Christopher Kent: The availability of business finance
Speech by Mr Christopher Kent, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, at the 30th Australasian Finance and Banking Conference, University of New South
Wales, 13 December 2017.
* * *
I thank Ellis Connolly and Ben Jackman for invaluable assistance in preparing these remarks,
which also draw upon an article they have authored: Connolly E and Jackman B (2017), 'The
Availability of Business Finance ', RBA Bulletin, December, pp 55-66.
It is a pleasure to be here to discuss the availability of business finance in Australia. Businesses
need funding for their day-to-day operations and to undertake investment. These funds can be
generated internally, from profits, or they can come from various external sources. The
availability of funding has an important bearing on current and future economic activity.
My remarks today are structured around three key issues.
First, I'll talk about the internal and external sources of funds and the way in which businesses
use those funds. External finance has become available on increasingly favourable terms for
large borrowers over recent years, including because of increased competitive pressures in this
market. However, for the business sector as a whole, internal funds are the key source of
funding for investment. Growth in external funding has only a weak relationship to investment.
Debt funding appears to be linked to mergers and acquisitions activity, which has remained
relatively modest compared with levels prior to the financial crisis.
The second issue I want to discuss is the experience of entrepreneurs seeking to start or expand
a small business. They are typically more reliant on external finance, which remains difficult for
them to obtain. Access to finance for such small businesses is important though, since they
generate significant employment growth, drive innovation and boost competition in markets.
The third issue I'll cover is the potential to improve access to finance for entrepreneurs.
Much of what I have to say today draws on the information from a Small Business Finance
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Advisory Panel that the Reserve Bank has convened each year for the past 25 years. We've
gained a variety of perspectives by talking to entrepreneurs from a range of industries and
locations across Australia. It's been an invaluable way to better understand the challenges faced
by innovative small businesses.
Business funding and investment
But first, I'll start with some observations about the business sector overall. Data from the
Australian Bureau of Statistics on the balance sheet of the Australian business sector shows that
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businesses are financed by around 60 per cent equity and 40 per cent debt (Graph 1). Business
debt is dominated by loans from financial institutions, with debt securities playing a relatively
minor role. This capital structure is similar to most other comparable advanced economies. The
United States, to which we are often compared, is actually an outlier. Bank loans are a much
smaller share of business funding in the US.
The primary source of new finance for Australian businesses is internal funding (Graph 2). That
is supplemented by funds raised externally. The primary use of funds is for productive
investment, such as commercial buildings, machinery, software and other forms of intellectual
property. A non-trivial share, though, is used to pay dividends and to purchase financial assets,
or for mergers and acquisitions.3
It is well established in the literature that businesses prefer to finance investment using internal
funds. Raising funds externally is more costly and can involve restrictions being imposed on the
managers.
Internal funding is closely related to business investment. They are similar in size. This is evident
in Graph 3, in which the dots comparing the level of internal funding (in a given year) with the level
of business investment (the following year) are clustered around the 45 degree line. Also, there is
a clear positive relationship between internal funding and investment.4
In contrast, the relationship between external financing and investment is less clear in the
aggregate data. External financing is generally much smaller than investment - that is, the
external funding dots in Graph 3 tend to be well to the left of the 45 degree line. Moreover, there is
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only a weak positive relationship between businesses' external funding and investment.
6
Debt funding has moved more closely with mergers and acquisitions activity (Graph 4). For
instance, in the period leading up to the global financial crisis, debt finance was used by a small
number of highly leveraged firms to fund several mergers and acquisitions.
Like the growth of external debt, listed equity raisings have been relatively modest over the past
10 years, with relatively little capital raised through initial public offerings (IPOs) (Graph 5). This
followed a period of significant equity raisings during the 2000s, partly driven by a number of
privatisations through public floats.
Overall, external finance has become more readily available over recent years. Monetary policy,
both here and abroad, is very accommodative, and interest rates on business loans and
corporate bonds are near historic lows. Accordingly, the interest being paid by businesses is
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around its lowest level since the early 1960s (relative to operating profits; Graph 6). Also, equity
raising is relatively attractive at current valuations.
A consistent message from business surveys and the RBA's liaison program has been that
funding conditions have generally improved over the past five years.
Despite this, the demand for borrowing by businesses has been relatively moderate. Following
the crisis, there was significant deleveraging across the corporate sector (Graph 7).
Subsequently, gearing ratios outside the resources sector have remained relatively low. Over
recent years, non-mining business investment has been growing and the outlook for investment
has improved. However, as I've already noted, firms have been able to finance investment from
internal sources. Even in the resources sector, while gearing rose after the global financial crisis,
it did not reach the levels that prevailed immediately before the crisis. It has declined in the past
couple of years, as resource companies have been using the boost to their cash flows from
higher commodity prices and rising output to pay down debt.
