4. Efficiency of Bank Lending to SMEs
A well functioning financial system is a key enabler of economic growth. SMEs are an important part of New Zealand's economic growth and bank lending is the primary source of external finance for SMEs.24 Therefore, it is important that the banking sector responds efficiently and effectively to the needs of SMEs.
Popular opinion is not always complimentary in this regard. Branch closures, loss of regular contact with branch managers and other bank personnel, perceptions of high interest rates and fee charges25 and inability to obtain finance26 are from time to time raised as "evidence" that SMEs (and other customer groups) are not always well served by banks. A report prepared for the Ministry indicated that 23% of small firms considered access to finance (not just bank lending) a barrier to business development.27
Competition can usually be expected to deal with over-pricing and/or poor quality of service. New Zealand's banking market is generally perceived as being competitive reflecting the number of registered banks and the competition provided for certain products (especially mortgages) by other forms of providers (finance companies, savings institutions, insurance companies and so on).
The banking sector is, however, different in some respects from the markets for other goods and services. A range of factors, discussed below, could create potential sources of market failure even if there is strong competition between banks. Market failure, for the purposes of this study has been interpreted in a general sense to mean any situation where banks do not supply facilities to SMEs on competitive terms and conditions (including interest rates which reflect underlying risk). In more formal terms, use of the term market failure has been used primarily in the context of allocative efficiency.
Potential Sources of Market Failure
There are a number of features of lending generally which potentially could affect the efficiency of the market for lending even if the market is competitive. The relatively small size of SMEs means that, in theory, these features may have a disproportionately greater effect on the market for lending to SMEs.
Information Asymmetry
Information asymmetry refers to a situation where business owners or managers know more about the prospects for, and risks facing, their business, than do lenders. Where information asymmetries exists, theory predicts that lenders may respond by increasing lending margins to levels in excess of that which the inherent risks would require. Theory also suggests that banks may also curtail the extent of lending - credit rationing - even when the SME would have been willing to pay a fair risk-adjusted cost of capital. The implication of raising interest rates and/or curtailing lending is that firms will not be able to finance as many projects as otherwise would have been the case. In short, investment will be below the level that would have occurred had there not been information asymmetry.
In short, the more information that banks obtain about borrowers, the less they have to improve borrower incentives by setting loan contract terms (including, in particular, interest rates and collateral requirements).28 Investing in information is, however, costly. Investments in gathering and analysing information will only be made up to the point where benefits just offset the costs involved.
If the relatively small size of SMEs means that it is uneconomic for banks to invest time and resources in developing an in-depth understanding of each enterprise, then banks may lack the information to accurately gauge the level of risk involved in lending to SMEs. Information asymmetry may, therefore, be more acute in the case of SMEs.
Granularity
Where the risk grading system does not evidence enough ability to discriminate between good and bad risks (i.e. it lacks granularity), an outcome can be that the relationship between risk grade and pricing loses its predictive capability resulting in the bank experiencing losses outside the predicted parameters. The consequence of this can be a tightening in credit terms, or an increase in prices, or both.
From the borrower's perspective, this leads to an outcome where the bank is over-pricing good risks and under-pricing bad risks. In turn, this causes the bank to end up with a greater proportion of poorer quality loans on its books as better quality borrowers seek alternatives elsewhere. This outcome is referred to as the adverse selection problem.
Pecking Order
From a borrower's perspective, and following on from the last point, if faced with a cost of lending that is above the true risk-adjusted cost, the borrower will have incentives to seek out alternative sources of funding. There is considerable evidence in the literature that businesses in this situation will prefer to utilise retained earnings ahead of raising loans from banks29. This is referred to as the pecking order hypothesis.
Moral Hazard
Once loans are made to businesses, the owners of the business may have incentives to take higher risks than they otherwise would. This is because the owner of the firm benefits fully from any additional returns but does not suffer disproportionately if the firm is liquidated. This is referred to as the moral hazard problem. The problem is analogous to people taking greater risk once they have taken out an insurance policy. The moral hazard problem can be viewed as creating a situation of over-investment.
