Study on Financing Growth Capital for SMEs

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1 Study on Financing Growth Capital for SMEs Remarks by Marion G. Wrobel Vice-President, Policy and Operations Canadian Bankers Association for The Standing Senate Committee on Banking Trade and Commerce Thursday, December 1, 2011 Ottawa CHECK AGAINST DELIVERY EXPERTISE CANADA BANKS ON LA RÉFÉRENCE BANCAIRE AU CANADA

2 Opening remarks On behalf of the Canadian Bankers Association, its 52 members and 267,000 employees, I would like to thank you very much for the invitation to speak to the Committee on the subject of Financing Growth Capital for SMEs. I am here with Gail Cocker, Senior Vice President, Commercial Banking at BMO Bank of Montreal. Before we take your questions we would like to take a couple of minutes to talk about: How banks serve SMEs; How SMEs are financed; and How banks assist fast-growing SMEs reach their business goals through both credit and non-credit products and services in the early and growth stages of their life. Banks and SMEs Lending and providing products and services to SMEs is an important part of a bank s business portfolio. As of December 2010, Canada s domestic banks authorized around $87 billion in credit and have relationships with more than 1.5 million SMEs operating across Canada. In lending to SMEs, Canadian banks have utilized prudent lending practices and excellent risk management systems that have led us to be ranked four years in a row as the most sound in the world by the World Economic Forum, and ranked first in the world for financial strength by Moody s Investor Service for two years in a row. Indeed, as the Superintendent of Financial Institutions said last week when she appeared before this Committee, it is strong banks who can lend. SMEs have benefited from this strength. Lending to SMEs has gradually increased and year-over-year growth has consistently remained positive over the last five years. Since Q when SME lending began to increase its pace of growth, total authorized lending has increased by 6% and in the last year, authorized lending has increased by 4%. 1

3 Our emphasis on serving SMEs is being recognized by the SMEs themselves. In a CBA survey taken in the midst of the financial crisis, seventy-eight percent of SMEs indicated that they have a positive relationship with their financial institution. Of those SMEs that have a credit relationship with their bank, ninety percent reported that relationship to be positive. Forms of Finance for SMEs Businesses rely on two main forms of financing: credit and equity. Banks are institutions that provide credit financing to businesses. That is lending out funds with the promise to repay at a later time. When it comes to business credit, there are two main types of loans. One is secured loans, where the business puts up collateral such as a building or a machine tool as a guarantee. This is similar to a mortgage. The other type of loan is operating capital, where the bank lends money based on expected cash flow or income. The difficulty is that companies that are just starting out have no assets, and often no income, to borrow against. That, unfortunately, means that a bank that would lend to that company would take on essentially the same risk as the equity financiers, with little of the same upside reward of equity investments. Equity financing essentially provides investors with the opportunity to provide funds to a business in exchange for an ownership stake and a chance for that upside reward. The equity financing of new or growing private companies is often called venture capital. While the rewards with this type of financing can be very high if the company is ultimately successful, there is no guarantee that this will be the case. As other witnesses have already pointed out, four out of five new companies never see their fifth birthday. The level of risk among new businesses is very high and, as you ve also heard, it s very difficult to make money by providing venture capital. 2

