Finance - Bottazzi Lecture 4

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Information about Finance - Bottazzi Lecture 4
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Published on May 11, 2008

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SME Financing in a Global Context: lending technologies, financial system architecture, and financial system shocks : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION SME Financing in a Global Context: lending technologies, financial system architecture, and financial system shocks Gregory F. Udell IGBS, Zagreb and Kelley School of Business Indiana University OUTLINE : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION OUTLINE SME lending: overview of a more complete framework SME lending, financial system architecture and the old framework A new framework: SME lending technologies A new framework: Financial institutions structure and lending infrastructure Financial system architecture: Cross-country differences and policy implications From the static to the dynamic: Shocks and lending channels SME LENDING OVERVIEW:A MORE COMPLETE FRAMEWORK : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION SME LENDING OVERVIEW:A MORE COMPLETE FRAMEWORK The availability of external finance for SMEs is of significant practitioner, research and policy importance. The conceptual framework commonly employed to analyze this topic has proven to be quite helpful, but… The current framework likely presents an oversimplified model that may be potentially misleading. FINANCIAL INSTITUTION STRUCTURE: COMMON RESEARCH FINDING : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION FINANCIAL INSTITUTION STRUCTURE: COMMON RESEARCH FINDING Large institutions have a comparative advantage in transactions lending based on “hard” information. Financial ratios, credit scores, etc. (relatively easily observed, verified, and transmitted). Small institutions have a comparative advantage in relationship lending based on “soft” information. Character of SME owner, knowledge of local community, etc. (not easily observed, verified, and transmitted). An implication that may seem reasonable is that a substantial market share for small institutions is needed to meet the needs of informationally opaque SMEs through relationship lending. THE IMPLICATION IS MISLEADING : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE IMPLICATION IS MISLEADING There are a number of very different transactions lending technologies based on hard information. Financial statement lending, small business credit scoring, asset-based lending, factoring, trade credit. Financial statement lending may be limited to transparent borrowers Thus, small institutions may not be as important as they at first seem because relationship lending is not the only technology that can be used for opaque SMEs. not everybody agree that large institutions cannot also serve opaque SMEs using other transactions technologies. SME LENDING TECHNOLOGIES : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION SME LENDING TECHNOLOGIES Financial contracting must address the informational wedge between borrowers and lenders Economists call this asymmetric information. Borrowers have superior information over lenders about borrower quality and intentions Lenders use different technologies to address this problem. These technologies are comprised of a combination of screening mechanisms, contract structures, and monitoring strategies. Existence and power of technologies ultimately provide borrowers more credit SME LENDING TECHNOLOGIES : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION SME LENDING TECHNOLOGIES The technologies: Financial Statement Lending (hard) Small Business Credit Scoring (hard) Asset-Based Lending (hard) Real Estate-based lending (hard) Factoring (hard) Trade Credit (hard/soft) Relationship Lending (soft) SME LENDING TECHNOLOGIES : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION SME LENDING TECHNOLOGIES The feasibility and cost effectiveness of the technologies in a global context depends on a country’s: Financial Institutions Structure Lending Infrastructure Based on limited data, we know use of lending technologies varies widely across the globe Factoring varies significantly across the world (Bakker, Klapper and Udell 2004) Asset-based lending exists only in common countries of Australia, Canada, U.K. and U.S. (Udell 2004) FINANCIAL INSTITUTION STRUCTURE AND SME LENDING : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION FINANCIAL INSTITUTION STRUCTURE AND SME LENDING Financial Institutions Structure: Large vs. small banks Foreign vs. domestic banks Private vs. state-owned banks Banking industry concentration FINANCIAL INSTITUTION STRUCTURE AND SME LENDING : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION FINANCIAL INSTITUTION STRUCTURE AND SME LENDING