New independent evaluation exposes World Bank’s flawed approach towards SMEs

The World Bank Independent Evaluation Group (IEG), the World Bank’s own internal watchdog, published an evaluation last month which assesses the World Bank Group’s targeted support to Small and Medium-Size Enterprises (SMEs) for the period 2006-2012. The findings of the IEG report point to serious failures in the current International Finance Corporation approach towards targeting SMEs and echo Eurodad and partners’ concerns about lack of development focus and the secrecy surrounding its financial intermediary lending. 

The World Bank Group (WBG) promotes SME growth through both systemic and targeted interventions. However, the IEG report focuses only on the activities specifically targeted at SMEs, which excludes a large part of both the World Bank and International Finance Corporation (IFC) portfolios that are aimed at systemic improvements in key areas, such as macroeconomic stability, infrastructure and education. For this review, the IEG assesses relevance, efficacy, efficiency and work quality of three organisations of the Group: the IFC, which lends to private sector, the Multilateral Investment Guarantee Agency (MIGA), the arm offering guarantees to investors and lenders, and the World Bank. The latter comprises the International Bank for Reconstruction and Development (IBRD), which lends to governments, and the International Development Association (IDA), which provides soft loans and grants to the poorest countries.  

According to the IEG, “targeted SME support is a big business for the World Bank Group.” It comprises a significant part of the Bank Group’s portfolio, averaging around US$3 billion a year in commitments, and 7 per cent of projects over the period 2006-12. For the IFC these interventions represent US$10.5 billion in investment commitments, which accounts for 16 per cent of total portfolio value during the same period. However, according to the evaluation, “the current portfolio [of the World Bank Group] does not consistently reflect a clear and strategic view of which firms should be targeted, why, and for which services, or of how serving them promotes market development to sustainably meet their demand.”  

Why, how and where the IFC targets SMEs 

The IEG report is particularly relevant for the analysis of the IFC, given its current strategic objectives. As the IEG report states, one of the five IFC’s strategic focus areas is “developing local financial markets through institutions building, the use of innovative financial products, and mobilisation, focusing on micro, small and medium enterprises.” This focus is based on SME’s potential for job creation, particularly in low and middle income countries. In addition, the IFC also claims that “working through financial intermediaries allows IFC to support far more micro, small and medium enterprises than it would be able to do on its own,” thus the reason for the massive increase in its financial intermediary lending, which today accounts for more than 50 percent of IFC investments. 

Since the IFC has no retail outlets, going through a “middleman” is often the only way to engage with and target SMEs. These institutions receive funding mainly through loans and equity investments, and subsequently lend to SMEs. In addition, they receive technical assistance, which the IFC believes will develop the capacity of the financial sector in “frontier states” where SMEs face limited access to credit. 

When it comes to analysing the IFC’s portfolio, there are three main findings that are striking: 

  • 74 per cent of net commitments for targeted SME support were indirect, that is, through financial institutions such as banks, funds and risk guarantee facilities; 
  • 97 per cent of total value of commitments was focused on the financial markets industry group;
  • 51 per cent of commitments were in upper-middle-income countries while less than 7 per cent were in low-income countries. 

Based on these figures, the IEG echoes civil society concerns and challenges the relevance of the IFC’s current portfolio and its efficiency as it does not seem to fit for development purposes. In IEG’s own words “the heavy emphasis on on-lending in high and upper-middle-income countries seems to be in direct contravention to the logic of using resources to redress poorly developed capital markets.” The report further warns against the risk of crowding out private sources of capital “in reasonably functioning financial markets” and of distorting the market by offering terms that are often better than those prevailing in local markets, thus “subsidise favoured partners or clients.” The IEG therefore calls on the IFC to focus on developing the financial sector in those regions where it is the weakest and in need of credit supply for SMEs. 

Unclear definitions and targets: who benefits? 

The IEG report casts serious doubts on how effective the IFC model is to target SMEs by unveiling key problems on how their interventions are designed and implemented. This is not new for civil society groups, including Eurodad and CAFOD, who have challenged the IFC approach to SMEs, starting from its definition of the target group. 

Although there is no one, universally accepted definition of what constitutes a “small business”, how it is defined is key for a relevant and pro-poor intervention. The IEG also confirms this, stating that “projects should be relevant to the defined beneficiaries and connected to some defined challenge they are seeking to resolve.” 

