Standardising risk weightings, extending CCR to SMEs, and increasing data sharing are among the measures that the Productivity Commission has identified will improve credit availability for small businesses.
The Productivity Commission (PC)’s final report on competition in the Australian financial system, presented to the public on 3 August, identified a number of issues with SME lending, including the predominant use of residential property as security, higher interest rates, restrictive contract terms, and obscurity around fees.
These are exacerbated by the comparatively small appetites of banks to lend to small businesses, the report stated, as it’s considered riskier, costlier, and less profitable than residential lending, especially if the business has a limited financial history and no property to secure the loan against.
For example, based on data provided to the PC, the average return of equity over the last five years for residential lending was 7 per cent higher than for SME lending for one major bank and 4 per cent higher for another.
For lenders, residential property is an easily liquidated asset in the event of default, according to the PC, more so than commercial property as it’s often structured in line with the needs of a business and does not have the same “market depth”.
“Due to the low-risk weightings on home loans and high-risk weighting on commercial loans, it is more economic for banks to focus on using the family home as security for finance in preference to SME loans or commercial equipment finance,” the final report stated.
Further, the limited knowledge lenders might have of a business’ performance — due to less detailed financial reporting requirements and a business’ lack of financial history — as well as their lack of expertise in many of the industries in which SMEs operate make it “difficult” and “costly” for lenders to differentiate the actual risk of lending to a small businesses, the government advisory body said.
“Lending for housing to a large extent involves a formulaic approach based on the income and credit history of the borrower relative to the value of the property,” the PC stated in its final report.
“In contrast, SME lending typically involves an examination of the financial records of the business, an understanding of the market in which the business operates and an assessment of the character, skills and business experience of the business owner/s and often requires the skills and expertise of experienced loans officers.”
The PC also acknowledged the “strong incentives” for SMEs to secure business loans against residential property, including access to lower interest rates.
However, with home ownership in the “key entrepreneurial period of life” — that is, between the ages of 25 and 34 years — dropping by one-third over the last 25 years, “the continued emphasis on home ownership in Australia’s risk weighting system will increasingly inhibit SME lending”, the report stated.
Small businesses without residential property to use as collateral often have to rely on more expensive and restrictive unsecured finance, the government advisory body said.
“Interest rates for small business loans and overdrafts secured by residential property are around one to four percentage points higher than the interest rates applying to residential housing and overdrafts for large businesses,” the PC report stated.
Further, as of March 2018, the Commission reported that the interest rate gap between property-secured small business term loans and low-rate credit cards was more than 6 per cent and over 13 percentage points for standard-rate credit cards.
Taking a ‘granular approach’ to risk weightings to improve access to finance
The PC believes the difficulties new businesses experience in obtaining finance is reflective of the “lack of financial and trading information lenders have to assess the creditworthiness of the business, including the business and management skills of the owner(s).”
It acknowledged that better access to information about businesses seeking credit, especially new businesses — for example, through comprehensive credit reporting (CCR), open banking, and accounting software — should allow lenders to more accurately assess risk.
However, the PC believes the most effective measure for improving SME access to finance would be to change underlying prudential requirements for small business lending.
It noted that for SME loans, the Australian Prudential Regulation Authority (APRA) applies a single risk weight (of 100 per cent) to all unsecured SME lending, which means that local lenders are generally required to hold more regulatory capital than lenders using internal ratings-based models and more than that required under the internationally agreed Basel requirements.
“This approach to risk weights skews competitive opportunity away from consumer interests and provides strong incentives for both lenders and SME borrowers to secure a business loan with a residence as collateral,” the PC report stated.
“More generally, it creates a strong preference for home loan lending over business lending (unless secured by residential property).”
The government advisory body recommended that regulators such as APRA adopt a “more granular approach” to risk weightings for SME lending. It said the prudential regulator should provide a schedule of risk weights that take into account the range of loan products provided, the risk profiles of different small businesses, alternative forms of security (such as commercial property), and various loan-to-value ratios.
The increasing number of fintech lenders was recognised by the PC as a positive for competition in the SME lending space, which is 80 per cent dominated by the major banks, as well as a positive for SMEs that need additional finance options.
The PC also acknowledged the Reserve Bank’s argument that “the small business market could most benefit from foreign entrants at present” given the limited risk appetite for SME lending in an era of increased regulatory scrutiny.
“However, where SMEs require the physical presence of a branch or rely on their lender for other products such as point of sale terminals, the large banks will likely retain much of their advantage,” the report noted.