From a theoretical standpoint, the extent to which moral hazard gives rise to over-investment is not clearly established. For example, incentives for over-investment might be influenced by the legal form of the entity. Where the entity is a proprietorship or partnership and the liability of the owner(s) is unlimited, it can be argued that the owner(s) may be less prone to moral hazard because the owner(s) may suffer loss in event of liquidation.
It can also be argued that when banks lend to a firm, their monitoring of the firm helps to impose discipline in the firm and, in so doing, reduces the tendency within the firm to over-invest.
Other Considerations
The relative size of SMEs may affect the market for lending to them in other ways as well:
- Small enterprises may have little or no collateral to offer as security against a loan.
- Small enterprises may find it harder to switch banks. Any enterprise will apply a benefit cost test to determine whether it is worthwhile switching banks. One cost that would be considered is the fixed costs involved in switching. The smaller the business, the more significant these fixed costs are likely to be, and therefore it may be less likely that the benefits of switching outweigh the costs involved.
- The costs which banks face in overcoming the information asymmetry problem may be more of an obstacle to efficient lending when the value of the loans is relatively low. In short, no bank will devote the time and energy to a $30,000 loan that it will to a $30 million loan.
Is There a Problem in Practice?
For a number of reasons, there are no obvious signs of inefficiency in the market for lending to SMEs. This conclusion rests on a number of considerations, (a discussion on each follows), including:
- The supply of loans.
- The level of interest rates.
- The level of bad debts.
- The policies and procedures that the banks have put in place to deal with the information asymmetry and related issues.
Supply of Loans
In general, the banks have indicated that they are willing lenders to the SME sector because they perceive it as being profitable. Opinions varied between the banks, however, in terms of the extent to which they believe rewards adequately offset the risks involved and the profitability of the SME sector relative to other sectors.
We asked the banks about their growth in lending as one way of gaining insights to the availability of finance. Only three of the banks responded, of which two reported growth rates in line with the growth in nominal GDP and Gross Fixed Capital Formation over comparable periods. The other bank reported no growth, although this reflects the particular circumstances of that bank.
While it has not been within the study's terms of reference to assess access to lending from an SME perspective, two surveys suggest that this is not a major issue for SMEs.
In one of these, the National Bank Small Business survey, less than 2.5% of respondents believed access to finance was the biggest problem faced by SMEs. Access to finance was rated 11th of 15 problems faced by SMEs.
Source: Small Business Monitor, April 2003, National Bank of New Zealand
The other survey, undertaken for the Ministry, concluded that 4% of small firms in New Zealand consider that funding for borrowing is not available and 11% that loans were available only on "unacceptable" terms.30
The results from these surveys are not out of line with other evidence:
- Recent studies in the United Kingdom indicate that access to credit or finance was an issue for only 1%-3% of SMEs.31
- Australian surveys suggest that difficulties in obtaining credit have not been a primary concern since 1999.32
Bad Debts
We note that the level of bad debts associated with SME loans is very low. Of the four banks that provided data, the level of bad debts ranged from 0.2% to 0.4% of SME loan book value. This compares to a bad debt ratio of between (roughly) 0.1% and 0.3% across the main banks in relation to their overall loan book (i.e. all forms of lending)33.
Very low rates of bad debts could be interpreted as evidence that banks are restricting the availability of lending (although theory would suggest that credit rationing results in only the highest risks obtaining finance). A more likely explanation, however, it that the low bad debt rates reflect the favourable economic conditions which New Zealand has experienced in recent times. It may also reflect increased monitoring by banks of their SME loans (which may result in early detection of adverse trends on an account).
The fact that bad debts for SME loans appear to be slightly higher than is the case across all loans is consistent with comments made by some of the banks that there is a higher risk of default in the SME sector.
Cost of Lending
Although the information provided relating to margins is relatively limited in scope, on the face of it there would not appear to be major issues in terms of the margins that SMEs have to pay for bank finance. Points to note in support of this conclusion include:
- The majority of SME loans are backed by residential property and standard home loan margins apply.
