Research Conference on

Key Lessons from the Crisis and Way Forward

16th -17th February 2011 Room II, International Labour Office, Geneva

Session 3: Financial reform and the Real Economy

Do policies work to alleviate the credit crunch for SMEs?

Bernd Balkenhol

Abstract

Complaints about the lacking responsiveness of banks to small firms’ financing needs are common and persistent, especially in crisis situations. Policies to address failures in the financial market have been put in place for decades: creation of public banks, credit lines on concessional terms to commercial banks, risk sharing schemes, improvements in the financial infrastructure and so forth. This paper explores the conceptual underpinnings of evaluations of the effectiveness of the SME finance policies. The paper is to be considered work in progress. It will be an ILO contribution to the G 20 Global Partnership for Financial Inclusion.

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Do policies work to alleviate the credit crunch for SMEs?

Bernd Balkenhol1

1. Context and Focus

With each economic and financial crisis policy makers are called upon by SMEs and their lobbies to intervene and help deal with what is presented to be a “credit crunch”. This notion is vaguely associated with an increased difficulty of smaller firms to obtain bank credit at reasonable terms. Whether or not such a credit crunch occurs in each downturn or recession is open to debate, simply because there is no clear-cut and universally agreed definition and understanding what a “credit crunch” is. Largely as a result of the multiple and often contradictory views on the existence or non existence of market imperfection for SMEs seeking capital, there is a corresponding debate about the effectiveness of policies that are meant to address this market failure. The renewed interest in constructing a conceptual framework to get a grip of the effectiveness of SME finance policies has several roots: such policies somehow seem to be a standard feature of any private sector development package, whether in growth or recession periods. Secondly, some – but not all – policy measures to address these market imperfections are costly to the tax payer resources; so there is a natural interest from a purely budgetary logic. Thirdly SME financing measures tend to be suspected of market distortions, a classic example being interest rate subsidies or dedicated credit lines only available to SMEs. And then there is the public policy angle that explains the renewed interest in evaluations of policies in this field. SME promotion and especially the promotion of more efficient financing instruments is justified with the net social benefits, largely in terms of job creation. Governments – whether with populist inclinations or not - like to be perceived to be doing something for jobs and it is all the more politically convenient if their action goes hand in hand with private sector promotion. For these reasons and given the important social benefits claimed to be associated with successful SME finance policies costs, it is to take a systematic look at evaluations of SME finance policies to extract factors of success and failure and to inform future policy making. This review examines SME finance measures put in place by national governments. It is true, other actors also design and implement “policies” to facilitate SME financing, like local government, regional or international development finance institutions, small business organizations, training or research institutes, corporations taking SMEs under subcontract, financial institutions and their professional bodies. The focus here, however, is on national government policies, be they channelled through subordinated structures or not, via state-owned banks or the private commercial sector. Moreover, the perspective is global, drawing on policy experiments from both low and high income countries, those with a competitive and others with a highly fragmented and inefficient financial market. This does not mean to gloss over the major contextual differences between SME financing in, say, Canada on the one hand and Cambodia on the other. High income countries have invested 1 Director of Social Finance at the ILO, Geneva.

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more resources into policy analysis with regard to their domestic situation, however, that does not mean that the lessons drawn would exclusively be valid for high income countries, even if the existence of huge informal economies in low income countries is likely to invalidate some of the findings. The underlying assumption is that there are indeed some general lessons that are valid irrespective of the level of development, responsiveness of banks and sophistication of smaller firms. SMEs face a host of constraints, access to finance is one of them. Other obstacles that keep them from growing, investing and creating jobs, have to do with their access to markets, public tenders, their subcontracting relations with corporations, with public authorities, local and national and so forth. SMEs are, often, excluded from reliable and continuous information about factor and product markets, local, national and export, they are the first to pay the price of the segmentation of capital markets2. Investment codes seem to be drawn up with for the use of incorporated firms with access to the capital market, not SMEs3. For this reason, other functional policies are not dealt with here, such as taxation, trade, labour law, business laws and regulatory frameworks, support to entrepreneurship and enterprise creation, “BDS”, which have their place in the promotion of SMEs4

.

Still, access to finance is a special constraint. Put differently: resolving the financing constraint is not everything, but resolving most of the other constraints is nothing unless the financing bottleneck is dealt with at the same time. It is a strategic constraint.5 The focus is on policies that target SMEs on the demand and banks on the supply side. This would seem to be justified considering the predominance of bank financing for SMEs compared to other forms of external financing. This is valid in developed and fragmented financial markets. In Colombia, for example, banks are by far the largest suppliers of external (formal) finance to SMEs6

. In the EU banks continue to be the most important source of external finance for small firms (79%), ahead of leasing companies (24%), public institutions (11%), private investors (7%).

The focus on SMEs on the demand side may seem obvious, but requires an explanation. SMEs are a mixed bag of firms, ranging from the self employed to firms with several hundred employees and standing, although in hard times bumpy banking relationships. The focus is best explained negatively: very small entities operating partly in the informal economy are not dealt with, nor incorporated firms that have an institutionally secure access to the capital market. What is left in the middle is still vast and heterogeneous. The typical SME is elusive. Countries use different definitions and benchmarks: number of employees, sales, assets or fixed assets or loan size or combinations of these criteria. The most commonly used criterion is the number of employees7

2 John M. Page, p. 20.

. The cut-off lines downscale are as fluid as they are up-scale. The maximum number of employees

3 Jacob Levitsky, World bank lending to small enterprises – a review, Industry and Finance series vol. 16, World, Bank Washington, 1986 lending 18-19.

4 Reinecke and White, op.cit. XVI. 5 “Financing is necessary to help…(SMEs) …set up and expand their operations, develop new

products, and invest in new staff or production facilities.”5. 6 Stephanou et al., pp. 7. 7 CGAP and WB Group, Financial Access 2010, pp. 37.

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for a SME is 50 in some countries, or 100 or even 250 in others8. Similarly the cut-off line to very small entities differs: in some countries it is 5 employees, in others 10 or 25.9

The purpose of this paper is to clarify the issues, unpack the underlying assumptions and make a case for a more systematic generation of effectiveness and efficiency indicators on SME finance policies. The body of knowledge about policy benefits being with high income economies, the main beneficiaries of this exercise are those countries that are venturing into SME finance policies later, hence the interest of the G 20 to support and endorse this work.

2. Rationale Public policy interventions for better matches in SME financing are generally defended in view of – alleged or real - market failures and imperfections due to the information asymmetry between banks and SMEs. The high fixed costs in risk appraisal, processing and monitoring, lead banks to favour larger transactions. The logic of corrective policy interventions is built on a number of assumptions:

• that objectively the market does not ensure the provision with financial services through a price mechanism,

• that there is a tendency towards no-price allocation of credit and • that there is a bias against smaller transactions because of the high

proportion of fixed costs in finance, • that the opaqueness of SMEs induces banks to charge a risk premium10

• that the risk perception by banks might be exaggerated, ,

• that a developed financial infrastructure with well defined property rights, quick insolvency procedures, professional and independent courts and up-to-date records would lower the level of information asymmetry.

Leaving aside technical considerations of market imperfections, SME finance policies are also being justified politically. SME make up the bulk of all private enterprises and create and retain the vast majority of jobs: 98% of all enterprises in Europe are SMEs, 67% of all private sector jobs are in SMEs. SME owners are voters. Public policy in support of SME could be considered a form of private sector promotion.

