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The Role of Collateral in Entrepreneurial Finance
Abstract
Previous research has suggested collateral has the role of sorting entrepreneurs either by observed risk or by private information. In order to test these roles, this paper develops a model which incorporates a signalling process (sorting by observed risk) into the design of an incentive-compatible menu of loan contracts which works as a self-selection mechanism (sorting by private information). It then tests this Sorting by Signalling and Self-Selection Model, using the 1998 US Survey of Small Business Finances. It reports for the first time that: high type entrepreneurs are more likely to pledge collateral and pay a lower interest rate; and entrepreneurs who transfer good signals enjoy better contracts than those transferring bad signals. These findings suggest that the Sorting by Signalling and Self-Selection Model sheds more light on entrepreneurial debt finance than either the sorting-by-observed-risk or the sorting-by-private information paradigms on their own. Copyright (c) 2009 The Authors Journal compilation (c) 2009 Blackwell Publishing Ltd.
... Studies show that because it is private information and not fully accessible to creditors, high-quality borrowing firms tend to voluntarily provide collateral to signal their low risk in the hope that they can obtain debt with lower interest rates (Jiménez et al., 2006). In terms of the moral hazard problem, studies find that observably riskier borrowers are more likely to be required to provide collateral (Boot et al., 1991;Han et al., 2009). Berger et al. (2011) provide empirical support for these arguments by showing that the ex post theory of collateral is relatively dominant, although both exist. ...
... More importantly, this flow enables the acquirer to possess greater asset collateral, and even more than if they had undertaken a conventional M&A transaction. As widely discussed in other studies (e.g., Han et al., 2009;Duarte et al., 2016) collateral is an important external mechanism to ensure creditors' benefits. It can restrain the borrowing firms' moral hazard and thus reduce the risk premium demanded by creditors. ...
... Consequently, creditors provide a range of contracting terms so that high (low) quality borrowing firms choose secured (unsecured) debt at lower (higher) risk premiums (Chen et al., 2013b). At the same time, high-quality borrowers are more inclined to provide asset collateral and signal their creditworthiness, which is usually private information and imperfectly provided to creditors (Han et al., 2009;Duarte et al., 2016). Overall, the use of collateral is helpful to mitigate ex ante and ex post informational problems. ...
In this paper, we investigate whether material asset reorganizations (MARs), a special form of merger and acquisition (M&A) transactions, can affect the acquirers’ cost of debt financing. Further, we examine the effect of acquiring firms’ accounting information quality on the cost of debt and on the association between MARs and debt costs. We predict that compared to conventional M&As, large-scale acquisitions through MARs can generate a much greater influx of assets from target firms. This raises the acquirers’ asset collateral and thus reduces the cost of debt. Because the quality of accounting information is a key factor affecting the cost of debt, we suggest that it has a spillover effect on the debt-cost effect of MARs. Using M&A transactions by listed companies in the Chinese A-share market from 2008 to 2014 as our sample, we find that MARs are associated with a higher asset collateral and lower ex post cost of debt than conventional M&As. Furthermore, we show that the acquiring firms’ accounting information quality has a significant negative effect on debt costs, and the negative association between MARs and the cost of debt is more pronounced when accounting information quality is higher.
... In addressing how borrowers' (un)observed risk is related to collateral requirements, empirical research has primarily focused on SMEs operating in developed countries and largely examines only a single country (e.g., Leeth and Scott, 1989;Berger andUdell, 1990, 1995;Cowling, 1999;Brau, 2002;Jiménez and Saurina, 2004;Hernández-Cánovas and Martínez-Solano, 2006;Jiménez et al., 2006;Han et al., 2009;Berger et al., 2011a, b;Duarte et al. 2016). In less-developed countries, information asymmetries are more pronounced, and it is often difficult for banks to conduct risk assessments; data might be sparse and of limited reliability because SMEs' financial statements are generally not audited (Menkhoff et al., 2012). ...
... We expect lenders to require more stringent collateral requirements from firms with a history of overdue payments or a track record of losses due to crime and less stringent requirements for borrowers with quality certifications. If there is a positive relationship between observable credit risk and incidence (and level) of collateral (e.g., Han et al., 2009;Duarte et al., 2016), we also expect an increase in the incidence (and level) of personal collateral versus business collateral, because the value of an owner's assets is more appropriate to sufficiently discipline a borrower's behavior. ...
... Because pledging collateral involves costs that can be recovered fully only with large loans through economies of scale, the likelihood of pledging collateral is greater for larger than for smaller loans (Jackson and Kronman, 1979). Yet some authors show that larger loans are more likely secured (Harhoff and Körting, 1998;Degryse and Van Cayseele, 2000;Han et al., 2009;Menkhoff et al., 2012;Gama and Duarte, 2015), whereas Boot et al. (1991) show the opposite. ...
Using a database of banking credit approvals for small and medium-sized enterprises (SMEs) operating in less-developed countries throughout Eastern Europe and Central Asia, this paper extends empirical evidence on the determinants of the incidence and the levels of business and personal collateral, reporting first-hand results regarding the impact of the recently reformed credit environment on collateral requirements. The findings endorse the importance of producing and sharing private information between lenders to reduce informational asymmetries and, consequently, the need to provide collateral to receive a loan. The results also suggest that market concentration increases “lazy” behavior on behalf of banks in the form of asking for collateral not to mitigate observable risk but rather to reduce screening efforts.
... To analyze the role of collateral in debt term contracts, Han et al. (2009) propose a "sorting by signaling and self-selection" (SBSS) model that emphasizes two unique views on how collateral can mitigate credit risk better than sorting by observed risk (SBOR) (e.g., Berger and Udell, 1990) or sorting by private information (SBPI) (e.g., Bester, 1985). In the SBOR model, borrowers' risk types are observable, so lenders require collateral and higher interest rate premiums (IRP) on the basis of borrowers' observed characteristics (demand-side argument). ...
