Working Capital Financing and the Canada Small Business Financing (CSBF) Program
Phase I: Review of the Literature
Overview of the Current Context for SME Borrowing
Commercial loans are the primary source of external capital for Canadian SMEs with the stock of commercial loans outstanding in Canada exceeding $350 billion. According to the 2003 and 2004 FDI Surveys of Suppliers of Business Financing, commercial lenders (banks, credit unions, and caisses populaires) had collectively authorized a total of $61.8 billion (2003) and $60.1 billion (2004) in lending facilities of less than $250,000. Of these amounts, $38.1 billion (2003) and $36.2 billion (2004) were outstanding, representing aggregated draw downs of 61.6 percent (2003) and 60.2 percent (2004). The CFIB (2003) notes that there has been a long-term decrease in the proportion of Canadian small firms that have sought external financing. According to their surveys, 60 percent of their members sought bank financing during the 2000-2003 period, whereas the corresponding proportion for the 1984-1987 period was 73 percent.
In 2002 the Canadian Federation of Independent Business, the Canadian Manufacturers & Exporters Association and RBC Financial Group collaborated to publish The Path to Prosperity: Canada's Small- and Medium-sized Enterprises. Among other things, this work compared lending experiences of Canadian businesses with those of counterpart firms in other countries, with a particular emphasis on the US.Footnote 3 The findings of this study are instructive, with their overall conclusion that “the [Canadian financial services] industry is a world leader on multiple measures of access to business financing and pricing,” and (p. 20):
Overall, the record of the Canadian financial services industry compares much more favourably than the U.S. industry on access to traditional loan products, their pricing and associated fees.
Particular findings of the study included (pp. 20-22):
… there exists a broad array of providers within Canada such as banks, credit unions, leasing companies, insurance companies, pension funds and government-sponsored lenders.
… the spread between typical lending and deposit rates in Canada is the fourth lowest among 75 countries. The United Kingdom, United States, Germany, Italy, France … have higher spreads [and] … the spread between rates charged for loans to all size classes of borrower, but especially to smaller borrowers, is far narrower in Canada than in the United States. Canadian businesses and SMEs in particular get a far better deal on financing costs than U.S. businesses at U.S. banks.
A basket of typical retail bank fees for small businesses in Canada are much lower than in the United States at virtually any modestly reasonable exchange rate assumption.
The Path to Prosperity noted (p. 20) that while there remains room for improvement “Canadian businesses … get a far better deal on financing costs that U.S. businesses at U.S. banks” and that (p. 21) “[t]his better deal on financing charges … does not come at the expense of refusing to grant credit.” The Path to Prosperity … findings suggest that the Canadian banking system may provide Canadian businesses with a competitive advantage with respect to foreign (especially US) counterparts despite “misperceptions that have been created in recent years (p. 20).”
Conversely, the CFIB (2003, p. 5) notes that Canadian SMEs have a very different perception of the banks, that (p. 9) “poor service quality, lack of credit availability, and unfair service charge practices were the most frequently cited reasons by small businesses for switching banks.” The CFIB (2003, p. 10) also notes that operating lines of credit – the type of facility most frequently employed to financing working capital – are important to Canadian SMEs, such that approximately twice as many SMEs maintain an operating loan facility than a term loan.Footnote 4 The CFIB also maintains – based on surveys of its members – that “it is the young, high performing businesses that are experiencing the greatest difficulty in obtaining financing from financial institutions” (Bruce, 2001, p. (i)).
The role of working capital was specifically addressed only in Manufacturing 20/20 (2005). As context, financing was not among the “top ten strategic challenges” cited by Canadian manufacturers (Manufacturing 20/20, Table 2). It was ranked as the 12th among 20 “key factors affecting innovation” (Manufacturing 20/20, Table 3) and 10th among 20 concerns with respect to bringing new products to market. Within that framework, however, obtaining working capital was the most-frequently cited among “difficulties obtaining financing” (mentioned by 18 percent of respondents, Manufacturing 20/20, Table 19).