8 Idem pp. 37. 9 Within the EU a revised SME definition adopted in 2005 takes into account price and productivity

increases since 1996 and introduces a typology of enterprises (autonomous, partner and linked): In addition to the staff headcount ceiling, an enterprise qualifies as an SME if it meets either the turnover ceiling or the balance sheet ceiling, but not necessarily both.

Enterprise category Headcount Turnover or Balance sheet total

medium-sized < 250 ≤ € 50 million ≤ € 43 million small < 50 ≤ € 10 million ≤ € 10 million micro < 10 ≤ € 2 million ≤ € 2 million

10 Thorsten Beck, Financing constraints …pp. 9.

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The case for encouraging SMEs, their growth and funding seems obvious: there are (or there are claimed to be) substantial social benefits to SME finance policies, in particular, in terms of growth and innovation, entrepreneurship and private sector development, equity in the distribution of incomes and assets and - and above all - job creation. 11

A high level of per capita income seems to go hand in hand with a large share of SMEs in firm size distribution12

.

.

In the EU SMEs contribute 58% to total value added in (2009), whilst large scale firms contribute 42%.13 SME are also seen as hotbeds of new ideas. A study of SMEs in Germany found that relative to their overall size and situation SMEs spent more on research and development, namely 5,2% of turnover compared to 5,6% of the private firm average14

.

11 Brian Levy, op.cit., pp. 3 and T. Beck, Financing constraints, passim. 12 Michael Klein op.cit. pp. 4. 13 EIM research, pp.35 14 Hühnert and Robl, pp.42

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Table 2: Size of the SME sector by level of development

There may, however, also be “reverse causation”15, in that growth may trigger the emergence of small firms: “a large SME sector is characteristic of fast-growing economies, but not a cause of their rapid growth”16

.

Table 3: SME contributions to production and employment by level of development

“In developed countries SMEs employ 67% of the formal employment in the manufacturing sector on average. In developing countries this number is lower at around 45%.”17

15 T. Beck et al, SMEs, Growth and Poverty p.3.

“In OECD countries

16 Idem.

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SMEs are responsible for between 60%-70% of net job creation.”18 “Around 23 million SME in the EU provide around 110 million jobs“19. In terms of job growth SME “significantly outperformed large scale enterprises in 2002-2008. However, on the other hand, it is LSEs that outperform SME in labour productivity increases.20

According to a USAID/GEMINI study of small enterprises in Botswana, Kenya, Malawi, Swaziland and Zimbabwe “expansion of employment in small enterprises has absorbed over 40% of the increase in the labour force, most of it through start-ups of new enterprises”.21 Following that line of argument it would be through enterprise creation that SME contribute to job creation, since “existing business do not seem to grow”. “Only about 1% of these very small starters graduated into intermediate size (…i.e. 10 workers or more…).”22

Additions to the stock of employed workers appear to be the more significant in absolute terms, the smaller the firm size. In the US between 1992 and 1996 the US SBA reported the largest increase in jobs in firms of less than 4 employees (5,8 million), ahead of those between 5 and 19 (2,3 million) and between 20 and 99 (1,4 million).23

The job absorption capacity of new smaller firms is, however, mitigated by their above average mortality. In the UK only a handful of small and medium-sized enterprises show signs of consistent employment expansion… and only 55% of all newly VAT registered firms survive more than three years…”24 A study of the survival rates of 250,000 US American firms in the period 1985 to 1994 shows a direct positive relation between firm size and survival rate. 25 Of those with less than 5 employees 74% were still around at the end of the period, whilst amongst those with more than 100 employees only 42% were. On the other hand it has been claimed that “SME survival rate is lower than for larger companies: manufacturing firms with fewer than 20 employees were five times more likely to fail in a given year than larger firms.”26 “Every year new SMEs enter the market amounting typically to 5 to 20% of all firms. A similar number of SMEs cease to exist every year. Within five years about 40 to 60% of SMEs fail.27

”

According to the OECD Employment Outlook “small enterprises are disproportionately responsible for both gross job gains and losses. There is a relatively high mortality rate of new, small establishments28

.

17 G 20 Financial Inclusion Expert Group, Scaling-up SME access to financial services in the

developing world, 2010, pp. 11. 18 OECD Policy Brief: Financing SMEs and Entrepreneurs, November 2006. 19 EU Commission, DG Enterprise and Industry, Staff Working Document SEC (2006( 842/2 p.6. 20 EIM research, op.cit. pp.38. 21 Donald Mead, pp.1881 and 1884. 22 Op.cit. 1885. 23 US Small Business Administration, Office of the Advocacy, 1997 Cognetics survey, Cambridge, MA. 24 Employment Policy Institute, Economic report, volume 10 no.9, December 1996. 25 Beaudin, pp.7 to 10. 26 OECD Policy Brief p.3. 27 Michael.Klein, op.cit. 4. 28 FT 20.7.1994 quoting the OECD Employment Outlook.

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Table 4: Share of micro and SMEs in total employment

Lastly, in terms of job quality the case for SMEs is far from clear, an aspect to which organizations like the ILO tend to pay particular attention.29 The smaller the entity the less attractive are pay levels, working conditions, working hours and other social benefits. “Evidence from both industrial and developing countries shows that large firms offer more stable employment, higher wages and more non-wage benefits than small firms.”30

3. Market failures in SME finance

Jobs in the SME segment are not quite of the same quality as jobs in larger firms.

The literature on SME finance policies distinguishes internal and external constraints, the latter being lack of high effective demand, product prices, capital market segmentation with DFIs failing to reach out and inefficient commercial banks31, a poorly developed institutional infrastructure that fails to deliver risk-relevant information on potential bank clients32. Amongst SME-internal factors one finds poor management standards, poor technical quality of products and services, weak entrepreneurship.33

Hence a certain variety of views on what exactly is the problem with SME financing and how these constraints can best be addressed by policy.

The views on what is wrong with SME finance and the policies that search to alleviate the problem are shaped by interests. SME owners naturally take a different perspective than bankers. Regardless of the development and competitiveness of financial markets it seems that compared

29 Gerhard Reinecke et al., page XII 30 T. Beck, SMEs, Growth and Poverty – Public Policy for the private Sector, Note 268, World bank,

February 2004 31 Page, op.cit.pp. 20 32 D. Anderson, op.cit. pp. 929 33 H. Schmitz, pp. 67

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to respondents from larger firms those running small and medium-sized entities do really think that access to finance is a “major constraint”34

.

The “probability that a small firm lists financing as a major obstacle is 39% compared to 36% for medium size firms and 32% for large firms”35

. Moreover, small firms not only report financing constraints more often, these constraints are “also more constraining for their operation and growth than in the case for medium-size and large firms”.

In a survey carried out in Tanzania and Indonesia Brian Levy36 examined SMEs in the leather and furniture business and enquired about the relative importance of the financing constraint compared to other obstacles, like regulation, lacking access to non financial services and high production costs, insufficient access to infrastructure or markets. It emerged that “lack of access to finance … is the leading (non-price) constraint”.37 According to an ILO survey of micro and small enterprises in seven countries “lack of finance was cited among the key factors that led enterprises to reduce the size of their workforce”. 38A more recent study by Beck and Demirgüc-Kunt reports that “35% of SMEs see the cost of finance as a major growth constraint.”39

The World Bank Enterprise Surveys 2006-9 shows a consistent pattern in the perception of the financing constraint: owners of small enterprises (with less than 20 employees) see this more often as a constraint than owners of medium-sided (20-99) businesses, who in turn have more complaints in this regard than owners of larger firms (100 and more). Similarly, the view is more 34 (Klein, pp. 14). 35 Beck, Th et al, Small and Medium…, pp.8. 36 Brian Levy, Obstacles to developing indigenous small and medium enterprises, WBER 1993. 37 Ibd, pp.70. 38 Gerhard Reinecke et al, pp.116. 39 T.Beck, Financing constraints…, pp.3.

