Small business credit gap?

As mentioned, banks are by far the most important source of credit for small businesses. The traditional definition of a bank is a financial institution which main function is to accept deposits from the public and create credit (Bank of England). By distributing capital to good investment projects, the banks have a central role in promoting economic growth (Hetland and Mjøs, 2012). They also serve a purpose in lowering transaction costs that would otherwise encounter individuals and entities in need of financing, by bringing together lenders and borrowers. Although most banks offer a range of financial services (e.g. payment, money transfer, pension and insurance), the thesis will focus on lending activity.

We are interested in the current state of small business lending and the recent developments. Do small businesses in Norway have sufficient access to credit? As we shall see, this is not a straightforward question.

The aftermath of the global financial crisis saw a tightening in the supply of credit by financial institutions. A number of regulatory frameworks, such as the Basel III were put in place to improve the capital adequacy of banks. In order to achieve a better capital adequacy, or even just to maintain the minimum capital adequacy ratio, capital-constrained banks began collecting outstanding loans or became reluctant to approve new lending (Wehinger, 2014). These austerity measures were felt by small businesses in Norway, where the banks have been increasingly dependent on international securities- and money markets for funding (SSB,

2009). Basel III is a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk (BIS, 2017). Designed to ward off a new global financial crisis, one of its most important features is the capital requirement that call for banks to carry a minimum proportion of equity at all times. Norway were among the countries committing to this framework, and the capital requirements were phased in between 2013 and 2016 (while the liquidity requirements are to be effective from 2019) (Finance Norway, 2017a). In fact, Norway imposed stricter requirements than most EU countries. By studying the credit growth in the business sector, it seems the financial crisis had two negative effects. Hetland and Mjøs (2014) show that the overall change in credit to business was negative from 2008 to 2009. Norwegian businesses received approximately 50 billion NOK less in bank loans than the year before. This can be seen as the immediate impact of the crisis. The other effect came with the implementation of the capital requirements a couple of years later. According to Finance Norway (2017a), there has been a steady decline in credit to businesses since mid-2012. At the same time, growth in credit to households has remained relatively stable. The new capital requirements have obligated the banks to gather more than 180 billion NOK in equity, which has made credit less available. And with recent developments in the housing market and a low unemployment rate, the banks have made more profit by lending to private people.

The annual compound rates of growth in lending indicates that credit might have been harder to obtain over the last five years, but does not account for the size of the firms. However, several studies suggest that small businesses are typically hit harder in the wake of a credit crisis because they are more dependent on bank capital to fund their growth (e.g. Gertler and Gilchrist, 1994; Kroszner, Laeven and Klingebiel, 2007). The extent to which this is a problem is hard to determine.

What is the appropriate level of available credit? In an efficient market, where actors are rational, and information asymmetry and transaction costs are absent, all projects with a positive net present value would receive funding (Hetland and Mjøs, 2012). In the real world, these factors (with special emphasis on

information asymmetry) tend to inhibit an optimal allocation of credit. The bank then serves an essential purpose in trying to bridge this gap by producing relevant information on the borrower's (Diamond, 1984). By assessing as much relevant information as possible and applying different credit analyses, the bank attempts to predict which businesses that are creditworthy and which that are not. This causes some issues. An important feature of all lending is that the lender holds a position with limited upside, and a potentially large downside if the borrower goes bust (Hetland and Mjøs, 2012). The bank does not have the same risk-reward incentive as the equity investor, and can not rely on the success of a particular project to cover the losses from other ones in the same way, and will therefore only tolerate a modest level of risk. Contrary to lenders, borrowers have lots to gain from successful credit financed projects, and little to lose, if they are not personally liable. In order to align interests, banks normally require businesses to have a certain amount of equity. Although this can prevent ruthless mismanagement of borrowed capital, it can also impede the funding of projects that would otherwise have been profitable if the borrower lacks the requested equity (Hetland and Mjøs, 2012).

If capital does not flow to the projects where it would be best put to use, it is a socioeconomic problem. But measuring just how problematic this is poses some challenges. First, there is a question of causality. There is no good way to observe supply (access to credit), nor demand (need for credit) directly, only actual loan amounts and terms and conditions (Hetland and Mjøs, 2012). If the growth in lending decreases, is it a result of reluctant banks or businesses in need of less credit? Second, businesses owners and managers do not think in socioeconomic terms. They tend to have strong faith in their own projects and will often apply for financing regardless of whether the project is objectively profitable or not. It is important to underline that excessively lenient credit standards are neither beneficial for businesses, nor the economy as a whole, as the financial crisis painstakingly proved. High levels of debt increases the risk of large-scale credit deficits which could lead banks and credit institutions to bankruptcy. Such an

event incurs major economic cost, either through governmental bail-out or a credit crunch if the financial institutions go under (NHO, 2015a). The challenge is for banks to resolve the lemons problem by separating the good projects from the bad ones. Not only does it call for accurate credit scoring processes by the banks, it also presents a methodological issue. Even if access to, and demand for credit could be adequately measured, one would have to find a proxy for the viability of the projects. This is likely to change over time, and be subject to economic ups and downs, as well as psychological factors.

Access to credit for small businesses in itself is not the crux of the matter. We are concerned with the extent to which the right businesses have access to credit for the right projects, but acknowledge the difficulties in measuring this. However, there are some worrying signs. In the following section, we will present data and statistics that suggest the presence of a potential gap in small business credit financing in Norway. We will also seek to address if the problem is structural or cyclical.