SMALL AND MEDIUM-SIZED BUSINESS
1. Information on the Financing
Needs of SMEs
2. Bank Lending
and Turnover of Business Account Managers
3.
Decentralisation of Credit-Granting Authority in Banks
4. Bank Lending to Higher Risk
Borrowers
5. Policy Analysis of Small
Business Finance Needs
6.
Definition of Knowledge Based Industries and Banks and Knowledge Based Industry Firms
7.
Provision of Credit by Financial Institutions to Aboriginal Individuals and Institutions
SECTION H
SMALL AND MEDIUM-SIZED BUSINESS
1. Information on the Financing Needs of SMEs
Background
In Canada, as in other countries, the most serious problem facing policy makers and financial institutions alike when they address the Small and Medium-Sized enterprises (SME) and Knowledge-based industry (KBI) markets is the inadequacy of information relating to the financing needs (both debt and equity) of SMEs and the supply of financing to them. Much better market information is critical for public policy development.
Surprisingly, a lack of data hampers understanding of small business in many developed countries. An OECD report concludes, "Demand for reliable, relevant and internationally comparable data on SMEs has been rising. Statistical offices have started to collect and publish relevant data but serious shortcomings persist."
This shortage of data on small business financing also exists in the United States even though the Community Reinvestment Act has required disclosure. A Federal Reserve study observes:
Surprisingly little is known about small firms as borrowers or about their credit market. Survey data do confirm that small businesses rely on financial intermediaries ¾ especially commercial banks ¾ as lenders, but the information available to us about the role of intermediaries as small business lenders, about the underlying costs and risks associated with small business loans, and about the factors that influence decisions to supply credit or demand credit is meagre at best. There is no single source of data that includes all the information to consider in assessing the availability of credit.
Substantial progress has been made in Canada recently in the collection of data on bank financing of SMEs:
- The Canadian Bankers Association now publishes detailed quarterly statistics on the lending activities of major chartered banks. These data give particular attention to lending to SMEs.
- The CBA also publishes annually the loan loss provisions taken by major banks against their business lending.
- Thompson Lightstone, under the sponsorship of the CBA, conducts an annual survey of SMEs concerning their "needs, expectations and satisfaction with financial institutions." This source also includes results from a survey of bank loan officers concerning credit applications and approvals.
In addition, several industry groups, including the Canadian Venture Capital Association and the Canadian Finance and Leasing Association, provide regular reports of their members’ activities in financing SMEs. The Canadian Federation of Independent Business also regularly surveys its members about their perceptions and experience with respect to the availability of credit.
Despite this progress, further information is needed in the following areas:
¨ Coverage of other suppliers of credit to SMEs. The CBA data cover only the lending activity of major chartered banks. Comparable coverage is needed of the activities of other significant suppliers of credit (such as trust companies, credit unions, insurance companies and pension funds). The coverage should include both direct lending and indirect lending through securitized instruments.
¨ Coverage of other types of financing. CBA data include only bank credit to SMEs. The coverage of types of finance should be extended to include loans, leases and equity finance.
¨ Further detail on the characteristics of borrowers. The current breakdowns in the data are comprehensive on matters such as size of credit authorisation and the industry of the borrower. Further information is needed on the rural urban division of credit and other measures of the size of the borrower.
¨ Data collected from the perspective of the SME. We have insufficient data from the perspective of the SME itself. Such data would indicate the significance of different sources of funds in the overall financing of SMEs.
¨ Data collected from independent sources. The CBA collects data on small business lending of major banks. In addition, it sponsors the surveys conducted by Thompson Lightstone to collect information on customer experience. Both types of information are crucial to understanding the availability of financing and the performance of institutions in meeting their customers’ expectations. The CBA and Thompson Lightstone surveys appear to be carried out objectively. Nevertheless, some groups seem unwilling to accept the findings out of concern about bias in collection or interpretation. Collection and interpretation of the data by a government agency would facilitate acceptance.
