SME Lending: When Does Distance Matter Gregory F. Udell Kelley School of Business, Indiana University Presentation at the conference on The Changing Geography.

SME Lending:When Does Distance Matter

Gregory F. UdellKelley School of Business, Indiana University

Presentation at the conference on

The Changing Geography of Bankingorganized by the

Department of Economics Università Politecnica delle Marche

Ancona, September 22-23, 2006

MOTIVATION

• There has been a considerable amount of interest in the spatial dimension of SME lending.

• A major focus of this research has been on the importance of distance in the accumulation of soft information for relationship lending.

• However, the direct and indirect empirical evidence on distance paints an inconsistent picture (e.g., Carling and Lundberg 2002, Petersen and Rajan 2002, Brevoort and Hannan 2004 Berger et al. 2005, Degryse and Ongena 2005, Alessandrini, Presbitero and Zazzaro 2006).

MOTIVATION (cont.)

• The framework used to analyze this issue (and, more generally, to analyze SME lending) has been quite useful but is not complete:

– SME lending may not be just relationship lending– It may not be just relationship lending vs. transactions

lending– A more complete paradigm may be important in

understanding SME lending including its spatial dimension

• Banks offer a variety of lending technologies beyond relationship lending

• The availability of these technologies depends on a country’s financial institutions structure and lending infrastructure (Berger and Udell (2006 forthcoming)

• The importance of distance may be directly linked to the lending technology deployed

PRESENTATION OBJECTIVES

• Present an alternative (and more complete) paradigm of SME lending based on Berger and Udell (forthcoming)– This paradigm recognizes the existence of many lending

technologies

– The feasibility and efficacy of lending technologies in depends on country’s

• Financial institutions structure• Lending infrastructure

• Discuss the potential link between the presence of these technologies and:– SME credit availability– Spatial dimension of the SME lending

A MORE COMPLETE FRAMEWORK(Berger and Udell 2006)

• SME lending may consist of a wide variety “lending technologies”

– One lending technology is based on soft information and may be well-suited for opaque SMEs:

• relationship lending

– Numerous transactions technologies based on hard information

• All but one of these may also be well-suited for opaque SMEs

– A departure from the conventional orthodoxy• All transaction lending is not same• Transactions lending is not reserved for the just relatively

less opaque SMEs

A MORE COMPLETE FRAMEWORK (cont.)

• In addition to relationship lending, there may be at least seven distinct transactions lending technologies of which at least six (and possible seven) are based on hard information.

– Financial statement lending– small business credit scoring– asset-based lending– Factoring– Real estate-based lending– Equipment lending– Leasing

– Trade credit*

*could also be relationship driven

• Only financial statement lending is likely limited to transparent borrowers.

A MORE COMPLETE FRAMEWORK (cont.)

• The current framework also overlooks that countries likely differ significantly according to:

1. Financial institution structure – Market presence of and competition among different types of institutions.

2. Lending infrastructure – Rules and conditions that affect financial institutions and their abilities to lend.

• And it overlooks how these “structures” may affect SME credit availability through the use of different lending technologies.

• This more complete framework hypotheses that:

STRUCTURE => LENDING TECHNOLOGIES => CREDIT

– May be viewed as part of the finance-growth nexus.

DEPLOYMENT OF THE LENDING TECHNOLOGIES VARIES GLOBALLY

• Example #1:

– Asset-based lending has a significant presence in only 4 nations: Australia, Canada, the U.K., and the U.S.

• Example #2:

– Factoring also differs widely: The ratio of (factoring)/(GDP) in 2002 was 11.9% in Italy, but only 0.9% in Switzerland.

• Why?: Suboptimal financial institution structures and/or lending infrastructures in many nations appear to limit the use of some lending technologies and promote the use of others.

– Limits on the technologies likely significantly reduces SME credit availability.

THE LENDING TECHNOLOGIES

• Financial contracting must address the informational wedge.

• Lenders use different technologies to address this problem.

– These technologies are comprised of a combination of screening mechanisms, contract structures, and monitoring strategies.

LENDING TECHNOLOGIES (cont.)

• Financial statement lending

– Key characteristics:

• Transactions technology,• Requires audited financial statements,• Based on strong financial ratios,• Relatively inexpensive technology for larger SMEs.

– Target SMEs: • Relatively transparent borrowers.

LENDING TECHNOLOGIES (cont.)

• Small business credit scoring

– Key characteristics:

• Transactions technology,• Multivariate statistical models,• Owner data from consumer credit bureaus sometimes

combined with business data from commercial credit bureaus,

• Very inexpensive and quick.

– Target SMEs: • Opaque borrowers with credit less than $250,000.

LENDING TECHNOLOGIES (cont.)

• Asset-based lending

– Key characteristics:

• Transactions technology,• Collateralized by A/R, inventory and sometimes

equipment,• Intensive collateral monitoring (Udell 2004),• Relatively expensive technology.

