Small and medium-sized enterprises (SMEs) that are unable to issue equity or debt securities rely on bank loans as the primary source of financing, with total loans outstanding to SMEs nationwide amounting to some 250 trillion yen. Collateral and personal guarantees have been playing an important role in obtaining loans from banks, as they prevent moral hazard on the part of borrowers and make it easier for banks to make loans.
At the same time, however, relying on collateral and personal guarantees has its negative side. For instance, those without collateralizable assets find it very difficult to get a bank loan. A business owner who has given a personal guarantee in taking out a loan would never be able to make a comeback in the event of bankruptcy. The presence of personal guarantees poses an obstacle to business succession because of the difficulty in finding a successor ready to take over the guarantees given by the predecessor.
Taking these negative side factors seriously, relevant government agencies such as the Financial Services Agency (FSA) and the Small and Medium Enterprise Agency have been encouraging banks to make loans available without relying heavily on collateral and personal guarantees. In reality, however, in many cases, banks continue to rely on the availability of collateral and personal guarantees in making loans.
According to the Basic Survey of Small and Medium Enterprises, the percentage of SMEs pledging collateral to their main creditor bank decreased from 51% to 40% between 2005 and 2011, the period for which statistical data are available, but the percentage of those providing personal guarantees increased from 51% to 65% (Figure). The FSA's report on the "Progress and Assessment of the Strategic Directions and Priorities" also shows that only 13.5% of the new loans made by regional banks in FY2016 were without personal guarantees.
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What does it take to make SME financing more accessible without relying on collateral and personal guarantees? In this article, I would like to first introduce a government-affiliated financial institution's initiative that has provided financing to SMEs on an extensive scale without demanding collateral or personal guarantees, presenting an analysis on the effects of such financing that I conducted with Kobe University Professor Hirofumi Uchida, Daito Bunka University Lecturer Hiromichi Iwaki, and Waseda University Professor Yoshiaki Ogura. Following this, I will explore the future possibilities of new financing approaches.
The Japan Finance Corporation's Small and Medium Enterprise Unit (hereinafter simply referred to as the "JFC"), which is the target of our analysis, furnishes relatively large SMEs with long-term capital for investment in facilities as well as working capital. It extended 1.6 trillion yen in new loans in FY2016 with outstanding loans amounting to nearly six trillion yen as of the end of the fiscal year, comparable to top regional banks. The JFC used to extend loans only to those borrowers that provided collateral and/or personal guarantees, but gradually introduced non-collateralized and non-guaranteed loan programs from FY2004 onward.
There were few applications for such new loans in the initial several years. However, non-collateralized loans increased sharply in terms of both the amount and number from August 2008 onward, following a significant increase in the ceiling loan amount, and that of non-guaranteed loans from around February 2014 with changes made to the program following the application of Guidelines for Personal Guarantees Provided by Business Owners. Non-collateralized loans made by the JFC exceeded collateralized loans in number in FY2011 and accounted for slightly more than one-third of the total amount of loans lent by the JFC in FY2014. With further changes made to the program, almost all of the loans made since FY2016 have been non-collateralized.
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The first characteristic of the JFC's new loan programs is that the JFC provide non-collateralized and non-guaranteed loans as additional options on top of the conventional collateralized and guaranteed loans, and make them available to those companies deemed qualified for such loans by its judgment. This scheme has made loans accessible to those companies that were previously unable to borrow due to a lack of real property or any other collateralizable assets. Indeed, the average ratio of tangible fixed assets to total assets of JFC loan borrowers has been in decline since 2008, showing that more companies without collateralizable assets have started to tap loans from the JFC.
The availability of non-collateralized loans as a new option has had an impact on the investment behavior of companies. When we look at the behavior of those that borrowed JFC loans for investment in facilities before and after the introduction of the non-collateralized loan program, the proportion of the funds used to purchase machinery—not collateralizable assets such as land and buildings—was higher among the latter group. This indicates that the introduction of the program has paved the way for securing funds without providing collateral and thereby reduced the need to purchase collateralizable assets in preparation for taking out bank loans. Both are positive effects of the non-collateralized loan program.
However, all borrowers would chose non-collateral and non-guaranteed loan options if all of the other terms and conditions were identical to those of conventional loans. Thus, as the second characteristic of the new loan programs, the JFC sets different terms and conditions, such as interest rates, when lending without demanding collateral or a personal guarantee so that companies of different attributes would choose different types of loans. More specifically, the JFC charges higher interest rates on non-collateralized loans than on collateralized loans, whereby corporate borrowers are to choose between a non-collateralized loan with a higher interest rate and a collateral loan with a lower interest rate.
As a result, companies with higher credit risk have tended to choose non-collateralized loans even at the cost of higher interest rates, whereas those with low bankruptcy risk have tended to choose collateralized loans with lower interest rates. This gives rise to the possibility of moral hazard on the part of those borrowers that have switched from collateralized to non-collateralized loans, because their property would not be subject to foreclosure even if they go bankrupt. Actually, business performance has deteriorated in companies that switched from collateralized to non-collateralized loans. This is a negative effect of the non-collateralized loan program.
Meanwhile, non-guaranteed loans made by the JFC in February 2014 or earlier not only carried higher interest rates than those on guaranteed loans, but also contained a covenant that would accelerate the loan if the borrower falls into balance sheet insolvency or fails to fulfill certain conditions. If the level of interest rates were the only difference between non-guaranteed and guaranteed loans, poorly performing companies would have flocked to non-guaranteed loans, just as they have opted for non-collateralized loans over collateralized loans. However, probably due to the presence of the loan acceleration covenant, highly performing companies with low balance sheet insolvency risk were the primary users of non-guaranteed loans and their subsequent business performance has been favorable.
From then and through the end of March 2016, the penalty for the breach of the covenant was less severe. However, the tendency to utilize non-guaranteed loans became particularly prominent among the highest performing companies, because the interest rate on non-guaranteed loans applicable to them became no different from that on guaranteed loans. Non-guaranteed loans made in FY2016 and thereafter contain no covenants.
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Given these findings, what does it take to increase lending to SMEs without demanding collateral or a personal guarantee?
First, it is advisable to focus on companies on which the provision of a non-collateralized loan will likely have a significant positive impact. We have shown that a non-collateralized loan program has the effect of increasing lending to companies without tangible fixed assets and/or promoting investment in non-collateralizable assets. The positive effect of the non-collateralized loan program can be magnified by providing such loans to companies that are relatively young and have no real property as well as those that are greatly in need of funds for investment in intangible assets including research and development (R&D) and software.
Second, we can focus on the function of loan covenants, and further consider what sort of covenants would have a positive impact on the attributes and subsequent performance of companies using non-collateralized and non-guaranteed loans. While business performance has deteriorated in companies that switched to non-collateralized loans, companies that switched to non-guaranteed loans have continued to perform fairly well. This may be attributable to the covenants attached to the non-guaranteed loans, which have had positive effects on the behavior of borrower companies. It is meaningful to ponder the possibility of having covenants substitute the function played by collateral and/or a personal guarantee, while giving due consideration to the cost of monitoring compliance with the covenants.
Collateral and personal guarantees have long served to facilitate SMEs' access to financing. However, given the need to create a more efficient flow of funds to SMEs, it is quite meaningful to work out a mechanism for enabling SMEs to secure financing without relying on collateral or a personal guarantee, including a study on the effects of covenants.