Finance for Small and Medium-Sized Enterprises - DTI Home Page

More documents

Recommendations

Info

Finance for Small and Medium-Sized Enterprises: A Report on the 2004 UK Survey of SME Finances I. BACKGROUND 1. ISSUES AFFECTING SME FINANCES 1.1 Potential market failure in SME finance markets Policy-makers have, for a long-time, voiced concern about poor access to external finance, among smaller firms, due to a market failure in credit markets (Bolton, 1971; Wilson, 1979; Graham, 2004). In short, this market failure means that some businesses with viable propositions are unable to access any, or sufficient, external finance. Analysis of the cause of this market failure has been at the core of financial research for over 20 years. Fundamentally, the problem arises because lenders are imperfectly informed about the characteristics of potential borrowers (asymmetric information). It may be impossible, as a result, for lenders to distinguish ‘good’ borrowers from ‘bad’ ones. 5 In these circumstances, using the price mechanism to allocate funds does not work since, from the lender’s perspective, it selects the wrong sort of borrower. Indeed, it may be more profitable for the lender to supply fewer loans, at a lower interest rate, than raise the interest rate to clear the market. However, as a consequence, some would-be borrowers, who are willing to pay a market rate of interest, are denied credit. This will impinge on some good borrowers unless, by some fluke, they access all the available funds. The problem of information asymmetries highlights the importance of relationships between lenders and borrowers. Longer and broader relationships increase the amount and flow of information to lenders, enabling good borrowers to obtain better access to finance over time. Riskier businesses may, on the other hand, prefer shorter relationships in order to hide their true nature. In the above scenario, some good borrowers, without a transactions history, will go without loans due to the failure of the price mechanism to allocate loans efficiently. However, the terms of a loan contract usually include more than just an interest payment. In reality, lenders can offer a menu of terms; and the terms which the borrower selects reveal the quality of the business (Bester, 1985). 6 For example, assuming collateral is available, good borrowers could signal their quality by takingup a secured loan, in return for a lower interest margin. In contrast, poorer businesses would probably prefer to pay a higher margin on an unsecured loan since they know they are likely to fail and hence lose their collateral. Despite the roles of relationships with lenders and collateral in improving access to finance, it remains a possibility that good borrowers with no transactions history or tangible assets could go unfunded. Indeed, public loan guarantee schemes, such as 5 By ‘bad’ we simply mean these businesses have a high likelihood of default on the loan – it does not imply these businesses are morally deficient, anymore than ‘good’ conveys virtue (over and above being able to make re-payments). 6 This is known in the economics literature as ‘sorting by private information’. Alternatively, if information asymmetries are not severe, then lenders will require high observed risk borrowers to pledge collateral (‘sorting by observed risk’ – Berger and Udell, 1990) 27
Finance for Small and Medium-Sized Enterprises: A Report on the 2004 UK Survey of SME Finances the SFLG in the UK, are based on the rationale that good businesses may go unfunded due to a lack of security or track-record. 7 The current state of SME finance markets In practical terms, it is questionable whether accessing debt finance remains a real concern for most businesses. A recent report by the Institute of Directors found that 71% of businesses did not think it was difficult to access finance (Wilson, 2004). In another report only 1% of small firms reported access to, or the cost of, finance as their main problem (NatWest/SBRT, 2003). Looking ahead to section 2, SMEF also places financial problems far down the pecking order of business problems. In a similar vein, the Small Business Omnibus Surveys shows businesses, reporting access to finance as a barrier to growth, falling from 6% (Summer, 2001) to 1% (Autumn, 2002) (SBS, 2001, 2002). Another study reports that, among businesses which did not seek new finance, 85% had no need for external finance because their internal cashflows were sufficient (Cosh and Hughes, 2003). This suggests that constraints on the supply of debt finance are not a major problem. This array of evidence sets a scene in contrast to the dark days following the recession in the early 1990s. At that time, a combination of poor communications and mistrust between lenders and small businesses led to widespread fears of a credit-crunch (Bank of England, 1994). In part, the improvement in accessing finance over the last decade may be due to changes in methods of credit assessment which have improved the ability of lenders to determine the risk of prospective borrowers. 8 Notably these assessments rely less on bank manager’s judgments and more on quantitative evaluations of business-owner characteristics and recent cash flows. As a result, most loans below £30,000 are now allocated by credit scoring and do not depend on whether the applicant is able to post security (Graham, 2004). Nonetheless, the possibility remains that good businesses, without a track record or with nonstandard characteristics, may find themselves with insufficient funds. Indeed, on larger loans, collateral remains a pre-requisite for obtaining funds. The UK government therefore continues to support small business lending, in particular for start-ups and high growth businesses, through the SFLG (Graham, 2004). Also, improving access to finance among ‘disadvantaged and under-represented’ groups, such as female and ethnic-minority businesses, is squarely on the current policy agenda. Assessing the evidence for market failure with SMEF data On the surface, looking at credit denial rates provides a direct indication of the extent of unsatisfied demand. However, since both good and bad types of business may be denied credit, such a figure provides, at best, an upper bound on the extent to which good projects are going unfunded. 9 Indeed, it is arguable that experienced lenders are 7 The problem of information asymmetries will diminish if the business is able to demonstrate objectively its past performance thereby helping the lender to predict future performances. 8 For the role of changes in the macroeconomic environment see Bank of England (2004). 9 This approach also ignores the contribution from groups of individuals who are discouraged from seeking finance because they anticipate rejection, making it not worth the effort to apply in the first place (Kon and Storey, 2003). In the presence of information asymmetries it is good borrowers who 28
Page 1 and 2: Finance for Small and Medium-Sized
Page 27: Finance for Small and Medium-Sized
Page 79 and 80:
Finance for Small and Medium-Sized
Page 81 and 82:
Page 83 and 84:
Page 85 and 86:
Page 87 and 88:
Page 89 and 90:
Page 91 and 92:
Page 93 and 94:
Page 95 and 96:
Page 97 and 98:
Page 99 and 100:
Page 101 and 102:
Page 103 and 104:
Page 105 and 106:
Page 107 and 108:
Page 109 and 110:
Page 111 and 112:
Page 113 and 114:
Page 115 and 116:
Page 117 and 118:
Page 119 and 120:
Page 121 and 122:
Page 123 and 124:
Page 125 and 126:
Page 127 and 128:
Page 129 and 130:
Page 131 and 132:
Page 133 and 134:
Page 135 and 136:
Page 137 and 138:
Page 139:
show all

Finance for Small and Medium-Sized Enterprises - DTI Home Page

Create successful ePaper yourself

Delete template?

Save as template?