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The Significance of Capital to Small Businesses Report

Discussion and Analysis

There are many critical issues regarding underfunding of small businesses in the wake of globalization and strong competition from mega businesses. In particular, the risk-averse behavior of financial institutions when funding small businesses, the government monetary policy, and the financial implications of recession influence funding of small businesses.

Additionally, inadequate capital base and ineffectiveness of government initiatives meant to solve the problem of funding to small-scale businesses. The problem of underfunding of small businesses has implications to the financial stability of the small businesses sector and the economy at large.

Small businesses contribute significantly to the growth and development of any economy. However, among the challenges that face the establishment and expansion of small businesses is inadequate capital. Thus, improving accessibility to loans from financial institutions by small businesses will enhance their growth. In addition, governments need to implement urgently measures to solve the problem of financial intermediaries and at the same time ensure stability of the small businesses sector (De Soto 2000, p. 132).

On the other hand, banks can actualize the objectives of small businesses through increasing credit accessibility by small businesses. Indeed, the principal reason why small businesses fail to obtain credit from banks is due to the problem of weak asset base and heavy collateral requirements.

However, by stabilizing the macroeconomic environment of through proper monetary policies, the interest rates will decline and at the same time stabilize prices to allow the small businesses to compete effectively. This report analysis highlights the significance of capital to small businesses and discusses the importance of stabilizing the financial sector to promote bank lending to assist small businesses.

The Bank Evaluation Rules on External Funding

Most mega businesses were initially small-scale with their expansion facilitated by more investments or funding. Indeed, generating an entrepreneurial idea alone is not sufficient but the capacity to access funding to actualize the idea is paramount. Many reputable entrepreneurial ideas simply die because of lack of funding from banks or financial institutions.

There are two main sources of finance for funding a new entrepreneurial idea: external and internal sources. Internal finance sources funds from personal savings or borrowing from friends or relatives (Berger, & Udell 2006, p.946). However, as the business expands external financing from lending institutions becomes necessary. The external funding is dependent on collateral security, which most small firms lack, and evaluation criteria of the financial institutions.

In external finance, two notable variants exist viz. equity financing and debt financing. In debt financing require the money lent to be secured by an asset-based collateral security of a certain value (Berger, & Udell 2006, p.953). In most cases, small businesses lack adequate collateral security to obtain a loan from the lending institutions.

Debt financing also involves a particular term-based interest rate on loans or overdrafts depending on the financial institution’s lending policies. Even if a small business affords the collateral to secure a loan, the exorbitant interest rates discourage from seeking for credit from financial institutions. Equity financing, on the other hand, does not require collateral security but gives the financier the right of ownership and management of the small business.

The critical problem in seeking for funding from external sources, from small business owner’s perspective, is not the interest rates or the collateral security requirement but the capacity of banks to evaluate the robustness of a business venture effectively. In most cases, the financial sector involved in lending finance to small size businesses has few financiers.

This results to high operating expenses and costs, which have implications for lending, which adversely affect the small enterprises. Among the recent developments in the banking sector that raises serious concern to monetary authorities is the high dependence of financial institutions on government deposits. In particular, government deposits to parastatals, affects the banking system and ultimately reduces credit availability to small business enterprises.

The Feasibility Appraisal of Small Business

In most financial institutions, the model of appraisal of the feasibility of a business idea or small businesses prior to extending credit is often risk-based. In this context, the business is subjected to risk assessment to warrant a commitment from external financiers.

According to Benavente et al, the risk assessment determines the probability that investing in a given business would result to loss of the investment (2006, p. 79). Often, the models for appraising the feasibility of small businesses involve qualitative and quantitative approaches. Quantitative techniques establish the financial projections using the available relevant financial information of the business.

Qualitative approaches, on the other hand, assess subjective information that may not be reflected in the financial numbers. These include the prevailing socio-political and business environment that indirectly influence the success of small businesses. The banks should design ways of identifying and providing loans to small businesses with little informational capacity (Peterson, & Rajan 1994, p. 341).

However, many factors may indirectly affect the lending patterns of financial institutions to small businesses. The recent bank consolidation through mergers and acquisitions threaten lending to small business enterprises.

These mergers in the banking sector are indications of their shift towards transacting lending or extending capital to large corporate businesses as opposed to small-scale enterprises. In addition, the mega banks establish their headquarters far from small business clients, which presents a problem to access credit facilities or relevant information.

Distresses in financial institutions during a ‘credit crunch’ determine credit availability of funding to small businesses. During times of financial crises, banks adopt a rigorous feasibility model for appraising small businesses, which often applies for large firms. More often, the small firms fail to meet certain aspects of the feasibility criteria.

Thus, for banks to increase lending to small firms there is a need to adopt lending rules that reflect the fundamental characteristics of small businesses and those of their owners.