... In testing the simultaneous impacts of observed characteristics and private information on debt term contracts, we extend Han et al.'s (2009) model in three ways. First, because loan term contracts (i.e., collateral and IRP) are jointly determined (Brick and Palia, 2007), we test the signaling value of collateral and consider the determinants of IRP, with the assumption that they can be determined endogenously, as predicted by the SBSS model (Godlewski and Weill, 2011). ...
... First, though some empirical studies examine the role of collateral in mitigating informational asymmetries in loan contracts (e.g., Jimenez et al., 2006;Menkhoff et al., 2006;Voordeckers and Steijvers, 2006;Berger et al., 2011), few explore the interdependencies of collateral and IRP. Those that do generally use US data (e.g., Brick and Palia, 2007;Han et al., 2009), which reflect market-based financial systems (La Porta et al., 1998). The current study instead analyzes the role of collateral in loans granted to SMEs in Portugal, a country characterized by a bank-based system and an economy dominated by SMEs. ...
This study tests the simultaneous impact of observed characteristics and private information on debt term contracts in a multi-period setting, using a dataset of 12,666 credit approvals by one major Portuguese commercial bank during 2007–2010. The main results show that borrowers with good credit scores that know they have a high probability of success and are unlikely to default are more willing to pledge collateral in return for a lower interest rate premium (IRP). Furthermore, lenders tailor the specific terms of the contract, increasing both collateral requirements and the IRP from observed risk, for borrowers operating in riskier industries and with less credit availability. The results are robust to controls for joint debt terms negotiation and the degree of collateralization offered by the borrower.
... Bank uses past information to classify current customer as good or bad customer [23]. Hence, the likelihood that a lender imposes a higher interest rate should relate positively to whether the firm has defaulted previously [31] For the bank, collecting information about small firms is costly [45], so banks rely on the use of collateral requirements, especially fixed assets with Number of financial products the firms has purchased from the main bank Control variables Industry Equals 1 it the firms belongs to industry x (x ϵ [1,9] to distinguish between 9 industries) (0,1) S-corp. Equals 1 it he firm is organized as a S-corporation (0,1) C-corp. ...
... Including the independent and control variables in the second specification produces the same results (Equation 6). Thus, borrowers with a delinquent history pay a higher interest rate [31]. The third specification shows a positive and statistically relation between fixed assets (instrumental variable for BC equation) and BC variables. ...
... These estimates partially support H5 and H6, which suggest a substitution effect between relationship length and BC requirements, and confirm Steijvers and Voordeckers's [50] prediction that relationship length decreases the likelihood of pledging collateral. According to Han et al. [31], a longer relationship could be an adverse selection device that substitutes for the role of collateral, yet the present study indicates that a long-term relationship with a bank exerts a positive effect on IRP charges (.344, significant at 5%), in line with Petersen and Rajan's [42] bargaining hypothesis. 3 The IRP increase over the duration of a lender-borrower relationship also suggests "inter-temporal shifting of rents is possible" ( [27], p. 107). ...
This study investigates how the use of collateral affects incentives for borrowers and lenders and the resulting loan pricing relationship. With data from the UK Survey of Small and Medium-Sized Enterprises 2008, a simultaneous equation approach reveals that high quality borrowers choose contracts with more collateral and lower interest rates, which suggests that collateral acts as an incentive in credit markets. By distinguishing business from personal collateral, the present study also reveals that personal collateral seems more effective as a sorting device, in line with screening models. Regarding the nature of the borrower-lender relationship, a substitution effect arises between relationship length and collateral requirements, but a primary bank uses an explicit loan interest rate as a loss leader to secure long-term rents on relationship business, suggesting the possibility of intertemporal shifting rents. © 2015, World Scientific and Engineering Academy and Society. All rights reserved
... Bank uses past information to classify current customer as good or bad customer [23]. Hence, the likelihood that a lender imposes a higher interest rate should relate positively to whether the firm has defaulted previously [31] For the bank, collecting information about small firms is costly [45], so banks rely on the use of collateral requirements, especially fixed assets with Number of financial products the firms has purchased from the main bank Control variables Industry Equals 1 it the firms belongs to industry x (x ϵ [1,9] to distinguish between 9 industries) (0,1) S-corp. Equals 1 it he firm is organized as a S-corporation (0,1) C-corp. ...
... Including the independent and control variables in the second specification produces the same results (Equation 6). Thus, borrowers with a delinquent history pay a higher interest rate [31]. The third specification shows a positive and statistically relation between fixed assets (instrumental variable for BC equation) and BC variables. ...
... These estimates partially support H5 and H6, which suggest a substitution effect between relationship length and BC requirements, and confirm Steijvers and Voordeckers's [50] prediction that relationship length decreases the likelihood of pledging collateral. According to Han et al. [31], a longer relationship could be an adverse selection device that substitutes for the role of collateral, yet the present study indicates that a long-term relationship with a bank exerts a positive effect on IRP charges (.344, significant at 5%), in line with Petersen and Rajan's [42] bargaining hypothesis. 3 The IRP increase over the duration of a lender-borrower relationship also suggests "inter-temporal shifting of rents is possible" ( [27], p. 107). ...
... High-creditworthy borrowers tend to accept loan contract configurations that have higher collateral requirements for a certain reduction in the interest rate than low-creditworthy borrowers. Building on Bester (1985), Han et al. (2009) further shows that high-creditworthy borrowers can offer collateral as a signal to lenders to obtain lower interest rate than lowcreditworthy investors with riskier and low-return projects. 5 ...
... Within the standard credit market model, we introduce loan applicants' perception toward their creditworthiness. Following the literature (such as Bester, 1985;Han et al., 2009;Longhofer and Peters, 1999), our key simplifying assumptions are: (1) both banks and borrowers are risk neutral, and risk-free interest rate is normalized to zero; (2) banks' loan offers depend on the observed signals that the loan applicants send; (3) banks can objectively predict applicants' creditworthiness based on the signals banks receive; and (4) borrowers have imperfect information about their true creditworthiness. Now, consider a project that succeeds with probability and fails with probability 1 − . ...
