As the European Union (EU) undergoes major banking regulations changes in an attempt to commoditize the European banking system, the Small and Medium-sized Enterprises (SMEs) and Corporate Banking industries are shifting drastically in response.
Since the 2008 financial crisis, the value and importance of SMEs and their role in the health of the economy has come to the forefront of policy and regulation concerns in the EU. As the government tries to address and resolve traditional barriers to financing for SMEs, corporate banks are being pushed to digitize their services in order to remain competitive in this new emerging marketplace.
The shift to an open banking system through the regulatory directives such as the Payment Services Directive 2 (PSD2), brings with it a host of opportunities and challenges for SMEs and their corporate banking partners alike. As these regulations begin to take full effect, the pressure for banks to be more competitive in the financial options that they offer gives rise to a new community of innovative third-party products and services being provided to banks and SME customers. While the full impact of these regulatory changes are not yet realized, the drastic rise in, and number of, Financial Technology (Fintech) solutions suggests that the future of European SME financing is still in the early stages of development.
Why getting financing can be a challenge for SMEs
Within the EU, SMEs account for about 99.8% of all companies, and about two-thirds of total employment. They are defined as having between 10 and 250 employees, and a turnover of between 2 and 50 million Euro.
Although SMEs make up such a large part of the economy, they have traditionally faced many barriers to financing from traditional lending institutions. It can be difficult to properly assess the risk on a loan to an SME due to incomplete information about the credit history of the potential investee. This can happen because traditional credit risk models do not always take into consideration non-traditional risk variables linked to the financial health of an SME. In addition, SMEs usually do not have enough assets to be used as collateral. This generally leads to higher premiums for SMEs, and can make it very difficult for SMEs to get financing in a timely and efficient manner. Traditional wait times for loan decisions last between three and five weeks, with average ‘time to cash’ lasting up to three months.
These lengthy wait times are potentially deathly to new companies, and seeing as SMEs already suffer from high mortality rates, this is especially problematic. All of these factors culminate into a very high barrier to switch banks, transforming SMEs into dependent borrowers. This system fosters an environment that is very closed off to smaller banks and non-traditional lending institutions.
Traditional SME financing has been problematic for years. However, it wasn’t until the financial crisis of 2008 that these issues pushed themselves to the forefront of emerging policy concerns. During the crisis, SMEs were hit particularly hard, with thousands either going out of business or having to lay off employees and drastically slash spending. Because they are such notable portion of the economy, this had exponentially negative effects on the health of the economy and directly impacted its recovery post-crisis. After the crisis, various new credit constraints and restrictions emerged, which only further denied crucial funding to SMEs. Suddenly, trying to foster an environment to help provide for and foster SMEs became one of the top priorities of the post-crisis recovering European economy.
The PSD2 Revolution (and what it means for SMEs)
The most important response has been the radical top-down approach towards an open banking system, also known as the PSD2 revolution. The PSD2 regulations require banks to grant qualified third parties access to customer transaction accounts. This means that for the first time, large well-established banks are being forced to compete with smaller, newer banks, alternate lending institutions, authorized Fintechs, retail organizations, and other technology firms. As Europe begins to see an increase in competition and transparency in the lending marketplace, lending services begin to become digitized, requiring banks to adopt new technology in order to remain relevant to their SME customer base. This gives the region a head start towards more open data sharing practices, with the end result being further innovation. These regulations went into full effect at the beginning of January 2018, and have drastic effects on all the players involved in SME financing.
One of the biggest impacts of these new regulations for SMEs is that it drastically lowers the cost of switching banks. With access to a wider variety of lending options, SMEs are not longer dependent on traditional banks for loans. The new digital lending services are oftentimes more flexible than traditional banking services, and can be better suited to addressing the needs of SMEs. They can also help to address other issues that SMEs face outside of just financing concerns.