Further confounding the debate is the question of whether debt financing is the appropriate form of financing for some firms. For example, MacIntosh (1994) and Black and Gilson (1998) both advocate that equity financing is, in many instances, a more suitable source of financial capital than debt. This is because debt increases the systematic risk of firms that are already subject to relatively high levels of uncertainty and business risk stemming from the commercialization potential of the innovation, risk of obsolescence, the need for future injections of staged financing, etc. The higher systematic risk makes borrower firms yet more vulnerable to economic downturns.
There are trends in the credit market worth noting. First, many commercial lenders treat small loans as if they were personal loans to the owner(s) of the business. Second, such loans are increasingly adjudicated through credit scoring methods. Third, lenders often require security either in the form of collateralizable assets of the business or its owners or risk mitigation from programs such as the Canada Small Business Financing program.
Looking forward, the implementation of Basel II also holds potential implications for commercial loans to small firms.Footnote 5 First, Basel II defines SMEs as businesses with sales up to $US65 million and loans of less than $US20 million. Loans to smaller businesses require less regulatory capital being allocated to them while loans to larger businesses require more capital. As noted in The Path to Prosperity … (p. 21), this will place an increased regulatory burden for bank lenders because they will have to track sales size and tie it to authorizations.
Second, Basel II requires loans be rated as to risk. While most Canadian banks evaluate SME riskiness, it appears likely that this will provide further impetus to credit scoring approaches.
Third, The Path to Prosperity … ( p. 21) observes that:
The fact that a size threshold exists that trips different capital requirements and, hence, opportunity costs of capital allocated by banks and how such loans are priced means that an artificial barrier to growth may exist for firms just beyond the size threshold criteria. Allocated capital across the size threshold will jump in discrete fashion, but the lending risks do not; SMEs will, therefore, likely have to develop more detailed documentation on their markets, potential, systems of control and strategies to provide lending institutions required information.
Jacobson et al examine the risk associated with retail and SME credit (R&SME) because of the differing bank capital requirements for these loans under Basel II. These loans are regarded as relatively less risky, and receive favourable capital treatment because of their supposedly smaller exposure to systemic risk. Their findings show that R&SME portfolios are usually riskier than corporate credit and accordingly, that special treatment under Basel II is not justified. Their results are consistent with those of Dietsch and Petey (2004) who find that on average, SMEs are riskier than large businesses and that although asset correlations in the SME population are very weak (1–3% on average) and decrease with size. On average, the correlations are not negative, as assumed by Basel II, but positive, especially at the industry level.
Review of Academic Studies
According to the OECD (2006) a credit market gap exists if:
- among loan applicants who appear to be identical some receive credit while others do not; or,
- there are identifiable groups in the population that are unable to obtain financing at any price.
This work focuses on the second of these definitions of a gap. The work seeks to determine if firms seeking working capital financing are disadvantaged with respect to access to commercial loans.On Gaps in the Capital Markets
Many of the public policy issues related to the financing of SMEs revolve around the concept of “gaps” in financial marketplaces. However, the word “gap” is in fact interpreted in a variety of ways. As used in the popular media the word “gap” connotes the idea of a shortage: a sense that the supply of the commodity in demand (here, financing) is insufficient and that the demand cannot be satisfied. However, in the context of economic theory a gap as defined above can only exist if an imperfection prevents prices from adjusting to the forces of supply and demand. For a shortage to persist some form of imperfection must interfere with the ability of the market to clear (at least, according to economic theory.Footnote 6 As Parker (2002, p. 163) states the case:
Information about [small] firms may be limited and asymmetric, stacked on the side of the borrower at the lender's hazard. This has led many influential academics and politicians to claim that these problems can be so severe that the supply of finance may disappear altogether. Banks, it is argued, may ration credit to new enterprises, strangling new, dynamic and innovative future industrial giants at birth.