Whereas the IFC has its own definition for what constitutes an SME – a registered business with 10–300 employees and assets or annual sales between US$100,000 and US$15 million – it is highly controversial. The IEG itself acknowledges “that standard has questionable relevance in some country contexts” and “whether or not the standard is ideal, IEG’s review finds that it is generally not applied.” In practice, “only a minority of projects define SME, and fewer still apply that definition through their provisions. A minority identifies the market or policy failure they are seeking to address, and a smaller minority provides a solid rationale for how the project will ameliorate that failure.” In fact, what is considered is the size of the loan or investment made, which is also problematic (in some countries a loan up to US$2 million still counts as an SME loan). As the report “Out of sight, out of mind?”, written by Eurodad partner Bretton Woods Project, argues, “though the size of loans and the size of the company are potentially related, there is no predefined relationship between the two.”  

The report finds the following:  

  • Less than half of the 384 targeted projects’ legal agreements defined SMEs, specified eligible sub borrowers as SMEs, or mentioned SMEs in the loan provision. 
  • A review of 250 Board documents of target SMEs investment projects finds that 82 per cent contained no definition of SME; 
  • A review of 166 IFC investment projects that target SMEs through financial intermediaries shows that only 20 per cent of the projects define SMEs and have provisions mentioning SMEs as beneficiaries. 

As the IEG report clearly says “failing to define SMEs or add specific provisions can increase the risk that clients do not adhere to the intention of projects, whereas specificity can strengthen the focus of lending on SMEs”. Therefore it is fair to question whether the IFC is effectively targeting the intended beneficiary or even who is benefiting from these interventions. 

Poor efficacy and serious lack of transparency 

Another critical point to consider is how effective the IFC is in their interventions when targeting SMEs. Here the IEG finds that “targeted SME projects generally had a lower [development outcome] rating than the overall portfolio and a lower rating that the rest of the financial markets portfolio,” although effectiveness varies substantially depending on product line, industry group and the type of country. Also problematic is the finding of the review of 82 IFC investment projects that sought to support SME through financial intermediaries. According to the IEG, “of these, around 40 per cent did not meet SME financing targets.” One of the reasons identified for this, is the “financial intermediary changing its strategy,” particularly in the case of banks. In addition, the IEG finds “problematic in gauging efficacy” the “secrecy surrounding the clients of banks supported by the IFC.” This echoes civil society concerns on this issue, as “it is, therefore, unclear what impact these investments are having at the firm level.” 

On top of this and despite the IFC’s general emphasis on the job creation potential of SMEs, the evaluation finds that “the degree to which IFC financing of intermediaries results in employment creation, poverty alleviation, or even SME investment goes unrecorded”. It is worrying that throughout the evaluation period the “IFC neither demanded nor received any information from financial intermediaries about their clients’ level of employment and investments.” 

The IFC generally claims that it cannot get more information due to the commercial sensitivity surrounding banks or private equity funds. In general, they are very reluctant to disclose disaggregated data on which projects they are investing in or which SMEs they supporting. However, according to the IEG “it is possible to gather such information” and the “IFC needs to know much more about what is done with such funds.” CSOs have also been pushing the IFC strongly on this front, particularly after the IFC’s Compliance Advisor Ombudsman (CAO) report on environmental and social impacts of investments in the financial sector. If the IFC cannot fully collect all necessary information from its clients, it cannot know if its interventions are actually working or not, nor can it guarantee that these interventions do not contribute to social and environmental violations. Unless this trend does not shift dramatically, there is no reason to believe that cases similar to the Dinant Corporation in Honduras will not repeat itself.

What’s next for the IFC? 

The IEG report makes clear recommendations and states that “the objective is not to benefit SMEs as an end in itself, but to create economics that can employ more people can create more opportunity.” These recommendations include: clarify the approach “to make clear the objectives and analytic justification for targeted SME support, how it relates to systemic reform, where it is appropriate, what main forms it will take, and how it will be monitored and evaluated;” and enhance relevance and additionality, which implies an important shift from better-served firms and markets to frontier states, frontier regions, and underserved segments.

The IEG also stresses the need for a meaningful definition of SMEs in order to target firms that experience special needs or contribute specially to the economy or the poor. As it stands the IFC definition does not reflect the reality of most developing countries and particularly low income countries, as both the upper and the lower limits of it look too high for some of them. 

Finally, it is relevant to note that financial services, and particularly access to credit, is just one of the many systemic needs that SMEs experience on the ground. According to CAFOD’s ground-breaking report “Thinking small”, other key priorities include infrastructure and services, demand, human capital and risk, stability and vulnerability, and all of them need proactive, targeting, comprehensive and locally appropriate interventions. Therefore, an excessive focus on financial services might lead to a biased approach in itself. 

If the IFC is to be considered as a true development actor, it should substantially review its approach towards the financial sector in general and SMEs in particular. As a public institution with a development mandate that aims to be the lead institution in financing the private sector, anything less should be deemed as institutional failure.