Prepared by John Anderson, Queensland University of Technology

1. Prepared by John Anderson, Queensland University of Technology

2. Chapter Nine Small Business Lending

3. Learning Objectives • Define what a small business is and provide an overview of the main characteristics of the market for small business lending in Australia • Explain the theory underlying small business finance, using the concepts of asymmetric information, credit rationing, adverse selection and moral hazard

4. Learning Objectives • Describe the distinctive risks of lending to small business • Outline the main characteristics of a relationship-managed approach to small business lending

5. Learning Objectives • Outline the main characteristics ofa credit-scored approach to small business lending (using recent experiences in the United States) • Comment on how lending to small business in Australia is likely to change over the next decade

6. Introduction • Small business lending is a specialised area of lending • Small business lending is gaining increased theoretical support • Two main approaches: • Relationship Management approach; • Credit Scoring approach

7. Overview of Small Business Lending • What is a small business? • Numerous definitions exist including: • ABS – Less than 20 employees; • RBA • Independently owned and operated • Closely controlled by owners/managers who also contribute most, if not all, of the operating capital • Has loans less than $500,000 • Generally has turnover less than $5,000,000

8. Overview of Small Business Lending • Small business in the economy • ABS • 1,175,000 small businesses in Australia representing 95% of total businesses • Produce 30% of all private sector output • On average has 3 employees –40% of total workforce and 50% of private sector • Half of business employment in the property and business services, construction and retail sectors

9. Overview of Small Business Lending • Small business in the economy • RBA • Higher working hours with 25% working more than 51 hours per week • In 1995-96, 8% of small businesses stopped trading, while only 5% of medium to large businesses did so • Legal structure • Company 43% Small v. 70% Larger Businesses • Sole Proprietorships, Partnerships and Trusts 17% Small v. 38% of Larger Businesses

10. Overview of Small Business Lending • Some characteristics of Small Business Lending (RBA, 1993) • SB Lending 1/3 size of Large Business • SBs pay 1.6% higher rates on average to reflect higher default risk and economiesof scale • Financing takes three main forms: • Floating rate finance; • Fixed rate finance; • Bill finance

11. Overview of Small Business Lending • Floating Rate Loans • Overdrafts • Very popular representing about 50% of SB borrowings • Highly flexible funding source but around 1.5% more expensive than bill finance

12. Overview of Small Business Lending • Fully Drawn Advance • Loan fully drawn down at start with repayments generally made in regular instalments • Floating rate finance generally provided at a risk premium over a benchmark rate

13. Overview of Small Business Lending • Fixed Rate Loans • 42% of SB loans are fixed rate for 3–5 yrs • Generally used to purchase non-current assets such as property and plant & equipment • Risk margin generally added to 3–5 year Treasury Bond rates

14. Overview of Small Business Lending • Bill Finance • Issuing of discounted securities with most at 90-day maturities • Lack flexibility compared to overdrafts with all funds being drawn down on issue • RBA 2001 statistics:

15. Overview of Small Business Lending • How do lenders organise their Small Business lending? • NAB: • Loans < $250,000 – Centralised Credit • Loans > $250,000 – Relationship Manager • CBA: • Loans < $500,000 – Centralised Credit • Exceptions where complex business, e.g. importer/exporter using credit finance andFX risk management products

16. Overview of Small Business Lending • Implications of bank cutoff levels • Lower cost ‘vanilla deals’ where strong financials support credit- scoring approach • May have negative implications for ‘good’ businesses operating just below cutoffs where notional credit scoring may be prejudicial

17. Overview of Small Business Lending • Cutbacks in relationship managers may lose clients seeking ‘solution- providing’ service • Moving business clients to ‘faceless’ banking and lending must be handled very cautiously

18. Overview of Small Business Lending • Competition in SB lending market • Fierce competition, particularly where loans backed by borrower’s property resulting in fixed risk-margin pricing • Changes include • Intensive efforts to reduce cost to income ratio • Where property used as security, loans can be assessed via simple credit scoring and capital funded at 50% risk-weighting concession v. 100% (up to 150%) for other business loans • Promotion of centralised credit analysis

