Philipp Grein University of Bern

1. Small business banking and financing: a global perspective, CagliariThe impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective Philipp Grein University of Bern

2. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective Agenda • Introduction • Characteristics of a lending relationship • IFRS versus German Commercial Code • Prior research on IFRS-adoption • The model • General assumptions • Information structure • Sequence of events • Equilibria for discrete strategies • Conclusion

3. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 1. Introduction • German SMEs primarily financed by relationship lenders due to their size and informational opaqueness. • Long-term lending relationships help to overcome financing constraints but relationship lender gains monopolistic position • Possible solution: Increased disclosure by adopting IFRS • Question: • Can a SME really reduce its dependence from relationship lenders by adopting IFRS? • Does an IFRS-adoption reduce the cost of debt for a SME? • Is an IFRS-adoption always beneficial for an SME with regard to the financing situation?

4. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 2. Characteristics of a lending relationship • Lending relationships are of long-term nature: • Relationship lender accumulates information over time • Relationship lender: • has access to private information, which is of soft nature • provides largest share of debt capital of a debtor • assists debtor during times of financial distress • Access to private information decisive factor for the existence of a lending relationship: • Competition on loan market is reduced  Problem of time inconsistency solved  inter-temporal contracts possible  Relationship lender is able to earn an information rent

5. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 3. IFRS versus German Commercial Code • German Commercial Code: • Influenced by tax accounting rules • Prudence principle very dominant • assets cannot be valued higher than at their historical costs • internally generated intangibles assets cannot be recognized  creation of hidden reserves • Relief for smaller and medium firms with regard to the notes (§326, § 327 HGB)  Main accounting purpose: • Determination of distributable income and capital maintenance • Provision of information only of subordinate importance

6. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 3. IFRS versus German Commercial Code • International Financial Reporting Standards (IFRS) • Not influenced by tax accounting rules • Prudence principle less dominant: • valuation at fair value of certain assets possible • broader definition of assets • internally generated intangibles assets can be recognized  less creation of hidden reserves • greater number of mandatory notes • No relief for smaller and medium firms  Main accounting purpose: • Provision of decision useful information (true and fair view) • IFRS-adoption increases amount and quality of disclosed information

7. 4. Prior research on IFRS-adoption Disclosure and cost of capital across different accounting standards Till now: evidence only for cost of equity capital Ambiguous results (e.g. Leuz/Verrecchia and Daske) Accounting quality and cost of capital Negative relationship for cost of equity capital as well as for debt capital (e.g. Francis et al, Bharat/Sunder/Sunder) Accounting quality of different accounting standards IFRS exhibit a higher quality than German GAAP (e.g. Gassen/Sellhorn and Daske/Gebhardt) The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 25.05.2007 7

8. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 5. The model 5.1 General assumptions • Model with two time periods • 3 Players: • Owners of an owner managed firm either of type G or of type B • Relationship lender • Outsiders • Investment program: • Owner can run two consecutive investment projects, initial investment of I each: • Project 1: starts in t=0,pay-off 0 or X in t=1 • Project 2: starts in t=1, pay-off 0 or Y in t=2 • Probability of success: πwith πB < πG • Both projects only for type G positive net present value

9. 5. The model 5.1 General assumptions Financing: Only debt financing possible Outsider and relationship lender simultaneously offer an interest rate Relationship lender incur relationship building costs cHB if chosen as financier Financing of both types in t=0 and t=1 is associated with a loss The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 25.05.2007 9

10. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 5. The model 5.2 Information structure • Sequence of events, pay off structure of investment projects, and ex ante probabilities are common knowledge • In t=0 only entrepreneur observes his true type • If relationship lender is financier of first investment project, it can observe true type of entrepreneur after completion of first project • Outsiders rely only on publicly observable information

11. 5. The model 5.2 Information structure In t=1 entrepreneur chooses either information systems HGB or IFRS If IFRS is chosen and entrepreneur is type G: IFRSG ΦG IFRSS 1-ΦG If IFRS is chosen and entrepreneur is type B: IFRSS ΦS IFRSG 1-ΦS IFRS as verifiable signal on type of entrepreneur Assumptions: 1. IFRS is informative: ΦG>0,5 and ΦS>0,5 2. German GAAP no information content, no signal sent The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 25.05.2007 11

12. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 5. The model 5.3 Sequence of Events 0 1 2 Return from project two: 0 or Y Loan is repaid if possible Relationship lender observe owner’s type If owner chooses IFRS, outsiders observe signal on owner’s type Owner starts second project Owner chooses an information system, IFRS or HGB Relationship lender or outsiders provide I Relationship lender or other lenders provide I Entrepreneur starts project one Return from project one: 0 or X Loan is repaid if possible

13. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 5. The model 5.4 Equilibria for discrete strategies • Assumption: • Relationship lender offers either rmax or rd • Outsiders offer either rd or make no offer • Without information system: • Outsiders never make an offer • Relationship lender earns information rent by financing second project with rmax • Information rent exceeds losses from first project  Relationship lender is willing to finance project in t=0

14. 5. The model 5.4 Equilibria for discrete strategies With information system two types of equilibria in t=1, separating or pooling Pooling equlibria: 1. Both types choose German GAAP  same equilibrium as in situation without information system  outsiders have sceptical expectations 2.Both types choose IFRS (assumption: no cost of adoption) Very high information quality: relationship lender offers rd, outsiders offer rd if signal indicates good type High information quality: equilibrium in mixed strategies Medium information quality: relationship lender offers rmax, outsiders offer rd if signal indicates good type The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 25.05.2007 14

15. 5. The model 5.4 Equilibria for discrete strategies Separating equilibrium (cost of adoption equals b) Type G entrepreneurs adopt IFRS, Type B entrepreneurs keep German GAAP Type G entrepreneurs receives financing in t=1 at rmax Type B entrepreneurs receive no financing in t=1  Equilibrium holds only if cost of adoption is sufficiently high but not too high The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 25.05.2007 15

16. 5. The model 5.4 Equilibria for discrete strategies Equilibrium of entire game depends on outcome of second stage If information rent is significantly reduced, relationship lender is not going to invest in a relationship  depends on information quality of IFRS, on adoption costs and on relationship building costs  Both entrepreneurs do not receive financing in t=1 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 25.05.2007 16

17. The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 6. Conclusion • Effects of an IFRS-adoption for the financing of SMEs depends on information quality of IFRS • If IFRS of sufficient information quality:  Mitigation of hold up problem possible  Cost of debt financing reduced • But: Relationship lenders looses ability to earn information rent • Nature of existing lending relationships alter:  willingness to provide assistance during financial distress declines • Banks may no longer be willing to establish lending relationships  Credit availability for very young SMEs declines