52. In the case of relationship lending, information is gathered directly by the loan officer through contact over time with the enterprise...
52. In the case of relationship lending, information is gathered directly by the loan officer through contact over time with the enterprise, the entrepreneur and the local community, and by observing the SMEs’ performance on all dimensions of its banking relationship, including loan contracts, deposits and other financial products. The loan officer may often remain the proprietor of the soft information,
may not be easily observed and verified by others. This gives rise to agency problems, which may be better addressed by small banking organisations with few managerial layers and closer coordination between the management and loan officers (Berger and Udell, 2002; Stein, 2002). Also, small banks are often headquartered closer to potential relationship customers, reducing problems associated with transmitting soft information from loan officers to senior management. In fact, greater hierarchical and/or geographical distance between the information collecting agent and the loan approving officer may lead to less reliance on subjective information and more on objective information (Liberti and Mian, 2009). 53. Empirical studies support the argument that small banks may find it more convenient than large institutions to engage in relationship lending. For instance, based on a survey of SMEs’ finance in Japan, Uchida (2011) finds that,
in the screening process to grant loans to SMEs, smaller banks give more importance to the relationship factor, also using third-party information as a reference. Furthermore, smaller banks tend to place greater emphasis on the collateral value of borrowers than large banks, suggesting that small banks might need to insure their relationship lending through the requirement of collateral. Matching data on US small businesses, the banks that lend to them and the contract characteristics of loans, Berger and Black (2011) also find that small banks have a comparative advantage in relationship lending. However, they also suggest that this advantage may be strongest for lending to the largest firms, whereas in the case of smallest firms credit scoring is increasingly preferred. 54. It is often the case, however, that banks adopt a mix of lending techniques to evaluate the firm’s creditworthiness and assess the credit risk. Investigating the choice of the lending technologies on a sample of SME loans in Japan, Uchida et al. (2006) find complementarity among technologies. In particular, financial statement lending and relationship lending are often used jointly. In a study on lending practices towards Italian manufacturing firms, Bartoli et al. (2010) also find the distinction between transaction lenders and relationship lenders to be rather blurred, as firms may obtain debt finance from the same bank through different lending technologies. This form of complementarity is found at both large and small banks, suggesting that transactions lending techniques, such as credit scoring, are used to “harden” - or codify - the soft information collected through relationship lending. However, the study also finds that the way soft information is embodied in the lending decision differs depending on the main approach used by the bank. In particular, soft information appears to raise (lower) the probability of credit rationing if the bank adopts mainly transaction (relationship) lending technologies. In other terms, banks that mainly use hard information to screen borrowers tend to use soft information as a mechanism for further discriminating loan applications.
2.2. Credit risk mitigation in traditional lending 55. Specific challenges limit traditional bank lending to SMEs. These are largely related to the greater difficulties that lenders encounter in assessing and monitoring SMEs relative to large firms (OECD, 2006, 2013b). First, asymmetric information is a more serious problem in SMEs than in larger firms. SMEs often do not produce audited financial statements that yield credible financial information and have no obligation to make public disclosure of their financial reports, although they are generally obliged to produce them and make them available to relevant authorities upon request.
Furthermore, in smaller enterprises, the line of demarcation between the finances of the owner(s) and those of the business is usually blurred. Unlike established public companies, which are expected to observe standards of corporate governance with clearly defined roles for shareholders, managers and stakeholders, SMEs tend to reflect the idiosyncrasies of their owners and their informal relationships with stakeholders. Hence, the entrepreneur has better access than the financier to information concerning the operation of the business and has considerable leeway in sharing such information with outsiders. The implications of asymmetries in information are made more severe by the large heterogeneity in the SME sector. SMEs are characterised by wider variance of profitability and growth than larger enterprises, and exhibit greater year-to-year volatility in earnings (OECD, 2006).