¨ Particular attention to KBI data. The data should include coverage of the suppliers and types of financing going to KBIs. As discussed below, establishing a consistent definition of KBIs should be a priority.
Task Force Recommendations
101)The Government should undertake a substantial program of information collection and analysis to ensure that there is adequate information relating to the financing needs of small and medium-size businesses (SMEs) for effective public policy development. To that end:
(a) Statistics Canada should collect data on the supply of debt and equity financing to small and medium-size enterprises, including in particular coverage of knowledge-based industries (KBIs), aboriginal enterprises, and other sectors or subsectors determined from time to time to be of particular public interest. The data collection program should cover all regulated and unregulated private- and public-sector financial institutions engaged in significant loan, lease, equity investment, or securitization activity in the small business market. Details of the information collection program, which should be comprehensive, should be determined by Statistics Canada in consultation with data providers, potential users in the community, and representatives of Industry Canada.
(b) Financial institutions should be required to publicly release their responses to Statistics Canada, with appropriate modifications to protect the confidentiality of commercial relationships.
(c) On a regular basis, Statistics Canada should publish compilations of the data collected for public review and analysis.
(d) Industry Canada should assume responsibility for co-ordinating an annual survey of SME attitudes to examine the availability of financing from the perspective of small businesses. The survey would be similar in concept to the studies currently being conducted under the auspices of the Canadian Bankers Association. The scope of the studies would be extended to cover all substantial providers.
(e) In addition, Industry Canada should conduct and publish periodic benchmark surveys of small business users, including knowledge-based firms, to provide a comprehensive benchmark picture of the financing they require and the sources of finance upon which they rely, as markets evolve. An initial benchmark survey should be completed as soon as possible, and follow-up benchmark surveys should be conducted once every three to five years. These surveys would complement the annual information collected by Statistics Canada and Industry Canada.
Views of Witnesses
There was general support for data collection initiatives. The President of the Canadian Federation of Independent Business, for example, indicated that her members are very supportive of further information collection on the small business lending area.
Over the last few years, the banks have been, by request, providing that information. It has been useful to everyone to understand the market better. (Catherine Swift, November 5, 1998)
The CEO of the Banque Nationale expressed his support for improving data quality, as well.
With respect to small- and medium-sized businesses, we applaud the MacKay report's recommendation to assure the quality of information available to public policy makers and the public in general. We recognise that there has been a vacuum in that regard. The National Bank and others do a much better job of that than is recognised. Forcing us to provide data will be a good way of furthering the debate and making it more transparent.(Léon Courville, September 29, 1998)
Witnesses from the Atlantic Provinces Economics Council told the Committee that poor data on small business financing have made their work on the identification of problems in the Atlantic region very difficult.
… the difficulty of obtaining a clear picture of small business financing due to the lack of adequate data. As an economist, you will know that I greatly appreciated the discussion of that in the report. I am also a member of the National Statistics Council which oversees Statistics Canada, and was pleased to see the discussion that will encourage Stats Canada and Industry Canada to come together to provide better data in this area.
APEC has done a number of studies, including one on venture capital, that have been very frustrating to undertake because of the lack of adequate data. This is not an insignificant point because, obviously, if we want to have good public policy in this area, we need to ensure that we have good data. I am very pleased to see that the recommendations for some new surveys in small business financing in this area. There is one proviso I do add in here. I hope the sample size is adequate enough to get data for Atlantic Canada. This is a continual frustration on many surveys, that the size is too small and we simply can't get any data that is usable for Atlantic Canada. (Elizabeth Beale, October 20, 1998)
Conclusions
The Committee has called for improved data on small business financing on numerous occasions; in its study of crown financial institutions, for example, as well as in its reports following consideration of amendments to the Small Business Loans Act. Meaningful policy debate requires relevant, accurate, and comprehensive data.
The Committee supports the Task Force recommendations on improving the adequacy of information relating to the financing needs of SMEs and the supply of financing to them.
