LOAN GUARANTEE PROGRAMS FOR SMALL FIRMS:
RECENT CANADIAN EXPERIENCE ON RISK, ECONOMIC IMPACTS, AND INCREMENTALITY
Allan L. Riding, Carleton University
George H. Haines, Jr., Carleton University
Dramatic increases in borrowing activity under the terms of the Canadian loan guarantee program has prompted questions about the economic impact of loan guarantees, the degree to which guaranteed loans are incremental, and changes in the risk profile of borrowers. This paper addresses empirically these issues and compares loan guarantee programs of Japan, the UK, and Canada. Implications for public policy regarding loan guarantee initiatives are derived and means towards financial self-sufficiency of loan guarantee programs are identified.
Expansion of small firms accounts for considerable new job creation; survival of small businesses provides for job retention, and a disproportionate share of innovation occurs within small companies. Access to capital fuels expansion, survival, and innovation. Accordingly, facilitating access to capital for small- and medium-sized enterprises [SMEs] is an important public policy issue. One public policy initiative by which access to financing can be enabled is a loan guarantee program.
Governments, however, face a predicament with respect to such initiatives. On the one hand, difficulty with respect to accessing capital is, indeed, a significant barrier to SME growth and the attendant economic development. On the other hand, firms that must avail themselves of loan guarantees are risky and subject to high rates of default. The costs of default can be significant for governments that face material budgetary deficits. At a more basic level is the question of whether or not the public should underwrite SME borrowing. This empirical study seeks to address these issues.
Accordingly, after a review of pertinent literature, this paper describes the loan guarantee programs of Japan, the UK, and Canada. The study then documents particular aspects of the recent performance of the Canadian program, the Small Business Loans Act [SBLA]. This is instructive because the Canadian government amended the Act in a variety of ways in 1993, after which, borrowing under the act increased eight-fold in 18 months!
With the increased lending activity, three issues have arisen, issues that this research study addresses: the economic impact of lending under the Act; the degree to which lending under the SBLA is incremental; and, potential changes in the risk profile of the SBLA loan portfolio. This paper reports on an empirical examination of these topics. Recommendations are advanced towards the design of a loan guarantee system that stimulates SME expansion yet which does not subject public budgets to undue strain.
THE RESEARCH LITERATURE
The decision to grant credit is critical, not just to the entrepreneur whose particular request is being considered, but also to society as a whole. Because of the economic development and job-creation that is attributed to growing small firms, access to capital is a public policy issue. In this vein, a basis of government intervention in financial marketplaces is the perception that markets are not fulfilling their role.
In Canada, the demand side of the marketplace for small business debt capital comprises approximately 900,000 small businesses. On the supply side, banks are the primary, indeed almost exclusive, suppliers of debt capital to small business. The supply side of the market comprises six national multi-branch banks, several smaller regional lenders, and (in two provinces) small co-operative lending institutions. The six large banks, however, hold more than 85 percent of the market share and loans from these lenders are the focus of this study.
The relationship between banks and small business lenders has been turbulent. Research findings (Wynant and Hatch, 1990; Orser, Riding, and Swift, 1993; among others) reveal that a high proportion of SME clients is dissatisfied. Bankers argue that poor management skills on the part of some small business owners are problematic. Banks' fiduciary responsibilities to their depositors mitigate against lending to firms that do not present fiscally responsible management.1
Smaller firms, in particular, are less able to obtain debt from banks. Grant (1988) reported that banks turned down newer, smaller companies most frequently; a finding confirmed by Orser, Riding, and Swift (1993). Difficulties at the bank-SME client interface, however, go beyond access to capital. Dunkelberg, Scott, and Cox (1984), in a study based on US data, noted that "bank performance was rated best on the non-personal aspects (location and service offerings) and worst on knowledge of the firm's business". Haines, Riding, and Thomas (1990) found that small businesses valued interpersonal aspects of the relationship, transaction-handling facilities, the economic value of services, and the knowledge and advice from the banker. However, they also documented perceptions of limited inter-bank competition: the belief that "bankers were all the same". This perception argues strongly for policies that would intensify competition in the market for small business lending. Finally, Wynant and Hatch (1990) and Riding and Haines (1994) find that (unlike in the US and other countries) the margins on bank loans to Canadian SMEs are almost universally less than three percent above prime. Riskier firms tend to be turned down in attempts to arrange bank financing. The pathology of this relationship is at the core of the laments that face government policy makers.
