Written by Crowdfund Capital Advisors
On September 21st I was invited to speak at the 1st Latin American & Caribbean conference on Innovation in SME Finance in Medellin, Colombia. The event was organized by the Inter-American Investment Corporation (IIC). It was attended by 450 participants
from 42 countries. The participants included the leaders of Latin America’s Commercial Banks, FinTech Companies, financial regulators and policy makers. I had the opportunity to moderate a panel about Alternative Lending and why it is gaining traction globally. The following represents some of the key findings I observed during the data intensive 2-day event.
Why SME’s are Important and the Benefits of Increasing Access to Capital to Them
The purpose of this event was to educate attendees about the advances in SME financing. The goal was to educate banks and other financial intermediaries on ways to integrate the latest FinTech solutions to foster access to capital. The stage was set with the following data points about SMEs and the challenges they face:
- The market opportunity is enormous: SMEs account for 9 out of 10 businesses globally.
- Jobs provide economic opportunity and tax revenue: SMEs provide more than 60% of overall employment worldwide and roughly 80% of jobs in the developed world. They represent more than 90% in the developing world.
- SMEs promote trade and commerce: They contribute 50% of global Gross Value Added and an even larger percentage in developed countries.
- SMEs face significant challenges in access to capital, this limits their ability to grow and rise above SME status:
- Where they do qualify for financing, raising capital by issuing debt or equity securities involves high transaction costs, onerous listing requirements and complex legal and regulatory frameworks. (Something only larger firms can afford and support).
- On the other hand, investors have been equally deterred from playing an active role in funding SMEs due to complex legal and regulatory frameworks. This not only deters investment but limits it only to the smallest few that care to overcome these challenges and have significant resources to do so.
- The formal economy is so complex or exclusive that 70% of SMEs do not use formal lending facilities, and another 15% are unfunded from such sources.
- SMEs predominantly use short-term financing options like overdrafts, credit lines and bank loans. Because SME tend to borrow less, this is a segment of the market that provides lower profit opportunities for large banking institutions and hence not a sweet spot for them.
- The global financial crisis caused banks and regulators to apply more cautious risk management and credit underwriting processes which has pushed the quantity of SME lending down and the price up.
- The total unmet demand for credit by all formal and informal SMEs is estimated to be $3.5T. The International Finance Corporation (IFC) estimated the formal SME gap to be $1.5T globally.
- When looking at the global opportunity, however, FinTech companies understand the “high transactions/low fee opportunity” is in the billions.
Where alternative financing is taking hold the following benefits are appearing:
- Transparency: Companies that tend to be successfully funded have spent a significant amount of time prepping for the raise, preparing their financials for review and creating necessary disclosures for investors to vet.
- Access to capital: Companies have access to short-term financing that the banks have been unwilling or unable to finance.
- Sophistication: Companies tend to follow a path of management discipline, internal governance and external communication.
- Deal flow: Companies that are transparent, leverage this capital smartly and execute on their plans are seen as quality deal flow for follow on investments, VCs and even traditional banks.
- Diversification: Investors have access to a broader and more diverse set of investment opportunities within a regulated and transparent environment at attractive yields.
The FinTech Solution
The solutions to challenges faced by both SMEs and Financial Institutions are already here and rapidly gaining traction. These solutions rethink problems and fill gaps with state of the art technologies that are algorithm based and customer friendly. While these solutions leverage advances in technology, they require that the private and public sectors come together to fully achieve economic growth and job creation.
To set the stage as to how these algorithm technologies seamlessly and transparently match supply and demand and improve efficiencies and costs, Uber and Amazon were discussed. Uber is a technology company that matches people who need rides (demand) with unmet driver’s capacity (supply). Uber is a cashless mobile application based on real-time geo-location. But Uber is much more than a tech company. It is also a payment company and an employer. (Uber is available in over 58 countries, 311 cities, provides over 200,000 rides a day and employees over 1M people). Since you need to have a bank account to receive payments, Uber has created more bank accounts for their drivers than anyone else in the USA. (The creation of a bank account is the first step in bringing the unbanked online and introducing them to more formal banking opportunities). Hence Uber is bringing online a segment of the population that was unbanked before (and hence ineligible for bank financing), creating economy opportunities and solving a supply/demand problem.
