The need to relaunch UK small business lending
Small and medium-sized enterprises (SMEs) in the UK are experiencing a period of resurgence following the impact of Brexit and the COVID-19 pandemic. According to the Barclays SME Barometer, in the second quarter of 2022, UK SMEs saw an 11.4% increase in revenue compared to the same period in 2021. At the same time, the segment underwent a systemic transformation spurred by macroeconomic catalysts and a digital overhaul of industries on a global scale. The emergence of digital-centric business models (such as D2C, vertical SaaS, and niche markets) and SME categories (such as influencers, gig workers, freelancers, and remote enterprises) have extended the long tail of small businesses seeking growth.
Traditional corporate finance is years behind this transformation. Current underwriting methodologies have struggled to assimilate new business and revenue models. Importantly, they fail to take advantage of the potential for adaptive and continuous risk assessment made possible by digital data streams. This is an important step towards lowering the barrier for SMEs with small files, or those who experience seasonal or cyclical variations in their income.
This article examines the imperatives for incumbent banks and financial institutions in the UK to lead innovation in SME finance.
The changing landscape of SME finance in the UK
Traditionally, SME finance in the UK has been led by the big banks. Following the distress of the 2008 crisis, SME lending, generally considered a high-risk, high-cost endeavor, declined significantly.
Around the same time, a slow but steady undercurrent of fintech disruption began to creep in. Policymakers have taken note of the decline in SMEs’ access to traditional sources of finance, as well as the potential of fintech to address these challenges, and released an important set of measures. Measures, including the Financial Services Act 2012 and the Small and Medium Enterprises (Financial Platforms) Regulations 2015, sanctioned challenger banks and alternative lending platforms, and enabled the creation of a market banking and alternative finance for SMEs in the UK.
Due to these tailwinds, the contribution to SME financing from alternative lenders, challenger banks and asset finance companies increased by 56% between 2014 and 2019. In comparison, the contribution from large banks fell by 14 % over the same period. According to Innovate Finance, the market share of alternative lenders was around 9% before COVID, which rose to almost 20% during the pandemic, boosted by government-backed financing programs like CBILS (Figure 1) . After the first quarters of strong demand from the pandemic, gross SME lending per quarter stabilized around the £4.9bn mark from the second half of 2021.
Opportunities for innovation in SME financing
Alternative lenders have targeted underserved niche businesses to lead the “unbundling” of SME financing across the value chain and industry verticals (Figure 2). Ancillary providers play an important role in enabling the open data network used by alternative lenders. Empowering trends for SMBs act as tailwinds for solution providers and SMB adoption.
Unbundling financing options between procurement, operations, and sales makes sense given the differences in ticket size, duration, and risk validation data points for each. Seen in this light, each link in the SME value chain offers opportunities for innovation in targeted loan products. Importantly, this forms an organic approach to identifying opportunities to integrate financing products at the point of need.
1. Supply Chain Finance
Fintechs like Muse, Finverity, Sonovate, Hokodo, and Tranch are tapping into the vendor or supplier payment space with solutions like purchase order financing, purchase financing, invoice discounting, and B2B buy now, pay later (BNPL). While most of these products exist on the market, fintechs are making them much more accessible to SMBs and dramatically reducing rejection rates.
2. Financing based on sales
On the sales and distribution front, multiple financing options are available for SMEs with different needs. Providers like Uncapped, Vitt, Liberis and Outfund use proprietary algorithms and multiple real-time data points to enable revenue-based funding, while big tech like Amazon and PayPal offer unsecured funding for e-commerce sellers .
3. Financing of operations
When it comes to maintaining business operations in functions such as employee payroll, employee expense management, working capital and business capital, the needs of SMEs can vary depending on the nature of their business. In such cases, specialized solution providers offer targeted products to small businesses. Companies like Soldo, Ben, and Expend provide physical and virtual cards for expense management and offer various value-added services to businesses. Hastee and Karma have developed solutions to improve employee financial health by providing on-demand access to earned income and payday advance loans. Iwoca, Funding Xchange and Outfund also offer various forms of unsecured business loans to SMEs looking for alternatives to loans secured by collateral.
Restarting the credit risk engine
Access to alternative, high-fidelity data from public databases and enterprise digital platforms, along with financial automation are transforming the speed and efficiency with which credit risk can be assessed. Banks can now:
Perform fully digital eligibility checks for requested credit products, dramatically reducing costs and turnaround times for banks and businesses
Run automated models to identify company-specific credit limits and repayment terms on different product types; this greatly enhances a bank’s potential to recommend and cross-sell across a diverse portfolio of lending products
Simulate the price elasticity of demand for risk-based pricing and trading
Leverage flow-based underwriting models for solvency, overcoming some of the biggest hurdles to move beyond collateral-backed financing
Assess behavioral and business patterns for risk and fraud indicators
Analyze cash positions for affinity and urgency indicators
Piece 3 illustrates some of these digital data sources and how they can help banks innovate credit products to contextually serve SMEs across business and revenue models.
The layer of digital technology that helps banks connect to SME business data is a critical part of lending innovation. Adopting this approach opens up nearly endless possibilities for banks to develop targeted, segment-specific lending products. Specifically, an enterprise-data-driven, unbundled approach to alternative lending will help banks innovate around some of the most entrenched challenges in SME lending:
Subscription of unsecured loans: The effort-to-value ratio for SME loan size has been a major sticking point for banks as well as corporates. SMEs find it intimidating or impossible to provide high value collateral even for small loans, while banks find it inefficient to perform such extensive risk assessments for small loans. Adopting automated risk assessment models based on accurate and current business data can help banks scale their unsecured loan portfolios risk-free.
Collateralization of cash flows: While historical cash flows have been used as evidence of business credibility, lenders have often overlooked the value of current and future cash flows as a way to granularly and accurately assess business stability. and the future growth potential of SMEs. This can allow lenders to introduce more innovative financing offerings such as revenue-based financing and merchant cash advance and significantly expand the addressable target market.
Flexible repayments: SMEs are particularly vulnerable to fluctuations in revenue, whether based on seasonal, cyclical or macroeconomic factors, resulting in high rejection rates. Financial automation capabilities can help banks innovate repayment models to account for this vulnerability, while providing adaptive and continuous risk monitoring to signal any potential long-term impact.
A call for innovation in SME lending
Changing SME business models have increased barriers to accessing finance from traditional lenders. A growing number of SMEs are low-capital, fast-growing businesses that are unable to reach traditional thresholds of security or profitability. SMEs are also experimenting with new revenue models, while existing revenue models experience greater fluctuations depending on macroeconomic conditions.
Currently, fintechs are leading the charge in innovating and proving use cases for alternative unbundled lending solutions. While the long-term advantage in this highly regulated product space lies with traditional lenders, they need to close the gap by leveraging the SME digital data ecosystem and adapting their underwriting models to regain the lead.