Weak business will and should be allowed to go under - it's the good ones we need to save, writes Bill Hobbs
Banks have tightened lending criteria, rationing credit as they shore up shattered balance sheets, improve liquidity and raise margins to rebuild profitability. Accessing affordable credit on favourable terms is now almost impossible for all but the best of borrowers. Last week Minister Mary Coughlan, demonstrating Government’s meek response to a financing crisis that threatens to destroy a generation of small businesses, announced her officials were considering a credit guarantee scheme for small businesses.
“FOGAPE”, the Chilean state credit guarantee scheme for small businesses – which is one of many – was mentioned as a model. Established in 1980 and active since 1998, this scheme guarantees - provides loan loss coverage - upwards of 80% of SME bank borrowings. The guarantee is provided to good small business borrowers who, were it not for the absence of good collateral, would otherwise be granted credit on favourable rates and terms. Fogapes’ small loss insurance fund of $200m can underwrite losses on upwards of $2bn on SME loans. Banks tender for its coverage and pay a commission which in turn funds any losses incurred by it. Evidence, dating from 2006, indicates the design of the scheme has led to an increase in favourable lending by banks to small business. In response to its economic crisis, the Chilean government increased funding to provide guarantees of upwards of $2bn dollars in November 2008.
It is one of the many innovative schemes enhanced or introduced by Governments worldwide to support small businesses. The jury is out whether many of these are effective in helping good businesses survive and prosper as emergency measures are known to delay the inevitable insolvency of bad businesses that ought to be allowed to fail.
Here, business trade bodies ISME, SFA, IFA and others have been pleading for a range of responsive measures from the Government since 2008. And its response starkly contrasts with the response of other Governments since the onset of the global crisis.
The OECD report on “The impact of the global crisis on SME and Entrepreneurship Financing and Policy Reponses” published in June 2009, illustrates how 29 countries implemented extensive measures for SME’s, including credit guarantee schemes designed to allow banks to make good loans to good borrowers. Other measures include export credit guarantees, credit mediators who mediate between businesses and their bankers, favourable tax regimes such as accelerated depreciation schedules, employment subsidies, faster payment by state and public bodies (British policy is to pay within ten days) and payment forbearance in “profit insensitive taxes” paid regardless of whether or not a business is making a profit.
These measures target three areas: stimulating demand for goods and services, preventing depletion of working capital and liquidity and helping to maintain capital investment levels.
Access to financing is one of the most significant challenges for the creation, growth and survival of SME’s, particularly innovative ones. This historic problem of accessing affordable credit on favourable terms has worsened considerably as they have suffered a double blow. There’s been a drastic drop in demand for goods and services and tightening in credit terms, as banks ration scarce funding to their better customers. This double whammy, amplified by Government’s deflationary fiscal policy, has severely affected their all important life sustaining cash flow and liquidity.
SME’s are facing significant challenges. They cannot downsize as they are already small. They are less diversified, have weaker financial structures (lower capital and higher debt), have no credit rating and are heavily dependent on bank credit and have limited financing options. If they are part of a global value chain they bear the brunt of difficulties as large companies implement cost reduction, inventory control and cash flow responses to declining demand.
Increasing delays in receiving payments when added to unsold stock results in an endemic shortage of working capital and decrease in cash or liquidity. Added to this rising defaults and insolvencies leave many without a key supplier or uncollectable bad debts.
Mazars’ “Review of Lending to SMEs” published in August last year highlighted the paucity of data available to assess banking credit to business and stark difference between what banks were saying they were doing and what small businesses were experiencing. The review illustrated what happens in a credit crisis as banks struggling for their own survival, tighten lending criteria and make only good loans to good borrowers who have good collateral.
Used to boom time growth, far too many small businesses are neither good borrowers or have good collateral. Far too many did not allow for business risk and failed to create cash flow, liquidity and capital buffers. Far too many business owners used boom time positive cash flow as a personal asset, plundering it to make investments in building personal wealth – more often than not investing in property. Many cannot prove they have a sustainable business case for the future as there is no demand for overpriced poor quality goods and services.
Banks cannot be expected to make bad loans to bad borrowers. Weak businesses will and should be allowed to go under - this is the nature of business. What’s important is to ensure that established good well managed businesses and innovative start ups with viable futures are supported and have access to credit on fair terms. It’s important to ensure where they cannot access credit due to lack of collateral then the state provides a temporary public guarantee. It’s also important that any guarantee scheme is designed to limit moral hazard risk of bankers selecting against the state by using the guarantee to support bad businesses. The danger is such behaviour while alleviating liquidity and cash flow problems only delays inevitable insolvency.
Considering credit guarantees in isolation of an integrated series of measures to help good businesses survive and prosper is not what is needed. Government has yet to design and implement a cohesive strategic policy response to the immediate and long term problems faced by SME’s. In the meantime far too many good businesses will fail.
This article appeared in the Irish Examiner, Business Section, Monday 1st February 2010
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