Working Capital Financing and the Canada Small Business Financing (CSBF) Program May 2006

Dr. Allan Riding Equinox Management Consultants Ltd.

This publication is available upon request in accessible formats. Contact: Multimedia Services Section Communications and Marketing Branch Industry Canada Room 264D, West Tower 235 Queen Street Ottawa ON K1A 0H5 Tel.: 613-948-1554 Fax: 613-947-7155 Email: multimedia.production@ic.gc.ca This publication is also available electronically on the World Wide Web at the following address: http://strategis.ic.gc.ca/epic/site/sbrp-rppe.nsf/en/rd02162e.html Permission to Reproduce Except as otherwise specifically noted, the information in this publication may be reproduced, in part or in whole and by any means, without charge or further permission from Industry Canada, provided that due diligence is exercised in ensuring the accuracy of the information reproduced; that Industry Canada is identified as the source institution; and that the reproduction is not represented as an official version of the information reproduced, nor as having been made in affiliation with, or with the endorsement of, Industry Canada. For permission to reproduce the information in this publication for commercial redistribution, please email: copyright.droitdauteur@pwgsc.gc.ca Cat. No. Iu188-39/2007E-PDF ISBN 978-0-662-45405-2 60214 Aussi offert en franais sous le titre Le financement du fonds de roulement et le Programme de financement des petites entreprises du Canada (PFPEC).

WORKING CAPITAL FINANCING AND THE CANADA SMALL BUSINESS FINANCING (CSBF) PROGRAM

E XECUTIVE S UMMARY
The objectives of this work were to undertake an assessment of whether there is a financing gap facing firms seeking to obtain working capital financing and to further inform Industry Canada so that it can determine whether the Canada Small Business Financing (CSBF) program could be an appropriate tool for filling any such gap. This work addressed these questions by drawing on reports from industry associations and the academic literature, interview data from commercial bankers and representatives of business organizations, and from analyses of survey data from the Small- and Medium Sized Enterprise (SME) Financing Data Initiative (FDI). Neither the qualitative nor the quantitative data sustained the hypothesis of a market gap either in terms of a shortage of debt capital or in terms of a capital market imperfection. The interview data with representatives of SME organizations and the review of related publications, while providing indications of the importance of working capital financing, did not argue for a gap particular to this usage of loan proceeds. Interviews with lenders indicated that the problem was not so much whether loan proceeds were to be used to finance working capital; rather, lenders stressed that certain categories of firms were less creditworthy than others. In particular, lenders viewed start-ups as especially risky and almost universally require collateral when they advance loans to start-up businesses. Lenders also identified particular industry sectors as especially risky. Lenders stressed that it was more important why a firm needed to finance working capital than that working capital financing was needed. Firms in need of working capital to support revenue growth were viewed differently from firms needing working capital because of poor fiscal management. These results were confirmed by the quantitative analysis of the SME FDI survey data. First, it was found that loan applications to support working capital were more frequent from firms in the categories identified as somewhat more risky (start-ups, firms in the wholesale/retail, knowledge-based, and professional services sectors, firms in rural areas, smaller firms). Second, after allowing for these risk factors (and others -- such as whether the firms export, their level of R&D investment, availability of collateral) it was found that using the proceeds of a loan for working capital financing did not materially affect the estimated likelihood of loan turndown. This was found to hold for both term loan applications and applications for new operating loans. While the data show that lending decisions are not directly affected by using loans to finance working capital, it remains that certain categories of firms are less likely to obtain loans than others: start-ups, smaller firms, innovative firms, firms in certain industry

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sectors. This situation is not unlike that of firms that use the CSBF for guarantees of term loans, many of which would be turned down based on attributes such as firm age and size and sectoral effects (approximately 75 percent of CSBF borrowers according to Incrementality of CSBF Program Lending, Volume 1: Insights from SME FDI Data, Prepared on behalf of the Small Business Policy Branch, Industry Canada, Equinox Management Consultants Limited, December 2003). Thus the two research questions that form the objectives for this project are separable. On the one hand, the work finds little evidence of a capital market gap. On the other hand, there appear to be a substantial number of firms that would have applications for loans rejected based on fundamentals of the business and for which loan guarantees might provide incremental access to credit. In particular, small and early stage firms, especially innovative firms, owned by individuals unable to assemble collateral or cosignatories are simply too risky for most commercial lenders. However, it is not clear that it is the role of the federal government to intervene in the market on behalf of such firms. This is so for two reasons. First, it is arguable that such firms should be seeking risk capital instead of bank debt. Second, risky firms may already be targeted by the mandates of the Business Development Bank or by other provincial or local programs.

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WORKING CAPITAL FINANCING AND THE CANADA SMALL BUSINESS FINANCING (CSBF) PROGRAM
Table of Contents

OBJECTIVE ................................................................................................................................................. 1 Working Capital Financing .................................................................................................................... 1 On the Need for Intervention .................................................................................................................. 2 METHODOLOGICAL APPROACH ................................................................................................................ 3 Phase 1: Qualitative Analysis................................................................................................................. 3 Phase 2: Quantitative Analysis............................................................................................................... 4 PHASE I: REVIEW OF THE LITERATURE ................................................................................................... 4 Overview of the Current Context for SME Borrowing ........................................................................... 4 Review of Academic Studies ................................................................................................................... 7 PHASE I: INTERVIEWS WITH KEY INFORMANTS .................................................................................... 12 Analysis of Interview Data ................................................................................................................... 12 PHASE II: ANALYSIS OF SURVEY DATA .................................................................................................. 16 Frequency of Loan Applications........................................................................................................... 16 Frequency of Loan Turndowns............................................................................................................. 17 Summary of Data Analysis ................................................................................................................... 22 LIST OF REFERENCES .............................................................................................................................. 24

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Working Capital Financing and the Canada Small Business Financing (CSBF) Program
O BJECTIVE
This work seeks to provide Industry Canada with: a) an assessment of whether there is a financing gap facing firms seeking to obtain working capital financing; and, b) the ability to evaluate whether the Canada Small Business Financing (CSBF) program could be an appropriate tool for filling any such gap. Working Capital Financing Essentially, working capital represents the amount of day-by-day operating liquidity employed by a business. Also known as operating capital, net working capital is most often measured as the difference between current assets and current liabilities.1 In practical terms, the need for working capital financing arises when investments in short term assets (especially inventories and accounts receivable) exceed financing from short term liabilities (trade accounts payable, also known as supplier financing). This difference can be filled either by drawing down cash or by obtaining short term financing. A company can be profitable and well-endowed with assets; yet it can be short of liquidity if short-term assets cannot readily be converted into cash. Working capital financing can be a particular problem for growing firms: rapid sales growth generally results in increased needs for inventories and receivables with the result that growing firms may be especially short on cash. It is widely accepted that working capital financing has two components: a so-called permanent element (the portion of the difference between current assets and current liabilities that persists over time) and a transient amount that varies over time. Working capital loans reflect this distinction between the permanent and transient elements of working capital because a loan facility will often have two parts. One portion of the credit facility may be set up as an installment or term loan. This portion of the facility may be used to finance the permanent component of working capital (as well as other fixed assets such as equipment). This part of the loan facility is usually structured as a medium-term loan that is amortized over time. The second portion is a line of credit or operating loan that operates essentially like overdraft protection.

