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Straight debt finance: transaction lending technologies - report 3

  1.2. Objectives of the project 43. The project aims to help broaden the finance options available to SMEs and entrepreneurs, by improving ...


 


1.2. Objectives of the project 43. The project aims to help broaden the finance options available to SMEs and entrepreneurs, by improving understanding about the full range of financing instruments they can access in varying circumstances and by encouraging discussion among stakeholders about new approaches and innovative policies for SME and entrepreneurship financing. By conducting in-depth analysis on the potential and challenges for policies that broaden the financing options available to SMEs and entrepreneurs, the project also contributes to the OECD initiative on New Approaches to Economic Challenges (NAEC). 44. Specifically, the project undertakes the following: i) Maps the full range of financial instruments available to SMEs and entrepreneurs, at different stages of the firm life cycle and across the entire risk-return spectrum. ii) Improves the understanding about opportunities and challenges of financing instruments alternative to traditional debt, in different economic and regulatory environments, and in the light of on-going financial reforms iii) Explores options for policy to foster the broader use of these instruments, taking particular account of policy design and implementation considerations. iv) Derives policy recommendations and encourages discussion among policy makers, financial institutions and SME representatives about new approaches to SME and entrepreneurship financing. 


1.3. Methodology 45. The project consists of two parts. The first part maps the financing instruments available to SMEs and entrepreneurs (‘Mapping Report’). This takes into account existing reports from governments, public agencies, international organisations, research institutes, non-governmental organisations, financial institutions and business associations, as well as the academic literature in the field. As lack of comprehensive data is a major obstacle to the analysis in this field, a specific effort is devoted to improving the factual base on market trends and diffusion of non-debt financing instruments, to complement the information on SME access to finance from the Financing SMEs and Entrepreneurs: An OECD Scoreboard, which largely focuses on debt instruments. 46. The second part consists of case studies on selected financing instruments (crowdfunding, securitisation, covered bonds, corporate bonds and private placements), developed in cooperation with the Committee on Financial Markets. The cases examine the characteristics, diffusion and uptake by new firms and SMEs of selected instruments, assess their effectiveness in supporting innovative or potentially highgrowth firms to overcome financing constraints, evaluate what contextual factors can improve or hamper SMEs’ access to these instruments, illustrate policy experiences and programmes outcomes, and identify good practices to promote broader use of alternative financing techniques. The case studies are based on secondary sources, including literature review and public reports, and on interviews with policy makers, SME representatives, practitioners in relevant public and private institutions, other market participants and independent experts.


 1.4. Objectives of the present report and next steps 47. This Mapping Report analyses the main features of a broad range of techniques alternative to straight debt, including “asset-based finance”, “alternative debt”, “hybrid instruments”, and “equity instruments” (see Table 1). The report aims to improve understanding about the functioning of these instruments; provide insights about the profile of firms that are suited for them; highlight key enabling factors for their development; describe major trends in the market and access by SMEs by conducting a preliminary exploration of data sources; and offer some preliminary examples of policies in this area. 48. Earlier draft reports were presented to the WPSMEE informal Steering Group on SME Finance in September 2013 and to the WPSMEE in October 2013 and April 2014. This final report extends the analysis to the broad range of alternative instruments, incorporates insights from the completed case studies on crowdfunding and on securitisation, covered bonds, corporate bonds and private placements, and reflects comments received by Delegates and experts. 


49. A synthesis report, which incorporates key findings from the mapping exercise and the case studies, has also been developed. The synthesis report contributes to the OECD initiative on New Approaches to Economic Challenges (NAEC). 2. Traditional debt finance and alternative financing instruments 50. Traditional debt finance - bank loans, overdrafts, credit lines and the use of credit cards- is the most common source of external finance for many SMEs and entrepreneurs. The defining characteristic of straight debt instruments is that they represent an unconditional claim on the borrower, who must pay a specified amount of interest to creditors at fixed intervals, regardless of the financial condition of the company or the return on the investment. The interest rate may be fixed or adjusted periodically according to a reference rate. Straight debt does not include any features other than payment of interest and repayment of principal, i.e. it cannot be converted into another asset, and bank claims have high priority in cases of bankruptcy (‘senior debt’). 2.1. Traditional lending technologies 51. In traditional debt finance, the extension of the credit is primarily based on the overall creditworthiness of the firm and the lender considers the expected future cash flow of the firm as the primary source of repayment. However, the techniques to assess and monitor the firm’s creditworthiness, thus addressing the problem of information asymmetry between lender and borrower, may vary significantly. Different lending technologies combine different sources of information about the borrower, screening and underwriting procedures, structure of the loan contracts, monitoring strategies and mechanisms. The literature distinguishes transaction lending, based primarily on ‘hard’ quantitative data, and relationship lending, largely based on ‘soft’ qualitative information (e.g Berger and Udell, 2002, 2006). Under the first category are: i) financial statement lending, which depends on the availability of informative and audited financial statements on the side of the borrower and thus applies to informationally transparent borrowers, and; ii) small business credit scoring, which, on the other hand, may be applied to informationally opaque SMEs, as much of the information concerns the personal history of the owner, rather than the enterprise (Box 1).


Box 1. Straight debt finance: transaction lending technologies Financial statement lending Financial statement lending is based primarily on the strength of a borrower’s financial position and implies availability of informative and reliable financial statements, such as audited statements prepared in accordance to widely accepted accounting standards. It is thus reserved for informationally transparent firms. The extension of the credit depends on a strong financial condition as reflected in the financial ratios calculated from these statements, such as current ratio (current assets over current liabilities), debt to equity ratio, gross profit percentage (gross profit over gross sales), return on assets (net income over total assets), and return on equity (net income over net worth). Small business credit scoring Small business credit scoring is based on the analysis of large amounts of historical data about the SME’s owner as well as the firm. It may thus be applied to informationally opaque SMEs. The data are entered into a loan performance prediction model,


 which yields a score for the loan. The approach allows reduction in costs and time of granting a loan, greater consistency of credit evaluation and focus on difficult cases or large loan requests. The scoring method was first adopted in consumer lending, based on the large amounts of data readily available for banks on the performance of consumer credits and on the characteristics of borrowers. In the case of SME lending, however, the data needed to manage credits on a statistical basis may be available only to large banks, which are in fact the main adopters of credit scoring, or to smaller financial institutions that share or ‘pool’ data. There exist also credit reference agencies that provide credit scoring systems to banks which lack their own historical database. The credit scoring provided to banks by external agencies can cover both the business and the individuals in the business, based on their personal credit experience and rating. Source: Berger and Udell (2006), DeYoung et al. (2010), OECD (2013e).

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