56. Second, the principal/agent problem, which is inherent in all financing operations, is particularly acute in the case of SMEs. Once financing is received, the entrepreneur may use funds in ways other than those for which it was intended. An entrepreneur might undertake excessively risky projects since all of the “upside” of the project belongs to the entrepreneur while a banker would prefer a less risky operation, even if profitability is less than under the riskier alternative. A large firm wishing to undertake a comparatively risky activity could select a different technique with appropriate formulas for sharing risk and reward, such as equity issuance, but the range of choice available to small firms is usually narrower (OECD, 2013b). 57. Financial institutions have developed several methods to mitigate the incidence of these challenges in SME lending. The main objective is to alter the risk-sharing mechanism in order to align incentives between lender and borrower. 58. Commonly used methods to manage SME credit risk include (OECD, 2013b): i) Requests for high equity contributions by prospective borrowers ii) Requirements for collateral. i.e. an asset of the borrower, the possessive right of which is provided to the lender in case of default iii) Credit guarantees, whereby should the borrower default the guarantor compensates a pre-defined share of the outstanding loan iv) Loan covenants, i.e. a condition imposed by the lender with which the borrower must comply in order to adhere to the terms in the loan agreement. Common loan covenants include: a) Hazard insurance/ content insurance, under which the borrower is required to keep insurance coverage on the plant/equipment or inventory in order to safeguard against the catastrophic loss of collateral; b) Key-man life insurance, which insures the life of the indispensable owner or manager without whom the company could not continue. The lender usually gets an assignment of the policy; c) Requirements for payment of taxes / fees / licenses, whereby the borrower agrees to keep those expenses up to date. In fact, failure to pay would result in the assets of the company being encumbered by a lien (i.e. legal claim on property) from the government, which would take precedence to the one from the bank; d) Provision of financial information on the borrower and guarantor, whereby the borrower agrees to submit financial statements for the continuing assessment by the bank; e) Borrower prevented from taking specific actions without prior approval, such as: change in management or merger, demanding more loans, or distributing dividends. 59. Over the last decade, the WPSMEE has conducted extensive work on access to debt finance by SMEs and entrepreneurs and on policies intended to ease SME debt financing, addressing structural limitations in lending markets and cyclical credit tightening.
The 2006 OECD Brasilia Action Statement for SME and Entrepreneurship Financing underlines the financing hurdle to firm creation and SME survival and growth, calling for innovative approaches to overcome structural constraints in SME financing. The assessment of government measures to support SMEs’ and entrepreneurs’ access to finance in the global crisis (OECD, 2010b) has highlighted the focus of most interventions was on easing credit constraints, mainly by injecting capital into loan guarantee programmes and direct lending programmes. The OECD Scoreboard on SME and Entrepreneurship Finance, largely based on debt-related indicators, has been providing a comprehensive framework for continuing to monitor SME financing trends and policies at the country and international level (OECD, 2012a). In 2011-12,
the WPSMEE produced analytical reports on policy measures intended to foster access to debt finance, such as credit mediation, a mechanism introduced in some OECD countries to support SMEs whose demand for credit has been entirely or partially rejected by financial institutions (OECD, 2013c), and credit guarantee schemes, which represent in many countries a key policy tool to address the SME financing gap (OECD, 2013d). 60. In the post-crisis environment, it is recognised that bank financing will continue to be crucial for the SME sector and policy measures in many countries are still largely oriented towards facilitating SMEs’ access to debt finance. However, it is increasingly acknowledged that more diversified options for SME financing are needed, to address the generalised “growth capital gap”, to support long-term investment, to reduce the vulnerability of SMEs to shocks in the credit market, and to cope with the changing regulatory environment and more rigorous prudential rules.
2.3. Alternative financing instruments 61. Traditional debt finance generates moderate returns for lenders and is therefore appropriate for low-to-moderate risk profiles. It typically sustains the ordinary activity and short-term needs of SMEs, generally characterised by stable cash flow, modest growth, tested business models, and access to collateral or guarantees. 62. Financing instruments alternative to straight debt alter this traditional risk-sharing mechanism. Table 1 provides a list of external financing techniques alternative to straight debt, categorised into four groups, characterised by differing degrees of risk and return, whose main features (modalities/operational characteristics, enabling factors, trends, support policies) will be outlined in detail in this report.
63. At the one end of the risk/return spectrum are financing instruments that sustain the short and medium-to-long term financing needs of SMEs, but that rely on different mechanisms than traditional debt. This is the case of asset-based finance, such as asset-based lending, factoring and leasing, whereby a firm obtains cash, based not on its own credit standing, but on the value that a particular asset generates in the course of its business. The close relationship between the liquidation value of an asset and the amount borrowed, as well as the broad range of assets that can be used to access lending, are the key factors that distinguish asset-based lending from traditional secured or collateralised lending, in which the loan amount and conditions also depend on the overall assessment of the firm’s credit worthiness. Furthermore, assetbased lending generally provides more flexible terms than conventional secured lending, often allowing for revolving funds; as advances are paid off, the borrower can secure additional funds backed by other assets. (see Section 3). 64. Trade credit is also an important source of finance for many SMEs and start-ups,
which can substitute or supplement short-term bank lending. This mainly consists of the extension of traditional credit instruments and credit-mitigation tools, such as loans and guarantees, to sustain import and export activities. Guarantees can take the form of letters of credit (L/C), which represent a bank obligation to pay, thereby reducing an export's payment risk on an importer/buyer. 65. Alternative forms of debt also exist, which can be considered “innovative” in the context of SME financing because they have had until now limited applicability to the SME sector. These alternative debt instruments include corporate bonds, securitised debt and covered bonds, in which investors in the capital markets, rather than banks, provide the financing for SMEs. While corporate bonds are direct instruments of debt finance for SMEs, securitisation and covered bonds represent “indirect” tools for supporting SME debt financing, in that the product issued to the firm is a loan. In particular, securitisation of SME debt allows banks to transfer their credit risk to the capital markets, as SME loans are sold to a specialised company, which creates a new security backed by the payments of SMEs. In this way, banks achieve capital relief and free up capacity for new loans to SMEs. Over the last decade, securitised debt has grown rapidly, although the financial crisis hit this market severely. On the other hand, few SMEs have succeeded in issuing corporate bonds, because of difficulties that small privately held companies have in meeting investor protection regulations and the high relative cost of bond issuance for small companies (OECD, 2013b). 66. At the other end of the risk/return spectrum are financing instruments that enable an investor to accept more risk in exchange for a higher return, and are expected to produce a better alignment of the interests of certain kinds of SMEs and the providers of finance. Hybrid instruments, such as mezzanine finance, form a bridge between traditional straight debt and pure equity. Seed and early stage finance addresses the high risk-return segment of the business financing spectrum, boosting firm creation and development, whereas other equity-related instruments, such as private equity and specialised platforms for SME public listing, can provide financial resources for growth-oriented SMEs. 67. The present study also considers the potential for SME financing of new instruments, such as crowdfunding or peer-to-peer lending. These have grown rapidly in some countries and have attracted increasing attention by policy makers and regulators, also with a view to address concerns about transparency, investors’ risk awareness and consumer protection.
