The financial crisis, small businesses and relationship banking in Wales

Transcription

1 FSB Wales Round Table Seminar Series No February The financial crisis, small businesses and relationship banking in Wales Hans Degryse (Katholieke Universiteit Leuven, Belgium and CEPR) Kent Matthews (Cardiff Business School, Cardiff University) Tianshu Zhao (Stirling Management School, University of Stirling)

2 Contents Foreword 1 Executive Summary 2 1. Introduction 3 2. Relationship banking and SME financing 4 3. Survey characteristics 6 4. Key findings from the analysis 8 5. Conclusion References 11

3 Foreword Good relationships are important in business, whether they are with suppliers or customers; but for some businesses the most important relationship that they will have is with their bank. We know from anecdotal evidence that many members of the FSB Wales value traditional relationship banking, and having a face-to-face relationship with their banker. But, in a post-financial crisis world, what are the costs and benefits of relationship banking to small firms? Does relationship banking make it easier to obtain credit, and does it influence the terms on which loans are offered? These are increasingly important questions and FSB Wales has worked with Professor Kent Matthews of Cardiff Business School to suggest some possible answers. In this pilot study Professor Matthews questioned FSB members, many of them micro-businesses, on their experiences of relationship banking, and I am certain that his results will make interesting reading. Although the sample size for this study is relatively small it has yielded some interesting findings. The FSB now hopes to work with Professor Matthews to expand the scale of the study to obtain a broader picture of the advantages and disadvantages of relationship banking to those small and medium-sized enterprises that the FSB represents across the UK. We hope that this work will be of interest not only to small businesses, but to those who are involved in the financial services sector deciding the shape of the future services that they offer to SMEs. Janet Jones, Chair FSB Welsh Policy Unit FSB Wales Seminar publications are based on the FSB Wales Round Table Seminar Series where leading academics present aspects of their latest research. The views expressed in this publication do not necessarily reflect the views of FSB Wales. 1

4 Executive Summary The purpose of this report is to present the results of an investigation into the value of relationship banking to SMEs in Wales in the period following the global banking crisis. A survey of FSB Wales members on their experience of relationship banking and credit conditions produced 217 responses of which around 25% were usable as valid responses. The distribution of the respondents indicated a strong representation of micro firms (1-5 FTEs) in the sample and that the majority of firms had been operating for over 9 years. Only 4% of the sample was start-up enterprises (operating for less than one year). The survey questioned respondents on whether their perceptions of credit conditions had improved, unchanged or worsened. The answers were coded and correlated with measures of relationship banking as well as firm characteristics. The results indicate that enterprises that had developed a customer-loan relationship with their banks had a lower probability of experiencing a worsened credit outcome than those that did not. This highlights the importance of relationship banking over the business cycle 2

5 1. Introduction It is an often heard complaint that the demise of relationship banking has made credit conditions tougher for small businesses. This has been a particular problem in Wales. The popular view is that the difficulty of SMEs obtaining bank finance has opened up a funding gap which constrains growth. While the evidence for the existence of such a funding gap is mixed, this complaint has received greater attention in the aftermath of the global banking crisis and the ongoing recession. The argument goes that the tightening of credit conditions for small businesses have occurred because of the absence of a lending relationship with a bank that would enable the use of soft information to overcome the lack of hard economic information. The economic implications of relationship banking, with respect to SME financing has been the subject of considerable research in recent years. The principal question we address in this report is whether there is value to a small business from relationship banking in Wales? Selected research suggests that there is a positive impact of relationship banking on easing the credit constraints faced by cautious borrowers. However, it also suggests that relationship banking creates the conditions for information capture and lock-in. This may result in unfavourable terms and conditions on the loan contract. The majority of empirical research into this issue has been conducted under normal economic conditions. The global banking crisis and the continuing tightening of credit conditions presents an opportune moment to revisit this issue. This report summarises the findings of a study that aimed to answer the research question by focussing on the SME bank financing experience for Wales. Wales is an interesting lens through which to explore the issue and is currently the focus of an independent review into access for SME finance which provided a useful context for our research. The data for this study was obtained from a sample survey of FSB Wales members. The survey was conducted during the summer of 2013 and was sent out to over 6000 of the FSB membership. A total of 631 responded with information about employment and firm type, and 217 responded with turnover information. Our analysis is based on a sub-sample of the 217 who provided a full set of responses to our questions and that could be used for more formal statistical analysis. The number of valid respondents varied from 185 to 110 depending on which category of credit condition was examined. This report is organised as follows. The next section sets out the context of relationship banking and SME finance by reviewing the recent literature. The following section describes the characteristics of the survey respondents. Section 4 summarises the results of our analysis and the final section concludes. A full version of the research paper underlying this report is available from the authors. 3

