Elsevier

Journal of Banking & Finance

Volume 30, Issue 11, November 2006, Pages 2945-2966
Journal of Banking & Finance

A more complete conceptual framework for SME finance

https://doi.org/10.1016/j.jbankfin.2006.05.008Get rights and content

Abstract

We propose a more complete conceptual framework for analysis of SME credit availability issues. In this framework, lending technologies are the key conduit through which government policies and national financial structures affect credit availability. We emphasize a causal chain from policy to financial structures, which affect the feasibility and profitability of different lending technologies. These technologies, in turn, have important effects on SME credit availability. Financial structures include the presence of different financial institution types and the conditions under which they operate. Lending technologies include several transactions technologies plus relationship lending. We argue that the framework implicit in most of the literature is oversimplified, neglects key elements of the chain, and often yields misleading conclusions. A common oversimplification is the treatment of transactions technologies as a homogeneous group, unsuitable for serving informationally opaque SMEs, and a frequent misleading conclusion is that large institutions are disadvantaged in lending to opaque SMEs.

Introduction

The availability of external finance for small and medium enterprises (SMEs) is a topic of significant research interest to academics and an important issue to policy makers around the globe. The conceptual framework to which most of the current research literature adheres has been quite helpful in understanding the institutions and markets that provide funds to SMEs in developed and developing nations. This framework has also provided insights into the effects of policies that affect access to funding by creditworthy SMEs in these nations. However, we argue that the current framework is oversimplified, and neglects key elements of the financial system that affect SME credit availability.

We propose a more complete framework in which lending technologies play a key role as the conduit through which government policies and national financial structures affect SME credit availability. We define a lending technology as a unique combination of primary information source, screening and underwriting policies/procedures, loan contract structure, and monitoring strategies/mechanisms.

An important oversimplification in the current framework is the way that lending technologies are often categorized into two types: transactions lending that is based primarily on “hard” quantitative data and relationship lending, which is based significantly on “soft” qualitative information. Under this categorization, transactions lending is generally viewed as being focused on informationally transparent borrowers, while relationship lending is seen as used for opaque borrowers.

In our view, this characterization is fundamentally flawed. Transactions lending is not a single homogeneous lending technology. There are a number of distinct transactions technologies used by financial institutions, including financial statement lending, small business credit scoring, asset-based lending, factoring, fixed-asset lending, and leasing. While financial statement lending is focused on transparent borrowers, these other transactions technologies are all targeted to opaque borrowers. Recognition of this heterogeneity among transactions technologies and its impact on credit availability to opaque borrowers is often missing from the academic literature.

Our framework specifies a causal chain from government policies to a nation’s financial institution structure and lending infrastructure. These financial structures, in turn, significantly affect the availability of funds to SMEs by determining the feasibility and profitability with which different lending technologies may be deployed. Financial institution structure refers to the market presence of and competition among different types of financial institutions and lending infrastructure refers to the rules and conditions that affect the ability of these institutions to lend. The extant research literature often neglects key elements of this causal chain, which may yield misleading research and policy conclusions.

To illustrate, consider the recent research on financial institution size, one dimension of financial institution structure. A common finding is that large institutions have a comparative advantage in transactions lending to SMEs based on hard information, while small institutions have a comparative advantage in relationship lending based on soft information. A policy implication that might at first blush seem reasonable is that the financial institution structure must include a substantial market share for small institutions to meet the demands of informationally opaque SMEs, since large institutions rely on hard information for their transactions lending technologies.

While the current conceptual framework is likely correct in associating large institutions with transactions technologies, the inference that large institutions are disadvantaged in lending to opaque SMEs is flawed. Large institutions deliver credit to many types of opaque SMEs through the transactions lending technologies that specifically address problems of informational opacity using hard information. For small business credit scoring, large institutions use hard information on the SME and/or its owner obtained from credit bureaus to infer future loan performance; for asset-based lending, these institutions use valuations of the assets pledged as collateral to evaluate repayment prospects; for factoring, they focus on the quality of the accounts receivable purchased; for fixed-asset lending and leasing, large institutions look to the valuations of the fixed assets that are pledged as collateral (fixed-asset lending) or directly owned by the institution (leasing). Thus, when informative financial statements are not available, institutions are often able to use other types of hard information to assess repayment prospects. Similar arguments apply to potentially misleading conclusions based on the current framework about other dimensions of a nation’s financial structures and the policies that affect these structures.

