Perhaps no sector has more to gain from innovations in financial technology than small- and medium-sized enterprise (SME) finance, especially in Asia. SMEs accounted for 42 percent of Asia’s GDP in 2014 yet received only 18.7 percent of bank lending according to the Asian Development Bank. Fintech can particularly leverage the rapid growth of Asia’s e-commerce and regional trade, trends that complement SME development.
SME lending gaps persist around the world in both developed and developing economies. Among the many factors limiting lending to the SME sector are limited availability of credit ratings of smaller firms, lack of tangible assets for collateral, and the high costs of making small loans for lenders.
Alternative Data Fill Gaps in SME Credit History
A typical constraint for small business financing is the lack of traditional indicators used to inform a credit score, or in some cases, the absence of comprehensive national databases with sufficient history to measure credit risk accurately. A small business simply may not have any prior history of borrowing and repaying a loan. Fintech-facilitated lending may have greater potential for small businesses in Asia because data sources captured by non-financial firms can support credit risk analysis even when national credit bureaus are still limited, as in countries like China and India.
For example, lenders could use data on a prospective borrower’s sales and payment activity from e-commerce firms like China’s Alibaba or Japan’s Rakuten to assess the borrower’s ability to repay a loan. Indeed, Alibaba is directly leveraging payment data from Alipay to support the activities of its Ant Financial affiliate. Lenders are also using data from service providers like utilities and telecommunications companies to confirm if a borrower has a history of paying bills on time. A lender can also corroborate basic elements of a loan application more quickly and cheaply, for example verifying a small business’s place of operations through geolocation data obtained from the entrepreneur’s telecommunications company.
Should the use of such alternative data sources accelerate, Asia may be able to leverage financial technology to leapfrog the requirement for a robust bank-driven national credit bureau, at least for smaller businesses and consumers. Indeed, Ant Financial’s Sesame Credit is a new rating agency that is trying to do just that.
Regulatory Implications of Alternative Data
There are a number of regulatory and legal concerns with the use of alternative data sources by lenders. Among the most important considerations are customer protection and privacy: laws, regulations, and supervision must ensure that data are used with the consent of customers and, equally important, that they do not promote discriminatory treatment in financing decisions. Even a well-intentioned fintech lender may use alternative data in ways that have disparate, negative impacts on certain populations like low income households.
The use of alternative data from non-financial firms, particularly those with strong market power, could also present competition and anti-trust issues. Traditionally, national credit bureaus share credit scores with other financial institutions, but development of alternative sources for scoring could encourage dominant players to create closed networks with data access limited to their own fintech affiliates, undermining the network effects required to stimulate SME finance. The best approach will welcome all stakeholders to share and collaborate in a more robust national credit scoring system that incorporates both traditional and alternative data.
Even if lenders can use fintech to improve credit risk management, in much of Asia they will still have only limited recourse to seize assets if loans go bad, a challenge faced even by traditional financial institutions. The dynamic has encouraged some unscrupulous fintech firms to use alternative forms of collateral. For example, loan sharks operating on Jiedaibao, a popular Chinese P2P platform, used embarrassing pictures of some borrowers to secure repayment of loans, with the right to share the pictures publicly should the borrower default.
Technology can Enable Trade Finance for SMEs
Fintech can also deliver trade finance services to small businesses, which have historically had more limited access. Trade is hugely important to the growth of small businesses in Asia, where substantial regional trade combined with the digitization of commerce dramatically expands their potential market. The Bank for International Settlements estimates that roughly one-third of global trade—$6 trillion—is supported by trade finance. Particularly in Asia, this activity is dominated by banks, which tend to serve larger corporate customers given the cost and complexity of existing processes for granting international letters of credit, providing foreign currency liquidity, and verifying that a transaction has been completed according to contract.
Yet, much of this complexity comes from the simple fact that trade finance remains remarkably old fashioned. For example, the continued use of paper letters of credit can create substantial delays in the settlement of cross-border trade. Digitizing such processes does not require fintech firms, but they may be more nimble, with lower overhead, streamlined online processes without legacy paper systems, and alternative data sources that allow them to serve smaller businesses more effectively at lower cost than traditional financial service providers.
Instead of merely digitizing old processes, the use of blockchain technology, for example, could dramatically streamline trade finance, eliminating intermediaries that previously verified a shipment was delivered to a given destination. Instead, the shipment’s arrival could be verified with geolocation data, which would automatically execute a smart blockchain contract, transmitting payment to the seller. The whole process could take place in a fraction of the time now required. For smaller firms with significant liquidity constraints, reducing the time between sale and payment can be the difference between growth and bankruptcy.
A Virtuous Cycle for SME Finance
Financial technology can improve the accessibility, convenience, and cost of finance for SMEs around the world. Asia’s small businesses may particularly benefit from the growth of regional trade and e-commerce, areas where fintech has the potential to have a major impact. In time, SMEs could begin to receive a share of loans commensurate with their contribution to economy.
In the long run, improvements to SME finance may even transform regulators’ views of the sector’s riskiness. Regulations can affect SME lending both in terms of accessibility and cost. If fintech can increase the sophistication of SME credit analysis and thereby reduce the expected risk of related loans, regulators may feel more comfortable easing rules related to SME finance, amplifying the benefits of innovation.
The views expressed here do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.