Small business finance
While most public, and particularly media, attention on banking focuses
on home loans, ensuring there is adequate competition in the provision of
appropriate credit to small business is also important. Small businesses employ
about half the Australian workforce and, unlike larger firms, are generally
reliant on financing from domestic lenders.
As the Committee produced a report into access of small businesses to
finance only in June 2010, and the Joint Committee on Corporations and
Financial Services recently reported on its an inquiry into 'Access for Small
and Medium Business to Finance'; this topic is not pursued in greater depth in
Some witnesses and submitters believe that reduced competition in the
banking market has hurt small business in particular:
...the exit of non-bank lenders and foreign banks has meant
that small business owners have had to adjust their business strategies. This
has involved delaying plans for expansion, downsizing or, in some cases,
closing an otherwise viable business. Many niche finance products, such as
fit-out finance, which is relied on extensively in the retail sector, simply no
longer exist...The question before this committee is whether... people who have
credible cases for access to business finance are being denied because of risk
rating by the institutions. Our concerns...are that businesses with a long
history of relationships with their institutions are being denied applications
for credit even in profitable circumstances...The overwhelming evidence is that
banks have gone beyond what is reasonable...
In March 2010, CPA Australia ran four round table events with
members involved with small business to gauge their views on small business
access to finance. Many participants stated that they have seen a reduction in
competition between lenders to small business since the beginning of the global
In some cases it is claimed that healthy small businesses were suddenly
subject to additional onerous requirements:
In their minds they were meeting all of the criteria that
were set by their lending institution. However, their loan arrangements have
been reviewed by the bank and, accordingly, they have had to either turn an
interest loan into retiring principal amounts or they have had other aspects of
the loan changed significantly to the detriment of their plans.
This accords with the views the Committee heard during its inquiry last
A strong consensus emerged from small businesses across
industries that competition had declined and was now inadequate among lenders.
Some submitters have suggested that credit was cut to small business in
an unduly harsh way during the GFC:
Through the GFC banks reacted negatively to SME Borrowers by
reducing LVR parameters and at times without notice or little notice to
existing SME borrowers even when an existing borrower had an unblemished credit
history, and increased serviceability requirements for new SME borrowers and
imposed much lower than historic LVRs to be geared... in some cases the
reduction in the LVR meant that SME Borrower/s had to find significant amounts
of cash to reduce debt or they would be placed into default without cause of a
poor repayment history.
There are suggestions that a fear of banks deterred small business from
seeking finance after the GFC:
...given the widespread perception as well that it is difficult
to obtain finance, many small businesses stopped approaching their banks. One
reason is they did not want their loan facilities re-rated and end up paying a
higher margin. The more they can stay away from the bank the better.
Availability of credit to small business
Lending to small business slowed since the GFC (Chart 6.1). The data do
not suggest lenders have discriminated against small business. Credit to small
business has been increasing, albeit at a slower rate, in recent years while
there has been an absolute fall in credit provided to larger firms.
Chart 6.1: Business
credit by type of borrower
Source: Reserve Bank of Australia, Submission 41, p 7.
The Committee examined the reasons for this last year, concluding:
The slowdown in lending to small business appears to reflect
a combination of demand factors such as;
less demand for finance by small business in the wake of the
global recession, as weaker sales mean that existing capacity is adequate and
there is not the need to borrow for investment;
less demand for finance by small business as reduced confidence
leads to a more conservative attitude towards debt;
and supply factors such as;
fewer small businesses being able to meet existing lending
standards in the wake of the global recession;
some tightening of lending standards by financial intermediaries.
It is arguable that banks were tending towards recklessness in the preceding
boom, and that some tightening of credit standards represents a prudent return
to 'normal' practice, but there may also be cases where banks are
non-bank lenders having fewer funds available as securitisation
and interbank lending markets dried up and/or interest rates in them became
Witnesses were reluctant to apportion the roles played by
these various factors.
The Reserve Bank suggest:
It appears unlikely that credit growth will return to the
very high rates that were sustained in the pre-crisis period, since credit
expansion during that period was significantly boosted by the one-time adjustment
to financial deregulation and the shift to low inflation... There have been no
notable changes in lending criteria at the smaller end of the business loan
Another factor mentioned as possibly restraining lending to small
business is the capital backing required to underpin it by rules set by APRA.
These are discussed further in Chapter 11.
Sources of credit for small business
Small business is largely reliant on the major banks for its funding.
