Small business lending is a specialized area that involves distinctive risks. There are two main approaches to small business lending: relationship management and credit scoring. Relationship management relies on analyzing financials and cashflow projections while assessing risks like key personnel. Credit scoring uses mathematical models to assess applications based on financial ratios and credit history. Both aim to overcome challenges like asymmetric information between lenders and small business borrowers.

1. Prepared by John Anderson,
Queensland University of Technology

2. Chapter Nine
Small Business Lending
2

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. 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. 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. 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. 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
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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. 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
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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. 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
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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. 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. 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 66,307
Share % 50 42 8 100
Wtd Avg Interest Rate 8.3 8.5 6.8 8.2
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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. 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
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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
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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. 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%
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20. Overview of Small
Business 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. 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
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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. 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
23

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
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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 interest
rate cycle
– Increased credit availability
25

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
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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. The Decision to Lend
to 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. 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. 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
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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
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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
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33. The Decision to Lend
to 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
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