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pronounced in low income countries – and across all enterprises size classes – than in middle income or high income economies40

.

SME owners in Europe, when asked about the most important problems they faced, mention access to finance first, ahead of issues such as “taxation, lack of skills, access to public procurements, unfair competition, labour law, access to the single market” and so forth.41 As for banks it is generally assumed that they stay away from the SME market segment for risk and cost reasons. That view may need to be differentiated. According to a World Bank Latin America Regional Study on SME finance “banks perceive the SME segment as being very profitable”42. More surprising is that they also react “positively to government programs supporting SMEs…” and “that prudential regulations are not considered a hurdle43

.” Rather than information asymmetries with SME clients, it is the macroeconomic environment that banks in developing countries see as the main constraint that keeps them from venturing more into this segment.

They may be more up-beat than expected but banks in Colombia are not imprudent: interviewed in the framework of this World Bank SME study, they see SMEs nevertheless as problem clients because of informality, unavailability of financial statements, weak management skills44. Banks have their own preferences and ideas on what public policy should do and which entry point to use for policy: more government assistance to upgrade SME financial management and literacy, skills training and incentives to formalize45

.

40 G 20 FIEG, op. cit. pp.26. 41 European Commission, Report on the results of the open consultation on a Small Business Act, April

2008. 42 Beck, Th., bank financing, pp.3. 43 Beck, Th at al, Bank financing, pp.3. 44 Stephanou, C. et al., pp. 6 45 Stephanou, op.cit. pp. 20

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4. SME financing constraints The multitude of policy prescriptions to close the SME finance gap is mirrored in a range of views of the exact causes of these financing constraints. Broadly, these causes are attributed to either the supply of banking services or to demand side factors inherent in small firms that make it difficult for banks to deal with them. Others put the blame on the political and macroeconomic environment, the legal and regulatory context, and shortcomings in the financial infrastructure and, deficiencies in the organization and structure of the financial market which may not provide sufficient incentives for banks to enter the SME segment. Yet another theory sees the main cause of sub-optimal bank financing of SMEs in policies that may be well intended, but objectively distort the market and deter banks to engage with SMEs46

4.1. Supply side

.

Banks face two basic problems: the small size of transactions and the opaqueness in small enterprises. The fairly large proportion of fixed costs in financial contracts penalizes smaller clients. In addition the owners of small enterprises tend to have a personalized style of management which makes it difficult for a bank to assess the default risk. Banks try to deal with the fixed transaction costs issue by setting minimum requirements for transactions. Savings banks in Germany, for example, a type of institution generally considered to be well disposed towards smaller firms, set a threshold at euro 25,000 for individual loan transactions for first time customers who wish to set up their own small activity. Most start-ups, especially those coming out of unemployment, have chosen activities for which, however, a much smaller amount of capital is required. Banks respond to the opaqueness and higher risks of SMEs by demanding collateral. Whether required by the central bank or regulatory authority or whether intended as a deterring screening device, collateral requirements can pose a problem if the collateral value is a multiple of the loan amount. This is a constraint for smaller firms that do not dispose of much machinery, equipment, land and other assets. Some regulators allow banks to be flexible in collateralization as in the case of the Reserve Bank of India. This has prompted banks to top up loan charges by a risk premium. The complaints by SME owners of the high interest rates and fees point to the charges set by banks to cover against the specific risks inherent in the information asymmetry of SME lending. SMEs also complain about the low responsiveness of banks to their loan applications. They find the documentation requirements excessive and the processing times unacceptable: red tape. Another supply side constraint often mentioned is the failure of banks to provide a range of products and services that come with a particular operation in a SME, for example the packing of a medium term, fully collateralized loan to acquire new machinery, with a short term working capital loan for inventories and affordable payment services. This incomplete offer of bank services can be a reason for SMEs not even to consider a bank transaction.

46 Paris gives a good overview of all these constraints (pp. 5).

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Limited competition between banks reduces the incentive to innovate and find delivery methodologies that compress transaction and risk costs and tap into potentially profitable future market, like SMEs. Banks that enjoy an oligopoly do not make an effort to inform and communicate about what they can offer and how they can help SMEs. The constraints mentioned so far all presuppose that the two parties for the transactions can physically meet and interact. But there is another supply-side constraint, namely the physical inaccessibility of banks due to the rarity of outlets, ATMs or branches. This affects particularly development finance institutions (DFIs), i.e. banks that have the explicit promotional responsibility to open up underserved market segment, like agriculture, rural non-agricultural activities and …SMEs. DFIs are also blamed for over-specific targeting. Donor agencies and IFIs make credit lines available for priority sectors or subsectors. The conditions for eligibility are sometimes so specific that the potential catchment area is negligible. As a result primary banks that should in theory on-lend these resources fail to respond and rather forego the opportunities of a credit line. In addition DFIs also lack staff who speak “the language of SMEs”. They are characterized by red tape and on insistence on conventional real guarantees.47

As a result of these supply side constraints SMEs in developing countries tend to go for sources of financing other than formal financial institutions:

47 Schneider-Barthold, op. cit., pp. 51; J. Page, op.cit. pp. 20.

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4.2. Demand side SMEs tend to be more affected by periodic credit crunches. Indeed, according to the European Central Bank in the first half of 2009 SMEs’ access to finance deteriorated48

From purely financing point of view small enterprises the world over show fairly similar characteristics compared to larger companies and corporations sources

. The question is what makes banks shirk away from SMEs as soon as a contraction in the economy or even a recession looms on the horizon? To better understand the dysfunctional bank – SME relation one needs to look at the particular features of SMEs from a financing point of view.

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:

• low proportion of fixed assets to total assets • high ratio current liabilities /total liabilities • relatively low return on equity or total assets • equity/total liabilities low • poor financial management • preference for informal sources • complexity and opaqueness of a household-enterprise.

Assuming a linear relation between firm size and the volume of transactions, then obviously firm size by itself is a problem in a market with high fixed transaction costs, as in finance. Larger transactions yield better returns to the supplier of such services. Still, that does not fully explain why banks pull back from established SME clients that have a track record and which they should know. Firm size by itself is not strong enough a reason to explain the unstable relationships between most SMEs and banks. From a financing angle it helps to distinguish between activities with insignificant marginal factor productivity and others that have the scope for productivity increases50

. The first type of SMEs cannot absorb debt, the second can. Another criterion of interest to external funding agents is the existence of fixed assets which can serve as collateral. The transparency of the firm-internal financial flows and stocks is another financially relevant criterion, as it helps to better control for default losses. Lack of it is often associated with household-enterprises in the informal economy, but plagues also occasionally slightly more formal and larger firms and their interactions with banks.

