “bank loans mostly finance working capital for large firms” and “47 percent of firms surveyed considered access to finance a major obstacle to doing business”[2]. In view of the difficult settings of post-conflict economies where entrepreneurs have limited management skills and there is lack of legal systems to formalize the use of land as collateral or resolve disputes, it is not surprising that banks are unwilling to lend to SMEs. Nonetheless, addressing this gap is crucial in order to provide jobs, income and stability through broad-based economic empowerment.

It is important to understand the inefficiencies that limit the provision of finance through market mechanisms in order to resolve problems at their source. The cost effective information gathering and innovative risk assessment techniques are crucial --- in spite of the challenging informality of systems. In the long term, this could be effectively dealt with by establishing land registries, drafting laws, building the functionality and capacity of courts and setting up credit bureaus.

However, these processes take a significant amount of time, and there is a short run need for innovative approaches that would effectively differentiate between risky and safe types (problems of adverse selection) and enforce responsible use and repayment of funds (problems of moral hazard).  There needs to be a process of ‘creative experimentation,’ where policymakers and researchers work together to think out of the box and learn from successes and failures.  A balanced solution involving backward linkages from viable sectors through the direct allocation of purchase contracts, equipment finance and business advice is one example. The coordinated funding of programs that adopt such measures would achieve significant short run impact in complex and still largely informal environments.

[1] IFC The World Bank Group, November 2010: Scaling-Up SME Access to Financial Services in the Developing World; and  McKinsey & Company, Fall 2010: “Two Trillion and Counting: Assessing the credit gap for micro, small and medium-size enterprises in the developing world”.

[2] The World Bank, December 2009: “Sudan – The Road Toward Sustainable and Broad-Based Growth”, p114, 112, 138 & 145, Poverty Reduction & Economic Management Unit Africa Region.