2. Bank Lending and Turnover of Business Account Managers
Background
The Task Force heard much from members of the small business community and their associations about the frustration caused by a rapid turnover of account managers and the resulting inability of the small business representative to build and maintain the personal credibility which underlies a sound small business-banker relationship.(Task Force Report, Background Paper # 4, p. 66).
Task Force Recommendations
102) The Task Force urges deposit-taking institutions, particularly banks, to find new and creative ways to address the problem in small business financing created by the frequent turnover of business account managers, including the establishment of career paths and compensation incentives that provide long-term meaningful careers for community-based SME account managers.
Views of Witnesses
Witnesses who addressed this issue saw it as a serious problem. One witness from the Atlantic Bank Merger Task Force discussed:
… the need to improve commercial account management by banks. Many of our members report that they have experienced a high turnover rate for commercial account managers at the big six chartered banks. This requires a small business to train a new account manager about their business every year or two. This is inefficient for both the bank and the small business. We recommend that banks adopt a policy of commercial account teams where each commercial account would have an account manager and assistant account manager. The transfer of an account manager could only be made if the assistant account manager had been on the job for at least one year and vice-versa for the transfer of an assistant account manager. This would eliminate most of the problems relating to knowledge of the account and would ensure proper coverage for vacations and illness. It would also reduce the heavy account load currently carried by many commercial account managers, and it would ease the transition when a commercial account manager leaves the bank for another job. The result would be continuous coverage of accounts and less frustration by commercial clients of the bank.
Another factor is the need for professional training of commercial account managers. All of the big six chartered banks have in-house training facilities for commercial banking, however, there are limited training facilities for educating new commercial account managers who may be employed by smaller financial institutions, credit unions or insurance companies that have not yet developed this expertise. Independent training facilities should be established in consultation with universities, colleges and private training schools to provide training to meet the need for professionally trained commercial account managers. (Terry Norman, October 20, 1998)
The CEO of the Banque Nationale described the problem from the bank’s point of view when he was asked to react to criticism that local managers get to know their clients only to be transferred out by head office after four or five years.
You have touched on a very sensitive issue that is actually one of my greatest concerns and that I am gradually giving up on. The rotation rate of our managers is much too high. The only ongoing complaints we receive from clients – and I meet with them for lunch twice a week and for breakfast once a week – is that we change our account managers too often. So I have been leading quite a battle on that front, telling everyone that I do not mind losing a battle now and then, but not the war. Yet, I have a feeling that I am losing the war. I am very familiar with the problem. We will find palliative measures that allow us to ensure that two people are familiar with a file and that both are not moved at the same time. Last year, our business clients liked our account managers so much that they actually hired one-fifth of them.
So you see, as soon as one leaves, it is difficult to move someone else because he may be the only person in that other region most familiar with our client base there, and he, too, would end up losing his clients. That makes two groups of clients that are unhappy each time a single manager leaves. … This kind of rotation results in lost information, lower efficiency and decreased marketing performance.
It is the value associated with the manager’s knowledge about our client base that is being lost each time. These costs are enormous and we are waging a real war against this problem. … There are … many factors that contribute to this particular phenomenon. … It is perfectly natural to want to follow a career path. We are trying to adjust salary brackets so we can say to people: you will be paid more if you do your current job well, rather than telling them they will be given another job. (Léon Courville, September 29, 1998)
In response to a question about the issues of account manager turnover and re-instituting credit decision making authority at the local level, specifically: "Am I right in saying that those two issues cannot be dealt with by public policy? (One issue is essentially a human resource issue within the institution, namely, you should not turn account managers over as frequently as they do. Where credit decisions are made is obviously a management decision, not a public policy decision.), the President of the Canadian Federation of Independent Business said:
I would agree. There is no question, and we have had many discussions over the years with the various financial institutions along those lines.