Some parts of the business sector haven't seen the supply of external funding improve over
recent years. The domestic banks have sought to constrain their exposures to the resources
sector and commercial property, partly in response to prudential supervision from the Australian
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Prudential Regulation Authority. Also, small businesses continue to find it challenging to obtain
external finance. Indeed, this could be one factor that helps to explain why investment by small
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businesses has been unusually weak over recent years (Graph 8).
Finance for small businesses
The challenge of obtaining finance has been a consistent theme of the Small Business Finance
Advisory Panel. In this context, it is important to distinguish between two types of small
businesses. First, there are the many established small businesses that are not expanding. Their
needs for external finance are typically modest. Second, there are small businesses that are in
the start-up or expansion phase. They are not generating much in the way of internal funding.
Accordingly, those businesses have a strong demand for external finance. I'll focus my
comments on the issues relevant to this second group of small businesses.
I should emphasise again that access to finance for small businesses is important because they
generate employment, drive innovation and boost competition in markets. Indeed, small
businesses in Australia employ almost 5 million people, which is nearly half of employment in the
(non-financial) business sector. They also account for about one-third of the output of the
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business sector.
Compared with larger, more established firms, smaller, newer businesses find it difficult to obtain
external finance since they are riskier on average and there is less information available to
lenders and investors about their prospects. Lenders typically manage these risks by charging
higher interest rates than for large business loans, by rejecting a greater proportion of small
business credit applications or by providing credit on a relatively restricted basis.
The reduction in the risk appetite of lenders following the global financial crisis appears to have
had a more significant and persistent effect on the cost of finance for small business than large
business. After the crisis, the average spread of business lending rates to the cash rate widened
dramatically. The increase was much larger and more persistent, though, for small business
loans (Graph 9). In part, this increase owed to the larger increase in non-performing loans for
small businesses than for large business lending portfolios (Graph 10). It's not clear, however,
whether the increase in interest rates being charged on small business loans relative to those
charged on large business loans (over the past decade or so) reflects changes in the relative
riskiness of the two types of loans.11
Over recent years, there has been strong competition for large business lending, which has
resulted in a decline in the interest rate spread on large business loans. Part of the competition
from banks for large business loans has been driven by an expansion in activity by foreign banks.
Large businesses also have access to a wider array of funding sources than small businesses,
including corporate bond markets and syndicated lending.
In contrast, competition has been less vigorous for small business lending. Indeed, some
providers of small business finance were acquired by other banks or exited the market following
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the onset of the crisis. Also, the interest rates on small business loans have remained
relatively high. This difference in competitive pressures is evident in the share of lending provided
to small business by the major banks, which is relatively high at over 80 per cent. This compares
with a share of around two-thirds in the case of large businesses. Small businesses continue to
use loans from banks for most of their debt funding because it is often difficult and costly for
them to raise funds directly from capital markets.
The RBA's liaison has highlighted that if small business borrowers are able to provide housing as
collateral, it significantly reduces the cost and increases the availability of debt finance. Lenders
have indicated that at least three-quarters of their small business lending is collateralised and
they only have a limited appetite for unsecured lending. However, there are a number of reasons
why entrepreneurs find it difficult to provide sufficient collateral for business borrowing via home
equity:
they may actually not own a home, or have much equity in their home if they are relatively
young;
similarly, they may not have sufficient spare home equity if they've already borrowed against
their home to establish a business and now want to expand their business;
and even if they have plenty of spare home equity, using their homes as collateral
concentrates the risk they face in the event of the failure of the business.
Many entrepreneurs have limited options for providing alternative collateral, since banks are far
more likely to accept physical assets (such as buildings or equipment), rather than 'soft' assets,
such as software and intellectual property.
Given the higher risk associated with small businesses, particularly start-ups, equity financing
would appear to be a viable alternative to traditional bank finance. However, small businesses
often find it difficult to access equity financing beyond what is issued to the business by the
founders. Small businesses have little access to listed equity markets, and while private equity
financing is sometimes available, its supply to small businesses is limited in Australia,
particularly when compared with the experience of other countries (Graph 11). Small businesses
also report that the cost of equity financing is high, and they are often reluctant to sell equity to
professional investors, since this usually involves relinquishing significant control over their
business.
Innovations improving access to business finance
There are several innovations that could help to improve access to finance by: providing lenders
with more information about the capacity of borrowers to service their debts, and connecting
riskseeking investors with start-up businesses that could offer high returns.