Research on SME finance suffers from the problem that the lending technologies are usually not identified. This makes it difficult to test theories that relate financial structures to credit availability for different types of borrowers and to make policy assessments of which financial structures function best in supplying funds to creditworthy transparent and opaque SMEs. The limited findings from studies that identify lending technologies suggest that significant variation in the deployment of these technologies exists across nations – an institutional fact that is not explained by the current conceptual framework. For example, asset-based lending has a significant presence in only four nations, Australia, Canada, the UK, and the US. A goal for our framework is to try to explain a significant portion of the variation in the use of lending technologies with differences in national financial structures.

The effects of a nation’s lending infrastructure on SME credit availability through determining the feasibility and profitability of deploying the different lending technologies is particularly under-researched in the literature. This infrastructure includes the information environment, the legal, judicial, and bankruptcy environments, the social environment, and the tax and regulatory environments in which financial institutions operate in a given nation. Lending infrastructures are quite heterogeneous across nations. We show how a nation’s lending infrastructure affects the extent to which each of the individual lending technologies are employed in financing SMEs.

Section 2 briefly discusses each of the major lending technologies used for SMEs. Sections 3 Financial institution structure, 4 The lending infrastructure focus on the financial institution structures and lending infrastructures of nations, respectively. We show how these structures may influence SME lending credit availability through affecting the feasibility and profitability with which the different lending technologies may be deployed. Section 5 provides some brief conclusions.

Section snippets

Lending technologies

We briefly define and describe each of the lending technologies, highlight its distinguishing features, and show how the technology addresses the opacity problem. Each technology is distinguished by a unique combination of the primary source of information, screening and underwriting policies/procedures, structure of the loan contracts, and monitoring strategies and mechanisms. In some cases, the technologies basically differ from one another in just one of these dimensions (e.g., fixed-asset

Financial institution structure

In this section, we focus on the effects of a nation’s financial institution structure on the feasibility and profitability with which the different lending technologies can be deployed to fund SMEs. The research literature provides a considerable amount of evidence on the effects of financial institution structure on SME lending, but the findings rarely go beyond the distinction between transactions lending technologies versus relationship lending to parse among the different transactions

The lending infrastructure

In this section, we turn our attention to the lending infrastructures of nations and how they affect the feasibility and profitability of using the different lending technologies in SME financing. The lending infrastructure includes the information environment, the legal, judicial and bankruptcy environments, the social environment, and the tax and regulatory environments. All of these elements may affect SME credit availability by influencing the extent to which the different lending

Conclusions

We offer a more complete conceptual framework for thinking about the research and policy issues surrounding the availability of credit to SMEs in various circumstances around the globe. We emphasize a causal chain in which the lending technologies provide the crucial link between government policies and financial structures on the one hand, and SME credit availability on the other hand. At the top of the chain, government policies affect a nation’s financial institution structure and lending

References (100)

  • L.G. Goldberg et al.

    The determinants of foreign banking activity in the United States

    Journal of Banking and Finance

    (1981)
  • T.H. Hannan

    Bank commercial loan markets and the role of market structure: Evidence from surveys of commercial lending

    Journal of Banking and Finance

    (1991)
  • T. Jappelli et al.

    Information sharing, lending and defaults: Cross-country evidence

    Journal of Banking and Finance

    (2002)
  • J. Jayaratne et al.

    How important are small banks to small business lending? New evidence from a survey of small firms

    Journal of Banking and Finance

    (1999)
  • J. Kallberg et al.

    The value of private sector credit information sharing: The U.S. case

    Journal of Banking and Finance

    (2003)
  • J. Peek et al.

    Bank regulation and the credit crunch

    Journal of Banking and Finance

    (1995)
  • R.G. Rajan et al.

    The great reversals: The politics of financial development in the twentieth century

    Journal of Financial Economics

    (2003)
  • P. Sapienza

    The effects of government ownership on bank lending

    Journal of Financial Economics

    (2004)
  • R.M. Stulz et al.

    Culture, openness and finance

    Journal of Financial Economics

    (2003)
  • E.I. Altman et al.

    Effects of the new Basel Capital Accord on bank capital requirements for SMEs

    Journal of Financial Services Research

    (2005)
  • R.B. Avery et al.

    Bank consolidation and the provision of banking services: Small commercial loans

    Journal of Financial Services Research

    (2004)
  • Bakker, Marie H.R., Klapper, L., Udell, G.F., 2004. Financing small and medium-size enterprises with factoring: Global...
  • T. Beck et al.

