Relationship Between Banking and Enterprises

This research is very vital for future studies in the area of banking and finance. The research serves as a basis of understanding the relationship that exists between the banking sector and small & medium enterprises. This relationship will be analyzed in terms of the contribution of banking sector to the growth of small enterprises in the economy. The research will help one understand the measures that have been put in place by governments in order to encourage various banks to support the growth of SMEs. The study will analyze in details those factors that influence the growth of SMEs as a result of efforts put across by various banks in order to stimulate growth in this vital sector of the economy. It is very important to understand these aspects as they form the basis of knowing and understanding the investment opportunities that arise in the SME sector and the ways to achieve full realization of these opportunities with the help of banking sector. The research will also help to identify the challenges that are been faced by SMEs as they borrow startup capital from various banks. The study will further analyze the policies that have been put across by monetary regulatory authorizes to stimulate the required growth in terms of relationship between SMEs and banks that lead to economic growth. The research will also review the various commonly held opinions concerning the relationship between banking and SMEs as put across by various scholars who have studied this subject.

I have very personal interest in the relationship that exists between banks and SMEs as I would like to have a deeper understanding of the opportunities that are brought about by this connection. I am also interested in learning about the pillars that are used to develop this mutual interrelation and how it can be made strong. Moreover, I would like to understand the significant contribution of banking sector to the growth of the economy and how these contributions are implemented in the enhancement of the growth of the SMEs’ sector. This study will form the basis for my future research thesis as I intend to continue my academic work in the area of small and medium business enterprises. The subject is very crucial for all those who intend to be future investors in the SMEs’ sector. The study provides vital information in terms of how one can raise capital to start a small or medium enterprise by getting money from a bank. The study will come up with the recommendations that will help in improving the existing relationship between the banking sector and SMEs. It will also help to identify the challenges that are been faced by banks in supporting SMEs and, finally, give ways to overcome these challenges. Therefore, this study is very important for future analysis of the relationship between banking and SMEs and making predictions on future expected trends in the two sectors.

Research background

Abstract

Over the years, many people have been making efforts and investing heavily in studying the various factors that influence different types of banks to lend to small and medium firms. The efforts have seen development of many diverse arguments on this subject. Different views have been put across with an aim of making the issue about banks and SMEs known to various people. Many of the efforts have been directed in studying the types of banks that lend to SMEs and the cost of borrowing from these banks. This study has carried out a survey with an aim of understanding these issues in order to come to prove the newly held opinion on lending to SMEs by foreign banks.

The study analyzes how the firm’s structure and lending style influences the decision of a bank about granting loans to certain firms. Using data from 80 large banks from 50 different countries, the study has showed that  domestic private foreign  as well government banks use numerous lending styles and technologies as well as organizational structures in order to finance small and medium enterprises. The types, extent and prices of loans for SMEs are somehow strongly correlated with lending styles and organizational structure adopted by banks; this suggests that SMEs’ financing should not be based upon relationship lending only, but rather it should be based upon many other factors. Based on the results of the study, I realized that some important distinctions in terms of type, extent as well as prices for SMEs’ loans vary among different banks. The study finds that some significant differences exist between the developing and developed countries; the differences are triggered by both legal and institutional environments.

Introduction

Financing for medium  and small sized enterprises has been an area of great interest to both  researchers and policymakers because of the importance of the SME sector as a private sector across the globe and the view held by majority that these types of businesses are usually financially constrained. The data that was collected in 2007 by Ayyagaria for 75 developing and developed countries shows that, on average, medium and small firms have about 60% of employment offered by manufacturing. More significantly, numerous researches using businesses survey data have indicated that SMEs perceive access to finance as the only difficulty, but they also consider the cost of finance to be another major obstacle for them compared to larger firms; these factors are the constraints to the medium and small businesses and this affects the performance of these firms compared to effects that they have on smaller firms (Weder and Schiffer 2001). In the recent times, a debate has erupted concerning the type of bank financing that they give to SMEs.

It is not until the recent years that some conventional knowledge concerning SMEs’ financing has developed. It says that domestic privately owned banks and small financial institutions are better placed to finance SMEs. This can be attributed to their good position that they are suited in to perform the lending relationship; this form of financing is mainly based on some soft information that has been gathered by various loan officers through a personalized continuous direct contact they have with the SMEs, the owners as well as the managers and the community in which they carry out their businesses (Keeton 1995, Udell and Berger 1996). These scholars argued that those firms are more centralized and their hierarchical firm’s structure can impact negatively the process of lending to small borrowers, for example, SMEs. However, recent research (Udell and Berger 2006) disputed the convectional knowledge and made new proposals on relationship that exist between banking and SMEs; they are of the view that foreign and larger banks can also be as effective in lending to SMEs as small and domestic privately owned banks. This is through their arms-length lending styles, for example, factoring, asset based lending, leasing, credit scoring as well as fixed asset lending and centralized firm’s structures rather than lending on the basis of relationship lending.