Current assets may or may not include cash and cash equivalents, depending on the company, and usually excludes short-term debt.

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For this component, the borrower and lender negotiate terms that include interest rates, fees, an upper limit, and a revolving requirement. On the Need for Intervention Working capital financing is important, in part because the most frequently-cited reason for seeking a commercial loan is to finance working capital (Industry Canada, Surveys on Financing of Small and Medium Enterprises; 2000, Table 7; 2001, Table 49). Financing working capital is of particular importance to growing firms, exporter businesses, and younger firms (Industry Canada, Surveys on Financing of Small and Medium Enterprises; 2000, Table 7; 2001, Table 49).2 Because of its importance, the possible need for government intervention in order to facilitate working capital financing has been raised on several occasions. In 1998, Industry Canada investigated and discussed with stakeholders the possibility of extending the (then) Small Business Loans program to include working capital. The idea was rejected at that time out of concern that financing for working capital could result in a proportionally greater number of loan defaults compared to asset-based financing. The expected increase in program costs would hinder the attainment of the program's cost recovery objective. In 2003 the Prime Minister's Task Force on Women Entrepreneurs raised the issue again. The report recommended that the federal government review the mandate and lending criteria of the Canada Small Business Financing Act with a view to amendments that would include the financing of working capital costs such as receivables, inventory and other costs of non-asset based companies. The rationale was that women-owned small firms were concentrated in the retail and services sectors, sectors where working capital needs were thought to be greatest. In December 2004 the issue resurfaced in the pre-budget report of the House of Commons Standing Committee on Finance, with the report stating: We feel that insufficient entrepreneurial activity is being financed, particularly at the start-up and early stages of businesses, despite actions that have been taken by the federal government in recent federal budgets. The 2005 comprehensive review of the CSBF (for 1999-2004) raised the issue of whether working capital should be eligible for financing under the program. In consultations with stakeholders that followed the release of the report there was agreement that there is growing demand for more flexible types of financing for businesses' working capital needs. There was general support for the idea of including working capital under the program, with the caveat that the viability of the core CSBF Program be protected. Stakeholders suggested this could be accomplished by separating working capital financing from the costing of the core loans program, and by having specific limits/restrictions on eligibility and/or the percentage of working capital financing allowed.

http://strategis.ic.gc.ca/epic/site/sme_fdi-prf_pme.nsf/en/00730e.html

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Accordingly, this project undertakes a program of research to address the issues noted above. This research program has two phases, the first of which gathers and analyses qualitative data and the second undertakes quantitative analysis of data from the 2004 SME Financing Data Initiative Surveys on Financing of Small and Medium Enterprises. This document reports the findings from this work.

M ETHODOLOGICAL A PPROACH
The two-phase design of the methodology was designed to allow qualitative data obtained from interviews with stakeholders and key respondents to inform the quantitative analysis that comprised the second phase. If fact, the interviews were extremely useful in this regard and identified several key variables that were employed as determinants of access to loans in the second phase of this work. Phase 1: Qualitative Analysis This initial phase of the work collected and analyzed qualitative data to guide the quantitative analysis undertaken in the second phase. These data were gathered from an environmental scan to assess the supply of, and demand for, working capital financing in the Canadian marketplace. In particular, the work involved: 1) A review of the literature regarding commercial lending with a special emphasis on working capital in the Canadian context. 2) Interviews with key informants about their perceptions of the need for guarantees of commercial loans to support working capital and how a loan guarantee program for this purpose might be structured. These interviews sought to ascertain whether respondents believe there is unmet demand for working capital. The interviews also gathered information about how lenders approach working capital financing and how working capital financing differs from asset-based debt financing. Interview participants included: o Eight representatives of commercial lenders, which included CSBF liaisons to Industry Canada of seven commercial lenders and one representative of the Canadian Bankers Association. Another lender representative provided written commentary. A conference call interview with approximately ten provincial representatives of Credit Unions was also held. o Interviews were held directly with two representatives of SME organizations. Both interviewees also referred the research team to research studies with which they had been involved. In addition a representative of the Canadian Federation of Independent Business (CFIB) declined to be interviewed but referred the research team to recent CFIB publications. Other organizations were invited to participate but declined, stating that they were not in a position to comment on financing issues.

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o Knowledgeable third parties were also interviewed, including a representative of the Canadian Institute of Chartered Accountants, a senior executive of the Business Development Bank of Canada, and one academic. o Documentary evidence was also employed, including publications from industry associations and SME organizations. 3) Assembly of data on government programs that support working capital financing, both in Canada (federal, provincial and/or municipal) and internationally. This information was collected from on-line sources and from other publications. Phase 2: Quantitative Analysis The second phase of the work involved the collection and analysis of quantitative data from multiple sources. These include: Studies of SME financing undertaken by Thompson-Lightstone Ltd. between 1996-98 on behalf of the Canadian Bankers Association. Reports on SME Banking published periodically by the Canadian Federation of Independent Business based on surveys of their members. A review and analysis of existing aggregate data tables of SMEs' demand for financing from the 2000, 2001 and 2004 surveys completed as part of the SME Financing Data Initiative. These data were provided by Industry Canada.

Phase 2 of this work also involved a synthesis of the information gathered in phases 1 and 2 so as to assess whether there is a gap in the marketplace for SMEs seeking working capital financing. P H A S E I: R E V I E W
OF THE

L I T E R AT U R E

Overview of the Current Context for SME Borrowing Commercial loans are the primary source of external capital for Canadian SMEs with the stock of commercial loans outstanding in Canada exceeding $350 billion. According to the 2003 and 2004 FDI Surveys of Suppliers of Business Financing, commercial lenders (banks, credit unions, and caisses populaires) had collectively authorized a total of $61.8 billion (2003) and $60.1 billion (2004) in lending facilities of less than $250,000. Of these amounts, $38.1 billion (2003) and $36.2 billion (2004) were outstanding, representing aggregated draw downs of 61.6 percent (2003) and 60.2 percent (2004). The CFIB (2003) notes that there has been a long-term decrease in the proportion of Canadian small firms that have sought external financing. According to their surveys, 60 percent of

