The Role of Banks in SME Finance

Abstract

Banks play a crucial role for the financing of small and medium-sized enterprises (SMEs). SMEs represent a large fraction of all firms in many economies and contribute significantly to employment and growth. But, SMEs are more informationally opaque, more risky, more financially constrained, and more bank-dependent than large firms, which creates serious challenges in SME finance. In this inaugural address, I focus on lending technologies to cope with key challenges in SME finance. I present evidence from two recent empirical studies. The first conclusion is that relationship lending works. Applying meta-analysis in a cross-country context, we show that, on average, borrowers benefit from relationship lending. SMEs obtain more credit and/or lower loan rates under relationship lending. Furthermore, bank competition makes benefits for borrowers more likely. The second conclusion is that trade credit has limited scope to replace bank debt when the latter is subject to a shock. SMEs in Europe have countered a shock to their bank debt to some extent with trade credit. However, substitution has become increasingly difficult during the financial crisis and was only possible for a subset of firms: the ones with better credit quality and intermediate financial constraints. Overall, a comprehensive understanding of lending technologies such as relationship lending and trade credit is critical for lenders, borrowers, and policymakers to ensure the proper functioning of SME finance.