19. Overview of Small Business Lending • Small Business attitudes to lenders • Source: RBA and Yellow Pages SB Index • 79% used finance from major banks • NAB and CBA held 48% of market share • 1/3 SB owners unhappy with service provided by major banks with ‘poor/no service’ at 42% and ‘no personalised service’ at 27%

20. Overview of Small Business Lending • Lower dissatisfaction figures for small banks and NBFIs at 37% and 14% respectively • 16% changed institution with disproportionate number moving to smaller institutions • Main reasons for change were ‘better service’ (47%) and ‘less/lower fees’ (32%)

21. Overview of Small Business Lending • 45–46% believed institution supportive and cared about them as customers • Only 1/3 believed institution’s fees for service was value for money, though better on these measures at smaller institutions

22. Overview of Small Business Lending • Political Importance of SBs and SB Lending • Government may become involved if dissatisfaction levels continue to increase

23. A Theoretical Basis for Understanding Lending to SB • While considerable emphasis on ratios, cashflow analysis, etc., many other issues to consider arise: • Asymmetric Information: Borrower is much better informed about the firm than lender (also ‘Informationally Opaque’ • Credit Rationing: Loan price set too high • Adverse Selection: Better borrowers depart while poor borrowers remain • Moral Hazard: Seeking of riskier projects

24. A Theoretical Basis for Understanding Lending to SB • Relationship lending helps reduce asymmetries via two information types: • Hard: Verifiable financial information • Soft: Borrower’s character/reliability

25. A Theoretical Basis for Understanding Lending to SB • Stronger lending relationships lead to • Lower interest rates • Reduced collateral requirements • Lower dependence on trade debt • Greater protection against interestrate cycle • Increased credit availability

26. The Decision to Lendto Small Businesses • Specialised SB risks: • Key-Person Risk: Is one person in the firm the key to business success/viability? • Lack of Capital: Due to limited funds, tax strategies, capital flexibility, etc. • Lack of Track Record: Often new business or first-time business owner • Poor Accounting Records: • No audit or lodgement requirements, delays, emphasis on tax-driven strategies, reporting freedoms and/or attempted deception

27. The Decision to Lendto Small Businesses • Risk and SB Failure • Over 30,000 fail each year • 1/3 fail in first year • Another 1/3 fail in second and third years combined • 3/4 fail after five years

28. The Decision to Lendto Small Businesses • Reasons for failure include • Inexperienced/incompetent management • Poor accounting and record-keeping • Problems with financial management and liquidity • Lack of expert advice • Too much reliance on debt funding

29. The Decision to Lendto Small Businesses • Two approaches to SB Lending • Relationship Management approach • Analysis of historical financials • Stage 1: Avoiding GIGO principle on financial statements being relied on for lending decision. Check ratios and financials for consistency • Stage 2: Detailed analysis of historical financials including analysis of short-term liquidity ratios, long-term solvency ratios and business performance ratios

30. The Decision to Lendto Small Businesses • Analysis of cashflow projections – be cautious of overoptimistic projections • Assessment of risks including key person, undercapitalisation, lack of track record, etc. • The importance of security – increasing reliance on property collateral • Problems with Relationship Management • Loan approval and management very labour intensive • Greater delegation can lead to credit problems as soft information is notoriously difficult to assess

31. The Decision to Lendto Small Businesses • Credit Scoring Approach • Relies on input, such as ratios, etc., into mathematical credit assessment models • Background to SB lending in US • SB loans defined as loans less than $100,000 • 8,149 US banks v. 51 Australian banks • Small local banks dominate SB lending • Past/Present Use of Credit Scoring in US • Increasing usage due to cost savings, availability of databases, ability to quantify credit risk in securitisation supported by political and regulatory change

32. The Decision to Lendto Small Businesses • Structure of US credit-scoring models • At least 30,000 applications needed for model • Fair Isaacs starts with 50 variables to determine 10 most significant • Financial ratios probably less important than previous 10 years’ credit repayment history

33. The Decision to Lendto Small Businesses • Changes in Credit Scoring and Predictions • Helps reduce information asymmetries • Flow of usage from larger to smaller banks • Greater credit supply to low–medium incomes • Greater reliance on simple form-based and/or online applications for SB lending • Greater cost reductions