4 Banks are not very active in providing financing to this area of the market. There are a number of reasons for this but the main one is prudential risk: banks are in the business of taking risks, but as both the Governor of the Bank of Canada and the Superintendent of Financial Institutions recently said before this Committee, there must be a limit on the amount of risk they are allowed to take. This makes sense if you consider what banks are and what they do. Banks operate large retail networks to take deposits and then invest those deposits, supported by shareholders capital. This means that that capital needs to be levered several times; not too much so as to create excessive risk, but enough to enable banks to operate efficiently and provide financing at low cost. Venture capital, because of its inherent riskiness, cannot be funded this way. It cannot be levered the way bank activities are. That is why banks do only small amounts of venture capital financing and that is why venture capital firms look very different from banks. Banks are using depositors money and hence keep risks low. Venture capital firms employ shareholder funds and hence can take bigger risks. We ve seen in other countries what happens when banks take too much risk or risks they do not fully understand. For the reasons I have just talked about, it s very difficult for banks to be active capital providers in the early stages of a company s growth. That doesn t mean, however, that the banks don t have a role to play. In the early stages, banks are able to provide financing and services to support them as they seek out venture capital. As companies grow, banks can play an increasingly important role in financing their growth. Bank Assistance for Fast Growing SMEs In the start-up and early stages of business formation, entrepreneurs attempt to prove that an idea has a reasonable chance of success, and then bring the product or idea to commercialization. These stages often witness the fastest growth. In these early stages, SMEs require seed and start-up financing to cover the marketing expenditures and organizational investments to begin to earn revenues. SMEs also require other products and services to help ensure their businesses are able to succeed and help them acquire additional debt and equity financing. 3

5 Because owners of SMEs often have relationships with their banks through their personal banking, we encourage them to approach their banker for advice. The banker can leverage their knowledge of the owner s personal situation to set up a number of small business financing solutions such as: introductions to potential customers, suppliers and sources of capital; economic trends and forecasts; specific information on special industries, information on companies for sale or looking for acquisitions; export solutions; and, bank short-term and long-term financing. SMEs can rely on banks short-term, day-to-day lending which includes overdraft, credit cards and lines of credit. Solutions to address unique short-term needs can also be arranged through banks. These include letters of credit to facilitate foreign transactions, bridge loans to close a purchase while permanent capital is sought, and bulge accounts to manage seasonal or cyclical requirements. SMEs can also arrange a variety of longer-term term financing solutions through their banks such as term loans, mortgages, leasing and factoring. Term loans provide the SME with the ability to purchase a new piece of machinery, equipment or technology or to acquire another company or operation, while mortgages allow the SME to expand their operations through the purchase of buildings or land. Leasing is a useful way to utilize equipment that is subject to rapid depreciation while factoring provides financing for accounts receivable. And of course banks provide access to loans through the Canada Small Business Financing Program operated through Industry Canada. Banks also provide non-credit products and services including: business chequing and savings accounts, in both Canadian and foreign dollar denominations; tax payment services; electronic funds transfers; payroll and filing services; and, coaching podcasts, booklets and seminars. 4

6 According to our customers, these non-credit products and services matter. In CBA surveys, a majority of business representatives consistently report that the selection of their main financial institution was driven by non-credit rather than credit products and services. The combination of these credit- and non-credit related products and services bolster and add credibility to a SME s attempts at obtaining venture capital finance from friends, relatives, business contacts, suppliers and private investors. For instance, a SME owner increases the likelihood of successfully attracting this venture capital finance if they can illustrate the cash flow needs of their business. Banks provide the tools, resources and assistance to enable SMEs to manage their cash flow needs. For instance, on-line banking allows SMEs to manage their expenses by monitoring their accounts and transaction details in real time, initiating electronic payments, obtaining foreign exchange quotes, and transferring funds between accounts. Tools such as on-line banking also help a SME owner and advisors (including their banker) to identify efficiencies and potentially reduce the need for those additional venture capital funds, and potential dilution of equity. Conclusion In closing, SMEs are integral parts of a banks business portfolio. Our strength and stability allowed us to finance SMEs throughout the financial crisis at a time when banks in other countries could not. This ability to serve is reflected in businesses satisfaction with the wide range of credit and non-credit products and services. Banks provide these products and services all through a SMEs life stages. While banks are not active capital providers in the early stages of a company s growth, we are able to provide debt financing and non-credit services to support them as they seek out venture capital from a variety of sources. As companies grow and mature, banks play an important role in financing their growth. Thank you for your attention. We would be pleased to answer any questions you have. 5