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their members sought bank financing during the 2000-2003 period, whereas the corresponding proportion for the 1984-1987 period was 73 percent. In 2002 the Canadian Federation of Independent Business, the Canadian Manufacturers & Exporters Association and RBC Financial Group collaborated to publish The Path to Prosperity: Canadas Small- and Medium-sized Enterprises. Among other things, this work compared lending experiences of Canadian businesses with those of counterpart firms in other countries, with a particular emphasis on the US.3 The findings of this study are instructive, with their overall conclusion that the [Canadian financial services] industry is a world leader on multiple measures of access to business financing and pricing, and (p. 20): Overall, the record of the Canadian financial services industry compares much more favourably than the U.S. industry on access to traditional loan products, their pricing and associated fees. Particular findings of the study included (pp. 20-22): there exists a broad array of providers within Canada such as banks, credit unions, leasing companies, insurance companies, pension funds and government-sponsored lenders. the spread between typical lending and deposit rates in Canada is the fourth lowest among 75 countries. The United Kingdom, United States, Germany, Italy, France have higher spreads [and] the spread between rates charged for loans to all size classes of borrower, but especially to smaller borrowers, is far narrower in Canada than in the United States. Canadian businesses and SMEs in particular get a far better deal on financing costs than U.S. businesses at U.S. banks. A basket of typical retail bank fees for small businesses in Canada are much lower than in the United States at virtually any modestly reasonable exchange rate assumption. The Path to Prosperity noted (p. 20) that while there remains room for improvement Canadian businesses get a far better deal on financing costs that U.S. businesses at U.S. banks and that (p. 21) [t]his better deal on financing charges does not come at the expense of refusing to grant credit. The Path to Prosperity findings suggest that the Canadian banking system may provide Canadian businesses with a competitive advantage with respect to foreign (especially US) counterparts despite misperceptions that have been created in recent years (p. 20). Conversely, the CFIB (2003, p. 5) notes that Canadian SMEs have a very different perception of the banks, that (p. 9) poor service quality, lack of credit availability, and
3

Path to Prosperity (2002) was co-sponsored by the CFIB, Canadian Manufacturers and Exporters, and RBC Financial Group. Its findings were based on Ipsos-Reid polling of a randomly-selected sample of 800 Canadian business owners and 400 US respondents.

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unfair service charge practices were the most frequently cited reasons by small businesses for switching banks. The CFIB (2003, p. 10) also notes that operating lines of credit the type of facility most frequently employed to financing working capital - are important to Canadian SMEs, such that approximately twice as many SMEs maintain an operating loan facility than a term loan.4 The CFIB also maintains based on surveys of its members that it is the young, high performing businesses that are experiencing the greatest difficulty in obtaining financing from financial institutions (Bruce, 2001, p. (i)). The role of working capital was specifically addressed only in Manufacturing 20/20 (2005). As context, financing was not among the top ten strategic challenges cited by Canadian manufacturers (Manufacturing 20/20, Table 2). It was ranked as the 12th among 20 key factors affecting innovation (Manufacturing 20/20, Table 3) and 10th among 20 concerns with respect to bringing new products to market. Within that framework, however, obtaining working capital was the most-frequently cited among difficulties obtaining financing (mentioned by 18 percent of respondents, Manufacturing 20/20, Table 19). Further confounding the debate is the question of whether debt financing is the appropriate form of financing for some firms. For example, MacIntosh (1994) and Black and Gilson (1998) both advocate that equity financing is, in many instances, a more suitable source of financial capital than debt. This is because debt increases the systematic risk of firms that are already subject to relatively high levels of uncertainty and business risk stemming from the commercialization potential of the innovation, risk of obsolescence, the need for future injections of staged financing, etc. The higher systematic risk makes borrower firms yet more vulnerable to economic downturns. There are trends in the credit market worth noting. First, many commercial lenders treat small loans as if they were personal loans to the owner(s) of the business. Second, such loans are increasingly adjudicated through credit scoring methods. Third, lenders often require security either in the form of collaterizable assets of the business or its owners or risk mitigation from programs such as the Canada Small Business Financing program. Looking forward, the implementation of Basel II also holds potential implications for commercial loans to small firms.5 First, Basel II defines SMEs as businesses with sales
The CFIB (2003) report, Banking on Competition, is based on a survey of its members to which 9,565 responses were collected. CFIB surveys are limited to its members and are therefore not representative of the larger majority of Canadian SMEs. Arguably, CFIB survey data include both selection and nonresponse biases: CFIB members who respond to surveys on banking are likely to represent survivor firms whose principals have a particular interest in banking issues. 5 Basel II is correctly known as the International Convergence of Capital Measurement and Capital Standards - A Revised Framework. Basel II is the second Basel Accord and embodies recommendations advanced by bank supervisors and central bankers from the G-10 countries (plus Luxembourg and Spain) to revise the international standards for measuring the adequacy of a banks capital. It was created to promote greater consistency in the way banks and banking regulators approach risk management across national borders. Under Basel II, loans to SMEs have been treated as relatively lower in systemic risk. Based on experience in the US and the UK, the improved risk sensitivity may mean that banks are more willing to lend to higher risk borrowers but that loans are more likely to be priced to risk. This could allow borrowers previously denied loans to have a better chance of establishing a good credit history. Implementation of the accord is expected by 2008 in many of the countries currently using the Basel I accord.
4

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up to $US65 million and loans of less than $US20 million. Loans to smaller businesses require less regulatory capital being allocated to them while loans to larger businesses require more capital. As noted in The Path to Prosperity (p. 21), this will place an increased regulatory burden for bank lenders because they will have to track sales size and tie it to authorizations. Second, Basel II requires loans be rated as to risk. While most Canadian banks evaluate SME riskiness, it appears likely that this will provide further impetus to credit scoring approaches. Third, The Path to Prosperity ( p. 21) observes that: The fact that a size threshold exists that trips different capital requirements and, hence, opportunity costs of capital allocated by banks and how such loans are priced means that an artificial barrier to growth may exist for firms just beyond the size threshold criteria. Allocated capital across the size threshold will jump in discrete fashion, but the lending risks do not; SMEs will, therefore, likely have to develop more detailed documentation on their markets, potential, systems of control and strategies to provide lending institutions required information. Jacobson et al examine the risk associated with retail and SME credit (R&SME) because of the differing bank capital requirements for these loans under Basel II. These loans are regarded as relatively less risky, and receive favourable capital treatment because of their supposedly smaller exposure to systemic risk. Their findings show that R&SME portfolios are usually riskier than corporate credit and accordingly, that special treatment under Basel II is not justified. Their results are consistent with those of Dietsch and Petey (2004) who find that on average, SMEs are riskier than large businesses and that although asset correlations in the SME population are very weak (13% on average) and decrease with size. On average, the correlations are not negative, as assumed by Basel II, but positive, especially at the industry level. Review of Academic Studies According to the OECD (2006) a credit market gap exists if: (a) (b) among loan applicants who appear to be identical some receive credit while others do not; or, there are identifiable groups in the population that are unable to obtain financing at any price.

This work focuses on the second of these definitions of a gap. The work seeks to determine if firms seeking working capital financing are disadvantaged with respect to access to commercial loans.