… and the interesting thing we find is that everyone agrees it is a problem but why have we not seen any movement? In fact, on the centralisation of decision making we have seen the exact reverse and much of the automation is an off-shoot of the automation of the financing decisions, the trend toward more credit scoring and the kinds of things which enhance centralisation to take place anyway. There are other developments which, like I say, it might not have even been a conscious policy but it just happened by association.
The account manager issue we find particularly vexing because all of the major banks we have met with have agreed that something should be done about it, but clearly it is not a priority because nothing has been done about it in a very long time. It would be very difficult to deal with in a public policy context (Catherine Swift, November 5, 1998)
Conclusions
While the Committee supports the Task Force recommendation urging the banks to solve this problem, it is clearly not a public policy problem. As the CEO of one of the chartered banks testified, the bankers acknowledge the seriousness of the problem and are working on possible solutions.
3. Decentralisation of Credit-Granting Authority in Banks
Background
The Task Force heard complaints from several individuals and groups about the impact of centralised bank decision making. The Task Force made inquiries of the banks and ascertained that all the large banks have delegated regional credit authority of up to at least $4 million. The Task Force acknowledged the need for the banks, as responsible stewards of the deposits they hold, to apply due diligence in all of their credit and other financing decisions. However, the Task Force also urged a continued decentralisation wherever it is feasible, including meaningful delegation to the local level. (Task Force Report, Background Paper # 4, p. 67).
Task Force Recommendations
103) The Task Force urges banks to continue to decentralise decision making in respect of credit-granting authority and collection practices, including a meaningful delegation to the local level.
Views of Witnesses
There were no views expressed by witnesses on this issue and recommendation.
Conclusions
As noted in the discussion of the turnover of account managers, while the Committee recognises that this is a serious issue for SMEs, it is not an issue that calls for the application of public policy
4. Bank Lending to Higher Risk Borrowers
Background
The Task Force believes that banks should be able to price appropriately for risk. What this means is that where higher loan rates than are now charged are necessary to extend credit to a borrower who today would be denied credit, the bank should feel that it can charge the appropriate amount for the credit without risking a negative community reaction. (Task Force Report, Background Paper # 4, p. 67)
Few, if any, loans are granted by Canada’s major banks at rates in excess of prime plus 3 percentage points. In contrast, in the United States, where credit to small business is perceived by that sector to be quite readily available, financial institutions offer their customers a much wider variety of terms and prices. There appear to be more innovative approaches in the U. S. market to the design of financing packages for SMEs and a greater willingness to price for risk. Similarly, the Business Development Bank of Canada is extending credit to Canadians at rates in excess of prime plus 3 percentage points.
Task Force Recommendations
104) The Task Force urges Canadian financial institutions to be prepared to make credit available to higher-risk borrowers with more innovative financing packages and appropriate pricing.
Views of Witnesses
In response to a question about why we do not price for risk in Canada, the CEO of Laurentian Bank of Canada stated:
It is a fact which is well documented in the Canadian marketplace that when a bank is proposing adjusting the rates for the risk, in most cases many businessmen will say no. I feel we should look at some factors like the capacity for small business to finance from government, provincial and federal, they have alternatives, so that on the demand side they have a way to say no, they can go to the other side. On the other hand, there are some negative aspects coming from the fact that if you charge the right price it is not accepted. I do not know why exactly, but I have seen that in the past. It is much easier for a Canadian banker to say this is too risky than to say if I loan you money I will charge you prime plus six.
I am running an institution and I am saying that to my people and they say the clients will jump on me, they will go to another bank. What people do is they turn around, they try to find some capital coming in, reduce the risk, and honestly I believe government programs are quite active. The Canadian Development Bank is a big competitor in that market and they are doing their job, and so are many other provincial subsidies. I believe taxation, government subsidies, government intervention and regulations are probably having some effect, but I do not know the exact answer. I just know that it is a fact of life that we do not have in Canada dynamic lending. That is why we have so many complaints coming from the marketplace. People feel they do not have access to capital but, at the same time, they do not wish to play in a risky business. (Henri-Paul Rousseau, October 22, 1998)
Then, in response to a question as to whether, in his bank, he had situations where he tried to price for risk, Mr. Rousseau responded:
Yes, and in most cases I am losing that to the competition or the business is not coming. We should have a look at this. I do not know the answer, but I am sure of the fact that we can talk to the bankers about activities in different areas, let us say Quebec, Ontario and B.C. and the western states and you will see a difference. A business person in the States will accept prime plus something much more easily if it is justified.