Another example was drawn to Amazon the online shopping site which proved how the internet can improve efficiencies, reduce costs and bring more consumers online. (Amazon has 2 billion products, operates in 100 counties and has 244M active users of which 19% are Millennials). Amazon effectively solved the supply and demand issue for consumers seeking products at competitive rates. But Amazon is much more than a shopping site, it is also a distributor and product validator. It introduced availability and reviews into the equation so that consumer’s time to wait for a product could be reduced to a couple days and allows users to share their opinions on a product which can drive purchasing behaviors. Products that receive high ratings, get purchased more and get flagged with further driving customer buying habits. Millennials were pulled into the equation because it was shown how they played a critical role in the adoption and transformation of the Internet from yesterday, make up a growing percent of the purchases online today, and how they will be the banking customers with cash in the future. Hence, since Millennials are active online today, financial institutions need to interact with them in the way they are used to transacting business – online.
FinTech’s goal isn’t necessarily about moving people from one place to another or selling products online but leveraging technology to circulate money (and as a by product create jobs) in a transparent and efficient manner. It is another way to look at the mismatch between the supply and demand that exists in the capital markets and solve it. FinTech is driven by artificial intelligence that moves identity away from things that we know like payment history and personal identification numbers (PINs) to things that we have like a social network, face, voice and fingerprints. It uses algorithms (much more advanced than ratings on Amazon) that are based on psychometrics, mobile usage, geolocation and social networks. These algorithms create feeds of millions of collective inputs that are analyzed and generate scores that are much better at assessing credit risk than a human ever could ever be.
There was an entire demo by FinTech companies that created credit algorithms (for cell phones and mobile money transactions) made up from nontraditional data feeds from Facebook, email, review sites, cell phone, etc. These FinTechs also demonstrated how response timing when completing forms can be indicative of behaviors. We saw how an algorithm on a phone using facial recognition was 5 times better at detecting fraud than a teller — this makes fraudulent check depositing harder. And we saw how computers could diagnose cancer with 95% accuracy while the world’s best oncologists were only 50% successful. Putting this together, it was easy to see how the digitally recording of billions of data points can create better credit risk profiles than we have today and better determine who should get funded and with how much.
Who is Working on this and Who Needs to Pay Attention?
It was pointed out that there are 40,000 FinTech’s globally and more than 8,000 alone in the USA. That means there are more FinTechs than banks in the USA. Banks and financial institutions need to pay attention. In China, one of the P2P lenders raised $93B in deposits in less than a year. All banks globally didn’t accomplish that last year. And the default risk of P2P lenders is half that of competing banks. Zopa, a P2P lending platform for example, has a default rate of .005%. Why? Because they have better data. Banks shouldn’t be afraid of or consider FinTechs competitors but figure out where they can partner based on where these companies have been successful at unbundling services, filling a void and meeting demand. Traditional banks provide a wide range of services from lending, to cash management, to payroll and merchant services. These technology players don’t aim to take on all those services. Banks need to understand where these FinTech’s fit in and align themselves.
By 2025 it is estimated that $2B will come into the banking system on smartphones. So if you want to make some money, figure out how you are going to be the depository of those funds! Consider the emergence of the credit card industry and what this has meant for MasterCard, Visa and American Express. When credit cards were first introduced, people didn’t use them, now everyone does. Credit cards addressed a barrier to purchasing that has since unlocked trillions of dollars in commerce (and billions of dollars for MasterCard, Visa and American Express). FinTech can address the existing internal barriers banks face that are inhibiting them from lending, unlocking trillions of dollars of economic productivity.
Brett King, the keynote speaker believes the future of banking will be driven by data scientists, customer experience specialists, behavior psychologists, risk programs and community managers. This mimics the investment thesis we have for our venture arm whereby the crowdfunding market is driven by technology platforms, trust and transparency tools, data analytics, payment gateways and a white space of technology plug ins. It was nice to see that our thesis is aligned with Mr. Kings’ thinking.
