Credit Management Chap 9

Prepared by John Anderson, Queensland University of Technology

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Chapter Nine

Small Business Lending

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Learning Objectives

• Define what a small business is and provide an overview of the main characteristics of the market for small business lending in Australia

• Explain the theory underlying small business finance, using the concepts of asymmetric information, credit rationing, adverse selection and moral hazard

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Learning Objectives

• Describe the distinctive risks of lending to small business

• Outline the main characteristics of a relationship-managed approach to small business lending

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Learning Objectives

• Outline the main characteristics ofa credit-scored approach to small business lending (using recent experiences in the United States)

• Comment on how lending to small business in Australia is likely to change over the next decade

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Introduction

• Small business lending is a specialised area of lending

• Small business lending is gaining increased theoretical support

• Two main approaches:– Relationship Management approach;– Credit Scoring approach

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Overview of Small Business Lending

• What is a small business?– Numerous definitions exist including:

• ABS – Less than 20 employees;• RBA

– Independently owned and operated– Closely controlled by owners/managers who

also contribute most, if not all, of the operating capital

– Has loans less than $500,000– Generally has turnover less than $5,000,000

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• Small business in the economy– ABS

• 1,175,000 small businesses in Australia representing 95% of total businesses

• Produce 30% of all private sector output• On average has 3 employees – 40% of

total workforce and 50% of private sector• Half of business employment in the

property and business services, construction and retail sectors

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• Small business in the economy– RBA

• Higher working hours with 25% working more than 51 hours per week

• In 1995-96, 8% of small businesses stopped trading, while only 5% of medium to large businesses did so

• Legal structure– Company 43% Small v. 70% Larger Businesses– Sole Proprietorships, Partnerships and Trusts 17%

Small v. 38% of Larger Businesses

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• Some characteristics of Small Business Lending (RBA, 1993)

• SB Lending 1/3 size of Large Business• SBs pay 1.6% higher rates on average to

reflect higher default risk and economiesof scale

• Financing takes three main forms:– Floating rate finance;– Fixed rate finance;– Bill finance

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– Floating Rate Loans• Overdrafts

– Very popular representing about 50% of SB borrowings

– Highly flexible funding source but around 1.5% more expensive than bill finance

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• Fully Drawn Advance– Loan fully drawn down at start with

repayments generally made in regular instalments

• Floating rate finance generally provided at a risk premium over a benchmark rate

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– Fixed Rate Loans• 42% of SB loans are fixed rate for 3–5 yrs• Generally used to purchase non-current

assets such as property and plant & equipment

• Risk margin generally added to 3–5 year Treasury Bond rates

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– Bill Finance • Issuing of discounted securities with most

at 90-day maturities• Lack flexibility compared to overdrafts with

all funds being drawn down on issue• RBA 2001 statistics:

Variable Fixed Bills Total

$ Million 33,037 28,042 5,228 66,307

Share % 50 42 8 100

Wtd Avg Interest Rate 8.3 8.5 6.8 8.2

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– How do lenders organise their Small Business lending?

• NAB: – Loans < $250,000 – Centralised Credit– Loans > $250,000 – Relationship Manager

• CBA: – Loans < $500,000 – Centralised Credit– Exceptions where complex business, e.g.

importer/exporter using credit finance andFX risk management products

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• Implications of bank cutoff levels–Lower cost ‘vanilla deals’ where

strong financials support credit- scoring approach

–May have negative implications for ‘good’ businesses operating just below cutoffs where notional credit scoring may be prejudicial

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–Cutbacks in relationship managers may lose clients seeking ‘solution- providing’ service

–Moving business clients to ‘faceless’ banking and lending must be handled very cautiously

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• Competition in SB lending market• Fierce competition, particularly where

loans backed by borrower’s property resulting in fixed risk-margin pricing

• Changes include– Intensive efforts to reduce cost to income ratio– Where property used as security, loans can be

assessed via simple credit scoring and capital funded at 50% risk-weighting concession v. 100% (up to 150%) for other business loans