– Target SMEs: • Opaque, high risk.

LENDING TECHNOLOGIES (cont.)

• Factoring

– Key characteristics:

• Transactions technology,• Purchase of receivables,• Receivables removed from bankruptcy estate,• Cross border receivable financing feasible.

– Target SMEs: • Opaque, high risk.

LENDING TECHNOLOGIES (cont.)

• Real estate-based lending

– Key characteristics:

• Transactions technology,• Collateralized by personal or SME real estate,• Proceeds can be used for other than real estate purchase• Based on appraised value of assets.

– Target SMEs: • Opaque, high risk.• Although used for all SMEs

LENDING TECHNOLOGIES (cont.)

• Equipment lending

– Key characteristics:

• Transactions technology,• Collateralized by equipment,• Based on appraised value of assets.

– Target SMEs: • Opaque, high risk.• Although used for all SMEs

LENDING TECHNOLOGIES (cont.)

• Leasing

– Key characteristics:• Transactions technology,• Purchase of equipment by a financial institution that

“rents” the equipment back to the lessee,• Equipment removed from bankruptcy estate.

– Target SMEs: • Opaque, high risk.

LENDING TECHNOLOGIES (cont.)

• Trade credit

– Key characteristics:• Extended by suppliers,• Ubiquitous although relative importance varies,• May have information advantage from observing supply

flow, liquidating inventory or other virtues.

– May be relationship-driven (Miwa and Ramseyer 2005, Uchida, Udell and Watanabe 2006)

– Target SMEs: • All.

LENDING TECHNOLOGIES (cont.)

• Relationship lending

– Key characteristics:• Relationship technology,• Lending decisions based on relationship strength,• Information culled from entrepreneur, SME, and local

community from provision of loans and other products,• May be relatively expensive,• Distance may matter – unlike the transactions

technologies.

– Target SMEs: • Opaque small business w/o collateral.

FINANCIAL INSTITUTION STRUCTURE AND SME LENDING

• The dimensions of financial institution structure:

– Large versus small institutions.– Foreign versus domestic institutions,– State-owned versus private institutions,– Financial institution market concentration.

• Empirical research suffers from the problem that the lending technologies are generally not observed.

– Difficult to test many theories of SME lending.• Example #1: large institutions may lend to opaque SMEs using

some transactions technologies (i.e., SBCS, ABL, factoring, leasing, RE-based lending, equipment lending)

• Example #2: Theories of concentration and SME credit availability only apply to the relationship lending technology.

THE LENDING INFRASTRUCTURE AND SME LENDING

• The lending infrastructure includes:– The information environment,– The legal, judicial and bankruptcy environment,– The social environment– Tax and regulatory environments.

• The lending infrastructure affects feasibility and efficacy of specific technologies

– Example #1: commercial law on movable assets determines feasibility of asset-based lending

– Example #2: information sharing affects feasibility of small business credit scoring.

– Example #3: weak bankruptcy laws may promote factoring– Example #4: overall weak infrastructure may promote trade

credit

THE IMPACT ON CREDIT AVAILABILITY

• This conceptual framework of SME finance focuses on:

– A nation’s financial institution structure and lending infrastructure.

– How these structures may affect SME credit availability through the use of different lending technologies.

• Many transactions technologies targeted to opaque, rather than transparent SMEs

– Small business credit scoring, asset-based lending, factoring, real estate-based lending, equipment lending and leasing.

– Thus, for example, large institutions in competitive markets may still be able to provide significant amounts credit to

opaque SMEs.

THE IMPACT ON CREDIT AVAILABILITY (cont.)

• Financial institution structure affects efficacy of the technologies.– Market presence of and competition among different types of

institutions affects ability to use the technologies.

• Lending infrastructure affects efficacy of lending technologies.– Information environment, commercial laws, bankruptcy laws,

enforcement, taxes, and regulations directly affect whether technologies may be legally and profitably employed.

– Regulations indirectly affect use of technologies by constraining the potential financial institution structure.

• Overall credit availability likely depends on the mix of the lending technologies => Hypothesis:– 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

CONCUSION: DISTANCE AND LENDING TEHCNOLOGIES

• Identifying lending technologies is an empirical problem

– The problem’s magnitude likely varies across countries

• A serious problem in common law countries where all technologies are important

– Problematic to test theories of relationship lending if can’t control for other technologies

• We suspect that distance matters relatively little for the transaction technologies

– Based on info that is easy to transmit – both operationally and functionally (Alessandrini, Presbitero and Zazzaro 2006).

CONCUSION: DISTANCE AND LENDING TEHCNOLOGIES (cont.)

• Therefore, the importance of distance at the country level depends on:

– Relative importance of relationship lending versus the other technologies

– This can change with policy initiatives

• Vietnam’s 2005 factoring law

• Longer distance doesn’t necessarily constrain opaque SMEs

– Transactions technologies can offset