2008-52
Influence of Intellectual Capital Information on Credit Risk Rating
Process/Criterion and Credit Conditions- Survey Analysis to Japanese Financial Institutions
Tadanori Yosano Chitoshi Koga

Influence of Intellectual Capital Information on Credit Risk Rating
Process/Criterion and Credit Conditions- Survey Analysis to Japanese Financial Institutions
Tadanori Yosano
Associate Professor, in Graduate School of Business Administration of Kobe University, Japan,
yosano@kobe-u.ac.jp
Chitoshi Koga
Professor, in Graduate School of Business Administration of Kobe University, Japan,
koga@kobe-u.ac.jp

1. Introduction
Intellectual capital is becoming increasingly important as a propellent or value driver for economic
activation. Lenders are increasingly paying more attention to not only resources of production suchas land, building, and machine/equipment, etc, but also intellectual capital including the businessmodel, the executive skill which practices it, knowhow, superiority of technology, relationship withcustomers/suppliers, are growth drivers of the firm. This trend suggests a qualitative conversion
from a past credit rating style which highly weighs the mortgage value of security required, to the
new financing form which fully accounts for intellectual capital to the financing of lenders.
Especially, a drastic conversion will be needed in the relationship banking of small /medium-sized
and regional financial institutions, whose main clients are small/medium-sized enterprises. This
trend was clearly described by the Financial Services Agency in their “General supervisory guidance
for small/medium-sized and regional financial institutions” (FSA guideline, July 2008). The
guideline emphasized the need for improvement in the ability to evaluate the importance ofintellectual capital.
Against such a background, the “Organization for Small & Medium Enterprises and Regional
Innovation, JAPAN” (SMRJ) set up a working group for financing based on the intellectual capitalof small and medium-sized enterprises under the committee for management of intellectual capital ofsmall and medium-sized enterprises. The SMRJ carried out survey, and analyzed the credit valuationin financing judgments, especially for small and medium-sized enterprises, which are of the mostconcern to the managers of such enterprises. Questionnaires were sent to all lenders in Japan (575financial institutions: responses [76.3%] returned by 6 commercial banks [100%], 42 regional banks[65.6%], 34 second regional banks [93.3%], 243 credit unions [86.2%], 99 credit cooperatives[68.3%], and 4 other financial institutions [12.1%]). The results and analysis of the survey werereported in the “Investigation research business for the use of intellectual capital by small andmedium-sized enterprises – a chapter of the investigation and research of financing based on1intellectual capital” (SMRJ report, September 2008). Firstly this paper reports on the realities
concerning the use of non-financial information, where main information are composed byintellectual capital, in the financing judgment of the small and medium-sized enterprises by lenders,
especially from the credit risk rating process/criterion points of view, based on the SMRJ report,
September 2008. Secondly this paper reports which intellectual capital information have a real
impact on financing decisions/credit conditions of given facilities, such as interest rate offered,amount granted, the length of financing, and mortgage value, based on the SMRJ report, September
2008.

2. Financing decision process of financial institutions -Statistics model vs. Judgment model
It is thought that the credit risk rating system of the financial institution is extremely varied andstrongly reflects characteristics or “credit culture” of individual financial institutions. In thefinancing judgment, some financial institutions attach great importance to a “Statistical model”
which primarily focuses on quantitative information, such as the financial index analysis and theadjusted balance sheet analysis, etc. Other financial institutions make decisions based on “Judgment
model” which primarily focuses on qualitative information, such as internal/outside businessenvironment, stake-holder information, history and track record of the firm, and strong/weak pointsof the business. The criteria and processes of credit risk rating of each financial institution differ
greatly, when in the financing judgment. In fact, it is thought of as a very wide spectrum, at one endof which are the “Statistical model,” types, and at the other, the “Judgment model” types (Morck etal, 2003, pp. 20-21).
The ratio of the use levels of non-financial information vs. financial information varies greatly, andis reported to be 72:28 on average [SMRJ report, September 2008, Table 1]. In fact, 293 financial
institutions (83.3%) are using non-financial information at a weight of 20% or more. The use ratio‘about 28%’ of non-financial information falls below use ratio (35%) of non-financial information as
in decision making for stock investment, which ratio was reported in the survey analysis toinstitutional investors in E.U. and U.S. (Mavrinac and Siesfeld, 1995, p. 13). Taking into
consideration the fact that the reward of financing is constant (interest income) and therefore the risk
financial institutions can take is limited, and this is totally different from the volatile reward of theinvestment by the investors, the use ratio of 28% in “conservative” credit risk rating is considerably
high. This ratio might reflect the current economic circumstances, in which financial institutions arebeing encouraged to convert into the financing style which focuses more on the ability to judge theborrowing firms’ intellectual capital.
9 financial institutions, 2.5% of the sample, whose standing point is nearest to one end of thespectrum, the “Statistical model” (100:0), explain the reasons why they stand there are the:“difficulty in evaluating” and “exclusion of arbitrary use of” non-financial information. 27 financial
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institutions, 7.6% of the sample, stand near other end the spectrum, the “Judgment model,” and value
the non-financial information more or to at least the same level as financial information. Somefinancial institutions (40:60) said that “Information not seen in the financial information isabundant.” Others (30:70) explained that “The company is small, and the shortage of or reliability offinancial information prompts the valuation of non-financial information.” Here, we understood thatthe subjective judgment of qualitative information that centers on intellectual capital is very
important, especially for the regional bank, the credit union, and the credit cooperative, whose mainclients are small and medium-sized enterprises, and whose business models are based on regional
relationship with clients.
All financial institutions, except for second regional banks (23.8%), use about 30% of non-financial
information when in financing decisions [commercial banks (27.5%), regional banks (28.2%), credit
unions (28.0%), and credit cooperatives (28.9%)] (Table 2), and there were no remarkabledifferences between type of financial institution.
[Table 1][Table 2]