It is this type of imperfection to which Brierley (2001, p. 75) refers when he states:
Public sector initiatives to support the financing of … small firms … may be justified if market imperfections mean that the private sector does not provide capital to firms on competitive terms… [However] In the absence of market failure, such initiatives may themselves cause distortions by subsidizing, at considerable public cost, non-viable firms which are not attracting enough capital because they do not offer good investment opportunities.
In the absence of an imperfection, intervention is not warranted. In the presence of an imperfection, remedial measures should ideally to be based on the nature of the imperfection.
The theoretical debate about whether or not some firms are subject to information-related imperfections (potentially leading to failure in the financial markets) dates back to Arrow (1962) and Demsetz (1969). This debate still continues (see, for example, Berger and Udell, 1998; Parker, 2002). If asymmetric information exists, lenders may be unable to discriminate between high- and low-risk borrowers. According to this theory, lenders react by increasing the price of debt to all potential borrowers, inducing all but the highest-risk borrowers to exit the market.Footnote 7 Conceptually, the ultimate result of this cycle is that lenders refuse finance to a high proportion of borrowers, a form of credit rationing. The existence of a market gap in the small business loan market is a matter of some considerable discussion in the literature. Views range from those of Parker (2002), who doubts the existence of a gap, to those of Boadway and Sato (1999) who develop theoretical arguments for its existence.
Parker (2002) presents an overview of the modern theory and evidence of credit rationing, and concludes that the case for credit rationing is weak. He suggests that theoretical arguments for or against credit rationing are inconclusive, so evidence is needed to decide the issue. He further submits that the evidence is not supportive of the view that credit rationing is an important or widespread phenomenon. Parker (2002) provides a review of the empirical literature pertaining to capital rationing from which he concludes (p. 162) that theoretical arguments are inconclusive and empirical evidence, which he notes is inherently difficult to obtain, does not support the view that credit rationing is important or widespread.
In contrast, Boadway and Sato (1999) consider that project risk includes idiosyncratic and aggregate components. They submit that banks can investigate aggregate risk and can evaluate the idiosyncratic risk of each entrepreneur and that they engage in competition for entrepreneurs using interest rates. They conclude that information obtained by a bank on aggregate risk is fully revealed, and that entrepreneur-specific risk is partly revealed. In their view, banks will not investigate aggregate risk and will evaluate entrepreneurs too intensively. As a result, efficiency can be improved by public acquisition of information on industry risk and by loan guarantees partially covering losses on projects that fail.
Theory does not specify the categories across which credit rationing might occur. Thus, if credit is rationed, it remains to identify the basis used by suppliers of funds to discriminate among applicants and the dimensions across which they may deny capital “among firms with the same risk characteristics” (Keeton, 1979). Binks and Ennew (1996) argue that high growth firms may be more informationally opaque than low growth businesses and may therefore face a greater degree of difficulty obtaining financing. However, rapid growth can also be a source of significant financial and managerial stress for a firm (Eggers, Leahy, Mikalachki, 1997). Rapid growth often leads to expansion of the need for working capital, in turn generating a need for additional cash. Hence, creditworthiness requires that good fiscal management accompany rapid growth. This argument poses the empirical challenge of distinguishing, in cases of low levels of creditworthiness, whether rapid growth is the causal factor or whether poor fiscal management is the problem.
Suppliers of risk capital tend to be more specialized in growth-oriented businesses than lenders' loan account managers. Typically, they also provide assistance with the commercialization process (Madill, Haines, Riding, 2003). As Brierley (2001, p. 67) notes, “venture capitalists may have greater information on the project's marketability and may be able to mitigate informational asymmetries”. This suggests that some high growth or knowledge-based firms seeking debt financing may be operating in the wrong segment of the capital market.
