Lending technologies for the Small and Medium Enterprises (SMEs)

Written by: Mohammad Ali Elabed & Abdullah Ali Elabed

Lending technologies can be distinguished based on many different dimensions such as structure of the loan contracts, screening and underwriting policies or procedures, monitoring strategies and mechanisms, and the primary source of information. These technologies are deployed to address the types of problems that can lead to either over lending or credit rationing. The changes in the economic environment in which banks and small businesses operate have heightened concern about the availability of credit to the small businesses. Part of this concern reflects the fact that the small businesses are often informationally opaque and have far fewer alternatives to external finance than large companies. Also, many small businesses are highly dependent on banks for external finance.

There are two main types of lending technologies that are distinguished by the type of information that the banks use in monstering and granting the loan. These lending technologies are used to finance small- and medium-sized enterprises (SMEs).

The first type is the Transaction-based lending technologies which are primarily based on borrowers’ hard quantitative information, like the strength of the financial statement or the value of their assets, which are relatively easily available at the time of loan origination, easily to document them, and transfer. It may come in a different forms, including financial statement lending, small business credit scoring, factoring, asset-based lending, equipment lending, real estate-based lending, and leasing. It is better suited for relatively transparent small businesses and it focuses on one transaction with a customer, or many repetitive and standardized transactions with various customers.  Lending decisions are made after borrowers go through a formally structured application process where they are required to meet certain requirements like providing specific financial information in order to qualify for a loan. The transaction-based lending or arms-length lending can be more cost-effective and also allows larger and non-local banks to lend to SMEs.

The second type is the relationship lending which is extended primarily based on borrowers’ soft qualitative information, such as the entrepreneurs’ characteristics that include skill and integrity, which are not easy to verify. As the soft information is accumulated through close bank-borrower relationships, broad and long banking relationships should accompany the relationship lending so they need to be located close to their borrowers which enables the loan officers to personally contact their borrowers at a lower cost.

The relationship lending was better suited for more opaque small businesses. Traditional literature emphasizes that the use of the relationship lending methodology when dealing with SMEs because these firms are considered informational opaque and lack collateral.

Relationship lending is one of the most important technologies that employed by banks in extending credit to informationally opaque small businesses. The process of relationship lending is not well understood. However, a clear understanding of how the relationship lending technology work, and how the organizational structure of the bank affects their ability to deliver this service that are needed to assess how recent changes in the economic environment are likely to affect the availability of the credit to the small businesses.

Key Words: Lending technologies, SMEs, Small Businesses, Relationship lending, Transaction based lending

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