IFC ADVISORY SERVICES | ACCESS TO FINANCE 94911 Closing the Credit Gap for Formal and Informal Micro, Small, and Medium Enterprises © International Finance Corporation 2013. All rights reserved. 2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433 www.ifc.org The material in this work is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. IFC encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly, and when the reproduction is for educational and non-commercial purposes, without a fee, subject to such attributions and notices as we may reasonably require. 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Additionally, “International Finance Corporation” and “IFC” are registered trademarks of IFC and are protected under international law. Cover photos: IFC Photo Library ii CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 1 Table of Contents Abbreviations 3 Acknowledgments 5 Overview 7 I. Closing The Credit Gap For Formal MSMEs 11 The Challenge Remains 11 MSME Credit Gap Around The World 13 What Can Be Done? 16 II. Informal MSMEs: The Missing Majority 21 Informal MSMEs: Introduction 21 Operational Challenges For Informal MSMEs 22 Challenges To Formalize And Experiments To Induce Formalization 25 Private Sector Models And Approaches To Meet The Needs Of Informal Firms 25 EndNotes 29 References 31 2 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 3 Abbreviations IFC International Finance Corporation ILO International Labor Organization IMF International Monetary Fund G-20 Group of Twenty GPFI Global Partnership for Financial Inclusion MSME Micro, Small, and Medium Enterprise OECD Organization for Economic Cooperation and Development PCG Partial Credit Guarantee SME Small and Medium Enterprise WBES World Bank Enterprise Surveys 4 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 5 Acknowledgments Closing the Credit Gap for Formal and Informal MSMEs was authored by Peer Stein, Oya Pinar Ardic, and Martin Hommes. The analytical support for finance gap estimations was provided by McKinsey & Company. Research and analytical support for the chapter on informal enterprises was provided by Gisela Davico. The report was edited by Mark Feige, designed by Aichin Lim Jones, and maps were prepared by Bruno Bonansea. The authors would like to acknowledge the contributions of the IFC peer reviewers Matthew Gamser and Anushe Khan. The content on informal enterprises presented in this publication is based primarily on the IFC Thematic Review on Informality presented by Martin Hommes and Aminur Rahman to the IFC SME and Jobs Committee in December 2012. The authors would, therefore, like to acknowledge the comments and inputs received from an extended peer review team for that initiative including: Hayat Abdulahi Abdo, Najy Benhassine Michel Botzung, Gisela Davico, Vladimir Hrkac, Luz Leyva, Rosy Khanna, Toshiya Masuoka, Takao Takahashi, and Panayotis Varangis. 6 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 7 Overview Job creation and economic growth through private sector development have become primary areas of focus for policy makers around the world in the aftermath of the global financial crisis. Recent evidence points to the importance of small and medium enterprises (SMEs)1 in providing employment across countries. In addition to employing the largest number of people in aggregate, SMEs generate the most new jobs (Ayyagari et al., 2011). But SMEs also face many challenges in day-to-day operations and to grow. Access to finance is often cited as one of the primary obstacles that affect SMEs disproportionately (Ayyagari et al., 2012), and lack of data has made it very difficult to determine the exact size of the financing gap. Using data from the World Bank Enterprise Surveys (WBES) in 2010, IFC estimated the size of the global micro, small, and medium enterprise (MSME) financing and deposit gap, and the regional variations (Stein et al., 2010). As more and better quality data became available, especially on the informal sector, IFC updated the database.2 In this note, we report back on the state of the credit gap for MSMEs with this new and updated data, while providing additional focus on the sizable informal enterprise sector in the developing world. MSMEs in developing countries face an estimated financing gap of $2.1 to $2.6 trillion, which is equivalent to 30 to 36 percent of current outstanding MSME credit (Figure 1). There are 200 to 245 million formal and informal enterprises that do not have a loan or overdraft, but are in need of one—also referred to as the unserved sector—or do have a loan but still find access to finance as a constraint—also referred to as the underserved sector. More than 90 percent of the unserved and underserved enterprises are formal micro enterprises or informal MSMEs. With this challenge, an opportunity arises for both policy makers and the private sector to intervene at various levels to try to encourage better banking services, higher deposit rates, and greater accessibility of capital for MSMEs. Financing constraints are also magnified for informal firms, which tend to be small in size, and although often less productive than formal enterprises, contribute significantly to economic activity and employment. Informal firms are estimated to account for around 74 percent of all MSMEs in the world, and around 77 percent of all MSMEs in developing countries (Figure 2). Unregistered firms rely mostly on informal financing, which—although important in facilitating access to finance—is associated with lower firm growth and increased firm illegality (Ayyagari et al., 2010a; Ayyagari et al., 2010b). Although a sizable amount of the unmet demand for credit lies in the informal sector, many firms remain informal as they lack the incentives or capacity to formalize. Creating the appropriate environment for firms to formalize may take a long time, as it not only requires building an enabling environment—with solid institutions, laws and regulations, infrastructure, and education—but there is also a need to identify business-oriented incentives for firms, such as access to new market opportunities and access to financial and non-financial services, making it a profitable decision for firms to register their business. 8 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs Figure 1. Formal and informal MSMEs sector—Total credit gap­ ­ 20 12 6 10 188 Europe and Central Asia 92 21 62 9 3 10 23 Middle East and North Africa East Asia and the Paci c 78 52 34 36 25 27 11 13 South Asia Latin America and the Caribbean 40 18 22 4 Sub-Saharan Africa Number of MSMEs (Millions) Credit Gap: Unserved & Underserved (Percent) >70 50 – 60 <40 IBRD 40159 | JULY 2013 This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information Total MSMEs With Checking With Loan/ Unserved + 60 – 70 40 – 50 NO DATA shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any (Formal & Account Overdraft Underserved endorsement or acceptance of such boundaries. Informal) Source: IFC Enterprise Finance Gap Database (2011) Figure 2. Number of MSMEs by segment and formality Global Developing Economies Millions Millions 310-380 420-510 280-340 360-440 70-90 60-70 35-45 25-30 Formal SMEs Formal Informal Total Formal SMEs Formal Informal Total (Includes very micro enterprises & (Includes very micro enterprises & small enterprises)* enterprises** non-employer small enterprises)* enterprises** non-employer rms rms Increasing level of uncertainty in estimates Increasing level of uncertainty in estimates Source: IFC Enterprise Finance Gap Database (2011). * Registered enterprises typically with 5 or more employees ** Registered enterprises with 1-4 employees CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 9 Various initiatives to expand SME financing including Using access to formal financial services as an incentive building or improving financial infrastructure, partial to formalize, though desirable, may be a big challenge. guarantee schemes, commercial banking models and This challenge is the most acute in countries where other private sector initiatives have been developed to small formal enterprises have very limited access to directly target SMEs. At the global level, the Global finance. This can create an opaque scenario, as there Partnership for Financial Inclusion (GPFI) and IFC as are poor prospects of accessing capital even if informal an implementing partner of the GPFI have undertaken enterprises were to formally register. Hence in the short various studies to improve access to finance by the run, attention should be on how to improve financial SME sector, including enhancing data availability and inclusion for both informal and formal enterprises. quality. This line of work identified innovative models On the data front, there has been progress in the last for SME finance, established the SME Finance Forum few