What is SME Banking, Exactly?

What is SME banking, Exactly?

August 29th, 2024.

Authored by Rodrigue Afota.

Executive Consultant, Banking & Fin Tech. Former Digital Banking C.E.O., Crypto Entrepreneur and AI Co-Founder, Former Managing Director (First Abu Dhabi Bank, Morgan Stanley).This article can only be reused with full attribution.

Following popular demand, I have decided to turn what used to be a private letter distributed only into my network of senior bankers, system-integrators executives and strategy consultants into a publicly available blog. All the blogs evolve around topical issues within banking, digital banking, Fin Tech and Crypto. This first public blog is the first in a series covering SME Banking, an especially complex space that very few institutions have been able to get right in the G.C.C. There is no comment section but interested readers with a legitimate business purpose can contact me.

In 2019, Dunia Finance, a company based in the United Arab Emirates, was shut down after suffering significant losses in its retail loan book. Unlike commercial banks, Dunia focused on unsecured lending at higher interest rates to small customers, particularly micro-businesses that could not secure loans elsewhere.

Commercial banks recognize the risks associated with SME lending and typically focus on larger SMEs with established and profitable businesses, documented financial histories, and assets that can be secured. For non-banks, lending to SMEs is inherently riskier because their customers are riskier, they are the one who can’t get funding from traditional banks. The interest rates charged by non-banks are also not competitive for established SMEs, they get cheaper rates easily from their commercial bank. Consequently, non-banks target smaller and less established businesses. These businesses include local shops, freelancers, and one-person operations. Lending to such a segment is far riskier, and like most lending in the G.C.C., more volatile compared to Western Europe or North America, due to credit cycles that are highly correlated with energy markets cycles.

Despite these challenges, micro-businesses constitute at least 95% of registered businesses in the GCC. They represent the often-overlooked underbelly of the economy.

Governments in the GCC recognize this and have shown a willingness to support SMEs through various mechanisms, such as the Khafalah reinsurance program and the SME Bank under construction in Saudi Arabia. In practice, however, government support is channeled through banks and primarily benefits more mature and larger SMEs, a small fraction of the total SME population. Micro-businesses face numerous practical and logistical barriers to accessing such support, which will be the focus of a separate blog.

In my view, the root cause of Dunia Finance’s predicament can be traced back to a common misconception: that the banking challenges faced by SMEs are primarily due to a lack of funding and overly stringent credit risk management policies by commercial banks. This misconception is also prevalent among many fintech entrepreneurs, who incorrectly believe there is a opportunity for fintech in lending to the underserved micro-segment.

We often use “SME” as a single acronym, but the reality is that it encompasses a diverse range of businesses with little in common. It would be more accurate to categorize them into freelancers, micro-businesses, medium SMEs (11 to 50 employees), and mature SMEs (more than 50 but fewer than 250 employees) and address the needs of each category separately.

Medium and large SMEs are already well-served by commercial banks, which have an unbeatable cost of funding advantage, can offer lower interest rates, and provide a range of complex services that fintech companies cannot match, such as trade finance. These SMEs are also less likely to default during economic downturns. Fintech companies can choose to target corporates or large SME segments, but lending cannot be a core part of that strategy, and it will be extremely challenging, if not naive, to believe that they can succeed. When fintech companies do succeed in that segment, they are not regulated financial institutions but rather software companies offering modern financial software platforms, such as trading and booking, FX integration, or core banking.

In the GCC, the many successful finance companies instead focus on strategies such as auto or mortgage finance, rather than unsecured lending to micro-businesses. These finance companies can repackage home or auto mortgage  loans and even access reasonably priced government funding, for example through the Saudi Real Estate Refinance Company. It may not be as effective as the European or the US securitization market, but it broadly works.

For regulated FinTech companies looking to offer banking services through an electronic money or retail payment service license, the obvious strategy is to serve micro-businesses with their banking needs without credit being key to their strategy. This approach makes sense for several reasons.

First, there are hundreds of thousands, if not millions, of these customers. Micro-businesses are essentially unwanted by commercial banks, which are not well-equipped to serve this segment. Banks require high minimum deposits, impose high account charges and fees, and burden micro-businesses with complex KYC processes. Micro-businesses do not maintain large deposits and are unlikely to secure loans, which are the bread and butter for banks. The situation has worsened after Basel II and III, leading to the well-documented practice of commercial banks closing unprofitable accounts held by small businesses.

If there is a significant upside for GCC economies in finding a smart way to develop more diverse economies that are less dependent on the energy market, then this is it: making business banking simple, cost-effective, and customer-friendly for micro-businesses and freelancers, allowing them to focus on what they do best. Achieving this requires developing financially profitable FinTech or neo-banks business models that can provide these services without relying on lending. A clear understanding of what really helps micro-entrepreneurs and business owners is therefore essential, what is it that they really need that they will pay for? This understanding can be derived from quantitative and qualitative analysis with a representative sample of micro-business owners and entrepreneurs to build a strategic roadmap.

If solving the lack of cost-effective business banking access were simple, we would not have so many micro-businesses in the GCC operating without bank accounts. Instead, many rely on their owner's bank account or operate on a cash-only basis without any annual financial statements. Solving this challenge requires dedication and focus, which diversified commercial banks cannot really provide.

There are valuable lessons and solutions for the micro segment from the US and Western European experiences. A range of companies, from community banks to dedicated neo-banks, have found ways to profitably and successfully serve this segment. I strongly believe some of these lessons can provide a remarkable strategic blueprint for business models that will work even better in the GCC, given the economic makeup, lack of banking access, and ever more complex needs for financial documentation and tax integration.

In a subsequent blog, I will expand on this niche, which I believe has not yet been successfully tackled.

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Publicly available sources:

(1) SME Digital Banking Guide: All You Need To Know | Clayfin. https://www.clayfin.com/blogs/sme-digital-banking-guide-all-you-need-to-know/.

(2) A digital approach to SME banking | McKinsey. https://www.mckinsey.com/industries/financial-services/our-insights/a-digital-approach-to-sme-banking.

(3) SMEs: The Key to Strengthening Your Content - Snap Agency. https://www.snapagency.com/smes-the-key-to-strengthening-your-content/.

(4) SME banking: Sustainable growth through new business models. https://www.sapfioneer.com/blog/blogpost/sme-banking-sustainable-growth-through-new-business-models/.