This study makes efforts to inform on recent debate by usage of recently collected data from 91 large banks selected from 45 different countries. As far as I am concerned, this is the first research to carry out the test on various hypothesizes that have emerged from earlier literatures making suggestions on merely found paradigm for medium and small firms’ financing. The first step is to examine whether various banks’ ownership forms are using different lending styles and firm’s structures in provision of finances to SMEs. Specifically, the examination focuses on whether foreign owned banks have the likelihood, compared to domestic privately owned banks, to use their arms-length based lending styles, laying their foundation on the hard information as well as the centralized firm’s structures.

The next focus is to investigate whether arms-length based lending styles and centralized firm’s structures are also very suitable for SME financing as a relationship of financing/lending. Thirdly, the test is carried on whether, even though they tend to make greater usage of arms-length based lending styles and centralized firm’s structures, foreign-owned banks do not make specialization less significant regarding SMEs’ financing or making SMEs’ loan products tend to offer less favorable lending terms compared to domestic privately owned banks. Finally, an analysis is carried out on whether legal as well as the institutional environments of a given country have an impact on the type, extent and prices of SME loan products. This study focuses on various banks as opposed to other financial institution; this is because researchers have indicated that banks tend to be the major sources of external finances for SMEs across various countries (Beck 2008). Furthermore, attention was put on larger banks due to the role they play as probable financiers of SMEs. However, some doubts exist on selection biases which may arise from restricting the samples that are used in larger banks. This may result in leaving out the most important niche of domestic banks, such as cooperative banks, which are mainly focused on provision of finances to SMEs. On the other hand, taking into account the extent to which larger banks across the globe are likely to be uniform to each other on the basis of lending styles and firm’s structure and the fact that many foreign banks are usually large, laying one focus on larger banks may downplay some potential differences in lending technologies and firm’s structures across various bank ownership forms.

The result of the study provides some empirical evidence to support the hypotheses that are posed by the various recent literatures advocating for a new type of paradigm for SME financing. It is clear that banks of different forms of ownership tend to use different lending styles and firm’s structures in providing finances to SMEs. For example, foreign banks tend to offer a larger share of loans that are collateralized and thus they are not likely to rate the information that is barely significant in evaluation of loans; they may also not decentralize approval of loans and various risk management decisions. However, some significant correlations exist between lending styles and firm’s structures of one part and type, extent and prices for SME loans in different foreign as well as domestic privately owned banks. Instead, some significant differences can be seen across various banks in developing and developed countries and they are driven by the differences that exist in terms of legal and institutional environments. For example, banks that are found in developing countries are to provide lower share in provision of investment loans; they also charge higher levels of fees on SMEs’ loans compared to those banks found in developed countries. On the other hand, banks that are found in developed countries charge larger fees on small loans taken by small firms.

The part of the remaining research has been created as follows. Part 2 makes a description of the survey that was used in gathering the data. Part 3 investigates the differences that exist between lending styles and firms’ structures across various bank ownership forms. Part 4 carries out an examination on the correlation that exists between lending styles and firm’s structures on the one hand, and the type, extent and prices for SMEs loans on the other hand. Part 5 makes an exploration on various differences that exist in type, extent and prices for SMEs across various bank ownership forms. Part 6 makes conclusion.

Theoretical framework

The survey

In order to collect information concerning bank lending to SMEs across the globe, a survey was designed with 50 questions with an objective of:

i. Documentation of perception of the banks regarding the SMEs segments

ii.Having an understanding of banks’ businesses models, especially, lending styles and firm structures that are used to serve the SMEs, and, finally,

 iii. Making quantification of the type, extent and prices of bank loans to SMEs.

The survey collected vital data concerning the views of both players in this sector that are banks and SMEs’ business about the role of each other in their growth. The survey collected data from different banks that had different lending styles as well as firm structure with an aim of understanding the difference that exists between these banks. The survey used different countries in order to see how a different legal and institutional factor influences the banks while lending to small and medium firms. The banks filled various questionnaires which were specially designed with question in relation to the subject under review.

The survey was a success as it managed to gather useful data from different banks such as foreign banks, domestically privately owned banks and, finally, from those banks that are owned by the government. The survey intended to understand the approaches employed by these institutions in provision of finances to SMEs. Using the data collected from bankscope, identification of the 4 largest commercial banks was made on the basis of their asset portfolio in about 80 countries around the globe and they were invited to make responses in the survey.