– Promotion of centralised credit analysis

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• Small Business attitudes to lenders• Source: RBA and Yellow Pages SB Index

– 79% used finance from major banks– NAB and CBA held 48% of market

share– 1/3 SB owners unhappy with service

provided by major banks with ‘poor/no service’ at 42% and ‘no personalised service’ at 27%

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– Lower dissatisfaction figures for small banks and Non-BFIs at 37% and 14% respectively

– 16% changed institution with disproportionate number moving to smaller institutions

– Main reasons for change were ‘better service’ (47%) and ‘less/lower fees’ (32%)

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– 45–46% believed institution supportive and cared about them as customers

– Only 1/3 believed institution’s fees for service was value for money, though better on these measures at smaller institutions

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• Political Importance of SBs and SB Lending

• Government may become involved if dissatisfaction levels continue to increase

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A Theoretical Basis for Understanding Lending to SB

• While considerable emphasis on ratios, cashflow analysis, etc., many other issues to consider arise:

• Asymmetric Information: Borrower is much better informed about the firm than lender (also ‘Informationally Opaque’

• Credit Rationing: Loan price set too high– Adverse Selection: Better borrowers depart

while poor borrowers remain – Moral Hazard: Seeking of riskier projects

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• Relationship lending helps reduce asymmetries via two information types:

– Hard: Verifiable financial information– Soft: Borrower’s character/reliability

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• Stronger lending relationships lead to– Lower interest rates– Reduced collateral requirements– Lower dependence on trade debt– Greater protection against interest

rate cycle– Increased credit availability

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The Decision to Lendto Small Businesses

• Specialised SB risks:• Key-Person Risk: Is one person in the firm

the key to business success/viability?• Lack of Capital: Due to limited funds, tax

strategies, capital flexibility, etc.• Lack of Track Record: Often new business

or first-time business owner• Poor Accounting Records:

– No audit or lodgement requirements, delays, emphasis on tax-driven strategies, reporting freedoms and/or attempted deception

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• Risk and SB Failure– Over 30,000 fail each year– 1/3 fail in first year– Another 1/3 fail in second and third

years combined– 3/4 fail after five years

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• Reasons for failure include– Inexperienced/incompetent

management – Poor accounting and record-keeping– Problems with financial management

and liquidity– Lack of expert advice– Too much reliance on debt funding

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• Two approaches to SB Lending– Relationship Management approach

• Analysis of historical financials– Stage 1: Avoiding GIGO principle on financial

statements being relied on for lending decision. Check ratios and financials for consistency

– Stage 2: Detailed analysis of historical financials including analysis of short-term liquidity ratios, long-term solvency ratios and business performance ratios

– ABC criminology- accept nothing, believe no one and confirm everything

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• Analysis of cashflow projections – be cautious of overoptimistic projections

• Assessment of risks including key person, undercapitalisation, lack of track record, etc.

• The importance of security – increasing reliance on property collateral

• Problems with Relationship Management– Loan approval and management very labour

intensive– Greater delegation can lead to credit problems as

soft information is notoriously difficult to assess

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– Credit Scoring Approach• Relies on input, such as ratios, etc., into

mathematical credit assessment models• Background to SB lending in US

– SB loans defined as loans less than $100,000

– 8,149 US banks v. 51 Australian banks

– Small local banks dominate SB lending

• Past/Present Use of Credit Scoring in US– Increasing usage due to cost savings, availability of

databases, ability to quantify credit risk in securitisation supported by political and regulatory change

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• Structure of US credit-scoring models– At least 30,000 applications needed for

model– Fair Isaacs starts with 50 variables to

determine 10 most significant– Financial ratios probably less important

than previous 10 years’ credit repayment history

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• Changes in Credit Scoring and Predictions – Helps reduce information asymmetries – Flow of usage from larger to smaller

banks– Greater credit supply to low–medium

incomes– Greater reliance on simple form-based

and/or online applications for SB lending

– Greater cost reductions

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