Small- and medium-sized enterprises
SMEs are major employers and drivers of economic growth. Australia’s 2 million SMEs employ almost 70 per cent of the workforce, which is large by international standards.34,35 SMEs account for over half of the output of the private sector and tend to be a major source of innovation in the economy.
Small business entrepreneurs will often use their families’ finances to fund their business. Some seek external funding, which can include extra equity or debt from family and friends, debt from financial institutions, or equity from venture capital funds. Banks’ business models and expertise are more suited to providing debt finance to established businesses, whereas venture capital is more suited to start-up firms in nascent industries.
Financing conditions for small and medium enterprises
Interest rates on SME loans are generally higher than those for large business loans and mortgages.
This largely reflects the higher costs and risks associated with bank lending to SMEs. Smaller businesses typically have less documentation and shorter financial histories, so it is generally harder and more costly for banks to acquire the required information to make accurate credit assessments. In addition, SMEs typically have more volatile revenue streams and are more likely to default. As such, lenders generally make higher provisions for loan losses than for larger corporates. However, lenders do differentiate on price and some businesses can pay below standard rates, depending on their credit history and quality of collateral.
Since the GFC, interest rate spreads on small business loans have increased relative to other loan types, which reflects the generally higher price of risk (Chart 3.6). This is similar to developments in some other advanced economies.
Access to external debt funding is not a major issue for most SMEs. In general, the majority are successful in getting a loan application approved. Since 2006–07, approval rates have been well above 80 per cent.36 Approval rates are much lower for new ventures, which reflect the relative riskiness of lending to such enterprises. New ventures usually lack collateral and sufficient proven credit history to qualify for a loan. Such firms can also lack sufficient cash flow until their product can be commercialised.
Chart 3.6: Cumulative change in domestic interest rate spreads
(since Jan 2007)
In some instances, lenders’ application processes can be overly cumbersome for SMEs.38 Business owners may not be directed to bank officers who are qualified to provide proper advice on business loan applications, or may be directed to personal loan products because some bank officers lack familiarity with business lending. In some cases, banks do not communicate to business owners why a loan application has been declined.39
There are structural impediments for small- and medium-sized enterprises to access finance. These impediments include information asymmetries, regulation and taxation.
Information asymmetries are the most significant structural factor contributing to the higher cost and lower availability of credit for SMEs and can be a barrier to competition in SME lending. Limited or no access to information for potential entrants in SME lending increases the cost of establishing SME lending operations.
Lenders typically will have limited knowledge about a new borrower’s financial position, the financial performance of the business and the financial behaviour of the business owner. In addition, the SME sector is extremely diverse, so lenders may have limited knowledge of the conditions in, and prospects for, particular industries. Lenders are less likely to lend to newer businesses because the lender lacks familiarity with the customer’s financial performance and behaviour.40 In its submission, the Australian Bankers’ Association (ABA) notes:
Small business loans carry higher risk as small business incomes are more volatile, the arrangements to secure the loans vary significantly, and lenders generally are offered less information to make an assessment of risk partly due to a shorter financial history. As a result, lenders charge small businesses a premium for the higher risk.41
These information asymmetries will be reflected in the price of loans. Banks may have to invest resources to acquire sufficient information to make a well-informed lending decision, which increases the cost of assessing and approving a loan application. When lenders are unable to access sufficient information to make a proper assessment, the risks associated with the loan are generally, and justifiably, perceived to be greater. This leads to higher provisioning and higher loan costs for the borrower.
Some submissions raise concerns about the nature of covenants in loan contracts for SMEs. In particular, submissions suggest that some non-monetary loan covenants are unfair, and the application of some clauses, particularly non-monetary default clauses, could be more transparent. The Consumer outcomes chapter explores this issue in further detail and notes that Treasury is currently consulting on the issue. However, some of these covenants are used to deal with the difficulties in bridging the information asymmetries involved in SME lending, and therefore facilitate greater access to lending for businesses.