Women are disproportionately disadvantaged in access to finance in Africa. While supply-side detriments, such as high interest rates and collateral requirements, are well documented in the literature, little is understood about how demand-side factors contribute to the observed gender gap in access to finance. This paper provides the first empirical evidence on how women managers’ perception about their creditworthiness contributes to the large gender gap in Africa, particularly in the Northern region. One of the innovations of the paper is introducing a theoretical model using the credit market framework with imperfect and asymmetric information to explain what may drive loan applicants to self-select. We use firm-level data for 47 African countries from the World Bank Enterprise Survey. We find that women entrepreneurs in Africa, in general, and in North Africa, in particular, are more likely to self-select themselves out of the credit market due to low perceived creditworthiness compared to their men counterparts. The results also suggest that the observed self-selection behavior is not a response mechanism to current discriminatory lending practices by the banks. The results are robust to different empirical specifications. The findings will inform policies towards greater financial inclusion of women in the region.
... We expect lenders to require more stringent collateral requirements from firms with a history of overdue payments or a track record of losses due to crime and less stringent requirements for borrowers with quality certifications. If there is a positive relationship between observable credit risk and incidence (and level) of collateral (e.g., Han et al., 2009; Duarte et al., 2016), we also expect an increase in the incidence (and level) of personal collateral versus business collateral, because the value of an owner's assets is more appropriate to sufficiently discipline a borrower's behavior. Trade credit and the track record of a borrower as a customer of financial services can be used as signaling instruments, mitigating the adverse selection problem and decreasing the value of collateral as a screening device. ...
... Because pledging collateral involves costs that can be recovered fully only with large loans through economies of scale, the likelihood of pledging collateral is greater for larger than for smaller loans (Jackson and Kronman, 1979). Yet some authors show that larger loans are more likely secured (Harhoff and Körting, 1998; Degryse and Van Cayseele, 2000; Han et al., 2009; Menkhoff et al., 2012; Gama and Duarte, 2015), whereas Boot et al. (1991) show the opposite. An asset can be pledged only once and its evaluation is costly, so by asking for collateral, the main bank ensures its loan seniority to other creditors' claims and creates a barrier to entry (Menkhoff et al., 2012). ...
... First, it has reviewed the impacts of the duration of relationships between banks and SMEs on the availability of bank finance (Ono and Uesugi, 2009) and its cost (Berger and Udell, 1995). Second, it has sought to examine the way in which banking relationships have had an impact on the provision of SME finance through 'business characteristics' (Han et al., 2009a) and entrepreneurial 'demographic profiles' (Cavalluzzo et al., 2002). Third, there has been a concentration upon the level of embeddedness of the relationship between banks and their clients (Kang et al., 2011). ...
... Both under-investment and over-investment may occur with the existence of asymmetric information. Theoretical models have been developed to capture the empirical implications of asymmetric information, such as the capital rationing model (Stiglitz and Weiss, 1981), signalling model (Bester, 1985) and sorting by the signal and self-selection paradigm (Han et al., 2009a). It has been argued that banks may alleviate information asymmetries by collecting private information about borrowers and using this in their lending decisions (Diamond, 1991). ...
This article examines an under-investigated area in relationship banking, i.e. the use of bank advice and support and its impacts on the financial conditions of small and medium-sized enterprises (SMEs). The findings indicate that the characteristics of businesses and entrepreneurs, among other factors, have determinant effects on the use of bank support by SMEs when they make financial decisions. SMEs can alleviate the severity of their financial problems significantly by using bank support more fully, through developing long-term relationships with banks as primary network partners. The article further recognises the value of advice from banks as a substitute for entrepreneurial human capital, especially when bankers use private information to determine the nature and level of financial and non-financial assistance that they are prepared to supply to their clients.
... Although there is rarely sufficient funding from these sources it does provide the capital to set-up and run the venture in the short-term (Jackson & Madison, 2022). In the longer term these forms of capital can act as a signalling mechanism to investors and lenders about the entrepreneur's commitment to the new venture and its future prospects (Boudreau, Jeppesen, Reichstein, & Rullani, 2021;Han, Fraser, & Storey, 2009b). As discussed above, investment by the owner forms a major component of a start-up firm's collateral (Cole & Sokolyk, 2018). ...
... In return for a government guarantee of 75% on unrecovered outstanding balances, there was an additional interest premium of 2.0% paid to government above the loan interest rate charged by the lending bank. This general interest ratecollateral trade-off-is particularly interesting as borrowers of different types are more likely to choose different, incentive compatible, contract features which in turn, signal to the lending bank important information about the quality of the borrower in respect of observable risk and private information (Han et al., 2009). There was also an expansion in the number of institutions permitted to offer loans under the scheme. ...
The UK has had a commitment to loan guarantee schemes since 1981 when it introduced the Small Firms Loan Guarantee (SFLG) scheme to address access to debt finance issues for smaller firms. Over the last 40 years, its support has been unwavering, and in the Covid-19 crisis, it once again turned to loan guarantees as a means of supporting smaller firms through the crisis-induced slump in trading activities. Of its three core Covid-19 guarantee schemes, the Bounce Back Loan (BBL) scheme was the most numerous with 1,531,095 loans issued amounting to a total of £46.5bn in lending. The BBL scheme provided a 100% capital guarantee on loans between £2,000 and £50,000, and firms were allowed to borrow up to 25% of their trading income, with a fixed interest rate of 2.5% of which the first years interest was paid by the government to the lending bank. Our findings suggest that the government losses may range between £7bn and £12bn depending on the underlying assumptions; however, we estimate Covid-19 guarantee schemes may have protected 118,639 businesses and 1,117,849 jobs. Looking to the future, we suggest that a new loan guarantee is justified that more resembles the former SFLG than the restrictive Enterprise Finance Guarantee (EFG) as more than one million small businesses will be heavily indebted and unable to borrow to invest in future growth opportunities. This would support the ‘levelling-up’ agenda and help prevent a post-Covid-19 low investment–low growth scenario.
