How Increasingly Digital Life can Boost Small Business Access to Finance in Asia

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Paul Tierno.

And I’m Cindy Li. We are analysts in the Country Analyst Unit and our job is to monitor financial and economic developments in Asia. Today we are revisiting the topic of FinTech in Asia. We are speaking with our very own Sean Creehan, a senior analyst and a colleague here in the Country Analyst Unit. Sean is the familiar voice of this podcast but today he will be on the other side of the table, as we talk to him about a paper he recently wrote on the role of small and medium sized enterprises in Asian economies. Like SMEs in the US, they are a huge driver of economic growth in Asia, accounting for more than 40% of the regions GDP and the more than half of all jobs.

That’s right, but despite the big role that SMEs play, they have a disproportionately low access to credit, creating a gap. Asia’s credit rating infrastructure just isn’t robust and SMEs by nature, have much shorter credit history. According to Sean’s report, technology might be changing all that.

That’s right. FinTech helping fill the gaps, from alternative data collection, simple digitalization, to more technologically advanced applications, like blockchain, financial technology is helping to reduce costs and improve efficiencies, which makes access to credit for SMEs less risky. Let’s hear from Sean. Sean, great to have you.

Thanks for having me

Sean, SMEs are critical to economic growth and job creation here in the United States and I guess it’s the same situation in Asia.

Yeah, I guess we could say around the world, SMEs have a large role to play in the economy and that is of course true in Asia. If you measure it from a few different indicators, SMEs tend to play a large role in employment. Typically, over 50% of jobs are created by small and medium-sized enterprises. In some countries in Asia that may be as high as 60, 70, 80% but typically is at least 50%. In terms of contribution to the overall economy, as measured by GDP, you might see a range of maybe 30% to over half of GDP is generated by SMEs.

Then if we look at specific sectors like the trade sector, in countries like India or China, over 40% of exports are generated by small or medium sized firms. Generally speaking, you could say SMEs are really a backbone of the economy. Large firms of course do a lot of important things but any healthy economy is characterized by small businesses.

Right, and your paper is motivated by something called the SME Credit Gap. Can you tell us a little bit more, maybe take a step back, what is the credit gap?

Sure, so when we think about access to finance from a policy’s perspective, whether it’s United States or any country around the world, one typical way of measuring whether banks or other financial institutions are serving potential customers, whether they’re consumers or businesses, is to look at what is the proportion that this sector plays in the economy and then how much credit are they actually getting?

Statistics are a couple of years old, but generally the trend has continued. The Asian Development Bank estimated that SMEs in Asia represent over 40% of GDP but get under 20% of total bank credit. Roughly speaking, they get about half as much bank credit as you would expect them to get, if they got a share of funding proportionate to their overall role in the economy. That’s a basic way of thinking about it, there’s other indicators we could use but I think that’s the simplest.

Looking at Asia SMEs, seems like they are less likely than global SMEs are, on average, to have sufficient access to finance.

Yeah, that’s right. Some of this is just coming from survey data and so we don’t have perfect comparative numbers from around the world but looking at a joint study from the Asian Development Bank and the Organization for Economic Cooperation Development, it looks as if Asian SMEs on average are less likely than global peers to have made investments recently and more likely, if they did, to rely on retained earnings, so revenues generated in their course of business, as opposed to external financing. They’re also roughly half as likely to apply for a loan and 50% more likely to be required to provide collateral if they do get financing.

Looking at the credit gap and also some of the trends for SMEs, what role can financial technology play in bridging the credit gap?

Sure, I guess maybe we can start by talking a little more about why that credit gap might exists for SMEs in general and then we can dive into some of the ways technology should help. I guess there are two essential reasons why SMEs may be under served by financial institutions. One is the cost of lending and the other is risk. So, from the perspective of cost, issuing a loan involves a lot of operational costs and activities, whether it’s on the back end, accountants, credit analysts, sourcing deals and then analyzing the risk, servicing a loan after it’s issued, etc. Typically, banks or other financial institutions will solve this challenge of certain costs by lending to larger customers. The larger a loan, the more likely it is you can recover those fixed operational costs and so it’s just a matter of economies of scale. That’s one reason why SMEs tend to be under served.

Another issue just generally, relates to risk versus return, so smaller businesses typically have less stable sources of revenue. They may have less of a robust financial history, so it may be harder to actually tell what they’re likelihood to repay is. They also, as I mentioned before, Asian SMEs, according to surveys tend to be more likely to be required to provide collateral if they’re borrowing and small businesses tend to have less collateral. It may be a small, single proprietor that owns a business, or a couple of people and their collateral may just be their house, for example. They might not have any fixed factory assets or something that they can use when they’re borrowing.