3. Credit risk rating process/criterion of financial institutions
The credit risk rating process in the financing judgment of financial institutions can be seen in Figure
1, from the aspect of the assignment and use of the rating points of view. Figure 1 was illustrated
based on Treacy and Carey (1998, p. 910, Diagram 1) and Chapter 1.1 (“The result of hearing
investigation of 7 financial institutions”) of the SMRJ report.
The process of assignment of rating includes (1) factors considered in rating, such as both financial
information (sales-current profit ratio, cash flow, the length of debt redemption time remaining, etc.)
and non-financial information(strong/weakpoints of the industry,

management,andcustomers/suppliers, etc.), and (2) ratings criteria which consist of written/formal elements andsubjective/informal elements (cultural). We assume that the latter is based on the “credit culture” ofeach financial institution as the knowledge form is not formally written in the banks’ own manuals(Treacy and Carey, 1998, p. 910; Morck et al, 2003, p. 19).
[Figure 1]
In the SMRJ report, it is confirmed that the majority of 50.1% financial institutions are collecting
non-financial information by using a fixed form of hearing or check sheet. The typical name of thehearing or check sheet is “Client management table,” “Input table of qualitative information forcorporate rating,” and “Informal decision sheet in the credit risk ranking system,” etc (pp. 31-32).
There is no standard, formal, universal form for the checking sheet used by all institutions.
Institutions which use one, make and fix their own, and use fix their own criteria and guideline, for
the usage of the forms and how the information included in the forms is used in making financial
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decisions. Almost all 95.5% financial institutions have an internal rule for a fixed form of hearing
sheet, etc (p. 32). Among these cases, 80% of financial institutions standardize/systematize andmanage a ruled fixed form of hearing seat, etc (p. 33). We conclude that financial institutions, whose
fixed form of the hearing sheet, etc is ruled, systematically manage non-financial information on
average. In the next section, we discuss which intellectual capital information is used morepositively for the financing judgment, and whether financial institutions prepare written/formal
rating criteria of non-financial information.

4. Fixed internal criterion/guidelines for evaluation of non-financial information
Table 3 shows to what degree financial institutions take into consideration –non-financial
information when in financing decisions (1= “Do not value at all”, 5= “Considerably value” by fivelikert-type scale) for 54 non-financial items in line with the SMRJ report categories, including
manager (13), internal/external business environment (3), business contents (6), customers/suppliers(9), employees (6), basis of organization (14), and risk management/governance (3). Table 4 shows
the positively significant differences compared to the average levels of evaluation for financial
institutions using or not using a fixed form of hearing/check sheet. Out of 54 items, 24 werepositively significant. The table also shows the difference between the users and non-users, ofhearing/check sheet, and the results are ranked by this difference.
[Table 3][Table 4](1) “Basic management philosophy” and “Outline of business character”“Guideline for Disclosure of Intellectual Assets Based Management” (GDIABM), issued by Ministryof Economy, Trade and Industry in Japan (METI) in October 2005, attaches importance to “showing
the overall picture of corporate management from top manager’s eye in a story” (chapter 2-2), andillustrates the description of the main story as “basic management philosophy” and “Outline ofbusiness” from general points of view, and as “management policy/visions of the past” and “pastinvestment performance” from ‘past to present’ points of view (Figure 3). Table 4 suggests that
financial institutions, which prepare the fixed form of hearing/check sheet for non-financial
information, make great account of “business model” in financing judgment, where the difference
from the average is the highest (0.18 points). Table 4 also shows other significant difference, such as“business schedules” (0.11 points) and “management philosophy” (0.09 points). On the other hand,“history and track record of business” was the 9th highest valued item [3.85] in financial judgments,
by financial institutions both using the hearing/check sheet, and not using it, might not be relatedwith fixed criterion/guideline.
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“Basic management philosophy” is shown to be by the ability to instill the use of the overall pictureof corporate management by many employees, such as “capability of management” (evaluationlevel=3.93), “the ability to make a plan/idea” (3.36), “leadership” (3.49), “character of management”(3.78), “age of top management” (3.47), “career in the sector” (3.35), “career of management” (3.41),“networks of management” (3.25), “health condition of top management” (3.61), “concentrationlevel of the business” (3.37), and “publicity activities” (3.08). Table 4 suggests that financial
institutions which prepare the fixed form of hearing/check sheet for non-financial information, put
the greatest importance on “capability of management” (highest in the above list) in financing
judgment, where the average level is 0.10 points higher than that of the financial institutions that
don’t prepare the fixed form. Table 4 also shows the significant difference for “career in the sector”
and “the ability to make a plan/idea” (both 0.11 points). Moreover, “successor's presence” (3.95) is a
powerful means for small and medium-sized enterprises to elect able leaders continuously, andalthough this might not be related with the fixed criteria/guideline, its evaluation level isconsiderably high (4th of 54 non-financial items) in the decision making of financing.
To recognize the “Outline of business character,” it is important to understand the status ofproducts/services, customers/suppliers, and supply chain, including upstream and downstream
parties, in the main business. As for the products/services, the SMRJ report listed “superiority andbrand of products/services,” (evaluation level = 3.68), “profit margin of products/services,” (3.81),
and “superiority of the main business” (3.84). As for customers/suppliers and supply chain, the
SMRJ report listed “customers and their status” (3.63), “suppliers and their status” (3.42),“relationship with customers” (3.41), “relationship with suppliers” (3.30), “customer satisfaction”(3.32), and “sales promotion/advertising campaign activities” (3.12). Table 4 also suggests that
financial institutions, which prepare the fixed form of hearing/check sheet for non-financial
information, put great importance on “superiority of the main business” and “superiority and brandof products/services” in financing judgment, where the evaluation level averages are 0.11 and 0.10
points higher than that of the financial institutions that don’t prepare the fixed form. Table 4 also
shows significant differences, such for items “customers and their status” (0.16 points), “suppliers
and their status,” “the relationship with customers” (both 0.12 points) and “the relationship with
suppliers” (0.1 points). We found that this non-financial information regarding external negotiation
power/relationships leads to the utilization when the financial institutions prepare the formal
criterion/guideline.
To grasp the “Outline of business character,” it is important to understand the status of the mainmarket and relationship with the competitors, as an outside environment over the main business. As
for this understanding, the SMRJ report listed “market share/position in the sector” (evaluation level=3.53 points), “business climate/sensitivity” (3.80), and “status of competitors” (3.73). Only
“business climate/sensitivity” shows the difference of the evaluation level of 0.10 points, when5

financial institutions prepare the fixed criterion/guideline.

