Small and medium enterprises (SMEs) are the backbone of Malaysia. They account for 98.5% of all registered businesses in the country and generate 37.1% of its GDP, according to official statistics. And yet SMEs face systemic hurdles that hinder their ability to take out loans from traditional financial institutions. Many banks believe that lending to SMEs is overly risky due to their lack of collateral, so the average rejection rate stands at 20%.
The inability to secure loans from banks constrains these companies’ growth, which in turn affects the development of the nation’s economy. Given the importance of SMEs to the Malaysian economy, the government has introduced a slew of initiatives to increase SMEs’ access to credit, including a peer-to-peer (P2P) financing framework that was introduced in 2016, making Malaysia the first country in Southeast Asia to regulate the sector. The government also proposed to set aside MYR 50 million (USD 12 million) for a Co-Investment Fund that will invest in equity crowdfunding and P2P financing campaigns.
Huge market potential
The most important reason why the Malaysian government stepped in three years ago is that the P2P lending market carries unignorable potential.
The SME Finance Forum, which was established by the G20 Global Partnership for Financial Inclusion in 2012, estimates that 9.22% of Malaysia’s SMEs are financially constrained. Since only half of the country’s banks even consider extending credit to this section of the country’s economy, there is a staggering USD 14 billion finance gap, which translates to a huge potential market for alternative financing.
Aside from the financing gap that exists in Malaysia, the global P2P lending market is projected to reach and aggregate value of USD 460 billion by 2020—a significant leap from USD 26 billion in 2015. To put it another way, that’s a compound annual growth rate of 51.5% from 2016 to 2022. The Malaysian government decided that they didn’t want to miss out as this sector takes off.
When SMEs’ loan applications are rejected, insufficient documentation is cited as the top reason. One of the factors behind the phenomenon is the culture of tax evasion, which more often than not is unintentional due to an unclear understanding of tax law. A common issue is the inability to differentiate deductible from non-deductible expenses, resulting in vague records that tend not to meet the requirements set out by major financial institutions.
In fact, a study on tax evasion among SMEs in Malaysia that uses data provided by the Inland Revenue Board of Malaysia shows that tax evasion occurs most frequently in suburban settings where tax agents are absent, leaving the companies with no recourse when they need to seek professional guidance and figure out how to comply with the relevant requirements and regulations.
Without tax agents in place, SMEs may not be able to achieve proper record keeping. The companies’ inadvertent mistakes may come to impact its creditworthiness.
Economic downturns exacerbate difficulties in securing loans from banks
SMEs in Malaysia tend to be shunned by banks. Often, they lose favor as clients in times of economic downturns.
Economic recessions have adverse effects on the earnings of all businesses and makes them more likely to default. Thus, during an economic downturn, banks see SMEs as high-risk loan applicants.
Those conditions are playing out in Malaysia now. The country’s economy is slowing down due to tensions arising from the US-China trade war, weak global demand for Malaysia’s exports, and soaring oil prices. In March, an economist with a local bank told The Star that the country is “entering a recessionary phase.” If you’re a small business owner, taking out a loan from a conventional financial institution is more difficult than ever.
Current state of affairs
When the government started regulating the sector in 2016, only six platforms were recognized as registered P2P financing platform operators. They were AlixCo, B2B Finpal, Funding Societies, Fundaztic, Nusa Kapital (NuKap), and Quickash. Together, they represent a range of services that have complementary focuses and capabilities.
For instance, NuKap is a shariah-compliant lender, making it suitable for Muslim investors who want to ensure their investments do not break religious laws. AlixCo is the only P2P operator in Malaysia that also offers equity crowdfunding for startups and SMEs, while Funding Societies was the first P2P lending platform in Southeast Asia to use escrow to verify all its investors and issuers prior to the transactions.
And in May this year, Malaysia’s Securities Commission (SC) announced the registration of five new P2P financing platform operators, namely Bay Smart Capital Ventures, CapSphere Services, Crowd Sense, FBM Crowdtech, and MicroLEAP PLT. This takes the number of P2P lending platforms in Malaysia up to 11, which marks significant progress considering the alternative financing industry in Malaysia is only two years old.
Under the current regulatory framework, a legally recognized P2P operator must be locally incorporated with minimum capital of MYR 5 million (approximately USD 120,000). The operators must also adopt a risk-scoring system that will rate all loans, offers, and investment notes on the platform.
Retail investors can only invest up to MYR 50,000 at any period of time, though other types of investors are not bound by this limit. And the issuer—the person or party that is raising money—must not be raising funds concurrently on different platforms.
Although different operators utilize different models to charge fees from their borrowers, the general rule of thumb is that the rate of financing must not exceed 18% per annum. The rationale is to reduce risks and encourage sustainable growth.
“To me, the key thing is balance. An 18% cap does to an extent limit the growth potential of P2P financing industry, but it also reduces its risks. With the cap, P2P operators cannot just recklessly lend, with the hope of balancing defaults with overly high interest rates. As P2P financing is new in Malaysia, risk minimization is more important than growth maximization. To me, SC got the balance right,” co-founder of Funding Societies, Kelvin Teo, told Digital News Asia.
According to the framework, the borrower is allowed to keep any amount that was raised on a P2P lending platform provided that the pooled funds reach 80% of the target amount. However, the borrower is not allowed to keep any amount that exceeds the initial target.
As of March 2019, the financing platforms had collectively raised MYR 344 million (USD 82.4 million) for over 900 MSMEs, but this is far from comparable to the USD 14 billion financing gap. As such, alternative financing is still a very small segment of the Malaysian market.“In advanced countries like the US, for example, alternative financing can be upwards of 20% of all financing for SMEs. But in our market, it’s only 3.4%. Alternative financing has a very small share here,” said Bank Negara Malaysia deputy governor Jessica Chew to The Star.
Small as it is, with the transformation of the economy, this form of alternative financing is essential.
“We can see from the P2P lending situation in countries like China and Indonesia in the past years that there are significant risks associated with this industry especially for less savvy investors who may be tempted by high returns. P2P lending offers a lot of promise when it comes to financing SMEs and bringing about greater financial inclusion, however there have been a multitude of instances where these platforms have defaulted on paying investors, are engaged in illegal activities or ponzi schemes. Left unchecked and unregulated, investors may end up suffering tremendous financial losses amounting to their entire life’s savings. In light of the above, sector regulation is both prudent and timely,” CEO of Singapore-based fintech firm 4xLabs Chris Vanden Berghe told KrASIA.
Regulating the sector is the first step towards providing better protection for investors as well as borrowers. With proper safeguards in place, the industry will continue to grow.