Empirically, it is extremely difficult to identify instances of credit rationing. Credit rationing requires that, from a set of observationally identical applicants, some will obtain financing and others will not (and that those who are rationed would still not receive a loan even if they offered to pay a higher price). As Parker observes (2002), it is virtually impossible to identify “observationally identical” loan applicants.
Overall, the empirical evidence is unclear. For example, Berger and Udell (1992, 1995) employed indirect tests for capital rationing. They concluded that (1992, p. 1071) “information-based equilibrium credit rationing, if it exists, may be relatively small and economically insignificant”. Oliver and Moore (1994) used a series of probit regressions to test the availability and cost of finance across a range attributes of firms in the UK. He found that the likelihood that firms face financing constraints increased with factors such as firm size and profitability. Oliver and Moore also found that the degree of innovation was not linked to the likelihood of financing constraints. Conversely, Westhead and Storey (1994, 1997) compared the reported financing experiences of firms located in science parks in the UK with those located outside science parks, finding that firms with relatively high R&D expenditures, high proportions of scientists, and high proportions of patents were more likely to report financing constraints.
Taken together, there is a strong theoretical literature that posits capital rationing but an inconclusive empirical literature. An explanation for this discrepancy is that testing for gaps in the capital market has been conducted across broad categories of firms, many of which may not have even sought financing and many of which were undoubtedly strong firms for which financing would not be a problem. Under this approach the effect of gaps that might conceivably have affected particular segments of the market (such as start-ups, growth firms, knowledge-based firms, etc.) may have been masked when such firms were combined with broader samples in which gaps might not have been in effect. This is worth remembering when interpreting the historical empirical literature. Of particular interest here are capital market gaps with respect to working capital financing.
Other researchers assume market failure as a point of departure. Felsenstein et al (1998) accept market failure in the small business loan market as the premise for their paper, as follows:
Capital subsidy programmes aimed at small businesses attempt to compensate for market failures that exist in the conventional financing markets. The existence of these market failures means that some small firms can be denied access to credit despite the fact that they have viable business projects. This rejection occurs because the 'risk profile' of the small business is likely to be weighted by factors other than project viability such as ownership structure, business experience and location of the firm. Information on firms with these characteristics is often limited and thus they are overlooked by otherwise well-functioning credit markets.
Herzog (1982) argues for the importance of small business to the Swedish economy, but points out that small firms often face obstacles such as insufficient security for loans, lack of risk capital, and sometimes insufficient management expertise in the fields of technical development, financial planning, or marketing. Herzog goes on to indicate that the aim of governmental policy is to remove these obstacles, and to achieve this goal a number of supporting institutions were launched. In their study of small firm financing in Sweden in the period 1960-1995 Sjögren and Jungerhem (1996) present the view that smaller firms not listed on the stock exchange and lacking financially strong ownership could not rely on the money market or secondary markets for their financing. Consequently, their relations with external actors such as banks and various public funds were crucial for survival and growth. The fact that there was reliance on various public funds suggests an underlying market failure.
Schenk (2004) analyzes industrial financing in Hong Kong in the period 1950 to 1970. Although she indicated the evidence suggests a bias toward financing large-scale industry at the time, she also refers to a “lack of evidence” of market failure. The small business sector applied political pressure over lack of financing because its members felt discriminated against because they lacked the collateral or reputation to establish their creditworthiness. There was also a cultural dimension to the issue of the demand versus supply of small business financing because, at the time, British expatriates controlled the largest bank while Chinese mainly conducted industry.
In a limited study, Zinger (2002) finds differential satisfaction among borrowers, depending on firm size. Although Zinger (2002) indicates that few of the sample borrowers can be classified as being disappointed with their present bank financing arrangements, he also points out that business size, as measured by the number of full time employees, is positively associated with the level of satisfaction with bank financing arrangements – that is, the smallest businesses are less satisfied than the largest businesses. The generalizability of the study is called into question due to its small sample size, and focus on a single geographic region, Northern Ontario.