With the access of third-party groups to the financial information previously withheld by banks, new technology has emerged to help SMEs handle problems such as accounting concerns, payroll technologies, and point of sale systems. The time for loan decisions has been cut way down, sometimes “bringing ‘time to yes’ down to five minutes, and time to cash to less than 24 hours” for SME loans, helping SMEs get of the ground quicker and helping them stay on their feet longer.
Corporate banking is looking for new solutions
Open banking policies also have important consequences for banks. While banks have struggled for years to effectively fund SMEs, these new regulations bring a new set of problems for banks to solve.
Previously, banks tried to solve the issues of SME funding internally. However, in the face of new competition, banks are looking for innovative solutions from external sources. As technological innovations (such as digital payments and cloud-based applications) expand, customers’ expectations for convenience and security continue to grow.
In order to remain competitive in the market, banks are more and more frequently partnering up with a variety of Fintechs to increase the number and type of digital products that they are able to offer their SME customers.
The resulting increase in competition for different products puts new pressure on pricing for banks. The other main challenge banks are facing is how to digitize their legacy IT infrastructure systems in order to remain relevant in the newly opened marketplace. In many cases, innovative Fintechs are able to help them work to digitize these systems, but the process is complex, slow, and costly.
The new digital tools that are changing the landscape
A variety of digital financial technology tools have emerged as a response to the different problems within the SME financing industry. Examples range from financial management tools (such as customer identity verification using video chat, AI-powered chatbots, and cardless banking technology) to distributed ledger technology (which can be described as a ledger of any transactions maintained in decentralized form across a blockchain, eliminating the need for central authority to check against falsification or manipulation). Some of the most important solutions, however, are open Application Programming Interfaces (APIs), Artificial Intelligence (AI) solutions, and Fintechs.
- APIs have various functions: they can be used to track data and statistics and imbed the information into dashboards; help customers integrate banking data into bookkeeping, investment, and account information software; deliver personalized products such as user authentication, fraud management, credit approvals, paying for services with cash or points, or finding and tracking subscriptions.
APIs are important because they can help simplify back-end processes by connecting internal systems (including legacy IT systems) to allow for quick access to data. This helps automate tasks, speeding up development. APIs also help to create a richer customer experience through innovative products that pull information from already existing data within a company’s system.
- AI solutions help to cut down time spent on repetitive processes, saving banks’ time and money. Some examples include smart workflows (client onboarding, end of month reports), machine learning (identifying patterns in large data sets, trade surveillance, product control), natural language processing (turning texts and speech into searchable data) or cognitive agents (computerized interaction with humans, i.e. help desks).
The role of Fintechs in SME financing
Fintechs are of particular importance to the SME banking scene since “almost three-fourths—of fintechs focus on retail banking, lending, wealth management, and payment systems for small and medium-sized enterprises (SMEs).”
Sometimes Fintechs try to work directly with SME customers, but many times they partner with banks in B2B (Business To Business) relationships. The range of services that they offer is as diverse as it is flexible. Products range from peer-to-peer (P2P) payments, micro-lending platforms, robo-investing services, payment transactions, asset management, loan and financing arrangements, and account management. They also create new lending approaches to SME financing through automated credit decisions based on alternative data sources, typically speeding the process for loan decision up substantially. The growth of relationships between banks and Fintechs are revolutionizing the SME financing industries.
While some big corporate banks are taking the wait and see approach to this regulatory overhaul, choosing to see how their competitors fair in the face of these major industry changes, most banks have recognized the need to digitize their systems.
Many are doing this by working with Fintechs and other nonfinancial firms to remain competitive in a changing marketplace. The growth trajectory of Fintechs in this industry has remained steep, with Fintech activity in capital markets infrastructure growing almost 300% since 2010, indicating that we have not yet seen the full effects of the PSD2 regulations on the SME banking industry. Since the regulations only went into full effect in January 2018, it stands to reason that this industry is continuing to react to the new market competitiveness and is continuing to develop new technologies and solutions.