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On Gaps in the Capital Markets

Many of the public policy issues related to the financing of SMEs revolve around the concept of gaps in financial marketplaces. However, the word gap is in fact interpreted in a variety of ways. As used in the popular media the word gap connotes the idea of a shortage: a sense that the supply of the commodity in demand (here, financing) is insufficient and that the demand cannot be satisfied. However, in the context of economic theory a gap as defined above can only exist if an imperfection prevents prices from adjusting to the forces of supply and demand. For a shortage to persist some form of imperfection must interfere with the ability of the market to clear (at least, according to economic theory.6 As Parker (2002, p. 163) states the case: Information about [small] firms may be limited and asymmetric, stacked on the side of the borrower at the lenders hazard. This has led many influential academics and politicians to claim that these problems can be so severe that the supply of finance may disappear altogether. Banks, it is argued, may ration credit to new enterprises, strangling new, dynamic and innovative future industrial giants at birth. It is this type of imperfection to which Brierley (2001, p. 75) refers when he states: Public sector initiatives to support the financing of small firms may be justified if market imperfections mean that the private sector does not provide capital to firms on competitive terms [However] In the absence of market failure, such initiatives may themselves cause distortions by subsidizing, at considerable public cost, non-viable firms which are not attracting enough capital because they do not offer good investment opportunities. In the absence of an imperfection, intervention is not warranted. In the presence of an imperfection, remedial measures should ideally to be based on the nature of the imperfection. The theoretical debate about whether or not some firms are subject to information-related imperfections (potentially leading to failure in the financial markets) dates back to Arrow (1962) and Demsetz (1969). This debate still continues (see, for example, Berger and Udell, 1998; Parker, 2002). If asymmetric information exists, lenders may be unable to discriminate between high- and low-risk borrowers. According to this theory, lenders react by increasing the price of debt to all potential borrowers, inducing all but the highest-risk borrowers to exit the market.7 Conceptually, the ultimate result of this cycle is that lenders refuse finance to a high proportion of borrowers, a form of credit rationing.
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See Vogel and Adams (1997) for a discussion of this. The seminal work of Stiglitz and Weiss (1981) has led to a considerable literature based on the idea that information asymmetry between borrowers and lenders is an imperfection consistent with the belief that commercial lenders may deny credit to certain categories of small firms. According to the most prevalent theories, information asymmetry leads to adverse selection or moral hazard problems which, in turn, lead lenders to set an optimal (for them) interest rate that is lower than the rate at which the market would otherwise clear.

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The existence of a market gap in the small business loan market is a matter of some considerable discussion in the literature. Views range from those of Parker (2002), who doubts the existence of a gap, to those of Boadway and Sato (1999) who develop theoretical arguments for its existence. Parker (2002) presents an overview of the modern theory and evidence of credit rationing, and concludes that the case for credit rationing is weak. He suggests that theoretical arguments for or against credit rationing are inconclusive, so evidence is needed to decide the issue. He further submits that the evidence is not supportive of the view that credit rationing is an important or widespread phenomenon. Parker (2002) provides a review of the empirical literature pertaining to capital rationing from which he concludes (p. 162) that theoretical arguments are inconclusive and empirical evidence, which he notes is inherently difficult to obtain, does not support the view that credit rationing is important or widespread. In contrast, Boadway and Sato (1999) consider that project risk includes idiosyncratic and aggregate components. They submit that banks can investigate aggregate risk and can evaluate the idiosyncratic risk of each entrepreneur and that they engage in competition for entrepreneurs using interest rates. They conclude that information obtained by a bank on aggregate risk is fully revealed, and that entrepreneur-specific risk is partly revealed. In their view, banks will not investigate aggregate risk and will evaluate entrepreneurs too intensively. As a result, efficiency can be improved by public acquisition of information on industry risk and by loan guarantees partially covering losses on projects that fail. Theory does not specify the categories across which credit rationing might occur. Thus, if credit is rationed, it remains to identify the basis used by suppliers of funds to discriminate among applicants and the dimensions across which they may deny capital among firms with the same risk characteristics (Keeton, 1979). Binks and Ennew (1996) argue that high growth firms may be more informationally opaque than low growth businesses and may therefore face a greater degree of difficulty obtaining financing. However, rapid growth can also be a source of significant financial and managerial stress for a firm (Eggers, Leahy, Mikalachki, 1997). Rapid growth often leads to expansion of the need for working capital, in turn generating a need for additional cash. Hence, creditworthiness requires that good fiscal management accompany rapid growth. This argument poses the empirical challenge of distinguishing, in cases of low levels of creditworthiness, whether rapid growth is the causal factor or whether poor fiscal management is the problem. Suppliers of risk capital tend to be more specialized in growth-oriented businesses than lenders loan account managers. Typically, they also provide assistance with the commercialization process (Madill, Haines, Riding, 2003). As Brierley (2001, p. 67) notes, venture capitalists may have greater information on the projects marketability and may be able to mitigate informational asymmetries. This suggests that some high growth or knowledge-based firms seeking debt financing may be operating in the wrong segment of the capital market.

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Empirically, it is extremely difficult to identify instances of credit rationing. Credit rationing requires that, from a set of observationally identical applicants, some will obtain financing and others will not (and that those who are rationed would still not receive a loan even if they offered to pay a higher price). As Parker observes (2002), it is virtually impossible to identify observationally identical loan applicants. Overall, the empirical evidence is unclear. For example, Berger and Udell (1992, 1995) employed indirect tests for capital rationing. They concluded that (1992, p. 1071) information-based equilibrium credit rationing, if it exists, may be relatively small and economically insignificant. Oliver and Moore (1994) used a series of probit regressions to test the availability and cost of finance across a range attributes of firms in the UK. He found that the likelihood that firms face financing constraints increased with factors such as firm size and profitability. Oliver and Moore also found that the degree of innovation was not linked to the likelihood of financing constraints. Conversely, Westhead and Storey (1994, 1997) compared the reported financing experiences of firms located in science parks in the UK with those located outside science parks, finding that firms with relatively high R&D expenditures, high proportions of scientists, and high proportions of patents were more likely to report financing constraints. Taken together, there is a strong theoretical literature that posits capital rationing but an inconclusive empirical literature. An explanation for this discrepancy is that testing for gaps in the capital market has been conducted across broad categories of firms, many of which may not have even sought financing and many of which were undoubtedly strong firms for which financing would not be a problem. Under this approach the effect of gaps that might conceivably have affected particular segments of the market (such as start-ups, growth firms, knowledge-based firms, etc.) may have been masked when such firms were combined with broader samples in which gaps might not have been in effect. This is worth remembering when interpreting the historical empirical literature. Of particular interest here are capital market gaps with respect to working capital financing. Other researchers assume market failure as a point of departure. Felsenstein et al (1998) accept market failure in the small business loan market as the premise for their paper, as follows: Capital subsidy programmes aimed at small businesses attempt to compensate for market failures that exist in the conventional financing markets. The existence of these market failures means that some small firms can be denied access to credit despite the fact that they have viable business projects. This rejection occurs because the 'risk profile' of the small business is likely to be weighted by factors other than project viability such as ownership structure, business experience and location of the firm. Information on firms with these characteristics is often limited and thus they are overlooked by otherwise well-functioning credit markets. Herzog (1982) argues for the importance of small business to the Swedish economy, but points out that small firms often face obstacles such as insufficient security for loans, lack
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of risk capital, and sometimes insufficient management expertise in the fields of technical development, financial planning, or marketing. Herzog goes on to indicate that the aim of governmental policy is to remove these obstacles, and to achieve this goal a number of supporting institutions were launched. In their study of small firm financing in Sweden in the period 1960-1995 Sjgren and Jungerhem (1996) present the view that smaller firms not listed on the stock exchange and lacking financially strong ownership could not rely on the money market or secondary markets for their financing. Consequently, their relations with external actors such as banks and various public funds were crucial for survival and growth. The fact that there was reliance on various public funds suggests an underlying market failure. Schenk (2004) analyzes industrial financing in Hong Kong in the period 1950 to 1970. Although she indicated the evidence suggests a bias toward financing large-scale industry at the time, she also refers to a lack of evidence of market failure. The small business sector applied political pressure over lack of financing because its members felt discriminated against because they lacked the collateral or reputation to establish their creditworthiness. There was also a cultural dimension to the issue of the demand versus supply of small business financing because, at the time, British expatriates controlled the largest bank while Chinese mainly conducted industry. In a limited study, Zinger (2002) finds differential satisfaction among borrowers, depending on firm size. Although Zinger (2002) indicates that few of the sample borrowers can be classified as being disappointed with their present bank financing arrangements, he also points out that business size, as measured by the number of full time employees, is positively associated with the level of satisfaction with bank financing arrangements that is, the smallest businesses are less satisfied than the largest businesses. The generalizability of the study is called into question due to its small sample size, and focus on a single geographic region, Northern Ontario. Uzzi (1999) takes a sociological approach to the small business loan market. In his study of acquisition and cost of financial capital in middle-market banking, Uzzi (1999) finds that firms that embed their commercial transactions with their lender in social attachments receive lower interest rates on loans. He also finds that firms are more likely to get loans and to receive lower interest rates on loans if their network of bank ties has a mix of embedded ties and arm's-length ties. He argues that these effects arise because embedded ties motivate the borrower and lender to share private resources, while arm'slength ties provide the borrower with access to public information on market prices and loan opportunities. The suggestion that there are two prices available in the market one if capital is sought in the context of social attachments to the provider of capital, and a second price if there are no social attachments is in itself evidence of a market imperfection. In a similar vein, Cole (1998) finds that a potential lender is more likely to extend credit to a firm with which it has a pre-existing relationship as a source of financial services. In the event one doubts the lending markets capability to lend differentially dependent upon factors that are not prima facie commercial in nature, consider Selz (1996), which discusses a study conducted in Denver that finds race-based differences in lending

