How our government missed the opportunity to fix our dysfunctional business banking system
In the UK, P2P lending to business has developed rapidly with support from the British Business Bank, set up in 2013 by the UK Government. It has a mandate to facilitate up to $20bn of SME finance by 2019. Whilst bank lending to London’s SMEs plummeted 40% in 2015, the UK capital’s companies raised an estimated £350m through peer-to-peer lending in the same year, according to the British Bankers Association.
In the US, the Small Business Administration has guaranteed over $112bn of loans with a bad debt rate of less than 1%. In 2015 alone, $24bn was advanced.
Credit guarantee schemes work. They overcome the clear risk aversion that affects our banking system when it comes to business loans by limiting the apparent downside. And taxpayers' money is put to work for a good return.
Over the last 3 years to June 2016, our banks have increased their housing related mortgage books from $1,178 billion to $1,472 billion according to the RBA and APRA. That's another $294 billion dropped into non-productive, dead assets.
Meanwhile, small business lending has increased by a miserable $26 billion, an annual rate of just 3.4%, to $269 billion over the same 3 year period - not 13-15% pa as stated recently by ANZ's Shayne Elliott.
Since 2013, only 11% of new business lending has gone to small businesses. Most of the $900 billion of loans outstanding to businesses goes to the big end of town.
However, the Productivity Commission finalised a report on Business Set-up, Transfer and Closure in December 2015 which carries a serious amount of weight in Canberra. It concluded that there was no problem in accessing business finance in Australia despite submissions to the contrary by many reputable bodies.
Unfortunately, many of its conclusions were unhelpful for SMEs because of the required focus on starting and exiting businesses - their mandate ignored the obstacles faced by growing businesses. As a result, mid-sized businesses, the engine room of our economy, were not even considered: they provide 1 in 4 jobs in Australia and represent our best chance of achieving the Government's Jobs and Growth objectives.
"With a combined annual turnover of around $1.1 trillion, if Australia’s mid-size businesses were a state, their economy would be larger than Queensland" according to Greg Keith, CEO of advisory firm Grant Thornton in releasing their Australian Mid-Sized Business Report 2015.
Recent announcements by Greg Hunt,Federal Minister of Industry, Innovation and Science, show that the message may be sinking in slowly despite the nay-sayers. He acknowledged that "As companies grow from $20 million to $200 million in value, there is often real difficulty in finding investment capital". However, this ignores the fundamental working capital funding gap - growth requires working capital as well as capital investment.
Credit guarantee schemes have been very successful overseas but the few dated studies reviewed by the Productivity Commission led to the wrong conclusion. To see what it is missing, our Government needs to study carefully the powerful positive effects of setting up the likes of the British Business Bank in the UK, the Small Business Administration in the US and the European Investment Fund in the EU.
Government funds should be invested alongside private sector funds to fix a clear market failure to finance the growth of established Australian businesses. The most effective way to do this is set up one well-equipped agency to make it happen across Australia.
Here is the relevant extract from Productivity Commission report:
Is there a role for a credit guarantee scheme?
Credit guarantee schemes (CGSs) can be structured in a number of ways, although most take the form of a public scheme whereby creditors are paid part or all of the value of defaulted loans made to businesses out of government budgets. In return, the government receives part of the return on a performing loan. CGSs are common internationally, although Australia does not have such a national scheme.
ACCI (sub. 11), while noting the potential problems with a CGS, proposed that the Government should consider implementing a scheme in Australia:
“The Government should explore the feasibility of a temporary small business loan guarantee scheme. Similar schemes operate in several other international jurisdictions, including the US, UK and Canada, with varying levels of eligibility and coverage. Such a scheme could suffer from ‘moral hazard’ issues. Further, it could impose contingent liabilities on the Commonwealth’s balance sheet. However, a well designed scheme would avoid the pitfalls associated with any risk sharing financial scheme by establishing rigorous eligibility criteria and assessment guidelines. If implemented, the scheme could have a sunset provision, preceded by a review date." (p. 15)
In their post draft submission, the Chamber of Commerce and Industry Queensland also endorsed a role for government in underwriting businesses access to finance (sub. DR44). The issue of credit guarantee schemes has also received attention in a number of recent reports. For example, it has recently been advocated by Deloitte Access Economics (2013a):
“Well designed and managed [credit guarantee] schemes can limit the call on public finances. If information asymmetry causes the potential lender to attribute a higher risk of default to a borrower in the absence of adequate security, the credit guarantee can address this. By reducing the loss given default with a guarantee, the CGS increases the likelihood of viable businesses gaining access to finance." (p. 30)
The Institute of Public Accountants also supported the introduction of a CGS in their Australian Small Business White Paper (2015):
“To increase the availability of much needed affordable loan finance to the small business sector, the Federal Government should introduce a state backed loan guarantee scheme. The scheme would provide a limited State backed guarantee to encourage banks and other commercial lenders to increase loan finance available to smaller and younger start up firms that face difficulty financing new investment opportunities through normal commercial channels." (p. 27)
Those in favour of CGS argue that it would improve lending to new or small businesses by:
• reducing the effects of information asymmetries on bank lending decisions, given that banks will be more willing to lend to new and small businesses if they know that part of their investment is covered in the case of default
• reducing the need for business owners to provide collateral to secure a bank loan
• reducing the risk weight attached to small and medium sized enterprise business loans under the Basel III framework — this in turn reduces the amount of capital banks need to hold to against these loans, which may encourage additional lending (Deloitte Access Economics 2013a).