    Bank competition and access to finance: International evidence

    Journal of Money, Credit, and Banking

    (2004)
  • Beck, T., Demirguc-Kunt, A., Maksimovic, V., 2004b. Financing patterns around the world: Are small firms different?...
  • T. Beck et al.

    Financial and legal constraints to firm growth: Does firm size matter?

    Journal of Finance

    (2005)
  • A.N. Berger

    Potential competitive effects of Basel II on banks in SME credit markets in the United States

    Journal of Financial Services Research

    (2006)
  • A.N. Berger et al.

    Small business credit scoring and credit availability

    Journal of Small Business Management

    (2006)
  • A.N. Berger et al.

    Did risk-based capital allocate bank credit and cause a ‘credit crunch’ in the U.S.?

    Journal of Money, Credit and Banking

    (1994)
  • A.N. Berger et al.

    Relationship lending and lines of credit in small firm finance

    Journal of Business

    (1995)
  • A.N. Berger et al.

    Small business credit availability and relationship lending: The importance of bank organisational structure

    Economic Journal

    (2002)
  • A.N. Berger et al.

    The globalization of financial institutions: Evidence from cross-border banking performance

    Brookings–Wharton Papers on Financial Services

    (2000)
  • A.N. Berger et al.

    The effects of dynamic changes in bank competition on the supply of small business credit

    European Finance Review

    (2001)
  • A.N. Berger et al.

    The dynamics of market entry: The Effects of mergers and acquisitions on entry in the banking industry

    Journal of Business

    (2004)
  • A.N. Berger et al.

    Further evidence on the link between finance and growth: An international analysis of community banking and economic performance

    Journal of Financial Services Research

    (2004)
  • A.N. Berger et al.

    Credit scoring and the availability, price, and risk of small business credit

    Journal of Money, Credit, and Banking

    (2005)
  • Berger, A.N., Rosen, R.J., Udell, G.F., 2006. Does market size structure affect competition? The case of small business...
  • J. Berkowitz et al.

    Bankruptcy and small firms’ access to credit

    The Rand Journal of Economics

    (2004)
  • M. Berlin et al.

    Bond covenants and delegated monitoring

    Journal of Finance

    (1988)
  • E. Bonaccorsi di Patti et al.

    Bank competition and firm creation

    Journal of Money, Credit, and Banking

    (2004)
  • A. Boot et al.

    Can relationship banking survive competition?

    Journal of Finance

    (2000)
  • C.M. Buch

    Information versus regulation: What drives the international activities of commercial banks?

    Journal of Money Credit and Banking

    (2003)
  • M. Burkart et al.

    In-kind finance. A theory of trade credit

    American Economic Review

    (2004)
  • Burkart, M., Ellingsen, T., Giannetti, M., 2005. What you sell is what you lend? Explaining trade credit contracts....
  • Carbó-Valverde, S., Rodríguez-Fernández, F., Udell, G., 2006. Bank market power and SME financing constraints....
  • M. Carey et al.

    Does corporate lending by banks and finance companies differ? Evidence on specialization in private debt contracting

    Journal of Finance

    (1998)
  • N. Cetorelli

    Bank concentration and competition in Europe

    Journal of Money, Credit, and Banking

    (2004)
  • N. Cetorelli et al.

    Banking market structure, financial dependence and growth: International evidence from industry data

    Journal of Finance

    (2001)
  • N. Cetorelli et al.

    Finance as a barrier to entry: Bank competition and industry structure in local U.S. markets

    Journal of Finance

    (2006)
  • Y.-S. Chan et al.

    Asymmetric valuation and the role of collateral in loan agreements

    Journal of Money, Credit and Banking

    (1985)
  • K. Chan et al.

    Earnings quality and stock returns

    Journal of Business

    (2006)
  • Cited by (0)

    The opinions expressed do not necessarily reflect those of the Federal Reserve Board or its staff. The authors thank the anonymous referees, Zoltan Acs, Thorsten Beck, Lamont Black, Cesare Calari, Asli Demirguc-Kunt, Scott Frame, and Leora Klapper for valuable direction with the paper, and participants in the World Bank Conference on “Small and Medium Enterprises: Overcoming Growth Constraints” and the Australasian Finance and Banking Conference for helpful discussion.

    View full text