... The past studies argued that the usage of collateral is obvious in securing loans and minimizing information asymmetries in the predetermined relationship between lenders and borrowers (Berger, Frame, & Ioannidou, 2011;Hall, 2012;Han, Fraser, & Storey, 2009). Almeida and Campello (2007) conclude that more tangible assets in a firm may sustain more external financing. ...
The main objective of this study is to examine whether firms follow the
financing hierarchy as suggested by the Pecking Order Theory (POT). The
External Funds Needed (EFN) model offers a financing hierarchy that can
be used for examining the POT
... The past studies argued that the usage of collateral is obvious in securing loans and minimizing information asymmetries in the predetermined relationship between lenders and borrowers (Berger, Frame, & Ioannidou, 2011;Hall, 2012;Han, Fraser, & Storey, 2009). Almeida and Campello (2007) conclude that more tangible assets in a firm may sustain more external financing. ...
... The past studies argued that the usage of collateral is obvious in securing loans and minimizing information asymmetries in the predetermined relationship between lenders and borrowers (Berger et al. 2011;Hall 2012;Han 2009). Almeida and Campello (2007) conclude that more tangible assets in a firm may sustain more external financing. ...
The main objective of this study is to examine whether firms follow the financing hierarchy as suggested by the Pecking Order Theory (POT). The External Funds Needed (EFN) model offers a financing hierarchy that can be used for examining the POT. As far as the EFN considers growth of sales as a driver for changing capital structure, it follows that shall firms plan for a sustainable growth of sales, a sustainable financing can be reached and maintained. This study uses data about the firms listed in two indexes: Dow Jones Industrial Average (DJIA30) and NASDAQ100. The data cover quarterly periods from June 30, 1999, to March 31, 2012. The methodology includes (a) cointegration analysis in order to test for model specification and (b) causality analysis in order to show the generic and mutual associations between the components of EFN. The results conclude that (a) in the majority of the cases, firms plan for an increase in growth sales but not necessarily to approach sustainable rate; (b) in cases of observed and sustainable growth of sales, firms reduce debt financing persistently; (c) firms use equity financing to finance sustainable growth of sales in the long run only, while in the short run, firms use internal financing, that is, retained earnings as a flexible source of financing; and (d) the EFN model is quite useful for examining the hierarchy of financing. This study contributes to the related literature in terms of utilizing the properties of the EFN model in order to examine the practical aspects of the POT. These practical considerations are extended to examine the use of the POT in cases of observed and sustainable growth rates. The findings contribute to the current literature that there is a need to offer an adjustment to the financing order suggested by the POT. Equity financing is the first source of financing current and sustainable growth of sales, followed by retained earnings, and debt financing is the last resort. Copyright © 2018 by Emerald Publishing Limited All rights of reproduction in any form reserved.
... Collateral requirements on loan contracts and the observed risk hypothesis have also received utmost attention from researchers. However, these studies are concentrated on a single country and dominated by the US market (Leeth, Scott 1989;Berger, Udell 1990Brick, Palia 2007;Han et al. 2009;Berger et al. 2011), with a handful concentrated on the European market (Cowling 1999 -UK;Jimenez, Saurina 2004 -Spain;Hernandez-Canovas, Martinez-Solano 2006 -Spain;Duarte et al. 2016 -Portugal). There are studies based on cross-country analyses but they cover both developing and developed markets (Godlewski, Weill 2011;Duarte et al. 2017). ...
The purpose of this paper is to examine the determinants of collateral for small and medium enterprises (SMEs) in the context of Visegrad countries: Czech Republic, Slovak Republic, Hungary and Poland. The data set for this paper was obtained from the Business Environment and Enterprise Performance Survey (BEEPS), which was conducted by the World Bank and the European Bank for Reconstruction and Development (EBRD) from 2012–2014. A binary logistic regression model with different specifications was employed to examine the effect of independent variables on the incidence of collateral. The results show that risky borrowers need to pledge collateral and the reduction of asymmetric information can lower the incidence of collateral for SMEs. Moreover, we find that female borrowers are more likely to pledge collateral than male borrowers are. The results also suggest that loans with a longer maturity are more likely to be collateralized than short-term loans. We find evidence that bank-borrower proximity can alleviate the incidence of collateral whereas bank concentration may increase collateral requirements. Policy makers may consider these results to implement policies that can promote bank competition and can lower collateral requirements for female borrowers. The paper contributes to the ongoing debate on the determinants of collateral.
... First, lowquality borrowers are required to provide more collateral to reduce lenders' risk. Second, high-quality borrowers are more likely to provide collateral to signal their quality to lenders (Berger and Udell, 1990;Han et al., 2009;and Godlewski and Weill, 2011). When the degree of information asymmetry between borrowers and lenders is lower, the former role is more prominent (Godlewski and Weill, 2011). ...
This paper investigates, both theoretically and empirically, how interactions among potential lenders may influence contract terms via informational cascade in the syndicated loan market. Our model shows that the ex-post observed interest rate is higher and the probability of syndication failure is lower when potential lenders can only observe the decisions of their predecessors versus when they can freely communicate with each other. Empirical tests confirm the model's predictions and the existence of a cascade effect on lending conditions. Using relational distance to proxy for the segmentation of communication, we find that relational distance is positively related to the loan spread and the requirements for collateral and guarantees, but negatively related to the probability of syndication failure.
... Asymmetric information is often stated as the cause of understand the relationship between bank and small business. This is confirmed by Han et al. (2009) and Fraser and Storey (2009) who investigated US small business and argue that " high type " entrepreneurs, who transfer secure and transparent information, enjoy preferential advantages with their bank obtaining lower interest rates than entrepreneurs who transfer weak information to the bank. The evidence suggest that, in contrast with larger listed firms, debt is not an appropriate external corporate governance mechanism for smaller unlisted businesses in terms of an expense ratio. ...