years. The quality of data collected has markedly to facilitate the debate on prevalent policy topics and improved over time, but there is still a lack of consistent showcase knowledge about SME finance, and channelled and high quality data on a global scale for both the extra capital to the sector through the newly established formal and the informal MSME sectors, which creates Global SME Finance Initiative. a big challenge to design public and private sector In addition, this report examines various operational interventions. Greater efforts are needed to collect more challenges that small and informal firms face, and some and higher quality statistical information about the formalization obstacles they often cite as the primary MSME sector at the country level, while public and reasons for not registering their business. A framework private sector, and multilateral stakeholders should also to differentiate the informal sector is offered, with the be prepared to take more risks to try to foster a more intention of segmenting the vast landscape of informal dynamic and inclusive MSME sector. firms—some of which exist today due to opportunistic The rest of this report is organized as follows. Section behavior, while others are just trying to survive—and I focuses on the credit gap for formal MSMEs, and to better design specific interventions depending on the offers some innovative models and interventions that stage of development and the willingness of the firm to can be used to more fully meet the financial and register its business. Additional research and tests are non-financial needs of formal MSMEs. Section II necessary to validate this framework. In this regard, new focuses exclusively on informal enterprises, and goes impact evaluations are designed and implemented to beyond the access to finance paradigm, describing understand firm dynamics and identify levers that could the operational challenges faced by informal firms, incentivize firms to register their businesses. reviewing the experiments that have tried to induce higher rates of formalization, and looking at a series of private sector models that if combined, could more fully meet the needs of informal firms. 10 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 11 I. Closing The Credit Gap For Formal MSMEs The Challenge Remains Policies to jumpstart economic growth and promote job creation have been among the top priorities of many developing and developed economies since the financial crisis. Studies have underscored the importance of SMEs in contributing to growth and job creation, putting SME sector development among the key topics on the global development agenda. However, the ability of SMEs to spur growth and foster job creation is limited by their ability to find adequate finance. Recent data from the IFC indicates that the size of the financing shortfall is in excess of $2 trillion, and suggests that an estimated one-half to two-thirds of formal MSMEs lack proper access to finance. This financing constraint appears to be more pronounced for women-owned enterprises. This section expands on these findings, and concludes with a review of some of the policy options available to improve access to finance for SMEs. SMEs are closely linked with economic growth. For example, studies reveal that the relative size of the SME sector in a country and economic growth are positively related (Beck et al., 2005), and formal SMEs contribute to 50 percent of GDP on average in high income countries (Ayyagari et al., 2007). In addition, there is evidence that SMEs are the major sources of employment in many economies (Beck et al., 2008). For example, SMEs employ around two thirds of the formal work force in OECD countries (Dietrich, 2010). According to the European Commission, the number of jobs attributed to SMEs increased by an annual average of 1.9 percent during 2002- 2008, compared with 0.8 percent for large enterprises (EC, 2009). A recent World Bank research report found that SMEs are the biggest contributors to employment in low-income countries (Ayyagari et al., 2011) and an IFC study revealed that small firms have the highest employment growth rates, followed by medium firms (Saliola and Bernt, 2012a and 2012b). Note, however, that further evidence is necessary to understand the quality of these jobs, and whether they benefit the poor or the excluded. Box 1 provides an overview of the link between access to finance and job creation. One major challenge for SMEs is access to finance, which affects them disproportionately more than large firms. Studies find that banks in developing economies—compared to those in developed economies—tend to be less exposed to SMEs, and to charge them higher interest rates and fees (Beck et al., 2008). This has been largely due to three factors: (i) informational asymmetries related to SMEs that create risks, e.g. banks are mostly unable to gauge the creditworthiness of SMEs and thus ask for higher charges and collateral requirements; (ii) low revenue per client; and (iii) the need for local presence, and thus for a large branch network, which may not necessarily be optimal from a cost perspective, especially in a developing country setting. New techniques and technologies are reducing the impact of these factors. For example, McKinsey & Co. estimates that bank revenues from serving the MSME segment in emerging markets could reach approximately $367 billion by 2015 (from $150 billion in 2010), implying an annual growth rate of 20 percent (Chironga et 12 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs Box 1. Access to finance and job creation Access to finance is one of the most important constraints faced by MSMEs, in addition to weak investment climate and poor infrastructure. The financing constraint is more severe in less-developed countries, where financial markets are not well-developed, regulatory and legal frameworks are weak, informational asymmetries are persistent, and risk management systems are not as robust. A developed financial sector helps mobilize and allocate resources, and manage risks, contributing to private sector development. Finance helps economic growth, and in turn, job creation. Data show that the financial sector provides more credit to the private sector and serves a larger proportion of firms in developed countries. Domestic private credit is around 150 percent of GDP in high income countries, while it is only around 30 percent in low income countries. At the firm level, studies have shown that having access to finance is correlated with higher job growth rates (Dinh et al., 2010). According to a recent IFC study (IFC, 2013), there are four channels through which finance leads to job creation: (1) finance helps start new businesses—entrepreneurship, (2) finance helps businesses make larger investments, (3) finance provides businesses with liquidity, and (4) finance supports indirect job creation through supply and distribution chains.* IFC Jobs Study (IFC, 2013) concludes that to close the financing gap and to reduce the financing constraints, governments, development finance institutions, financial intermediaries and other private sector actors should all intervene. Regulatory reforms, better financial infrastructure, higher competition in the financial sector, and support measures to financial intermediaries as well as to unserved and underserved groups are among the measures that can improve access to finance, and in turn help job creation. For example, programs aimed at lowering costs of financial services for underserved and unserved SMEs can encourage job creation. Financing SMEs by targeting underserved groups such as women, youth, or poor can provide help where it is needed the most. * See, for example, Kapstein and Kim (2010a and 2010b) on the social and economic impact of Standard Chartered in Ghana and Indonesia. al., 2012). This estimate is based on the expectation Can we quantify the extent of the that about 60 percent of banking revenues will be in problem? the emerging markets during 2010-20, and the fact that There is a lack of consistent, standardized, and reliable new technologies and methods are available to more and data on the MSME segment. Even when data are more banks to overcome the traditional difficulties to available, it can be difficult—if not impossible—to serve MSMEs. For example, some private companies make cross-country comparisons, as definitions of what have developed psychometric tests to assist commercial constitutes a micro, small, or medium-sized enterprise banks in their SME credit decisions. Such tests are are largely dependent on the local context. To fill the promising, and may be useful in significantly lowering gap in the data landscape, IFC estimated the number transaction costs in the absence of SME collateral or of MSMEs in the world, as well as access to