- Where SMEs are backed by other forms of collateral, the margins do not appear to be excessively above those for large businesses.
- Margins for SME loans compare favourably with those in Australia as summarised below.
Banks' Indicator Lending Rates for Small Businesses in Australia (February 2002)
| Residential secured: | % |
| 2.55 |
| 2.00 |
| Other security: | |
| 3.25 |
| 2.60 |
Source: Reserve Bank of Australia (2002) "Recent Developments in Small Business Finance" RBA Bulletin
- Internationally, margins in New Zealand for bank lending to businesses (small and large) compare favourably with other developed countries.
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Source: KPMG Financial Institutions Surveys, 1998-2003
Policies and Processes for Managing Information Asymmetry and Moral Hazard
Further reasons for concluding that the efficiency of the market is not, in general, adversely impacted by information asymmetry and related issues stem from the policies and processes which the banks have in place for dealing with these issues.
The most obvious of these is the role of risk grading as discussed above. Other steps taken by the banks also assist in addressing information asymmetry and moral hazard issues.
Collateral
Banks look for two sources of repayment as noted earlier. The fact that almost all SME loans are backed by some form of collateral (usually in the form of property) in our view is the single most important factor beyond risk grading that the banks rely upon to deal with information asymmetry and agency costs.
The existence of collateral means that banks do not have to rely as much as they otherwise would on detailed investigation and analysis of the borrower's business. At one level, collateral can be viewed as a relatively efficient form of insurance for banks. But at a more fundamental level, collateral serves as an important incentive acting upon borrowers to avoid defaulting on loans and as a means by which borrowers can signal their creditworthiness to lenders.
In situations where the owner of a SME is willing to offer the family home as security against the loan, it is reasonable to argue that the incentives on the owner to avoid default will be relatively strong. Collateral assists with agency issues in this regard.
Collateral also provides a useful signalling device. A borrower's willingness to accept a collateralised loan contract offering lower interest (relative to unsecured loans) will be inversely related to its default risk.34
The importance of collateral does, however, depend on other factors. As a generalisation, collateral is more important when one or more of the following conditions apply:
- The business is small. Larger firms generally have other attributes that diminish the need for collateral such as strong cash flow, credit rating etc.
- The enterprise has only been in business a short time (or is a start-up business). In this situation, the banks have less track record to call upon to inform their lending decision.
- The borrower does not have an established relationship with the bank. Reputation and character are important variables in the lending decision.
While collateral is a key tool for dealing with the implications of information asymmetry and moral hazard, it is possible that the incentives it creates are something of a "double-edged sword". The emphasis on collateral, particularly where this involves residential property, could be argued to create an environment that discourages risk taking.
As noted earlier, the incentives to avoid the risk of default are likely to be stronger where the family home is used to obtain business finance. To the extent that taking risks is an important part of business and, moreover, growing businesses, factors that impede risk taking might not always be a good thing.
This study has not interviewed or assessed small businesses and so it is not possible to conclude whether this is an issue in practice.
Relationships
The length of relationship between the bank and its SME customers is also an important factor in reducing information asymmetry. Each time a loan contract is renewed, the renewal acts as an acknowledgement of the firm's ability to meet its debt obligation. An established relationship helps to create economies of scale in information production.35
We asked the banks for an estimate of the average length of their relationship with SMEs. While there were only 2 responses to these, both were significant; in one case an average of 8.5 years and in the other, an average of 11 years.
Relationships of this duration allow the banks to build up a good picture of the firm, the industry within which it operates and the calibre of the people running the business. The closer the relationship, the better the signals banks receive concerning managerial attributes and business prospects.
In this context, we note the trends discussed in the context of monitoring and relationship management and, in particular, the indicators that point toward renewed focus on relationship management.