Traditionally, banks assess applicants for debt capital according to criteria known as the "5 C's" of commercial credit.2 Jankowicz and Hisrich (1987) point out that two of the "5 C's", capacity and character, "depend largely on the intuitive judgment of the loans officer." Jankowicz and Hisrich also concluded that account managers apparently prefer "stability and conformist behaviour". The way in which Canadian banks have dealt with small firms has changed considerably during the last decade. During the 1980's most of these institutions established centralised small business banking centres. This has reduced banks' costs and has led to a high degree of standardization. Because of this standardization, owners are somewhat insulated from the subjective judgments of loans officers. This has led to less emphasis on "character" and more emphasis on the objective measures of credit worthiness. This trend may militate against smaller businesses; moreover, for very small businesses, credit decisions may remain at the level of the local branch and the protection afforded by standardization foregone.
Arguably, the micro-business sector would not, in general, rate highly according to the traditional "5 C's" criteria. Smaller firms tend to be younger single proprietorships for which track records are more difficult to document. Small size mitigates against having as much capacity, capital, and collateral. A smaller firm is less likely to be in a position to hire a financial manager.
The banks' dilemma in their relationships with small firm clients stems from the economics of small business lending. Inherent inefficiencies diminishes the likelihood of a profitable relationship if the commercial loan is considered a stand-alone profit centre. The median lending balance of loans to small business clients is less than $50,000 (Riding and Haines, 1994), a low margin situation that results in account managers being obliged to administer of the order of 100 accounts. Thus, the account manager is hard-pressed to reach an adequate assessment of each business and, with a target loan loss rate of less than one percent, may well err on the side of caution. This setting provides fertile ground for misunderstandings and miscommunications. The potential for problems is exacerbated when account managers are rotated frequently (as required if they are to gain experience and training).
Three alternatives provide for potential amelioration of this situation. First, the banking system could be re-organized. This would involve changes that would make the small business market segment more competitive on the supply side. To accomplish this, legislation at some provincial levels is required to permit additional involvement of such lenders as credit unions and co-operative financial institutions in business banking. Second, banks could be encouraged to reorganize to attend better to this market segment. Changes, however, in the organization of such large institutions, while ongoing, are slow: some improvements have been made. It is questionable, however, that further internal changes will provide meaningful incremental impact without the impetus of additional competition. Finally, public policy interventions that share the risk, initiatives such as loan guarantee programs, recognize the public benefit of easing SMEs' access to credit.
The role of a government guarantee is then clear. The guarantee acts as a proxy for the security that a bank needs in advancing depositors' funds to a risky client. The guarantee is of particular value to very small firms, start-ups, and firms facing survival issues. From the banks' perspective, the guarantee reduces the need for, and costs of, due diligence and monitoring. Most developed countries have enacted loan guarantee programs. The next section describes three models of loan guarantee programs and the appendix of the paper tabulates current salient operating features of the loan guarantee systems of Canada, Japan, and the UK.
MODELS OF LOAN GUARANTEE PROGRAMS
Most developed countries have schemes designed to facilitate SME financing. In the Netherlands and Germany, governments provide guarantees for all or part of business loans. Organizations external to government issue loan guarantees on behalf of the governments in Belgium, Luxembourg, Ireland, France, Portugal, and Greece. Loan guarantee associations are formed in Spain to guarantee loans for their members. In the USA, the Small Business Administration provides guarantees of 75 to 90 percent of loans borrowed through commercial banks. The operating policies and details of the various programs differ considerably across jurisdictions. To illustrate the gamut of such programs, and also because they each display particularly interesting attributes, the loan guarantee programs of Japan, the UK, and Canada are described in more detail presently.
The Japanese Credit Supplementation System
The Credit Supplementation System was founded in Japan in 1958. It comprises two levels of operation. The Credit Guarantee Corporations (CGCs, of which there were 52 in 1993) provide lenders with guarantees for their loans to SMEs. When a small firm applies for a loan, the prospective lender may ask the CGC to act as guarantor. If, after investigation, the CGC agrees, the lender extends credit to the business and the business pays a guarantee fee to the CGC. As a rule, the guarantee is then automatically insured by the second component of the Credit Supplementation System: the national Credit Insurance Corporation (CIC). The CGC pays an insurance premium to the CIC.