deposits reliable financial infrastructure such as credit bureaus. and loans for formal and informal MSMEs, based on Better data availability and mining may also significantly data from the Enterprise Surveys by the World Bank improve the way banks manage risks. (WBES) in 2010.3,4 In 2011 the estimations were updated as new data from Enterprise Surveys became available.5 The database as a result of this effort, the IFC CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 13 Enterprise Finance Gap Database, will be hosted by the data on access to finance on a global scale for both SME Finance Forum at www.smefinanceforum.org.6 the formal and the informal sector, which creates big Based on this new study, the total unmet demand for challenges in estimating these figures. WBES currently credit by all formal and informal MSMEs in developing has comparable data for about 130 developing countries, economies today is estimated to be $2.1 to $2.6 trillion primarily on the formal sector. Therefore, to reach ($3.2 to $3.9 trillion globally), which is equivalent to global and regional estimates of the financing gap, 30 to 36 percent of current outstanding MSME credit. country-level estimations need to be done as a first step. The total number of formal and informal MSMEs IFC Enterprise Finance Gap Database uses regional is estimated to be 360 to 440 million in developing averages for countries with no data in the estimations.7 economies. Approximately 13 to 16 percent of these To obtain figures for the total number of MSMEs, reported to have a loan or overdraft while 36 to 44 national statistical databases were used.8 percent reported not having access to a financial institution loan or overdraft even though they were in need of one. Combining the figures for these unserved MSME Credit Gap MSMEs with those that are underserved, a total of 45 to Around The World 55 percent of MSMEs in developing economies identify There are around 36 to 44 million formal SMEs access to financial services as an operational constraint. globally, including high income OECD countries. 65 While the quality of data collected has improved over to 70 percent of these formal SMEs are in developing time, there is still a lack of consistent and high quality economies. Figure 3 shows the regional dispersion of Figure 3. Formal SMEs in developing economies Breakdown of Formal SMEs by Segment Percent of Formal SMEs in Region Millions Europe and 59-72% 27-33% 4-5% 2.8-3.4 Central Asia East Asia and 72-88% 17-21% 1% 11.2-13.7 the Paci c Latin America and 56-69% 29-35% 5-6% 3.1-3.7 the Caribbean Middle East and North Africa 35-43% 36-44% 19-23% 1.9-2.3 South Asia 82-100% 7-9% 0% 2.1-2.6 Sub-Saharan Africa 22-27% 53-65% 15-18% 3.5-4.3 Total 25.0-30.0 (Approximately 65-70% Very Small Small Medium of formal SMEs in the world) Source: IFC Enterprise Finance Gap Database (2011) 14 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs formal SMEs in developing economies. In the developing SMEs, respectively. Another important source is state world, East Asia and the Pacific is the region with the owned banks or other government agencies. For SMEs, highest number of formal SMEs (11.2 to 13.7 million), these provide around 30 percent of the funds, while while Middle East and North Africa is the one with the for micro enterprises, the figure is around 21 percent. smallest (1.9 to 2.3 million)—although to a large extent The rest of the sources include non-bank financial this reflects differences in regional populations: more institutions and others. than 30 percent of adult population in the world lives Today, around 55 to 68 percent of formal SMEs—13.8 in East Asia and the Pacific compared to slightly more to 20.4 million firms—in developing economies are than 5 percent in Middle East and North Africa. Hence, estimated to be unserved or underserved by the formal in per capita terms, South Asia is the outlier—although financial sector (see Figure 4).9 This amounts to a credit it also has the lowest unemployment rate, suggesting the gap of $0.9 to $1.1 trillion, and is equivalent to 26 to possibility of a higher degree of informality, and/or a 32 percent of current outstanding SME credit. Almost larger number of self-employed and micro enterprises half of this credit gap is for medium sized enterprises, (see Table 1). Needless to say, across all regions, there while small and very small enterprises constitute 29 to is pressing need to find employment opportunities 36 percent and 19 to 23 percent of the total credit cap for growing populations. The unemployment rate in for formal SMEs. In contrast, in developed economies, Middle East and North Africa is almost 15 percent, around 16 percent of formal SMEs are unserved or about three times that in East Asia and the Pacific. underserved, which amounts to a credit gap of 5 to 6 The level of unemployment in a country or region can percent of current outstanding SME credit in these have pronounced effects on the level of entrepreneurial economies. activity and in increasing the level of informality in an economy as many individuals seek opportunities The gap relative to current outstanding SME credit to survive. Further details on the informal sector and varies widely across regions. For example, Sub-Saharan informal enterprises in particular will be subsequently Africa and Middle East and North Africa would require mentioned in Section II of this note. more than 300 percent increase in outstanding SME credit to close this financing gap, compared to 7 to 8 percent and 25 to 30 percent in East Asia and the Pacific, Breaking down the financing gap and Europe and Central Asia, respectively (Figure 5). Commercial banks are the major source of funding for The availability of credit is not the only issue for SMEs: MSMEs. Private commercial banks provide about 70 6.6 to 8 million SMEs around the world do not have percent and 58 percent of funding to formal micro and Table 1. The distribution of formal SMEs and unemployment across regions # Formal SMEs Adult Population Unemployment Rate # Adults/Formal (Range, Millions) (Ages 15+, Millions) (Ages 15+, %) SME (Range) High Income OECD 11.0 14.0 859 8.5 61 78 Europe and Central Asia 2.8 3.4 327 9.3 96 117 Middle East and North Africa 1.9 2.3 266 14.5 99 120 Latin America and the Caribbean 3.1 3.7 420 7.0 113 135 East Asia and the Pacific 11.2 13.7 1,530 4.3 112 137 Sub-Saharan Africa 3.5 4.3 492 6.9 114 140 South Asia 2.1 2.6 1,118 3.8 430 532 Source: IFC Enterprise Finance Gap Database (2011), World Bank World Development Indicators (latest available). CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 15 Figure 4. Formal SME sector—Total credit gap­ ­ 3 3 2 2 Europe and Central Asia 12 8 2 7 2 1 1 2 Middle East and North Africa East Asia and the Paci c 2 2 3 3 1 2 2 0 South Asia Latin America and the Caribbean 4 3 3 1 Sub-Saharan Africa Number of SMEs (Millions) Credit Gap: Unserved & Underserved (Percent) >70 50 – 60 <40 IBRD 40160 | JULY 2013 This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information 60 – 70 40 – 50 NO DATA shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any Formal With Checking With Loan/ Unserved + endorsement or acceptance of such boundaries. SMEs Account Overdraft Underserved Source: IFC Enterprise Finance Gap Database (2011) Figure 5. Formal sme sector—Total credit gap relative to outstanding sme credit, regional variations­ ­ Source: IFC Enterprise Finance Gap Database (2011) Total Formal SME Implied Increase in Outstanding Credit Formal SME Credit Gap Outstanding SME Credit US$ in Billions US$ in Billions Percent East Asia and 2,000-2,500 150-180 7-8 the Paci c Europe and Central Asia 600-700 150-190 25-30 Latin America and the Caribbean 180-230 210-250 100-125 South Asia 95-115 10-20 13-16 Middle East and North Africa 80-100 260-320 300-360 Sub-Saharan Africa 25-30 70-90 270-320 High-Income OECD 11,000-13,500 600-700 5-6 Total 14,000-17,000 1,500-1,800 9-11 Total Excluding High-Income OECD 3,000-3,700 900-1,100 26-32 Source: IFC Enterprise Finance Gap Database (2011) 16 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs access to deposit services either, and the total value of the deposit gap is estimated at $300 to $360 billion.10 What Can Be Done? What is the recipe to close the MSME credit gap and to When analyzing the same set of data, but for the formal help create jobs? A few options to close the financing micro sector, the total number of formal microenterprises gap include—but are not limited to—regulatory reform is estimated to be around 70 to 90 million globally—60 to support the enabling environment, strengthening to 70 million of which are in developing economies. An financial infrastructure, implementing specific public estimated 52 to 64 percent of the formal microenterprises programs, and private initiatives specifically tailored in the