This study investigates the linkage between agency costs, ownership structure and corporate governance in small business. Eleven years of data for 100 unlisted small businesses, are collected and 1099 observations are analysed using as dynamic panel GMM estimation. Various diagnostic tests are utilised to check for stationary and convergence of variables. The results indicate that ownership concentration has the most significant governance effect and also has the largest impact on corporate governance. Moreover, this study finds U-shape relationship between internal ownership and performance, which under that agency proxy. Agency costs vary with leverage the life of the business and with its size.
Existing evidence has shown that SMEs make great contributions to innovation, job creation and economic growth. This chapter reviews recent literature on (1) the important roles played by SMEs in emerging markets and (2) the impacts of financial development on SME finance in such markets. It also uses a unique database form World Bank Enterprise Survey (WBES) to document the financing patterns, constraints and other financial issues of SMEs in emerging markets. The descriptive statistics derived from WBES show clear variations of SME financing patterns between emerging and developed markets and shed light on the important role played by financial development in financing SMEs.
This paper examines whether and how housing market prices affect entrepreneurship activities. To this end, we empirically test the hypothetical collateral channel, exploiting a large-scale household-level survey from China. We find that a higher growth rate of house prices is associated with a higher propensity of being self-employed of a family member. We further find that lower house price volatility and higher liquidity in the real estate market boost entrepreneurial choices by households. Overall, the results provide favorable empirical evidence for the collateral channel.
Existing evidence has shown that SMEs make great contributions to innovation, job creation and economic growth. This chapter reviews recent literature on (1) the important roles played by SMEs in emerging markets and (2) the impacts of financial development on SME finance in such markets. It also uses a unique database form World Bank Enterprise Survey (WBES) to document the financing patterns, constraints and other financial issues of SMEs in emerging markets. The descriptive statistics derived from WBES show clear variations of SME financing patterns between emerging and developed markets and shed light on the important role played by financial development in financing SMEs.
This article examines two contrasting interpretations of how bank market concentration (Market Power Hypothesis) and banking relationships (Information Hypothesis) affect three sources of small firm liquidity (cash, lines of credit, and trade credit). Supportive of a market power interpretation, we find that in a highly concentrated banking market, small firms hold less cash, have less access to lines of credit, and are more likely to be financially constrained, use greater amounts of more expensive trade credit, and face higher penalties for trade credit late payment. We also find support for the information hypothesis: relationship banking improves small business liquidity, particularly in a concentrated banking market, thereby mitigating the adverse effects of bank market concentration derived from market power. Our results are robust to different cash, lines of credit, and trade credit measures and to alternative empirical approaches.
This article reviews literature on the important role played by asymmetric information in entrepreneurial finance from two perspectives: asymmetric information and relationship lending, and the theoretical modeling of asymmetric information. Then it examines the relationship between capital market conditions and entrepreneurial finance and attempts to answer two questions: Why is the capital market condition important for entrepreneurial finance? and What are the effects of capital market conditions on entrepreneurial financial behavior in terms of discouraged borrowers, cash holding, and the availability and costs of finance?.
Starting a business successfully requires numerous skills and resources. The alarming rate of failures associated with new ventures suggests that potential entrepreneurs would welcome expert advice at the most vital stage in the life of any business.
This article seeks to answer two questions. What drives the capital structure of microfinance institutions? Does the effect of variables at the microfinance institution’s level vary depending on whether the institution is shareholder based or not? Results show that a reliance on external debt has a significant correlation with tangible assets, profit distribution status, and size. Tangible assets, past due loans and size provide donors with useful information. Donations are significantly correlated with past due loans and tangible assets, indicating that donors or their mandates care about risk when they decide to give. Profitability and ratings ensure transparency but have a very limited impact on the institution’s funding policies. The results do not lead to the conclusion that for-profit microfinance institutions are more able to raise external financing than not-for-profit ones. Furthermore, except for profitability, other variables at the microfinance institution level have the same impact on both for-profit and not-for-profit MFIs.
After the fall of Lehman Brothers and the start of the financial crisis is a break in economic activity, evidences a lack of financial attributed to information asymmetry experienced by the financial system. This paper will see how it has been analyzed by different economists this phenomenon that makes credit rationing and moral hazard. This issue is more severe because banking regulation establishes strict coverage criteria to operations that boost this exclusive effect. guarantee activity is beneficial for the entrepreneur and for financial institutions, finding common interests on them that, joined to the public sector, shape the guarantee activity as a policy that find the most effective coordination vectors between agents. However, test how the system no develops guarantee on the Spanish economy to achieve the desired volumes.
Despite the fact that the firm's economic value has a subjective nature, various procedures have been devised to measure it for objective reasons, primarily for establishing the best credentials on financial markets.
This study explores the impact of bargaining power of venture capital (VC) firms on the valuation of their portfolio companies. We argue that VC firm types with greater bargaining power vis-à-vis the entrepreneur negotiate lower valuations compared to VC firm types with less bargaining power. We find that VC firm types with stronger bargaining power, namely university and government VC firms, value investments lower compared to independent VC firms. The valuations of captive VC firms equal those of independent VC firms. Our findings suggest that valuations in the VC contract reflect the relative bargaining power of the VC investor.
Private Equity restructuring of companies using debt finance has been criticised for increasing financial distress and bankruptcy in the corporate sector and this was especially so in the aftermath of the financial crisis. We build a unique data set comprising the population of over eight million company year observations and 153,000 instances of insolvency covering the period 1995-2010 and encompassing the recessionary cycle. We examine the whole spectrum of buyout ownership types (pre and post buyout) in comparison with the private and public corporate population and over time. We provide direct evidence relating to whether buyouts and buy-ins, private equity backed or not, are more or less likely to fail in terms of entering formal insolvency proceedings than other firms and how this varies over the economic cycle. Controlling for size, age, sector and macro-economic conditions (base hazard) we find that private-equity backed buyouts are no more prone to insolvency than the non-buyout population and pre-buyout credit risk. Conditioning on company performance and operational characteristics we show that PE-backed companies do not carry more insolvency risk than other (distressed) companies and other buyout types. We find that leverage does not distinguish buyouts that fail from those that survive.