Comprehensive credit reporting
Comprehensive credit reporting will provide more information to lenders about the credit history
of potential borrowers. The current standard only makes negative credit information publicly
available. When information about credit that has been repaid without problems also becomes
available publicly, the cost of assessing credit risks will be reduced and lenders will be able to
price risk more accurately; this may enhance competition as the current lender to any particular
business will no longer have an informational advantage over other lenders. It may also reduce
the need for lenders to seek additional collateral and personal guarantees for small business
lending, particularly for established businesses. Indeed, the use of personal guarantees is more
widespread in Australia than in countries that have well-established comprehensive credit
reporting regimes, such as the United Kingdom and the United States.
For several years, the finance industry has attempted to establish a voluntary comprehensive
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credit reporting regime in Australia. Participation has so far been limited. However, several of
the major banks have committed to contribute their credit data in coming months. The Australian
Government has announced that it will legislate for a mandatory regime to come into effect mid
next year.
Open banking
The introduction of an open banking regime should make it easier for entrepreneurs to share their
banking data (including on transactions accounts) securely with third-party service providers,
such as potential lenders. When assessing credit risks, lenders place considerable weight on
evidence of the capacity of small business borrowers to service their debts based on their cash
flows. For this reason, making this data available via open banking would reduce the cost of
assessing credit risk. A review is currently being conducted with a view to introducing legislation
to support an open banking regime.
Large technology companies
Technology firms can use the transactional data from their platforms to identify creditworthy
borrowers, and provide loans and trade credit to these businesses from their own balance
sheets. This could supply small innovative businesses that are active on these online platforms
with a new source of finance. Amazon and Paypal are providing finance to some businesses that
use their platforms. For example, Amazon identifies businesses with good sales histories and
offers them finance on an invitation-only basis. Loans are reported to range from US$1 000 to
US$750 000 for terms of up to a year at interest rates between 6 and 14 per cent. Repayments
are automatically deducted from the proceeds of the borrower's sales.
Alternative finance platforms
Alternative finance platforms, including marketplace lending and crowdfunding platforms, use
new technologies to connect fundraisers directly with funding sources. The aim is to avoid the
costs and delays involved in traditional intermediated finance.
While alternative financing platforms are growing rapidly, they are still a very minor source of
funding for businesses, including in Australia. The largest alternative finance markets are in
China, followed by the United States and the United Kingdom. But even these markets remain
small relative to the size of their economies (Graph 12).
Marketplace lending platforms provide debt funding by matching individuals or groups of lenders
with borrowers. These platforms typically target personal and small business borrowers with low
credit risk by attempting to offer lower cost lending products and more flexible lending conditions
than traditional lenders. Data collected by the Australian Securities and Investments Commission
indicate that most marketplace lending in Australia is for relatively small loans to consumers at
interest rates comparable to personal loans offered by banks (Graph 13).
It is unclear whether marketplace lending platforms are significantly reducing financial constraints
for small businesses. Unlike innovations such as comprehensive credit reporting, which have the
potential to improve the credit risk assessment process, marketplace lenders do not have an
information advantage over traditional lenders. As a result, they need to manage risks with prices
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and terms in line with traditional lenders. Nevertheless, these platforms could provide some
competition to traditional lenders, particularly as a source of unsecured short-term finance, since
they process applications quickly and offer rates below those on credit cards.
Crowdfunding platforms have the potential to make financing more accessible for start-up
businesses, although their use has been limited to date. Crowdsourced equity funding platforms
typically involve a large number of investors taking a small equity stake in a business. As a result,
entrepreneurs can receive finance without having to give up as much control as expected by
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venture capitalists. Several legislative changes have been made to facilitate growth in these
markets, including by allowing small unlisted public companies to raise crowdsourced equity.
Conclusion
The provision of external finance to Australian businesses is dominated by the banks. Funding
from that source has generally become available on increasingly favourable terms for large
borrowers over recent years. Even so, much of business investment is financed from internally
generated funds, while growth in business debt is more closely related to mergers and
acquisitions activity, which has remained relatively modest compared with levels seen before the
global financial crisis.
Entrepreneurs starting or expanding a small business are typically more reliant on external
finance, which remains difficult to obtain. Lending to small businesses is dominated by the major
banks and, there is less competition in this market. Interest rates paid by small businesses are
also much higher than those paid by large businesses; it's not clear the extent to which this
difference reflects the greater risk involved in extending loans to small businesses.
Entrepreneurs starting businesses often resort to personal credit cards for day-to-day funding,
while those seeking to expand their businesses are concerned by the collateral required to obtain
funding at lower interest rates.
There are several innovations that have the potential to improve access to finance, although their
use has been limited to date. The most promising development in the near term is mandatory
comprehensive credit reporting, which has the potential to lower the cost of credit risk
assessment for all lende
1
The Panel's discussion are a useful input into Bank work, for example Reserve Bank of Australia (2012), 'Small
Business Finance Roundtable: Summary of Discussion', RBA Bulletin, June, pp 91-94. Information about the
panel can also be found on the RBA website:
www.rba.gov.au/about-rba/panels/small-business-financeadvisory-panel.html.