(2) Unique intellectual assets and strength/value creation method based on themIn the next section of the general perspective of “Basic management philosophy” and “Outline ofbusiness characteristics,” GDIABM illustrates “management policy in the past,” “investment basedon that policy,” and “unique intellectual assets accumulated in the firm, strengths/value creation
method based on them,” from the ‘past to present’ perspectives. Firstly, we could list “superiority oftechnologies,” (evaluation level =3.85), “intellectual property (rights)” (3.44), “corporate brand”(3.32), and “status of research and development” (3.26), of non-financial items in the SMRJ report.
“Corporate brand” and “status of research and development” show the difference of the evaluationlevel of 0.15 points, each, when financial institutions prepare the formal criterion/guideline, thoughboth items’ evaluation level are not high (below the average of all 54 non-financial items).
Moreover, as for non-financial information which express organizational power (collective strength)
and solidarity as a unity of individual capacities, we could list “the number of employees”(evaluation level =3.13), “average age of employees (year to year)” (2.95), “turnover ratio” (3.04),“incentive system” (2.77), “know-how” (3.23), “holders of qualifications/technologies” (3.24), as foritems concerning employees, and “the number of branches” (2.99), “smoothness ofmanagement-labor relations” (3.09), “in-house improvement proposal system/the number of
improvement executions” (2.87), “personnel evaluation system” (2.81), “enhancement level ofcorporate education” (3.03), “situations of introduction of the IT system” (3.06), “in-housemechanism” (3.28), “support system of the parent company” (3.66) and “affiliates” (3.88), as foritems concerning the teamwork/organizational knowledge and base. Generally, the evaluation levelin financing decision is low for these items, except for “support system of the parent company” and“affiliates,” which is consistent with the low evaluation level for the items relating employees andquality assurance when financial analysts evaluates the small and medium-sized enterprise(Sakakibara, Hansson and Yosano, 2005, p. 8). However, “in-house mechanism,” “the number of
employees,” and “smoothness of management-labor relations” shows differences of the evaluationlevel for 0.16, 0.12, and 0.11 points respectively, when financial institutions have the fixed
criterion/guideline, as well as “support system of the parent company” and “affiliates” show thedifference for 0.17 and 0.14 points respectively.

(3) Identification of future uncertainty/risk
Following the section of ‘past to present’ perspectives, GDIABM shows the importance of“identification of uncertainty factor for future profit” and “how to manage and deal with future
uncertainty/risk (method and system of risk management),” from the ‘present to future’ perspectives.
As for non-financial information, which is related to the capital cost that has much effect on future6

profit, we could list “presence of main financial institutions” (evaluation level=3.86), “financing
from another main financial institutions” (3.96). As for the items concerning the risk
management/compliance system, we listed “risk management of information leakage” (3.34), “legalrisk management” (3.60), and “compliance system” (3.64). Here, “legal risk management” and“compliance system” are valued to a higher degree 0.16 and 0.10 points respectively, on average,
when financial institutions prepare the fixed criterion/guideline of non-financial information.

4. Application mechanism of credit rating criteria
Figure 2 is a concept diagram to show how to control and validate “credit rating process/criteria” and“quantitative loss characteristics of financing” (When the financing was executed, what loss,
including any loss in event of default and the probability of default were multiplied, is expected)
when the financing was decided. Controls and validation are practiced by the incentive and training
system in the financial institutions.
[Figure 2]
The SMRJ report shows that the collection of non-financial information and the skill improvementof financing and reviewing were attempted by at least 40% of financial institutions; using aninternal/external seminar, in each main section [marketing, financing, and reviewing]. Moreover, an
external educational institution has been used in about 30% of financial institutions. 15% of financial
institutions internally shared their knowledge in the shape of a document through in-housemagazines etc; This is considerably less than the former two incentive/training systems (Table 5).
[Table 5]

5. Intellectual capital and framework of credit risk analysis
The basic attributes of credit risk of loan or other exposure over a given period involves “probabilityof default; [PD],” and “loss in the event of default; [LIED].” “Probability of default” is theprobability that the borrower goes into default. “Loss in the event of default” is the portion ofamount granted if the borrower goes/faces bankruptcy and financial institution cannot collect. The“expected loss; [EL]” is the product which is “probability of default” being multiplied by “default
loss”[PD*LIED=EL].

The

conceptof lossinfinancingdecisionsis classified

asone-dimension/two-dimension model by the interview investigation to large banks in U.S. (Treacy
and Carey, 1998, pp. 899-900). 60% of large banks adopt a one-dimensional rating system, in which
the rating is assigned to a given facility. Here, EL is approximately the scale of this dimension. The
remainder, 40%, adopts a two-dimensional rating system, in which one-dimension is assigned togeneral creditworthiness, the other is to the exposure risk of a facility. Here, PD is approximately thescale of one-dimension, and EL is approximately the other.
Thus, two attributes, “probability of loss” and “default loss,” lie in the basis of the concept of loss.
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Intellectual capital is the nexus of knowledge systems which are the resources of value creation. It
include intellectual property rights (legally recognizable rights, such as patents, trademarks,
programme copyrights, etc), and intangible competences/latent faculties (not legally recognizable
assets, such as employee training programmes, incentive systems, channels of distribution, capabilityof management, the ability to make a plan/idea, etc). Intellectual property rights, which include legal
rights, could be grasped from the expansive view points of mortgage financing, where the value liesin the proprietary rights, such as traditional tangible/financial assets. On the other hand, the“intangible competences,” which are represented by incentive systems and the channels of
distribution, and the “latent faculties,” such as the ability to make a plan/idea and corporate culture,
could be grasped as the influencing knowledge to the capability of the borrower to generate future
cash flows. Therefore, we could understand that the ‘improvement of the ability to evaluate
intellectual capital’ needs the perspective which relates the “probability of default” to the firm’s
capability to generate future cash flows.