Over the years we have said to borrowers that we know you do not wish to pay prime plus five, but how about if you pay prime plus two and you give us a kicker if your business is going up. This is working. In some cases the business people will accept that since we are sharing the risk we will share the profit going up. It is a rare occasion though.
… it is not easy to change a culture of both borrowers and lenders. People have been trained to do things in other ways. We are pretty conservative institutions, that is why we are not risky but, at the same time, implementing change is a challenge.
Only the businessmen who have activities in the States and in Canada are accustomed to pricing for risk, then they are no longer a small business. In most of the cases they will turn around and go to government subsidies and try to get their loans in other ways. (Henri-Paul Rousseau , October 22, 1998).
The CEO of the Hongkong Bank Canada also indicated that there is a "Canadian" approach to risk-based lending.
One of the things that has come up on a number of occasions when we have been discussing lending for small and medium-size businesses, one of the areas or issues that has been brought forward by people who have appeared before us is what is known as, and I am sure you are well familiar with this, a risk-based lending. In the States, this seems to be available, I guess almost prevalent, but here in Canada, they say our large banks do not get involved in risk-based lending, and we are trying to find out why and a lot of the answers are, "Well, this is the Canadian way, and Canadians would not like this, and it would get us into a lot of trouble, so we are staying away from it." (Youssef Nasr, October 29, 1998)
The CEO of the Toronto Dominion Bank explained the Canadian attitude to pricing for risk and the approach his bank is taking.
In a sense, it is the Canadian way I guess, that we would be usurious if we did. We have started something called SCC Canada, where we invest, it is with a company called Sirrom out of Nashville. We own 60 per cent, they own 40 per cent and we invest in Canadian growth companies, buy junior debt in them and have some warrants and that. Now, they have not all worked out, but it seems to be working pretty well, and is it about 60 or 70 million?
And so that is a way we get a higher return and we are getting more confidence and comfort with that. We are going to try experimenting with charging a little more. We had a presentation to our board on small business at the last board meeting and we undertook to them that we were going to, we had started the experimenting, and were going to come out with some programs whereby we charge a little more and can take a higher risk.
The Thompson-Lightstone Survey showed us approving 93 per cent of our loans to small business. That is a pretty high ratio. I do not think we are that high, really. We are doing, we are getting a higher percentage approved all the time, but I think at 93 per cent, you would probably be approving some you should not be approving. (Charles Baillie, November 2, 1998).
The CEO of the Farm Credit Corportion said that his organisation does price for risk.
Our rates would be prime-two-and-a-quarter, in that range. Yes. That is what we, I guess, internally have as a target for the corporation. What we are finding is you have to look at – and I think it has come out in the MacKay Task Force – what degree of risk are you actually taking? We have, as a corporation, moved to a more customised interest rate based on the risk itself. We still have, I think, some room to move in that particular area. We do find, as we do more on the value-added side, for example, it should dictate a different rate than what we would see in the primary producer. I am making a general statement here, as I hope you can appreciate, we have to look at the individual risk associated and price accordingly. (John Ryan, October 26, 1998).
The CEO of Banque Nationale indicated that his bank was starting to price according to risk.
Commercial banking in Canada has always been done under the section of the Bank Act, which used to be called 188 and now is 432, whereby we would lend a margin of credit operations to commercial clients and therefore we would have automatically, as a guarantee, the assets, receivables and inventory, and we would take account of the recuperation as the failure occurs and that would be it. We would offer more or less homogenous rates. We were not taking into account any risk factors in that lending because it was a bit automatic.