Uzzi (1999) takes a sociological approach to the small business loan market. In his study of acquisition and cost of financial capital in middle-market banking, Uzzi (1999) finds that firms that embed their commercial transactions with their lender in social attachments receive lower interest rates on loans. He also finds that firms are more likely to get loans and to receive lower interest rates on loans if their network of bank ties has a mix of embedded ties and arm's-length ties. He argues that these effects arise because embedded ties motivate the borrower and lender to share private resources, while arm's length ties provide the borrower with access to public information on market prices and loan opportunities. The suggestion that there are two prices available in the market – one if capital is sought in the context of social attachments to the provider of capital, and a second price if there are no social attachments – is in itself evidence of a market imperfection. In a similar vein, Cole (1998) finds that a potential lender is more likely to extend credit to a firm with which it has a pre-existing relationship as a source of financial services.
In the event one doubts the lending market's capability to lend differentially dependent upon factors that are not prima facie commercial in nature, consider Selz (1996), which discusses a study conducted in Denver that finds race-based differences in lending practices. Consider also the results in Cavalluzzo and Cavalluzzo (1998) who find that, although white men and women can expect similar treatment in credit markets, minorities fare worse than whites.
Glennon and Nigro (2005) examine the default risk of small business loans granted under the Small Business Administration (SBA). They report that, although medium-maturity loans originated under the SBA 7(a) loan guarantee program [Small Business Administration; the US federal government's loan guarantee program] are targeted to small firms that fail to obtain credit through conventional channels, the default experience is comparable to that of a large percentage of loans held by larger commercial banks.
To those who might think that small firms can resolve risk issues with lenders through collateral, note that Hulburt and Scherr (2003) find that collateralization is actually positively related to firm size. They surmise that this is a reflection of economies of scale in secured lending due to the fixed costs of setting up a secured lending arrangement and monitoring it over time. It would therefore appear that provision of collateral is not necessarily the solution to the small business owner's inability to borrow.
- 3 back to footnote reference 3 Path to Prosperity (2002) was co-sponsored by the CFIB, Canadian Manufacturers and Exporters, and RBC Financial Group. Its findings were based on Ipsos-Reid polling of a randomly-selected sample of 800 Canadian business owners and 400 US respondents.
- 4 back to footnote reference 4 The CFIB (2003) report, Banking on Competition, is based on a survey of its members to which 9,565 responses were collected. CFIB surveys are limited to its members and are therefore not representative of the larger majority of Canadian SMEs. Arguably, CFIB survey data include both selection and non-response biases: CFIB members who respond to surveys on banking are likely to represent survivor firms whose principals have a particular interest in banking issues.
- 5 back to footnote reference 5 Basel II is correctly known as the International Convergence of Capital Measurement and Capital Standards - A Revised Framework. Basel II is the second Basel Accord and embodies recommendations advanced by bank supervisors and central bankers from the G-10 countries (plus Luxembourg and Spain) to revise the international standards for measuring the adequacy of a bank's capital. It was created to promote greater consistency in the way banks and banking regulators approach risk management across national borders. Under Basel II, loans to SMEs have been treated as relatively lower in systemic risk. Based on experience in the US and the UK, the improved risk sensitivity may mean that banks are more willing to lend to higher risk borrowers but that loans are more likely to be priced to risk. This could allow borrowers previously denied loans to have a better chance of establishing a good credit history. Implementation of the accord is expected by 2008 in many of the countries currently using the Basel I accord.
- 6 back to footnote reference 6 See Vogel and Adams (1997) for a discussion of this.
- 7 back to footnote reference 7 The seminal work of Stiglitz and Weiss (1981) has led to a considerable literature based on the idea that information asymmetry between borrowers and lenders is an imperfection consistent with the belief that commercial lenders may deny credit to certain categories of small firms. According to the most prevalent theories, information asymmetry leads to adverse selection or moral hazard problems which, in turn, lead lenders to set an optimal (for them) interest rate that is lower than the rate at which the market would otherwise clear.
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