The legal form of a SME is another criterion that a banker will take into account. Incorporation and partnerships entail disclosure requirements of information that interests the financial partner of the SME, in contrast to sole proprietorships51

48 EIM Research, op.cit. pp. 45.

. In turn, sole proprietorships and partnerships imply an unlimited liability of the SME owner, whose personal net worth does not show in the SME financial

49 B. Levy, op.cit. page 70; Koch p.119; Peel/Wilson, pp.58; Delbreil pp. 6pp; E.Chuta, pp. 275 and 283; Schmitz, pp. 7.

50 Page, op.cit. pp. 1 51 Cressy et al, pp. 34-35

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statements. On the other hand, unlimited personal liability is also a powerful argument that signals to the bank the SME owner’s expectation and confidence for the return of a credit-financed activity. Compared to larger entities SMEs have proportionately less equity52

. This is valid for SMEs in developed and less developed financial markets and has implications for capital costs and tax charges: SMEs tend to pay more for debt than large firms. Also, they cannot use depreciation allowances on machinery and equipment as much as larger firms do to cut down on tax charges.

Undercapitalisation limits the access to bank financing for the occasional investment: “small firms finance less than 10% of their investment needs with bank finance, while large firms with over 20%”.53

However, there are differences even amongst countries of comparable levels of market development and competitiveness: “German small and medium-sized enterprises …are much more indebted than large German firms. Two thirds of German firms operate with an equity ratio lower than 20%, and 41% of German firms report equity ratios below 10%. This compares to a European average equity ratio of around one third….While the average European, French and Italian SME does not appear to be undercapitalised, German SMEs are.”

A low equity/total assets ratio means that SMEs are obliged to pay higher interest charges.

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SMEs rely more on short term loans and overdraft than large companies. As a result the current liabilities of SMEs are higher as a share of total liabilities compared to large firms. This applies also to the share of liabilities to trade and other creditors.55 The higher interest charges are justified according to banks precisely by the shortfall in equity and fixed assets that could serve as collateral. This could be true – it could also be a pretext. A risk premium on SME loans can be justified on the ground of demonstrated higher default probabilities and loan losses to banks. This presupposes, however, that there is evidence of such higher default statistics. One suspects, though, financial service providers take advantage of crisis situations and charge extra points, justified or not. “Banks may succeed in over-charging SMEs due to limited competition in (local) banking markets and …a lock-in effect.”56

SME owners may be fully aware of the undercapitalisation of their firm, but that does not necessarily mean that they would be prepared to take on new associates or mobilize equity elsewhere. SME owners may want to grow, yet are reluctant to give up the full control in their venture. In fact, the use of overdrafts may be just a defensive device to ensure that ownership and control in the small firm are not diluted. Also the profitability of smaller manufacturing firms is inferior to that of large firms in manufacturing. 57

4.3. Linked to the organization of the market

In comparison to other markets the scale of operations matter substantially in finance. Systemic market access constraints call for action addressed at the supply and the demand sides, i.e. market-correcting or – enhancing measures and policies, legal or regulatory dispositions.

52 Hax, p. 5; Cressy et al., pp. 9-10. 53 T. Beck, Financing constraints,, pp. 4. 54 Rien Wagenvoort, op.cit. pp. 14. 55 Cressy et al., pp.18. 56 Wagenvoort, op.cit. pp. 15. 57 Cressy et al, op.cit.pp.18, Monatsberichte der Deutschen Bundesbank, pp. 24.

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The cause for suboptimal allocation of financial resources to SME may be a monopoly or oligopoly of banks and other financial institutions restricting competition and the drive to expand and deepen the financial sector through innovations that allow the opening up of new market segments on a sustainable and profitable basis. There is evidence, though, that such a suboptimal market structure remains suboptimal, even after financial sector deregulation and liberalisation58

.

A second reason could be the scarcity of reliable and up-dated information about the solvency status of client firms. This is often attributed to a failure in the financial infrastructure to generate and disseminate such data, for instance through credit bureaux. Where they do not exist, banks will have perceptions of risk that may be exaggerated. Other examples of the financial infrastructure that raise the level of risk-relevant information are “low entry and exist barriers, well-defined property rights, effective contract enforcement”59

4.4. Constraints attributable to policy

, but also credit guarantee schemes, fast track insolvency procedures, automated and updated property registries, independent and quickly operating judiciary. Under-informed banks tend to be trapped by adverse selection, failing to notice the credit-worthy SME client, but opting for the risk-taking SME instead.

The constraints in the access of SMEs to bank finance can also the result of distortions generated by well-intentioned, but poorly designed and implemented policies. Some credit lines managed by a government-owned development bank may, for example, fail to give a sufficiently large margin to primary banks. Governments may also alleviate the debt burden of SMEs by writing off a stock of debt incurred up to a point in time. This will send the signal to lenders and borrowers that repayment obligations can be taken lightly. Generally, there can be too little, or too much intervention, interventions may come too early or too late – as the setting up of credit guarantee funds in the current global financial crisis showed, when financial transactions had already picked up to the pre-crisis level. Some policies may choose the wrong targets, whilst some other policies may not lend themselves to being targeted and instead tend to attract free riders. Dosage of measures is a challenge: it does not make much of a dent on the economy if a credit guarantee fund engages with barely 10% of all commercial banks and reaches indirectly at best 1% of all eligible SMEs without any sign of replication. Financial repression is most associated with interest rate ceilings. The administrative capping of interest rates is considered justified with the affordability of loan products for smaller market participants. The net effect is, however, that few banks, if any, will consider the remaining net margin sufficient to cover the default risk. Rather than allocating credit via the market price they will tend to ration out credit, confronted with excess demand that is attracted by lower than market interest rates60

.

58 Fischer in E.Brugger, ed., pp.11. 59 Beck Th et al, Small and Medium-sized…, pp.2. 60 I.M.D.Little, pp. 206-7.

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The Effects of an interest rate ceiling: Savings gap, allocation by credit rationing, moral hazard

Obstacles in the access to finance can also be the result of policies adopted in other domains, like taxation, trade, construction, public tenders, technologies, or even labour that put SMEs at a disadvantaged position, lower the profitability of an activity and lead the bank to withdraw61

5. Policies to promote SME finance

.

There is no lack of policies, programs, schemes, funds and other interventions to promote SMEs and specifically approach banks and SMEs. A review of SME promotion schemes in Mexico found 151 programs run by a variety of government agencies62, some providing credit and guarantees, others business development services like feasibility studies, marketing strategies, management audits, training, advise and internet-based information, a few provide full packages. Beck et al (WB regional Latin America SME survey) present a sample of SME promotion schemes in which “government programs to promote SME finance exist in 6 out of the 7 developed economies and 32 out of the 45 developing countries” reviewed.63

5.1. Targeted or untargeted policies?

Most common are guarantee schemes, followed by directed credit programs and interest rate subsidies.

Policies fall either into the category of “size oriented” or “level playing field” varieties64

61 Haggblade et al., pp. 64.

. The first are based on the assumption of SME specific constraints corresponding to bank internal specific incapacities to deal with them. The second view sees shortfalls primarily in the financial and

62 Lopez and Tinajero, pp. 2. 63 Beck, Th et al, Bank Financing, op.cit. pp. 7. 64 Beck, Th et al, Small and Medium…, pp. 2.