Foreign banks and smaller lenders are unlikely to compensate for reduced
competition between the major banks:
...experience shows us that foreign lenders are mostly
interested in corporate lending and lending to particular sectors such as
commercial property development...Second tier lenders (smaller banks and credit
unions) ...without larger distribution networks and larger back office
support...[are] unlikely...[to] become a major source of competition in small
There may be scope for mutuals to lend more to small business,
especially as mergers increase their size. Already, Credit Union Australia, the
largest credit union, reports over 20,000 small business customers.
The WA Small Enterprise Network was particularly concerned about the
implications for young entrepreneurs of banks' reliance on mortgages on homes
to secure small business loans:
... the relative cost of a house measured against average
weekly earnings is significantly greater than it has been in the past. As such,
it is becoming more difficult and costly for the younger generation of
Australians to enter into home ownership. As a result, it is possible that by
the time future entrepreneurs have purchased a home and built up sufficient
equity to act as collateral against a business loan, they will be on average
older than is the case now. They may be past the current average age where
people currently seek out finance to start their own businesses.
The cost of credit for small business
Even if small business is able to access credit, a lack of competition
may manifest in credit being unduly costly. Since the GFC, finance for small
business has become more expensive, both absolutely and relative to housing
loans (Charts 5.6, 6.2 and 6.3).
The banks offer three justifications:
...(a) small business loans are riskier and so attract a higher
risk-premium than residential housing loans; (b) the margins being charged
before the GFC were too low and the higher margin today reflects a more
appropriate rate, and (c) higher levels of capital are required for small
business loans (compared to housing) as part of the prudential regulatory
As noted above, lenders are paying more attention to the risk in loans.
This has led to a wider range of interest rates being charged to borrowers.
(Chart 6.2). But while banks may be more cognisant of risks, this does not mean
the riskiness of their small business loans has increased (compared to pre-GFC
levels; risk certainly goes up during a recession). Indeed to the extent banks
are being more selective in their lending the average risk of their loans
should have been lowered:
...if they are lending to the less risky businesses, the
aggregate risk that they bear should have reduced and that should in turn
result in them being able to lend at a lower cost than would otherwise be the
Chart 6.2: Range of
indicator rates for small business variable rate loans
Source: Reserve Bank of Australia, Submission 41, p 18.
The Committee heard that small business is increasingly reliant on
expensive credit cards for financing:
...63 per cent of small and medium business owners are now
using their credit card facility as a form of business finance. That is
extremely high by international standards...[they are paying] extremely high
Increasingly for small business their primary means of
finance is through credit card facilities.
Banks have been criticised for charging more for a small business loan
secured against a residential property than for a home loan secured against the
We can see no reason why a fully secured business loan should
attract a higher interest rate than a housing loan similarly secured. We
suggest that one way of addressing this issue would be to add a properly
drafted anti‑price discrimination clause to the Trade Practices Act
which could, among other things, prohibit differential pricing of loans and
other financial services unless it can be demonstrated that costs or risks
attached to these are different.
So it is very difficult to justify an interest price premium
when the ultimate asset that is being used to balance it is the same.
The loan of funds for use in the operation of small
businesses is unjustifiably subjected to higher rates of interest and more
arduous conditions than loans made to other customers who provide the same
security...Given that this practice is common across all banks it has the
appearance of being collusive behaviour.
The banks responded:
...you have to look through the security. The security is not
something you should be relying on. The security is there and it is an
important component, but you have to look through that to the underlying
fundamentals of the business, particularly the ability to service the debt... It
is timeliness as well. In a business situation it could take quite a bit of
time to unwind security, or you have to have a business plan prepared to see
whether the business can trade through and so you might be working against a
couple of scenarios for a while. So there is a timeliness element to it, and
then there is cost of recovery...The long-run loss profile on those loans is
higher than normal residential secure mortgages, and that will drive the risk
profile, that will drive the cost.
Chart 6.3: Spread
between small business and home loan rates
Source: NSW Business Chamber, Submission 84, p 10.
The Australian Prudential Regulation Authority supported the banks'
The underlying default rates and arrears rates on owner
occupied homes and investor lending is a lot lower than it is for small and
medium sized enterprise loans that are secured against the residential
mortgage. They have a far higher likelihood of what they call 'probability of
default rates' and 'loss given default' than do the normal residential
The Reserve Bank quantified these differences:
The interest rate must cover the expected loss of making a
particular loan. The expected loss is, in turn, largely determined by a
borrower’s probability of default and the loss given default. In
the first case, rough estimates suggest that small business borrowers are more
than twice as likely as standard mortgage customers to default [Chart 6.4]. In
the second case, once a default has occurred, APRA statistics suggest that a
lender is likely to lose close to 30 per cent of the small business loan’s
value, compared with 20 per cent for housing loans.