The reality is the technology is here and not going away. When used appropriately these technologies can allow lenders to scale, decrease cost and reduce subjectivity in their funding decisions. PayPal is already doing this. Because they can predict how much their customers can afford based on the invoices processed on PayPal, they can calculate and provide working capital loans. This transactional data not only allows PayPal to make smarter decisions but because it is digitally stored there is more transparency. It turns out that transparency is good for regulation. The greater the digital footprint, the more accountability, the less the need for strict regulation.
None of this financial technology, however, can operate in a silo. These tools might be good at customer experience and engaging users but they still rely on banking partners that can operate in a regulated environment. It was suggested that the biggest banks in the world in 2025 will be technology companies. (Steve Jobs also suggested this 20 years ago). However, the banks are bigger today than they’ve ever been – remember ‘to big to fail?’ The reality is the banks aren’t going anywhere but we can all win (banks, FinTechs, customers, investors, entrepreneurs, governments and regulators) if we can figure out how to work together.
Governments must lead with policies that promote the use of information systems. These online data technologies can bring the informal economy online, promote further information gathering and intelligence, leverage banks as facilitators and foster the growth of sustainable businesses. Government must provide the slogan and vision, and the private sector must follow with good ideas and the execution. It must be understood that no one policy can be applied to all counties and there can be too much government intervention. But governments can help foster the emergence and adoption of FinTech with warranties and funds to de-risk and co-invest alongside the crowd as well as tax regimes to encourage investment as opposed to discourage it.
With the millennial generation coming to their financial maturity banks need to speak to them in the way they are used to being treated – with love and a customer interface that is simple and easy to use. As Anne Hubert of Viacom mentioned, this generation doesn’t believe in selling credit but financing human endeavor. Banks that look through the lenses of the Millennial generation will be the winners in the future.
As I mentioned during my opening, technology is something to get in front of, not behind. It is a way to bring the informal economy online and match the demand for capital with supply. The byproduct will be greater financial inclusion, reduced bureaucracy, and increased data transparency. The opportunity is to create an ecosystem that consists of technology, banks, borrowers, lenders, governments and policymakers where all the members benefit, goods (exports) increase and capital flows in a way that increases productivity and promotes jobs.
Carl Musana, CEO of the Inter-American Investment Corporation summed it up with the following 8 points:
- We are living in a technology revolution — Meaning it isn’t going away so jump on board.
- Investments in this field are increasing — Meaning investors see the opportunity in these technologies.
- We need to use the data coming out of the technology to build better companies — Meaning not only use the data to fund companies but to help scale strong companies faster.
- There are more financing options today than yesterday — Meaning while access to capital might still be a challenge there are more solutions today than before (and there will be more tomorrow).
- Regulators need to pay attention — Meaning they need to follow the data and create policy that is data intensive and prescriptively light.
- This has to be a partnership between the existing incumbents and the new entrants.
- Millennials are in the driver’s seat and
- There are many ways to innovate.
If we can do this, we can overcome the financing challenges for SMEs and efficiently and transparently bring the informal economy online.
 An SME is a Small Medium Enterprise. The definition of an SME varies by country usually scaling in definition from developing economy to a developed one. In the European Union, a small-sized enterprise is a company with fewer than 50 employees, while a medium-sized enterprise is one with fewer than 250 employees. It considered smaller than this in developing economies.ransparency s of dollars for asy to understand how get market of the future, ticularly if etitive rates. It also introduced ava
 The following data points come from Towards Better Capital Market Solutions for SME Finance by Oliver Wyman that was distributed during the eventtransparency s of dollars for asy to understand how get market of the future, ticularly if etitive rates. It also introduced ava
 Gross Value Added is defined as the dollar value for the amount of goods and services that have been produced, less the cost of all inputs and raw materials that are directly attributable to that production.
 The report looks at the cost of listing on a SME Equity platforms and estimates it around $200k.
 IFC Enterprise Finance Gap Database 2011 – The report states 1/3rd for high-income OCED states and 2/3rd for emerging markets and developing countries.