In the event of default, the CGC repays the remaining principal to the original lender. The CGC then applies to the CIC under the terms of the insurance and normally the CIC would pay the CGC 70-80 percent. The CGC takes the remaining 20-30 percent as a loss, pending recoveries. The CGCs must make "the utmost efforts" to recover the outstanding debt directly from the business. From recoveries, 70-80 percent must be refunded to the CIC.
The CGCs obtain their capital from contributions by banks and local governments and they borrow their operating funds from local governments and the CIC. The CIC was initially endowed with a capital fund by the national government. Between 1987 through 1991 the CIC's insurance payouts have been less than incomes received from insurance premia and recovered moneys. The 1992 recession resulted in a deficit.
This approach has a number of advantages. First, it clearly meets the goal of enabling small firms to overcome financial disadvantages. Second, it removes from the lender much of the onus for due diligence and efforts towards recoveries. Third, the CIC's impact on the national budget is minimal: from 1987 through 1991 revenues from recoveries and fees exceeded insurance payouts by more than ¥325 billion (c. $Cdn 3.5 billion).
The UK DTI Loan Guarantee Scheme
In the UK, the Department of Trade and Industry (DTI) restricts loan guarantees to firms that have tried and failed to obtain a loan. The scheme is a joint venture between the DTI and lenders. Lenders must satisfy themselves that they would have offered conventional loans but for the lack of collateral or track record and all available personal assets have been used for conventional loans.
The small firm's application to a lender for credit initiates the process. In the event that the lender decides that the applicant has a viable business proposal but that there is insufficient security to justify the loan, they apply to the DTI. On acceptance, the DTI provides the lender with a guarantee for 70 percent of the total loan. In return for government backing, the borrower must pay the DTI an annual premium. In addition, the lender may require a pledge of real assets as security and will usually take a fixed or floating charge on such assets. The security applies to the whole loan, and the borrower remains liable for the full debt. Lenders seek recovery, possibly through liquidation, in the event of default.
There are two other aspects of the DTI approach that warrant mention. First, the scheme differentiates between new and "established" businesses. "Established" businesses are those that have been trading for two years or more. For established firms, the guarantee and the maximum loan size are higher. Second, the loan guarantee may be obtained, up to the maximum amount only once by any one individual.
This approach has several attractive features. First, the relatively low guarantee encourages lenders to carry out full due diligence and to seek recoveries. Second, the fees are relatively high and represent annual payments to the guarantor, reducing the cost of the program by means of reducing default risk. Conversely, to the extent that DTI approval is involved, the program is one that is not fully delivered by the private sector. Moreover, the program is somewhat restrictive and unwieldy and requires lenders to undertake the expense of the due diligence process. Nonetheless, the program has provided at least £1 billion in loans to more than 33,000 SMEs between 1981-1993.
The Canadian Small Business Loans Act [SBLA]
Since its inception in 1961, the SBLA has provided for a guarantee of term loans and restricts the purposes of the loan. According to the program, a small firm that approaches a lender for a qualifying term loan can, with agreement of the borrower, obtain a loan guarantee. The borrower must pay a fee through the lender to the SBLA. The role of government is entirely passive. It is limited to collection of fees, making good on loan losses, and collection of some basic registration data.
In April 1993 the Canadian federal government amended the Act in a variety of ways. These changes including: widening eligibility to firms with annual revenues of up to $5 million (the previous limit was set at $2 million); increasing the maximum loan size from $100,000 to $250,000; widening eligibility to firms in sectors such as finance, insurance, mining, the professions; and, providing for a higher interest rate spread to 1.75 percent over prime on floating rate term loans and allowing for interest rates as high as 1.75 percent over the residential mortgage rate on fixed rate term loans.
Subsequently, borrowing under the terms of the Act has increased from approximately $500 million ($Cdn.) during 1992 to approach the legislated ceiling of $4 billion by September of 1994. With the increased lending activity, three issues have arisen, issues that this report addresses. These are: the need to assess the economic impacts of lending under the SBLA; the need to determine the extent to which loans made under the terms of the SBLA are incremental, incremental in the sense that the loans would not otherwise have been granted; and, the requirement to examine the extent to which broadening of the eligibility criteria (and the significantly increased take up) of the program is likely to change the riskiness of the portfolio so that costs of defaults can be assessed. These issues may all be translated into statistically testable hypotheses:
H01: the SBLA has no direct or indirect economic impact;
H02: Lending under the terms of the SBLA would have occurred in the absence of the Act.
