Closing the SME credit gap to reignite the economy

In Australia, more than 2 million small and medium enterprises (SMEs) employ 65% of the nation’s total workforce and contribute to approximately 50% of Australia's total gross domestic product (AU$600B)¹. They are therefore the lifeblood of our economy.

However, many SMEs are financially fragile and the supply of capital is critical to run and grow their business. For some time and exacerbated by the pandemic, SMEs access to capital has been cumbersome to say the least. Globally and in Australia there is a major credit gap.
 

The impact of COVID-19 on SMEs

SMEs have been hit hardest by the COVID-19 pandemic. A recent report by the RBA showed that small businesses in certain industries such as hospitality, tourism, and entertainment lost significant revenue during the health crisis².  While there may be light at the end of the tunnel now, it’s still uncertain as to how many SMEs will survive once the support from the Government such as JobKeeper and JobSeeker and loan repayment holidays with financial institutions end.

However, Australia’s Big Four banks are reporting encouraging numbers in regards to SMEs loan deferrals. During the height of the pandemic, almost AU$60B SME loans were on repayment holidays. Since then, this has dropped by almost 80% to AU$12B in loans to an estimated 30,000 SME customers.

Some SMEs have done well to weather the COVID-19 downturn. Those that did pivoted early and leveraged digital channels to tap into new opportunities the pandemic brought on. As more interactions turned online, innovation and bringing technology to the core of the business has become vital.
 

Why Australia has a credit gap problem

Firstly, many banks and even regulators view lending to SMEs as “high risk”. Being an entrepreneur inherently means taking risk and there is a general perception that many SMEs are likely to fail. Research shows that over a four year period, survival rates for SMEs is only about 65%³. However, the data on non-survival rates are often fuzzy, since many SMEs change their legal form, ownership or industry altogether. Some SMEs also close business without any financial loss (e.g. retirement). So the data doesn’t always tell the whole story.

Also, many banks often shy away from lending to SMEs in order to protect their reputation. In 2018, the Royal Commission exposed banks and their irresponsible lending practices which put many Australians at risk of bankruptcy. Since then, it’s been even tougher for SMEs to get access to financing as banks don’t want to risk their reputation when loans go pear shaped. Regulators, such as the Australian Prudential Regulation Authority (APRA), share a similar view on lending to SMEs, so prudential capital requirements for SMEs are relatively high, potentially pushing interest rates up. 

SMEs, like any other enterprise, require a significant amount of credit to run and grow their business. In Australia, SMEs have borrowed AU$290B⁴, just a little over 10% of all outstanding retail and business debt with the banks. However, their need for financing is a lot higher and to extend credit beyond AU$100,000 without collateral in the form of real estate or personal guarantees is often very difficult. The lending application process for SMEs is also cumbersome, requiring businesses to submit a large amount of information and the approval process can be lengthy and slow. This is particularly problematic if the business opportunity is time sensitive.
 

Closing the credit gap

A key part of the solution is the “continuity of data” - the idea of having more and ongoing availability to data. Data about why businesses fail, financial data from SMEs on their day-to-day activities, and new data sources that can better inform lenders during credit assessments. Greater transparency will lead to less friction and more informed decision making.

Policy initiatives such as comprehensive credit reporting (CCR) and open banking can also help close the credit gap by giving banks and other non-bank lenders better access to information. Based on these policies, lenders will be able to make credit decisions faster and put the banks in a better position to assess if loans will default. Studies have shown that this will increase the supply of credit (see article on risk-based pricing).

Institutions need the support of technology to achieve these goals, whether it is to support the availability and continuity of data (open banking), the ability of computing the data on a very large scale (cloud), the interpretation of the data (advanced analytics) and constant learning and adopting of credit models (AI/ML).

Up until now the vast majority of investment has been directed towards retail banking; and the time has come for the lessons learnt from retail banking to be applied to the SME space. Financial institutions need to make investments in digital with a customer experience lens; focusing on simplifying the onboarding process and reducing the decisioning time ensures that SMEs can be supported with finances when they need them.

More accurate decisioning can be supported by greater data sources; continually updated models and increased processing power in the cloud enables institutions to make better decisions faster and enables them to address potential customers who previously would have fallen outside the institution's risk appetite. The automation of controls and application of ‘continuous compliance’ further de-risks portfolios of loans and enables constant re-balancing to ensure the portfolio stays within risk.

The Government, financial institutions, regulators and SMEs all have an important role to play in closing the credit gap. The Government can simplify processes and remove barriers to entry, allowing for new market entrants and creating a more competitive landscape. Lenders can also invest in financial education of SMEs as a basic duty of care (most businesses fail because of financial mismanagement). In turn, when SMEs invest in becoming more financially fit, they can also improve access to credit. Lastly, regulators such as APRA also have the power to establish a more diversified set of capital requirements for different SME risk profiles, which would lower the cost of capital for lenders and borrowers.
 

---

1. https://www.abs.gov.au/statistics/economy/business-indicators/counts-australian-businesses-including-entries-and-exits/latest-release
2. https://www.rba.gov.au/publications/bulletin/2020/sep/the-covid-19-outbreak-and-access-to-small-business-finance.html
3. https://www.oecd-ilibrary.org/sites/2bf6bc72-en/index.html?itemId=/content/component/2bf6bc72-en#:~:text=SME%20interest%20rates%20in%20Australia,2007%20to%205.29%25%20in%202018.&text=Total%20outstanding%20SME%20loans%20increased,of%20total%20outstanding%20business%20loans