52. In the case of relationship lending, information is gathered directly by the loan officer through
contact over time with the enterprise, the entrepreneur and the local community, and by observing the
SMEs’ performance on all dimensions of its banking relationship, including loan contracts, deposits and
other financial products. The loan officer may often remain the proprietor of the soft information,
may not be easily observed and verified by others. This gives rise to agency problems, which may be better
addressed by small banking organisations with few managerial layers and closer coordination between the
management and loan officers (Berger and Udell, 2002; Stein, 2002). Also, small banks are often
headquartered closer to potential relationship customers, reducing problems associated with transmitting
soft information from loan officers to senior management. In fact, greater hierarchical and/or geographical
distance between the information collecting agent and the loan approving officer may lead to less reliance
on subjective information and more on objective information (Liberti and Mian, 2009).
53. Empirical studies support the argument that small banks may find it more convenient than large
institutions to engage in relationship lending. For instance, based on a survey of SMEs’ finance in Japan,
Uchida (2011) finds that,
in the screening process to grant loans to SMEs, smaller banks give more
importance to the relationship factor, also using third-party information as a reference. Furthermore,
smaller banks tend to place greater emphasis on the collateral value of borrowers than large banks,
suggesting that small banks might need to insure their relationship lending through the requirement of
collateral. Matching data on US small businesses, the banks that lend to them and the contract
characteristics of loans, Berger and Black (2011) also find that small banks have a comparative advantage
in relationship lending. However, they also suggest that this advantage may be strongest for lending to the
largest firms, whereas in the case of smallest firms credit scoring is increasingly preferred.
54. It is often the case, however, that banks adopt a mix of lending techniques to evaluate the firm’s
creditworthiness and assess the credit risk. Investigating the choice of the lending technologies on a sample
of SME loans in Japan, Uchida et al. (2006) find complementarity among technologies. In particular,
financial statement lending and relationship lending are often used jointly. In a study on lending practices
towards Italian manufacturing firms, Bartoli et al. (2010) also find the distinction between transaction
lenders and relationship lenders to be rather blurred, as firms may obtain debt finance from the same bank
through different lending technologies. This form of complementarity is found at both large and small
banks, suggesting that transactions lending techniques, such as credit scoring, are used to “harden” - or
codify - the soft information collected through relationship lending. However, the study also finds that the
way soft information is embodied in the lending decision differs depending on the main approach used by
the bank. In particular, soft information appears to raise (lower) the probability of credit rationing if the
bank adopts mainly transaction (relationship) lending technologies. In other terms, banks that mainly use
hard information to screen borrowers tend to use soft information as a mechanism for further
discriminating loan applications.
2.2. Credit risk mitigation in traditional lending
55. Specific challenges limit traditional bank lending to SMEs. These are largely related to the
greater difficulties that lenders encounter in assessing and monitoring SMEs relative to large firms (OECD,
2006, 2013b). First, asymmetric information is a more serious problem in SMEs than in larger firms. SMEs
often do not produce audited financial statements that yield credible financial information and have no
obligation to make public disclosure of their financial reports, although they are generally obliged to
produce them and make them available to relevant authorities upon request.
Furthermore, in smaller
enterprises, the line of demarcation between the finances of the owner(s) and those of the business is
usually blurred. Unlike established public companies, which are expected to observe standards of corporate
governance with clearly defined roles for shareholders, managers and stakeholders, SMEs tend to reflect
the idiosyncrasies of their owners and their informal relationships with stakeholders. Hence, the
entrepreneur has better access than the financier to information concerning the operation of the business
and has considerable leeway in sharing such information with outsiders. The implications of asymmetries
in information are made more severe by the large heterogeneity in the SME sector. SMEs are characterised
by wider variance of profitability and growth than larger enterprises, and exhibit greater year-to-year
volatility in earnings (OECD, 2006).
56. Second, the principal/agent problem, which is inherent in all financing operations, is particularly
acute in the case of SMEs. Once financing is received, the entrepreneur may use funds in ways other than
those for which it was intended. An entrepreneur might undertake excessively risky projects since all of the
“upside” of the project belongs to the entrepreneur while a banker would prefer a less risky operation, even
if profitability is less than under the riskier alternative. A large firm wishing to undertake a comparatively
risky activity could select a different technique with appropriate formulas for sharing risk and reward, such
as equity issuance, but the range of choice available to small firms is usually narrower (OECD, 2013b).
57. Financial institutions have developed several methods to mitigate the incidence of these
challenges in SME lending. The main objective is to alter the risk-sharing mechanism in order to align
incentives between lender and borrower.