6. Previous research of intellectual capital information and credit conditions of lendersIntellectual capital report [IC report] is regarded as a communication tool for financial institutions toaccelerate an understanding of the “intangible competences” and “latent faculties” of the borrowing
firm, which are a value driver of the firm’s competition, and reinforce a credit rating positively.
Guimon (2005) is the first research to investigate whether IC report has an impact on the credit
conditions of a bank or not. He interviewed 12 experienced credit analysts of Banco Santander
Central Hispano (BSCH), where the market share and size (market value) is top ranked in Spain, andinvestigated the influence of intellectual capital information to credit conditions [interest rate,
amount offered]. In his laboratory research procedure, credit analysts firstly decided the credit
conditions from the annual report and the business schemes of a given facility of a virtual company.
Secondly, they could reconsider whether to change their financing decisions after reviewing
additional an IC report thoroughly. The style of IC report followed guideline of MERITUM. The
results showed that 2 credit analysts (16.7%) answered that IC report is an influencing tool for credit
conditions [interest rate, amount offered]. Koga, Sakakibara, and Yosano (2007) also investigated theimpact of IC report on credit conditions [interest rate, the amount offered, and the value of security
required], in Japan. They surveyed 13 commercial bankers from the reviewing section of one of the
3 largest multi-national banks in Japan, and 9 regional bankers from the financing section of theirbank. Here, bankers firstly decided the credit conditions from the company information, annual
report and the business schemes of a given facility of a virtual company, which are in line with theinformation/material of Japanese typical financing practice, following the advice of a commercial
banker. Secondly, they could reconsider whether to change their financing decision after reviewing
additional IC report following the MERITUM style. The result of commercial bankers showed that8

(1) 3 bankers (23%) answered ‘Probably yes,’ that IC reports had an impact on the decision of theinterest rate, (2) 5 bankers (38%) answered ‘Probably yes,’ that IC reports had an impact on thedecision of the amount offered, and (3) 6 bankers (46%) answered ‘Probably yes,’ that IC reports
had an impact on the decision of the value of security required. Contrarily, the result from regional
bankers showed that IC reports had less impact on the credit conditions than commercial bankers;(1) 2 bankers (22%) answered ‘Probably yes,’ that IC reports had an impact to the decision of theinterest rate, (2) 1 bankers (11%) answered ‘Probably yes,’ that IC reports had an impact to thedecision of the amount offered, and (3) 3 bankers (33%) answered ‘Probably yes,’ that IC reports
had an impact to the decision of the value of security required. Here, no bankers answered‘Definitely yes’ to all credit conditions, but focusing on commercial bankers, where financing
services are spread out internationally, Japanese bankers put more importance on intellectual capital
information to influence credit conditions than Spanish bankers, on average. These analyses werebased on the laboratory procedure where bankers make a financing decision on a virtual company, so
the sample size must have been limited. In the next section, we report the results of the questionnaire
analysis to investigate the influence of the non-financial information, where intellectual capital
information is centered, to the credit conditions.

7. Non-financial information which has an impact on the decision of the interest rate
Table 6 shows the positively significant difference between the users and non-users of non-financial
information in the decision of the interest rate. Out of 54 items, 8 non-financial items were positively
significant, and the results are ranked by this difference. These results suggest that, “businessschedules” (evaluation level of the users of non-financial information in the decision of the interest
rate=4.03) and the elements of “business characteristics and outline” concerning selection andconcentration of products/services, such as “superiority and brand of products/services” (3.74) and“profit margin of products/services” (3.86), have an impact on the decision of the interest rate.
Moreover, it is interesting that the ability to execute “basic management philosophy” and instill theuse of its philosophy by employees, such as the “health condition” (3.67) “leadership” (3.54) and“the ability to make a plan/idea” (3.41) of top management, have an influence on the interest rate.
These abilities, reinforced by the centre leadership, are considered as the key factors, which generatevalue creation/forfeiture, to predict future cash flows of the firm. Lastly, the results suggest that
“holders of qualifications/technologies” (3.29) have an impact on the interest rate.

8. Non-financial information which has an impact on the decision of the amount offered
Table 7 shows the positively significant difference between the users and non-users of non-financial
information in the decision of the amount offered. Out of 54 items, surprisingly 45 non-financial
items were positively significant, and the results are ranked by this difference. Especially focusing9

on the top 20 items, the main items are concerning supply chain, including upstream anddownstream parties, in the main business. That is, the main items are related to negotiation
power/relationship, such as “customers and their status” (evaluation level of the users of
non-financial information in the decision of the amount offered=3.74), “relationship with customers”(3.51), “suppliers and their status” (3.50), and “relationship with suppliers” (3.38), and concentrationof products/services, such as “superiority of the main business” (3.94), “profit margin of
products/services” (3.86). Moreover, non-financial items concerning “unique intellectual assets
accumulated in the firm,” such as “corporate brand” (3.41), “superiority of technologies” (3.93), and“status of research and development” (3.33), is centered in top 20 items. The “risk management of
information leakage” (3.44) and “compliance system” (3.73), that are concerning the risk
management/compliance system, are distinguishingly ranked in the top 5 items, which suggests thatthe items concerning recognition of future uncertainty/risk have an impact on the decision of theamount offered. Lastly, it is interesting that the ability to execute “basic management philosophy”
and instill the use of its philosophy by employees, such as the “character” (3.87), “career” (3.49) and“leadership” (3.56) of management, also have an influence on the amount offered, although
influencing items are different from those used in the decision of the interest rate.

