Credit offers to small and medium-size businesses: an overview of considerations that influence the decision process of an active lender with regard to commercial loans and trade credit.

Commercial loans and trade credit are necessary to allow companies to go beyond the limitations of the reinvestment of earnings and to avoid financing by issuing stock. Their importance can be illustrated by the fact that in 1993, nearly half (49.63 percent) of the assets of U.S. small and medium enterprises (SMEs) were financed by debt. (1) More specifically, commercial loans from financial institutions and trade credit from suppliers accounted for 26.66 percent and 15.78 percent of SMEs' assets, respectively. From a Canadian standpoint, a study conducted by St-Pierre et al. (2) among more than 2,000 SMEs shows that 45 percent applied for a credit margin and 28 percent applied for medium or long-term financing in the three years that preceded this study.

Loan Offers by Financial Institutions

Concerned with maximizing their profit, financial institutions target their development on the most profitable sectors. According to this premise, bank loan offers to SMEs are motivated by the attractiveness of the business segment. Schwarz (3) states that small and medium businesses generate a 21-percent and 15-percent return on invested capital (ROIC), respectively, compared to a ROIC of only seven percent for large businesses.

A number of characteristics of the financial institution can influence its loan offer, including the following:

* Competitive environment

* Size of the lender and technology used

* Financial situation of the lender

Competitive Environment

With respect to the access to a loan, research by St-Pierre et al., (4) which explains the acceptance rate for a loan application, indicates that rural and urban businesses are not at a disadvantage compared to businesses in metropolitan areas. However, the presence of credit unions could also be beneficial for SMEs, since their acceptance rate is higher both for credit margins (85.8 percent versus 80.4 percent) and long-term financing (93.6 percent versus 83.2 percent). As for loan terms, research suggests that the interest rates taken on by SMEs are higher for markets in which competition is weaker. (5) Extending these results to the other variables of credit transactions indicates that the terms of the contract could be less advantageous for the borrower in the absence of strong competition.

Size of the Lender and Technology Used

Berger et al. (6) advanced the hypothesis that there is a negative relationship between the size of a financial institution and its propensity to lend to SMEs. The stated arguments were the high cost of decentralized management of files and the transactional approach with the client. The results of their study, which was completed in Argentina, did not invalidate the hypothesis that large financial institutions are less willing to lend to SMEs. In a U.S. context, based on the fact that, to a large extent, loans of less than $1 million are granted to SMEs, financial institutions seemed to be less interested in that market in the second half of the 1990s. In fact, according to Ely and Robinson, (7) between 1994 and 1999, the portion of assets allocated by financial institutions to this business segment dropped by 8.75 percent. However, we cannot conclude that the large U.S. banks are moving away from the SME loan market, since the facts show that between 1994 and 1999 their market share went from 47 percent to 51 percent. In other words, for these banks, the growth of loans to SMEs was inferior to that of other lines of business.

Traditionally, large financial institutions approach loans to SMEs in a transactional manner, whereas small institutions follow a more relational approach. (8) For Ferrary, (9) the importance of taking into account the characteristics of the management team in the case of SMEs results in an ineffective transactional approach because it is based too much on quantifiable financial information. Large financial institutions would have a hard time following a relational approach since it is difficult for them to move qualitative information through the organization. (10) As a result, large financial institutions have tended to place a greater importance on collateral compared to smaller financial institutions. (11) Recent works by Berger et al. (12) are very critical of the fact that large financial institutions are less well positioned to serve the SME market. (13) They concluded instead that large institutions allocate a smaller portion of their assets to this market, that they hold a less risky SME loan portfolio and that they require a smaller risk premium than their smaller competitors.

Financial Situation of the Lender

The financial situation of a financial institution could also have an impact on its ability to lend to SMEs and to take on the associated risks. For a financial institution in a weaker financial situation, granting loans to SMEs would be less appealing since it amplifies the risk perceived by the regulatory authorities. Berger et al. (14) tested this hypothesis with a sample of Argentinean financial institutions without being able to determine if financial institutions in difficulty were practicing any loan rationing. However, since SMEs place great importance on banker-business relationships, they tend to stay away from financial institutions experiencing financial difficulties when looking to secure new financing. (15)

How the Banker-Business Relationship Affects the Loan Offer

Many studies demonstrate the benefits of adopting a relationship approach when completing commercial loans. Results show that the length of the relationship reduces the cost of the loan (16) and allows the borrower to benefit from more stable interest rates throughout the different stages of the economic cycle. (17) Also, Boot's paper (18) presented some factors that facilitate granting a loan when a banker-business relationship exists. They are the knowledge of the borrower's business, the modulation of the risk premium throughout the duration of the business relationship, the profitability of the other banking services provided and the reduction of information asymmetry.

It is a lot easier for a financial institution to know about the SME's operations if the entrepreneur does all of its banking with the financial institution that is processing the loan application. The institution is thus better positioned to assess its credit risk, and it can better distribute the cost of gathering information among the different services offered to the SME. (19) Moreover, if the entrepreneur …