Large versus small institutions. Evidence is strong that large institutions have a comparative advantage in transactions lending and small institutions are advantaged in relationship lending. Evidence is weak whether large institutions are significantly disadvantaged in serving opaque SMEs, as they use transactions technologies other than financial statement lending. FINANCIAL INSTITUTION STRUCTURE AND SME LENDING : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION FINANCIAL INSTITUTION STRUCTURE AND SME LENDING Foreign versus domestic institutions. Greater presence of foreign institutions is associated with higher SME credit availability in developing nations (e.g. Beck, Demirguc-Kunt, and Maksimovic 2004, Berger, Hasan, and Klapper 2004). However, they may have a disadvantage in relationship lending (Berger, Klapper and Udell 2001). These institutions appear to have advantages in some of the transactions technologies. State-owned versus private institutions. Greater presence of state-owned institutions is associated with lower SME credit availability in developing nations. These institutions appear to be generally disadvantaged. FINANCIAL INSTITUTION STRUCTURE AND SME LENDING : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION FINANCIAL INSTITUTION STRUCTURE AND SME LENDING Concentration of institutions. Theory predicts reduced credit access through any lending technology due to exercise of market power. Others argue that concentration may encourage institutions to invest in relationships and make greater use of the relationship lending technology (e.g., Petersen and Rajan 1995). The empirical evidence is mixed on which hypothesis dominates. The literature on all of these topics suffers significantly because the lending technologies are generally unobserved, making it difficult to test competing hypotheses. THE LENDING INFRASTRUCTURE AND SME LENDING : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE LENDING INFRASTRUCTURE AND SME LENDING The lending infrastructure includes: The information environment, The legal, judicial and bankruptcy environment, Tax and regulatory environments. THE LENDING INFRASTRUCTURE:THE INFORMATION ENVIRONMENT : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE LENDING INFRASTRUCTURE:THE INFORMATION ENVIRONMENT Information infrastructure likely has a significant effect on the availability of credit to SMEs. Accounting infrastructure. Considerable cross-country variance in accounting standards (e.g., La Porta, Lopez-de-Silanes, Shleifer, and Vishny 1998). Likely affects relative efficacy of financial statement lending. THE INFORMATION ENVIRONMENT : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE INFORMATION ENVIRONMENT Information sharing. Linked to credit availability (Padilla and Pagano 1997, Pagano and Jappelli 1993, Love and Mylenko 2003). May decrease cost of loans and loan defaults (Miller 2003). Adds power in firm failure prediction models (Kallberg and Udell 2003). Information sharing empirically linked to growth and cost of capital (Jappelli and Pagano 2001). THE LENDING INFRASTRUCTURE: THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE LENDING INFRASTRUCTURE: THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT The legal infrastructure that affects business lending consists of: Commercial laws that specify the property rights associated with a commercial transaction and, Enforcement of these laws. The latter determines the confidence of contracting parties in financial contracts. Collectively, these two features constitute the rule of law as it relates the extension of credit. THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT Countries differ significantly on this dimension: The best: Unambiguous commercial laws governing commercial transactions. Predictable enforcement. The worst: Ambiguous and incomplete laws. Problematic enforcement. Criminal and racketeering behavior. Countries in the latter category inhibit the creation of new businesses, undermine existing ones, and deter foreign investment. THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT The importance: Countries with greater financial development and stronger property rights have increased levels of investment funded by external finance (Beck, Demirguc-Kunt, and Maksimovic 2004). Smaller firms may be particularly affected. Financial, legal and corruption problems consistently constrained the growth of smaller firms more than larger firms (Beck, Demirguc-Kunt, and Maksimovic 2003). THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE LEGAL, JUDICAL AND BANKRUPTCY ENVIRONMENT Specific issues. Commercial law governing security (i.e., collateral) interests and lien registration. Efficiency in adjudicating commercial disputes. Efficiency of the bankruptcy system: Time in bankruptcy, Competence of bankruptcy judges, Adherence to absolute