developing economies are unserved or underserved. for SMEs.11 This amounts to an estimated credit gap of $0.4 to $0.5 trillion in developing economies, and of $0.5 to $0.6 trillion including high income OECD countries. Figure Financial infrastructure and partial 6 shows the regional dispersion of the credit gap. As is guarantee schemes (PCGs) the case for SMEs, microenterprises also suffer a gap in Recent financial infrastructure reforms in China deposit services, which is estimated to be $195 to $238 demonstrate the effects of regulatory reforms in billion in developing economies. Figure 6. Formal micro sector—Total credit gap­ ­ 8 6 4 4 Europe and Central Asia 23 19 5 4 13 2 3 3 Middle East and North Africa East Asia and the Paci c 12 11 7 9 8 4 1 3 South Asia Latin America and the Caribbean 9 7 6 3 Sub-Saharan Africa Number of Micro Enterprises (Millions) Credit Gap (Percent of Unserved & Underserved) >70 50 – 60 <40 IBRD 40161 | JULY 2013 This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information Micro With Checking With Loan/ Unserved + 60 – 70 40 – 50 NO DATA shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any Enterprises Account Overdraft Underserved endorsement or acceptance of such boundaries. Source: IFC Enterprise Finance Gap Database (2011) CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 17 improving SME lending. In 2004, China began a and establishing a risk-based approach with reasonable reform of its movable collateral framework to encourage fees that depend on the default rates. FOGAPE has an financing against valuable moveable collateral. Before annual reach of 30,000 guarantees and a low net loss the reform, bank lending took place mainly through ratio of 1.5 percent (IFC, 2011a). real estate collateral, which SMEs often did not possess. Moveable assets accounted for over fifty Commercial banks and other financial percent of assets owned by Chinese SMEs. There were institutions three main phases to the establishment of the movable collateral framework which included: the development A variety of financial institutions, and even real sector of a property law; the creation of an electronic registry companies are providing solutions to better serve the for pledging assets; and training for lenders in order to SME sector, especially in competitive markets where teach them how to use moveable assets as a basis for different sized institutions are allowed to be licensed lending. In the first two years following the adoption of to provide financial services. Examples of private sector the property law and the establishment of the electronic initiatives to support SME finance include supply registry for account receivable, total commercial loans chain finance solutions, which will be discussed in involving moveable assets grew by an annual rate of 21 more detail in Section II, and tailored financial services percent, while the value of loans increased by 24 percent. and products targeting SMEs, developed by various By May 2013, in a period of 5 ½ years, cumulatively financial institutions. Best practice banks in developing about one million registrations—including loans based economies have been able to profitably lend to this sector on accounts receivable and financial leases—have been by combining a set of criteria that fully meet the customer recorded by the Credit Reference Center (collateral life-cycle of the small and medium entrepreneur. These registry) in China. These transactions involved at least include (1) a strategic focus in the sector and fully 36 trillion Yuan in total amount disbursed (1 US$ = understanding the segment’s economics to identify 6.2 Yuan).12 the best customers to serve; (2) market analysis to segment the customer base, to improve acquisition and PCGs are also a successful example of specific public to reduce costs by optimizing the products and services programs to support SME access to finance. Such PCGs offered; (3) appropriate sales culture and distribution were instituted in several developed and developing channels to increase revenue by cross selling and up- countries, and were noted as a market-friendly type of selling; (4) activation and retention strategies in place intervention—though they may add little value unless to sustain a solid and loyal customer base; (5) a solid they are properly designed or evaluated (Saadani et al., risk management structure with sound credit risk 2011).13 Designing PCGs optimally requires managing and collection departments to optimize lending and the complex balance between high outreach and minimize losses; and (6) information and database additionality, and financial sustainability (Saadani et management technology to develop risk scoring models, al., 2011). Studies have shown that PCGs have the value models, and customer preference models to fully ability to extend further financing to SMEs. In Canada, understand the risks and manage the critical moments for example, it is estimated that 75 percent of the total of the customer life-cycle (IFC, 2012b). guarantees used in the country were being used by firms that would have faced difficulties obtaining a There are multiple examples of best practice banks loan in the absence of the scheme (Riding et al., 2007). in SME lending. ICICI Bank in India, for example, FOGAPE—a public fund to guarantee loans to small strategically serves the SME market by segmenting the firms in Chile—used innovative design parameters that market into three groups including: a Corporate Linked include targeting small firms (low ceiling), instituting Enterprise Group; a cluster Banking Group, consisting variable coverage ratio (70 to 80 percent), having a of pre-defined and pre-selected customer industry unique bidding procedure where banks can bid for the clusters with good market opportunities; and a Business guarantees according to the risk profile of the SMEs, Banking group where all other businesses are placed in 18 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs (IFC, 2010). Another example is Türk Ekonomi Bankası G-20 and financial inclusion (TEB) which, despite being a latecomer to the Turkish Financial inclusion also became a priority in the global SME banking sector, has become a market leader development agenda, as illustrated by the recent efforts among Turkish banks by instituting an array of the led by the G-20. At the 2009 Pittsburgh Summit, the practices described above, and by experimenting with G-20 launched a one-year Financial Inclusion Experts new approaches to improve SMEs’ business preparation Group (FIEG), which later evolved into the GPFI in and growth. TEB offered a range of innovative non- 2010 at the Seoul Summit. The GPFI prioritized SME financial services including training services specifically finance as one key area of the global financial inclusion focused on gaining competitiveness, increasing access agenda, and formed an SME Finance Sub-Group, led to information, and building the business capacity of by IFC as an implementing partner. The G-20 activities SMEs. Ultimately TEB was able to increase customer to support SME finance include (1) the SME Finance loyalty and expanded its core SME customer base from Challenge in 2010—a competition to identify models 20,000 customers in 2005 to over 700,000 SMEs in that enable access to finance for SMEs, and supported 2011 (IFC, 2012a). the establishment of the SME Finance Innovation Fund Commercial banks are also using innovative approaches for the Challenge Winners; (2) the SME Finance Forum to serve women-owned SMEs. Earlier best practice in 2012—an inclusive knowledge sharing web platform examples include Garanti Bank in Turkey, which for SME finance data, research, and best practices; (3) extended $158 million in loans to women entrepreneurs the Global SME Finance Initiative in 2012— to expand during 2006-2010 using a package including non- financial services to SMEs including women-owned financial services designed for women entrepreneurs, businesses through an investment facility, advisory along with loans and supplementary banking products. services for banks targeting SMEs and the development Access Bank PLC of Nigeria loaned $35.5 million to of financial infrastructure. The initiative, through women entrepreneurs throughout the same period, its investment facility, provides financing to banks using a similar package (IFC, 2011a). Box 2 reports the including risk sharing mechanisms to help them mitigate extent of the financing problem women entrepreneurs the risks of moving into more challenging underserved face, and illustrates a few approaches to overcome the SME markets; (4) the Women’s Finance Hub in 2013— challenges. an initiative to improve access to financial services for Continued and greater efforts are necessary to women entrepreneurs and promote the sharing of collect more and high quality data, and to conduct knowledge and best practices. impact evaluations to determine the true impact of such initiatives, as well as to develop models and interventions that try to reduce financial disparities and increase the quantity of loan and lines of credit that fund the working capital and investment needs of SMEs in developing countries. CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 19 Box 2. Financing women-owned businesses Women entrepreneurs contribute greatly to the formal economy. An estimated 31 to 38 percent of formal SMEs in developing economies are owned fully or partially by women (IFC, 2011b).