6 2. Relationship banking and SME financing In his survey of SME finance in the UK, Hughes (1996) concludes that the evidence for a debt or equity financing gap is weak. Hughes argues that a general funding gap does not exist although gaps in particular modes of funding may exist. However, there is evidence that very small firms and start-ups face problems of obtaining finance and it is accepted that the over-reliance on bank financing makes SMEs particularly vulnerable to interest rate shocks at times of financial stress. With respect to relationship banking, the conventional view is that the main factor that hinders SME finance is the opacity of its near term income flow. Banks that specialise in transactional lending - that is lending based on hard information of income flows, find dealing with opaque enterprises costly to administer, whereas banks that employ relationship lending can mitigate problems of opacity by interpreting soft information passed between the SME and the relationship banker. For a review, see for example Boot (2000) or Degryse, Kim and Ongena (2009). The trend in the UK is to concentrate lending decisions at regional centres. Accelerated branch closures during the 1990s have fuelled the accusation that relationship lending has increasingly been replaced by transactional lending. However, this narrow dichotomy between the two modes of lending has been criticised by Berger and Udell (2006) as too simplistic. Banking institutions offer a range of lending technologies to SMEs besides relationship lending and transactional lending. These would range from credit scoring, through to factoring and leasing and with relationship lending not solely confined to the specialised or niche bank. All large banks have an SME operation and even within the confines of the two recognised technologies, the proportion of resources devoted to each will depend on the relative net returns which will not just include interest returns but also the potential for cross-selling of fee services. Theory suggests that the relatively higher cost of supplying relationship bank services is reflected in a higher relative price (Baas and Schrooten, 2006, or Bolton et al (2013)), which implies that SMEs pay for relationship lending through a higher cost of credit. The informational advantage of relationship banking reduces the adverse selection and adverse incentive problems associated with higher interest charges on loans to SMEs (Dell Ariccia and Marquez, 2004). In contrast to the conventional wisdom that large banks overlook the potential returns from SME lending, de la Torre et al (2010) show that large and international banks have a comparative advantage in SME finance and are relatively aggressive in this area of lending and furthermore this has remained robust to the global banking crisis. The literature on relationship banking has concentrated on the motivation from the supply-side meaning from the bank s standpoint. However, it is insufficient to concentrate on loan size or interest cost alone. A partial analysis that fails to take into account on constraints such as maturity and the covenant would produce an incomplete picture (Hainz and Wiegand, 2013; Bharath et al, 2009). 4

7 Recent research highlights the outcome of restrictive covenants in relationship lending which enables the efficient absorption of new information to loosen the terms and conditions ex-post (Boot, 2000; Rajan and Winton, 1995; Park 2000). Similarly, the literature suggests that stronger relationship lending results in longer loan maturities (Demiroglu and James, 2010). Most recently Bolton et al (2013) have developed a model from the perspective of the SME, where the choice is borrowing on a relationship basis or a transactional basis or a combination of both. Bolton et al (2013) examine the post crisis period of lending to 72,000 Italian firms by a total of 179 Italian banks. The findings of their research are that because firms that rely on relationship banking are those that are most exposed to business cycle risk and have riskier cash flows, they are prepared to pay a higher borrowing cost in order to secure better continuation of financing in times of crisis. However, competition from banks that offer lower cost transactional based lending can drive SMEs to substitute away from relationship based lending and invest in producing hard information. An implication of this is that during times of crisis firms that have developed transactional based lending may find it harder to secure lines of credit than those that have invested in relationship based lending. Other research that has looked at the value of relationship banking in the post-crisis period has been Gobbi and Sette (2013) and Hainz and Weigand (2013). Focusing on the availability of credit of Italian firms, Gobbi and Sette (2013) investigate whether the extent to which firms concentrate their borrowing from banks mitigates the credit contraction that followed the default of Lehman. They find that firms borrowing from fewer banks and those with more concentrated borrowing suffer on average a smaller contraction in bank credit and have a lower probability of being credit-rationed. Similarly Hainz and Weigand (2013) utilise survey data from 1,139 German firms to answer the question of whether relationship banking helped firms to avoid financing constraints. They find that firms that have single relationships with a bank lower the probability of deterioration in the conditions of the loan (non-price conditions such as collateral and maturity) but that it does not lower the probability of credit availability. The effect of relationship banking on the likelihood of a worsening of the interest rate charged is ambiguous. Beck et al (2013) focus on how the presence of relationship banks impacts on firms credit constraints over the business cycle. Employing cross-country data for 21 countries, they find that firms that have in their vicinity more relationship banks are less likely to be credit constrained in the downturn of the business cycle. This applies in particular for small and informationally opaque firms. 5

