SME Financing in Times of Crisis

MURAMOTO Tsutomu

The global financial crisis and SME business sentiment

The shock caused by the collapse of Lehman Brothers in September 2008 triggered a sharp downturn in the real economy that severely affected small and medium-sized enterprises (SMEs) in Japan. The ongoing global financial crisis differs from ordinary economic recessions with respect to the following areas in particular. First, the accumulation of nonperforming assets is approaching an uncontrollable level. Second, the soundness of securitization as a viable financial business model is being questioned now that the major investment banks that were the driving force behind the securitization boom virtually vanished in a matter of weeks. And third, the crisis is affecting key industries, such as the automobile industry, that had been propelling the world economy.

According to the Bank of Japan's quarterly TANKAN business confidence survey conducted in March and released on April 1, 2009, the diffusion index (DI) of confidence among large manufacturers hit an all-time low of minus 58 when it plummeted beyond its previous low point set in May 1975 during the deep recession that followed the first oil crisis. The latest reading was down a record 34 points from the preceding December survey, a drop that far exceeded the previously steepest decline of 26 points in August 1974. The latest TANKAN DI also marked the sixth consecutive quarter of deterioration.

Meanwhile, according to the separate Survey on SME Business Conditions that is jointly conducted by the Small and Medium Enterprise Agency (SMEA) and the Organization for Small & Medium Enterprises and Regional Innovation, Japan (SMRJ), the diffusion index of business confidence among SMEs began deteriorating three years ago before entering a virtual free fall last autumn and plunging below its previous record low (Figure 1; The SMEA-SMRJ survey is more heavily weighted toward smaller enterprises than the BOJ's TANKAN survey). A similar trend is also visible in a business confidence survey of the member companies (i.e., SMEs) of shinkin cooperative banks that is conducted by the Shinkin Central Bank (SCB) Research Institute.

The business confidence DI in the SMEA-SMRJ survey, which reflects the sentiment of relatively smaller enterprises, typically shows a declining trend ahead of the corresponding TANKAN survey's DI that expresses the outlook of companies at the medium-sized end of the SME spectrum. In other words, the global financial crisis is having a profound impact on smaller enterprises that were struggling even before its onset. As the economy worsened, the lowest level ever reported for the financial position diffusion index confirmed the deteriorating situation among SMEs. SMEs are now facing imminent failure as their cash flows dry up and their future economic prospects remain uncertain.

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Why are SMEs affected by declining exports?

Financial conditions are deteriorating for SMEs because borrowing becomes more difficult as banks tighten their lending standards in the worsening business environment. Although this situation is common in economic downturns, the magnitude of its impact is unusually severe this time around. Business confidence has worsened in Japan's automobile industry, where roughly 10% of Japanese workers are employed, and in the electronics industry due to a sharp decline in exports, particularly to the United States.

These events have had a direct impact on employment and consumption, and are now threatening a number of SMEs in supporting industries. Despite not being exporters, these SMEs are involved in export-related production and thus affected by the business environments of their associated export industries. For instance, one analysis has shown that roughly half of the total production of SMEs in automobile-related industries is either directly or indirectly related to exports, with the indirect portion, i.e., parts and components for exporting companies, accounting for 80% of the total amount related to exports.

Immediate financial measures

The government has taken a series of steps to address the situation of SMEs affected by macroeconomic conditions and the poor business performance of their export-oriented parent companies. As a measure to help SME borrowers, the government introduced an enhanced emergency credit guarantee system effective from October 31, 2008, by setting aside a total budget of ¥20 trillion to guarantee loans to SMEs in 760 eligible industries. The budgeted amount and scope of eligible industries have both been expanded beyond what was initially planned.

Under this emergency temporary measure that is effective through the end of March 2010, local credit guarantee corporations (CGCs) provide 100% coverage for any losses incurred by banks on loans to eligible SMEs, rather than requiring banks to bear a portion of the losses per the ordinary guarantee system. In addition to a maximum amount of ¥80 million per general guarantee, a special guarantee of up to ¥80 million would be available for each eligible SME without collateral (maximum of ¥200 million in general guarantees and another ¥200 million in special guarantees with collateral). By the end of February 2009, approximately 410,000 guarantees collectively worth ¥8.8 trillion had been issued. Furthermore, a total of ¥900 billion in safety-net loans specially designed to help stabilize SME businesses had been extended by the Japan Finance Corp. (JFC), a government financial institution.

Chronic borrowing by SMEs, often referred to as "pseudo-equitization of debt," has been acknowledged to be problematic. A debt-equity swap (DES) under which a lender subscribes for newly issued shares in exchange for debt cancellation, thereby enabling the borrower to reduce its debt burden and beef up its capital base, is one way to solve this problem. This scheme, however, is beyond reach for most SMEs. Another scheme that is more accessible and functionally similar to a DES is a debt-debt swap (DDS), which amounts to converting debt into subordinated loans that are treated as capital in certain situations.

A supplementary financial inspection manual issued by the Financial Services Agency (FSA) regarding the treatment of loans to SMEs initially authorized SMEs to include DDS-related subordinated loans as capital provided that certain conditions - including the presence of a viable business reconstruction plan - were fulfilled. The provision was revised in March 2008 to stipulate that borrowings, when recognized as being similar to capital in nature, may be considered capital in an assessment of assets.

