Why a Trusted Identity is the First Step to Financial Inclusion for SMEs
Micro, small and medium enterprises (MSMEs) generate significant wealth for countries across the world and thanks to the digitalization of the global economy, they have more opportunity for growth than ever before. This blog highlights the importance of financial inclusion for MSMEs to generate shared prosperity, and how an easy first step for business owners is to acquire a trusted digital identity.
Author: Stephan Wolf
The global economy depends on micro, small and medium sized enterprises (MSMEs) for job creation, innovation and financial development. According to the World Bank (World Bank on SME Finance – related links), these entities represent about 90 per cent of business and more than 50 per cent of employment worldwide, with formal SMEs contributing up to 40 per cent of national income (GDP) in emerging economies. This number rises significantly when informal SMEs are included. Yet, despite the critical role they play, these businesses face the same universal barrier to expansion and job creation across the world – an inability to access finance. The World Bank notes that this is the “second most cited obstacle facing SMEs to grow their businesses in emerging markets and developing countries.”
Estimates from the most recent International Finance Corporation (IFC) MSME Finance Gap (IFC Report ‘MSME finance gap’ – related links) study suggest that 65 million firms, which is equivalent to 40 per cent of formal MSMEs in developing countries, have an unmet financing need of $5.2 trillion annually. This is equal to 1.4 times the existing levels of global MSME lending. The finance gap varies considerably from region to region, with developing economies having the highest proportion of unmet financing needs. East Asia and Pacific has the largest share (46 per cent) of the total global finance gap, followed by Latin America and the Caribbean (23 per cent) and Europe and Central Asia (15%).
Finding new ways to increase financial inclusion for MSMEs is a critical agenda item for national governments and global bodies alike. Indeed, the World Bank has identified financial inclusion as one of its key Sustainable Development Goals, because of its potential to reduce extreme poverty and boost shared prosperity.
Risk assessment challenges: A key barrier to MSMEs accessing finance
In 2019, the IFC released a study, titled ‘Banking on SMEs: Trends and Challenges’ (IFC Report ‘Banking on SMEs: Trends and Challenges’ – related links). In this report, which gave perspectives from SME banking leaders, credit risk was cited as one of the biggest challenges SME banks contend with globally. Specifically, information asymmetry was noted as a driver of credit risk challenges, with “a lack of verifiable information to properly assess the SME’s financial situation” making risk assessments difficult.
The lack of a trusted identity which can be linked to key business information and provide transparency, prevents many companies and individuals acting in a business capacity from participating in global trade and money flows. Successful trading and financing conditions rely on absolute confidence that transactional partners are known to each other and that their identity can be verified. A bank or financial institution will not lend money to an unknown or unverified business, in the same way that the average person would not usually loan a significant sum to a stranger they meet on the street – the associated risk of not recovering the investment is just too great.
Yet many MSMEs are unregistered and therefore lack an official trusted identity. In some developing countries, more than 50 per cent of economic activity is conducted by unregistered businesses (Ann Low, Deputy Director of the Office of Investment Affairs, US Department of State on Global Enterprise Registration – related links) who lack transparency and identity and as a result remain cut off from important services such as payments and supply chains. In addition to the obvious limitation on business growth, this can also result in higher vulnerability to corruption and bribery and a higher dependency on development aid.
Trusted identity: A first step to financial inclusion
GLEIF’s vision is that prosperous economies start with transactional trust. For MSME owners, the first step is being able to prove the legitimacy and credibility of their enterprise. While national business registries exist for this very purpose, there is a significant additional benefit in having a trusted identity which is recognized universally and provides transparency across the global marketplace. The Legal Entity Identifier (LEI) is an obvious solution.
The LEI is a 20-character, alpha-numeric code based on the ISO 17442 standard developed by the International Organization for Standardization (ISO). It connects to key reference information that enables clear and unique identification of legal entities and any business can register for one. Each LEI contains information about an entity’s ownership structure, answering the questions of ‘who’s who’ and ‘who owns whom’. It provides a universally recognized identifier paired with essential entity data, rigorous verification processes and high data quality.
While usage of the LEI to date has been driven by regulation in capital markets, it offers abundant economic benefits when used by market participants across all sectors: financial inclusion opportunities for MSMEs, enhanced risk management for finance partners and the ability to better address fraud to name a few.
While MSMEs can certainly help themselves by seeking to acquire an LEI, pull-adoption from the marketplace should be aided by government and regulatory adoption programs to enable more of these businesses to access finance. After all, anything that can be done to help businesses secure verified identities and, as a result, support economic development should be pursued with enthusiasm.
Encouragingly, in June 2019, the Bank of England’s (BoE) Governor, Mark Carney announced that it would consult on developing an open platform for competitive financing to plug a £22 million funding gap for small and medium sized enterprises (SMEs). He said: “Part of the problem is that the assets that SMEs are seeking to borrow against are increasingly intangible – like a brand or user base – rather than physical machinery or buildings”, inferring that this makes a bank’s lending decisions trickier. He continued: “This should not be the case in a data-rich world. Lenders should be able to access a broader set of information on which to base credit decisions,” The BoE suggested that SMEs could create a ‘portable credit file’ which could be shared with lenders through a national SME financing platform. According to the BoE, the identification of business and verification of their data will be crucial to make this work. The BoE noted the LEI system could be adapted for British SMEs for this purpose.
This is one example of how the LEI can be embedded as a mechanism to promote transparency and trust to support the future prosperity of economies by opening up access to finance. Similar innovations by authorities in the future should be applauded and emulated.
MSMEs: How to obtain an LEI
Registering for an LEI is a straightforward process. The service is supported by LEI issuers who have been accredited by the Global Legal Entity Identifier Foundation (GLEIF). Through self-registration, a legal entity that wishes to obtain an LEI must supply accurate reference data to its LEI issuer, including:
Business card information, e.g. the official name of a legal entity and its registered address.
Relationship information, which allows the identification of the direct and ultimate parents of a legal entity, if applicable.
Once the LEI issuer verifies the reference data with the local registration authority, such as a national business register, an LEI can be issued. Each LEI is published within the Global LEI Index, which is the only global online source that provides open, standardized and high quality legal entity reference data.
By applying for an LEI, MSMEs gain a trusted universal identity that can open up financing opportunities within a global, increasingly digital marketplace. LEIs can take the complexity out of business transactions and enable both trade and finance partners to make smarter, less costly and more reliable decisions about who to do business with.
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Stephan Wolf is the CEO of the Global Legal Entity Identifier Foundation (GLEIF). Since January 2017, Mr. Wolf is Co-convener of the International Organization for Standardization Technical Committee 68 FinTech Technical Advisory Group (ISO TC 68 FinTech TAG). In January 2017, Mr. Wolf was named one of the Top 100 Leaders in Identity by One World Identity. He has extensive experience in establishing data operations and global implementation strategy. He has led the advancement of key business and product development strategies throughout his career. Mr. Wolf co-founded IS Innovative Software GmbH in 1989 and served first as its managing director. He was later named spokesman of the executive board of its successor IS.Teledata AG. This company ultimately became part of Interactive Data Corporation where Mr. Wolf held the role of CTO.