G-20 SME Innovation Challenge and Entrepreneurial Finance Lab

Last week during Learning Week 2011 at the World Bank Headquarters in Washington, DC, I attended a session, “Innovative Approaches to Financial Inclusion: How is the G-20 Addressing the Access Challenges?” The panel included Bailey Klinger, Cofounder and Director of the Entrepreneurial Finance Lab; Raúl Hernández-Coss, Director General for Access to Finance; Tilman Ehrbeck, CEO, Consultative Group to Assist the Poor; and Samuel Munzele Maimbo, Lead Financial Sector Specialist, Finance and Private Sector, Africa, World Bank.

In order to address a wide credit gap between the needs of small and medium enterprises (SMEs) and the funding that is currently being provided, G-20 nations pledged more than $1.5 billion towards the SME Innovation Fund. This gap exists because banks find it risky to lend to SMEs and it is too expensive to go through the due diligence process of checking credit histories and evaluating various business plans for SMEs. To address these problems, a better process is needed to allow banks to capture as many loan applicants as possible so as not to decline loans to those SMEs that have the potential to succeed, and necessary improvements should be made so that the screening process is less labor intensive and more streamlined. If these issues are addressed, SMEs in the developing world will have improved chances of receiving loans and interest rates on these loans would be lower. But even when banks exercise due diligence and process loan applications, default rates are still very high so industry innovators have been looking at ways to identify high-potential SMEs.

One such initiative is the SME Innovation Fund, which is managed by Ashoka Changemakers and the Rockefeller Foundation. Through the Fund, these organizations conducted a competition for the most innovative proposals on how to help small and medium enterprises in the developing countries access financial services. In November 2010 the Fund announced that Entrepreneurial Finance Lab (EFL) was selected as the winner of the G-20 SME Finance Challenge. 

EFL was founded by Asim Ijaz Khwaja and Bailey Klinger from Harvard Kennedy School to address the SME credit gap and provide more SMEs with access to finance. EFL utilized psychometric screening tools to assess the entrepreneurial ability of the applicants. The test takes only 30 minutes and, among other things, it focuses on evaluating the applicants’ drive, intellect, and dedication to their project. Usage of psychometric screening tests increases the pool of potential applicants by allowing lenders to consider applicants with no prior credit history. Results have shown that qualitative screenings like this have reduced loan defaults by 25 to 40 percent because they assess the character of the entrepreneur and detect indicators that are not captured through the traditional methods of evaluating loans. Finally, since this test is very cost effective and efficient, it reduces operational costs associated with processing loan applications.

In short, EFL is addressing the challenges that lenders face when extending credit to SMEs by expanding markets through adding more applicants to the initial pool, and reducing defaults and costs of processing loans. The EFL strategy has been used in seven countries and conducted in nine different languages.