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institutional infrastructure that hinder a more socially beneficial flow of funds to SMEs65. Theoretically one could organize a policy assessment by other features, for example the instruments used (transfer of cash or transfer of know-how, use of financial institutions as channels or public sector agencies, temporary or quasi-permanent interventions, interest-rate-neutral or interest rate-sensitive measures etc.). The differentiation of policies by the degree of targeting reveals however the way public authorities interpret and analyze market failures, and this is relevant for the recommendations for better policies. Untargeted policies presuppose that improvements in the infrastructure (laws, regulations, institutions that generate risk-relevant information and so forth) are sufficient. In this view shortcomings in the business environment affect all firms, regardless of their size, whether this relates to market entry and exit, property rights, contract enforcement and so forth.66

In this view targeted policies would not yield the optimal social benefit, as they exclude non-eligible firms. Every market participant will benefit, large or small, but the smaller will benefit disproportionately more. Untargeted policies are based on the hypothesis that the market can be made to function more efficiently.

Targeted measures, by contrast, are built on the assumption that the market alone cannot close the financing gap. Targeted approaches presuppose that the constraints are mostly size-specific. The analysis underpinning this view tends to emphasize the fixed cost argument in financial transactions that will always tend to discriminate against smaller market participants, no matter how efficiently credit bureaux operate, or other parts of the financial infrastructure. A second consideration is the political economy behind policy choices. A government that launches a SME friendly scheme and labels it as such flags its intention to be seen to be doing something for SMEs. Targeted policies therefore tend to carry a whiff of a “clientiliste” approach. This is not farfetched given the articulate lobby of SMEs in many high income countries: associations, chambers, and so forth. Targeted policies can also be better communicated and visualized to the general public and the media, whilst untargeted policies go more unnoticed, they seem somewhat abstract. Taking into account these considerations it is hardly surprising that interest groups and lobbies opt for targeted approaches when asked about their policy preference. ILO constituents, i.e. employer and worker organizations, for example, feel that SME development “should contain a provision to promote improved access by SMEs to finance and credit, and that … improved access by SMEs to finance and credit should be consistent with the principle of equal opportunity for all enterprises irrespective of size”.

5.2. Untargeted policies There is a broad consensus that a healthy dose of competition amongst banks, price stability and a diversified and transparent infrastructure underpinning the financial market create an environment

65 To complicate matters further most government schemes contain features and elements that

targeted and others that address infrastructural issues, under the same administrative title. See an example in Colombia Stephanou, pp. 39.

66 T.Beck et al., SMEs, Growth and Poverty pp. 2.

17

in which most SMEs should not have systematic problems getting their financial resources on affordable and equitable terms.67

Beck draws attention to the role of the business environment: property rights, protection against expropriation, contract enforcement, competitiveness in factor markets and business-friendly legal framework.68

This leads him to advocate a shift away from the size-oriented (“targeted” SME policies) to policies eliminating size-specific constraints, thus creating a level playing field.

Banking regulation can facilitate – or impede - the entry of banks to the market and competition amongst them. This indirectly benefits SMEs, even if they are not explicitly mentioned or focused (Lamberte on Japan). Price stability is another general policy area advocated by adherents of untargeted approaches. It is good for the economy as a whole, but it tends to benefit SMEs and their access to bank financing even more so because they do not have the same array of options as large corporation to raise capital on the financial market and hedge against price instability. Banks will also perceive SMEs as more risk exposed than large corporations in inflationary times, hence they become more conservative on credit allocation. One digit inflation rates will also make it possible for central banks to pursue a regime of low interest rates, which benefits all market participants but SMEs disproportionately so. Governments even “sell” price stability measures as a strategy to promote SMEs. Tax-based incentives specifically geared to SMEs make not much sense to some observers, as many SMEs tend to operate partly outside of corporate income and personal income tax provisions. According to this view a general simplification of the tax system would benefit all, including SMEs, and provide even incentives to formalize progressively69

.

Other general policies geared to stimulate growth and investment is considered also implicitly good for SMEs: for example a foreign trade and capital market regime that leaves the exchange rate at the market level that lowers the level of effective protection and generally liberalized the market70. However, financial sector deregulation and liberalization alone do not seem to entice banks to enter into competition in the SME market.71 “The Sri Lankan experience suggests that it is premature to conclude that the unsupported, market-driven provision of non-targeted credit by competing private banks will be sufficient to secure access for SMEs to formal finance.” 72

5.3. Targeted policies

Targeted policies and measures fall broadly into two categories: those that establish more or less exclusive eligibility barriers for beneficiaries of cash grants, fiscal privileges, training, business development services, marketing support etc, and others that flag the intended preferred beneficiary. This does not necessarily mean to restrict cash and other benefits to SMEs. The idea

67 Brian Levy, in WBER, pp. 73. 68 T. Beck, Financing constraints,pp. 2. 69 Elkan, W.op.cit. pp. 20. 70 Biggs et al., op.cit. pp.41. 71 See working papers produced under the IFLIP initiative of the Social Finance program, see

www.ilo.org/socialfinance 72 Brian levy, op. cit. pp. 73.

18

behind targeted measures is just to offset a comparative advantage enjoyed by larger firms. Targeted policies are more ambitious: they require a minimum of administrative capacity and they can be costly to put in place and to run. It needs specialized staff to verify compliance with eligibility criteria and supervise use of funds. Targeted measures therefore tend to be more time-bound than general open policies73

.

Based on field surveys of SMEs in two sectors in Sri Lanka and Tanzania, Levy74

finds that liberalization of the local financial market with “competition amongst independent banks…, positive real interest rates and determined efforts at collecting outstanding loans…” is not enough to “secure access by SMEs to formal finance”. It is this empirical finding has justified the considerations of policy interventions aimed at bringing about a better match between the demand of SMEs for funding and the supply of capital. These interventions can be classified by the entry point chosen by policy makers: SMEs, financial institutions and the local financial market.

Possibly the most cost effective intervention on behalf of SMEs is to check existing macro policies for any possible hidden bias against SMEs. Public procurement procedures in the construction business are a case in point. The cash flow of small contractors is often jeopardized by the slowness in settling outstanding payments, more so than large building firms. The following overview differentiates broadly between targeted measures addressed at the supply and those at the demand side. In real life governments prepare packages of measures that are simultaneously activated and affect both the supply and the demand sides. The Access to Finance initiative of the EU’s Enterprise and Industry DG, for example, consist of two instruments, one that seeks to improve the financing environment and another that pumps funds into the market through the SME Guarantee Facility (SMEG) and the High growth and innovative SME Facility (GIF).

5.3.1. Targeted at the supply of financial services Loan portfolio quotas are sectoral quantitative ceilings on lending by commercial banks. In Ghana during the period of “credit management policies” 1981-88, the Bank of Ghana stipulated by which percentage a primary bank could exceed lending to a sector compared to a previous period75

. Banks that exceeded this ceiling would be required to deposit an amount as reserve with the central bank twice the amount of excess lending. At the end of the 1980s the Bank of Ghana found that lending to priority sectors – like SMEs – had fallen short of expectations and dropped this measure.

Alternatively central banks can also impose norms on the sectoral distribution of bank portfolios. Such static portfolio quotas are applied for example in Korea where a minimum of 35% of loans of commercial banks and 80% of local banks lending have to be allocated to SMEs76

Preferential discount rates make it more attractive to commercial banks to finance SMEs, because they are awarded a slightly wider margin. By differentiating the interest rates banks are 73 Gerhard Reinecke et al, op. Cit. pp. 81. 74 Brian Levy, WB Economic Review pp. 73. 75 Ernest Aryeetey, Sectoral credit allocation…., pp. 191. 76 Brian Levy, op.cit. pp. 46.