2
The finances of the business sector are challenging to measure, since the boundary between businesses,
households and the government is not clearly defined and evolves over time. Unincorporated businesses tend
to be closely intertwined with the households that own them and, as a result, it is virtually impossible to
separately identify their balance sheets. In addition, the privatisation of many public corporations over recent
decades has shifted the responsibility for financing these businesses from the public sector to the private
sector. To deal with these challenges, the business sector is defined here to include all private and public
corporations.
3
Mergers and acquisitions within the Australian business sector are not captured in the data shown in Graph 2,
which is based on net transactions by the Australian business sector with other sectors, including foreigners.
4
A similar positive relationship is observed between internal funding and investment in the same year. However,
the correlation is larger between internal funding this year and investment next year, which is consistent with
businesses being secure about their finances ahead of committing to sizeable investment outlays. External
funding is somewhat positively correlated with investment in the same year and that correlation is a bit stronger
than between external funding this year and investment next year. This result makes sense as it would be costly
for a business to obtain external funding and then not put that funding to use as quickly as possible.
5
Similarly, relatively timely indicators such as business loan approvals and credit have not been found to be
useful for forecasting investment. Previous RBA research has found a significant relationship between
investment and variables such as the user cost of capital, cash flow, sales, business confidence and the terms
of trade: La Cava G (2005), 'Financial Constraints, the User Cost of Capital and Corporate Investment in
Australia', RBA Research Discussion Paper No 2005-12 and Cockerell L and S Pennings (2007), 'Private
Business Investment in Australia', RBA Research Discussion Paper No 2007-09.
6
The ABS data on business debt funding, which is a broad measure of loans and debt securities, have been
weaker over the past year than RBA business credit, which measures lending by ADIs to businesses. The
weaker growth of total debt is likely to reflect companies repurchasing debt securities and reducing offshore
borrowing, particularly in the resources sector. The repayment of government loans following the privatisation of
some public corporations has also played a role.
7
The decline in interest paid since the late 1980s has been driven entirely by lower interest rates, as the ratio of
debt relative to operating profits has increased a little over this period.
8
See Byres W (2017), 'Prudential Perspectives on the Property Market', Remarks at CEDA's 2017 NSW Property
Market Outlook Sydney, 28 April. Available at: .
9
See Debelle G (2017), 'Business Investment in Australia', Remarks at UBS Australasia Conference 2017,
Sydney, 13 November. The estimates for Graph 8 are sourced from the ABS' BLADE (Business Longitudinal
Analytical Data Environment) database. The results of these studies are based, in part, on ABR data supplied by
the Registrar to the ABS under A New Tax System (Australian Business Number) Act 1999 and tax data supplied
by the ATO to the ABS under the Taxation Administration Act 1953. These require that such data are only used for
the purpose of carrying out functions of the ABS. No individual information collected under the Census and
Statistics Act 1905 is provided back to the Registrar or ATO for administrative or regulatory purposes. Any
discussion of data limitations or weaknesses is in the context of using the data for statistical purposes, and is
not related to the ability of the data to support the ABR or ATO's core operational requirements. Legislative
requirements to ensure privacy and secrecy of this data have been followed. Only people authorised under the
Australian Bureau of Statistics Act 1975 have been allowed to view data about any particular firm in conducting
these analyses. In accordance with the Census and Statistics Act 1905, results have been confidentialised to
ensure that they are not likely to enable identification of a particular person or organisation.
10
These shares have been relatively stable over the past decade. These data refer to businesses that employ
fewer than 20 people and are sourced from Australian Industry, 2015-16, ABS Cat no. 8155.
11
Note that Graph 10 is based on default probabilities, not expected or actual losses, which will also depend on
losses given default. Those, in turn, will depend (among other things) on collateral held against the loans,
which in the case of many small business loans is housing.
12
These included, for example, Bankwest, St. George Bank and GE Capital.
13
Productivity Commission (2017), 'Data Availability and Use: Overview & Recommendations', Productivity
Commission Inquiry Report No 82, Canberra.
14
A survey by the Federal Reserve Bank of New York found that small businesses were noticeably less satisfied
with online lenders than with traditional lenders, with more complaints about the interest rates charged and the
repayment terms imposed by online lenders. Federal Reserve (2016), 'Small Business Credit Survey', Report
on Employer Firms', April, available at .
15
Some crowdfunding platforms also allow businesses to raise funds through presales of a new product. These
platforms offer some advantages to small business, since they receive direct funding from customers, require
no collateral, and can provide a gauge of market interest. However, success on these markets is unpredictable,
and the sites are geared towards consumer-oriented products.