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practices. Consider also the results in Cavalluzzo and Cavalluzzo (1998) who find that, although white men and women can expect similar treatment in credit markets, minorities fare worse than whites. Glennon and Nigro (2005) examine the default risk of small business loans granted under the Small Business Administration (SBA). They report that, although medium-maturity loans originated under the SBA 7(a) loan guarantee program [Small Business Administration; the US federal governments loan guarantee program] are targeted to small firms that fail to obtain credit through conventional channels, the default experience is comparable to that of a large percentage of loans held by larger commercial banks. To those who might think that small firms can resolve risk issues with lenders through collateral, note that Hulburt and Scherr (2003) find that collateralization is actually positively related to firm size. They surmise that this is a reflection of economies of scale in secured lending due to the fixed costs of setting up a secured lending arrangement and monitoring it over time. It would therefore appear that provision of collateral is not necessarily the solution to the small business owners inability to borrow.

P HASE I: I NTERVIEWS

WITH

K EY I NFORMANTS

As a first step to providing empirical information to the current Canadian setting for working capital, a series of interviews was undertaken. Interviews included senior executives of banks, representatives of small business organizations, and other knowledgeable individuals. Qualitative data analysis was supplemented by examination of industry reports and research digests. Representatives of financial institutions were queried as to their views of the current Canadian environments, about the specific lending policies of their respective institutions, and about their views of how the market for SME working capital needs might be further improved. Representatives of SME groups were asked about borrowing experiences of SMEs, firms needs for working capital, and their ideas about how the marketplace for working capital might be further improved. Analysis of Interview Data Generally speaking, most commercial lenders have segmented the SME lending market into small borrowers and large borrowers. Small loans tended to be defined as lending facilities of less than $200,000 ($500,000 in some cases). Small loans tend to be treated as of they were personal loans to the business owners. They are, in almost every case, adjudicated through credit scoring models. The last fifteen years have witnessed several fundamental changes in how banks relate to SMEs. In their 1991 review of the Canadian SME banking market, Wynant and Hatch (pp. 139-140) reported that loan account managers typically managed loan portfolios of

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80 to 120 borrower clients. At that time, Wynant and Hatch (pp. 139-140) identified the following as the key criteria for screening loan requests: Character of the key principals of the firm Competitive position of the industry Borrowers ability to compete and viability Companys net worth position Borrowers cash flow prospects Availability of business and personal assets as security Sector (certain sectors were identified as high risk, including restaurants, small retailers, trucking firms, etc.) Start-up businesses Loans for assets with little collateral value

It is noteworthy that the purpose of the loan (that is, whether or not the proceeds of the financing would be used for working capital) was not specified. Perhaps the most striking change in SME lending Wynant and Hatchs work then has been the transition towards credit scoring as the preferred means of adjudicating credit applications. Credit scoring models were being used, or initiated, by almost every large commercial lender. However, none of the bank representatives interviewed for this work identified loan purpose as being among their lending criteria or as being incorporated into credit scoring models. The single most frequently mentioned risk issue identified by the lenders was whether a loan applicant was a start-up firm. Where firms were not start-ups, the most-frequently mentioned reasons for loan turndowns were poor credit history of the owner(s), low personal net worth, insufficient equity in the business, and poor cash flow. In the case where the applicant was a start-up, the need for full security behind the loan was a core requirement. For several institutions, lack of security for a business start-up precluded any consideration for a loan, regardless of the use of the loan proceeds. Lenders reported that small loans were usually structured as revolving operating lines of credit, overdraft facilities, or (increasingly) loans based on business credit cards. Small loans did not tend to be highly structured or closely followed. Several lenders commented that the administration costs associated with monthly tracking of inventory and receivables were too onerous for aligning the limit of the credit facility to levels of working capital. For small loans, borrowers typically faced a ceiling on the credit facility available and the requirement that the loan be revolving. Ceilings might be set at two to three times monthly sales (assuming reasonable inventory turnover). Interest rates on loans tended to be between prime and prime plus 300 basis points. The CFIB (1993, p. 11) notes that the majority of small businesses that have loans/credit lines are for amounts under $200,000. This is confirmed by the Survey on Financing of Small and Medium Enterprises.8 It is the large loans (those in excess of $200,000),
According to the Survey on Financing of Small and Medium Enterprises (2004, Table 12), the average loan authorization is approximately $145,000 and 85 percent of loan applications are for less than $200,000.
8