Seems to me that different lenders have a different risk-return appetite, so how can financial technology help change some of the existing barriers to support credit to SMEs?

Good question. Thinking about it from those two overall perspectives of cost and then risk, on the one hand I think we see this throughout the economy, technology has the ability to drastically lower cost, reduce rote processes, automate certain things, whether it’s allowing for reduced use of humans reviewing contracts, putting together back office numbers, things like that, just basic automation can reduce costs.

I think what may be more interesting, from the perspective of SMEs and financial technology in general, is the role of alternative data in improving firms’ ability to assess the risk of a loan to a smaller borrower. Around the world, so this isn’t just specific to Asia but it is also true in Asia, SMEs tend to just have what we would call a thin credit file. They may have no history of borrowing as an SME. Maybe it’s someone who’s founding their own company and maybe they borrowed before to buy a house, so maybe they have some personal credit history, or they may not even have that.

When you’re making a loan to a company like that, you really are flying blind, to some extent. That being said, the rising digitization of commerce in Asia and the digitization of life in general, use of social media, etc. is creating a wealth of alternative forms of data that could be potentially used to assess someone’s credit risk. We’re seeing a lot of firms getting creative in this space. In China, we see some of the most famous FinTech firms, for example, Ant Financial, which is an affiliate of Alibaba, the major e-commerce provider. Leveraging data from Alibaba, from its e-commerce platform to get a sense for is this individual, is the small business paying their bills on time? What are their relationships like with other vendors on the network etc? That can be really powerful.

Can you elaborate? Can you talk about some of the other ways that big data or alternative data is being used to help create alternative credit scores or credit profiles?

Sure. Just taking that example of China, and apologies to our listeners, who hear us talk about China a lot on the podcast, but of course a lot of the FinTech innovation in the space of SME finance is taking place in China. Recently, several financial technology firms, in collaboration with the Internet Finance Association of China have created a new credit scoring bureau, called Baihang Credit. That bureau is essentially consolidating a series of trials by several of these FinTech firms to use alternative data, whether it’s that Alibaba e-commerce data that I mentioned before, whether it’s data from the famous messaging platform, WeChat, which is run by Tencent, which is another major Chinese tech company that also has some financial technology affiliates. That data feeding into a potential credit score.

This is an effort, combining the private sector and the Chinese government to promote a more cohesive consolidated national credit scoring, using this alternate data. I should note that this new initiative is focused on personal consumer credit, but with many SMEs, the founder of a new company was first a consumer, an individual borrower. Even if that person has no prior history borrowing on a commercial basis, maybe they’ll have a personal credit score. I see this as a really potentially impactful first step for a lot of small business owners in China.

Let me just add one more thing. In India, we’re seeing a lot of different experimentation but I recently was looking at a firm called Tala Mobile, that is using data from an individual smartphone, that could be something as seemingly irrelevant as how often you call a loved one, so they’re asking their users to give them permission to see this data, but that sort of information, how often you’re connecting with a loved one, whether you’re showing up at a certain geolocation regularly, as you may have told the bank previously in some credit application. This sort of data from a phone can actually inform a credit score.

It sounds very innovative, using what would otherwise be mundane data, to create a credit profile or a different type of credit score or bureau. What are some of the concerns? I’m thinking about privacy in particular and what large companies or large data collectors might…what are some of the privacy concerns?

Sure, of course as we record this today, there’s been a lot of concern in the United States over issues with firms like Facebook. I think that’s an ever present issue and there’s varying levels of concern in different jurisdictions in Asia. I will say in India, privacy is a huge issue. We see this with the rollout of universal national identification cards in India, called Aadhaar, which are being used by a lot of different firms to increase financial inclusion, including to this SME sector. The Indian Supreme Court has actually held up some of this activity because of privacy concerns, so yeah I think at a basic level the issue is, I’m giving this FinTech startup information about how often I call my mom or how often I come into work and what time I get there. I think on a basic level, we want to make sure we understand how firms are using that data, what their protections are, are they sharing it with third parties? I think that’s something that we’re seeing here in the United States bubble up in conversations about privacy. That’s a clear concern.

I think another issue that we’ve talked about in the past is how is an alternative credit score being formed from the data? Is there any potential for a discriminatory impact from the use of this data? Are we going to see people of certain backgrounds that are being privileged by the use of this data? Whereas other people, maybe they don’t even have this sort of online profile. Is that going to disadvantage them? I think those are some issues.