When we do asset-base lending in the U.S., first we measure the risk of the loan. We now do it in Canada, and I will get to that later. We measure the risk and price accordingly. We also monitor the receivables and the inventory. We do not wait for the guy to fail before we start monitoring. We have auditors going in on a weekly basis, if it is riskier, or on a monthly basis. We have lock box system where we do not authorise the treasurer or the owners of the company to write a cheque unless it is approved by the bank, so if he wants to buy a Jaguar and we say no, he will not have money for that. He has to comply. We monitor the quality of these assets. Therefore, we are able to assess risk and to charge more for risk for those who enter into riskier operations, but we also monitor assets, which has never been done in Canada.
We are trying to import that formula into Canada to some extent. There are already a few players here. Nations Bank has an ad in the Globe and Mail yesterday for 5 million. To Nations Bank it is nothing. They want to tell people they are doing asset-based lending. GE Capital is doing it. Congress is doing it. We are starting to do it. Newcourt is doing it as well, but it is more commercial and less asset-based lending than we do. (Léon Courville, September 29, 1998)
Conclusions
Based on the testimony it heard during these hearings, as well as in a number of other hearings dealing with small business financing, the Committee is convinced that the existing loan policy of not pricing for risk, of most financial institutions in Canada is a serious impediment to the availability of funds for SMEs.
Currently, few if any loans are granted by Canada’s major banks at rates in excess of prime plus 3 percentage points. In contrast, in the United States, where credit to small business is perceived by sector to be quite readily available, financial institutions offer their customers a much wider variety of terms and interest rates.
What this means is that there are small businesses who would be willing to pay more than prime plus 3 percentage points for a loan — to make the risk involved in their loan acceptable to the bank — but who are refused the funds because banks simply refuse to make such a loan rather than increase the interest rate on the loan. Such businesses, therefore, either go without credit, or abandon their business plans, or do not begin in the first place because lack of credit available. Alternatively, owners are obliged to finance the business personally by still more expensive means, such as extended payment terms on their personal credit cards. A more flexible pricing policy by financial institutions would resolve these problems.
The Committee agrees with the Task Force and the Canadian Federation of Independent Business that the availability of credit, properly priced for risk, would provide more financing to businesses which need it. At the same time, measures proposed in this report to increase competition in the small business financing market, will ensure that the banks do not use the pricing for risk policy as a veil behind which they can increase their spread on the SME loans, that they would grant anyway, at lower rates.
5. Policy Analysis of Small Business Finance Needs
Background
The state of small business at any time depends on the general state of credit markets. Policy makers in Canada, the United Kingdom, the United States and other industrialised countries turned their attention to the financial needs of small business in response to the credit cutbacks in the early 1990s. The urgency of SME financing and the attention directed to it will always rise as businesses face cuts in their funding. But to the extent that there are structural issues, the financing of SMEs remains important after the attention dies down. (Task Force Report, p. 87-88)
There is a need for a sustained effort to improve understanding of small business financing from a longer-term perspective. More systematic and rigorous policy analysis is required.
The U.K. and U.S. governments have recognised the need to monitor SME financing regularly. The Bank of England now reports annually on small business financing. Its report consists of discussion of current developments in SME finance together with highlighted topics. Similarly, the Federal Reserve must now report to Congress every five years on the availability of small business financing.
Canada needs similar reporting on the state of small business financing.
Task Force Recommendations
105)There should be more systematic and rigorous policy analysis of small business finance needs. To that end:
(a) An SME Finance Group should be established within Industry Canada to undertake continuing research on SME finance, including KBI enterprises. The SME Finance Group should oversee the user surveys, analyse the data collected by Statistics Canada and report annually to the Industry Committee of the House of Commons on the state of small business financing.
(b) The SME Finance Group should also pursue a program of special research on topical small business finance issues, such as the regional availability of finance, gender discrimination in SME finance, and aboriginal finance.
Views of Witnesses
There were different points of view on whether there is a problem in the small business financing market. According to the President of the Canadian Federation of Independent Business.