H03: The 1993 amendments of the Act have no impact on the riskiness of the overall SBLA portfolio.
If the lending under the act has no economic impact (H01 not rejected), modifications of targeting criteria and questions regarding the role of public policy are implied. Failure to reject only H02 implies that banks are simply passing the costs of due diligence and poor lending decisions along to the public. In this event, it has been argued that modifications related to the banks' responsibilities would be warranted. Rejection of H03 implies changes to the level of guarantee support so that the taxpayers are somewhat immunized from defaults. If the data do not reject the first two hypotheses but do reject the third, abolition of the Act is implied. Failure to reject the others implies the need for further modifications. Other combinations of hypothesis rejection or acceptance imply a variety of remedial measures.
This report addresses each of these issues by putting these hypotheses to statistical test based on empirical evidence drawn from bank loan files and follow-up telephone interviews of SBLA borrowers.
Data from bank loan files was collected during the period May-August 1994. The data collection form was based on that used by Wynant and Hatch (1990) in their survey of bank lending patterns to SMEs. The data collection form was pre-tested, refined in light of the pre-testing, and administered according to a random sampling design of loan files maintained by Canada's six large chartered banks. A copy of the data collection form is available on request.
The sampling program was designed to reflect the approximate market shares of the six major Canadian banks and the geographic distribution of Canadian SMEs according to telephone area codes. A random selection of bank branches within area codes by bank from listings supplied by each of the banks. Loan files were selected randomly from within each bank branch.
Data collection resulted in 1,393 case histories of lending experiences. All banks were sampled from all major geographic regions in which they operate. The file data were derived from a variety of documentation events in the small business/bank relationship. In 57 percent of the cases the event is an annual review; requests for term loans (14 percent), new lines of credit (7 percent), and increases in existing operating loans (5 percent) constitute most of the remaining cases.
Among the 1,393 cases collected from bank loan files are 426 borrowers who had indicated that they had obtained financing under the terms of the SBLA. Where possible, these borrowers were contacted by means of follow-up telephone calls to gather additional data regarding incrementality, economic impact, and risk profiles. (The data collection form used for this purpose is also available on request..) Not all the 426 borrowers could be contacted. In numerous cases the principal of the firm was not available. In other cases, researchers had not fully identified the owners from bank file data. Twenty-six individuals refused to respond to the telephone interview and three others denied having SBLA loans even though their bank loan files stated otherwise. Nonetheless, a sample of 176 SBLA borrowers was accumulated.
ANALYSIS AND FINDINGS
The profile of the 'average' SBLA borrower was a firm that: comprises 7.5 employees; reports annual sales of $769,000 and before-tax profit that averages $49,000; is 8.7 years old. has been with their current banker 5.7 years; is, on average, smaller and younger than non-SBLA borrowers; and, has, on average, fewer assets, less equity, and lower profits than non-SBLA borrowers. The primary uses of the borrowed funds were to obtain new equipment or to fund new property or floor space. SBLA borrowers had benefited from the loan through increased sales, cost reductions, and aversion of failure. Plant expansion furthered national goals of economic development and job creation.
On average SBLA borrowers appear to be those targeted by the Act: they tend to be smaller, more risky, and with fewer resources than counterpart firms. SBLA borrowers tend to be smaller and more marginal than the general population of bank SME clients. Expansion of the eligibility criteria for SBLA borrowing has resulted in some incremental activity. Approximately 8.6 percent of borrowers reported sales of $2,000,000 to $5,000,000; 8 percent of borrowers are in the professions and; another 4 percent are in the finance, insurance, and real estate sectors.
Table 1 compares SBLA borrowers with non-SBLA borrowers by stage of development. Clearly, SBLA borrowers display a greater tendency to be at earlier stages of development than non-SBLA borrowers. Nonetheless, a significant proportion of SBLA borrowers constitute what, under the UK system, would be regarded as "established" businesses.