Another related concern that I thought about is, to the extent we see the emergence of these really powerful platforms, whether it’s a company like Alibaba, say here in United States if a company like Amazon got involved in financial services, they have some extremely powerful proprietary data. They can see how is a firm doing on its platform? How much are they selling etc? That data, to the extent we assume this trend continues and we see more and more traditional firms or FinTech firms using the data to make these decisions, that data could be really powerful. But as a customer, do I have the right to understand exactly how that data is used when you’re making that decision? That seems like a valid concern. If I want to go to another firm, another bank, another FinTech firm, do I have the right to take that data that I’ve built up through my own activity on a platform and bring it to this other bank?

We could see that maybe promoted through the use of an open API, so an API is application programming interface. You could have maybe policies that mandate any firm, creates an API that any other firm can use to access that data and then make a decision based on it. Without policy making and some further regulation, it may be that we see monopolies develop around this. I’m not saying any of that exists today but that’s another issue in addition to privacy, that I see potentially coming up with the use of this alternate data.

It seems like all this new business model, new ways of application of financial technology also raise some challenges for regulators, especially in the field of consumer protection.

For sure. This is a bit more speculative but historically, because of the greater riskiness of SME loans, when you look at capital regulations for banks, there’s a higher capital requirement associated with loans to small businesses, to the extent that as we go through this transformation of the sector and we get more and more data on small businesses, to the extent it seems that the ability to assess risk in the actual riskiness of these types of loans is going down, maybe we’ll even see regulators adapt their approach.

It seems like financial technology really helps, in terms of a price finding, of bringing more transparency and making more alternative that are readily available for lenders, which should help them better price risk and returns. Also, financial technology has the potential, as you mentioned, to lower cost and improve efficiency. Can you talk about some of the application for financial technology in trade finance, which is the focus of your paper?

Sure, so in addition to alternate data, I definitely took a deep dive on trade finance. The motivation there was from a few perspectives. For one, Asia is a growing center of global trade. I think that’s fairly well understood, we know that a lot of our consumer goods come from Asia, whether it’s China or Southeast Asia, or what have you. In terms of the headline numbers, Europe is still the largest source of global trade if you look at trade between countries within the European Union, but Asia is a closer and closer second. Roughly a third of global trade now comes from Asia. If we assume continued economic growth in Asia, catch-up growth versus the rest of the world, I think that number will continue to grow and we may see that Asia become the largest trading region in the world quite soon.

But in terms of trade finance, this isn’t just specific to Asia but historically, trade finance has been a fairly old fashioned business. We see the use of a lot of paper processes, for example. In general, there’s a lot of parallel steps taking place when you have a trade finance transaction, so you typically have three to four financial institutions involved. I don’t want to get too much into the weeds, but essentially if you’re a small business in India and you have a local bank, chances are that bank get may not necessarily have an ability to provide assurances to a buyer overseas, say in the United States and they need some sort of intermediary financial institutional help, so that’s one issue.

The other issue is generally when you have a letter of credit issued, so I’m buying some widgets in India from here in the United States, I’m going to send some money but I want some assurances that a few steps are taken, the goods are sent, I receive them, they pass customs, etc. There’s a lot of steps there. They need to be tracked. Once a certain number of steps are completed, that money may flow through those financial institutions but because of all the steps and the fact that a lot of them are not automated, they’re done in paper form, there’s a lot of room for potential error, for fraud. There’s a lot more time involved, it costlier, there’s a lot of intermediaries. If you bring that all together, getting back to that issue of cost, it makes it costly to provide trade financing for any firm, whether it’s a huge multinational, Fortune 500 company or a very small business.

To the extent that new technology can standardize some of these processes, consolidate them, we hear a lot of hype about blockchain and our listeners may be sick of hearing about it but I think actually in this case, blockchain may have a potential clear use case because of all of these different axes across which trade finance is going on, whether it’s different languages, different currencies, different laws, regulations, customer regimes, etc. Having some sort of distributed ledger, that is still accessible by all the different parties, to a trade finance transaction, that may be very powerful.

Then I would just add why I think this may be particularly relevant in Asia, I talked about Europe earlier. Trade finance is already big in Europe, but it makes sense because of huge role of trade there, but I would argue that a trade finance transaction in Asia is inherently more complicated because when we’re talking about two firms and you’re trading cross border, typically you’re trading across a common currency, there is a common market, harmonized laws and regulations, customs regimes. That makes it a lot simpler from a trade finance perspective. In Asia, we don’t have that and that’s another reason why I think this is an area of potential focus.