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however, that tend to be managed by loan account managers. In such cases, the prototypical process is that a business approaches the lender for a loan which is then structured by the account manager, generally into a lending facility that comprises both an installment loan and an operating line of credit. Lending criteria tend to mirror those in effect for smaller loans with age of firm (start-up or not) and sector as being heavily weighted along with the owner(s) track records (credit bureau report, relationship with lender). According to the lenders representatives interviewed here the decision to grant a loan does not usually depend on the purpose of the loan; that is, on whether the loan is being used to finance working capital. Larger loans for working capital financing tend to be linked to the level of working capital and structured in consultation with a loan account manager. One formula that was identified by several lender representatives was that upper limits on operating lines of credit were set at 75 percent of receivables (of less than 90 days aging) plus 50 percent of inventory. It bears emphasizing that for smaller firms, such lending formulae were not the norm because of the cost of monitoring. For both small and large loans the lending decision does not appear to reflect whether or not the credit sought is to finance working capital: risk, according to the lenders, is determined primarily by the quality of the borrower and the quality of the collateral. When asked if they believed that there was a credit gap related to working capital, several replies indicated that the issue was not supply of capital; rather, the issue was one of risk. Some examples of lenders responses include the following. There are always businesess looking for more than we are willing to lend; but we would not lend more given the risk of borrowers at the margin. The supply exists but is not accessible to SMEs with weak balance sheets; security is not sufficient, [there can be] little depth to address bumps in the road. Banks are low risk lenders - some firms (especially start-ups) are off their risk scale. When asked specifically if loans for working capital were relatively risky, several of the interviewees opined that working capital loans are much riskier and working capital is the most risky loan you can do. A more moderate response from one lender was that working capital loans were Not necessarily more or less risky [but that the] relative risk of working capital loans goes to why liquidity needs to be financed [whether the problem is] poor management [or the need to finance] growth. As a response to the risk, lenders usually require such loans to be fully secured, especially those to start-ups. In terms of risk, the primary issue identified by the lenders

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was related to the risk of financing start-up firms and not the risk of financing working capital needs. According to one lender, Start-ups are the issue [and] the owner needs to bring working capital financing to the table. Several other responses identified the problem as being related to start-up firms: For new entrepreneurs, financing working capital is a key challenge. Is there an adequate supply? No the turndown ratio for start-ups [is high]. By and large, SMEs have very good access to capital [but there are] issues for early-stage firms with respect to working capital. This result is reinforced by the CFIB (2003, p. 13, who noted that younger SMEs face higher rejection rates) and is confirmed by the 2004 FDI Survey of Financing SMEs (Table 7). Several lenders noted that they expected that business owners would finance part of working capital using their equity stake in the firm. The query to lenders about a gap really put forward the same question posed at the outset of the section of this report that reports on the literature, namely, what is a gap? Lenders are often in the position of turning down loan requests; however, this does not mean that a gap exists. Turndowns represent a pricing decision only to the effect that the lender, if pricing the loan to risk, would assess such a high interest rate that no loan agreement would result. In the words on one lender representative: We control by how much we are willing to lend rather than by a pricing premium. It was interesting that respondents did not generally know how to respond to the direct query of whether or not they believed that there was an adequate supply of working capital for Canadian SMEs. The respondents were evenly split on the question. Those who believed the supply of working capital was inadequate offered responses such as: The availability of working capital is tied to cash flows of SMEs, with changes in the dollar profit margins are squeezed, cash flows are down; so it is more difficult to get working capital. Others expressed concerns that firms in rural areas faced a shortage, in part because of the centralization of lending authority. For example, several of the responses included: May not be a question of availability as accessibility - rural areas more of an issue.

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[The problem is] centralization, rotation of account managers, of lending authority in cities. Lack of local lending authority in rural areas. Both lenders and SME representatives were asked if applications for working capital were increasing relative to applications for other types of loan and whether or not such applications were being turned down with greater frequency. However, none of the respondents maintained records of application rates or turndown frequencies. Lenders using credit scoring methods could query their systems to report application and turndown rates for loan applications that had entered the system but, universally, could not estimate the frequency of informal applications and turndowns (for example, where a business owner would be discouraged from seeking a loan based on a discussion with a loan account manager). During the interviews, several groups referred the research team to publications. For example, the CFIB declined to be interviewed but referred the research team to its 2003 report. These reports have been summarized in a preceding section of this report as part of the review of the literature. To explore further the needs for working capital, the report turns to the findings from analyses of survey data that comprises Phase 2 of this work. However, the review of literature and the interview data provide important direction for the empirical analysis of survey data. The interviews and literature indicate several factors, aside from the use of loan proceeds, that are widely used in commercial lending decisions: these include the age of the firm (whether or not it is a start-up), the industry sector, the track record of the business and that of the firms owners, the availability of collateral, the firms location (urban or rural), whether the firm is an innovative firm, etc. Therefore, the analytical challenge of the Phase II analyses is to determine the extent to which, after allowing for these determinants of credit decisions, use of proceeds for working capital remains a factor in credit decisions.

P HASE II: A NALYSIS

OF

S URVEY D ATA

Frequency of Loan Applications Table 5 of the 2004 FDI Survey on Financing of SMEs reports that of all loan applications, 55 percent involve working capital financing. Further analysis of the survey data breaks down this figure as follows: Proceeds used for working capital only: 24.1 percent of all loan applications Proceeds used for fixed assets and for working capital: 18.5% percent of all loan applications

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Proceeds used for R&D and for working capital: 5.3% percent of all loan applications Proceeds used for debt consolidation and for working capital: 6.7% percent of all loan applications

The data from Table 5 of the 2004 Survey on Financing of Small and Medium Enterprises reveals several statistically significant patterns to the incidence of loan applications for financing working capital. These differences include the following: Firms in the wholesale/retail, knowledge-based, and professional services sectors were more likely to identify working capital as the reason for their loan applications. Common to these sectors is a relative scarcity of tangible assets that could be used to secure loans. The professional services and knowledge-based sectors prototypically lack tangible assets whereas assets of firms in the wholesale and retail sectors tend to be short-lived are subject to rapid obsolescence. Thus, applications for working capital loan from these sectors will carry with them this risk factor. Firms located in urban (as opposed to rural) areas, exporters, and innovative firms were all significantly more likely to apply for loans for working capital financing than other firms. Table 8 of the 2004 FDI Survey on Financing of SMEs shows approval rates of 77 percent, 76 percent, and 56 percent for firms located in urban areas, exporters, and innovative firms, respectively. Young firms were more likely to apply for loans for financing working capital than were more mature businesses. This repeats concerns about access to capital from the qualitative data that start-ups faced particular difficulties qualifying for a loan. Again, loan application approval rates appear to increase with age of firm (Table 8, 2004 FDI Survey on Financing of SMEs). Lenders interviewed for this work were virtually unanimous in their views that early-stage firms were relatively riskier.

Frequency of Loan Turndowns Collectively, these findings suggest that applications for loans to finance working capital will disproportionately represent firms in categories that lenders would view as risky. One would logically expect, therefore, that loan applications for working capital financing would be lower than average. This is confirmed by further analysis of the 2004 FDI Survey on Financing of SMEs data, as shown in the following table.
Table 1: Selected Loan Application Turndown Rates

Proceeds to be used for Working Capital Applications for Term Loans* 28.4% (N=203)

Proceeds not to be used for Working Capital 6.48% (N=478)

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Applications for New Operating Loans*

14.72% (N=586)

10.32% (N=111)

*Excludes applications pending at time of questionnaire administration and loans subject to loan guarantee programs.

