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EXECUTIVE SUMMARY
Introduction
The purpose of this research has been to investigate further the difficulties that a significant minority of Scottish SMEs that took part in the 2005 and 2006 Annual Small Business Surveys ( ASBS) (Scotland) reported in accessing finance from banks. Just under a third (29 per cent) of SMEs in the 2006 survey had sought external finance for their business in the previous twelve months, just under a quarter of whom (24 per cent) reported problems. Specifically in relation to bank finance, just under a fifth (19 per cent) of all surveyed SMEs had sought bank finance, with about one in eight of these (12 per cent) reporting problems.
The key question at the heart of this research is whether Scottish SMEs are experiencing difficulties in accessing bank finance because of the unsuitability of the business case that they are putting to finance providers ( i.e. demand-side issues), or whether the difficulties result from sub-optimal lending practices, resulting in some potentially viable proposals being rejected ( i.e. supply-side issues).
The research aimed to provide detailed insight into the demand and supply-side processes relating to SME bank finance in Scotland, building on the limited information provided by the ASBS for Scotland in 2005 and 2006.
Methodology
The research involved a multi-method approach, comprising of:
(i) An analysis of the ASBS (Scotland) survey data for 2006;
(ii) An extended telephone survey of 51 owner-managers of SMEs reporting difficulties in obtaining finance, drawn from the 2005 and 2006 ASBS (Scotland) respondents;
(iii) Selective in-depth case studies, involving the seven most likely examples of market failure, from which detailed borrowing scenarios were re-created;
(iv) Assessment of the seven case study scenarios by a bank lending expert who narrowed them down to five cases that were suitable for the protocol analysis that was to be used in the interviews with bank managers;
(v) Face-to-face interviews with eight bank managers, at different seniority levels, within three of the four major Scottish commercial banks. Protocol analysis was used to re-assess the five selected case scenarios, to yield information on the processes decision-makers use in banks, how loan applications are dealt with and the main reasons for acceptance, referral within the bank and rejection.
Demand-side Business Survey Findings
1. Thirty-nine of 51 surveyed SMEs experienced problems accessing bank finance. These were typically well established businesses that were growth seeking and disproportionately from the manufacturing, retailing, wholesaling and hospitality sectors.
2. The most frequently mentioned financial constraints were lack of development finance, particularly affecting manufacturing firms, and cash-flow problems, particularly affecting the retail and hospitality sectors.
3. The median project cost for finance sought was £105,000. On average, 81 per cent of the project cost was sought from external sources. However, the scale of borrowing requirements amongst the surveyed businesses ranged from £5,000 to £80 million.
4. Two-thirds of businesses seeking bank finance also considered alternative sources, with around half of them actually approaching alternative sources, mainly for grants, soft loans and equity finance (for some larger firms).
5. There is some evidence of a perceived 'gap' in the equity investment market for finance of up to £1 million due to the lack of interest from equity investors for investments below the £1 million threshold and, according to owner-managers, the cautious and risk averse approach of the banks.
6. A striking finding is that almost two thirds of the businesses approached only one bank, typically their existing bank, and did not 'shop around' once their application for finance had been rejected. This may suggest concerns about the time and resources involved in approaching other banks, uncertainty in approaching banks with which they were not familiar, or a 'discouraged borrower' effect. Supply-side banking interviews indicated that difficulties are more likely to be encountered by 'new to the bank' customers - relationship banking suggests that the existing bank is likely to be more sympathetic to funding requests.
7. Just over half of those businesses seeking bank finance had their application turned down. The less successful applicants for bank funding tended to be: manufacturing firms; businesses operating at a loss; businesses seeking smaller scale loans; projects relating to working capital requirements (typically overdrafts and small scale loans); and projects related to new products and market development (typical of manufacturing firms).
8. Half of businesses used external assistance with their loan application: one third from accountants and one fifth from either Business Gateway or Scottish Enterprise (typically larger firms seeking equity finance). A number of firms complained about the cost of accountancy and consultancy advice required in order to support bank loan applications, which cost around £2,000 in some cases.
9. A number of owner-managers were in favour of banks providing a broader range of SME advisory services and nearly one fifth mentioned that they would like to see banks becoming a one-stop-shop for all sources of business finance.
10. Almost one third of the businesses that were unsuccessful in obtaining bank finance indicated that a lack of collateral and/or lack of trading record were the main reasons for not receiving a bank loan, whereas less than a fifth of them mentioned providing an insufficient business case as the reason for rejection. Some businesses complained about receiving inadequate feedback from the bank as to why their application was unsuccessful.
11. A major area of criticism amongst two-thirds of the businesses that had problems accessing bank finance focused on the applications process. Complaints included: delays in the decision making process, misleading information (particularly about overdraft facilities and differences of opinions between local and centralised levels of the banks) and that there was no link between bank finance and alternative sources of finance.
12. Two-fifths of applicants for bank finance took more than six months to get a final decision. Delays were caused by referring applications to centralised teams and bureaucratic procedures.
13. A number of owner-managers referred to specific difficulties in obtaining overdraft facilities, particularly for new businesses in the retail and hospitality sectors. Some claimed to have initially been offered overdrafts at start-up, but were then unable to obtain them once they had started trading.