Asian economies are very integrated into the global supply chain as well.

Yeah, so roughly half of global supply chain exports come out of Asia.

It sounds like there are some cutting edge technologies, whether it’s a blockchain or smart contract. But that Asian companies and countries can also advance through smaller ways, through digitization and standardization, so there to sort of balance between more advanced technologies and just regular digitization and standardization.

Yeah, I think that’s right. It doesn’t necessarily have to be blockchain. You can imagine a future where there is a platform that everyone uses for trade finance, that has this aggregating role of bringing all these different processes and tracking them and standardizing them and digitizing them. It doesn’t have to be blockchain. We’ve talked a little before about the digitization of commerce in Asia and there’s just basic ways that that can help. To the extent these contracts are standard digital format, it just takes away some of that effort of taking a paper document, inputting it…it reduces the role of human error, potentially.

Actually, I should note that the Hong Kong Monetary Authority and the Monetary Authority of Singapore, the two central banks for those countries are collaborating on a new initiative to use blockchain to link trade finance platforms. Their main reasons are to reduce the role of fraud and reduce error, this is all related.

It seems like Asian regulators are being proactive in pushing forward the use of financial technology to help out SMEs.

Yeah, I think that’s right. That example with Hong Kong and Singaporean regulators, the earlier example of Chinese authorities working with the private sector to create an alternative finance platform. I certainly see the potential for this in other markets, so actually Japan, getting back to the data issue, Japan has an SME credit database that generalizes credit risk across the economy for small businesses. It doesn’t create specific scores for a specific firm, so different use case, but it helps potential lenders think through what the risk will be. I see a potential role for the use of alternate data within an organization like that or in other countries in the region.

We talked a little bit about data and we’ve talked about digitization and standardization and the potential use of other technologies, where do you see changes taking place besides those? And you talked pretty heavily about factoring in your Asia focus paper, I was wondering if you wanted to talk a little bit more about that?

Sure, I think this is one of the more wonky topics I’ve encountered in my research, in terms of finance, so factoring refers to this concept of invoice financing, which is not as really prevalent in the United States so people may not be as familiar with it. It’s more common in Europe and it’s growing in importance in Asia. Essentially, the idea is typically for a smaller firm that may be producing a product for a larger buyer, the larger buyer presumably has a longer history of good credit, has lower credit risk. The smaller firm essentially borrows against that buyer’s credit rating. There’s a firm called a factoring firm that will buy the bill owed by that larger buyer, from the smaller firm. It will give them cash at a discount and then it will be responsible for collecting that money later, from the large customers. All this does is it accelerates the financing for a smaller firm.

Typically, this has been used for working capital, short term liquidity needs of small firms but I think there’s some potential with again, this digitization of commerce, to see more and more Asian small businesses rely on this form of finance. It could just be a simple as giving them more liquidity and if you’re talking about a firm that’s living month to month and maybe it’s really innovative but it just needs to get to that next 90 days or 180 days, in order to get that product really taking off, that sort of liquidity can be the matter of thriving or actual bankruptcy. We could dig more into that. It’s a bit technical but I think the standardization of commerce on digital platforms, which you mentioned earlier, Paul, that would be part of the potential here. To the extent that invoices standardize across Asia. It makes it easier to price and to trade.

There are some countries, such as China and India, they show up in lots of our previous FinTech related podcasts and you also gave some case studies, so looking at their successful adoption of financial technology, what do you think are the catalysts or what are the turning points?

The continued growth of e-commerce, so I just was looking at stats on this. Last year in China, online retail sales grew at roughly 34% year-over-year pace. In the United States, by comparison, where we have pretty strong online sales, the year-over-year growth was 16%, so I think Asia really is the center of a lot of e-commerce activity. That’s actually from both the business to business and a business to consumer perspective, so that’s a pretty obvious one is see. That will create a lot of opportunity for the use of alternative data as well.

Another one I would say, is just the adoption of smartphones, increased connectivity to the internet. I think in China now, for the most part, the market is fairly well penetrated by smartphones. I think some people in the countryside may still be waiting to get their first smartphone. In India, it’s a little bit different. There’s still probably hundreds of millions of Indians who are waiting to get that first smartphone and we’ll see it happen over there next five to 10 years, so I think that’s definitely a catalyst. The more you have people operating on their phones and generating this sort of data and just thinking mobile or online first, that could be really big. Yeah, I think that would be where I’d focus. Beyond, of course, policy initiatives, which we already discussed a bit.

