Prepared by John Anderson,Queensland University of Technology
Chapter NineSmall Business Lending                         2
Learning Objectives• Define what a small business is and  provide an overview of the main  characteristics of the market f...
Learning Objectives• Describe the distinctive risks of  lending to small business• Outline the main characteristics of a  ...
Learning Objectives• Outline the main characteristics of  a credit-scored approach to small  business lending (using recen...
Introduction• Small business lending is a  specialised area of lending• Small business lending is gaining  increased theor...
Overview of Small       Business Lending• What is a small business?  – Numerous definitions exist including:    • ABS – Le...
Overview of Small       Business Lending• Small business in the economy  – ABS    • 1,175,000 small businesses in Australi...
Overview of Small        Business Lending• Small business in the economy  – RBA     • Higher working hours with 25% workin...
Overview of Small       Business Lending• Some characteristics of Small  Business Lending (RBA, 1993)    • SB Lending 1/3 ...
Overview of Small     Business Lending– Floating Rate Loans  • Overdrafts     – Very popular representing about 50%       ...
Overview of Small   Business Lending• Fully Drawn Advance    – Loan fully drawn down at start with      repayments general...
Overview of Small     Business Lending– Fixed Rate Loans  • 42% of SB loans are fixed rate for 3–5 yrs  • Generally used t...
Overview of Small            Business Lending    – Bill Finance        • Issuing of discounted securities with most       ...
Overview of Small     Business Lending– How do lenders organise their Small  Business lending?  • NAB:     – Loans < $250,...
Overview of Small  Business Lending• Implications of bank cutoff levels   – Lower cost ‘vanilla deals’ where     strong fi...
Overview of SmallBusiness Lending– Cutbacks in relationship managers  may lose clients seeking ‘solution-  providing’ serv...
Overview of Small       Business Lending• Competition in SB lending market    • Fierce competition, particularly where    ...
Overview of Small        Business Lending• Small Business attitudes to lenders     • Source: RBA and Yellow Pages SB Index...
Overview of SmallBusiness Lending– Lower dissatisfaction figures for small  banks and Non-BFIs at 37% and 14%  respectivel...
Overview of SmallBusiness Lending– 45–46% believed institution supportive  and cared about them as customers– Only 1/3 bel...
Overview of Small       Business Lending• Political Importance of SBs and SB  Lending    • Government may become involved ...
A Theoretical Basis forUnderstanding Lending to SB• While considerable emphasis on  ratios, cashflow analysis, etc., many ...
A Theoretical Basis forUnderstanding Lending to SB   • Relationship lending helps reduce     asymmetries via two informati...
A Theoretical Basis forUnderstanding Lending to SB   • Stronger lending relationships lead to      – Lower interest rates ...
The Decision to Lend     to Small Businesses• Specialised SB risks:     • Key-Person Risk: Is one person in the firm      ...
The Decision to Lend to Small Businesses• Risk and SB Failure   – Over 30,000 fail each year   – 1/3 fail in first year   ...
The Decision to Lendto Small Businesses• Reasons for failure include   – Inexperienced/incompetent     management   – Poor...
The Decision to Lend     to Small Businesses• Two approaches to SB Lending  – Relationship Management approach    • Analys...
The Decision to Lend     to Small Businesses• Analysis of cashflow projections – be cautious  of overoptimistic projection...
The Decision to Lend    to Small Businesses– Credit Scoring Approach  • Relies on input, such as ratios, etc., into    mat...
The Decision to Lend to Small Businesses• Structure of US credit-scoring models   – At least 30,000 applications needed fo...
The Decision to Lendto Small Businesses• Changes in Credit Scoring and Predictions   – Helps reduce information asymmetrie...
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Credit Management Chap 9

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Credit Management Chap 9

  1. 1. Prepared by John Anderson,Queensland University of Technology
  2. 2. Chapter NineSmall Business Lending 2
  3. 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 3
  4. 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 4
  5. 5. Learning Objectives• Outline the main characteristics of a 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 5
  6. 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 6
  7. 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 7
  8. 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 8
  9. 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 9
  10. 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 economies of scale • Financing takes three main forms: – Floating rate finance; – Fixed rate finance; – Bill finance 10
  11. 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 11
  12. 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 12
  13. 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 13
  14. 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: Variable Fixed Bills Total$ Million 33,037 28,042 5,228 66,307Share % 50 42 8 100Wtd Avg Interest Rate 8.3 8.5 6.8 8.2 14
  15. 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 and FX risk management products 15
  16. 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 16
  17. 17. Overview of SmallBusiness 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 17
  18. 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 18
  19. 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% 19
  20. 20. Overview of SmallBusiness Lending– Lower dissatisfaction figures for small banks and Non-BFIs 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%) 20
  21. 21. Overview of SmallBusiness 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 21
  22. 22. Overview of Small Business Lending• Political Importance of SBs and SB Lending • Government may become involved if dissatisfaction levels continue to increase 22
  23. 23. A Theoretical Basis forUnderstanding 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 23
  24. 24. A Theoretical Basis forUnderstanding Lending to SB • Relationship lending helps reduce asymmetries via two information types: – Hard: Verifiable financial information – Soft: Borrower’s character/reliability 24
  25. 25. A Theoretical Basis forUnderstanding Lending to SB • Stronger lending relationships lead to – Lower interest rates – Reduced collateral requirements – Lower dependence on trade debt – Greater protection against interest rate cycle – Increased credit availability 25
  26. 26. The Decision to Lend to 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 26
  27. 27. The Decision to Lend to 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 27
  28. 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 28
  29. 29. The Decision to Lend to 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 – ABC criminology- accept nothing, believe no one and confirm everything 29
  30. 30. The Decision to Lend to 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 30
  31. 31. The Decision to Lend to 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 31
  32. 32. The Decision to Lend to 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 32
  33. 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 33
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