It is clear from Table 1 that loan applications for working capital tend to be for operating loans and loan applications that are not intended to finance working capital tend to be for term loans. This is to be expected from the interview data. It is also clear that, for both types of loan, the loan turndown rates are higher for loan applications in which the proceeds are destined to finance working capital. What is not clear, however, is whether the higher turndown rates are the result of the loans being used for working capital or because they are more likely to originate from applicants that are, on average, inherently more risky because they are innovative firms, start-ups, firms in urban areas, or in sectors that lack tangible collateral, etc. To resolve this question requires analysis of turndown rates while simultaneously controlling for the risk factors identified from the preceding analysis and from the interviews. This was accomplished by estimating logistic regression models of the turndown process. This is akin to credit scoring but where the outcome (dependent) variable is whether or not a given loan was turned down. Control variables in the model need to include sector, location (urban/rural), age of firm (start-up or not), whether a firm is an innovative firm or an exporter or not.9 If after controlling for these confounding variables, firms seeking financing for working capital are still turned down more frequently, then a gap would be implied. In the event that turndowns of applications for working are explained by the confounding risk factors (that is purpose of loan adds negligible explanatory power to the regression model) a gap is not supported. Accordingly, the following logistic regression model was estimated.

Where

Here, the Xi represent the various independent variables in the regression model (sector, firm age, etc.). When the exponent of e in the above equation is large, approaches a value of 1 (for example, here, the loan application was turned down). When the exponent of e is small, approaches a value of 0 corresponding to the loan application not being turned down. The estimates of i allow inference about the relative impact of each variable.
Additional control variables included size of firm as measured by the number of full-time employee equivalents and other factors identified based on the interviews and other qualitative data from the first phase of this work.
9

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Logistic regression models of loan turndowns were estimated separately for new applications for operating loans (697 cases) and for term loan applications (681 cases). The results are presented in Tables 2 and 3 respectively. Each of the logistic regression models were developed in three stages. First, the models were estimated employing all variables suggested by previous research and the interviews. The results of this step are shown in the left-most panels of Figures 2 and 3. In the second step, variables that were not statistically significant were sequentially deleted from the model and the model reestimated with each deletion until a final model was obtained. These are shown in the middle panels of Figures 2 and 3. In the final step, a binomial variable representing whether or not the proceeds of the loan were to be used for working capital financing was added to the model. If addition of this variable to the model improved significantly the goodness-of-fit of the model then one would conclude that use of proceeds for working capital would be a factor in the loan decision. The results of this step are shown in the right-most panels of Tables 2 and 3. The regression models show that, for both types of loan, size, age of firm, and sector influence turndown frequency. Loan turndowns are more likely for smaller firms and for start-ups. Turndown rates for term loans, which are often secured by the asset(s) being financed, are not correlated with lenders collateral or co-signature requirements; however, operating loan decisions are correlated with lenders requirements for personal property as collateral and with co-signature requirements. Applications for operating loans from firms engaging in relatively high levels of R&D were more likely to be declined, a result that is worth further investigation. All of these findings are consistent with the interview data obtained during the initial phase of this work. However, after allowing for these factors, the introduction of the additional variable connoting the use of proceeds for working capital did not improve the models. That is, use of proceeds was not correlated with turndowns to a statistically significant extent after allowing for size, sector, age, etc. Expressed differently, the data are not consistent with the idea that applications for working capital loans are turned down any more frequently that other loans, given age, size, sector, and other reasonable factors in the loan decision.

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Table 2: Logistic Regression Results, Operating Loans

Start-up firm Sector Agriculture etc. Manufacturing Wholesale / Retail Professional Services KBI Tourism Personal property as collateral Commercial property as collateral Co-signature requirement Exporter Urban location No R&D Investment Innovative firm Full-time equivalent employees Proceeds to be used for working capital Constant Number of cases Cox & Snell R Square Nagelkerke R Square Hosmer and Lemeshow Test (p-value) In-sample Classification Accuracy (%) 0.76 -0.81 0.29 -0.40 -0.29 0.26 0.57 0.62 0.15 1.27 -0.07 0.44 -0.38 0.69 -0.03 -2.54 697 0.097 0.171 84.8

p-value 0.002 0.078 0.101 0.461 0.286 0.514 0.545 0.122 0.010 0.543 0.000 0.811 0.153 0.140 0.069 0.020 0.000

Exp() 2.14 0.44 1.34 0.67 0.75 1.29 1.77 1.85 1.16 3.56 0.93 1.55 0.68 1.99 0.97 0.08

0.79 -0.94 0.26 -0.40 -0.26 0.27 0.52 0.66 1.28

p-value 0.001 0.054 0.049 0.499 0.272 0.560 0.510 0.149 0.005 0.000

Exp() 2.20 0.39 1.30 0.67 0.77 1.31 1.69 1.93 3.59

0.78 -0.91 0.27 -0.38 -0.24 0.29 0.50 0.66 1.28

p-value 0.001 0.073 0.055 0.490 0.299 0.591 0.482 0.166 0.005 0.000

Exp() 2.19 0.40 1.31 0.68 0.79 1.34 1.66 1.93 3.58

-0.38 0.72 -0.03 -2.18 0.094 0.166

0.128 0.056 0.024 0.000

0.68 2.05 0.97 0.11

-0.38 0.73 -0.03 -0.23 -2.00 0.095 0.167

0.134 0.055 0.025 0.437 0.000

0.69 2.07 0.97 0.80 0.14

0.770 84.6

0.266 84.8

0.170

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Table 3: Logistic Regression Results, Term Loans

Start-up firm Sector Agriculture etc. Manufacturing Wholesale / Retail Professional Services KBI Tourism Personal property as collateral Commercial property as collateral Co-signature requirement Exporter Urban location No R&D Investment Innovative firm Full-time equivalent employees Proceeds to be used for working capital Constant Number of cases Cox & Snell R Square Nagelkerke R Square Hosmer and Lemeshow Test (p-value) In-sample Classification Accuracy (%) 0.58 -0.04 1.75 1.70 0.59 1.30 2.09 -0.20 -0.26 0.37 0.17 0.08 -0.22 0.35 -0.03 -2.61 681 0.099 0.192 88.0

p-value Exp() 0.063 0.000 0.930 0.000 0.000 0.352 0.020 0.000 0.460 0.350 0.377 0.551 0.835 0.448 0.472 0.004 0.000 1.78 0.96 5.76 5.45 1.81 3.68 8.05 0.82 0.77 1.45 1.19 1.08 0.81 1.42 0.97 0.07

0.66 -0.15 1.84 1.72 0.74 1.60 2.12

p-value Exp() 0.027 0.000 0.749 0.000 0.000 0.235 0.002 0.000 1.93 0.86 6.27 5.60 2.11 4.94 8.30

