The new frontier for SME financing
The global financial landscape has evolved significantly in recent years, yet small and medium enterprises (SMEs) in emerging markets and developing economies (EMDEs) continue to rely mainly on bank financing, which is often limited, imposing a major hurdle for business operations and growth. Access to alternative financing sources is particularly critical in turbulent times, when bank credit might tighten, leaving SMEs exposed to shocks. Capital market financing in particular can act as a “spare tire” to bank financing, helping SMEs weather these shocks, ensuring they remain liquid and can allocate resources efficiently. Furthermore, the development of these markets can be important for SMEs undertaking innovative activities as they may lack tangible assets, such as real estate, to offer as collateral for bank financing and for SMEs with high growth potential, as capital markets enable access to large-scale, long-term funding and greater flexibility in financing structures. Hence, capital markets can drive meaningful change in SME financing.
Today, capital-market financing for SMEs is almost non-existent in most EMDEs. Capital markets have more significance for SMEs in High-Income Countries (HICs) and a few EMDEs. For example, in Italy, Peru, and Brazil, capital markets are becoming an alternative source of direct-debt financing for SMEs through instruments such as minibonds and credit funds. In many HICs, capital markets are the key source of financing for start-ups through venture capital and, for growing firms, through private equity. In selected jurisdictions, such as China, Poland, and the Republic of Korea, SME exchanges are an important component of the equity financing ecosystem. In addition, in countries like Brazil and Malaysia, fintech solutions, in particular crowdfunding platforms, have been expanding rapidly, supporting both debt and equity financing for SMEs. Finally, capital markets are also supporting lenders improve their funding conditions through instruments such as plain-vanilla bond issuances and in more developed markets, through SME securitization. This, in turn, enables lenders to expand their outreach to SMEs.
How can more EMDEs leverage capital markets for SME financing?
The right policies make a big difference. The recent World Bank report Boosting SME Finance for Growth: The Case for more Effective Policies, offers eight recommendations for government authorities to create an enabling environment for diversification of SME debt financing and to support the growth of equity financing, including by leveraging financial innovation. These reforms are not expensive for tight public budgets. In most countries, more costly, targeted financial interventions, such as lines of credit, credit guarantee schemes, and investment programs, will also be needed to address key challenges that hinder the flow of capital to SMEs. Given their sizable fiscal costs, the report outlines seven recommendations to ensure these interventions are well-targeted and effectively mobilize private capital.
This dual-track approach—through a robust enabling environment and more effective targeted financial interventions—can enhance the role of capital markets in SME financing in EMDEs.
In some countries, policymakers should consider regulations to support direct access of SMEs to capital markets, particularly medium-sized companies, for both equity and debt, as well as frameworks for specialized instruments, like credit funds and SME securitization. Policymakers should also implement laws and regulations to support the expansion of digital intermediaries, such as crowdfunding platforms, in line with recent developments in many HICs and EMDEs. Additionally, governments should build supportive financial infrastructures, including credit reporting systems, secured transaction frameworks and collateral registries, specialized SME insolvency regimes, and critical digital public infrastructure. Authorities should also consider mechanisms to foster competition and innovation, such as implementing open finance. In tandem, policy makers should assess the need for reforms to the regulations of institutional investors to allow them to invest in SME related assets.
However, for many countries, a robust enabling environment will not be enough to spur capital market financing for SMEs. Targeted financial interventions, such as publicly funded credit guarantees and investment programs, will likely be needed. They might be expensive, but the experience of more developed markets indicates that these interventions can help align the risk-return appetite of investors for SMEs—and SME-related—assets. They can also build confidence in new financing solutions, thus mobilizing investors and achieving scale. Policymakers could consider deploying guarantee facilities and other risk-sharing arrangements in cases where the key underlying concern in financing SMEs is their high risk. Countries like Spain and Italy have successfully implemented such solutions in the context of SME securitization and minibonds, respectively. Investment programs can build confidence and scale-up solutions, for example, for early-stage equity investments and venture capital as in Jordan and the Kingdom of Morocco, as well as for debt funds, as in the United Kingdom. Tax incentives can encourage equity investment in venture capital and, in some cases, in a broader range of SMEs. Finally, other type of complementary interventions, such as capacity building for MSMEs and for financial institutions might also be needed. Ultimately, governments should assess the trade-offs of different interventions in the context of their own development goals and their budget situation.
Capital market solutions tend to thrive only when a series of preconditions are in place—including a stable macroeconomic environment, a relatively well-developed financial sector with a sizeable institutional investor base, and robust institutions, from the rule of law to robust regulation and supervision of capital markets. For many EMDEs, especially low-income countries, strengthening these preconditions will be necessary before a deeper role for capital markets can materialize. The benefits can be immense, not just for SMEs but for the broader development goals of emerging markets and developing economies.
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