Many lenders are requiring more security, usually residential property, against business loans.42, 43 Requirements for collateral to be held against SME loans can result in allocative inefficiencies, where loans are made to businesses with the best collateral, rather than those that are the best business prospects. The requirement for residential security for a loan disproportionately disadvantages new ventures and younger Australians, who are less likely to have ‘bricks and mortar’ collateral. This issue has become increasingly problematic as housing has become more expensive and many individuals are forced to purchase housing later in life.44
Several submissions claim that APRA’s capital requirements have reduced the availability of and/or increased the price of lending to SMEs.45 Two examples cited are the capital requirements for small business lending and the distinction that is made between corporate and retail business lending.
The Inquiry has received little evidence that capital requirements have affected either the supply of lending to SMEs or the relative pricing of secured and unsecured loans beyond what reflects the relative riskiness of the loans. APRA’s submission presents data showing that the average default rate of unsecured small business loans is generally higher than for secured small business loans, which is reflected in the higher risk weights applied to unsecured loans.46 That said, under the internal ratings-based approach to determine risk weights, discounts are applied to the capital requirements for lending to smaller businesses.47
Lenders generally make higher provisions for loan losses to reflect the higher expected losses on small business loans. This tends to increase the cost of small business loans, particularly unsecured loans.48, 49
Distinction between corporate and retail business lending
As part of the Basel II ‘advanced’ approach, a loan can only be treated as ‘retail’ if it is subject to standardised loan management processes, and if the loan is managed as part of a pool with similar risk characteristics for the purposes of risk assessment and quantification.50 APRA has deemed that loans less than $1 million, and subject to such processes, can be treated as ‘retail’.51 This reduces administrative costs for the lender and lowers capital requirements relative to corporate exposures.52 For borrowers with smaller-sized and less-complex loans, this reduces compliance costs, because these borrowers are generally not subject to the more intensive annual review requirements that apply to borrowers with loans of $1 million or above.
Increasing the loan-size threshold by which banks distinguish retail from corporate lending might, at the margin, increase SME lending. Some submissions argue that the $1 million threshold provides a disincentive for firms to borrow more to expand their business activities. Several submissions support raising the threshold. APRA indicates it would be “willing to consult on raising the $1 million retail/corporate boundary to $1.5 million, which would bring it into line (at current exchange rates) with the Basel II framework”.53
Barriers to accessing capital markets directly
SMEs face prohibitively higher fixed costs of raising funds in capital markets, which reduces the capacity of SMEs to use market-based finance.54 Requirements to prepare a prospectus may discourage some SMEs from seeking equity financing. A prospectus is not required where securities are sold to sophisticated investors, or where a small-scale offer is made that raises no more than $2 million through offers to no more than 20 investors in any rolling 12-month period. This issue is discussed in more detail in the Equity markets section in this chapter.
Venture capital and private equity
Venture capital and private equity funds tend to finance more innovative and high-growth firms. These firms are drivers of long-term productivity growth. Australia’s venture capital and private equity markets are small, and there are barriers to generating significant investor interest.
New ventures can typically take several years of development before any cash flows are generated from their activities, and failure rates are high. As a result, new ventures have limited access to credit, and market-based financing can be inaccessible or too costly to acquire.
Over the past two decades or so, the returns from domestic venture capital funds have not provided investors with adequate compensation for the associated risks. Indeed, all Australian venture capital funds formed between 1985 and 2007 had a pooled internal rate of return of minus 1.4 per cent.55
The fee structures of venture capital and private equity funds may also discourage some investors. Venture capital fund managers often charge a 2 per cent management fee and take 20 per cent of returns. However, unlike other fund managers, venture capital fund managers are typically very involved in managing the ventures in their funds. Venture capital fund managers provide mentoring services, business expertise, and access to industry and market connections, which is reflected in management and monitoring costs. However, fee structures and the services these fees reflect may not always be transparent to investors. Greater transparency would allow investors to make more informed investment choices and lead to greater competition.
Another barrier to the growth of the venture capital sector is scale. The Australian market may be too small for some ventures to be viable, particularly when it comes to commercialising a product. In addition, certain cultures, particularly relating to risk, and extensive networks need to be developed to facilitate a thriving venture capital industry.