3. Asset-based finance 68. Asset-based finance, which includes asset-based lending, factoring, purchase-order finance, warehouse receipts and leasing, differs from traditional debt finance, as a firm obtains funding based on the value of specific assets, rather than on its own credit standing. Working capital and term loans are thus secured by assets such as trade accounts receivable, inventory, machinery, equipment and real estate. 69. The key advantage of asset-based finance is that firms can access cash faster and under more flexible terms than they could have obtained from a conventional bank loan, regardless of their balance sheet position and future cash flow prospects. Furthermore, with asset-based finance, firms that lack credit history, face temporarily shortfalls or losses, or that need to accelerate cash flow to seize growth opportunities, can access working capital in a relatively short time. In addition, asset-based financiers do not generally require any personal guarantee from the entrepreneur, nor that s/he give up equity. 70. On the other hand, the costs incurred and/or the complexity of procedures may be substantially higher that those associated with conventional bank loans, including asset appraisal, auditing, monitoring and up-front legal costs, which may reduce the firm’s levels of profits. Also, funding limits are often lower than in the case of traditional debt.
3.1 Asset-based lending Modalities 71. Asset-based lending (ABL) is any form of lending secured by an asset. It is thus a transactions lending technology in which financial institutions address the problem of information asymmetry by focusing on a subset of the firms’ assets, as the primary source of repayment (Berger and Udell, 2006). Typically, four types of asset classes are secured under ABL: accounts receivable, inventory, equipment and real estate. 72. The amount the firm can borrow depends on the appraised value of the selected assets, rather than on the overall creditworthiness of the firm, taking into account the ease to sell off the assets should the borrower be unable to generate cash to repay the loan. The amount of credit extended is linked to the liquidation value of the assets, which is estimated and monitored on the basis of hard data, often relying on industry-specific knowledge. Thus, monitoring and asset evaluation methodologies are of the utmost importance for this type of lending, which explains the historical use of ‘tangible’ assets to secure loans and, on the other hand, the limited exploitation of intangibles, such as trademarks, patents and copyright. However, as methodologies for evaluating intangible assets become more accepted, these assets can also increasingly be used as collateral (Box 2).
Box 2. Intangible Asset-Based Lending (IABL) Intangible Asset–Based Lending (IABL) leverages a portfolio of Intellectual Property (IP) or other intangible assets to secure a loan. The loan can be backed by the stream of revenues tied to a single intellectual asset or to the firm’s entire portfolio. In either case, firms can secure their intellectual assets in addition to a blanket lien against common collateral such as real estate or receivables. In recent years, a variation on IABL, royalty financing arrangements, has developed, especially in the pharmaceutical and biotechnology sectors. In this case, lending is secured by royalty interest and revenue interest transactions, whereby, similar to a securitization transaction, loans are backed by a current or prospective royalty stream. Whereas “royalty interests” are already cash-flow positive, the “revenue interests” are riskier for the financier, as these are revenues anticipated to be derived from an identified product and related intellectual property. They apply to firms that are close to the commercial launch of a product or device and, due to the greater level of risk, the investing institution is generally able to negotiate more favourable terms. Unlike a securitisation, the loans are generally not bundled and sold to the general public, but held by a speciality investment fund Typically, firms specialising in IABL partner with banks or private equity firms that ultimately provide the funds, to secure a line of credit for the target company. As IABL requires flexibility and specialisation to account for differing and unique factors inherent in intangible assets, these specialised firms provide financial institutions with additional protections to offset the complexity and uncertainty surrounding intellectual assets valuation. Source: Ellis and Jarboe (2010), Jung and Tamiseia (2010), EC (2014)
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