Most of the borrowing under the terms of the SBLA were new loans in the sense that less than five percent of the loans replaced a previous debt. In 51 percent of the cases the loan was prompted by the suggestion of the firms' bankers. A large majority of respondents (91%) pronounced themselves either "very satisfied" or "somewhat satisfied" with the manner by which the loan was handled. This high level of satisfaction suggests that the program has helped business owners achieve their objectives.
Small loans predominate. Almost six out of ten SBLA loans are for less than $50,000. From the perspective of the lenders, such loans are not, in and of themselves, cost-effective. Moreover, bankers contend that lending to SMEs is, in general, an unprofitable segment of the banking business. To the extent that bad debt losses can be mitigated by means of a guarantee, lenders have incentive to encourage guaranteed loans to firms that may not otherwise be considered. If only to reduce investigation costs, lenders may be tempted to make guaranteed loans where the guarantees are not needed.
The primary uses of the borrowed funds were to obtain new equipment or to fund new property or floor space: 75 to 80 percent of respondents indicated these uses of the funds. In 28 percent of the cases this was accomplished, at least in part, through leasehold improvements. Responses indicated: 64.5 percent of respondents reported that sales increased as a result of the loan; 56 percent of respondents reported that new jobs were created; 29.1 percent of respondents reported cost decreases; 9.2 percent reported an increased ability to export; and, 41.7 percent reported that the SBLA loan helped the firm to survive.
These are impressive findings. The SBLA appears to provide significant impetus to economic development, job creation, and prosperity. To the extent, however, that borrowing under the SBLA would have occurred even in the absence of the guarantee, not all of this economic impact can be regarded as attributable to the program. This caveat raises the issue of incrementality.
Expansion of the eligibility criteria for SBLA borrowing has resulted in incremental activity. However, it does not seem likely, a priori, that these changes account for the magnitude of the unprecedented increase in SBLA lending. This raises issues of incrementality, a concept with two different (both of which are relevant) interpretations.
The first relates to the 1993 revisions to the eligibility criteria. In this first sense, some borrowers are incremental in that they would not have been eligible prior to April 1993. According to these changes, firms with sales of $2 million to $5 million became, incrementally, eligible borrowers. In addition, firms in particular industrial sectors became newly eligible. An estimated 8.6 percent of borrowers reported sales in excess of $2,000,000 and 8 percent of borrowers are in the professions; another 4 percent are in the finance, insurance, and real estate sectors.
The second interpretation of incrementality relates to the "bankability" of the firm. The question has arisen as to whether or not firms that have borrowed under the SBLA would have qualified for a term loan without the need for a government guarantee. That is, "...what proportion of SBLA lending is really incremental, in the sense that the loans would not have been made without the program?"3
Evaluation of incrementality in this second sense, or 'bankability', is less straightforward. Based on telephone follow-up interviews with 176 SBLA borrowers, 11 percent of respondents reported that all other loan requests had been turned down. Fifty percent believed that they could have borrowed elsewhere without the SBLA. Another 27 percent replied that the SBLA loan wasn't necessary in the sense that the firm could have survived without the loan. (Without the loan, however, these businesses might not have employed more people, increased sales, reduced costs, or increased exports.) These, of course, are perceptions. They provide a good first impression of incrementality and they reflect beliefs at large in the community. However, additional, more direct, empirical evidence is available.
A more informative means of investigating incrementality is to examine the banks' treatment of SBLA clients with respect to terms of credit on operating loans and non-SBLA term loans. For example, 254 firms had borrowed under the terms of the SBLA and also maintained an operating loan facility with the same lender. Likewise, 326 firms had both a term loan under the SBLA as well as one or more term loans that were not guaranteed. Table 2 presents the distributions (and cumulative distributions) on operating loans held by SBLA borrowers and by non-SBLA term loan borrowers. Table 3 presents similar distributions of rates on non-SBLA term loans for borrowers who also held a SBLA loan and for term loan borrowers who did not report an SBLA loan.
The median rate on operating loans paid by non-SBLA borrowers is 125 basis points above prime. In finance theory and according to stated bank practice, the interest rates charged by lenders reflects the lenders' assessments of client riskiness. From Table 2, it is seen that among SBLA borrowers, 30.3 percent have been assessed an operating loan interest rate that reflects a ranking that lies in the lower half of rates (i.e., riskiness) as assessed operating loan clients. Even though SBLA borrowers are, on average, smaller, younger, and have less assets etc., 30.3 percent of these firms do not seem to have been regarded by the lender as among the riskier firms.
