Importance of Basel III for lending alternatives to SMEs

Contents

1. Introduction

2. Lending Alternatives
2.1. Leasing
2.2. Factoring
2.3. SME-Bonds
2.4. Asset-Backed-Securities

3. The Importance of Basel III for Lending Alternatives to SMEs
3.1. A short introduction to Basel III
3.2. How Basel III may influence Leasing and Factoring
3.3. Access of SMEs to Finance
3.4. Riskiness of the Leasing and Factoring Business

4. Conclusion and Prospect for the Leasing and Factoring Business

1. Introduction

Basel III is currently on everyone’s lips. Some weeks before the introduction of the first requirements it is still not fully clear how and which parts of it will be implemented. Several studies about the impact of Basel III on bank loan availability for small and medium sized companies (SMEs^[1] ) do exist (e.g. McKinsey (2010)) which have shown that the introduction of those new regulatory requirements hamper the access for SMEs to sufficient sources of funding. This raises the question if these restrictions for bank lending can be substituted by some alternative funding source or if the availability of external finance to SMEs will be constrained under Basel III. This seminar paper focuses on the lending alternatives apart from bank loans and the possibility of gathering additional equity capital. This is basically the so called asset based finance. Thereby the paper concentrates on European SMEs as long as their conditions are quite similar to those of Austrian SMEs and the introduction of Basel III can be expected to be most strict for European financial institution and thus may hit those SMEs the most.

Before starting with the explanation of different lending alternatives the importance of SMEs for the global economy should be pointed out. The importance is especially present in Europe. SMEs account for two third of the total employment in the EU-27 area and they generated more economic growth from 2002 to 2008 than large firms did (Oxford Economics, 2011). Moreover they represent 99% of all businesses that exist in Europe (European Commission, 2005). So SMEs are the main driver of economic growth, employment and wealth in Europe. Apart from that each single SME does not have a systematic risk and they were also not responsible for the current financial crisis. Thus SMEs should generally be supported to sustain growth and employment. Nevertheless the rules of Basel III may have highly negative influences on their financing possibilities which moreover has a negative effect on the real economy.

This seminar paper is structured as follows. In section 2 the the most important lending alternatives are explained. Section 3 is concerned with the main part of this seminar paper. After a short introduction of Basel III rules two different ways are described in which lending alternatives are affected. Furthermore the access of SME to finance and the riskiness of the leasing and factoring businesses is investigated. Finally section 4 gives an outlook for the business of lending alternatives and concludes the whole topic.

2. Lending Alternatives

2.1. Leasing

Leasing is presented first as the probably most important lending alternative especially for SMEs. The idea behind leasing is very simple. The asset is not bought by a firm directly using its own cash or a bank loan. Instead the asset belongs to a leasing company called Lessor which “lends” the asset to a firm for usage (the lending company is called Lessee) over a certain period of time. The Lessor receives a regularly payment as a compensation (see Brigham and Erhardt, 2005). Many different types of leasing contracts do exist with various specifications. Leasing is mainly differentiated between operating and financial leasing^[2]. It is not necessary to list all possible configurations here. Instead the most relevant aspects should be mentioned. The usage of leasing has a positive impact on the balance sheet and thus the rating of a company improves by lowering its leverage ratio in contrast to lending. This is simply because the firm does not increase its debt which it otherwise would do by using a bank loan. This balance sheet effect is only present if the leased asset doesn’t have to be balanced by the Lessee. If one of the following criteria is fulfilled the asset has to be balanced by the Lessee (Müller et al. 2011):

- Lessee owns the asset < 40% or > 90% of the total usage time
- Buying Option: Price < residual book value (linear depreciation)
- Rental-Extension-Option: Rental charge < depreciation (linear)

Nevertheless contracts may be designed in the right manner anyway if the asset should not be balanced by the Lessee. This accounting benefit of leasing may be the most intuitive aspect, but apart from that leasing offers some other positive effects that are valued by European SMEs to be even more important. On top of the aspects for the usage of leasing is pricing according to a survey contacted by Oxford Economics in 2011. The lower price can be explained by various aspects like lower default rates and higher recovery rates for the business leasing which will be explained in more detail later on. Afterwards European SMEs see tax benefits on second and liquidity management on fourth place. Tax benefits can actually not be seen as an advantage in comparison to bank loans as long as both, bank loan repayments and leasing rates can be deducted from taxable profits. The third crucial aspect is that leasing does enable to finance 100% of the asset price without requiring additional collateral (Oxford Economics, 2011). This is especially valuable for start-ups or very small firms, so called micro firms^[3] which don’t have the resources to put in additional guarantees. Furthermore leasing can shift the risk of possible value losses of the asset from the Lessee to the Lessor. This is intensely important when a firm buys an asset which is not commonly used by them and thus the estimation of future value of the asset may be very uncertain and risky.

So now that we have seen what leasing is and what its main benefits are the question is whether leasing is anyway important for European SMEs or not? The answer is clearly yes. At about 40% of all SMEs use leasing in some way which is really high in comparison to other finance types. This can be seen in Figure 1. It is less used by micro firms with 28% and more used by medium sized firms with 53%. This is caused by the fact that smaller SMEs generally use less external financing sources. Leasing has a proportion of total investments (called penetration rate) done by European SMEs of 16.7% in 2010. This rate was at the time of publication of the survey expected to even increase to 18.6% in 2011. Whereby the penetration rate is very similar across Europe except of Nederland’s having a much lower rate at about 6%. This proportion of investments is distinguished for different sectors where it is most used in the transport and storage sector and least used for agriculture. Moreover the rate is equal to the usage proportion much lower for micro firms than for medium sized companies. In comparison to other forms of financing leasing can be stated as being very important for SMEs and is often used.