* Women-owned SMEs face the same challenges as every other SME. However, these challenges are usually amplified, and/or harder to overcome. And these seem to reflect the size of women-owned enterprises: they are mostly very small and small firms. Is this by choice, or are women entrepreneurs specifically constrained? In terms of access to finance, there is evidence that women entrepreneurs have a disadvantage compared to their male counterparts. IFC (2011b) reports that across the developing world, more women-owned SMEs cite access to finance as a major constraint than SMEs with no women ownership. Other studies state that terms of loans for women entrepreneurs are more unfavorable when compared to those for men.** Around 5.3 to 6.6 million women-owned SMEs in developing economies, which amount to 63 to 69 percent of women owned SMEs, are estimated to be unserved or underserved by financial institutions.*** This amounts to a credit gap of $260 to $320 billion. Access to finance by women-owned enterprises is constrained by legal and regulatory environment, firm- specific/owner-specific characteristics (e.g. education, training, size of firm, etc.), and cultural barriers, which may impact women entrepreneurs disproportionately, in addition to other barriers to access faced by SMEs in general. Although microfinance has partly filled the credit gap for women entrepreneurs, there is need to move beyond microfinance as many women-owned businesses need more varied services and products, and larger loans than microfinance institutions can provide. While promoting greater gender equality across the board can help women entrepreneurs in getting finance, it is also important for financial institutions to understand the importance of women-owned businesses in their markets. Better data and analysis are necessary to visualize the size of the market, and the needs of women entrepreneurs. Market research reveals that women-owned enterprises, in general, do not require new and specific products designed for them. They need the same products and services as others. What is needed is custom-tailored marketing for women, specific distribution channels, and effective customer management by financial institutions. Recent case studies conducted by IFC with “best practice” banks such as Westpac and RBS show the importance of (1) establishing a female-friendly, distinguishable brand, (2) providing a number of non-financial services to women (e.g. capacity building, networking, and information dissemination), and (3) a holistic view and full integration of women program into the businesses of the bank. A recent case in point, the WE Initiative by BLC Bank of Lebanon, shows the relevance of this approach. Since the launch of the program, BLC was able to double the ratio of the value of loans to women-owned SMEs to the value of loans to SMEs. While similar in spirit to the case of BLC Bank, Rawbank of Democratic Republic of Congo used specifically designed products to target women in addition to targeting women through specific distribution channels and effective customer management, especially to address challenges faced by women entrepreneurs in DRC such as lack of credit history and collateral, as well as registering businesses, and getting husband’s permission to open an account. The global financial inclusion agenda is increasingly underlining the significance of advancing gender equality. For example, to promote and improve access to financial services by women entrepreneurs, the GPFI launched the Women’s Finance Hub in April 2013—a platform to share knowledge and best practices—managed by IFC (www.womensfinancehub.org). * An enterprise is defined as women-owned if at least one of the owners is a woman (regardless of share). ** See, for example, World Bank (2008). *** Source: IFC Enterprise Finance Gap Database (2011). 20 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 21 II. Informal MSMEs: The Missing Majority Informal MSMEs: An Introduction Addressing the needs of small and informal firms is an important priority for policy makers and development practitioners. An estimated 80 percent of all enterprises in developing economies—approximately 280 to 340 million—are informal firms,14 and the informal sector in developing economies absorbs around 60 percent of the labor force. However, informality is associated with low levels of economic development and poverty, and it can induce lower productivity levels and lower quality jobs.15 The degree of informality varies significantly across developing economies. For example, at the low end of the scale, studies have estimated that the percentage of employment in the informal sector in non-agricultural activities is less than 10 percent for countries such as Serbia, Mauritius, Ukraine, and the Russian Federation. At the high end of the scale, the percentage surpasses 75 percent for countries such as India, Mali, and Bolivia. As a result, different country strategies to cope with informality may be necessary depending on the degree of informality present in the economy (ILO, 2011). In addition to access to credit, there are a number of challenges that informal firms face to operate and to register their business. This section will first explore some of the operational challenges that informal firms face and will propose a framework that could be used to differentiate informal enterprises to more efficiently meet their needs in the future. Some of the challenges that firms face to register their business will then be discussed, citing various interventions to encourage firms to formalize their business. The evidence thus far in inducing greater rates of formalization will also be summarized. Lastly, specific private sector models and approaches that directly or indirectly target small and informal firms will be presented. These, if used in a systematic fashion, could increase informal firms’ access to markets, banking services, and raise their capacity to operate their businesses. This could in turn change the incentive paradigm for informal sector firms that are both willing and able to register their business, hence inducing higher rates of formalization in the future. The focus of Section II is not limited to access to finance. Additional topics are discussed to describe the framework and potential solutions to address the critical areas that could strengthen the operations and sustainability of informal enterprises in the short run, with an aim of helping more firms formalize in the long run. Defining informality The definition of informality varies across countries and institutions. Historically three basic paradigms (Dualist, Structuralist, and Legalist/de Soto) have been established to explain the existence of the informal sector. The Dualist paradigm argues that the informal sector is the residual component of an economy, and it exists as a subsistence economy, reflecting the inability of the formal economy to provide enough jobs. The Structuralist paradigm argues that the informal and formal sectors are interdependent, and the informal sector is part of—and subordinate to—the formal sector: the informal 22 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs sector provides cheap labor, inputs, and products to formal firms, and contributes to the economy’s flexibility Operational and competitiveness. The Legalist/de Soto paradigm Challenges For argues that the informal sector is comprised of businesses that prefer to operate informally to evade the exorbitant Informal MSMEs costs of complying with regulations (Chen, 2007). Evidence from the WBES informal sector surveys across 15 developing economies shows that access to finance Informality is composed of both informal firms and is one of the leading operational challenges cited by informal employment. The former being defined as informal firms that obstruct the sustainability and all firms that are unregistered with the registration growth of their enterprise, with the problem getting more office, municipality, or tax authority, or owners and severe as the size of the firm grows. Other operational employers of micro enterprises that employ few paid challenges include crime, theft, and disorder; access workers (WBES Informal Sector Survey; ILO, 