Exploring Frontiers to Expand Banks' Lending to SMEs

The middle credit risk group of small and medium-size enterprises (SMEs) is being counted on as a potential market for banks to expand lending. However, the scale of this market is still limited according to the findings of analysis data taken from the "Survey of Financial Environment" (2002) conducted by the Small and Medium Enterprise Agency; SMEs falling under the typical middle credit risk group are estimated to account for only 0.5% of the total number of SMEs.



Meanwhile, an analysis of the microdata from the same survey found that borrowers from shinkin banks/ credit cooperatives, non-bank financial institutions, and government-affiliated financial institutions tend to be of less sound financial condition compared to borrowers from banks (Zenkoku-ginkou, member banks of the Japanese Bankers Association). However, to a considerable extent, these markets overlap each other. Also, lending by banks is sharply lower for borrowers in the seventh quantile and those that of lower financial soundness.



Taking all these into account, it would not be very effective for banks to try to expand lending by finding fresh borrowers. They can expand lending more effectively by approaching their existing borrowers to take over portions of loans currently taken out from other lenders – non-bank financial institutions, government-affiliated financial institutions and so forth – or by stepping up efforts to increase lending to borrowers in the seventh quantile or those of lower financial soundness. The effect of such efforts, calculated under certain conditions, would increase banks' lending by 8.5%. As a prerequisite for expanding lending, however, banks need to increase lending rates – which are currently too low relative to the risk involved – to an appropriate level. The increase in the amount of lending combined with the raising of lending rates would expand banks' interest-rate spreads by 0.1%, thereby increasing interest income and net business profits by 10.8% and 17.7% respectively. This would result in considerable reinforcement of banks' operating foundations.



On the other hand, recurring profits for SMEs (borrowers) would decrease by 4.2% under the same assumption as above, that is, if they are charged interest rates that reflect their respective credit risks. However, SMEs would be able to absorb the negative impact of such a decrease in profits at a time when the economy is expanding, considering the positive effect derived from the improved cash flows of SMEs.



In order to realize the situation described above, local financial institutions and banks need to focus on their respective strengths, namely, the former on relationship banking and the latter on credit scoring. This would rectify the ongoing excessive competition in lending to SMEs and increase profitability for banks and shinkin banks/ credit cooperatives whereby it is expected that SMEs fundraising abilities will eventually improve.