Profiting From A Closer Banking Link

The banking sector is the main external supplier of finance to growing businesses, no matter how well developed a local venture capital industry may be. The dependence on bank finance is evident in both the UK and the US, where there are well-developed venture capital providers, and is even more extensive in countries, such as Germany and Japan, where venture capital is less well developed.

This heavy reliance on bank finance (in the form of either long or short-term debt or a mixture of the two) means that any problems or inefficiencies in providing such finance can result in enterprising businesses losing growth potential. Aside from any negative impacts on individual entrepreneurs, there may also be a significant cost to the economy if enterprising businesses are unable to grow.

 

When banks consider debt provision for an entrepreneur they are effectively making an investment in the enterprise and looking for a return in the form of interest payments and repayment of the initial capital. A bank must evaluate the potential of the proposed project and the likely commitment of the management to ensuring its success. This process is by no means straightforward. It provides a classic example of the problems that may arise when contracts are being negotiated in the presence of what economists call asymmetric information.

Asymmetric information is a situation in which one of the parties to a contract does not know or cannot observe some of the information that is necessary to the contracting process.

In the case of bank finance, a bank typically cannot perceive the true abilities of the entrepreneur and the real prospects for the proposed project. This is a problem that arises in advance of contracting and may be compounded by monitoring problems once finance has been provided.

Having provided finance, a bank may not be able to ascertain whether the entrepreneur is actually devoting the necessary effort to ensuring the projects success. Such information problems are not unique to entrepreneurial companies but are considerably more prevalent because these businesses tend to be smaller and the costs of information collection higher.

Credit rationing

Economists have evaluated the problems and implications of such debt finance provision from both theoretical and empirical angles.

One perspective suggests credit rationing will occur and potentially viable projects will fail to obtain funding. However, another viewpoint is that there will be an oversupply of credit rather than a debt gap. Others have suggested that the extent of these problems may be overstated and decisions to lend or not and the price of funds only reflect a banks knowledge of the entrepreneur and the particular business.

Clearly further work is needed to understand the effects of information asymmetries. However, there is evidence to suggest that some of the apparently conflicting views may not be mutually exclusive.

A study of lending decisions to smaller US businesses, for example, suggests that while the macro effects of credit rationing may be small, credit may still be rationed to some entrepreneurs and be more readily available to others. In particular, this may be related to the role of collateral in debt finance.

Companies may overcome bank uncertainty by offering sufficient collateral to secure the debt and provide reassurance that the business will perform to the best of its abilities in undertaking the project.

Offering collateral, in the form of either personal or business assets, can be regarded as an entrepreneur signalling the quality of a project and the willingness to accept the risk of surrendering collateral in the event of failure ensures he or she is fully committed to the venture.

However, if collateral is in limited supply debt gaps may still exist and valuable projects may be lost. Lack of collateral may be particularly prevalent among smaller and more enterprising businesses.

In addition, taking personal collateral in the form of a guarantee or house deeds effectively erodes limited liability status and the protection it provides. This is likely to discourage investment at the margin, given the additional personal risk it implies.

Information flow

An alternative approach to collateral is to consider how to improve the quantity and quality of information flows between the bank and the business.

Although perfect information is an unobtainable goal, the quantity and quality of information available to a bank will be influenced by the nature of the relationship with each business. A close relationship can provide a bank with a better understanding of the operating environment facing a business, a clearer picture of the owners managerial abilities and a more accurate overview of the prospects for the business.

Thus, from the banks perspective the relationship provides the basis for understanding customer needs and resources and identifying the most appropriate ways of meeting needs. This relationship is not a simple one-way process. An effective banking relationship requires a positive contribution from both parties. The banks ability to meet customer needs requires that the owner/manager provides the bank with appropriate and timely information and is receptive to suggestions and advice from the bank.

This process imposes costs on both sides and each party may only be prepared to invest in developing a relationship if the benefits are expected to outweigh the costs. Furthermore, a close relationship may not be necessary or appropriate for all businesses. The established, stable smaller business with no growth aspirations and limited financing needs may have little to gain from investing in improving the flow of information to its bank. However, for the entrepreneurial business with significant financing needs to fund growth, a relationship may be essential for success. Equally, banks may see significant benefits from investing in the development of a relationship with such a business because of the impact of its current and future success on bank performance.

The changing nature of the relationship between small businesses and their banks has been closely monitored in the UK since the

Committee to Review the Functioning of Financial Institutions (the Wilson Committee) reported in 1979.

This monitoring has been continued through regular surveys of the membership of the Forum of Private Business (FPB), which have taken place every two years since 1988. The Forum of Private Business is a representative body for businesses similar to the National Federation of Independent Businesses (NFIB) in the US.

These surveys provide evidence of an initially poor relationship between banks and smaller businesses but also show that significant improvements have been made since 1992. More significantly, recent surveys have shown that businesses that have a closer relationship with their banks may benefit from better financing terms and conditions and a better quality of service. Banks, too, appear to benefit from closer relationships since customers are generally more satisfied and appear to be significantly more loyal.

The 1996 FPB survey received responses from nearly 4,000 companies. On the basis of these it is possible to categorise companies and their banks into Participative (P) and Non-Participative (NP) and observe the respective financing conditions (see Figure 1).

Competitive environment

The increasing emphasis on the relationship between entrepreneurs and their banks is particularly apposite now because of changes in technology and the competitive environment in which bankers operate.

Much has been made of the contrasting experiences of Anglo-Saxon banking methods in the UK and US and a more relationship-based industrial banking approach, such as that operating in Germany, Japan and, to some extent, France.

Some of the claims for the supremacy of the industrial banking systems have been exaggerated in that the benefits of such a longer-term approach were usually enjoyed more by medium and larger-sized businesses than by smaller entrepreneurial organisations. Nevertheless, these traditions have appeared to engender a longer-term perspective on the growth and development of businesses as well as more highly qualified bank staff.

The effect of these alternative approaches to banking relationships is hard to measure but should be apparent in qualitative differences in the exchange of information between banks and entrepreneurs. Certainly evidence suggests that information flows in the UK bank/business relationship are improving and developments in information technology could enhance this process significantly, both by improving the quality of information sharing and reducing the costs of so doing.

The impact of new technology on the banking industry has been augmented by the growing emphasis upon cost reduction as a result of increasing competition in banks traditional markets. At the same time pressures to engender a more effective relationship have also grown.

Countries, such as Germany, in which banking relationships were traditionally more effective, may be slower to embrace the potential offered by new technologies. Changes in the UK and the US may lead to the integration of information exchange between entrepreneurs and their banks with rapidly developing management information systems, credit-scoring decision-support models and expert or knowledge-based systems.

This may enable businesses and banks to be much more accurate in tailoring the closeness of the relationship to the needs of both parties. The resulting efficiency gains could lead to significant advances in the competitiveness, both of the banking industry and the enterprises they serve.