Likewise, in Table 3, 39.4 percent on SBLA borrowers paid lower than median (150 basis points above prime) rates on non-SBLA term loans from the same lender from whom an SBLA loan had been advanced.
These results indicate that from 30 to 40 percent of SBLA loans were to firms that are among the least risky in the lenders' portfolios: to firms that banks already regard as among the least risky. Moreover, approximately 80 percent of SBLA borrowers received other bank loans at rates less than 200 basis points above prime. These are "bankable" firms. This finding speaks directly to the question of incrementality.
Incrementality, however, is a double-edged sword. On the one hand, extension of loans to less risky SMEs is good news for the government: each firm pays a fee but the likelihood of default (for non-incremental borrowers) is low. Moreover, lenders have been subject to considerable pressure to increase lending to SMEs. The SBLA provides a useful vehicle through which this goal may be accomplished. On the other hand, non-incremental loans use up part of the $4 billion limit legislated under the terms of the SBLA.
The first requirement is to establish a profile of the current SBLA portfolio in terms of industrial sector, size of business, age of borrower firm, use of funds, and lender. These data indicate the importance of the SBLA in economic development and, in conjunction with sector-specific default rates, will provide a more clear estimate of prospective loan losses. The next task is to determine how risk and the expanded eligibility criteria relate to each other. This second task is to identify the relationships between loan default rates and the expanded eligibility criteria. For example, larger firms, firms with sales of $2 million to $5 million, may arguably be less risky than smaller firms. Professionals may also be less risky, etc.
Data from the bank file survey provided information business sector, age of firms, sizes of firms, location, etc. In addition, the follow-up telephone survey asked respondents if they had defaulted on a term loan or been involved in a business bankruptcy. Therefore, these surveys provide micro-level data that permits statistical modeling of the relationships between propensity to default and profile characteristics.
This modeling was carried out using basic statistical breakdowns of default experience with respect to profile characteristics, According to this approach, industry, and firm size seemed to govern default rates. However, identification of the nature of this multi-dimensional relationship requires more powerful statistical methods.. The technique of choice is logistic regression and is described in Haines, Riding and Thomas (1990). As employed here the logistic regression function forecasts the probability of a default given the right hand side variables. Logistic regression was employed using such inputs as firm size, sector, etc. to predict jointly the probability of default and revealed only two significant factors:
Thus, the risk profile of the incremental portion of the SBLA portfolio has increased.
This report addressed three primary issues. It employed empirical evidence drawn from bank loan files, follow-up telephone interviews of SBLA borrowers, and other secondary data to investigate:
Initial indications were that the empirical evidence suggests rejection of the first null hypothesis, that the SBLA has no direct or indirect economic impact. However, it was also determined that a significant component of the borrowing, as much as 80 percent, is non-incremental. Yet even if only 20 percent of the stated economic impact obtains, the SBLA nonetheless contributes significantly to economic prosperity and job retention and creation. The evidence is clear regarding the second hypothesis, in that a material proportion of lending under the Act was advanced to firms that lenders did not regard as very risky. The lenders had other outstanding loans to these same customers at favourable rates.
The third null hypothesis, that the risk profile of the SBLA portfolio has been invariant, was rejected in that newly-eligible firms have historically exhibited higher risk. The April 1993 amendments to the Act are likely to change historical loan loss rates. In particular, firms with sales of $2,000,000 to $5,000,000 were more likely to default than other firms. Thus, among the "risky" 20 percent (approximately) of the SBLA portfolio, risk has increased.
Accordingly, the risk profile of the SBLA portfolio has changed, but in two respects. On the one hand, a high proportion of SBLA loans are to firms whose level of risk is much lower than that of historical SBLA clients. On the other hand, expansion of eligibility criteria has resulted in slightly increased levels of risk within the risky segment of the SBLA portfolio. The issue of potential default is serious in view of the dramatic increase in take-up rates of SBLA loans. The eight-fold increase in loan guarantee liabilities has, at first glance, significant implications for program costs. Both administrative costs and costs of guarantees could be material for a government already concerned about national budgetary deficits. Fortunately, the 'worst-case' scenario is unlikely because of issues of non-incrementality.