14. Despite the difficulties they encountered, over half of the SMEs were eventually able to undertake the whole project that they had required funding for and a further eighth to partially deliver projects. Just under a third were unable to go ahead with the project because of lack of funding.
Supply-side Bankers Interview Findings
Key findings from the protocol analysis of five case studies and the analysis of bank lending processes with bank lending officers and key informants provide the following overall conclusions:
15. Bank managers place heavy reliance on personal relationships and knowledge of SME business owners, building up relationships over a period of time. They are prepared to invest considerable time, visiting premises and becoming familiar with businesses.
16. A primary requirement for any proposition from either existing or new business customers is to understand the nature of the proposition and the serviceability and sustainability of the proposed venture. Thus, it is easier for existing business customers to seek funding, particularly where this might fall outside established 'norms'; for example, for highly geared propositions.
17. Banks have standard financial 'models' that are followed in terms of financial requirements, although there may be considerable discretion exercised by individual bank managers, dependent on seniority. In addition, it was clear that bank managers would, as far as their discretion allowed, seek to support established businesses with which they have an established personal relationship.
18. The financial modelling process indicates the strength of the proposition in terms of risk/reward, but with latitude for bank managers to use discretion. However, given the segmentation applied by the banks, it will be easier for larger SMEs to obtain funding. Micro and small firms are more likely to have their propositions credit-scored, reducing the extent of bank manager discretion and flexibility.
19. Entrepreneurs seeking to start new businesses will find it more difficult because of the lack of any trading history. In such circumstances previous experience, age and credit history of the entrepreneur will be important.
20. Credit-scoring may limit the flexibility of bank mangers, especially as such proposals are referred for final approval to a central credit department. Propositions that do not match bank preferences and modelling requirements will be difficult to support.
21. Although no sectors are excluded by the banks, SMEs in competitive sectors may find it difficult to raise finance, especially if they are operating in ways that do not fit the banks' own internal guides on benchmarking for the sector.
22. Rural locations can be difficult environments for SMEs, having limited local markets and limited networks and resources. Large areas of Scotland, the Highlands and Islands and the South of Scotland, qualify as rural under Scottish Government definitions. SMEs in such localities seeking to grow and raise finance may find it difficult to raise bank finance, especially if reliant on local and regional markets.
23. Security is a secondary factor, but nonetheless important. Established SMEs with limited security will find it difficult to raise finance for propositions that contain higher risk or do not meet banks' financial modelling requirements. Changes to the Small Firms' Loan Guarantee Scheme under the Graham Review, has meant that the banks have in some cases reduced their use of the Scheme, moving from 'occasionally' having referrals under the Scheme to 'rarely'.
Is there Evidence for Market Failure?
24. Taking the ASBS (Scotland) 2006 survey as a whole, only a small minority of businesses that experience problems in accessing finance (3.4 per cent of 1014 surveyed businesses) had approached banks for finance.
25. The ASBS (Scotland) data also show that 1.6 per cent of SMEs that were unable to go ahead with investment projects in 2005-06 because of problems in accessing bank finance, suggesting that even in cases where bank finance was refused, many firms were able to find other ways of funding their projects.
26. Twenty SMEs in the business survey received no bank funding and these are the focus of attention in assessing the extent of supply-side market failure relating to the banks.
27. Almost two-thirds of the owner-managers of these SMEs believed that they had been rejected because of lack of collateral and trading status, whilst around one third believed that they had been rejected due to the bank's concerns about the business case that they were putting forward. From these latter cases the five scenario cases forming the basis of the interviews with the bank managers were selected as the strongest cases of potential market failure.
28. Of these five, it is significant that there were only two that the interviewed bankers considered were worth serious consideration and likely to be supported, since the others raised too many concerns about financial and strategic management issues. Furthermore, of these two, one did actually receive the funding it was seeking by 'shopping around' the banks.
29. This leaves just one case that was actually turned down for finance that would appear to be an example of supply-side market failure. The protocol analysis conducted with bank managers would appear to show that there were very few SMEs from the 20 that were turned down for bank funding that might be considered 'borderline' cases. For the rest, it was not difficult for the researchers to understand why the applications for finance had been refused.
Conclusions
Although there is very little evidence from this research to support the market failure argument, the research has nevertheless identified a number of problems in the relationship between banks and SMEs which need to be addressed. In particular:
30. There are clearly a number of difficulties experienced by manufacturing businesses that relate to the problems of financing new product and market development and investing in upgrading plant and machinery. The owner/managers of manufacturing businesses frequently criticise the banks for being risk averse and having difficulties understanding the nature of their business.
31. One of the most common criticisms of the banks by SMEs is the length of time that it takes to come to a decision and how initially favourable indications at the local level can be misleading when the application is later rejected at a higher level within the bank. The research identified a number of cases where the application for bank funding was in the end successful but where the delays on the part of the banks were at a cost to the businesses they were servicing.
32. There were very few start-up firms in the ASBS survey which was the primary data source used for this research so they are under-represented in this study. More work is therefore needed on the relationship between start-up businesses and banks and the extent to which market failure may be occurring here. The interview conducted with the PSYBT indicated that young entrepreneurs are facing gaps for relatively small amounts of funding as well as perceived problems in obtaining funding from external sources.
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