9. Non-financial information which has an impact on the decision of the length of financing
Table 8 shows the positively significant difference between the users and non-users of non-financial
information in the decision of the length of financing. Out of 54 items, extremely 40 non-financial
items were positively significant, and the results are ranked by this difference. The different items ofTable 7 (influence on the amount offered) and Table 8 (influence on the length of financing) are
shown in shade. Especially focusing on the items concerning the management practical capability,
Table 7 shows the significant difference for “leadership” (evaluation level of the users of
non-financial information in the decision of the length of financing=3.56), “health condition” (3.68),
and “capability” (4.00) of management. Table 7 also shows the significant difference for “successor's
presence” (4.01), which is a powerful means for small and medium-sized enterprises to elect able
leaders continuously. Moreover, the “age of top management” (3.61), “career in the sector” (3.45),
and “concentration level of the business” of a manager (3.44) are distinguishingly ranked. Thus, it isinteresting that financial institutions are taking different items into consideration, between thedecision of the amount offered and the length of financing.

10. Non-financial information which has an impact on determining the value of the property
which the loan is secured on
Table 9 shows the positively significant difference between the users and non-users of non-financial
information in determining the value of the property which the loan is secured on. Out of 54 items,
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24 non-financial items were positively significant, and the results are ranked by this difference.
When focusing on top 15 items of 24, we could firstly understand that “support system of the parent
company” (evaluation level of the users of non-financial information in determining the value of
security required=3.83) “personnel assets of the manager” (4.08), “presence of main financial
institutions” (3.94) and “affiliates” (3.97) are related with the portion of the amount which a lendercannot collect when in the default. The “relationship with customers” (3.52), “customers and theirstatus” (3.72) and “relationship with suppliers” (3.40) that are concerning negotiation
power/relationship, are distinguishingly ranked in the 15th place. Moreover, the results showed thatthe items which express a unity of individual capacities, such as “smoothness of management-labor
relations” (3.20) and “turnover ratio” (3.15) have an impact on the value of security required,although evaluation levels in financing judgments are comparatively low. Here, it is also interestingthat the ability to execute “basic management philosophy” and instill the use of its philosophy byemployees, such as the “capability of management” (4.03), “leadership” (3.59), “concentration levelof the business” (3.47), “networks” (3.34) and “career in the sector” (3.43) of management, have an
influence on value of the property which the loan is secured on. Lastly we expect the positive sign ofdifference for intellectual property in the judgment of security required, because these legal
properties have proprietary rights which reduce the portion of the amount that a financial institution
cannot collect when in bankruptcy. However the results suggest that the intellectual property has apositive impact on decision of amount offered, but don’t show significant impact on deciding thesecurities. This is a puzzle, and we expect to solve this matter in the progress of our future research.

11. Concluding remarks
There has been hardly any investigation into which procedure and to what degree non-financial
information is used in financing process, and which non-financial items have an impact on credit
conditions [interest rate, the amount offered, length of financing, and the value of the security
required]. The SMRJ report was the first and only comprehensive survey analysis to investigate
prospective non-financial information on risk rating process/criteria and credit conditions.
Especially, being focused on the financing decision, the financial institutions are strongly
recognizing the importance of non-financial information, the main characteristics of which areintellectual capital, and taking into consideration this information, on average, though there is adifference the level of importance for each financial institution. PRISM reported that financial
institutions are interested in non-financial information such as intangible assets to a limited degree(Morck et al, 2003, pp. 12-13). However, the SMRJ report shows that over half of financial
institutions in Japan record non-financial information by using the hearing/check sheet such as a
“Client management table” in their daily business process, and attempt the collection/analysis of
non-financial information by inputting this information into the “customer management/support
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system.” We found that this fixed criteria/guideline leads to positive use of intellectual capital
information, such as business model and external negotiation power/relationships. Nearly half offinancial institutions control and validate risk rating criteria by giving employees guidance in thecollection and rating of non-financial information, through internal/external training and seminar,
and attempting skill improvement of financing and reviewing.
Moreover, as for financing conditions, our results suggest that the elements of “businesscharacteristics and outline” concerning selection and concentration of products/services, the ability
to execute “basic management philosophy” and instill the use of its philosophy by employees, and“holders of qualifications/technologies,” have an impact on the decision of the interest rate. We also
found that the ability to practice “basic management philosophy,” among which “leadership” ofmanagement is central items, has an influence on all of the credit conditions, although influencing
items are different from those used in the decision of each other. It is also interesting that
non-financial items concerning negotiation power/relationship are ranked high of the significant
difference between the users and non-users of non-financial information in the decision of theinterest rate, the amount offered, and the value of the property which the loan is secured on. We also
found that non-financial items concerning “unique intellectual assets accumulated in the firm,” suchas “corporate brand” and “superiority of technologies,” have an impact on the decision of the amountoffered. Lastly we found that the items concerning recognition of future uncertainty/risk, such as the“risk management of information leakage” and “compliance system,” are distinguishingly ranked in
the top 5 items, when in deciding the amount offered.
[October 2nd, 2008]12

