Updated: Sep 15, 2021
In the last 20 years, the Small or Medium Enterprise (SME) has been rocked by two major events. The global financial crisis of 2007-8, and now, the COVID-19 world-wide pandemic. The former was brought on by potentially predictable and fallible financial activities of human beings. The latter was brought on by potentially predictable and fallible socio-environmental activities of human beings. And SMEs always tend to be the first and hardest hit. But there is also an ambient unwillingness to provide finance to what are perceived as the more vulnerable corners of the sector. Irrespective of trade financing entities trying to protect themselves when adversity hits, why does the general hesitancy to provide finance - even during affluent times – continue to persist?
You would be forgiven for believing the reason for the suffering of SMEs, when trying to locate finance, is market segmentation. There is a palpable contrast between geographies and cultures when comparing developed countries with developing ones. Equally, developed countries have rich and diverse economies. On the other hand, developing countries tend to have poorer, and more homogenized ones. There is a multitude of reasons why these differences exist: natural resource availability, regional history, inherent climate, educational standards, belief systems, geography, ecology, and meteorology, to name but a few. These elements have served to augment the populations over time, and perhaps because of this, the wider community of the world has become compartmentalized. International trade has to overcome these economic and cultural differences, and the liquidity of trade finance is critical.
Why No Finance?
There are many reasons why an SME can have their application rejected. In as much as there are finite rules and regulations that any organization must adhere to in order to be able to qualify for trade finance (such as those issues that arise with compliance), there are also some reasons that change from bank to bank. Figure 1 shows some of the more conceptual reasons (survey conducted by Close Brothers regarding Britain’s SMEs) why an SME may fail in their application.
Figure 1: Conceptual reasons why SMEs might fail to get trade finance.
Where SMEs have a poor understanding of the marketplace, they may not be aware that most trade finance goes through a narrow corridor of larger financiers and that alternatives may be open to them should they be rebuffed. Increased robustness in the face of rejection, and the tenacity to find an alternative, might mean the difference between success and failure. It should also be noted that the advent of technology has seen the inception of a new way to conduct trade finance. SMEs – and especially those who reside in developing economies – tend to embrace new technology later and lag behind trends that could prove revolutionary for the financial welfare of their businesses.
Trade finance, for the most part, is low risk. The reasons for this include usually being underwritten by firm collateral, being thoroughly indexed by credit operations, length of the trade deals themselves - they are normally quick, and trade deals are self-converting (so capital is immediately available to pay financiers). The concept of collateral is especially interesting because a borrower might utilize goods involved in the trade to pay the entity financing the deal, if said deal falls through. Traders have a readily available commodity they can liquidate given the need. Banks and the like should find this attractive: it offsets risk. Of course, some SMEs are rejected for trade finance because they are still legitimately a poor bet: withholding credit is sound business practice.
Trade Perception Gap
A joint paper between the World Trade Organization (WTO) and the Massachusetts Institute of Technology (by Auboin and DiCaprio) depicts the difference between perception and reality when it comes to trade finance. In the period between 2007-2014, the transaction default rate in Asia-Pacific was only 0.29%. However, in 2014, the rejection rate for financing was 29% (source data from ICC and ADB). Indeed, according to the International Finance Corporation, 75% of all rejected requests for finance between 2010 and 2018 relate to SMEs. The sheer size of the finance gap that exists is debatable depending on one’s source, but the fact that it exists and that it is substantial is undeniable, and it seems there is a mindset of liability when financial entities measure the trustworthiness of smaller businesses in developing marketplaces.
What we have then, is what might be referred to as a trade perception gap. SMEs are being rejected for finance for reasons that are beyond risk. Whether or not these reasons are necessarily fair, is debatable. In the same paper by Auboin and DiCaprio - and in contrast to the findings given by Close Brothers – there were eight reasons given as to why SMEs failed in their applications (survey data from Asia Development Bank and covering SMEs having already established a banking relationship). These reasons can be divided into three categories: ‘bank-specific constraints, ‘risk-related’, and ‘regulatory’. Respondents cited the biggest reason for SME rejection was regulatory, and of this, AML and KYC requirements. Whereas financial entities define risk as being a core and initial reason why an SME can be rejected, it is apparent that the reason why additional finance wasn’t granted was because of the stringency of regulation.
In recent years, banks and associated entities have been subject to increased scrutiny. Certainly, the financial crisis of 2007/8 has been a major reason for this. This is perhaps rightfully so since there has always been a conspicuous lack of repercussions for those people responsible for it. More rigorous capital and lending controls have been the fallout and said organizations have been forced to reassess their balance sheets. Major suppliers of trade finance have been counted among these and what with their almost institutional presence in the international markets, the provision for trade finance has, albeit debatably, suffered.
Post the crisis, banks generally expressed the view that regulation around AML/KYC and Basel became more expensive and more complicated. These sorts of complaints by financial entities are not novel, but they do appear to be on the increase especially in the trade finance sector. A painful and inevitable logic seems to be emerging. If compliance rules set out by governing bodies are becoming more expensive and time consuming to meet, and if there is a perceived higher risk of lending to SMEs in less developed economies, the irresistible outcome is that there will be a significant shortfall in credit availability to any business that is collaterally poorer and resides in a market that is still immature. And this is not to even speak of the vulnerability of developing markets to bad actors who are involved in money laundering and other illegal activities. It seems the climate in trade finance, and with special regard to SMEs, is that the cost of providing finance is not parallel with the risk of providing it. Even though it would be difficult to argue this is the whole picture (it’s obviously a more nuanced issue) perception and regulation appear to contribute significantly in any case.