The importance of non-bank lending to small businesses

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McGeown, Eimear
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University College Cork
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This thesis investigates the role of non-bank debt in the SME finance ecosystem in Ireland. Non-bank debt is defined as external debt, contractually provided by formal institutions other than banks. An important source of funding to large firms, non-bank debt has more recently emerged as a significant source of SME finance, both nationally and internationally (CBI, 2021a; Gopal and Schnabl, 2022). This thesis examines the characteristic of SME lenders, borrowers and the impact of non-bank debt on firm performance. On the supply side novel data gathered through fieldwork with non-bank lenders is used to identify the characteristics on the non-bank lenders. On the demand side, secondary data from the Irish Central Statistics Office’s Access to Finance Survey is used to examine the characteristics of SME firms that use non-bank debt. In addition, secondary data from the Irish Department of Finance’s SME Credit Demand Survey is employed to examine the impact of the use of non-bank debt on SME firm performance. Despite its importance as a source of SME funding, there is little research on the SME non-bank lending sector. This is mainly due to the lack of data as the sector is not prudentially regulated. This thesis addresses this gap by gathering primary data in face-to-face interviews with 40 non-bank lenders from Q2, 2019 to Q1, 2020 to describe the characteristics of the non-bank lending market in Ireland. This study is the only supply-side study on SME non-bank debt. It generates a number of key findings. Specifically, it finds that (1) non-bank debt is reducing the funding gap for bank rejected borrowers; (2) non-bank lenders use both transaction and relationship lending technologies to screen and monitor borrower firms; (3) collateral is important to non-bank lenders in overcoming information asymmetry; and (4) non-bank lenders differ from bank lenders in their provision of more diverse and bespoke lending products. These features assist the non-bank lenders in closing the funding gap for small and medium SME firms but not for micro or young borrowers. On the demand-side the thesis contributes to the literature by examining the non-bank lending channel inclusive of all the non-bank debt lending technologies. The focus on non-bank debt reflects the SME preference for debt and the policy focus on reducing SME dependence on bank debt. Whilst banks are expected to continue as the dominant source of SME finance, the growth of non-bank lending, particularly for higher risk borrowers, appears to contradict the financial intermediation literature which asserts that banks are best able to monitor opaque firms through their lending relationships. However, it is reflective of the changing nature of the borrower-bank relationship and structural changes in the banking sector (consolidation and rationalisation) and developments in the use of transactional lending technologies, innovation and technology to screen and monitor borrowers. The thesis also examines the impact of non-bank debt on SME firm performance differentiating from previous studies examining the effect of fund sources on firm performance (Li et al., 2018; López-Gracia and Sogorb-Mira, 2008; Michaelas et al., 1999; Sogorb-Mira, 2005; Trinh et al., 2017) by differentiating between the bank and non-bank lending channel. This novel finding highlights the importance of controlling for credit risk when assessing the impact of capital structure on firm performance. This study highlights the negative impact of finance gaps on firm performance and the importance of a resilient debt sector for SME performance, allocative efficiency, and growth within an economy. Structural changes to the SME finance model were in response to the financial crisis. Given the importance of the SME sector and the challenges ahead including economic and environmental shocks, governments need to understand the non-bank sector and its impact on the supply and demand for funds to support business growth and the performance of small firms. Policy makers should consider addressing the micro enterprises funding gap using the credit union model. Governments need to engage with, and monitor, the non-bank debt sector to fully understand both the benefits and risks to the sector. In particular, the non-bank funding model should be reviewed for cyclicality and subsidised funding, particularly for SME investments in targeted areas such as greening supply chains and digitisation. SMEs need to be educated on the alternatives to bank finance and on financial literacy, so that they can signal their ability to repay and avail of non-bank funding products.
Non-bank debt , SME finance
McGeown, E. 2023. The importance of non-bank lending to small businesses. PhD Thesis, University College Cork.
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