Hearing the difference of smartphone penetration in China and India makes me think of whether there’s opportunities for leapfrogging and I wonder if you have any thoughts on that?

Yeah, so specifically from the perspective of SMEs, I don’t know if it’s a matter of leapfrog, because I guess the leapfrog potential to me, is more of the use of alternative data and alternative credit score. Leapfrogging in the where some of these credit score bureaus are not well developed, particularly for small businesses. It may be that some of these countries are in the process of trying to form traditional credit scoring bureaus and it may be that these trends actually make that process unnecessary. That would be one area where I’d focus, particularly from the perspective of SMEs and financial technology. Of course, there’s other, broader leapfrog opportunities. I think mobile in general, mobile payments we see in China is a huge place of growth vis-a-vis countries like United States and we’re seeing that in India too, so just that general trend will provide opportunities we probably can’t even foresee yet.

Your paper specifically is on increasing the breadth of SMEs and especially considering their large impact on the economies of employment in Asia, but you think that large firms may also benefit from some of these advances?

Yeah, there’s no doubt. I think the reason why I find it helpful to focus on SMEs is that generally speaking, as we talked about at the beginning, larger firms tend to be better served by traditional financial institutions, whether it’s in Asia or around the world. They’re typically lower risk customers, they have more collateral, they have steadier revenues, all of those issues that we talked about. There’s more economies of scale and lending to them and larger loan sizes, but that doesn’t mean that larger firms wouldn’t benefit from a lot of this. My guess is that any firm that engages in trade finance now would probably would not mind seeing some improvements in the process, the reduction in time required and cost.

Then if you think about it, we only talked briefly about this idea of factoring or invoice financing, but if you’re larger firms, that are basically back-stopping the credit for a smaller firm, that’s borrowing from a factoring firm…Sorry, that’s confusing. It’s almost a little bit easier if you took a look at the paper because there’s some flow charts that will make it clear how that relationship works. But if you’re a larger firm, you would like to see more invoice financing if it makes your supply chain stronger, more resilient from a financial perspective. It should mean fewer disruptions in supplies so that sort of benefit could be there for everyone.

I wonder, how do banks fit into the picture? Will traditional lenders also be able to leverage financial technology to increase SME lending, or will they see FinTech firms getting a larger share in this market segment?

Yeah, I would think that banks for sure can benefit from the use of alternative data. I mean sometimes banks may not be lending to certain borrowers because they don’t have a good insight into their credit risk, to the extent they have better insight from alternative credit scores, there’s no reason why they shouldn’t be able to, particularly if the issue of proprietary datasets pops up, to the extent that that issue is handled and this data is shared amongst all providers of credit, then that should definitely be helpful for them.

In terms of trade finance, one issue is the role of so-called correspondent banks. I think there may be some disruptions there, to the extent it’s easier for bank A and bank C to transact directly and not involve a bank B across borders. That would disrupt a bank that’s focused on that sort of service. But in general, my guess here is if some of these trends unfold the way I see in the paper, the overall pie of SME lending should get a lot bigger and the relative size of the bank slice or the traditional firm slice, it may be a little bit smaller but I would imagine that overall, they would still see fairly solid growth in their overall lending to small businesses. Maybe new competition, hard to say exactly FinTechs versus traditional firms. But even in a scenario where FinTech firms were really growing rapidly and competing I would think the implied scenario also involves just overall strong growth that would benefit everybody.

A big part of this potential benefit is of financial inclusion.

For sure, yep.

You’ve given us a lot to think about. It seems like technological innovations can shrink the SME credit gap and generally broaden economic impact of SMEs across Asia.

For sure, and I think what’s exciting here, and this is true of the financial technology developments in general, and innovation in general, is that I think a lot of these solutions can help small businesses around the world. Sometimes we think of Asia versus the US, or versus other markets. Are they ahead in this way or that way? I think a lot of this experimentation is going to lead to good things around the world and I think that’s exciting. As Cindy alluded to, to the extent this improves financial inclusion and gets more people involved in the financial system and makes these firms more resilient, it’s good for everybody.

This has been great, Sean. Thanks. For those who haven’t checked it out, check out Sean’s Asia Focus on how digital innovation can increase small business access to finance in Asia.

Thanks.

Thank you.

We hope you enjoyed today’s conversation with Sean. For more episodes like this, you can find us on iTunes, Google Play, and Stitcher. If you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. And for even more content, look up our Pacific Exchange blog available at frbsf.org. Thanks for joining us.