Meanwhile, in April 2008 the Japan Finance Corporation for Small and Medium Enterprises (JASME), as the JFC was then called, launched a new specialized loan program to help SMEs deal with challenging business environments. Then in October 2008, the government clarified that debt should be counted as capital if it is converted into new debt similar to capital in nature, as part of a business restructuring led by Chusho Kigyo Saisei Shien Kyogikai, an accredited local association for supporting the reorganization of SME businesses.

Meanwhile, in an initiative concerning creditors (financial institutions), on November 7, 2008, the FSA revised its financial inspection manuals and guidelines on the supervision of financial institutions to ease the conditions under which rescheduled loans to SMEs could be excluded from nonperforming loans. The revision allowed such exceptional treatment to be applied only if the borrower SME designs and implements a viable and highly promising plan to fundamentally restructure its business.

Previously, banks had been required in principle to classify rescheduled loans as "loans requiring special attention," disclose them as nonperforming loans, and set aside sufficient loan loss reserves in accordance to this classification with exceptions allowed only under strict conditions. The November 2008 revision was intended to exclude rescheduled loans to SMEs both from this particular classification and from disclosure as nonperforming loans. That is, the presence of a viable and highly promising business restructuring plan is now regarded as providing sufficient grounds for excluding rescheduled loans from nonperforming loans. At the same time, the maximum planning horizon for business restructuring - i.e., the time frame within which an SME is expected to restore its business - was extended from three years to five years (and ultimately 10 years if restructuring proceeds as planned).

Apart from Article 102 of the Deposit Insurance Act, a temporary law - the Act on Special Measures for Strengthening Financial Functions - was instrumental in injecting public funds into banks during Japan's last financial crisis. However, the temporary legislation that enabled the injection of public funds into sound banks in a preemptive manner expired at the end of March 2008. In response to the global financial crisis this law was revived in December 2008 with amendments including a mechanism for preemptively injecting public funds to make it more accessible to local financial institutions and those dealing primarily with SMEs.

The new scheme is less stringent than the previous one in terms of requiring bank managers to clarify their responsibilities. The revised law is also more accessible to smaller financial institutions as it has paved the way for injecting public funds into financial cooperatives through their central umbrella organizations. The scheme, which was designed to beef up bank capital levels, effectively prevents credit crunches in cases where banks are unable to lend due to insufficient capital caused by declines in the values of their securities holdings. Thus, it is hoped that the scheme will be made great use of.

On November 7, 2008, the FSA announced plans for a temporary measure introducing flexibility into the capital adequacy requirements of banks, which would be effective through the end of March 2012. Specifically, banks subject to domestic capital adequacy standards do not have to deduct valuation losses on securities from Tier 1 capital (core capital), while those subject to international standards do not have to include valuation gains on securities carrying a zero risk weight as part of Tier 2 capital (supplementary capital) nor deduct valuation losses on such securities from Tier 1 capital. Furthermore, the FSA has endorsed and taken steps in accordance with the Practical Solution on Measurement of Fair Value for Financial Assets (PITF No. 25) released by the Accounting Standards Board of Japan (ASBJ) on October 28, 2008. (PITF No. 25, issued for the purpose of clarifying the notion of "fair value," states that the "rationally calculated value based on management's rational estimation" should be treated as "fair value" in cases where the market is in disorder.)

Immediate financial measures

To nurture the development of SMEs it is necessary to enhance relationship banking, but this cannot be accomplished simply by urging banks to work toward that end. In order to take risks, banks need to go beyond the traditional financial intermediary role and utilize investment funds and hybrid loan programs. As an alternative to conventional lending that heavily relies on real-estate collateral and the personal guarantees of business owners, asset-based lending (ABL) allows for loans to be secured against movables and claims. While accounts receivable have been typically used as collateral, a new registration system was established in November 2004 for security interests in movables and claims. To date, such movables as frozen tuna and pigs tagged with integrated-circuit chips have been used as collateral.

More importantly, one of the essential qualities of relationship banking has been its focus on soft (nonfinancial) information, which is qualitative in nature rather than relying solely on hard (quantitative financial) information. In other words, the ability of banks to discern the creditworthiness of borrowers is what counts most in relationship banking. Within the spectrum of soft information, intellectual assets including technology, organizations, brands, networks, customer satisfaction, quality of employees, patents, management's ideas and strategies, and various other forms of intellectual property rights have all been attracting a considerable amount of attention recently. (These assets are referred to as "human capital," "structural capital," and "relational capital" in the European Union's MERITUM 2000 guidelines for managing and reporting intangibles.) They are the primary source for generating cash flows and creating new value for companies. Thus, it is important to present such intellectual assets in a visible form (i.e., documentation) so that they can be evaluated by banks. In screening potential corporate borrowers, banks should examine not only hard information but also soft information, which represents the true potential of borrowers.

Furthermore, a system capable of electronically recording monetary claims is an important infrastructure for SMEs. Preparations are now underway to enable the use of electronic promissory notes in place of physical promissory notes. The Electronically Recorded Monetary Claims Act came into effect in December 2008. The Bank of Tokyo-Mitsubishi UFJ established an electronic monetary claim recording institution to provide settlement and other relevant services for electronic promissory note transactions beginning in June 2009. The Japanese Bankers Association also plans to establish another recording institution. When these institutions become fully operational, SMEs will be able to use electronic promissory notes received from major companies as a means of payment to other companies. Furthermore, unlike those in paper form, electronic promissory notes are free from the risk of loss and theft and can be divided into smaller components and applied to the payment of multiple transactions.

To summarize, in order to improve the financial condition of SMEs it is necessary to implement a diverse and comprehensive set of new policy measures such as those described here.

The original column was published in Japanese on April 14, 2009.