Quality of Information
Accurate risk assessments obviously rely upon good information regarding the SME and its prospects. We noted earlier that the quality of information provided to banks varies markedly. It is worth noting, however, that the banks are making efforts to encourage SMEs to improve the quality of information provided (but we do not have data to ascertain the degree of success in this regard).
The banks do not see it as their role to directly provide business advisory services to SME clients. However, a number of banks commented to us that they will readily suggest that their client obtain professional advice and, in some cases, will point the client to specific advisers.
Customer Considerations
The efficiency with which markets operate depends, in part, on the extent to which customers can influence the price and other terms of trade. In this regard, a significant incentive for efficiency comes from the threat of losing customers to competitors.
The SME market is somewhat different to the corporate market in that corporate customers generally have a wide range of financing options to choose from and are not as dependent on bank financing as is the case for SMEs.
The extent to which SMEs can easily switch to another bank is another factor that can influence the level of competitive pressure on banks. Evidence suggests, however, that switching between banks by customers is not a widespread phenomenon. One study36 estimates that less than 5% of business customers switch banks annually although the point is made that once the customer has switched banks, they are unlikely to return.
During the course of interviews with the banks, the point was made that customer migration is a more prevalent form of customer response. That is, customers will tend to seek out facilities from a competing bank without necessarily terminating the relationship with their existing bank.
This is an area that could be worth further investigation as the extent to which customers are "locked" into an existing bank relationship could give rise to a "dual" market in which loan terms and conditions are less favourable for existing customers relative to new customers.
Regulatory Issues
In addition to considering issues surrounding information asymmetry and related issues, consideration has also been given to the regulatory environment for banks and the implications this has for the efficiency of lending to SMEs.
In brief, the view of banks is that the regulatory environment they have to operate under is not imposing any undue impediment to lending to SMEs. All banks noted, however, that their SME clients face a wide range of compliance costs under various Acts and regulations (e.g. RMA, GST, ACC).
Reserve Bank of New Zealand Act 1989
Banks are subject to the regulations under, and the requirements of, the Reserve Bank of New Zealand Act 1989. The Act is a key part of the regulatory environment for banks. None of the banks regard the Act, or regulations, as being impediments to their lending to the SME sector. Accordingly, we have not focused any further on this legislation.
Personal Property Securities Act 1999
The Act provides for the:
- creation and enforceability of security interests in personal property;
- determination of priority between security interests in the same personal property;
- determination of priority between security interests and other types of interests in the same personal property;
- enforcement of security interests in personal property other than consumer goods; and
- establishment of a register of security interests in personal property.
Potentially, this Act could have implications on banks' in respect of the security or collateral they are willing to accept. Incorporated within the Personal Property Securities Act is the concept of a Purchased Money Security Interest (PMSI).
A holder of a registered PMSI (a seller of goods or a lender if the loan proceeds are used to purchase specific collateral from a third party) is granted priority over the bank for claims on the security covered by the PMSI, assuming certain conditions are met. The priority exists not only over the specified collateral, but if the collateral is used to create a good or on-sold, then the finished product or proceeds from sale can be attributed to the PMSI holder, assuming the original collateral can be traced through. Consequently, the presence of registered PMSIs can affect the banks' priority over stock and debtors.
Discussions with the banks suggested that in general the Act has not adversely impacted upon the way banks do business. Many of the banks already heavily discount stock and debtors anyway (often up to 50%) and special purpose assets, when assessing the value of such security. Only one of the banks noted a "slight" reduction in credit availability to SMEs due to the risk of not being able to realise security in the event of liquidation.
The Act was seen by some banks to be beneficial as it enhances the transparency of outstanding claims on borrowers' assets (and so reduces information asymmetry). With the requirement to register, banks have the ability to (and do) monitor claims made on the security.
Basel II
Under the 1988 Basel Accord, capital requirements for credit risk were based on broad classes of asset with no differentiation for the risk of the asset in question. The new Accord (Basel II) aims to align regulatory capital more closely with risk with the implication that lending to lower risk borrowers will attract lower capital requirements.