The tax treatment of Venture Capital Limited Partnerships (VCLPs) is complex and may be a barrier to fundraising. Investments made under the VCLP regime are accorded special tax treatment based on whether the investor is domestic or international, and whether the treatment of any gains is made on the revenue or capital account. The submission from the Australian Private Equity & Venture Capital Association Limited states that some features of the VCLP tax framework:
... put Australia’s funds management sector at a competitive disadvantage, including ongoing uncertainty in the treatment of some classes of investors. This makes attracting investments into Australia challenging for local fund managers, particularly those that manage funds for offshore clients.56
A recent Board of Taxation Review into the regime’s effectiveness made recommendations to simplify and reduce uncertainty, which would reduce barriers to investment.57
Although financial issues affect the rural sector, submissions do not identify significant structural issues related to rural finance.
Agricultural incomes are volatile and uncertain. Rural businesses are exposed to large and sometimes prolonged weather events, and weather and pest conditions have a marked effect on the quantity and quality of agricultural products. Prices for agricultural products can be volatile, typically reflecting conditions in international markets, and yields can vary from season to season. However, for those commodities for which Australia is a significant global supplier, domestic supply conditions can materially affect global prices. Rural businesses have access to a range of insurance products to protect against income loss, as well as financial instruments to hedge against commodity price and exchange rate losses.
Debt levels in the agricultural sector have more than doubled over the past decade and have outpaced farm incomes, although the debt-to-income ratio for the rural sector has stabilised since 2011 at around two years of income.58 Increased indebtedness reflects financial factors, such as lower interest rates and increased availability of credit, and non-financial factors, such as periods of prolonged drought.
Farmers are most likely to experience difficulty meeting debt repayment obligations during periods of low revenue, such as during a drought or a period of low commodity prices. Despite these challenges, the sector has a long history of servicing debt, albeit with government support. Currently, less than 1.5 per cent of loans to the rural sector are more than 90 days in arrears and bank losses on the portfolio of rural loans are less than 0.5 per cent.59 Many lenders work closely with farmers in times of financial hardship, often accommodating arrangements such as repayment holidays and using independent mediators to help resolve issues with their customers.
Policy options for consultation
Policy options to address the structural impediments to funding SMEs range from direct government intervention in the SME lending market to initiatives to reduce information asymmetries.
An important consideration for this Inquiry is whether competition and technological developments will resolve issues related to financing SMEs and early-stage ventures.
Reducing information asymmetries between lenders and borrowers and facilitating more competition in SME lending would improve SME financing. As such, the Inquiry is requesting suggestions and opinions about mechanisms to narrow information asymmetries between lenders and SME borrowers.
One such option, mentioned in some submissions, is to facilitate the development of an SME finance database that could provide business-level data to lenders and potential new market entrants. Data could include details from tax returns and business activity statements, and financial information from lenders.
Ideally, such a database would be managed on a commercial basis, but the Inquiry recognises the barriers to the private sector establishing such a database. Such barriers include restrictions on access to particular information. Entities with the relevant information would need to be able or willing to provide such information. Privacy issues would also need to be considered, and some lenders and borrowers may be reluctant to supply information that could be deemed commercial-in-confidence.
Some submissions suggest the Government could provide facilities that make direct loans to small business, subsidies on loans, or guarantees on loans. Although this would improve the cost and availability of finance to small businesses, taxpayers could bear significant costs and risks, which would be exacerbated by adverse selection as riskier lending prospects are pushed to Government schemes.
Other submissions suggest encouraging superannuation funds to invest in securitised SME loans and venture capital funds. Although this might increase the availability of finance for SMEs, there are currently very few impediments. A mandate requiring superannuation funds to do so may also involve an implicit guarantee by the Government, which the Inquiry does not consider to be appropriate. Although it is doubtful that a deep market of securitised SME loans could develop, the Inquiry would value views as to how this might be achieved. Superannuation funds could consider investing in venture capital funds as part of a broader approach to diversifying their asset portfolios. This may involve taking a broader view of their investment options and require them to engage the required expertise.
A well-developed broker market for SME lending would likely increase competition among lenders and improve access to finance for SMEs. In recent years, brokers have become more prevalent in some areas of small business lending, particularly equipment finance. However, for other areas of SME lending, the broker market remains relatively undeveloped. This may reflect a combination of transitional issues for the broker industry and structural impediments.
Venture capital funds argue that changing the research and development (R&D) tax credit system to a quarterly basis for new ventures would help alleviate cash flow constraints. New ventures tend to make significant cash outlays in the early stages of the product lifecycle. This is an issue that should be considered as part of the Tax White Paper process.