2012). to land; and corruption. Formal sector firms in these Informal employment is defined as employment without same 15 countries also state that access to finance is the a contract, unregistered with the relevant authority leading operational challenge—but with the problem such as the social security agency or Ministry of Labor, becoming less acute as the size of the firm grows— and employment not entitled to receive social security followed by political instability, practices of informal benefits (ILO, 2012). sector competitors, and access to electricity.16 The informal MSME landscape and Opportunity vs. necessity firms access to finance When differentiating informal sector firms, some Data on the number of informal firms and on the studies have noted that there are both opportunity and number of credit constrained informal enterprises are necessity type firms in the informal sector. Opportunity relatively scarce. When approximating the absolute size firms are those that began operations because they of the informal MSME sector in developing economies, wanted to take advantage of a business opportunity, IFC estimated that South Asia and East Asia and the while necessity firms are those that began operations Pacific have the highest number of informal MSMEs, because the entrepreneur had to find a means to survive. followed by Latin America and the Caribbean, Sub- Analyzing the characteristics and performance of firms Saharan Africa, and Middle East and North Africa. across the two categories, studies note that opportunity Figure 7 shows the regional variation of informal firms showed 180 percent higher sales than necessity MSMEs in developing economies with estimated results firms in the manufacturing sector and 30 percent higher on the number of firms with checking accounts, loans sales in the services sector, while productivity levels were and overdrafts, and the number of informal firms that higher by 200 percent in the manufacturing sector and are unserved and underserved. When looking at access 30 percent higher in the service sector. In terms of access to credit and making a comparison with all informal to finance, necessity firms had lower number of bank MSMEs, approximately 55 percent of enterprises in accounts, lower number of separate banks from personal developing countries have been estimated not to have accounts to run their businesses, and greater use of credit at all, or not to have enough credit to grow their internal funds to fund working capital and investments. business. The credit gap for informal MSMEs when The owners of opportunity firms also showed higher measured in percentage terms is most acute for Sub- levels of education and a greater willingness to formalize Saharan Africa and East Asia and the Pacific. Compared in the future.17 to the formal MSME sector, the credit gap for informal enterprises is larger in South Asia and for some countries Data from the 15 informal sector surveys conducted as in southern Africa and East Asia and the Pacific where part of the WBES show that firms willing to register large populations of informal enterprises exist. their business were found to have higher rates of access to education, finance, and markets. These firms, CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 23 Figure 7. Informal MSMEs—Location and access to credit 9 4 1 4 Europe and Central Asia 153 14 95 5 2 6 44 Middle East and North Africa 18 East Asia and the Paci c 69 29 34 37 10 13 5 14 South Asia Latin America and the Caribbean 28 19 11 2 Sub-Saharan Africa Number of Informal MSMEs (Millions) Ratio of Informal MSMEs Over Total MSMEs (Percent) >90 60 – 75 <40 IBRD 40162 | JULY 2013 This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information Informal With Checking With Loan/ Unserved + 75 – 90 40 – 60 NO DATA shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any MSMEs Account Overdraft Underserved endorsement or acceptance of such boundaries. Source: IFC Enterprise Finance Gap Database (2011) compared to firms not willing to register, have a higher A framework for informal enterprises share of bank accounts, separate bank accounts to run It is possible to develop a framework to differentiate their business, and their median annual sales were informal sector firms between those firms willing and higher by 31 percent for the manufacturing sector, by not willing to register, as well as firms that have and 48 percent for the retail sector, and by 460 percent for do not have the capacity to formalize. Figure 8 shows the service sector. In addition, a higher share of firms a 2x2 matrix with such a classification—illustrating willing to register were found to be part of a value chain a range of interventions that could potentially suit in the manufacturing and service sector, and suppliers each segment to strengthen the firm’s capacity to were a key source of financing for informal firms in the operate, as well as interventions that could increase manufacturing sector. Further analysis of high potential the rate of formalization. For example, the upper left firms—firms defined as willing to register, that are part quadrant shows the classification of firms that have the of a supply chain, and whose owners have a minimum capacity to formalize, but their willingness to do so level of education of secondary school—showed similar is low. Possible interventions could include awareness results: they have greater access to bank accounts, campaigns and an amnesty to register the business by separate business accounts to run their business, and providing tax breaks for a period of 3 to 5 years for higher median annual sales, and a higher share of firms firms that register their business and obtain a tax ID, fund working capital and investment needs through coupled with a set of factors that increase the incentives suppliers and customers. These high potential firms for firms to formalize—such as strengthening value account for only 4.3 percent of the total informal sector chain linkages and providing new market opportunities firms across the 15 countries. 24 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs Figure 8. Informal MSMEs framework Owner’s Willingness To Formalize The Firm NO YES Defensive Evader* Opportunity Firms (Perry 2007) (High Potential) Awareness campaigns Amnesty to register Firm’s Capacity To Formalize Amnesty to register** Access to Finance - leasing, working capital YES Regulatory Reform nance, insurance, and deposits Increase incentives (e.g. markets, strengthen Access to clusters or associations value chain linkages) Access to new markets Access to Finance - leasing, working capital nance, insurance, and deposits Necessity Firms Wannabe Formal Firms (Amin 2007) NO Access to Finance to reduce risks and Support business plan development vulnerability: insurance, deposits Insertion into value chains Training * Defensive evaders: firms that do not formalize due to high registration costs, regulatory burden, and high ongoing costs to full integration with the state. ** Amnesty to register may involve providing a tax break for a period of 3-5 years for firms that have been operating for a preset minimum number of years that register and obtain a tax ID. Tax filling may be required but no tax liability is applied for the first 3-5 years. for firms, as well as greater access to finance through growth in the future. The data from the informal sector a variety of products such as leasing, working capital surveys of the WBES also show that these firms have loans, insurance, and deposit products. In contrast, a tendency to have higher levels of productivity and the bottom right quadrant shows the firms that have sales. From a public policy perspective, if these firms the willingness to register, but their capacity to do so is were to formalize in the future, government authorities low. Interventions for these set of firms could include may potentially reap higher levels of tax revenue from training and business plan development to increase these businesses’ future operations compared to other their financial literacy, and insertion into value chain to firms in the informal sector that register their business. strengthen the market opportunities for their operations Interventions for these set of high potential firms could and increase the chances of firm survival rates. include an amnesty to register, greater access to finance, Working with opportunity firms or high potential the provision of new market opportunities, and access to firms, firms in the upper right quadrant of the matrix, clusters or associations that could also help strengthen presents a very interesting opportunity for intervention, the market opportunities for firms, thereby increasing given that these firms have the highest potential for the incentives to register the business. CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 