References
Financial Service Agency in Japan, General Supervisory Guidance for Small/medium-sized andRegional Financial Institutions, July 2008.
Koga C., Accounting for Intellectual Assets, Toyokeizai co. ltd, 2005. (in Japanese)
Koga C., S. Sakakibara, and T. Yosano, Explore Financing Based on Intellectual Assets, Chuokeizaico. ltd, 2007. (in Japanese)
Mavrinac S. and T. Siesfeld, “Measures that Matters: An Exploratory Investigation of Investors’
Information Needs and Value Priorities,” Measuring Intangible Investment, OECD, 1998, pp. 1-25.
Ministry of Economy, Trade and Industry in Japan, Guidelines for Disclosure of Intellectual Assets
Based Management, October 2005.
Morck, F., Hall, M. and E. Vali, “Banking and Venture Capital Metrics,” Work Package 7, Policy
Research into Innovation and Measurement Practice in the Intangible Economy (PRISM), June 2003,
pp. 1-53.
Organization for Small & Medium Enterprises and Regional Innovation in Japan, Investigation
research business for the use of intellectual capital by small and medium-sized enterprises – achapter of the investigation and research of financing based on intellectual capital, September 2008.
Sakakibara, S. Hansson, B, and T. Yosano, “Japanese analysts’ perception of intellectual capital
information,” Proceedings of 1st Work Shop on Visualising, Measuring and Managing Intangibles
and Intellectual Capital, pp. 1-26, 2005.
Treacy, W. and M. Carey, “Credit Risk Rating at Large U.S. Banks,” Federal Reserve Bulletin, Vol.
84, No. 11, November 1998, pp. 897-921.
Young, D. W., “Toward a Set of General Principles for Measuring and Reporting on Intangible
Assets,” Work Package 4, Policy Research into Innovation and Measurement Practice in the
Intangible Economy (PRISM), March 2003, pp. 1-16.

13

Table 1 Distribution of the ratio of the use levels of non-financial information

ratio of the use levelsof non-financial information
0 through 10%
10% through 20%
20% through 30%
30% through 40%
40% through 50%
50% or more

N

ratio

9
51
110
127
29
27

2.5%
14.4%
31.2%
36.0%
8.2%
7.6%

cumulative ratio
2.5%
17.0%
48.2%
84.1%
92.4%
100%

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, p. 49, Table 3-4-2.

Table 2 The ratio of the use levels of non-financial information by type of financial institution

categories
allcommercial banks
regional banks
second regional banks
credit unions
credit cooperatives
others

N

ratio
428
6
42
34
243
99
4

27.9%
27.5%
28.1%
23.8%
28.0%
28.9%
40.0%

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, p. 48, Table 3-3.

14

Table 3 Results of what degree lenders taking into consideration when in financing decisions

SMRJ Categories

non-financial items

personal assets of management
successor's presence
capability of management
character of management
health condition of top management
leadershipmanagerage of top managementcareer of management
concentrative level of the businessthe ability of make a plan/idea
career in the sector
networks of management
publicity activities
internal/external business climate/sensitivity
status of competitors
businessmarket share / position of the sector
environment
history and track record of businesssuperiority of technologies
superiority of the main businessbusiness contents
profit margin of products/services
superiority and brand of products/services
intellectual property (rights)
financing affordable
financing from another main financial institutions
presence of main financial institution
customers and their status
customers /suppliers and their status
suppliers
relationship with customers
customer satisfaction
relationship with suppliers
sales promotion/advertising campaign activities
holders of qualifications/technologies
know-howthe number of employees
employees
turnover ratio
average age of employees (year to year)
incentive systembusiness schedules
affiliates
support system of parent company
management philosophy
business model
corporate brandbasic of
In-house mechanism
organization
status of research and development
smoothness of management-labor relations
situations of introduction of the IT systemenhancement level of corporate education
the number of branches
in-house improvement proposal system/the number of improvement executions
personnel evaluation systemcompliance systemrisk management /legal risk management
governancerisk management of information leakage

15

evaluation levelaverage
3.99
3.95
3.93
3.78
3.61
3.49
3.47
3.41
3.37
3.36
3.35
3.25
3.08
3.80
3.73
3.53
3.85
3.85
3.84
3.81
3.68
3.44
4.01
3.96
3.86
3.63
3.42
3.41
3.32
3.30
3.12
3.24
3.23
3.13
3.04
2.95
2.77
3.95
3.88
3.66
3.45
3.43
3.32
3.28
3.26
3.09
3.06
3.03
2.99
2.87
2.81
3.64
3.60
3.34

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, pp. 61-62, Researchmaterials.

Table 4 Positively significant differences of credit evaluation for lenders using or not using afixed form of hearing/check sheet ranked by difference

non-financial items

using a fixed form of not using a fixed form
hearing/check sheetof hearing sheet
averagebusiness model
support system of the parent company
legal risk management
customers and their status
In-house mechanism
corporate brandstatus of research and development
affiliates
suppliers and their status
the number of branches
personal assets of management
relationship with customers
career in the sector
superiority of the main businessbusiness schedules
the member of employees
the ability of make a plan/idea
capability of management
compliance system
relationship with suppliers
superiority and brand of products/services
business climate/sensitivity
management philosophy
smoothness of management-labor relations

average
3.52
3.74
3.68
3.71
3.36
3.40
3.33
3.95
3.48
3.05
4.05
3.47
3.40
3.90
4.00
3.18
3.41
3.98
3.69
3.36
3.73
3.85
3.50
3.12

significant
level
difference
3.33
0.18 ***
3.58
0.17 ***
3.52
0.16 ***
3.55
0.16 ***
3.20
0.16 ***
3.25
0.15 ***
3.19
0.15 ***
3.81
0.14 **
3.36
0.12 **
2.93
0.12 **
3.93
0.12 **
3.36
0.12 **
3.29
0.11 **
3.79
0.11 *
3.89
0.11 **
3.07
0.11 **
3.31
0.11 **
3.88
0.10 *
3.59
0.10 *
3.25
0.10 **
3.63
0.10 *
3.75
0.10 *
3.41
0.09 *
3.06
0.07 *Note) *** shows 1% significant level (two-tailed), ** shows 5% significant level (two-tailed) and *shows 10% significant level (two-tailed), by Mann-Whitney U test.

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, p. 52, Table 3-8.

