Ciarán Mac An Bhaird
The perennial issue of small firm financing is once again to the fore as small and medium sized firms (SMEs) are experiencing a challenging financing environment in the aftermath of the global economic and financial crisis. A combination of factors has contributed to a credit crunch for small firms. Businesses struggling with negative effects of the recession are experiencing liquidity problems because of increased bad debts and slower payments by debtors.
Whilst these issues affect firms in all financing systems, they are particularly severe for firms dependent on bank financing for a significant proportion of external funding. The volume of loans and credit advanced to small firms by banks worldwide has decreased significantly, as banks seek to reduce their balance sheets and rebuild capital reserves. Additionally, firms that availed of ample credit at relatively low interest rates in the period of economic growth and expansion from 2001-2007 have to wean themselves off this once-abundant credit, and will have to pay higher rates for this funding.
The provision of credit to SMEs by the banking sector worldwide has decreased due to a number of reasons. Firstly, demand for loans by small firms has fallen as business activity has dropped, and firms seek to deleverage. Secondly, bank lending to the sector has declined because of the poorer financial condition of firms during the economic downturn. Thirdly, restricted liquidity in the interbank markets means that financial institutions must curtail their lending to the sector.
This is a particularly frustrating issue for business owners in countries where governments have provided support to the banking sector, and continue to commit sovereign resources to shore up banks in difficulty. The rationale provided by governments advancing support to the banking industry was that it would enable them to resume lending, thereby stimulating activity in the real economy. In general this has not happened, as banks seek to accumulate capital reserves rather than advance them to SMEs. Additionally, banks seek to protect their limited capital reserves by investing in securities perceived as less risky, including sovereign and corporate paper.
Although a number of economists view expansion and contraction of the credit cycle as a fundamental factor in business cycles, nonetheless national governments frequently intervene to provide funding and supports to the SME sector. This is addressed at the highest level of government, as witnessed by President Obama’s launch of the small jobs act 2010 in the United States in September, which provides for increased supports for the small business sector. Similarly, the recent “Merlin agreement” between the UK government and the banking sector to provide £190 billion in lending to business in 2011, including at least £76 billion to SMEs, is symptomatic of government reaction to employment crises as political leaders need to be “seen to do something”. Banks should be under no obligation to lend money, however, and it is very difficult and unwise to compel them to do so. Rather, policy makers should be focussed on building financial systems and facilitating the design of lending mechanisms to ensure adequate provision of finance at all times, and not just at times of crisis.
The credit crunch currently being experienced by SMEs is remarkably similar to that experienced by small firms in the UK in the early 1990s. Although that credit crunch is still a relatively recent memory, it appears that similar mistakes are presently being made as small firms were ill prepared for the present crisis. There are two particular aspects to the current liquidity crisis that may be addressed in seeking to improve the financial environment for SMEs and alleviate potential funding difficulties in illiquid financial markets. Firstly, firms should become less dependent on bank financing, an issue stressed by Uriel Lynn at the ISBE conference in November. This can be achieved by retaining greater reserves within the firm, and by seeking sources of external private equity rather than debt finance.
Although not all equity investors may be interested in some sections of the SME sector, other equity providers, such as business angels, may willingly provide funding. Small firm owners should be encouraged to seek out investment from the plethora of Business Angel networks across the UK. These angels provide not only capital, but more importantly, technological knowledge and specialist skills, which are particularly invaluable for young, nascent firms.
A second pertinent issue to emerge from the present liquidity crisis, and which needs to be urgently addressed, is the issue of financial management. In a recent study, firm owners stated that the greatest constraint to growth and development is a lack of adequate financial management skills. This self-perceived deficit in financial management expertise and skills can be addressed in a number of ways, employing a number of participants, including SMEs, private professionals, and financial institutions.
Provision of treasury management programmes may be enhanced by assigning mentors to firms with little experience of raising, managing, and investing capital. For example, management training courses may be offered in partnership with funders, which would have the additional benefit of informing potential applicants for external funding of supply-side requirements and expectations, thus potentially enhancing future funding applications. It may take the form of embedding financial officers from banks in SMEs through secondment or otherwise, thus ensuring that key officers acquire essential financial management skills. Professionals in accounting and consulting firms can also perform this role.
Another means of implementing financial management training is to provide it as part of a holistic support package for small businesses, whereby a complete business diagnosis – financial, marketing, product development, etc. - is provided by a team of experts, and is funded partly by the firms themselves, partly by private consultants, and partly by government. This would greatly benefit the management of finances in firms, and improve the liquidity position, and therefore the sustainability of the sector, ensuring not only further employment opportunities, but also ensuring the sustainability of employment in firms which account for over 60% of employees in the non-financial sector in OECD countries.
Finally, it is imperative that banks significantly alter their lending practices. For many years, debt finance has been advanced on provision of collateral. This model of lending is inefficient and is costly both for SMEs and financial institutions. It results in inefficient allocation of resources based on property, and is not related to profitability or performance. It also leads to inadequate monitoring of investment, as well as incentives for inappropriate risk taking. This model – if it ever worked – is now well and truly broken. Even if banks wanted to return to this model of lending, it is not possible because of present difficulties in valuing property assets.
A new model of lending by financial institutions is required, whereby prudent lending decisions are made to advance funds to viable firms, with a greater appraisal of investment opportunities, employing techniques and analysis that take account of the level of risk and realistic return. New lending models need to be based on profitability and projected cash flow, rather than on property and personal guarantees. Banks need to train lending officers in assessing investment opportunities and risk analysis, ideally having a specialist sectoral focus, rather than basing lending decisions solely on fulfilment of a number of limited standard criteria. Of course this will be an iterative process, and banks competencies will increase as lending officers gain knowledge and cognitive skills in appraising loan applications.
The SME sector is crucial to economic recovery and return to growth, not only in terms of creating employment but in maintaining current levels of employment. This importance is increased because of rationalisation programmes and downsizing by large corporations, emphasising the central role of the SME sector in the revitalisation of world economies. Development of a vibrant, sustainable small firm sector is dependent on sufficient resourcing of SMEs, particularly during periods of tightened credit. The present contractionary phase of the credit cycle has resulted in illiquid financial markets for small firms, precipitating the closure of many SMEs that might have otherwise survived. The challenge remains to create a financing system that can respond to variations in the supply of credit, although one hopes that the lessons of the present credit crunch can be learned in order to mitigate the ill effects of future crises.
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Dr Ciarán Mac an Bhaird, Lecturer of Business and Management, Dublin City University