The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:
- No change to current arrangements.
- Facilitate development of an SME finance database to reduce information asymmetries between lenders and borrowers.
The Inquiry seeks further information on the following areas:
- To what degree will technological developments resolve issues related to information asymmetries in SME lending?
- What are the best options to narrow the informational gaps between lenders and SME borrowers?
- Could the use of certain loan covenants be reduced, while still providing SMEs with adequate access to finance and lenders with appropriate protection?
- What are the prospects for a market for securitised SME loans developing?
- What are the main barriers to greater broker activity in SME finance? Are these barriers transitional or structural in nature?
- What are the best options for improving the tax treatment of VCLPs?
34 This reflects ABS categories. Australian Bureau of Statistics (ABS) 2013, Counts of Australian businesses, including entries and exits, cat. no. 8165.0, ABS, Canberra.
35 This reflects ABS categories. Australian Bureau of Statistics (ABS) 2013, Australian Industry, cat. no. 8155.0, ABS, Canberra.
36 Australian Bureau of Statistics (ABS) 2012, Selected Characteristics of Australian Business 2011–12, cat. no. 8167.0, ABS, Canberra.
37 Reserve Bank of Australia (RBA) 2014, Statistical Tables, Interest Rates, Indicator Lending Rates (F5), RBA, Sydney.
38 NSW Business Chamber, First round submission to the Financial System Inquiry, page 2.
39 NSW Business Chamber 2013, Small Business Access to Finance, NSW Business Chamber, Sydney, page 44.
40 NSW Business Chamber 2013, Small Business Access to Finance, NSW Business Chamber,Sydney, page 36.
41 Australian Bankers’ Association 2014, First round submission to the Financial System Inquiry, page 73.
42 Reserve Bank of Australia 2011, Submission to the Inquiry into Access of Small Business to Finance. Cited in Export Finance and Insurance Corporation 2014, First round submission to the Financial System Inquiry, page 5.
43 Westpac 2014, First round submission to the Financial System Inquiry, page 63 : “as a responsible lender … [Westpac] has strict requirements and a limited appetite around the types of unsecured lending made available.”
44 Export Finance and Insurance Corporation 2014, First round submission to the Financial System Inquiry; Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry; Minister for Small Business the Hon. Bruce Bilson 2014, First round submission to the Financial System Inquiry.
45 NSW Business Chamber 2013, Small Business Access to Finance, NSW Business Chamber, Sydney; Export Finance and Insurance Corporation 2014, First round submission to the Financial System Inquiry, page 38.
46 Australian Prudential Regulation Authority 2014, First round submission to the Financial System Inquiry, page 79.
47 Australia’s four major banks and Macquarie Bank Ltd use the Basel II internal ratings-based approach to determine risk weights.
48 Reserve Bank of Australia 2011, Submission to the Inquiry into Access of Small Business to Finance. Cited in Export Finance and Insurance Corporation 2014, First round submission to the Financial System Inquiry, page 5.
49 Westpac 2014, First round submission to the Financial System Inquiry, page 63: “as a responsible lender … [Westpac] has strict requirements and a limited appetite around the types of unsecured lending made available.”
50 Australian Prudential Regulation Authority (APRA) 2008, Prudential Standard APS 113, Capital Adequacy: Internal Ratings-based Approach to Credit Risk, page 12.
51 Australian Prudential Regulation Authority (APRA) 2014, First round submission to the Financial System Inquiry.
54 Matic, M, Gorajek, A and Stewart, C 2012, Small Business Funding in Australia, RBA Small Business Finance Roundtable, Sydney, 22 May.
55 As of 30 June 2008. Treasury and Department of Industry 2012, Review of Venture Capital and Entrepreneurial Skills, Final Report, Treasury, Canberra, referencing the Australian Private Equity and Venture Capital Association, page 39.
56 Australian Private Equity & Venture Capital Association Limited 2014, First round submission to the Financial System Inquiry, Submission 1, page 19.
57 The Board of Taxation 2011, Review of Taxation Arrangements under the Venture Capital Limited Partnership Regime, June 2011, Canberra.
58 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry, page 132.
59 Australian Bankers Association 2014, Submission to Senate Inquiry: Reserve Bank Amendment (Australian Reconstruction and Development Board) Bill 2013, page 6.