Continued Stiff Lending Attitude toward SMEs: Eliminate overdependence on financial statements in credit analysis

Faculty Fellow, RIETI

The argument regarding how loans to cash-strapped small- and medium-sized enterprises (SMEs) should be facilitated is becoming heated. Following The Democratic Party of Japan's manifesto for the August election campaign, which proposed the harmonization of financial services to SMEs, Minister of Financial Services Shizuka Kamei, advocated that a moratorium on loan repayments be offered to SMEs, including micro businesses.

So, what is the optimum situation for SME financing? Considering the arguments made by Chiiki Kyousou Network Inc. CEO Tadahiro Sakamoto (formerly of the Financial Services Agency of Japan) and i Connect Partners CEO Hiroyuki Nakamura, both of whom are very familiar with the actual practices within the financial services industry, I offer my thoughts as follows.

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If asked whether financial institutions are currently meeting the borrowing needs of SMEs, I would be unable to say that they are performing adequately. In recent years, banks have tended to lend to SMEs based on their short-term viability gleaned from financial results rather than their potentiality as a "living organism."

Under the current circumstances where high growth of the macro-economy is unlikely, if financial institutions look at merely the recent financial results and cash flows of borrowers and focus on risk management, i.e. securing collectability by concentrating on the appraisal and review of collateral, the likelihood that they will become reluctant to lend new or additional money to their borrowers or try to coerce them into repaying the loans remains high. Meanwhile, even if precautionary measures such as a moratorium program are legally mandated to prevent such SME troubles from worsening, they will not resolve the nature of the problem.

One of the fundamental causes of the current financial crisis, in respect to SME loans, lies in the massive moral hazard, which arose in the following manner: as risks were excessively dispersed through securitization and other measures, it became difficult to identify the entity that was responsible for the loans, and as a result, the relationships between debtors and lenders also became distant. Even with a moratorium program, a variety of moral hazards may still occur. If financial institutions are forced to accept moratoriums from SMEs in financial difficulty or provide fresh and additional loans by law, they may again become reluctant in SME lending. On the debtors' side, if taxpayers' money is injected to provide compensation for the bad loans, it may cause another sort of moral hazard, resulting in an increased amount of bad loans as well as the public funds required to cover them.

The emergency credit guarantee system, which has already been implemented as one of the precautionary measures in SME financing, is causing some confusion for local financial institutions, who are earnestly responding to the needs of companies in their local communities. They feel perplexed as, now that lenders are secured fully by this governmental guarantee program, megabanks have become aggressive by mobilizing their impressive workforce to increase loans to local companies, without considering the outcome such loans may bring in the future.

If lenders were to sincerely consider what was best for a debtor, they would not opt to defer the borrower's financial problems by providing such easy additional loans, instead they would endeavor to fully understand the borrower's current liabilities and examine their future business prospects. Then for those companies (debtors) who appear to have a viable future, lenders should help them to reduce and reschedule their total borrowing. It would be reasonable to extend a certain guarantee when mandatory rescheduling is granted upon a moratorium subject to such credit analysis with an in-depth insight rather than providing additional credit under the emergency credit guarantee program. While the action that should be taken once the initial grace period expires under the emergency credit guarantee program is an issue yet to be discussed, there has been a call for measures to prevent banks from passing on bad loans to the Government and being indemnified so easily.

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Under the current economic conditions, merely waiting until the situation returns to normal is unsatisfactory. Each SME needs to determine how to deal with the various changes in their business environment by strengthening their existing management resources and the relationships with external stakeholders, then formulate management guidelines and adjust their fundamental management concept accordingly.

The role of financial institutions does not end with negotiating the terms of loans with their borrowers, they are expected to go beyond that and assist borrowers with any management issues they face as well. It is very important for a lender to not to become content with just scrutinizing the financial statements of a borrower, but also to get to know these companies (i.e. borrowers) and endeavor to act a type of business partner. In other words, what the government should do is to implement measures that encourage financial institutions to create a collaborative relationship with SMEs in order to help them tackle their issues, instead of legislating a moratorium on loan repayments and expanding the framework of the emergency credit guarantee program.

In such a partnership, it is imperative for the lender to grasp the current business condition of the SME through fundamentals such as: the organization's financial statements and management plan; their "human assets" in respect to the capability and potentiality of both management and employees; their "organizational assets" in relation to skills and expertise empirically learned and accumulated within the management process and job flows, and "stakeholder assets" in respect to relationships with customers/ suppliers, or production/sales alliance partners.