Results of the survey

The survey showed mixed results from different corners of the world. Various banks employed different lending technologies/styles depending on the legal and institution factors that faced them. Majority of the banks that were lending to small and medium firms were mainly those that are small in size. Foreign banks even if they do provide loans to small and medium firms tend to do this at a very high interest rate. The survey revealed that this makes the loans from these banks more costly to the borrowers. The data collected also revealed that different banks within different economic localities had the different cost of lending to the SMEs.

Large institution in developed countries tend to finance small and medium firms at higher interest rate compared to the same institution which lends at lower rate in developing countries. The data collected indicates that the type of a bank has some implications on how it finances small and medium businesses activities. The data collected also indicates that majority of the loans offered by banks to SMEs are short term loans. It was also revealed that the banks that are owned by the government charge low interest rates on their loans; this is not the case as those firms that benefit from these interest rates are larger banks. The survey indicates that the type, extent and structure of a firm have an influence on how the firm lend to small and medium firms and the rate at which it charges the loans.

Differences between lending styles and firms’ structures

The following question was answered about the extent to which there is a difference between lending styles and firm’s structure in terms of type, extent and prices for SME loans. Traditional view of the literature was that SME lending was mainly based on soft information as well as decentralized firm’s structure; researches proposing new views on SME financing have been conducted. Share of lending to small and medium firms have been used as an indicator for SME lending and, on the other hand, the percentage of loan approved to SMEs is expressed in terms of total lending ratio. The study indicates that there is no relationship that exists between how large a firm is in determining whether to lend to small and medium firms, but the study found that SME loans are mainly short term loans. Overall, the prediction is made by the researchers proposing a new form of paradigm for SME financing: the firm’s structures and lending styles used for SME financing indicate limited correlations to type, extent, or prices of SME loans. Furthermore, for example, results do not provide some support for the commonly held notion that relationship lending is usually consistently associated with cheaper and bigger number of loans for SMEs.

The type, extent and prices of SME loans across various countries and bank types

In this final section a research is done on how the, type, extent and prices of SME loans tend to vary across various bank ownership forms. On the one hand, some earlier researches show that foreign banks are not likely to involve themselves in SME financing because they usually make an adoption of arms-length financing style and have hierarchical and centralized firm’s structures (Sengupta 2007). On the other hand, recent researches advocating for new paradigm for SME loans take a more centered view arguing that even foreign banks can also be involved in financing SMEs, which at the same time acknowledges the differences in financing  technologies/styles and firm structures between domestically owned private and foreign banks (Udell and Berger 2006).

When we look at government owned and managed banks, the bank-level information and evidence that exists show that while governmentowned commercial banks tend to take charges that are compared to domestic privately owned banks, they may be likely to end up lending to larger firms and it may be based on political reasons (Cole 2009). Furthermore, some researchers have found that less SME loans are readily available in nations where larger market shares of banks are government owned (Beck 2004) and larger shares of government owned bank ownership forms are usually associated with very unfavorable macroeconomic implications and  tend to have less developed economic and financial systems.

In this part, we also make exploration on the differences in the type, extent and prices of SME loans across various countries. The literature on private loans shows that financing will be heavily impacted by legal and institutional environment of the country in question.

Conclusions

This study made use of the data that was collected from a survey conducted in the large banks across the globe to investigate how SMEs financed by larger banks tend to differ in various countries as well as bank ownership forms, and to carry out an investigation on the link that exist between lending styles and firm’s structures and SME loans. For example, this tends to be the first research to empirically carry out a test on the new paradigm in SME financing first suggested by Berger and Udell (2006), which indicates that SME financing is not in any way dependent on relationship financing.

Our collected data yields some of the most interesting findings. Firstly, different banks tend to use different lending styles/technologies and firm structures. For example, foreign banks are the ones that are likely to use arms-length financing technologies/styles and centralized firm’s structures. Secondly, we did not find any strong link that exists between lending styles and firm’s structures on the one hand, and type, extent, and prices of loans to SMEs on the other hand. Thirdly, even though some differences were found in lending styles and firm’s structures used across various bank ownership forms, we come across few crucial differences across various bank types in the type, extent and prices of SME loans. Overall, we found that the  existing link between lending styles, firm’s structures, and the SME financing is not in any way  consistent with the popular notion that SME lending is mainly based on relationship financing, a type of financing deeply rooted in the usage of soft information and decentralized firm’s structures. Finally, the differences were found in the type, extent and prices of SME lending across various countries, which appeared to be driven by differences that exist due to legal and institutional environment.