Basel II sets out two different methods for measuring credit risk. A standardised approach, which has only limited sensitivity to risk and which, broadly speaking, reflects the current (Basel I) approach. The other approach - internal rating based approach or IRB - is more sophisticated and involves banks calculating capital requirements according to their internal assessment of the risk on each loan.37
Those banks that adopt the IRB approach will be required to maintain detailed statistics on a far more detailed basis than is required under current capital adequacy regulations. The banks' performance in credit risk management in terms of processes, data and statistics collected, as well as actual experience, will drive the minimum capital requirements for each bank.
Implications
In general, those banks that have sophisticated risk measurement techniques will have lower minimum capital requirements. Potentially, therefore, there may be scope for increasing the supply of lending to SMEs and/or reduction in margins (as banks more closely align interest rates with economic cost). Those banks which successfully employ the IRB approach should, in theory, be better placed to avoid over-pricing good risks and under-pricing bad risks. It follows that there may, therefore, be some migration of higher risk SME loans to those banks which do not adopt the IRB approach and which, by implication, rely on less sophisticated and more standardised measures of risk.
The extent to which the introduction of Basel II has an impact in lending to SMEs remains to be seen. The issue was not discussed at any length by the banks during the course of interviews and the impression gained was that the potential impact is perceived by the banks as being small.
One possible explanation for this is that the Reserve Bank has signalled that for regulatory purposes, banks will be required to report and hold capital as if using the standardised approach under Basel II (which is broadly comparable with existing regulatory requirements). Thus, from a regulatory perspective little change in mandatory capital requirements is anticipated. In this regard, Basel II is not seen as being an impediment to lending.
A further explanation may be that it is simply too early to know what the impact of Basel II may be. Work is continuing on establishing the relationship between the probability of default and the amount of capital that a bank must hold under the IRB approach. The latest Basel II proposals are being tested involving banks from a large number of countries. The results of these tests are being incorporated into a further round of consultation. Finalisation of the new Basel Accord is still some months away.
A third possible explanation is that the major banks consider that they are pricing SME loans according to the true risk of exposure anyway. Therefore, any enhanced sensitivity of regulatory capital requirements to risk may be doing nothing more than aligning the regulatory environment with current practice.
In summary, the introduction of Basel II is not being perceived by the banks as an impediment to lending to SMEs (or other customer groups) and, indeed, may be being perceived as ratifying current practice. In any event, Basel II should be viewed as a positive development from SMEs' perspective since it promotes the alignment of interest rates with true economic cost.
Consumer Credit Review
There is the prospect of replacing the Credit Contracts Act and the Hire Purchase Act with new legislation the aim of which is to ensure that financiers and consumers are treated fairly, and that the law is reflective of modern credit practices.
As currently drafted, the new legislation is not applicable to business borrowers.
As a generalisation, many small business proprietors would be considered to be unsophisticated borrowers, and would be likely to require as much protection as consumers. We understand that the Ministry of Economic Development has been tasked to look at whether specific legislation is required for this sector.
Only one bank mentioned the changes during our interviews. Possibly this might reflect an expectation by the banks that there will not be legislation specific to SMEs.
Start-Up SMEs and SMEs Based Around Intellectual Property
While the foregoing suggests that the potential for "market failure" is not a major issue in the context of SME lending, it is clear from discussions with the banks that not all SMEs have good access to bank lending. In particular, the banks have indicated that they either do not, or are unwilling to, lend to start-up SMEs and SMEs where the only asset or collateral is intellectual property (IP).
Start-Ups
Banks will lend to start-ups only if there is guaranteed or likely cash flow and sufficient collateral (such as a residential property) backing the loan. Their reluctance to lend reflects the following:
- The banks do not regard it as their role to fund start up ventures. In large part, the basis for this view stems from concerns about risk and, in turn, the responsibilities of banks toward their shareholders, providers of debt capital and regulators.
- There is a perception by the banks that a high proportion of small businesses fail within a few years of starting operations. Several banks commented to us that they do not perceive the SME sector as being unduly risky. Such views would be consistent with policies that focus lending to SMEs on those businesses that have already established themselves.