This discussion of the paper by Han, Fraser and Storey (hereafter Han et al.) consists of three parts. I start off by analysing the theoretical model. To highlight its contribution I position the model in the existing literature, and compare it with some key related models. Subsequently I discuss the data and empirical tests. The paper's results raise some new questions. I therefore conclude with a brief section which outlines possible directions for future research.
Although the field of entrepreneurship is recognized as being of fundamental importance for our economy, and although many researchers throughout the world have turned their attention to it, there is, as yet, no agreement as to the research object in this scientific field. Empirical research has described the phenomenon from different standpoints. It has also shown that the phenomenon is much more complex and heterogeneous than was thought in the 1980s. However, to advance knowledge and produce tools that are useful in practice, it has become necessary to establish theories that will generate more productive empirical research. Some effort at definition is therefore needed.
A major new database (OneSource) of UK companies is used to estimate the contribution of independent companies of all sizes to employment change in the corporate sector over the period 19901992. Our estimates cover jobs gained and lost by corporate births and deaths as well as employment change in surviving companies. There is no tendency for the corporate birth rate to decrease monotonically with increases in company size and there is certainly no case for postulating that new companies tend to have one optimum size such as Minimum Efficient Scale. In contrast, the corporate death rate does decrease with increases in company size. Over this period the net effect of births and deaths was negative for virtually all sizes of company. Overall, 0.614 million jobs were gained by births but 1.119 million lost by deaths. Another 600 thousand jobs were lost in surviving companies. Much of this loss occurred in large companies but medium size companies (33-512 employees) also shed jobs in large numbers. Taking account of births, deaths and survivors, only companies with 1-8 employees were net creators of jobs over this period. But the absolute numbers created were fairly small to set against losses amongst larger companies.
According to basic economics, if demand exceeds supply, prices will rise, thus decreasing demand or increasing supply until demand and supply are in equilibrium; thus if prices do their job, rationing will not exist. However, credit rationing does exist. This paper demonstrates that even in equilibrium, credit rationing will exist in a loan market. Credit rationing is defined as occurring either (a) among loan applicants who appear identical, and some do and do not receive loans, even though the rejected applicants would pay higher interest rates; or (b) there are groups who, with a given credit supply, cannot obtain loans at any rate, even though with larger credit supply they would. A model is developed to provide the first theoretical justification for true credit rationing. The amount of the loan and the amount of collateral demanded affect the behavior and distribution of borrowers. Consequently, faced with increased credit demand, it may not be profitable to raise interest rates or collateral; instead banks deny loans to borrowers who are observationally indistinguishable from those receiving loans. It is not argued that credit rationing always occurs, but that it occurs under plausible assumptions about lender and borrower behavior. In the model, interest rates serve as screening devices for evaluating risk. Interest rates change the behavior (serve as incentive mechanism) for the borrower, increasing the relative attractiveness of riskier projects; banks ration credit, rather than increase rates when there is excess demand. Banks are shown not to increase collateral as a means of allocating credit; although collateral may have incentivizing effects, it may have adverse selection effects. Equity, nonlinear payment schedules, and contingency contracts may be introduced and yet there still may be rationing. The law of supply and demand is thus a result generated by specific assumptions and is model specific; credit rationing does exist. (TNM)
We analyze credit applications, loan denials, and interest rates paid by small businesses across owner gender, race, and ethnicity. In addition, we examine data from owners who said they did not apply for credit because they believed that their applications would have been turned down. After controlling for a rich set of explanatory variables, including personal and business credit histories, substantial differences in denial rates between firms owned by African Americans and white males remain. Moreover, consistent with Becker's classic theories (1957), we find evidence that increases in competition in the firm's local banking market reduces these differences.
This paper empirically examines how close ties between a firm and its creditors affects the availability and the costs of funds to the firm. We analyze data collected in a survey of small firms by the Small Business Administration. We find that the primary benefit to a firm of building close ties with a creditor is that the availability of financing increases. We find no analogous effect on the price of credit. Attempts by a firm to widen its circle of relationships by borrowing from multiple lenders increases the price and reduces the availability of credit. An increase in the amount of potential competition in credit markets appears to destabilize relationships and reduces the availability of funds. In sum, we find that relationships are valuable and appear to operate primarily through quantities rather than prices.
Subsidized credit programs have been introduced in virtually every country in the developing world. These programs have mostly proved to be failures and large financial burdens have been imposed upon governments. Failure of credit market intervention can be attributed to incorrect understanding of the workings of the rural credit markets. These markets are strictly neither monopolies nor perfectly competitive. Credit markets are inherently risky because they involve a contract between two parties to be executed over time. Moreover, there is asymmetry in information between borrowers and lenders, and so cannot be completely replaced by formal markets. Some empirical evidence bearing on these issues, particularly relating to impacts of risk attitudes of market participants, is presented. It is argued that new institutional forms, including formal-informal linkages, could improve credit market performance.
Recent developments in the banking and bank lending literature have highlighted the significance of bank-corporate relations. This paper expands the concept of relations, and places the credit relationship within the broader context both of comprehensive financial service supply relationships and multiple bank-corporate relationships. The expanded concepts of relations are based on extensive case study research and are explored through the use of theoretical constructs. These concepts of relations are then used to investigate bank rationales for relationship banking and to identify enhanced research opportunities for the related bank lending research programmes.
