Can capital markets play a vital role in supporting SME financing?

In the wake of the 2008 financial crisis, a sweep of forces – the ability for consumers to compare prices and purchase services directly (cutting out the middleman like travel agents or shop assistants), the low-interest rate environment and greater banking sector regulation - have reshaped the SME financing landscape. In the last few years, alternatives to traditional bank financing have been key to supporting global economic activity. For many firms and households, these alternatives now represent a source of more diversified credit supply, injecting a robust dose of competition into the funding ecosystem. 

With this backdrop, increasing support for SME funding through capital markets would provide important benefits:  

• capital markets offer novel financial products and market segments, elevating diversification and liquidity to new heights  
• SMEs stand to gain access to a wider array of funding options 

Nevertheless, this is only likely to be effective if the products crafted for SMEs are bespoke. The large entities, with traded corporate bonds with a minimum size of $250, are a mismatch for the size of most small businesses. Maturities, guarantees, issuance costs, and disclosure must also be scaled proportionally for SMEs to be attracted to this domain. This presents a policy challenge: as more sophisticated and innovative arrangements that meet the specific needs of these small businesses are required. 

For SMEs, stepping into the capital markets comes at a cost, not just in direct listing fees but also in the loss of control in embracing transparency and heightened visibility to external investors. While this transition is still relatively rare, SMEs worldwide are gradually adopting more transparent governance and diversifying their financial sources. 

But SMEs are not turning to capital markets out of desperation. Our analysis shows that the risk profile of SMEs availing of capital markets for funding is above average. So why are they making this move?  

• As a conscious choice to diversify funding sources and gain more financial independence 
• To gain more visibility and experience in dealing directly with investors while approaching an IPO 

For capital markets to retain their vitality and catalyse economic growth, they must incentivise issuers, investors and market intermediaries. The latter, through their underwriting, research and secondary-market trading operations, have long been linchpins in financial market development.  

Sound credit assessment of issuers strikes the delicate balance between risk and reward, ensuring optimal capital allocation. In our experience, the markets that thrive the most are those where Exchanges and Regulators are supporting investors in the screening and risk assessment of issuers.  

Building a strong credit culture is critical in: 

• helping dismantle information asymmetry,  
• building trust, and 
• facilitating a more effective allocation of funds 

Today, cutting-edge data and credit risk models stand ready to support investors in gauging SME’s credit worthiness, mitigating the risk of early failures and enabling constant monitoring of credit profiles and covenants.