However, in the last decade, as the branches of financial institutions became occupied with cleaning up bad loans under the direction of their headquarters, jobs were streamlined and contact with borrowers decreased. Job cuts through restructuring also resulted in a generation gap within these institutions. Branch staff are so busy promoting the various financial products, developed to meet customers' diverse needs, through repetitive campaigns, that they are too exhausted to afford any time for borrowers, which in turn diminishes their ability to analyze organizations' business situation.

In connection with the government's financial administrative policies, it is undeniable that more financial institutions now tend to categorize their borrowers in a uniform way, based on for example the debtor classification defined in the bank inspection manual, since the reorganization of their asset assessment systems. Among regional financial institutions, there are some, but unfortunately very few, top managers who insist that, "The debtor classification definitions should only be used for mandatory asset assessment. We should examine borrowers by analyzing their future sustainability and/or potentiality and then base lending decisions and techniques on this information."

Although promotion of "relationship banking (or locally rooted financial services)" has been emphatically advocated, loan decision making based purely on the quantitative analysis of financial data tends to be rather prevalent. Such a procedure takes qualitative data assessment out of the process of rating a borrower due to the aversion of a lender to assume analysis responsibility, with the intent to allow the loan proposal to be authorized as smoothly as possible.

In this way, the currently dominant manner of borrower assessment at financial institutions is based on the analysis of past financial data and short-term forecast in respect to the possibility of default, but such assessments do not contain medium- and long-term forecasts in respect to the borrowers' sustainability and/or potentiality based on qualitative information. In order words, those management resources that are not directly reflected in the financial statements (i.e., soft information) remain a kind of "vacuum in corporate credit assessment." How to fill this vacuum is actually the essential key to the problem.

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In order to fill this vacuum, it is important for a financial institution to continuously examine an SME as if it were a "living entity" or tree for the purpose of this analogy. The financial statements of an organization should not be purely observed like "fruit on a tree," it is essential to look at the business plan and strategies, which form the "trunk of the tree," along with "roots of the tree," to ascertain how firmly they spread out to generate earnings from the management resources it is grounded on. Financial institutions are also expected to serve SME customers in their local communities by not only offering loans and other financial services to them but, in addition, providing organizational restructuring support. In other words, lenders seek to "build a mutually beneficial relationship" with SMEs in order to reduce the risk of bad loans.

One possible way to realize this idea would be for a financial institution to ask an SME borrower to disclose and share raw fundamental information on its business (as a business partner would) and jointly make a "business-strengthening scenario" for it. "Assessment of management based on intellectual assets" is one of the diagnostic methods for forming a basis for the scenario to be drafted. According to this method, management resources of a borrower are categorized into "human assets," "organizational assets" and "stakeholder assets," and analyzed in the aspects of its products and services, its business model and the industrial environment in which it operates. The diagnosis thus extracts the key elements of the current status and the future perspective, envisaging what the advantages and weaknesses are now and indicating what to do with them in the future.

The Financial System Council, a council of advisers to the Prime Minister, has in fact referred, in a report, to the assessment of management based on intellectual assets as a useful method to apply for financing based on the ascertained value of the business, and loan practices that are not overly dependent on mortgage collateral or personal guarantees provided by top management. Prior to this report, the Industrial Structure Council, a council of advisers to the Minister of Economy, Trade and Industry, and others had been pioneering the study of intellectual-asset-based management as a business style for sustainable corporate growth. Among them, the Organization for Small & Medium Enterprises and Regional Innovation, an independent administrative agency, is currently conducting a study into its practical use.

The regional financial institutions mainly responding to SMEs' everyday financial needs should put their weight behind building a firm medium- and long-term relationship with each of them. Japanese regulations should not be a simple translation of the international regulations, nor applied in a uniform way according to them, such as in respect to capital adequacy and liquidity, the strengthening of which is now under global discussion. Instead, they should be modified after considering the characteristics of "shinkin" banks and other cooperative financial institutions, as well as the distinctively Japanese nature of bank deposits. In respect to conflicts of interest, better regulations that fit a banking business rooted in the local communities should be crafted, rather than importing American-style methodology.

* Translated by RIETI with minor revisions.

>> Original text in Japanese

October 2, 2009 Nihon Keizai Shimbun

November 30, 2009

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