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

conference held at the World Bank’s headquarters on May 5 and 6 brought together academics, practitioners and policy makers for an interesting discussion on Small Business Finance; this built on our 2004 conference on SMEs – Access to Finance as Growth Constraint.  A major theme of the 2004 conference was that small enterprises face traditionally higher obstacles to accessing external finance than other groups—such as large enterprises, and even consumers. Financial and institutional development helps level the playing field between firms of different sizes, so that all deserving firms – including small ones- would be able to access external finance.  The 2008 conference picked up where the last one left off, by looking specifically at which banking practices and government interventions are helpful to foster small businesses’ access to external finance.  Fourteen interesting papers, and a stimulating panel discussion, addressed an array of issues related to overcoming SMEs’ financing constraints.

Bank-level surveys indicate 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 than between small and large enterprise lending within the same country.  All types of banks perceive SMEs as a core and strategic business, and do cater to SMEs.  Indeed, larger multiple-service banks and foreign banks have a comparative advantage in offering a wide range of products and services to SMEs on a 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. 

Competition plays an important role.  Evidence from Belgium suggests that the organizational structure and technology of rival banks in the vicinity influence local bank competition.  A study on Mexico found 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.”  This is particularly evident 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, which 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 indicates.  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 been seen as the technique of choice for large banks, community banks in the U.S also use them to a surprisingly wide extent.  Furthermore, 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—which is also reflected in 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. In addition, 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. The fast growth of Chinese private sector firms is often taken as evidence that it is alternative financing and governance mechanisms which support China’s growth.  However, financing from the formal financial system is associated with faster firm growth, whereas fund raising from alternative channels is not. Furthermore, 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 as opposed to credit constraints.


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