Small Business Finance - What Works, What Doesn't?

May 5 and 6 saw an interesting research conference here in DC on Small Business Finance, looking at which banking practices and government interventions help foster small businesses' access to external finance. Twelve interesting papers and a stimulating panel discussion addressed an array of issues, ranging from banks' lending techniques over competition, government policies to informal and trade credit. Many papers and speakers questioned conventional wisdom on what we know and what policies are helpful.

Bank-level surveys show that banks engage more with SMEs than commonly thought, and beyond just offering credit services. Interestingly, differences in banking practices, such as collateral requirements, appraisal techniques and interest rates are more pronounced between developed and developing countries, but less so between small and large enterprise lending within the same country. All types of banks perceive SMEs as a core and strategic business and are catering to SMEs. Indeed, larger multiple-service banks and foreign banks have a comparative advantage in offering a wide range of products and services in large scale, through the use of new technologies, business models, and risk management systems. On the other hand, analysis for the U.S. suggests that large banks do not have comparative advantages over small banks in all of the hard lending technologies and the comparative advantages of large banks in the hard technologies are not increasing in firm size.

Competition plays an important role. Evidence for Belgium shows that the organizational structure and technology of rival banks in the vicinity influence local bank competition. A study on Mexico finds that banks with decentralized lending structures – where branch managers have autonomy over the terms of lending - give larger loans to small firms and those with more “soft information” particularly in states with weak legal enforcement of financial contracts. However, decentralized banks are also more likely to restrict credit and to charge higher interest rates when they have market power, more so to smaller firms and those with more soft information that have fewer options for external finance. Competition, however, is not necessarily an impediment for banks to get together and exchange information about borrowers, as experimental evidence shows, especially in the case of consumer credit where borrowers are more mobile. Credit information sharing can also be very important at the lower end of the credit market, as a paper on Sri Lanka showed. Informing and helping microentrepreneurs to fill out loan applications helps some entrepreneurs get credit, but not necessarily the most profitable ones. While credit scoring has often seen as the technique of choice for large banks, US community banks in the U.S also use them to a surprisingly wide extent. Further, credit scoring is generally associated with increased small business lending after a learning period, but without any significant change in the quality of the loan portfolio. Most banks use credit scoring to supplement other lending technologies, such as relationship lending.

What is government role's in small business finance? Partial credit guarantee schemes are the intervention tool of choice, as the above mentioned bank survey shows and confirmed by the great interest in our March conference on this topic. The rigorous evaluation of a French partial credit guarantee scheme, however, provides a rather somber picture. The results suggest that the program indeed alleviates credit constraints with little evidence of selection issues, but there is no evidence that the program fosters new entry into entrepreneurship. Further, the costs of the program are quite substantial, in the form of higher bankruptcy of participating firms. Another study confirmed that small firms face higher average default risk, but lower unexpected loan losses, which has important repercussions for bank capital regulations.

A final set of papers considered alternative financing sources using Chinese firm-level survey data. While the fast growth of Chinese private sector firms is often taken as evidence that it is alternative financing and governance mechanisms that support China's growth, financing from the formal financial system is associated with faster firm growth, whereas fund raising from alternative channels is not. Further, Chinese firms are more likely to finance receivables with payables and to match the maturity of contracts between receivables and payables when they enjoy stronger market power in the input market or when firms face stronger competition in the output market. Trade credit supply thus appears to be more responsive to the competition firms face than their credit constraints.