Investment by Funding Type by SMEs

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Figure 1: Investment by Funding Type by SMEs in 2010

Source: Oxford Economics (2011)

Cash and Equity has the highest penetration rate with 39.4% and bank loans the second highest with 28.3%. 13.8% account for other debt. So leasing is nearly as substantial for SMEs than bank loans. Apart from that the average investment financed by leasing is much lower with €60,000 compared to the average investment for all finance types with €358,000. It should also be noted that SMEs account for 52% of the total leasing business in Europe at 2011 (Oxford Economics, 2011).

Moreover the usage of leasing varies across different asset types and thus across different branches. Leasing is used the most for cars, machines, IT equipment and a little surprising also for real estate. Based on that leasing is especially important for such companies which heavily use these kinds of assets. For example a cab company or a software firm may be able to finance most assets via leasing whereas this may not work for hospitals since medical equipment is financed most seldom via leasing (Oxford Economics, 2011). As a conclusion of all these statistics it can be stated that the leasing business is not only important for SMEs, SMEs are also very important for the leasing business.

Except for all these nice numbers which should have clearly shown that leasing is important for SMEs another crucial topic is how substantial leasing will be in the future and how severe leasing does and can influence economic growth. According to Oxford Economics the penetration of leasing on GDP growth lies between 0.1% and 0.15% per year. So the economic growth is increased by leasing at that rate each year. How much it actually is depends on different economic scenarios. Based on an assumed average GDP growth in Europe of 2% each year this is a really significant impact. So for scenario 1 the penetration rate of leasing is assumed to increase from 16.7% to 18.6% holding the amount of investments financed by other sources constant. This results in a higher GDP growth per year of 0.1%. In other words if investments financed by leasing is increased at 11.3%^[4] that additional economic growth can be realized (Oxford Economics, 2011).

This shows that leasing does already substantially support the real economy. Moreover leasing is especially important to SMEs which are the main driver of economic growth and wealth in Europe.

2.2. Factoring

Apart from leasing factoring is also an important source of finance for SMEs and thus can be seen as an alternative to traditional bank loans. This section describes factoring together with its pros and cons in more detail.

All kind of businesses in various sectors have partially thousands of different customers. In most cases they don’t have to pay their goods immediately after buying it. Especially regular customers have sometimes long periods of payment. As a result this can create large outstanding claims from customers which have to be financed in some way. This can especially be difficult for SMEs as their excess to funding sources is more limited. At this point factoring comes into play which sells the claims of customers prior to its maturity to a so called Factor. Again there are several varieties of factoring but I won’t go into detail here. Albeit this paper focuses on several positive and negative aspects which can arise for a company selling its claims (called factoring firm) (see Brigham and Erhardt, 2005).

The most important aspect of factoring especially for SMEs is liquidity. Hartmann-Wendels in 2012 asked 265 companies with a yearly turnover of less than € 10 million which are the most important aspects for their usage of factoring. 95.1% of these companies considered liquidity as being important for their decision whether to use factoring are not. This supports the general idea of factoring to sell claims prior to its maturity to get liquidity which can then be used for other business activities. This also increases the cash turnover and thus should raise profitability. On second place with 57% is the independence from banking institutions. This is especially important for SMEs as many of them gather their bank loans only at one institution, there house bank, which is than partially able to exercise some pressure onto the corporate issues of the company. Moreover this problem is more relevant for European companies as they traditionally rely more heavily on bank loans than companies of other continents. This negative influence of banks on corporate issues can be avoided by using factoring. Furthermore the shift of risk onto the Factor and thus a protection against defaults of customer claims is seen as very important. One aspect that is often stated in literature as the probably most crucial point is the improvement of rating or the balance sheet effect. Though only 26.8% of these small companies consider this aspect at their decision, so far less than we could have expected according to theory. The mechanism of the balance sheet effect is again quite simple. Factoring reduces debt and thus the rating is improved. This may lower the interest payments on new or existing debt or even make additional financing possible which would otherwise not have been. This may lead to higher business activities and so on. The balance sheet effect may not be considered that much because very small companies usually focus on their core business and are not really concerned with their financing structure until they get into trouble and have to think about it. This is also supported by Hartmann-Wendels. He also asked large companies about their motives to use factoring and 56% of them, so more than double in comparison to small companies see the balance sheet effect as being important (Hartmann-Wendels, 2012a).

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^[1] SMEs are defined by the European Commission as having ≤ 250 employees and annual turnover ≤ € 50 million or annual balance sheet total ≤ € 43 million. For further details see European Commission (2011)

^[2] for more information about various leasing types see Müller et al. (2011) and Brigham and Erhard (2005)

^[3] Micro firms have < 10 employees and an annual turnover < €2 million. Small firms have be< 50 employees and an annual turnover < €10 million (European Commission, 2005).

^[4] Represents the increase or penetration rate from 16.7% to 18.6%