A question of character for SME lending

Getting to know the ‘missing middle’​

​Micro, small and medium enterprises (MSMEs) are the lifeblood of economic growth; however, they need investment to thrive, and often face the same tough due diligence requirements as larger enterprises.

Lenders often rely on limited data to make credit decisions, giving them little insight into who they are really lending to.

Character can predict small business success. For example, studies have shown that small businesses operated by someone who demonstrates high levels of ambition, are three times more likely to succeed.

The inclusion of alternative data in the decision-making process can help lenders assess credit worthiness for those with unconventional financial backgrounds.

By incorporating alternative data such as character traits, lenders can better serve a diverse, inclusive and modern economy.

Credit inclusion for the ‘missing middle’​

​SMEs account for more than 95% of registered firms worldwide and more than 50% of jobs. Yet there is a substantial funding gap. The World Bank has described this as the ‘Missing Middle’ i.e: “the gap in capital which is larger than microfinance, yet smaller than traditional institutional financing”.​

A 2022 report from the AFI (Alliance for Financial Inclusion) found that access to finance for MSMEs remains as one of the main hurdles in many developing countries. MSMEs have a significant impact on employment creation, GDP contribution and overall economic growth. It is estimated that the total MSME credit gap is USD5.22 trillion every year from the estimated total demand of USD8.9 trillion.

Many MSMEs lack the formal financial statements and documentation that are demanded by lenders in traditional finance applications, excluding them from access to credit.

For example, in South Africa, MSMEs make up about 98.5 percent of all businesses in South Africa and are a critical force in the country’s economy, yet historically they have struggled to access the capital they need to grow and thrive. While in Spain there are over 2.4 million micro enterprises, contributing over 2.75 billion euros to the economy each year.

​The rise of the Gig Economy demands modern solutions

The Gig Economy is a growing portion of micro enterprises worldwide. Those working in the Gig Economy, and our reliance on them, has grown as the nature of work has evolved in the last two years.

As many as 55 million people in the United States were gig workers – or 34% of the workforce – in 2017, according to the International Labor Organization, and the total was projected to rise to 43% in 2020.

As per a recent article in Fortune, while we rely on these workers, their financial needs are not being met by legacy systems. These gig workers are an important part of both developed and developing economies and deserve access to credit.

Their lack of access is due to credit-rating systems which consider limited data.

The question of character in small businesses

Around the world many economies are moving from being dominated by industrial enterprises to include a growing portion of entrepreneurial businesses. This is particularly true in the MSME space.

In smaller businesses (those in the ‘micro’ or ‘small’ of MSME), the entrepreneurial orientation, decision-making style and capabilities of the leader have a direct link to the performance of the business.

A large European study published by the ERSJ1 examined over 20,000 small businesses in which the leader played a dominate role in the firm. They analysed over 25 variables related to the character and abilities of the leader, compared with various metrics of success for the business.

The results “found a statistically significant correlation for all selected research characteristics and behaviors of the leader and those characterizing business successes”

In this study, the characteristics which turned out to be particularly important for the company’s development and success were belief in the possibility of achieving set goals; high aspirations and a constant search for new challenges; passion and commitment; knowledge of the company’s market.

The researchers estimated that leaders’ belief in the possibility of achieving set goals increased the chance of achieving success by almost three times compared to the leaders who did not note the importance of this feature. High aspirations and constant search for new challenges increased the odds of achieving success almost twofold.

Character as a measurement

Not only is character a key indicator of small business success, but there is also growing research to support that character traits be measured.

Alternative data analysis helps us understand how character relates to credit risk. While traditional credit scores look at ability to repay. Character-based credit insights indicate willingness to repay.

For example, using character-based credit insights it would be possible for a sole-trader or micro business to demonstrate strong entrepreneurial traits, ambition, a moderate appetite for risk and strong tendency to honesty. These types of traits, when included in a broader loan application journey, can help lenders understand not only who to lend to, but how to help their customer succeed in their financing objectives.

Many lenders today understand the importance of not just finding more borrowers, but in understanding those borrowers and supporting them in their goals, providing extra education or resources if necessary and treating

To find out more about how to include character in credit journeys for SMEs and Sole Traders, talk to an expert at Begini.

  1. Elzbieta Stanczyk Et Al (2020). The Impact of Personality and Competence of Leaders on Business Success, European Research Studies Journal Volume XXIII Issue 2, 612-623

Photo by bruce mars on Unsplash

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