The study analyzes the formation, development, contribution and management of small firms in the United Kingdom. It explores the differences that smaller firms and larger companies face in the business environment, and studies how far their success or failure depends on the wider economic climate. The analysis also examines different locations and the effect of small businesses on the outside community. The study of the internal organization of small companies includes discussions of employment, entrepreneurship, management strategies, organizational cultures, finance and the variety of challenges the small business owner faces in all these areas. Identifies five reasons for undertaking long-term research on small firms: 1) the small business sector plays an important role in employment creation, in innovation, and in the economy in general, which means that small business policy must be a part of social and employment policy, which requires long-term research; 2) the interests of the small business owner and those of society do not always coincide, and wider social and economic considerations need to be examined; 3) it is reasonable to devote a lot of time to research because reaching a judgment on policy requires careful assessment of high-quality evidence, and because reading historical accounts about small business reveals that many issues remain similar over long periods of time; 4) long-term research can provide an antidote to the ‘knee-jerk' policy making which characterized the small firm environment in the UK during the 1980s; and 5) researchers need to have an opportunity to make theoretical as well as empirical contributions. This analysis offers an overview of the small firm sector in developed countries. It discusses the problem of defining small firms and concludes that, no matter how they are defined, they constitute at least 95 percent of businesses in the European Community. The study examines the reasons for that - such as increasing unemployment and the lowering of the unemployment benefit - and the likelihood of the continuation of this trend in the future. Also examines facotrs influencing the birth rate, growth and death of small firms, their job creation potential, and financing concerns. Discusses the role of governments in promoting the small enterprise sector and in locating small firms within a wider economic and social framework. It articulates a need for a statement about objectives and targets for small firm public policy in the form of a government White Paper, so that targets can be identified and measured. The key findings are laid out to provide a basis for further action by small firms themselves, by financiers, and by governments. (AT)
The paper analyzes the structure of credit market equilibrium under imperfect information. Collateralization and credit rationing are compared as alternative means to cope with problems of adverse selection and moral hazard. It is shown that lenders may use collateral as a self-selection and incentive mechanism. Rationing occurs only if the borrowers' collaterizable wealth is too small to allow perfect sorting or to create sufficiently strong incentives. Whenever there is rationing in an equilibrium, some borrowers are charged the maximum amount of collateral.
Instrumental variable (IV) methods are commonly used in accounting research (e.g., earnings management, corporate governance, executive compensation, and disclosure research) when the regressor variables are endogenous. While IV estimation is the standard textbook solution to mitigating endogeneity problems, the appropriateness of IV methods in typical accounting research settings is not obvious. Drawing on recent advances in statistics and econometrics, we identify conditions under which IV methods are preferred to OLS estimates and propose a series of tests for research studies employing IV methods. We illustrate these ideas by examining the relation between corporate disclosure and the cost of capital.
Is the capitalist function distinct from the entrepreneurial function in modern economies? Or does a person have to be wealthy before he or she can start a business? Frank H. Knight and Joseph A. Schumpeter held different views on the answer to this question. The authors' empirical findings side with Knight: liquidity constraints bind, and a would-be entrepreneur must bear most of the risk inherent in his venture. The reasoning is roughly this: the data show that wealthier people are more inclined to become entrepreneurs. In principle, this could be so because the wealthy tend to make better entrepreneurs, but the data reject this explanation. Instead, the data point to liquidity constraints: capital is essential for starting a business, and liquidity constraints tend to exclude those with insufficient funds at their disposal. Copyright 1989 by University of Chicago Press.
This article examines the role of relationship lending in small firm finance. It examines price and nonprice terms of bank lines of credit extended to small firms. The focus on bank lines of credit allows the examination of a type of loan contract in which the bank-borrower relationship is likely to be an important mechanism for solving the asymmetric information problems associated with financing small enterprises. The authors find that borrowers with longer banking relationships pay lower interest rates and are less likely to pledge collateral. These results are consistent with theoretical arguments that relationship lending generates valuable information about borrower quality. Copyright 1995 by University of Chicago Press.
I. Introduction, 651.—II. The model of borrowing behavior, 652.—III. Lender and market behavior under competitive conditions,
658.—IV. Market solutions under monopoly, 663.—V. Conclusion, 664.—VI. Appendix, 665.
This paper shows that under plausible assumptions, the inability of lenders to discover all of the relevant characteristics
of borrowers results in investment in excess of the socially efficient level. Raising the rate of interest above the free
market level will restore optimality. This conflicts with generally held views and is contrasted with the Stiglitz-Weiss model.
It is shown that the assumptions which yield overinvestment support debt as the equilibrium method of finance. However, under
the Stiglitz-Weiss assumptions, used to derive an underinvestment result, equity is shown to be the equilibrium method of
finance.
We examine the relation between borrowing costs and the presence of loan collateral. We find the presence of collateral increases with default risk, consistent with low quality borrowers reducing their risks and borrowing costs through the use of collateral. By explicitly controlling for the interdependence between the decision to pledge collateral and borrowing costs, we find that secured loans have predicted spreads substantially lower than if they had been made on an unsecured basis. Alternatively, loans made on an unsecured basis have spreads not substantially different from if they had been secured. The evidence suggests that collateral pledging decisions are generally consistent with borrowing cost minimization.
This paper is designed to test whether the factors which affect the decision to collateralise business loans affect the level of collateralisation in the same manner. If the level of collateralisation does matter, the provision of collateral becomes more than a goodwill gesture to placate banks and more a device to ameliorate the risk of lending. We use a thitherto unseen dataset from a U.K. retail bank comprising 4,618 transfers and start-ups (TS group) who applied for business loans and overdrafts between January 1998 and January 2000. The control sample comprised 9,596 existing businesses from the same period. Our unique dataset permits an analysis of this kind for the first time because it contains a continuous variable for collateral unlike previous studies. Existing businesses exhibit a higher frequency (binary outcome) and level (tobit outcome) of collateral than the businesses who are start-ups or have transferred from another bank only when distortions within the data are not controlled for. These distortions negate the value of binary collateral variables. Factors such as business type and loan purpose are useful at explaining the likelihood of a borrower having his loan collateralised and the level of collateralisation for borrowers who provided collateral or not. Copyright 2002 by Kluwer Academic Publishers
This paper shows that long-term contracts can be used in competitive financial markets to separate entrepreneurs of different abilities. In equilibrium, poor entrepreneurs are financed with a sequence of standard-debt contracts. Good entrepreneurs are financed with a modified contract in which the terms of the second part of the contract are contingent upon whether default is observed at the first date. Sorting is achieved through the contingent term in the contract. In equilibrium, good entrepreneurs will typically pay high interest rates to start with, followed by relatively lower rates later if they are successful. The solution in the paper is contrasted with the use of collateral. Copyright 1991 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.
