Think outside the stocks (and bonds): How capital markets indirectly contribute to SME finance

Small and medium-sized enterprises (SMEs) are essential to development, accounting for over 98% of businesses in low- and middle-income countries (LMICs) and providing the majority of jobs[1]. They are not only central to job creation but also to other economic objectives such as inclusive development or economic diversification and resilience by providing contributions that are complementary to those of larger firms. However, a staggering finance gap – estimated by the World Bank to be between $2.6 and $5.2 trillion[2][3] – severely constrains SMEs’ growth and development. The relative financing gap (financing needs relative to outstanding SME loans) is particularly large in Sub-Saharan Africa and the MENA region [2]. Since SMEs’ most common source of external finance, bank loans, are insufficient, attention has repeatedly turned towards capital markets to close the financing gap. Hence, this piece explores the role of capital markets for SME finance in LMICs.

Potential benefits and challenges of capital market financing for SMEs

Equity finance (e.g. publicly traded stocks, private equity (PE) venture capital (VC)) allows for long-term finance without repayment obligations and the transfer of entrepreneurial risk to investors. For some SMEs, it may be the only or the most cost-effective external financing option due to their (risk) profile (high growth potential but new, unproven business models and/or limited collateral and financial track record). Market-based debt financing such as bonds may also come with lower interest rates and without bank restrictions on firms’ activities.

However, numerous challenges, both on the supply and demand sides, impede SMEs’ involvement with capital markets. SMEs struggle with the costs of issuing securities, reporting, and corporate governance requirements and, in the case of equity, with concerns about dilution of ownership. Investors on the demand side are discouraged by imperfect information and limited exit options.

SMEs’ lack of direct access to capital markets

Due to these challenges, SMEs in LMICs rarely access finance through capital markets directly. Across economies of different income levels, only a few of the largest firms issue shares in the vast majority of countries. Even dedicated SME stock exchanges with lighter pre-listing and admission requirements mostly fail to change this pattern, as they suffer from limited market capitalization and liquidity. PE and VC markets are nascent and in their early stages, meaning that their actual contributions to SME finance are still marginal – even in countries with vibrant and fast-growing capital markets such as China[4]. Market-based debt instruments are even less suitable for SMEs: Bond-issuing firms are even larger than equity-issuing firms; and bond markets, in general, can be described as underdeveloped in LMICs[4]. In short, SMEs’ direct access to finance through capital markets is negligible in most countries, in particular in LMICs.

Capital markets’ indirect contribution to SME finance

Nevertheless, markets can contribute towards fostering SME finance through an indirect channel. In their theoretical work, Song and Thakor (2010) explain how banks and markets complement each other through to their respective strengths[5]. Banks are relatively better at screening, monitoring and other information-related activities, while capital markets excel at providing liquidity and access to a broad base of investors, which allows for cost-effective financing, since some investors may value the project surplus similarly to the firm seeking finance. They also outline that several financial instruments exploit the respective comparative advantages and establish interactions between banks and markets, which results in benefit flows from banks to markets (e.g. securitization, covered bonds) and from markets to banks (e.g. bank equity capital[1]), and subsequently in the complementarity and co-evolution of markets and banks.

Relatively cheap equity finance from capital markets allows banks (through bank equity capital) to improve their funding structures, thus enabling them to lend to previously unserved businesses and households – including riskier clients such as SMEs, as they can meet higher capital requirements. Securitization or covered bonds enable banks to fund lending activities through asset-backed securities instead of deposits, which allows for further lending expansions. Consequently, one of the central predictions of the theoretical work by Song and Thakor holds that capital market development is associated with increased bank lending, in particular to smaller and riskier firms.

Using a cross-country analysis covering 50 mostly LMICs for the period from 2006 to 2019[6], we provide the first empirical evidence for this prediction, that is, for this indirect channel: Smaller firms in industries that are more dependent on external finance are more likely to have sufficient access to loans if they reside in economies with better-developed capital markets. In line with the arguments of Song and Thakor (2010), the effect runs through increased capital market usage by financial institutions and expanded lending activities. This further underlines that markets and banks co-evolve and, secondly, that capital markets primarily contribute to SME finance indirectly through their effect on bank lending and loan availability – the latter has also been put forth as a theoretical argument by World Bank and OECD[7][8].

What this means for policymakers

However, this does not imply that capital market development is the first-best option to foster SME finance for several reasons. First, establishing deep and liquid capital markets that generate such positive spillovers on SMEs’ financing situation may require lengthy reforms to create suitable framework conditions for capital markets. For many LMICs, this is not achievable in the near future. More immediate and direct policies that tackle SMEs’ financing constraints in the short and medium term are indispensable until capital markets are established; most importantly, this involves addressing country-specific bottlenecks for bank loans to SMEs, that is, creating an environment that facilitates lending towards SMEs. Second, even in countries with well-functioning capital markets, it requires a banking sector and a broader financial system infrastructure that is equipped to channel loans to SMEs. Otherwise, capital market development may create positive spillovers in the banking sector, but the increased loan availability and lending activities will not be directed to SMEs. This implies the following:

• Policymakers need to tailor their decisions to the most promising ways of fostering SME finance to local contexts. While SME promotion may involve capital market development in some middle-income countries, this is still way off for many LMICs, as it may take strenuous institutional and structural reforms over a prolonged period to create an environment for thriving capital markets.

• Policymakers should foster non-traditional instruments to provide SMEs with direct access to capital market financing. Receivables and lending platforms are especially promising for LMICs, as these non-traditional instruments do not require (relatively) developed capital markets. They can be promoted through specialized regulatory frameworks, information, and capacity-building, as well as co-investments and tax incentives.

• Policymakers should scale up policies to improve SMEs’ access to loans; this serves both as an immediate response to SMEs’ financing constraints and as a complement to policies to ensure that banks’ increased lending activities (spillovers from capital market development) can (also) be channeled towards SMEs. Depending on country-specific bottlenecks, this may include addressing well-known problems in SME lending through the installment of credit bureaus and registries as well as moveable asset registries; strengthening contract enforcement and insolvency laws; and implementing a regulatory framework conducive to digitalization.

Please click here to download the full academic article on the role of capital markets for SME finance; for downloading the full policy brief, please click here.