Access to financing generally is an ongoing challenge for small businesses. We have documented these issues time and time again. We begin to feel as if we are repeating ourselves, however, if we saw some concerted action on them we would not feel as compelled to repeat ourselves.
The last recession was pretty instructive. We saw a severe restriction of financing to the small business sector. We believe that the recession indeed was worsened by excessive restriction of financing to small businesses.
We have also found subsequently that it has taken an awfully long time for lending levels to the small firm sector to get back to where they were. The banks tended to increase their lending to larger business even during the recession. When we looked at the data, it was only in 1998 that we saw loan levels to the small firm sector actually reaching its pre-recession peaks. That cannot be justified on the basis of difficult economic conditions alone.
A trend that has lasted over decades that we find disturbing is that so many businesses repeatedly tell us: "I never want to need a bank again. I had such unpleasant experiences, so I am not going to expand my business. I am not going to make that investment because it means getting beholden to some other lender again and I do not want to get into that situation." We see lost opportunity costs there for the Canadian economy as people forego what could be positive additions to the economy because they do not want to link up with a financial institution.
We also certainly would be the first to acknowledge that the small firm sector is not an easy one to lend to. It is quite challenging. It takes special expertise. The major banks have taken quite a while to understand the needs of the market. They are still facing challenges with the knowledge-based sector and some other sub-segments of the market. (Catherine Swift, November 5, 1998).
Witnesses from the Fraser Institute presented a different point of view.
We made a presentation to the House of Commons Committee on Industry on the Small Business Loans Act. There has been a lot of concern raised about small business lending and inadequate lending. Most of the surveys which have been done by the CBA, amongst others, seem to suggest that the loan approval rate in the first instance is around 92 per cent in 1997. That is a very high approval rate for loans in the first place. Most of the time small and medium-sized enterprises usually manage their cash flow problems with respect to accounts receivable and accounts payable and inventory. In terms of capital financing of those small and medium-sized enterprises our argument is that most of the businesses are owned by sole proprietors and partnerships. Surveys from Statistics Canada also show that most of the small and medium-sized enterprises finance their services by services and retained earnings.
If that is the case we want to make sure that personal income taxes are reduced so that they do have savings which they can plough back into their businesses (Fazil Mihlar, October 29, 1998).
I would quickly reiterate Mr. Mihlar's comment that in a 1996 Statistics Canada report it was found that the chief cause for bankruptcies was difficulties in the management and they particularly noted financial management. Within that what they noted was capitalisation structure and working capital. So really if we want to encourage capitalisation and equity financing, the easiest way to do that, the clear-cut way with very little distortionary effect is simply to reduce corporate and individual taxes. A corporation is taxed at the corporate rate and a sole proprietor or partnership is taxed at the individual rate.
Additionally, the capital gains rate we see a very strong relationship between venture capital investment and capital gain tax rates. In the United States, there is 1,400 per cent increase in the level of venture capital investment in the tax cuts of President Reagan in the early 1980s.
When we are talking about expansion into a new market or the development of a new product we are really talking about high risk capital.
In the presentation that Fazil Mihlar and I made in a 30-minute period I found over the internet 60 separate companies and then another association that had another 108 companies that are all involved in venture capital financing in Canada. Last year venture capital funding totalled $1.8 billion. The question is, how do you facilitate that type of investment? Clearly by a reduction in the capital gains rate and a reduction in corporate and personal income taxes.
I would reiterate the large amount of loans outstanding by the big banks to SMEs in terms of financing. (Jason Clemens, October 28, 1998)
Conclusions
Policy analysis of the small business financing market is linked to the data quality issue. It is the view of the Committee that better data on the small business financing market, and careful analysis of that data, are needed to serve as the basis for the debate that is needed on the design of public policy toward small business financing.