- It is often difficult for start-ups to satisfy bank requirements in terms of demonstrating experience in industry, meeting minimum equity levels, and having in place contracts for sales to support business plans.
- Personnel with specialist skill sets are sometimes necessary to understand the risks inherent with particular start up ventures. The banks do not necessarily have such staff.
There are some forms of start-up that will attract bank lending. Start-ups that are franchisees may be more readily financed by banks depending on the level of support given to the franchisee by the franchiser. Comments were made by a number of banks that there is a strong appetite for lending to franchises.
IPSMEs
Apart from the lack of collateral issue, banks are also unwilling to lend to IP-based enterprises because they traditionally do not have employees with the necessary skill sets to assess the likelihood of success or failure of highly specialised new ventures. Such ventures are often based on the perceived value of intellectual property and market potential in new products, and require specialist skills and a deep understanding of industry specifics to form a sound view of the venture's prospects. Further, IP businesses often are characterised as selling products that have little or no track record, are largely untested in markets and are usually subject to high obsolescence rates.
Consequently, there is a distinct reluctance by banks to lend to ventures that are exposed to risks not understood by the banks employees, or that undertake operations that are exceptionally risky. Five of the seven banks observed that it is "not the banks role" to finance start-ups or the IP market.
Pecking Order Considerations
Theory suggests that where information asymmetry and moral hazard are prevalent, firms are likely to fund themselves firstly from retained earnings and then from bank debt rather than issuing equity. Based on the information provided by the banks, this would seem to be borne out in practice.
IP and start-up SMEs present a slightly different problem in that often there are little or no retained earnings available for finance. As discussed above, bank lending is unlikely to be forthcoming for these types of firm. The pecking order hypothesis suggests that bank lending may not in fact be the right sort of product for these types of firms where the problems, from a bank perspective, of information asymmetry and moral hazard are particularly acute.
There is theoretical and empirical support38 for the idea that equity is the preferred form of funding for IP-based businesses, particularly those that are in start-up phase. The underlying logic for this is that certain categories of equity investors - venture capitalists - may in fact have better information than either the business or bank about the prospects for the firm. This might be because the venture capitalist knows more about the market that the firm is trying to enter than does the firm itself. Particular forms of equity such as preferred and/or convertible stock might on theoretical grounds at least be a much better form of finance for IP/start-up SMEs than is bank lending.
It has not been within the scope of this study to investigate the supply of venture capital in the New Zealand market and we note that considerable work has already been undertaken in this regard.
Summary
Several theoretical considerations raise the possibility that the market for bank lending may have a degree of inefficiency even though the banking market in New Zealand is generally regarded as being competitive. Key among the issues is information asymmetry.
The small size of SMEs means that the information asymmetry problem may be more acute for this segment of the market.
In practice, the banks deploy a range of policies and processes for dealing with information asymmetry and related issues. In the SME market, the use of collateral is a particularly important feature in this regard. This feature, coupled with observations regarding the supply of loans and margins charged suggest that the market for SME loans is working efficiently.
Further, the regulatory environment for banks is not perceived by the banks as having major adverse implications for the efficiency of bank lending to SMEs. The impending implementation of Basel II, to the extent that this will impact upon the SME market, is likely to have beneficial effects as a result of further aligning interest rates with true economic cost.
Notwithstanding these general conclusions, it is clear that there are some specific segments of the SME market where banks are reluctant to provide loans. Specifically, start-up SMEs that lack collateral and SMEs that are based around intellectual property present interesting challenges that make bank lending a relatively inefficient source of finance. Both theory and practice would appear to suggest that other forms of finance are to be preferred ahead of bank lending. It is important to emphasise, however, that this is not due to inefficiency on the market for bank lending.
It has been beyond the scope of this study to investigate the supply of other forms of finance (including, for example, venture capital) to SMEs, but this is an area that the Ministry may wish to consider further.
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