16

Table 5 Incentive/Training system of collection of non-financial information and the skill
improvement of financing and reviewing

49.2%
41.5%

Section of
PublicRelations

14.8%
29.8%
9.3%
14.4%
51.3%
Seminar (internal)

43.3%

Section of
Financing

Seminar (external)
sharing knowledge inthe shape of the
document throughin-house magazine

14.4%
28.7%
8.2%
13.9%

external educational
institution

35.8%
44.9%

Section ofReviewing

13.2%

others
None

27.6%

8.7%
17.3%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Source: “Investigation research business for the use of intellectual capital by small and medium-sized enterprises - achapter of the investigation and research of financing based on intellectual capital,” by Organization for Small &Medium Enterprises and Regional Innovation, Japan, p. 42.

17

Table 6 Positively significant difference between the users and non-users of non-financial
information in the decision of the interest rate

non-financial items
business schedules
superiority and brand of products/services
health condition of top management
leadership
holders of qualifications / technologies
profit margin of products/services
the ability of make a plan/idea
business model

ImpactNo impact（ N=223） （ N=203 ）averageaverage difference significant level
4.03
3.86
0.16 ***
3.74
3.62
0.12 **
3.67
3.55
0.12 **
3.54
3.43
0.11 **
3.29
3.19
0.10 **
3.86
3.75
0.10 *
3.41
3.31
0.10 **
3.47
3.37
0.10 *Note) *** shows 1% significant level (two-tailed), ** shows 5% significant level (two-tailed) and *shows 10% significant level (two-tailed), by Mann-Whitney U test.

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, p. 54, Table 3-10.

18

Table 7 Positively significant difference between the users and non-users of non-financial
information in the decision of the amount offered

non-financial items

Impact（N=233）

No impact（N=195）averageaveragedifference

3.49
3.21
3.29
3.73
3.52
3.67
3.17
3.22
3.31
2.71
3.91
3.71
2.99
3.43
3.75
2.95
3.32
3.17
3.21
3.40
2.99
3.52
2.78
3.04
2.68
3.71
3.14
3.85
3.16
3.36
3.29
3.52
3.35
3.88
2.88
2.92
3.59
3.79
3.18
3.66
2.99
3.79
2.96
3.89
3.07

0.24
0.23
0.22
0.21
0.21
0.21
0.20
0.10
0.19
0.19
0.18
0.18
0.18
0.18
0.18
0.17
0.17
0.17
0.17
0.17
0.16
0.16
0.16
0.16
0.16
0.16
0.15
0.15
0.14
0.14
0.14
0.13
0.13
0.13
0.13
0.13
0.13
0.13
0.12
0.12
0.12
0.12
0.12
0.11
0.09

customers and their status
risk management of information leakage
relationship with customers
superiority of the main businesscompliance systemcharacter of management
in-house mechanism
corporate brandsuppliers and their status
personnel evaluation systemfinancing affordable
profit margin of products/services
smoothness of management-labor relations
market share/position of the sector
superiority of technologies
turnover ratio
career of management
status of research and development
relationship with suppliers
leadership
publicity activities
health conditions of top management
in-house improvement proposal system / the number of improvement
the number of employees
incentive systembusiness climate/sensitivity
know-howcapability of management
holders of qualifications/technologies
intellectual property (rights)
the ability of make a plan/idea
legal risk managementbusiness model
successor's presence
average age of employees (year to year)
the number of branches
support system of parent company
presence of main financial institution
networks of management
status of competitors
situations of introduction of the IT system
history and track record of businessenhancement level of corporate education
business schedules
sales promotion/advertising campaign activities

3.74
3.44
3.51
3.94
3.73
3.87
3.37
3.41
3.50
2.90
4.10
3.89
3.17
3.61
3.93
3.12
3.49
3.33
3.38
3.56
3.15
3.68
2.95
3.20
2.84
3.87
3.30
4.00
3.31
3.50
3.43
3.66
3.49
4.01
3.01
3.05
3.72
3.91
3.31
3.78
3.11
3.90
3.08
4.00
3.16

significant level
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
**
**
***
**
**
**
*
**
**
**
**
*
**
**
*
*
*
*
*
*

Note) *** shows 1% significant level (two-tailed), ** shows 5% significant level (two-tailed) and *shows 10% significant level (two-tailed), by Mann-Whitney U test.

19

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, p. 56, Table 3-11.

20

Table 8 Positively significant difference between the users and non-users of non-financial
information in the decision of the length of financing

non-financial items
legal risk management
compliance system
support system of parent company
market share/position of the sector
relationship with customers
status of competitors
corporate brandin-house mechanism
customers and their status
presence of main financial institution
age of top management
profit margin of products/services
affiliatesrisk management of information leakage
business model
the number of branches
suppliers and their status
publicity activities
incentive systemsmoothness of management-labor relations
financing affordable
relationship with suppliers
superiority of the main businesscareer of management
the number of employeessuperiority and brand of products/services
customer satisfaction
know-howstatus of research and development
history and track record of businesscareer in the sector
turnover ratio
character of management
superiority of technologies
enhancement level of corporate education
the ability of make a plan/idea
networks of management
holders of qualifications/technologies
financing from another main financial institutions
concentration level of the business

Impact（N =126 ）aver age

No impact（ N=302 ）average

3.80
3.80
3.82
3.68
3.56
3.88
3.47
3.43
3.77
4.00
3.61
3.95
4.02
3.47
3.55
3.12
3.54
3.20
2.89
3.21
4.13
3.42
3.96
3.52
3.23
3.79
3.43
3.33
3.36
3.95
3.45
3.14
3.87
3.94
3.12
3.45
3.34
3.33
4.05
3.44