0.58 -0.16 1.82 1.64 0.72 1.53 2.11

p-value Exp() 0.054 0.000 0.743 0.000 0.000 0.251 0.004 0.000 1.79 0.85 6.15 5.17 2.06 4.62 8.26

-0.03 -2.83 0.093 0.180

0.002 0.000

0.97 0.06

-0.03 0.40 -2.94 0.096 0.186

0.002 0.127 0.000

0.97 1.50 0.05

0.655 88.1

0.461 88.0

0.016

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Summary of Data Analysis Neither the qualitative interview data, nor the analysis of quantitative data, are consistent with the presence of gaps related to working capital financing in the debt market in which SMEs borrow. Both qualitative and quantitative data reflect that the use of the proceeds of loans do not figure into commercial lenders decisions on loan applications. The data show that loans for working capital are sought relatively more frequently by business borrowers in high-risk groups: start-ups, sectors in which collateral may be problematic, smaller firms and innovative firms. After allowing for these risk factors, loan applications from firms that borrowed to finance financing working capital were not turned down with any greater frequency than firms that used the proceeds for other purposes. Both quantitative and qualitative data strongly demonstrate that lending to start-up businesses is a significant risk factor. Lenders require that such firms be fully secured. With the advent of Basel II, it may be expected that the use of credit scoring and the requirement for security will intensify. Those new firms that lack track records or a long bank relationship with the founders may be hard-pressed to obtain any type of financing if they lack the collateral necessary to secure loans. While the data do not support the contention of a credit gap according to the classic definition, it remains that certain categories of firms are, on average, less creditworthy than others. These include start-ups, smaller firms, and firms in particular industry sectors. This poses several questions. The first is whether intervention is warranted to assist less creditworthy firms gain better access to credit. If intervention is deemed advisable, it is not clear that the intervention should be from the federal government. With only a few exceptions, respondents to the interviews did not see it was the responsibility of the federal government to redress this problem. Most lenders believed that founders should, as part of the financial equity they are expected to bring to their firms, use some of this equity to finance working capital. Others felt that other governments could play a role. The interview with the credit union representatives revealed that Nova Scotia has established a loan guarantee program for working capital that is specific to credit unions. This comment aroused considerable interest among other credit union representatives who participated in the interview/conference call. Other respondents saw this problem as being a responsibility of the private sector: one suggestion was the re-establishment of the Business Centurions network where the new organization would have the dual responsibility of mentoring founders of new businesses and administering loan guarantees based on a pool of capital allocated for this purpose. In looking at 42 loan guarantee programs internationally (Europe, Asia, North America) and domestically, it was found that the majority of programs allow for loan guarantees for working capital. In many countries, loan guarantees are based on mutual guarantee systems and are administered by trade associations.

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Only one lender felt strongly that this problem could and should be addressed by the federal government through a CSBF-like program. This respondent offered several suggestions to this effect, by linking the loan ceiling to working capital requirements, age of firm, and fixed asset acquisitions through a sequence of formulas. Most lenders, however, disagreed with a complex structure and advocated that if the federal government were to establish a means of guaranteeing loans for working capital financing, it should be through a separate program from the CSBF and that it should be simple to administer. While the data show that lending decisions are not directly affected by using loans to finance working capital, it remains that certain categories of firms are less likely to obtain loans than others: start-ups, smaller firms, innovative firms, and firms in certain industry sectors. This situation is not dissimilar to firms that use the CSBF for guarantees of term loans, many of which would be turned down based on attributes such as firm age and size and sectoral effects (approximately 75 percent according to Incrementality of CSBF Program Lending, Volume 1: Insights from SME FDI Data, Prepared on behalf of the Small Business Policy Branch, Industry Canada, Equinox Management Consultants Limited, December 2003). Thus the two research questions that form the objectives for this project are separable. On the one hand, the work finds little evidence of a capital market gap. On the other hand, there appear to be a substantial number of firms that would have applications for loans rejected based on fundamentals of the business and for which loan guarantees might provide incremental access to credit. In particular, small and early stage firms, especially innovative firms, owned by individuals unable to assemble collateral or cosignatories are simply too risky for most commercial lenders. However, it is not clear that it is the role of the federal government to intervene in the market on behalf of such firms. This is so for two reasons. First, it is arguable that such firms should be seeking risk capital instead of bank debt. Second, risky firms may already be targeted by the mandate of the Business Development Bank or by other provincial or local programs.

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Cavalluzzo, K. S. and Cavalluzzo, L. C. (1998). Market Structure and Discrimination: The Case of Small Businesses. Journal of Money, Credit & Banking, Vol. 30 Issue 4, p771-792. Cole, R. A. (1998). The importance of relationships to the availability of credit. Journal of Banking & Finance, Vol. 22 Issue 6-8, p959-977. Cressy R., 1994. Are Business Startups-Debt Rationed? Working Paper No. 20, The Warwick Business School Small and Medium Enterprise Centre, Coventry. Cressy, R., 1995. Staying With It: Some fundamental determinants of Business Start-up Longevity (Coventry: Warwick Business School, Small and Medium Enterprise Centre, Working Paper no. 17). Cressy, R., (2002). Funding Gaps: A Symposium, The Economic Journal, 112 (February): F1-F16. Demsetz, H. (1969). Information and efficiency: another viewpoint, Journal of Law and Economics 12 (April): 1-22. Dietsch, M. and Petey, J. (2004). Should SME exposures be treated as retail or corporate exposures? A comparative analysis of default probabilities and asset correlations in French and German SMEs. Journal of Banking & Finance, Vol. 28 Issue 4, p773-788. Eggers, J., K. Leahy & Al Makalachki (1997). Challenges of Managing Rapidly Growing Companies: http://www.babson.edu/entrep/fer/papers97/sum97/egm.htm. Felsenstein, D., Fleischer, A, and Sidi, A. (1998). Market failure and the estimation of subsidy size in a regional entrepreneurship program. Entrepreneurship & Regional Development, Vol. 10 Issue 2, p151-165. Glennon, D. and Nigro, P. (2005). Measuring the Default Risk of Small Business Loans: A Survival Analysis Approach. Journal of Money, Credit & Banking, Vol. 37 Issue 5, p923-947. Hart, Oliver, and Moore, John (1994). A Theory of Debt Based on the Inalienability of Human Capital. Quarterly Journal of Economics, 109, 841879. Herzog, H. (1982). Small and Medium-Size Firms in Sweden and Government Policy. American Journal of Small Business, Vol. 7 Issue 2, p13-22. Hulburt, H. M. and Scherr, F. C. (2003). Determinants of the Collateralization of Credit by Small Firms. Managerial & Decision Economics, Vol. 24 Issue 6/7, p483-501. Jacobson, T., Lind, J., and Roszbach, K. (2005). Credit Risk Versus Capital Requirements under Basel II: Are SME Loans and Retail Credit Really Different? Journal of Financial Services Research, Vol. 28 Issue 1-3, p43-75.

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