The past twenty years have seen great theoretical and empirical advances in the field of corporate finance. Whereas once the subject addressed mainly the financing of corporations--equity, debt, and valuation--today it also embraces crucial issues of governance, liquidity, risk management, relationships between banks and corporations, and the macroeconomic impact of corporations. However, this progress has left in its wake a jumbled array of concepts and models that students are often hard put to make sense of. Here, one of the world's leading economists offers a lucid, unified, and comprehensive introduction to modern corporate finance theory. Jean Tirole builds his landmark book around a single model, using an incentive or contract theory approach. Filling a major gap in the field, The Theory of Corporate Finance is an indispensable resource for graduate and advanced undergraduate students as well as researchers of corporate finance, industrial organization, political economy, development, and macroeconomics. Tirole conveys the organizing principles that structure the analysis of today's key management and public policy issues, such as the reform of corporate governance and auditing; the role of private equity, financial markets, and takeovers; the efficient determination of leverage, dividends, liquidity, and risk management; and the design of managerial incentive packages. He weaves empirical studies into the book's theoretical analysis. And he places the corporation in its broader environment, both microeconomic and macroeconomic, and examines the two-way interaction between the corporate environment and institutions. Setting a new milestone in the field, The Theory of Corporate Finance will be the authoritative text for years to come.
Most commercial loans are made on a secured basis, yet little is known about the relationship between collateral and credit risk. Several theoretical studies find that when borrowers have private information about risk, the lowest-risk borrowers tend to pledge collateral. In contrast, conventional wisdom holds that when risk is observable, the highest-risk borrowers tend to pledge collateral. An additional issue is whether secured loans (as opposed to secured borrowers) tend to be safer or riskier than unsecured loans. Empirical evidence presented here strongly suggests that collateral is most often associated with riskier borrowers, riskier loans and riskier banks.
Using a large random sample of U.K. start-ups and a rich data set, the paper demonstrates that human capital is the 'true' determinant of survival and that the correlation between financial capital and survival is spurious. Provision of finance is demand-driven, with banks supplying funds elastically and business requests governing take-up. Firms self-select for funds on the basis of the human capital endowments of the proprietors with 'better' businesses more likely to borrow. A reason why others have seemingly identified start-up debt gaps may be the failure to test a sufficiently rich empirical model. Copyright 1996 by Royal Economic Society.
This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. The authors analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. The authors find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple leaders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices. Copyright 1994 by American Finance Association.
Using a unique data set collected from financial statements of all Singapore listed firms from 1983 to 1991, we provide international evidence on the determinants of the amount of secured loans as a fraction of total secured and unsecured loans. This data set comprises a much wider range of firms than most previous studies. We show that consistent with the agency-cost hypothesis, firms with more growth opportunities use more secured loans. This is in contrast to the opposite result reported in Barclay and Smith (1995b) who measure secured debt as a fraction of total long-term fixed claims. We also find strong support for the hypothesis that smaller firms use more secured loans. In contrast, Leeth and Scott (1989), using survey data on small firms, find an insignificant firm size effect. Finally, we show that the use of secured loans is positively related to asset riskiness and loan size, and is negatively related to asset specificity. Firm quality has no explanatory power. Copyright Blackwell Publishers Ltd 1998.
This paper develops an occupational choice model in which entrepreneurs, who are initially uncertain about their true talent, learn from experience. As a consequence, both optimistic bias in talent beliefs and uncertainty diminish with experience. The model gives rise naturally to a heteroscedastic probit estimator of occupational choices, in contrast to the commonly used homoscedastic estimator. The model is applied to British data on self-employment and optimism for the period 1984-99. The empirical analysis supports the main propositions of the model: principally, entrepreneurs are found to be more optimistic than employees, and both optimism and uncertainty diminish with experience. Copyright (c) The London School of Economics and Political Science 2006.
The purpose of this study is to evaluate the information contained in static and dynamic inventory cash management models to predict failure in a sample of 41 small and middle-sized Finnish bankrupt firms and their nonbankrupt counterparts. The results indicate that the estimates of the (scale) elasticity of cash balance with respect to the volume of transactions (approximated by net sales) is significantly lower for the failed firms. Furthermore, only the scale elasticity appears to be a statistically significant discriminating variable, and only in the first year before bankruptcy. This estimate remarkably increased the Lachenbruch validated classification accuracy based on traditional financial variables. Copyright Blackwell Publishers Ltd 1998.
DoBinaryCollateralOutcomeVariablesProxyCollateralLevels?TheCase of Collateral Form Start-ups and Existing SMEs
- A Hanley
Hanley,A.(2002),‘DoBinaryCollateralOutcomeVariablesProxyCollateralLevels?TheCase of Collateral Form Start-ups and Existing SMEs’, Small Business Economics, Vol. 18, No. 4 (June), pp. 315–29
Are Business Startup Debt-rationed?', The Economic Journal
- R Cressy
Cressy, R. (1996), 'Are Business Startup Debt-rationed?', The Economic Journal, Vol. 106, No. 438 (September), pp. 1253–70.
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- Greene
Fraser, S. (2005), UK Survey of SME Finances 2004, Colchester, Essex: UK Data Archive [distributor]: SN 5326. ——— and F.J. Greene (2006), 'The Effects of Experience on Entrepreneurial Optimism and Uncertainty', Economica, Vol. 73, No. 290 (May), pp. 169–92.
Report of the Committee of Enquiry on Small Firms
- J E Bolton
Bolton, J.E. (1971), Report of the Committee of Enquiry on Small Firms, Cmnd 4811 (London, HMSO).
Entrepreneurial Finance
- J. K. Smith
- R. L. Smith