58. Commonly used methods to manage SME credit risk include (OECD, 2013b):
i) Requests for high equity contributions by prospective borrowers
ii) Requirements for collateral. i.e. an asset of the borrower, the possessive right of which is provided
to the lender in case of default
iii) Credit guarantees, whereby should the borrower default the guarantor compensates a pre-defined
share of the outstanding loan
iv) Loan covenants, i.e. a condition imposed by the lender with which the borrower must comply in
order to adhere to the terms in the loan agreement. Common loan covenants include:
a) Hazard insurance/ content insurance, under which the borrower is required to keep
insurance coverage on the plant/equipment or inventory in order to safeguard against
the catastrophic loss of collateral;
b) Key-man life insurance, which insures the life of the indispensable owner or manager
without whom the company could not continue. The lender usually gets an assignment
of the policy;
c) Requirements for payment of taxes / fees / licenses, whereby the borrower agrees to
keep those expenses up to date. In fact, failure to pay would result in the assets of the
company being encumbered by a lien (i.e. legal claim on property) from the
government, which would take precedence to the one from the bank;
d) Provision of financial information on the borrower and guarantor, whereby the
borrower agrees to submit financial statements for the continuing assessment by the
bank;
e) Borrower prevented from taking specific actions without prior approval, such as:
change in management or merger, demanding more loans, or distributing dividends.
59. Over the last decade, the WPSMEE has conducted extensive work on access to debt finance by
SMEs and entrepreneurs and on policies intended to ease SME debt financing, addressing structural
limitations in lending markets and cyclical credit tightening.
The 2006 OECD Brasilia Action Statement
for SME and Entrepreneurship Financing underlines the financing hurdle to firm creation and SME
survival and growth, calling for innovative approaches to overcome structural constraints in SME
financing. The assessment of government measures to support SMEs’ and entrepreneurs’ access to finance
in the global crisis (OECD, 2010b) has highlighted the focus of most interventions was on easing credit constraints, mainly by injecting capital into loan guarantee programmes and direct lending programmes.
The OECD Scoreboard on SME and Entrepreneurship Finance, largely based on debt-related indicators,
has been providing a comprehensive framework for continuing to monitor SME financing trends and
policies at the country and international level (OECD, 2012a). In 2011-12,
the WPSMEE produced
analytical reports on policy measures intended to foster access to debt finance, such as credit mediation, a
mechanism introduced in some OECD countries to support SMEs whose demand for credit has been
entirely or partially rejected by financial institutions (OECD, 2013c), and credit guarantee schemes, which
represent in many countries a key policy tool to address the SME financing gap (OECD, 2013d).
60. In the post-crisis environment, it is recognised that bank financing will continue to be crucial for
the SME sector and policy measures in many countries are still largely oriented towards facilitating SMEs’
access to debt finance. However, it is increasingly acknowledged that more diversified options for SME
financing are needed, to address the generalised “growth capital gap”, to support long-term investment, to
reduce the vulnerability of SMEs to shocks in the credit market, and to cope with the changing regulatory
environment and more rigorous prudential rules.
2.3. Alternative financing instruments
61. Traditional debt finance generates moderate returns for lenders and is therefore appropriate for
low-to-moderate risk profiles. It typically sustains the ordinary activity and short-term needs of SMEs,
generally characterised by stable cash flow, modest growth, tested business models, and access to collateral
or guarantees.
62. Financing instruments alternative to straight debt alter this traditional risk-sharing mechanism.
Table 1 provides a list of external financing techniques alternative to straight debt, categorised into four
groups, characterised by differing degrees of risk and return, whose main features (modalities/operational
characteristics, enabling factors, trends, support policies) will be outlined in detail in this report.
63. At the one end of the risk/return spectrum are financing instruments that sustain the short and
medium-to-long term financing needs of SMEs, but that rely on different mechanisms than traditional debt.
This is the case of asset-based finance, such as asset-based lending, factoring and leasing, whereby a firm
obtains cash, based not on its own credit standing, but on the value that a particular asset generates in the
course of its business. The close relationship between the liquidation value of an asset and the amount
borrowed, as well as the broad range of assets that can be used to access lending, are the key factors that distinguish asset-based lending from traditional secured or collateralised lending, in which the loan amount
and conditions also depend on the overall assessment of the firm’s credit worthiness. Furthermore, assetbased lending generally provides more flexible terms than conventional secured lending, often allowing for
revolving funds; as advances are paid off, the borrower can secure additional funds backed by other assets.
(see Section 3).
64. Trade credit is also an important source of finance for many SMEs and start-ups,
which can
substitute or supplement short-term bank lending. This mainly consists of the extension of traditional credit
instruments and credit-mitigation tools, such as loans and guarantees, to sustain import and export
activities. Guarantees can take the form of letters of credit (L/C), which represent a bank obligation to pay,
thereby reducing an export's payment risk on an importer/buyer.
65. Alternative forms of debt also exist, which can be considered “innovative” in the context of SME
financing because they have had until now limited applicability to the SME sector. These alternative debt
instruments include corporate bonds, securitised debt and covered bonds, in which investors in the capital
markets, rather than banks, provide the financing for SMEs. While corporate bonds are direct instruments
of debt finance for SMEs, securitisation and covered bonds represent “indirect” tools for supporting SME
debt financing, in that the product issued to the firm is a loan. In particular, securitisation of SME debt
allows banks to transfer their credit risk to the capital markets, as SME loans are sold to a specialised
company, which creates a new security backed by the payments of SMEs. In this way, banks achieve
capital relief and free up capacity for new loans to SMEs. Over the last decade, securitised debt has grown
rapidly, although the financial crisis hit this market severely. On the other hand, few SMEs have succeeded
in issuing corporate bonds, because of difficulties that small privately held companies have in meeting
investor protection regulations and the high relative cost of bond issuance for small companies (OECD,
2013b).
