Box 4.2. Financial innovation
Firm-level innovation – and private-sector dynamism more generally – may pose challenges to banks and other financial intermediaries that need to decide which entrepreneurs deserve funding and which do not. The more quickly technologies evolve, the more difficult it is for banks to distinguish between creditworthy loan applicants and firms that are too risky.
To some extent, this is simply because business plans that involve new and untested products or processes are more difficult to evaluate. It may also be complicated to value collateral that involves new technologies. Consequently, if they are to continue lending to innovative firms, banks will have to constantly update their screening processes. Thus, banks themselves will need to innovate if they are to continue facilitating firm-level innovation.23
Across the transition region, various forms of financial innovation are currently helping banks and other financial service providers to continue lending to a broad spectrum of clients.
Factoring: Factoring involves the sale of accounts receivable, at a discount, to a specialist lender. This is an important source of external financing for small and medium-sized enterprises (SMEs) around the world. Total global turnover from factoring stood at €2.2 trillion in 2013 and has been growing at an average annual rate of 15 per cent in the wake of the global financial crisis. This suggests that factoring has acted as a substitute for traditional bank lending in the tight credit environment currently faced by SMEs. An important innovation in the area of factoring has been the emergence of invoice-trading platforms. These platforms enable SMEs to auction off their receivables to a broader range of institutional investors with greater flexibility. This helps firms to gain access to more cost-efficient working capital. Following the success of the US-based Receivables Exchange, a number of similar start-ups have emerged in other countries. Slovenia’s Borza Terjatev is the first online receivables exchange in the EBRD region.
Credit scoring: Banks use credit scoring to automatically process information on a small number of standard characteristics of borrowers in order to predict the credit risk associated with each borrower. This was originally used for consumer and mortgage lending, but in the 1990s it began to be used for small business loans as well, after Fair, Isaac and Company developed a credit-scoring model for SME lending in the United States. Today, over 90 per cent of US small business lenders use this technique. Across the transition region, more and more banks and microfinance institutions are introducing credit-scoring tools as part of broader improvements in screening and underwriting policies. One particularly interesting example is the recent introduction by various Turkish banks of a credit-scoring tool aimed specifically at farmers and small-scale agricultural firms. This agricultural client assessment programme was developed by the Frankfurt School of Finance & Management to help financial institutions lend to agricultural firms. The innovative credit-scoring tool allows relationship managers and loan officers with limited knowledge of agriculture to process loan applications submitted by farmers and entrepreneurs working in the areas of crop production, dairy production, cattle fattening, apiculture and poultry.
Online lenders: Online financial service providers vary widely – from those that lend to businesses from their own balance sheets (such as the US-based OnDeck or Kabbage) to peer-to-peer (P2P) business lenders (such as the UK-based FundingCircle), which link institutional investors with borrowers and charge a fee for the origination and vetting. These organisations use proprietary credit algorithms to gain a better understanding of small businesses’ financial health and make quick decisions on lending. In the transition region, the first online lenders are only just beginning to emerge. The Estonian company isePankur has gained traction in the area of P2P lending, although it focuses on consumer loans, rather than lending to businesses.
“Big data” and alternative data sources: The screening of SMEs is particularly challenging in emerging markets, where credit bureaus often have only patchy coverage, firms’ financial histories are limited and collateral is often unavailable. A number of start-ups are trying to address this issue by leveraging alternative data sources (such as applicants’ online transaction records, mobile phone usage and activity on social networks) to evaluate repayment risk. German company Kreditech, which has offices in Prague, Moscow, Warsaw and Ukraine, sells a credit-scoring tool that is based on “big data” (such as e-commerce transactions). It also underwrites its own consumer loans in a number of countries (including Russia and Poland). Meanwhile, Friendlyscore.com is a Polish start-up that sells lenders credit scorecards that are based on Facebook data.
Psychometric testing: A growing number of financial institutions are assessing business owners’ creditworthiness using computer-based psychometric tests. By asking questions about applicants’ characters, abilities and attitudes, they hope to identify high-potential, low-risk entrepreneurs (who may not have a credit history or collateral). A psychometric test developed by the Entrepreneurial Finance Lab – a spin-off from a Harvard University research project – is currently being applied by various financial institutions across Latin America, Asia and Africa.