19

encouraged to redirect lending to priority sectors like SMEs (see BCEAO). This instrument requires a substantial investment on the part of a central bank to check on compliance with the eligibility criteria. The BCEAO found that few commercial banks made use of the preferential discount rate in the 1980s. It therefore was decided to discontinue it. Monetary authorities can impose ceilings on bank lending rates, making credit less costly to priority sectors, but narrowing at the same time the gross margin of banks. Unless compensated by an equivalent reduction in the discount rate, this is unlikely to lead to the desired effect. In Ghana in 1983 for example commercial banks could not charge more than 8% on loans to small scale farmers, one point below the market rate. The differential between the administered and the market rates grew subsequently to 3 to 4%77

. The actual flow of resources to priority sectors such as SMEs fell considerably short of expectations. One reason – not specific to Ghana – was the high level of inflation, leading to negative interest rates. Another reason – even in a scenario of positive real interest rates – is the modest size of the differential considered insufficient by commercial banks to cover the costs and risks of SME lending. A third reason is attractive safer alternatives. When treasury bonds carry an interest rate close to the rate on priority sector resources, it is hardly surprising that banks are less than enthusiastic in responding to the policy signal.

Differentiated reserve requirements: a central bank can differentiate the conditions at which commercial are required to deposit liquidities at the central bank, either by modifying the maturity of such blocked funds or the interest rate at which these funds are remunerated. While this is a tool to control liquidity in the banking system it could theoretically be used as a signal to commercial banks to go more towards priority sectors, like SMEs. Refinancing lines: the possibly most popular targeted measure is a credit line, channeled either through the central bank or a development bank made available to commercial banks on preferential terms to induce them to lend to SMEs. The popularity of this measure has several reasons. One is its market-conformity. Whether a bank picks up or not on the facility offered depends entirely on its perception of the growth potential of the SME segment. Another reason is the relative speed and outreach by which the resources can get to the beneficiaries compared to, for example, technical assistance directly provided. Yet another reason is the sheer volume that can be absorbed by the entry point institution for a refinancing facility compared to a training or institutional building project. However, the record is less than consistently positive, notably in terms of the replication and spread by banks on own resources. The pick-up has often been suboptimal because of the conditions attached in terms of reporting, spread allowed, conditions attached etc. Government-controlled banks and funds that operate at the retail level represent the most interventionist policy variant targeted at the supply of funds to SMEs. The government creates its own bank or fund to channel its resources to SMEs. SIDBI in India or the Banque Tunisienne de Solidarité are examples of government owned banks that serve the SME market. The transmission mechanisms are specialized government-owned financial institutions, like DFIs. To address perceived market failure in specific financing needs, public authorities have also been seen to set up dedicated funds, for example for leasing to SMEs, factoring or equity finance. 77 Ernest Aryeetey, op.cit. 191.

20

The IFC survey of SME equity funds78 lists 62 funds worldwide with a combined capital of $ 2,8 billion, almost always with a sizeable partial public sector ownership79. Some governments try to boost the supply of equity and especially venture capital to SMEs by providing high net worth individuals a preferential tax treatment for long term risk-taking investments in SMEs. Two evaluations have been carried out on this specific measure: the Boyns and PACE paper of 2003 and the CBI study of 199980

. Both come out relatively inconclusive reporting the absence of performance benchmarks and verifiable targets or an excess of eligibility criteria.

Encouragement of SME friendly types of banks: another policy geared to address constraints in SME finance is the promotion and encouragement of banks not owned or controlled by government, but closer to SMEs than other banks, by virtue of their origins, mandate, business model and political orientation. The classic examples are municipal savings banks and cooperative banks. These tend to have a larger portfolio share with SMEs than private commercial banks. Public policy in their support can, for example, consist in providing guarantees. This has been the case until recently in Germany where the municipalities backed up municipal savings banks with a guarantee which gave these banks a high ranking with rating agencies, which in turn caused private commercial banks to complain to the European Commission. The principle of fairness in competition – as perceived by the European Commission – prevailed over the principle of backing up locally rooted financial institutions with a social mission. The supply of credit and other services to SMEs by cooperative banks can be encouraged by government through the preservation of fiscal privileges awarded to cooperatives in other sectors. There are also privately initiated SME banks adopting a specific business model of “green field” institutions that cater exclusively to the local SME segment (IMI in Latin America and Eastern Europe). Foreign banks per se do not seem to be better positioned or more interested in SME financing compared to domestic banks81. However, it has been claimed that “foreign banks can bring the necessary know-how and scale to introduce new transaction lending techniques. By competing with domestic banks… they can force domestic banks to go down market to cater to SMEs82

In addition to ownership, there is also size of banks that might matter. Not all banks are equally disposed towards or interested in SME lending. “Large banks devote a lesser proportion of their assets to small business loans in comparison to small, often regional banks.”

.”

83 Based on empirical studies of a Latin American regional study on SME finance, Beck finds that “the conventional wisdom that relationship lending by small and niche banks is at the heart of SME finance is misguided84

.”

78 IFC Survey of SME Funds 2007. 79 African Venture Capital Association www.avcanet.com, Aureos Capital www.aureos.com, Belgian

Investment Company www.b-i-o.be, Small Enterprise Assistance Fund www.seaf.com, FINNFUND www.finnfund.fi, EMPEA www.empea.net, FMO www.fmo.nl, NORFUND www.norfund.no, Swiss Investment Fund www.sifem.ch.

80 OECD, Framework…., pp 41. 81 Beck, Th, Bank financing, pp. 3. 82 Reported by Beck, Th et al, Small and Medium…pp. 16. 83 Rien Wagenvoort, SME Finance in Europe: introduction and review in: EIB Papers, volume 8 No. 2,

2003 pp. 11. 84 Beck, Th et.al., Banking Financing, pp. 3.

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Micro-finance institutions tend to be more geared to cater survival activities in the formal economy below the threshold of SMEs. Traditionally and predominantly MFIs cater to livelihood activities, the working poor, i.e. a clientele characterized by a blurred line between household and enterprises assets and liabilities. MFIs on the whole do not go into the SME market. However, there are a few MFIs that started to venture up-scale into “meso-finance”: ACEP, ACLEDA, ADEMI, BancoSol, BASIX, BRAC, Centenary and others85

. Anything that a government takes an encouraging stand, it indirectly facilitates conditions for the SME clients, present or potential.

Some MFIs create a special dedicated SME department (“window”), like RCPB in Burkina Faso, ACEP/PME in Senegal, ADEFI in Madagascar and Bai Tushum in Kyrgystan. Other MFIs innovate in their product range, offering services of particular use to small firms, like micro-leasing (BASIX in India), packages of asset-based and health insurance (TYM in Vietnam, ASA and Cashpor in India and AMACTS in Mexico). Yet others lift the ceiling on maximum loan amounts and join commercial banks as distribution agents, thus making their offer more attractive to SMEs: ICICI and Cashpor in India. Finally some MFIs seek to cater to slightly up-market firms by modifying their delivery technique and allowing for more individual lending in addition to or substitution of joint liability-based lending like PRIZMA in Bosnia, CVEVA in Mali or CONSTANTA in Georgia. Public policy addressed at the supply side can also mean to disseminate information about lending techniques that the government feels are more suitable for bank transactions with SME, but not really known in the market. Addressing the opaqueness of SMEs and their shortcomings in collateral, governments can promote and encourage “asset-based lending, factoring, leasing, fixed asset lending, credit scoring etc86.” In fact, there is more variety in the transaction modalities between banks and SMEs than had been often assumed. Lumping these differences under the notion “relationship lending” obscures, rather than explain. Berger and Udell have elaborated the range of lending technologies that underlie “relationship lending”: financial statement lending, credit scoring, asset-based lending (emphasizing the use of accounts receivable and inventory), factoring and leasing87

, all of which are meant to deal with the information asymmetry in SME financing. If government policies induce banks to shift and adapt their lending technology, then this will have – according to Berger and Udell – a substantial impact on the availability of funds for SMEs.

