The existence of an SME credit gap, the difference between demand for loans by SMEs and provision of those loans by commercial banks, and its effects on SMEs has been discussed in detail in a separate article on this blog. The effects on large corporates is no less serious. Using some simple statistics from the earlier article, if SMEs are the source of greater than 50% of GDP and their share of bank lending is only 4% then either SMEs are super efficient, big corporates are super inefficient, or somebody else is financing these SMEs. I think that we can safely agree that it is highly unlikely for the SME sector to be super efficient or big corporates to be super inefficient. That leaves some, or all, of the USD 260 billion SME credit gap funded by a segment of the economy other than banks. Let’s unravel this mystery.

There are two basic ways to finance a company: increase equity and/or increase liabilities. SMEs use both. Equity is the most expensive financing choice, as it is the highest risk tranche of corporate funding. Many people make the mistake of thinking that since equity does not carry interest payments then it is cheaper than debt, a costly mistake that is nicely explained by Investopedia. This means that SMEs that are forced to use equity instead of bank loans are inefficiently increase the cost of their goods and services and tying up risk capital from other parts of the economy. This results in unnecessary price increases of goods and services as well as denial of production of goods and provisions of services in other sectors of the economy due to a lack of equity risk capital. Double whammy.

The other way to fund is by increasing liabilities. The standard method is take out a bank loan. In the absence of bank loans other liabilities can be increased, usually payables to trade creditors. A simple example is a company that takes delivery of six heavy trucks with payment terms of 90 days. This is effectively a short term loan. It happens quite often but the problems start when payment terms increase in tenor or there are defaults. At this point the trade creditor, e.g. the company that sold the six heavy trucks, starts acting as a bank.

Why is this a problem? For starters it is not the core business of a vendor to act like a bank. They don’t have the personnel or the systems. So this increases the business risk of the vendor dramatically. It also forces the vendor to lose focus of its strategy as it manages its effective loan book. Much more frightening is the misallocation of the vendor’s balance sheet. The fact that the SME has been financed does not resolve the issue of where the ultimate financing comes from, it simply moves the problem from one balance sheet, the SME, to a different balance sheet, the vendor.

The vendor has three ways to fund. Just like the SME it can fund using equity or payables, but it usually can fund from banks. All three choices are terrible. Funding from equity has the same problems as that by SMEs: equity is being using for debt financing which is hugely cost ineffective.

Funding via trade creditors lengthens the chain of default risk in the non-bank economy. As this chain grow, and interweaves, default by a single link in the chain can trigger defaults across who sectors of the economy. This systemic risk exists with banks, but in the banking sector they have the Central Bank to regulate them and act as lender of last resort. With trade vendors this doesn’t exist. In effect this creates an unregulated shadow banking system with businesses that are not banks, do not understand banking and have no regulator for such activity. The last method for vendors to fund their financing of SMEs is for them to borrow from the banks. It is clear that a system whereby the commercial banks use large corporates as a buffer to the SME sector is non-sensical.

The last two methods also suffer from the problem that large corporates end up dramatically increasing their balance sheets for non-core business. The credit and liquify risks this creates are large and also costly.

It is clear that the SME credit gap is not only harmful to the SME sector but to large corporates as well, not only in terms of risks created but also in misallocation of risk capital that clearly has a significant drag on GDP. The systemic risk also creates risks to the economy that, due to a lack of a regulator, are opaque. The sooner that this is resolved, the better.

You might also like: The SME Credit Gap and SMEs: The Ignored Middle Child of Banking?