66. At the other end of the risk/return spectrum are financing instruments that enable an investor to
accept more risk in exchange for a higher return, and are expected to produce a better alignment of the
interests of certain kinds of SMEs and the providers of finance. Hybrid instruments, such as mezzanine
finance, form a bridge between traditional straight debt and pure equity. Seed and early stage finance
addresses the high risk-return segment of the business financing spectrum, boosting firm creation and
development, whereas other equity-related instruments, such as private equity and specialised platforms
for SME public listing, can provide financial resources for growth-oriented SMEs.
67. The present study also considers the potential for SME financing of new instruments, such as
crowdfunding or peer-to-peer lending. These have grown rapidly in some countries and have attracted
increasing attention by policy makers and regulators, also with a view to address concerns about
transparency, investors’ risk awareness and consumer protection.
3. Asset-based finance
68. Asset-based finance, which includes asset-based lending, factoring, purchase-order finance,
warehouse receipts and leasing, differs from traditional debt finance, as a firm obtains funding based on the
value of specific assets, rather than on its own credit standing. Working capital and term loans are thus
secured by assets such as trade accounts receivable, inventory, machinery, equipment and real estate.
69. The key advantage of asset-based finance is that firms can access cash faster and under more
flexible terms than they could have obtained from a conventional bank loan, regardless of their balance
sheet position and future cash flow prospects. Furthermore, with asset-based finance, firms that lack credit
history, face temporarily shortfalls or losses, or that need to accelerate cash flow to seize growth opportunities, can access working capital in a relatively short time. In addition, asset-based financiers do
not generally require any personal guarantee from the entrepreneur, nor that s/he give up equity.
70. On the other hand, the costs incurred and/or the complexity of procedures may be substantially
higher that those associated with conventional bank loans, including asset appraisal, auditing, monitoring
and up-front legal costs, which may reduce the firm’s levels of profits. Also, funding limits are often lower
than in the case of traditional debt.
3.1 Asset-based lending
Modalities
71. Asset-based lending (ABL) is any form of lending secured by an asset. It is thus a transactions
lending technology in which financial institutions address the problem of information asymmetry by
focusing on a subset of the firms’ assets, as the primary source of repayment (Berger and Udell, 2006).
Typically, four types of asset classes are secured under ABL: accounts receivable, inventory, equipment
and real estate.
72. The amount the firm can borrow depends on the appraised value of the selected assets, rather
than on the overall creditworthiness of the firm, taking into account the ease to sell off the assets should the
borrower be unable to generate cash to repay the loan. The amount of credit extended is linked to the
liquidation value of the assets, which is estimated and monitored on the basis of hard data, often relying on
industry-specific knowledge. Thus, monitoring and asset evaluation methodologies are of the utmost
importance for this type of lending, which explains the historical use of ‘tangible’ assets to secure loans
and, on the other hand, the limited exploitation of intangibles, such as trademarks, patents and copyright.
However, as methodologies for evaluating intangible assets become more accepted, these assets can also
increasingly be used as collateral (Box 2).
Box 2. Intangible Asset-Based Lending (IABL)
Intangible Asset–Based Lending (IABL) leverages a portfolio of Intellectual Property (IP) or other intangible
assets to secure a loan. The loan can be backed by the stream of revenues tied to a single intellectual asset or to the
firm’s entire portfolio. In either case, firms can secure their intellectual assets in addition to a blanket lien against
common collateral such as real estate or receivables.
In recent years, a variation on IABL, royalty financing arrangements, has developed, especially in the
pharmaceutical and biotechnology sectors. In this case, lending is secured by royalty interest and revenue interest
transactions, whereby, similar to a securitization transaction, loans are backed by a current or prospective royalty
stream. Whereas “royalty interests” are already cash-flow positive, the “revenue interests” are riskier for the financier,
as these are revenues anticipated to be derived from an identified product and related intellectual property. They apply
to firms that are close to the commercial launch of a product or device and, due to the greater level of risk, the
investing institution is generally able to negotiate more favourable terms. Unlike a securitisation, the loans are
generally not bundled and sold to the general public, but held by a speciality investment fund
Typically, firms specialising in IABL partner with banks or private equity firms that ultimately provide the funds, to
secure a line of credit for the target company. As IABL requires flexibility and specialisation to account for differing and
unique factors inherent in intangible assets, these specialised firms provide financial institutions with additional
protections to offset the complexity and uncertainty surrounding intellectual assets valuation.
Source: Ellis and Jarboe (2010), Jung and Tamiseia (2010), EC (2014)