Packages of interventions: supply-oriented government measures to encourage banks to lend to SMEs rarely come alone. The cases of Japan and Korea show the simultaneous and coordinated use of several instruments: direct supply through public banks, SME earmarked refinancing, credit portfolio quotas and credit guarantee systems.88

Levy finds that this combination of interventions worked well in Japan because it was embedded in a competitive financial system, a culture of high repayment morale and the prevalence of real positive interest rates. These conditions did not prevail in other countries characterized by subsidized directed credit, and the predominance of state banks in the financial sector.89

85 Paris, op.cit. pp. 29.

86 Beck, Th et al, Bank Financing of SME..., pp. 2. 87 Berger, A and Udell, G, pp. 1. 88 Brian Levy, op.cit. pp. 46. 89 Idem, pp. 53.

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5.3.2. Targeted at the demand side Fiscal incentives to encourage the reinvestment of gross profit can bolster the position of SMEs, thus dealing with a notorious obstacle that keeps them from securing bank finance. By taxing retained earnings less heavily than paid-out earnings governments send a signal to SME owners. Another fiscal measure that goes in the same direction are depreciation allowances that entail a tax credit and can be adjusted to allow for higher deductibles in SMEs balance sheets than in corporate statements. In order to strengthen the equity position of SMEs Government can encourage the participation of employees in the capital. However, given the reluctance of SME owners to dilute their control and the ownership this measure has rarely been put in place. To address the opaqueness of SMEs most demand-side oriented policies seek to improve the level of financial management and planning in small firms. The idea is to get more realistic financial statements at the end of the year, making the firm more readable and thus adjust the risk perception by banks. Such training courses or advisory services focus, for example, on the techniques to valuate liabilities and assets, apply common accounting norms for the depreciation of fixed assets and adjust for customers of SME that fall behind in their payments due. The active advocacy of fair and mutually beneficial subcontracting arrangements between corporations and SMEs is a possibility to improve the conditions for bank finance on the demand side. Well organized smaller firms are also better positioned to make their dissatisfaction known to the general public, as could be witnessed in the recent credit crunch following the 2008 global financial crisis, which SME professional bodies claim affected them disproportionately more than other clients. Organized SMEs can also pool financial resources to constitute mutual guarantee associations that can intervene when an individual firm fails to offer sufficient collateral90

SMEs take part in informal networks. These can be ethnically based. In Sub-Sahara Africa these networks have been observed to have a significant effect on access to supplier credit: in other words an SME that belongs to the same informal network as the raw material supplier is more likely to obtain advances

.

91

5.3.3. Targeted at the financial market

. That is advantageous for the firm, but less good for outsider SMEs that are excluded simply on the basis of their indigenous African identity, not because of a lack of seriousness.

Policies focusing on the market as a whole but still targeted at SMEs as their explicit ultimate beneficiary, are close to untargeted policy measures. The rationale is often information asymmetry at the expense of SME financing, a failure that the market by itself is not likely to resolve. The targeting lies here in the express wish of policy makers reflected in the legislative, regulatory and administrative language that SMEs are to be better off as a result of the changes implemented. To address information asymmetry in finance and to raise the overall level of information about risk, government put in place legal dispositions to better define property rights – including faster and less complicated insolvency procedures, as well as rules to ensure more compliance with 90 Balkenhol, B., PME et Financement - Les Sociétés de Cautionnement Mutuel en Suisse et en

Allemagne, Bruylant, Bruxelles, 1995. 91 Biggs, Tyler et al, pp.3045.

23

contracts. Whatever helps to cope with information asymmetry in the financial market also benefits those firms that are perceived - rightly or wrongly – to be the least acceptable for banks, namely SMEs. Other measures provide for rating agencies and credit bureaux that rapidly confirm or reject claimed ownership claims on land and fixed assets. Making legal dispositions that govern the acquisition, transfer and sale of assets, repossession, succession, insolvency and general law enforcement more transparent, lowers the level of uncertainty in financial contracts. Again, since SME have the reputation of being less transparent and therefore riskier any such general measure can help structurally. A particular set of measures concerns the use of collateral and innovations in collateralization. Policy makers and bank supervisors can, under certain conditions, give banks certain latitude in the use of collateral types and substitutes, if this is indeed an issue for SMEs92

.

Guarantee funds can have substantial outreach. The Korean CGF catered to 13% of all SMEs93

. It should also be stable and self financing so as to survive as a reliable partner of banks and SMEs: in terms of this criterion FOGAPE in Chile did well as it largely covers its costs and operates on the whole without subsidies. Since guarantee funds always have a pilot or demonstration purpose, one might also look at the number of banks and other formal financial institutions that operate with it. Measured in these terms the credit guarantee company in Egypt performs impressively as it interacts with 32 participating banks. Another measure of the capacity to entice banks to risk their own resources is the leverage (for example as high as 1: 8 in Malaysia) or the risk sharing formula (50/50 in Egypt).

BOX I

There are conflicting views based on contradictory evidence whether market power is good for SME finance or not94

92 Bernd Balkenhol and Haje Schütte, Collateral,.Jahe.

. Turned around, this argument means that policy measures for more

93 Bernd Balkenhol, Access to Finance: the Place of risk-sharing instruments- Savings and Development, vol. XXXI, no1, 2007. 94 Berger, A. and Udell, G, op.cit. pp.14.

CG Company Egypt: initial USAID grant of $ 27 mio (2004); 2% fee; 50 – 65% risk sharing; 5000 guarantees issued (cum.); 32 participating banks; 5% default rate Korean CG Fund: funded by tax on all banks; 80,000 g p.y.; outstanding portfolio $ 10 billion!; risk sharing 70% GS in Malaysia operated by Central Bank; 70% risk share; refinanced by National Dev Bank with WB resources; 185,000 guarantees issued; (1979 to 1996); cost per entrepreneur $ 157; claims rate 2%. FOGAPE (Chile): Banco Estado administers; $52 mio assets; 34,000 g issued in 2004; average $ 100,000; risk share up to 80%; up to 10 years; fees up to 2%; F. deals with banks, not borrowers; leverage: 1: 8,9; default rate 0,1 – 2,4% in 2000-4; 15 banks on board; self financing.

24

competition in the financial market make possibly no difference to the availability of finance to SMEs. According to Beck the jury is still out whether bank concentration and competitiveness are good for fund availability to SMEs95

6. Impact of SME Finance Policies

. It all seems to depend how one views the propensity to innovate in banks. It is quite conceivable that a bank that disposes of a certain market control feels comfortable enough to try out approaches – even riskier ones – even if this does not necessarily lead to a positive net return in the short run. On the other hand, the rent seeking behaviour in banks may be stronger than such entrepreneurial impulses.

