By Zheng Xingchen

Research Report Vol.18 No.2, 2016

As it is a common concern that small and micro businesses have difficulties in financing, regulators have taken a series of policies and measures to promote banks to grant them loans. Local governments and financial institutions have been studying innovative service models and mechanisms. To uproot the problem, it is vital to make it easier for banks to grant loans and make innovation in the risk control model. At the critical stage of economic transformation and upgrading, China calls for financial support to boost mass entrepreneurship and innovation. Innovation in the credit business mechanism for small and micro businesses helps boost economic transformation and upgrading.

I. Financing Difficulties Are Attributed to Banks’ Lack of Understandings of Small and Micro Enterprises

The difficulty for small and micro enterprises to get funding at high cost, on one side, is the difficulty for banks to lend money on the other side. Based on the current credit business model in banks, it is difficult to guarantee loans and apply for loans with collateral, including arduous lawsuits concerning the disposal and liquidation of collateral.

The problem reflects the fact that banks are so dependent on collateral when offering loans to small and micro businesses that the current risk control model needs to be improved. Why is such high dependence? Because banks, before issuing loans to small and micro businesses, fail to collect their accurate and effective key information as follows. The first is about their financial situation. Banks generally complain about their incomplete and inaccurate financial statements as well as different versions of account books with low credibility, which make it impossible for banks to get to know the financial situation of such businesses, including profits, investment benefits, and cash flow, or evaluate the reliability of the first source of repayment. The second is about the actual owners, who, with a decisive role in business, will lead to tremendous credit risks, should they are addicted to bad habits like gambling or have serious disputes within their families. Banks only have limited channels to get to know the actual owners, let alone affecting their behaviors. The third is about the state of business. Unlike large-sized enterprises, small and micro ones are weaker resisting risks and more likely to be knocked out of the market in their early development. Therefore accurate information about their operation is crucial for credit risk control. Under the traditional risk control model, banks can hardly know about the operation of small and micro businesses, especially the production and sales.

As banks get no key information of small and micro businesses, there will be a lose-lose situation for both sides as well as systemic adverse effects.

1. Pressure from non-performing loans

If banks cannot get true information about the financial situation, operation, investment returns and cash flow of small and micro businesses, credit management will face plenty of uncertainties, with a number of credit risks. For enterprises unable to repay loans, even they pledge real estate like commercial real estate property, banks are bound to suffer from loss, because of the complicated, time-consuming and expensive law-based process of disposing mortgage assets. However, as banks fail to know about small and micro businesses and unable to decide who can repay and who cannot, they can only grant loans by raise the bar for collateral, and cannot exclude risky clients without stable ability to repay. Therefore the effect of risk control is far from satisfying.

Banks can better control risks and reduce the ratio of bad loans, should they are able to pick out small and micro businesses with stable ability to repay and grant loans based on their repay ability.

2. High financing cost for enterprises

Banks, for stable and sound development, require that risks should be controllable. As the first source of repayment is not secured, banks, without accessto key information of small and micro businesses, will ask for higher credibility to avoid risks. For example, small and micro businesses without collateral must seek guarantee, otherwise they cannot get loans. Under the current regulatory model, financing guarantee companies face a high cost of using capital and great business risks, causing a high cost for small and micro businesses to get guarantee and even loans. As a matter of fact, private financing guarantee companies only provide limited services due to the high operation cost, so small and micro businesses guarantee each other to obtain bank loans. Nonetheless, negative effects from doing so result in higher cost for enterprises to get guarantee.

Small financing companies, though tolerating more risks than banks, consider risk premium when determining the loan interest rate and have a high cost of using capital, thus leading to high loan interest rates.

This means small and micro businesses, though well-run, have to pay extra risk premium or even fail to get loans, because banks cannot get to know about these businesses and their first source of repayment cannot be approved. As a result, small and micro businesses have a high cost of financing.

Banks, if with sufficient information about small and micro businesses, will distinguish those with stable first source of repayment and lower the bar for collateral and guarantee, which, for one thing, can expand market and increase profits by offering loans to those well-managed enterprises without much collateral, and for another, create more favorable conditions for such enterprises to get guarantee and lower their financing cost.

3. A number of regional financial risks

Small and micro businesses will guarantee each other, as banks lack confidence in their first source of repayment, such enterprises lack collateral and difficulties abound in financing. Regionally speaking, mutual guarantee among enterprises fails to reduce risks in general or for individuals, but, on the contrary, causes serious Domino effect, namely, there will be much more regional financial risks as one risky enterprise affects many other well-run ones.

From the perspective of banks, every enterprise is guaranteed by another, the source of repayment, and forced repayment through judicial means is feasible if necessary. With the slowing economic spurt and unsatisfying business operation, however, banks hardly get repayment from guarantors through lawsuits. On the one hand, banks call in loans ahead of the scheduled time, which severely affects enterprises, employment and social stability; on the other hand, banks will suffer from more bad loans, a lose-lose situation.

For small and micro businesses, they have no choice but to guarantee each other, which, nonetheless, lead to the fact that bad lenders drive out good ones. Well-managed enterprises may, at any time, repay loans and endure risks of inferior ones, but fail to regulate their operation. Such a mechanism embeds serious moral hazards, therefore bad lenders will drive out good ones and enterprises in the same region will face more risks.

II. Main Reasons for Information Asymmetry

1. Financial statements of small and micro businesses are not standardized

Banks usually get to know the liability and operation of small and micro businesses based on their financial statements which are not well prepared following the standards. That’s why both sides have asymmetric information. Reasons are as follows. First, small and micro enterprises are reluctant to disclose some key information, and financial statements are not professionally audited. Many banks complain about different versions of financial statements in enterprises, making it difficult to get to know the true situation. Second, such enterprises have limited human resources, unable to provide high-quality financial statements. The smaller enterprises are, the less likely their financial statements will be standardized with complete information. ...

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