According to Benavente et al., appropriate small-scale lending rules should encompass four main aspects: the asset-base, the financial statement, relationship lending and credit scoring of small firms (2006, p. 87). The need to develop unique credit lending rules for small businesses arises because of the problem caused by adverse selection by most lending institutions.

Poor selection often arises when financial institutions fail to verify the profitability of projects undertaken by small businesses. According to Stiglitz (2006, p. 120), financial institutions have concerns over moral hazards that come with lending to small firms.

Moral hazards arise when small businesses divert funds from financial institutions to other projects that may not be profitable, hence posing a risk to investments. De Meza and Webb argue that, the problems of moral hazard and adverse selection of small firms that deserve external financing lead to credit rationing or in some instances, over lending (1987, p. 281).

Lending Rules that affect Small Businesses

Various financial lending rules adopted by financial institutions affect lending to small business enterprises. In particular, the financial statement rule, which lays emphasis on the information contained in the financial statements of a firm, affect financing of small firms. Under this rule, the decision to lend and the lending terms depend on the strength of a firm’s financial statements. In this regard, the financial-statement-based lending favors large firms relative to small businesses.

Large firms have audited financial statements regarding their assets and liabilities, which coupled with high transparency, make them a lending choice by financial institutions. However, adopting the same financial statement rule for small businesses will result to most small firms not meeting the necessary requirements.

Berger and Udell argue that, the rule should be only applicable to small business enterprises with relatively transparent transactions and regularly audited financial statements (2001, p. 91). However, in most cases, most small firms lack these characteristics hence receive less credit facilities from the financial institutions.

Another lending rule that influence lending to small firms is the asset-based lending. Under this rule, the quality of the collateral security available for small businesses determines the lending decisions of the financial institution. However, this rule requires monitoring and evaluation of the small business performance, which sometimes can be expensive to undertake.

The collateral for asset-based lending is the business assets receivable and thus, asset turnover is constantly monitored by the bank. This rule is the common lending rule for small businesses in most countries. The credit-scoring lending rule analyses the borrower’s expectations regarding the performance of the loan (Stiglitz 2006, p. 118).

It assumes that the credit history of a small business or their owners predicts the business’s loan repayment capacity in the future (Peterson, & Rajan 1994, p. 338). The credit scores in the U.S. are used to underwrite personal loans but recently, the credit scores have been applied to small business credit facilities (National Foundation for Women Business Owners 1998).

Personal information used in credit scoring usually includes previous loan defaults, financial assets and personal income (Gertler, & Gilchrist 1994, p.314). This method gives weight to the financial status and credit worthiness of the owner(s) of small businesses. Consequently, the funding from the financial institution relies on the personal credit history. This affects the growth and expansion of small businesses given the close relationship that exists between the owner(s) and the firm for small businesses (Miller 2003, p. 46).

In contrast, the relationship-lending rule relies on the relationship developed between the lending institution and the small business owner over time. The relationship develops through regular provision of loans (Gertler, & Gilchrist 1994, p.311) and other financial information such as deposits (Miller 2003, p. 51).

Additionally, more information regarding the business can be obtained from the local community, customers and suppliers of the small firm, who provide general information about the firm or its owner(s). Most importantly, the information gathered over time results to a strong relationship that overrides the need for the financial statements, credit scores or collateral security.

According to Burger and Udell (2001, p. 101), a stronger relationship lending affects the interest charged and credit availability for small businesses. In addition, relationship lending offers reliable protections to fluctuations in interest rates. However, relationship lending has additional expenses on the bank as it involves constant gathering of customer information.

Changes in the economic environment or organizational structures of financial institutions have had a significant effect on the capacity of the financial institutions to deliver and credit availability to small firms.

Banks and the Problem of Financing Small Businesses

The importance of small-scale firms to world economies is evident especially with regard to promoting industrialization and economic growth. However, two serious problems affect their growth: unfavorable business environment and inadequate access to credit from financial institutions.

Although most financial institutions show the willingness to extend credit to small businesses, the risky nature of small businesses discourages them. Since financial institutions do not provide adequate capital to small businesses, the firms rely on limited capital to operate, which significantly hinders their growth and development. Additionally, the lack of adequate capital affects the capacity of small businesses to improve their technology in line with globalization trends.

The lack of sufficient information on small businesses raises concerns over the risks associated with some specified businesses. In particular, the lack of information on the financial performance of small businesses, the inability to enforce the financial contracts, the risk-prone business environment and the inability of small businesses to service their previous debts affect lending to small firms.

Because of these factors, banks usually resort to stringent lending rules such as asset-based lending or credit scores for small businesses. Asset-based lending is usually preferred because of its collateral requirements and the market interest charged. However, these conditions discourage small businesses from seeking credit facilities from the financial institutions and banks.