These factors are often argued to have positive flow on effects on employment or economic growth, although the cost to the community of achieving any such effects is not usually considered. Advocates also note that Australia is one of the few developed countries that does not operate a CGS.
Arguments against the introduction of a CGS include that:
• It simply involves a transference of risk from private lending institutions to taxpayers. Further, it may dissuade lending institutions from undertaking sufficient vetting and monitoring processes when making loans, increasing adverse selection and moral hazard problems. In other words, a CGS can reduce a lender’s loss in the event of default, but does not reduce the probability of default (and could actually increase it if banks are discouraged from undertaking adequate vetting and monitoring).
• There is little conclusive evidence that a CGS results in more business loans being made (box 7.5). In other words, there is not clear additionality or incrementality from introducing a CGS.
• The costs of setting up and maintaining a CGS are high. They also represent a significant contingent liability on the public budget that can become large very quickly should many loans default (as might be the case in a severe recession for example).
• Despite not having a CGS, Australia’s entry rate for new businesses is higher or comparable to many countries that do — for example, Canada, Italy, Spain and the United States. Further information about how Australia’s entry rate compares with other economies can be found in chapter 2.
Box 7.5 Studies on credit guarantee schemes
The effectiveness or otherwise of CGS in increasing the ease of access to debt finance is a subject of much debate within the existing empirical literature. Several studies identify positive effects. For example:
• Craig, Jackson and Thomson (2005) found a statistically significant but small relationship between the level of guaranteed lending under the United States CGS in a local banking market and future per capita income growth in that market.
• Riding, Madill and Haines Jr. (2007) found that the Canadian CGS facilitates lending to SMEs that would not otherwise qualify for loans, with this having flow on effects to job creation.
• Zecchini and Ventura (2009) found the Italian CGS has been effective in reducing the borrowing costs of SMEs and easing their financing constraints.
• Uesugi, Kaki and Yamashiro (2006) found that the Japanese CGS increased credit allocation to businesses that used the scheme.
However, Green (2003) and O’Bryan III (2010) concluded that it is difficult to prove that CGS do contribute to additional lending to small businesses while De Rugy (2007) suggested that the rate of business start ups in the US would be the same both under and without the 7(a) CGS in the US.
Empirical work examining the effects of CGS on business survivability is also inconclusive — for example, Oh et al.(2008) found that businesses supported under the Korean CGS did experience significantly higher survival rates, however this contrasts to research by Uesugi, Sakai and Yamashiro (2010) that found that participants in the Japanese scheme were significantly more likely to experience financial distress than businesses that did not take part.
Studies have also examined whether CGS distorts the credit market — for example, Cowan, Drexler and Alvaro (2012) find that CGS reduces the effort exerted by banks in collecting loans, which has marked effects on the proportion of loans considered to be delinquent (behind in repayments by more than 60 days). As CGS typically see defaulted loans repaid at least in part by governments, the cost of these delinquent loans is partially borne by taxpayers. Green (2003) suggests that schemes available for loans made to small businesses may see an undesirable substitution of credit away from large (uncovered) borrowers towards small (insured) borrowers. The possibility of distortions is also acknowledged by Honohan (2010) who notes:
“Even if fiscal costs are low, the economic costs of misallocated resources can be high. While it is clear that public interventions into the credit market will tend to have distorting incentive effects, these distortions are subtly different depending on the type of scheme, for example, resulting in too much entry, too much risk, too little monitoring or entrepreneurial effort or in rent seeking behaviour." (pp. 6–7)
Setting the optimal price of a CGS is also problematic for governments. If the price is too high, the scheme is likely to be weighed down by adverse selection and moral hazard problems as only high risk applicants self select into the scheme (lower risk borrowers seek finance elsewhere). Too low a price and there will be a tendency for lower risk businesses (that are capable of sourcing finance outside of the scheme) to select into the scheme. In this case, government has taken on a credit risk and an actual and contingent cost with no additionality in business lending (OECD 2013d). A further complication is the fact that the optimal price that strikes a balance between these outcomes is subject to constant change depending on the interest rates, ease of credit access and overall conditions of the wider economy.
The Commission examined public guarantee schemes in 2014 as part of its inquiry into public infrastructure and noted that such schemes place contingent liabilities on government balance sheets (that then puts pressure on credit ratings), act as a source of moral hazard risk, distort financing decisions and are often not transparent (PC 2014a).
In relation to its current inquiry, the lack of systemic financing problems for new businesses substantially weakens the case that Australia needs a CGS. Furthermore, as discussed above, CGS are distortive and inefficient, they transfer risk from private parties to taxpayers, and may adversely affect the vetting and monitoring behaviour of lenders. Whether CGS materially increase either the amount of loans for new businesses (that is, delivers additionality) or business survival rates is also disputed in a number of studies. For these reasons, the Commission recommends that CGS not be pursued by Australian governments.
Australian governments should not pursue credit guarantee schemes as a means of enhancing the ability of new businesses to access debt finance.