Small business feeling the lending crunch – and three ways to help

Since the global financial crisis, credit growth in Australia has returned. But while growth in home lending between 2008 and 2014 was relatively strong (0.49% per month), it was actually negative for business lending (-0.04% per month).

This pattern of weaker business credit for corporates and small to medium enterprises is not unique to Australia but has been reflected around the globe due to long-term factors, such as the consolidation of banks and the centralisation of credit assessment. The issue has been accelerated by shorter term cyclical factors, such as increased business risk since the GFC and reduced demand for business credit.

Small and large business borrowers are relying more heavily on internal funding sources, such as retained earnings, and in the corporate sector there has been an evident diversification towards more market-based funding. But it is the “bank dependent” SME sector, with limited access to alternative markets that is feeling the pinch.

Small business: the engine of the economy

While it’s recognised businesses should not be funded unless they can generate an adequate return of capital, restricting the flow of funds to the SME sector can have a significant impact on the economy.

In Australia, for example around two million SMEs account for 68% of all industry employment and 56% of industry gross value added. Starving these businesses of funding will impact on employment growth and growth in GDP.

Negative credit growth for business has its roots in both demand and supply factors. In terms of the demand for credit there has been:

• reduced business leverage:
• business diversifying funding sources post GFC
• increased price of SME credit
• stricter lending covenants and increased cost of eligible collateral.

On the supply side, factors that have led Australian banks to have a preference for housing over business lending include:

• regulatory capital requirements
• consolidation in the banking sector, and
• costs of credit assessment for SMEs.

The ratio of business credit to total credit has been declining since the late 1980s. This longer-term trend is driven by concerns about increased credit risk arising from the business loan failures that occurred at that time, and the introduction of risk weighted capital ratios under the Basel I accord in 1988.

Under the Basel II Accord (2004) a new framework was introduced, leading to a greater differential in capital requirements for home and business lending.

This differential has had a major impact on bank balance sheets. Australian banks, with almost 63% of assets in residential property loans, have the largest proportion of residential real estate loans to total loans on bank balance sheets of all countries surveyed by the IMF. Although, the extent to which this focus on property “crowds out” business lending, and especially lending to higher risk SMEs, is difficult to determine.

The potential for capital requirements to adversely impact SME lenders was noted by the Financial Stability Board and Basel Committee’s Macroeconomic Assessment Group which stated in 2010 that as a result of tighter regulatory standards “bank-dependent small and medium-sized firms may find it disproportionately difficult to obtain financing.”

Regulations that provide disincentives for banks to engage in lending to SMEs have particularly grave implications for Australian business as approximately 90% of all intermediated credit in Australia is provided by banks.

Assessing SME credit risk

Increased consolidation in the banking sector has led to greater economies of scale in business lending. Where SMEs are concerned reliance on low cost credit scoring models, rather than traditional relationship banking can have adverse consequences. First, where young, high-growth SMEs are concerned, there is a high probability that such businesses will be denied credit, as their financial profile approximates that of a bankrupt firm with few assets, low liquidity and a low solvency ratio.

Second, given the importance of the capability of the business owner, credit assessment models that ignore this aspect are also more likely to make a Type 2 error, that is approve a loan which subsequently defaults. Third, individual banks may view SMEs as a segment rather than as heterogeneous businesses with varying risk profiles, leading to reduced business lending to SMEs in the aggregate.

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