Breaking Out of the Missing Middle

L'Atelier du Chocolat is a gourmet chocolate factory in Mexico with $2 million in annual sales and 63 employees. Among the factory's clients is Liverpool, one of Mexico's largest department store chains, but L'Atelier du Chocolat can only supply seven of Liverpool's 130 stores.

"To be able to serve them all I would have to invest in machinery," says owner Marisol Alfaro. "But I don't have access to financing because I don't have the contract." And Alfaro can't secure the contract until she can prove that she has the means to fulfill it. "It is a vicious circle," she says.

L'Atelier du Chocolat is among the millions of Latin American small and medium-sized enterprises, or SMEs, stuck in the "missing middle": Too big to qualify for microloans, but not big enough to interest mainstream lending institutions, SMEs struggle to obtain much-needed funds.

Some world leaders have declared this gap one of the most significant deterrents to growth and job creation. Former President Bill Clinton, whose foundation will soon launch a $20 million fund for SMEs in Colombia, recently told a group of Latin American policymakers, business leaders and civil society representatives at The Miami Herald's Americas Conference that "the biggest capital shortage in the world today is investment capital for small and medium-size businesses."

And it isn't just because of the current financial crisis. Even in times of greater liquidity, SMEs were largely underserved by traditional financial institutions. According to a 2006 survey by the World Bank, only one in five businesses in Latin America and the Caribbean received bank loans. In Mexico, only roughly one in 38 businesses did.

"We see it very much as a segment that has been ignored," says Greta Bull, manager of the access-to-finance program for Latin America and the Caribbean at the International Finance Corporation, the private-sector arm of the World Bank Group. The IFC and other groups are trying to make the case to banks that SME banking and finance can be just as profitable as corporate lending.

Thus far, though, Latin American banks looking to tap into new markets have shown more interest in lending to micro entrepreneurs than to owners of small and medium-sized businesses.

This is easily explained by microfinance's well-documented high rate of return, in general, and its long track record of success in Latin America, in particular. Weeks ago, a new global microfinance ranking from the Economist Intelligence Unit showed that of the 10 countries in the world most "supported by active microfinance sectors and strong levels of institutional development," six are in Latin America.

Some financial institutions in the region that have previously focused on micro-lending, such as Banco de Credito in Peru, have begun to consider SME finance. But as Bull observed, such lenders are "a rare thing" in Latin America.

One reason, some may argue, is informality: Most SMEs in Latin America fall outside the purview -- and protection -- of their governments. As such, banks consider them too high-risk an investment. But the widespread success of microfinance in the region has proven that informal is not synonymous with irresponsible -- that informality does not portend default.

A more plausible explanation is that banks are too quick to treat SMEs just as they would large companies. The administrative costs that come with lending, for instance, are stumbling blocks for both banks and SMEs. If banks have to go through the same time-consuming process for SME loans that they would for corporate clients, a loan of a few hundred thousand dollars will always be less attractive than a multi-million-dollar loan.

Development experts propose that banks rely more on other forms of collateral, such as inventory, to approve an SME loan. More traditional forms of guarantees, such as audited financial statements, are not as readily available to SMEs.

Last year, the Guatemalan government tried to facilitate lending to SMEs by creating a collateral registry for movable assets, such as machinery. But according to the World Bank's annual "Doing Business" report, few other governments in the region have made similar efforts.

Perhaps the biggest challenge for banks is that of reconsidering the terms of their loans. Today, Alfaro needs a $1 million loan. To provide it, Mexican banks would ask for $3 million in collateral and would charge between 24 and 26 percent interest, she says. "With our profits at 30 percent," she adds, "I would be working for them."

Alfaro, who recently attended the Pathways to Prosperity Women Entrepreneurs Conference organized by the U.S. State Department, says she has been looking for banks that understand the difficulties SMEs face. Now she is considering applying for a loan from a financial institution in the U.S. -- a sweet opportunity lost by a Mexican lender.