8 3. Survey characteristics This section describes the characteristics of the firms surveyed. The overall response rate was around 10% but about a third of this provided valid information and only about 30% of the valid respondents answered the questions that enabled statistical evaluation. A distinguishing feature of the businesses that provided a valid response that also differed strongly from other surveys (such as the US SSBF) was the concentration of size around what would be termed as micro-firms. As Chart 1 indicates the distribution of the valid respondents is highly skewed towards firms reporting 5 full-time-equivalent employees or less. This distribution is not out of line with the population of SMEs in Wales. Chart 1: Distribution of respondents by employment size (FTE) 70 Percentage of respondents % Number of employees The sample contained 7 firms which employed FTEs and 4 who reported over 135 FTEs. The distribution of turnover reflects this and is indicated in Table 1. What is also interesting is that for most of the SMEs in the sample there was no significant change in turnover between and Table 1: Annual Turnover Period Mean Median Minimum Maximum , ,000 1,000 13,000, , ,000 1,000 12,000,000 6

9 As Chart 2 shows, the proportion of start-up businesses in the sample was small 4% in total and mature business (over 9 years of operation) counted for 56% of the sample. Chart 2: Age of business % Less than 1 Year 2 3 Years 14 Years Years 9 13 Years Turning to the break-down of the business type Chart 3 shows that the number of sole traders amounted to 26% of the sample and partnerships represented 19%, confirming the different nature of the sample, relative to other studies reported in the literature. Chart 3: Business type % Sole Trader Partnership Private & Other Ltd 7

10 4. Key findings from the analysis The survey had a series of questions that focussed on firm-specific characteristics. These related to the provision of credit by a banking institution, the services provided by the bank, and the experience of economic and credit conditions in recent years. The survey questioned the respondents on their perception of the change in credit conditions regarding: the interest rate on loans the size of available loans the maturity of loans the covenant of the loan contract in the post financial crisis period, compared to pre-crisis (the questionnaire also asked the respondents experience of bank financing during the last year) the change in the respondents financial and operational position in the post-crisis period compared with the pre-crisis and that in last 12 months. The survey focussed on specific questions concerning the post-crisis (post-2008) experience of the enterprises. Specifically the survey collected information regarding the borrower s perception on whether credit conditions as measured by the above indicators had improved/unchanged or worsened compared with the pre-crisis period. The survey also recorded the experience of firms in applying for bank credit and the outcome of the application in the past 12 months. The survey had questions on the duration of the relationship with the main bank and whether the main bank represented a single borrowing relationship, which was used to measure the strength of the relationship between the SME and the lender in line with the literature. To correct for the potential bias associated with perception-based indicators the survey had questions regarding the criteria the firm values when it choose the main borrowing relationship. Specifically, the survey asked the respondents to value the following criteria; personal relationship with the bank; range of services and their feature; quality of the services delivered by the bank; international network of the bank; local network of the bank; dominant position of the bank in the market; reputation of the bank in general; bank s industry expertise; proven track record; bank acts as one institution with the relationship manager taking the lead in the contact; the relationship manager knows about my business and industry and understands my problems; willingness by the bank to bend the terms for me when negotiating a contract; and price offering (incl. terms and conditions) into most important, important, neither important or unimportant and unimportant. The statistical analysis revealed (shown in Table 2): 8

11 The longer the duration of the relationship tie with the bank the lower the probability of a worsened interest cost. However, an exclusive relationship increases the probability of worsened interest cost. This suggests that exclusivity binds the customer to the bank and enables the bank to extract rent in the form of a higher interest rate. However, the longer the relationship the greater the likelihood that the risk-premium associated with SME declines. It can be argued that the analysis captures the ability of the relationship manager to develop stronger information flow and reduce the asymmetric information that gives rise to the risk-premium. That relationship banking results in a better lending outcome in terms of both maturity and size of loans. A consistent picture emerges that relationship banking does improve loan conditions. The longer the duration of the relationship, the lower the probability that the financial condition of the SME worsened in the post-crisis period. Overall the findings suggest that relationship banking as measured in terms of duration tend to reduce the probability of worsened financial outcomes for the borrower. The longer the relationship the higher the probability of improved/unchanged interest cost, size, maturity of the loan and financial condition in the post-crisis period. But exclusivity has mixed effects on the perceived lending experience. An exclusive relationship increases the probability of a worsened interest cost but lowers the probability of a worsened loan size, maturity and conditions of the loan. 9