Interventions entail direct and indirect fiscal costs. Money spent on SME promotion and financing is not available for improving public health care or the rail infrastructure. To be justifiable there has to be a good case demonstrating that the social costs of not doing anything exceed the costs of the intervention including possible negative externalities that can be attributed to the intervention, like substitution, displacement, deadweight and other unintended effects. Put differently, the social benefits of intervening on behalf better SME finance arrangements have to exceed the private benefits accruing to SMEs (and banks) as a result of the intervention. Not every policy or program geared to facilitate bank financing of SMEs can be evaluated. In fact, in most cases the determination of impact is a matter of heroic assumptions and conjecture. A rigorous impact assessment presupposes that the policy or program has been designed in such a way that it lends itself to evaluation. This requires that

• the expected changes are specified: Change in terms of what: access? Usage? Client benefits?

• The robustness of these changes over time are laid out; • The designers of the policy have a general idea of the cost benefit ratio to be

attained; • the replication by banks on own resources is built into the plan. In other words: is

the outreach increasingly self sustaining? • additionality is dealt with: would the changes had occurred also in the absence of

the policy measure? How would we know? • The displacement effect can be measured; • the indicators reflecting theses changes be defined beforehand96

• the time frame over which the change is expected to occur is spelled out. ;

• the expected beneficiaries are named (i.e. mostly SMEs ultimately, but also intermediary institutions)

If a policy has not been designed in a manner that lends itself to evaluation then it will be impossible to rectify it ex post. A politically sensitive domain as SME finance policies tends to come under scrutiny for political reasons: unless the design has been put right years earlier it is impossible to invalidate or confirm certain criticisms of ineffectiveness and waste of taxpayers’ money: an outcome that leaves everyone frustrated. The political economy surrounding SME

95 Beck, Th et al, Smaller and Medium…,pp. 16. 96 DG Enterprise and Industry of the EU Commission wants to develop indicators on the effects of

policies on SME finance (starting September 2006 to Dec 2013) p.4 of SEC (2006) 856 “Commission staff working document: Implementing the Community Lisbon programme: Financing SME growth – adding European value COM (2006) 349.

25

finance policies in turn explains why many measures in this area are shaped more in response to pressures from certain lobbies, rather than with a clinical assessment of the future state of the economy in mind. Then there is the usual attribution problem of any policy evaluation, whether of SME finance policies or any other domain. There are always other promotion measures going on at the same time that might interfere. The problem with evaluations of SME finance policies is not that they have not been carried out; to the contrary, there is a plethora of assessments, reviews, evaluations, impact studies and so forth. The problem is rather that the findings and policy recommendations emerging out of this body of reviews fail to give guidance on how to shape future policy better. This stems largely from the choice of method that cannot deliver firm findings. Chile, for example, has seen a string of evaluation studies of SME support programs, not just on SME finance, but always including it. While the approach was experimental and applying difference in difference and propensity score matching methods, 97 the observation periods were too short, making it impossible to detect any changes at the firm level. Another flaw is that this method cannot deal with the contamination that occurs when SMEs start to interact with support programs other than the one evaluated. Also, the randomization may have been less than perfect as the control group might possibly contain firms that had benefited from support measures other than the one evaluated98

.

One of the rare quasi-experimental reviews of the effectiveness of SME promotion and finance policies is Tan’s evaluation of seven SME support programs in Chile over the period 1992 to 2006 based on a random sample of 600 firms from six manufacturing sectors. The evaluation did not specifically focus on SME finance support measures (only two of the seven measures were strictly financial, CORFO credit lines for working capital and debt rescheduling), but more generally at a package of measures encompassing also training, technology transfers, networking and so forth. Another challenge to policy evaluations is that the analysis tends to stop at the level of intermediate outcomes. This “audit” logic focuses on the delivery of planned outputs and the timely conclusion of activities, rather than the changes induced at the firm level (investment, productivity, job creation, formalization) that could be attributed to a policy. Intermediate outcomes are more easily observable and measurable. They can be rapidly reported back to the funding agency. But “client satisfaction and program outcomes” are not a good substitute for actual benefits to SMEs, i.e. ultimate outcomes, like structural changes in the market for SME finance, improvements in bank procedures and operations or changes in the way SME operate or finance themselves. Intermediate outcomes do not answer the question whether a firm has actually benefited from having used a service provided by a government policy or program. Tan finds that participation is associated with “improvements in intermediate outcomes (training, adoption of new technology and organizational practices) and causally with positive and significant impacts on sales, production, labour productivity, wages and exports99

97 Tan, op.cit.pp. 7.

”. Interestingly enough, when differentiating between types of program the finding is that “programs providing subsidized

98 Tan, op.cit. pp. 8. 99 Tan, op. cit. pp.3.

26

technical assistance support for cluster formation and technology up-grading lead to positive outcomes for the firm, but not “financing programs”.100 In fact, “no significant treatment effects were found for use of credit and loans programs alone. Suggesting that access to finance alone is unlikely to spur firms to make needed organizational and technological changes to improve performance101

7. Factors of success: what works?

.”

Start small: Pilots can be stopped more easily and without much reputational risk to the Government agency advocating a specific measure. If promising, however, they can be rolled out at a manageable pace. Local commitment: Starting at a modest scale makes it also more likely that the participating banks or other financial and promotional institutions are committed. Government can choose the pilot site depending on the good will and interest of potential cooperation partners. This is more difficult to negotiate at a national level, where an individual institution tends to hide in the crowd. Sound participating institutions SME finance policies are for SMEs, they are not intended to rehabilitate a bank that is in imbalance for a variety of reasons, and not just its SME portfolio. Participating institutions should be sound, they should be able to go about their business, policy or no policy. It is the condition for any self sustaining change that the participating banks and other institutions are fundamentally solid. Market based prices: For the longer term sustainability of any SME finance measure it is key that prices – i.e., fees and interest rates charged on SME loans – reflect scarcities, transaction costs and risks102

. This may not necessarily be a requirement from the onset of a new policy, but a gradual alignment to market conditions is key, if only to avoid possible distortions by the SME finance policy itself.

Growth and development: Some factors of success advanced in the literature appear trivial: that growth and a competitive financial sector ensure the success of SME finance policies would seem obvious. One wonders whether in such circumstances there is even a need for SME finance policies103. Similarly, policy prescriptions for competitiveness in the financial sector104

, high liquidity levels and sound bank portfolios seem to miss the point: if these conditions prevailed, then there would not be any need for SME finance policies.

100 Tan, op.cit. pp.3. 101 Tan, op.cit. pp.26. 102 L. Webster, pp. 7. 103 Mead, pp. 1882. 104 Aryteey et al, pp. 2.

27

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Annex ILO policy statements on SME finance policies ILC 1986 72nd session conclusions: “Govs should…make one of their primary objectives the creation and maintenance of a social and economic climate conducive to the enhanced creation and healthy development of SMEs with particular attention to …availability of finance at appropriate interest rates…” (para. 7 (ii)) ILC 1986 72nd session conclusions and resolutions, para. 15 define the scope of SME financing policies: “a good network of financial institutions and programmes, encourage entrepreneurs to use their own funds, encourage banks and DFIs, notably through guarantee funds; non-traditional sources of finance like cooperatives, associations, solidarity organizations, liberalize loan terms; simplify procedures; training of bank personnel; venture capital needs…”. REC 189 adopted by ILC 86th session 1998 uses slightly different language in para 14: “members should facilitate access to SMEs to finance and credit…on commercial terms to ensure their sustainability, except in the case of particularly vulnerable groups of entrepreneurs; supplementary measures should be taken to simplify administrative procedures, reduce TCs and overcome problems related to inadequate collateral…; SMEs may be encouraged to organize in mutual guarantee associations…”;