3.51
3.57
3.60
3.46
3.35
3.66
3.26
3.22
3.57
3.80
3.41
3.75
3.83
3.28
3.37
2.94
3.36
3.03
2.72
3.04
3.96
3.25
3.80
3.37
3.08
3.64
3.28
3.18
3.22
3.81
3.31
3.00
3.74
3.81
2.99
3.33
3.22
3.21
3.93
3.34

difference significant level
0.29
0.24
0.22
0.22
0.21
0.21
0.21
0.21
0.21
0.20
0.20
0.19
0.19
0.18
0.18
0.18
0.17
0.17
0.17
0.17
0.17
0.17
0.16
0.15
0.15
0.15
0.15
0.15
0.15
0.14
0.14
0.14
0.13
0.13
0.13
0.13
0.12
0.12
0.12
0.09

***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
***
**
***
***
***
**
**
***
**
**
**
**
**
**
**
*
*
**
**
*
**
*
*

Note) *** shows 1% significant level (two-tailed), ** shows 5% significant level (two-tailed) and *shows 10% significant level (two-tailed), by Mann-Whitney U test.

21

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, p. 58, Table 3-12.

Table 9 Positively significant difference between the users and non-users of non-financial
information in the decision of the value of security required

non-financial items

Impact（N=160）

No impact（N=268）averageaverage

3.83
3.52
3.20
3.15
3.74
4.03
3.59
3.47
3.72
3.40
4.08
3.94
3.34
3.97
3.43
4.03
3.41
3.60
3.80
3.85
3.02
3.49
3.06
3.14

support system of parent company
relationship with customers
smoothness of management-labor relations
turnover ratio
compliance systemcapability of management
leadershipconcentration level of the businesscustomers and their status
relationship with suppliers
personal assets of management
presence of main financial institution
networks of management
affiliates
career in the sectorbusiness schedules
corporate brandmarket share/position of the sector
status of competitors
character of management
average age of employees (year to year)
business model
the number of branches
publicity activities

3.56
3.34
3.03
2.98
3.57
3.87
3.43
3.31
3.57
3.25
3.94
3.80
3.20
3.83
3.30
3.90
3.28
3.48
3.68
3.74
2.91
3.39
2.96
3.05

difference significant level
0.27 ***
0.18 ***
0.17 **
0.17 ***
0.17 **
0.16 ***
0.16 ***
0.16 **
0.15 **
0.15 **
0.14 **
0.14 **
0.14 **
0.14 **
0.13 **
0.13 **
0.13 **
0.12 *
0.11 *
0.11 *
0.11 **
0.10 *
0.10 *
0.09 *Note) *** shows 1% significant level (two-tailed), ** shows 5% significant level (two-tailed) and *shows 10% significant level (two-tailed), by Mann-Whitney U test.

Source: “Investigation research business for the use of intellectual capital by small and medium-sizedenterprises - a chapter of the investigation and research of financing based on intellectual capital,” byOrganization for Small & Medium Enterprises and Regional Innovation, Japan, p. 60, Table 3-13.

22

Figure 1 Risk rating process of financial institutions
Use of ratings

Assignment of ratings

Factors considered
in rating・Financial information（Sales-current profit ratio，Cash flow，Length of debt
redemption time remaining
etc.）
・Quality of financial data
・Financial analysis（ Financial index analysis ，Cash flow analysis，Adjusted
balance sheet analysis etc.）
・Internal/outside businessenvironment (businesssensitivity/strong/weak pointsof the industry etc.)
・Information of historicaltransaction
・Firm size/value
・Stakeholders’ information(manager, customers/
suppliers, financial
institutions, etc.)
・Terms of facility / Lost in theevent of default
・Other considerations

Rating criteria
・Written/formal
elements
・Subjective/informal
elements (cultural)・Rater’s own
experience andjudgment

Preliminary
ratingproposed forloan approval
process
Relationshipmanager
and/or credit
staff

Quantitativeloss
characteristics

Approval
process(per policy)
assigns
final rating

Source: Treacy and Carey 1998, p.910, Diagram 1.

23

Risk rating
General credit
qualitycharacteristics

・Portfolio monitoring
・Loan loss reserve analysis
・Loan / business line pricing and profitability
analysis・Internal capital allocation and return on capital
analysis・Assessing attractiveness of customer
relationship
・Evaluation of rater effectiveness・Administrative and monitoring requirements
・Frequency of loan review

Figure 2 Application mechanism of credit rating criteria

Factors, definitions, and weighting
・Written / formal elements
・Subjective / informal elements
・Rater’s experience and judgment
・Asset type

Criteria chosen to obtain desired
characteristics

When available, loss experience analyzed toevaluate rating effectiveness

Quantitative loss characteristics
・Probability of default (PD)・Loss in event of default(LIED)
・Expected loss (EL)・Distribution of loss experience

Promote accuracy and consistency
Controls and validation processes
・Incentives and training
・Documentation and approval requirements
・Validation processes, especially loan review

Source: Treacy and Carey 1998, p.913, Diagram 2.

24

Figure 3 Typical style of intellectual assets based management report by “Guidelines forDisclosure of Intellectual Assets Based Management”[Main body](General) Basic management philosophy
Outline of business characteristics(From Past to Present)
A: Management policy in the past
B: Investment (based on A) (performance figures included)
C: Unique intellectual assets accumulated in the company, strengths based on them, and value
creation method (based on A and B) (supporting intellectual assets indicators included)
D: Actual performance in the past, such as profits (as a result of value creation C) (figures
included)(From Present to Future)
E: (Based on C and the assessment of the past to the present) Intellectual assets that rooted in thecompany and will be effective in the future, and future value creation method based on them
(supporting intellectual assets indicators included)
F: Identification of future uncertainty/risk, how to deal with them, and the future management
policy including those elements
G: New/Additional investment for maintenance and development of intellectual assets needed (inline with the management policy F) (figures included)
H: Expected future profits, etc. (based on E to G) (numerical targets included)[Attachment]
Other intellectual assets indicators (optional)［2008. 10. 30 897］25

26