As the default rate on home mortgages is around 1 per cent, this would
imply the interest rate on small business loans should be around 50 basis points
higher than for housing loans.
This is more than the difference in interest rates charged had been for most of
the past decade but less than the current difference (Chart 6.3).
Probabilities of default
Source: Reserve Bank of Australia, Financial
Stability Review, September 2010, p 22.
This is consistent with the response when Westpac was challenged about
why the differential was previously so much lower:
...we have seen banks losing more money than they would like to
on small business because of the mispricing for risk.
The inquiry by the Joint Committee on Corporations and Financial
Services reported last month that:
On the basis of the evidence submitted to the committee, it
appears there are sound reasons for the higher interest rates for SME loans
compared to residential loans, and the increased cost of SME lending that
resulted from the GFC.
Loan guarantees for small business
The Australian Chamber of Commerce and Industry recommended the
Government explore the feasibility of a temporary small business loan guarantee:
There are schemes of this nature in a number of other
industrialised nations— Canada, the United States, the United Kingdom—that are
worthy of some serious assessment at the very least. What governments in those
jurisdictions have done is to provide some mechanisms for government to provide
some guarantees on small business loans where there is some clearly
demonstrated market failure that is not being met by the market.
This was supported by other small business representatives:
We would absolutely, totally support it.
Master Builders recommends that government extend guarantees
to small business loans.
The NSW Business Chamber is concerned about the design of such a scheme,
and argues it should involve a price for the guarantee and should not cover 100
per cent of the value of the loan to ensure banks retain an incentive to
consider loan applications carefully.
They also argue that not all a bank's loans should be covered:
For instance, if a bank had, say, 100 loans to small
businesses all covered by the guarantee, you could put a cap on to say that
only 10 per cent of those loans can ever be claimed against the government
guarantee. So if all 100 went belly up, you would get financing back for only
Treasury does not support such schemes:
The majority of OECD countries have implemented or expanded
existing guarantee schemes for small business loans since the onset of the
global financial crisis. However, these schemes have generally been
unsuccessful in stimulating credit to small businesses. According to the OECD,
such guarantee schemes and extensions have not produced the desired results,
and ‘the stagnation in lending is true even of banks in countries where...credit
guarantee schemes exist.
International examples of such
Some small business representatives gave the following examples of such
Most OECD countries have small business loan guarantee
programs, with the exception of Australia and New Zealand.
Other countries have introduced guarantees on small business
loans to assist with alleviating small business credit constraints:
In the United Kingdom, the Enterprise Finance Guarantee, managed
by the Department for Business Innovation and Skills, provides a loan guarantee
scheme to facilitate business lending to SMEs.
Under Canada’s small business financing program, the Canadian
government guarantees 85 per cent of eligible small business loans. The
guarantee is provided to the small business in exchange for a fee, and in this
way, the scheme is self financing.
In the United States, the Small Business Administration (SBA)
guarantees loans made to small businesses by financial institutions.
The Reserve Bank provided comparative information on overseas schemes to
the Committee last year.
A survey by some World Bank economists made the following observations:
Many countries around the world have therefore made Partial
Credit Guarantee (PCG) funds a central part of their strategy to alleviate SMEs
financing constraints. Multi- and bilateral donors have supported the set-up of
such schemes around the developing world. These schemes seek to expand lending
to SMEs, sometimes focusing on specific regions or sectors through reducing
lending risk. Specifically, a PCG fund is a risk transfer and risk
diversification mechanism; it lowers the risk to the lender by substituting
part of the risk of the counterparty by that of the issuer of the PCG...PCG funds
(and full credit guarantee funds) have existed at least since the beginning of
the 20th century
and have become more popular over the past decades. In spite of their recent
growth and initial evidence suggesting success of some of these funds, there is
a dearth of analysis to systematically inform the process of design of PCG funds, pricing of their
guarantees, their regulation, and the implication that PCG fund characteristics
have with respect to the prudential regulation of banking portfolios covered by
Their analysis leads them to conclude:
Our survey shows an important role of government in partial
credit guarantee schemes around the world, but mostly limited to funding and
management, and much less in credit risk assessment and recovery. This might be
for the better, as we also find that where government is involved in credit
risk assessment and recovery, default rates are typically higher. Older schemes
are also more likely to be government funded and managed and also have higher
loan losses, consistent with the notion that the costs and liabilities of a PCG
fund become obvious only after some time. We find a surprisingly low incidence
of risk-based pricing and limited use of risk management mechanisms.