25 Challenges To The results from these experiments show that future experiments must go beyond simplifying registration Formalize And and cost recovery. Further data and understanding of Experiments To Induce the incentives that convince entrepreneurs to register their business is needed. Such incentives may involve Formalization combining a series of elements such as access to market opportunities, access to finance, capacity building, and According to the 15 informal sector surveys by WBES, simplifying business registration. One impact evaluation the main reasons that firms state for not registering their currently in progress by the World Bank in Malawi, for business are the lack of information on how to register an example, combines costless registration procedures with enterprise, the time to complete the registration process, information sessions, and the provision of business bank taxes that registered businesses would need to pay, accounts. Preliminary results from this experiment show and the lack of perceived benefits from formalization. a 70 percent take up rate for business registration and Studies have also indicated that high entry costs, strict only a 5 percent take up rate for tax registration.20 Future labor regulations, lack of access to resources such as experiments and interventions may need to also focus land, credit and taxes, as well as complicated registration on the provision of market opportunities for firms that procedures are also important factors that have been make registering a business a profitable decision even identified to contribute to low rates of formalization.18 when incurring a tax liability. To do so, further research Experiments and interventions in Bangladesh, Bolivia, is needed to understand how business associations, for Peru, and Sri Lanka show that simplifying business example, or large corporations with value chains could registration channels, reducing registration costs, be approached to assist in the design of a more attractive and providing greater information on the benefits of package for small informal firms interested in expanding registering a business have proven to have had little their customer base and potential sources of revenue. effect to increase the formalization of firms.19 One impact evaluation conducted in Sri Lanka went further than just offering greater information and reimbursed Private Sector Models for registration costs by offering a cash lump sum payment equivalent to two month’s median profits. This And Approaches To experiment induced half of the firms that were offered Meet The Needs Of such an incentive to register their business. Additional analysis conducted for a sample of 387 Sri Lanka micro Informal Firms and small firms showed that as a result of the cash grant, Formalization should be a priority from a public policy monthly profits for male owned firms increased by and private sector perspective, given that formalization US$8 to $12 per month—equivalent to 6 to 12 percent could lead to higher tax revenues, better quality jobs, of their real monthly return. For female owned firms, access to new markets, suppliers, and clients, more the experiment found no short or long term effects, as reliable supply chains, and higher rates of productivity, to there was capital diversion to the household. In terms name a few examples. Registered firms have better access of firm survival rates and employment generation, the to technology and human capital, and by complying results showed an increase in firm survival rates by with the law the firm has better business predictability, 10 percent and a positive but insignificant impact on and may avoid situations where paying fines or bribes employment and capital stock levels. In addition to is the norm to stay in business (Perry et al., 2007; and the monetary incentives that increased the registration Alcazar et al., 2008). Formal firms may also access the incentives, 15 percent of firms found formalization to judicial system for any contract enforcement procedures. be advantageous because it permitted the enterprise to Formal firms have better access to credit, especially in sell goods and services to the government and/or other some countries where a tax ID or registration certificate registered businesses (de Mel et al., 2012b). is needed to open a bank account. However, not all firms 26 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs have the capacity or willingness to formalize, and it is retail model. The business model relies on expanding important to identify various models and approaches the provision of products and services by leveraging the that can address the needs of informal firms. This existing small retail outlets, many of which are located can help them operate more effectively, thus allowing in rural areas and are informal in nature, developing more informal firms to survive—and for some to grow specific products that match the needs of small firms, their business—making it attractive to register in the and making customized deliveries to small retail future. Evidence from impact evaluations conducted in shops given their operational constraints to store large Bangladesh and Sri Lanka, for example, show that for quantities of inventories. Because small retail outlets all firms with five or more employees, registration rates have financial and managerial capacity constraints, surpassed 90 percent in Bangladesh, while the same large corporations have also included a set of training figure was over 70 percent in Sri Lanka. The evidence and coaching initiatives to better educate the business confirms the understanding that the larger the business entrepreneurs. In addition, some have created specialized is, the higher the likelihood that the business will financial solutions such as inventory purchases on credit register.21 to ease the access to finance constraints that small and There are a number of private sector models and informal firms face to operate and finance their working approaches that directly or indirectly target small and capital needs (IFC, 2011c). informal firms which should be studied further to understand the challenges, key success drivers, and the Mobile banking and e-transaction enabling environment that have allowed private sector platforms intermediaries to work with small and informal firms. A second model includes the use of mobile and The models and approaches include: e-transaction platforms to reduce the transaction costs • a micro distribution and retail model that that financial intermediaries face when trying to reach manufacturers and wholesalers are using to integrate small and informal businesses. Examples include FINO micro and small retail firms into their business PayTech (FINO) in India, which deploys field agents distribution chains; to enroll consumers in rural and semi-urban regions of • mobile and e-transaction platforms that can be India and conducts low-cost electronic transactions. Its leveraged to overcome problems with high transaction service model relies on the provision of biometric smart costs and to increase penetration rates in the small cards used for saving accounts and transferring funds, and informal sectors; point of sale terminals, and accounting and management information systems. FINO has a client base consisting • small business banking solutions to overcome the of 27 banks, 15 government entities, and four insurance typical barriers that financial intermediaries face agencies. Other examples include YellowPepper, which when servicing micro and small firms; is a leading mobile financial network in Latin America • supply and value chains to better integrate the small and the Caribbean and which has over 3.6 million and informal businesses, providing them with new monthly users in nine countries, conducting 18 million market opportunities to increase their business financial and informational transactions per month. potential and profitability. The YellowPepper business model has relied on mobile banking solutions enabling banks to deliver financial The micro distribution and retail model services via mobile phones, m-wallet solutions obtained via a pre-paid account accessed using the mobile A number of corporate clients in the manufacturing, devise, and business to business (B2B) products which service, and wholesale sectors—such as Coca Cola in facilitate mobile payments and collections between large East Africa, Grupo Martins and Tribanco in Brazil, corporate clients such as Coca Cola and SABMiller and and Mi Tienda in Mexico—are working with small their suppliers, distributors, and retailers (IFC, 2011c). and informal firms using a micro distribution and CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 27 Small business banking solutions benefiting and strengthening the capacity of the SMEs receiving these