priority. Impact on financial contracting. Affects tools used in lending to solve adverse selection and moral hazard problems. Affects efficacy of specific lending technologies. Likely is the reason that asset-based lending found in only four countries May explain perception that there is an “inventory funding gap” in Contintental Europe THE TAX AND REGULATORY ENVIRONMENTS : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION THE TAX AND REGULATORY ENVIRONMENTS Direct effects: may explicitly constrain SME finance. Bank regulations and regulatory scrutiny that might precipitate a credit crunch (e.g., Berger and Udell 1994, Peek and Rosengren 1995). Basel II (Berger 2004). Indirect effects: changes in regulation that affect financial institution structure. Regulatory changes allowing foreign bank entry in many countries. FINANCIAL SYSTEM ARCHITECTURE: CROSS COUNTRY DIFFERENCES AND POLICY IMPLICATIONS : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION FINANCIAL SYSTEM ARCHITECTURE: CROSS COUNTRY DIFFERENCES AND POLICY IMPLICATIONS Hypothesis 1: SME credit availability maximized when all lending technologies are feasible and cost effective Lenders and borrowers can then choose lending technology best suited to solve information problems Hypothesis 2: Financial systems (i.e., countries) should choose policies to promote financial institutions structure and lending environment that facilitates feasibility and cost effectiveness of all lending technologies Testable implication: SME credit availability maximized in countries where this is achieved (– the four common law countries - ???) The research evidence: Still mostly circumstantial More evidence needed LENDING CHANNELS : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION LENDING CHANNELS A lending channel consists of a two-dimensional conduit for delivering commercial finance The type of lending (i.e., the lending technology) The type of institution that delivers the technology An economy can have many different lending channels LENDING CHANNELS AND SHOCKS : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION LENDING CHANNELS AND SHOCKS Shocks to the financial system can block one or more lending channels There are many kinds of potential shocks, e.g. Capital shocks to the banking system Regulatory and legal shocks to the banking system Monetary policy shocks These shocks can affect the availability of one or more of these “lending channels” SME LENDING CHANNELS : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION SME LENDING CHANNELS The concept of lending channels takes the static notion of lending technologies to a dynamic setting Extends the framework of lending technology and institutional structure by adding the concept of a “lending channel” Shocks to the financial system may block, or partially block one or more lending channels. Also, depending on substitutability, shocks to the financial system may change the relative supply of credit extruded through these respective lending channels within a given financial system. COUNTRIES DIFFER WITH RESPECT TO LENDING CHANNELS : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION COUNTRIES DIFFER WITH RESPECT TO LENDING CHANNELS As we noted earlier, the data indicate that even just the lending technologies themselves differ across countries Countries also differ in terms of the type of institutions that can deliver the respective lending technologies, e.g., State-owned banks in developing economies Slide 26: 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION US Small Business finance: Estimated Distribution of Equity and Debt Slide 27: 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Estimated distribution of Small Business Debt from Financial Institutions Slide 28: 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION Firm Continuum and sources of finance SHOCKS AND LENDINGCHANNELS IN THE U.S. : 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION SHOCKS AND LENDINGCHANNELS IN THE U.S. Large literature on the U.S. credit crunch (1990-1992) Main issue: Was there a contraction in supply of credit? Several hypotheses, e.g. Risk-based capital (RBC) hypothesis Regulatory scrutiny hypothesis Bank capital shock hypothesis Lending regulation hypothesis (e.g., collateral and “HLT” restrictions) This academic literature not caste or analyzed in the context of alternative lending channels Slide 30: 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION LENDING CHANNELS: NORMAL TIMES Slide 31: 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION LENDING CHANNELS: CREDIT CRUNCH – RBC Slide 32: 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION LENDING CHANNELS: CREDIT CRUNCH REGULATORY SCRUTINY Slide 33: 8204 ENTREPRENEURSHIP, FINANCE AND INNOVATION LENDING CHANNELS: CREDIT CRUNCH CAPITAL SHOCK

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