Because of the low level of incrementality, historical default rates on SBLA loans are not reliable indicators of future loan losses. It is possible to reason with some degree of logic as to the net impact of these changes on program cost. First, all firms pay an up-front fee for the SBLA guarantee. For a $4 billion portfolio and a 2 percent fee, this amounts to income of $80 million. Assume: (a) that, conservatively, 70 percent of the portfolio presents the same level of risk as non-SBLA small firm borrowers; and, (b) lenders target a one percent loan loss rate. Then, estimated defaults from the "less risky" segment of the portfolio would be of the order of $28 million. Assuming a loan loss rate of seven percent on the 30 percent of the SBLA portfolio that is more risky, losses of an additional $84 million are indicated. Under these conditions, then, net losses of the order of $32 million might be expected.
Reasoned estimates of loan losses indicate that a 3 percent fee is likely to offset, in whole, expected loan losses. In the December 1994 "Orange Paper" that advances a variety of initiatives targeted to small firms, the Canadian federal government indicates their plans to increase the legislated maximum size of the SBLA portfolio from $4 billion to $11 billion, but with an additional one percent fee. On balance, it appears that the new level of fees will compensate for anticipated loan losses.
The Canadian SBLA has much to recommend it. Among other aspects, the program: is delivered by the private sector without undue government intervention; relieves lenders of the need to establish security; viewed positively by small businesses; allows lenders to lend at fair rates of return; and, is inexpensive to administer. In spite of the increased take-up of the program, loan losses net of fees are likely to be marginal (and, indeed, the program may be self-financing) because many of the borrowers are not high risk. In spite of these advantages, beneficial changes to the program could be effected. In particular, the counterpart UK and Japanese programs provide some insights into possibly useful changes.
First, the recoveries from defaulted firms are very low. Both the UK and Japanese arrangements provide more explicitly for recoveries: indeed, almost one half the income of the Japanese CIC stems from recoveries of defaulted loans. In the Canadian setting, the maximum loss of 10 percent of the principal of the (small) loan does not provide material incentive for the lenders to pursue aggressively recovery of lost funds. The SBLA administration does not seem charged with the task of recovery, recoveries are minimal.
There are at least three ways of attending to this situation.
1) The level of the guarantee could be reduced. Lenders would then have greater incentive to seek recovery. One downside of this modification, however, might be to make lenders more selective and might defeat the very purposes of the program.
2) Private sector collection firms could be encouraged to bid for loans in default, with the proceeds of bidding being shared by the lenders and the government while collection agencies would benefit from recoveries.
3) A public sector body could be established to seek the full recovery of loans in default.
While the DTI program in the UK seemed less efficient, there were particular attributes of the system that could be considered: the differentiation between established firms and newer firms; and the regulation that prohibits multiple usage of the guarantee by any one individual.
At the more basic level, the question of whether or not government intervention is necessary has been answered affirmatively. The pathology of the bank-SME marketplace demands intervention to help attain national goals of prosperity and economic development. Governments of Japan, the UK, and other developed countries clearly recognize the need for intervention. The public need not underwrite such intervention. Viewed as an insurance program, a facility by which SMEs can purchase security against loan default, income from premiums and bad debt recoveries can insulate the national budget against undue strain. Even if the assumptions behind the simulations carried out in the context of this work are not universally acceptable, the experience of the Japanese Credit Insurance Corporation provides clear testimony.
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1 Thornton (1981) added some empirical substance to these contentions. Thornton used discriminant analysis to study several aspects of the financial management of Canadian small businesses. One dependent grouping was whether or not the small firm owner respondent had been turned down for financing in the past three years. Fifty-two of 289 respondents reported loan turndowns. Thornton found that significant variables associated with the turndown decision included: an industry dummy variable (a variable which took the value 1 if the respondent was a manufacturer and 0 if the respondent was not a manufacturer); financial management ability (which took the value of 1 if the person managing the firm's finances had a formal designation in accounting or finance, and 0 if not); and the size of the firm as measured by the number of full time employees. 2 Capacity is the extent to which an organization is able to meet its obligations as they fall due. Capital relates to the amount of equity investment made by the owner(s). Collateral relates to the value of assets available to secure the loanable funds against liquidation or default. Character includes the track record of the business and its owners. Conditions refer to the proprietary nature of the product or service, the size of the market, and the industrial climate. 3 Internal memorandum, Entrepreneurship and Small Business Office, Industry Canada, April 1994.
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