services, notwithstanding the need to The provision of small business banking solutions is a more systematically documenting the business case and third approach that can be studied further. The most return on investment in some of these cases (IFC, 2012). common challenges that financial intermediaries face when servicing small and informal firms include poor customer knowledge, lack of skills and literacy of the The supply chain model owners of MSMEs, low profitability, lack of collateral, Finally, supply and value chains can be used as a assets, credit history, and land registry certificates, private sector model to provide market opportunities among others. However, financial intermediaries in for informal firms. Large corporations, notably in the various developing countries have been able to overcome extractive industries, power, tourism and hospitality, these barriers through various means including cash flow agribusiness and forestry, and telecommunication based lending, introducing psychometric tests to identify sectors, want reliable and standardized supply chains the higher ability entrepreneurs, and leveraging leasing for the production and distribution of their products solutions when the firms do not have any collateral or and services. Several multinational companies have pre- assets to pledge in exchange for investment financing. requisites for companies that become part of their value In addition, one large bank in East Asia is actively chains that involve, among others, having a registered targeting small firms by identifying the inter- business. This presents a great opportunity to identify connections and fund flows that these firms have with large corporations and multinationals that would be other firms in the bank’s portfolio. Many of the small interested in working with small and informal firms firms are informal given the bank’s own definition of by providing market opportunities and training for informality, which is based on a firm’s ability to generate registered firms that become part of their value chain. reliable financial records. The bank starts the enterprise- This approach could provide informal firms with bank relationship by first opening a deposit account for greater incentives to integrate themselves into the formal the informal firm. This allows the bank to monitor the economy, giving the firms the possibility of accessing firm’s cash flows, which are then used to determine the new clients, contracts, and market opportunities. To do creditworthiness of the firm as a potential borrower. so, various factors may also be needed to successfully Based on past banking records and receipts obtained integrate the firms into the value chains. For example, from the firm, the bank acts as a financial advisor by in Sri Lanka a business association of rickshaw helping the firm (re)construct its financial statements. A motorcycle drivers was instrumental in helping several final credit verification is done by obtaining references rickshaw entrepreneurs obtain the licenses, training, from the suppliers and customers of the firm before a and connections that were needed to integrate their loan can be approved and disbursed. operations with a large luxury hotel interested in Other banks such as Türk Ekonomi Bankası, Standard providing reliable local transportation services to their Chartered Bank, and ICICI Bank are using non- clients. Removing business registration barriers is also financial advisory services such as financial literacy a key component to make it an attractive option for and business operations training, face-to-face or web firms to register their business and become part of the seminars, web portals and e-learning courses, as well corporate supply chain. as specialized small business consulting services to increase the capacity of the firm, strengthen the client- bank relationship, and determine which firms and what sectors are of lower risk to lend to. Offering such non-financial services is increasingly becoming an interesting opportunity for banks looking to strengthen the long-term bank-client relationship, while greatly 28 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 29 endNOTES 1 This report discusses both SMEs and MSMEs—the latter also includes micro- enterprises. Most of the existing literature and data have focused on SMEs, although the IFC Enterprise Finance Gap database incorporates data that also includes micro-enterprises to the extent possible. This report uses the term MSME unless a relevant data set or study refers only to SMEs. 2 The analytical support for both rounds of this initiative was provided by McKinsey & Company. 3 This study and the current one define micro, very small, small and medium enterprises as follows: micro (1-4 employees), very small (5-9 employees), small (10-49 employees), and medium (50-250 employees). Informal MSMEs include MSMEs that are not registered with the municipality or tax authority and all nonemployer firms (independent of registration). 4 See Stein et al. (2010) for the results of this study and http://www.enterprisesurveys. org for details on World Bank Enterprise Surveys (WBES) methodology and data. 5 The updates include: (i) 17 updated surveys - 14 in Latin America, in addition to China and India; (ii) 12 new surveys - 7 in Middle East and North Africa; (iii) informal sector data for 15 countries, all of which were used as a basis to gauge the informal sector credit gap for the current study. 6 The SME Finance Forum is a collaborative knowledge sharing platform for data, research and best practices for SME finance. It promotes the dissemination of good practice guidance to agencies, donors and regional networks to improve the effectiveness of the industry. 7 The extrapolated data is not useful as a stand-alone country-level estimate, but rather should be used in calculating regional and global values. Country-specific characteristics must be factored in the estimation method for the estimates to be used at the country level. 8 These were published earlier in the IFC MSME Country Indicators. See Kushnir et al. (2010) and http://www.ifc.org/msmecountryindicators. 9 Access to finance as a constraint has an impact on both the unserved and the underserved enterprises. The IFC Enterprise Finance Gap Database uses four credit constraint levels (1) well-served, (2) underserved, (3) unserved (4) no need. While “unserved” and “no need” definitions are based on factual data reported by firms to Enterprise Surveys, “well-served” and “underserved” distinction depends on data on “perceptions”, i.e. the question which asks the respondents whether access to finance is a constraint. 10 Deposit services include transactions, checking, and savings accounts as well as time deposits. 11 See IFC (2010) and IFC (2011a) for a more complete set of approaches. 30 CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 12 See China Credit Reference, a monthly publication (in Chinese) by the Credit Reference Center of the People’s Bank of China; also IFC China Team. 13 Various well-established schemes in developed and developing countries have received a lot of attention given their long track record and their design parameters which includes Canada’s SLFP, Chile’s FOGAPE, France’s OSEO, and Korea’s KODIT, among others. 14 IFC Enterprise Finance Gap Database (2011). 15 See, for example, Loayza and Rigolini (2006); Schneider (2006); Perry et al. (2007); ILO (2011). 16 WBES informal sector surveys were conducted for the following countries (along with formal sector surveys): Angola, Argentina, Botswana, Burkina Faso, Cote d’ Ivoire, Cameroon, Cape Verde, the Democratic Republic of Congo, Guatemala, Madagascar, Mali, Mauritius, Nepal, Peru, and Rwanda. 17 Amin (2009) based on WBES in Ivory Coast, Madagascar, and Mauritius; also Bruhn (2012) using data from Mexico. 18 Such studies include Oviedo et al. (2009), Bruhn (2012), Amin (2009), Straub (2005), Maloney (2004), and de Mel et al. (2012a). 19 Impact Evaluations were reviewed for Bangladesh (De Giorgi and Rahman, 2013), Bolivia (McKenzie and Sakho, 2010), Peru (Alcazar et al. 2008), Sri Lanka (de Mel et al. 2012a), and Malawi (preliminary - Campos, Goldstein, and McKenzie, 2013, preliminary results from ongoing impact evaluation, World Bank Group). 20 Source: Campos, Goldstein, and McKenzie (2013), preliminary results from ongoing impact evaluation, World Bank Group. 21 Bangladesh Firm Census (2010) conducted by EGI, with a sample size of 55,817 firms (McKenzie and Rahman, 2010) and Sri Lanka Firm Census (2008) conducted by the Sri Lanka Longitudinal Survey of Enterprises (SLLSE), with a sample of 2,865 firms (de Mel et al., 2012a). CLOSING THE CREDIT GAP FOR FORMAL AND INFORMAL MSMEs 31 References Alcazar, Lorena, Raul Andrade, and Miguel Jaramillo (2008). 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