The Risk-averse behavior of Banks

The financial institutions risk-averse behaviors affect lending to small business enterprises. Normally, in most countries, banks are reluctant to extend long-term credit to small businesses citing risks associated with small business projects. Furthermore, even the banks that do extend small term credit facilities to small firms place high collateral requirements, and the term is normally less than a year (De Meza, & Webb 1987, p. 283).

This indicates the bank’s tendency to risk aversion, which affects lending patterns of financial institutions. According to De Soto, risk aversion implies that a bank expects the returns on an investment to be lower than the value of the investment over a given period (2000, p.135). In other words, if the interest earned by keeping the money is higher than the expected returns from investing in a small business, then the bank will opt for the former.

The consequences of the risk-averse behavior of banks coupled with high interbank rates constrain long-term growth of small businesses. The small businesses that rely on loans to implement their long-term plans cannot do so because of failure to access the essential credit facilities.

The risk-averse behavior of financial institutions arises due to three main reasons: management problems within small businesses, unfavorable macroeconomic environment and poor infrastructural facilities to support that can support the growth of small firms (United States Small Business Administration Office of Advocacy 1999).

Shocks in the macro-economic environment including unstable exchange rates, high interest rates and government monopolistic policies on the financial sector especially during budgetary allocation lead to risk-averse behavior by most banks. The interest rates in various sectors of the economy discourage potential small firm investors due to the risk of losing the investment. Additionally, large firms get comparatively lower interest rates compared to small businesses (World Bank Survey 2001, p. 10).

This result into more prominent firms seeking credit facilities from financial institutions, which ultimately forces small firms out of the credit market. In addition, the lack of government consistency with regard to industrial policies also promotes the risk aversion behaviors by banks, which affects the growth and expansion of small businesses.

Many banks fail to fund the small businesses because of poor economic conditions in a country. In particular, poorly performing public utilities and infrastructural facilities threaten the funding of small businesses. Unstable infrastructural facilities such as power supply and transport network imply that the cost of doing business is high.

This adversely affects small businesses more than large corporate firms. A high cost of doing business makes banks, being risk-averse, to limit lending to small businesses because the likelihood of recouping their investment is low. Additionally, internal organizational structures of small businesses act as a deterrent to their growth and discourage banks from extending credit to small businesses.

Poor management of small businesses characterized by inefficient control systems and poor financial records discourage lending from financial institutions. In addition, poor accounting standards within small businesses especially involving financial transactions provide loopholes for fraud and consequently limits small businesses’ accessibility to credit facilities.

Furthermore, capital requirement constraints have an adverse effect on the monetary policy that ultimately affects credit availability (Berger, & Udell 2001, p. 98). Usually, monetary tightening decreases reserves in banks, which forces them to reduce their lending. The reduction in lending particularly affects small businesses that cannot access other external sources of finance, and depend on entirely on relationship lending.

Consequently, investments and growth of small businesses decreases as the interest rates rise to discourage potential borrowers. Therefore, a monetary policy that induces an increase in bank lending and at the same time regulates the interest rates could create a stable macroeconomic environment suitable for the growth of small businesses.

A stable macroeconomic environment attracts investments and promotes lending by financial institutions that ultimately promotes the growth and expansion of small business enterprises.

Reference List

Benavente, J., Galetovic, A., & Sanhueza, R., 2006. FOGAPE: An Economic Analysis. Washington, DC: World Bank.

Berger, A., & Udell, G., 2001. Small Business Credit Availability and Relationship Lending: The Importance of Bank Organizational Structure. Federal Reserve Board Working Paper, pp. 87-102.

Berger, A., & Udell, G., 2006. A more Complete Conceptual Framework for SME Financing. Journal of Banking and Finance, 30(11), pp. 945-966

De Meza, D., & Webb, D., 1987. Too Much Investment A Problem of Asymmetric Information, Quarterly Journal of Economics, 102, pp. 281-283

De Soto, H., 2000. The Mysteria of Capital. New York: Bantan Press.

Gertler, M., & Gilchrist, S., 1994. Monetary Policy, Business Cycles, and the Behaviour Of Small Manufacturing Firms. Quarterly Journal of Economics, 109, pp.309 – 314.

Miller, M., 2003. Credit Reporting Systems and the International Economy. Cambridge, MA: MIT Press.

National Foundation for Women Business Owners. 1998. Characteristics of woman Entrepreneurs worldwide are revealed. Web.

Peterson, M., & Rajan, G., 1994. The Benefit of Firm Creditors Relationship: Evidence from Small Business Data. Journal of Finance, 49, pp. 337-341

Stiglitz, J., 2006. Economics of the Public Sector. London: W.W. Norton & Co. Inc. United States Small Business Administration Office of Advocacy. 1999. Minorities in Business. Web.

World Bank Survey. 2001. World Development Report 2001: Washington, Oxford University Press for the World Bank.

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