12 5. Conclusion This study has surveyed a sample of the membership of FSB Wales on the post-crisis financial conditions of their business and their perceptions of the significance of relationship banking. The results provide a qualified yes to the research question is there value in relationship banking? The evidence from the perceptions of the respondents is that relationship banking, as measured by length of relationship with the bank and the exclusivity of the relationship, makes a positive contribution to the probability of an improved outcome in most of the credit indicators in question. The one area of ambiguity is in the case of the interest cost of credit where our analysis suggested that banks use the relationship to lock-in and hold-up the borrower, this was supported by a finding that increased local market power lends itself to an increased likelihood of a worsened interest cost outcome. While the results from the sample provide a largely positive assessment of the role of relationship banking we note the analysis was based on a small sample such that further research would be useful on a larger number of firms. Moreover, by definition the survey method employed means that it is survivor firms that are examined with no means available to examine firms that failed over the period. A further qualification relates to start-ups of small firms. The Jones-Evans (2013) Report finds that small firms in Wales have suffered a greater decline in bank credit financing than in any other economic region of the UK. Indeed it is smaller firms in general that are struggling to get bank financing but small firms in Wales particularly. The results therefore suffer from the additional bias that start-up firms that have been refused funding may not be included in the sample and therefore biases the results in favour of firms with established bank relationships. Hence the qualification of the conclusion is that firms that have survived and also engage with relationship banking have had a positive experience in terms of credit conditions, compared with firms that do not fall into this category. 10

13 6. References Baas T and Schrooten M (2006), Relationship Banking and SMEs: A Theoretical Analysis, Small Business Economics, 27, Beck T, Degryse H, De Haas R and van Horen N (2013), When Arm s Length is Too Far. Relationship Banking over the Business Cycle, mimeo. Bharath, S., Dahiya, S., Saunders, A., Srinivasan, A., (2011), Lending relationships and loan contract terms, Review of Financial Studies 24(4), Bolton P, Freixas X, Gambarcotta L and Mistrulli PE (2013), Relationship and Transactional Lending in a Crisis, BIS Working Paper, No 417, July. Bolton P and Freixas X (2006), Corporate Finance and the Monetary Transmission Mechanism, Review of Financial Studies, 3, Boot A (2000), Relationship Banking: What do we know?, Journal of Financial Intermediation, 9, Degryse H, Kim M and Ongena S (2009), MicroEconometrics of Banking: Methods, Applications and Results, Oxford University Press. De la Torre A, Martinez-Periá MS, and Schmukler S (2010), Bank Involvement with SMEs: Beyond Relationship Lending, Journal of Banking and Finance, 34, Dell Ariccia G, and Marquez R. (2004), Information and bank credit allocation, Journal of Financial Economics 2004, 72, Demiroglu, C and James, C (2010), The Information Content of Bank Loan Covenants, Review of Financial Studies, 23, Gobbi G, and Sette E (2013), Do Firms Benefit from Concentrating their Borrowing? Evidence from the Great Recession, Review of Finance, Hainz C and Weigand M (2013), How does Relationship Banking influence credit financing? Evidence from the financial crisis, IFO Working Papers, No 157, April. Hughes A (1997), Finance for SMEs: A UK Perspective, Small Business Economics, 9, Jones-Evans D (2013), Access to Finance Review: Stage 2, Bristol Business School, November. 11

14 Mason CM and Harrison RT (1994), Informal Venture Capital in the UK in A Hughes and DJ Storey (eds), Financing Small Firms, London: Routledge. Ongena S and Smith D (2001), The duration of bank relationships, Journal of Financial Economics, 61, Park, C (2000), Monitoring and Structure of Debt Contracts, The Journal of Finance, 55, Rajan, R. G and Winton A, (1995), Covenants and Collateral as Incentives to Monitor, The Journal of Finance, 50, Contact: Professor Kent Matthews Cardiff Business School Colum Drive Cardiff CF10 3EU Matthewsk3@cf.ac.uk 12

15 Table 2: Results from Probit estimation: Marginal effects at the means (contribution to probability) Interest cost (improved/ unchanged = 0; worsened = 1) Size of loan (improved/ unchanged = 0; worsened = 1) Maturity (improved/ unchanged = 0; worsened = 1) Covenant (improved/ unchanged = 0; worsened = 1) Financial position post-crisis, compared with pre-crisis (improved/ unchanged-0; worsened=1) Turnover * *.072* Turnover Current Ratio * ** Current Ratio ** Duration -.041* -.047** -.077*** ** Exclusivity.225* -.311** -.423*** -.346** Share.009** ** Employees Labour cost Factor *** Factor *** HHI.000 Pseudo R Observation *** Significant at the 1%, ** Significant at the 5%, * significant at the 10% 13

16 FSB Wales Round Table Seminar Series No February Contact: Federation of Small Businesses Wales 1 Cleeve House, Lambourne Crescent, Llanishen, Cardiff CF14 5GP Telephone: ISBN Number Federation of Small Businesses 2014 This report can be downloaded from our website at All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior permission of the Federation of Small Businesses (FSB). While every effort has been made to ensure the accuracy of the facts and data contained in this publication, no responsibility can be accepted by the FSB for errors or omissions or their consequences. Articles that appear in the report are written in general terms only. They are not intended to be a comprehensive statement of the issues raised and should not be relied upon for any specific purposes.