Last year the Committee concluded:
The Committee notes the suggestion of a guarantee for loans
to small business but prefers to increase competition within the commercial
banks rather than for a government entity to assume the risk.
Banks' service to small business customers
In last year's inquiry into banks and small business, the Committee
A number of submissions referred to customer dissatisfaction
with banks' services to small businesses, including claims about unreasonable
increases in interest rates, poor communication and changes to loan conditions
made unilaterally without notice.
There are suggestions that as banks become larger the quality
of service to small business may decline, particularly if duplicate branches
are closed and local managers moved. 
There was also concern that branch bank managers no longer had the
experience and familiarity with local business conditions to make well-informed
credit decisions and sometimes lacked the authority to take such decisions.
...as much as the banks have tried to present the view that
they are becoming more locally focused, we are not seeing that in practice yet.
What we are seeing is that a risk factor is applied to businesses fitting a
certain profile across the nation, irrespective of the different business
Even one of the major banks conceded there were virtues in:
...doing business with customers you can see from the local
Code of conduct
Small business believes:
...it is inappropriate that small business are excluded from
coverage under the Uniform Consumer Credit Code...
The banks have a general code of conduct but some submitters thought
they ought to develop a code specifically relating to small business:
Bank and bank client relationships have also been strained.
One initiative that may contribute to improving relationships between banks and
small business and reduce the possibility of this relationship being damaged
again in the future, is for the Australian Bankers’ Association (ABA) to
consider expanding its existing Code of Banking Practice to include a code of
conduct on small business lending.
...such a code is the only process by which small businesses
–and other bank customers – can engage on reasonably even terms in negotiating
dispute resolution. The inordinate, indeed overwhelming power of the banks and
their huge financial resources simply precludes the use of the courts for all
but the wealthiest of the bank’s customers.
Some submitters would like to see Australian banks adopt international
practice in this area:
...the UK, Canada and Ireland have specific codes of conduct
relating to lending to small to medium sized enterprises and that such a Code
would therefore bring Australian banking into line with best practice.
The Committee called for such a code last year.
A further discussion of the codes of practice developed by the banks and
mutuals, and lists of those intermediaries subscribing to them, are available
in the report by the Joint Committee on Corporations and Financial Services
The Committee recommends that the Australian Bankers' Association
meet with small business representatives to develop a code of practice specifically
relating to lending to small business.
Bank mergers and small business lending
Small business may suffer disproportionately from further mergers within
the banking system. A survey of the economics literature by the Committee last
year found that:
As banks become larger they are more able to make large loans
to large companies. It has been suggested that this may lead to them being less
interested in lending to small business. Overseas studies have found some
empirical evidence that larger banks make a smaller proportion of their loans
to small business.
The Australian Prudential Regulation Authority observed that:
Regional banks as a group tend to have a relatively high
share of small business loans to total loans.
Bank mergers are discussed further in Chapter 9.
Better information about the sector
The Committee called last year for better information about the small
business credit market:
The Committee recommends that the Government request the
ACCC, APRA and the Reserve Bank to provide a joint annual report to parliament
on competition in the retail banking market in Australia, and the provision of
finance to small business, but taking care not to increase unduly the reporting
burden on financial institutions.
This view was echoed by some submitters to this inquiry:
CPA Australia recommends that the government (or its
agencies) introduce a Bank Lending Survey measuring changes in demand for debt
finance by business (categorised by business size) as perceived by senior
bankers. Such a survey would assist government, regulators and the business
community understand trends in business lending.
This is the practice in some comparable economies:
The governments or their agencies of a number of major
economies (including US, UK and Canada) produce a regular Bank Lending Survey.
Currently, Australia does not have a dedicated senior loan
officer survey to determine the supply and demand conditions prevailing in the
small and medium-sized enterprise (SME) lending market. Such lending surveys
currently exist in a number of countries including the United States of America
(US), the United Kingdom, Europe and Japan, and have been useful in researching
the lending demand and supply dynamics for both SMEs and large firms. For
example, the US Federal Reserve issues the ‘Senior Loan Officer Opinion Survey
on Bank Lending Practices’.
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