6. Definition of Knowledge Based Industries and Banks and Knowledge Based Industry Firms
Background
There is no single agreed definition of KBI. Knowledge-based firms are those in which the development and application of knowledge is critical to the production of goods or services. To state this is to illustrate the difficulty in coming to a precise definition, since all production requires knowledge of one form or another. Drawing the line is difficult and can be somewhat arbitrary.
Increasingly, as innovation spreads throughout the economy, more and more industries that have traditionally not been considered knowledge-intensive are adopting new, sophisticated methods of production. Knowledge and its applications will soon be critical to the production of most goods and services in a modern economy, from computer software design to dairy farming. In a very real sense, all modern enterprises can claim to be knowledge-based firms. (Task Force Report, Background Paper #4, p. 70, 79-81)
The primary need of KBI firms, at various stages in their early life, is equity. But they require debt as well for working capital in the early stages of their existence, and as when they grow past the venture stage. Banks are active participants in financing KBI firms, and over the past three to four years have substantially changed their strategic approach to KBI financing.
Banks have been active in providing credit to KBI firms. At the end of the third quarter of 1997, the seven major banks (including the Hongkong Bank, which has a strong presence in this market) had made $7.1 billion in loans under outstanding authorisations of $25.3 billion. There were 16,071 KBI loan customers and 15,555 of them had loans of less than $5 million. The Royal Bank and the Bank of Montreal together with Hongkong Bank are the major providers of loans under $1 million to small KBI firms, and were among the first to open specialised banking centres for KBI clients.
On consulting study indicates that most banks are developing KBI-specific lending models and risk assessment approaches to assess enterprise value rather than just individual assets, and to recognise the lending value of intangible assets. Indeed not all banks require full collateralization of loans in the traditional sense. But the definition of what can be accepted as collateral for KBI clients with intangible assets needs further development and circulation into the field.
In 1994, as part of a broad review of SME financing, it was recommended that deposit-taking institutions should "accelerate the process started by some banks of establishing special units to serve knowledge-based SMEs." All major banks have now established special KBI units within their retail banking groups. These units have dedicated personnel for KBI financing at between 4 and 20 regional centres per bank. The purposes and activities of these groups have been described as follows:
These groups are trying to develop their bank’s share of this segment of the small and medium-size commercial market. ... These banks have embedded their KBI groups for the most part within their commercial (retail) banking units. The banks intend to grow their KBI units as the market develops, particularly through development of KBI teams within their regional banking centres, using specialised staff to scout for new opportunities.
In addition to direct lending, the banks have also been actively participating in partnership agreements with federal economic development agencies and with the Business Development Bank. In partnership with Western Economic Diversification, the Federal Office of Regional Development-Quebec and Federal Economic Development Initiative in Northern Ontario, the banks make loans on commercial terms for R& D and for product and market development, and the agency contributes a loan loss reserve of up to 12.5 per cent. The banks have also concluded agreements with BDC under which BDC will offer quasi equity loans to bank KBI clients. This helps BDC extend its customer network and allows banks in effect to expand their product offering.
In 1992, federal legislation was changed to allow banks and other federally regulated financial institutions to create "specialised financing corporations" that could be used to make equity investments in SMEs and KBI firms. Financial institutions are able to commit up to 5 per cent of their regulatory capital to these corporations. In turn, the corporations can take ownership interests in other businesses for up to 10 years, for amounts of up to $90 million each.
Banks are increasingly providing equity as well as debt through these specialised financing corporations. All the major banks now have venture capital funds, which they operate directly or (more commonly) in partnership with others having more experience in venture capital.
Further, several of the funds are dedicated to specific areas, including seed capital. For example, the Bank of Montreal is involved with partners in a Western Seed Investment Tech Fund ($25 million); the Royal Bank and partners have launched the Canada Growth Company ($30 million), which specialises in life sciences, information technology and advanced materials; and the Royal Bank, with another set of partners, has launched the NeuroScience Partners Fund ($ 52.5 million to $100 million). The Bank of Montreal Capital Corporation has $200 million with several technology programs, and the Royal Bank has RB Capital Corporation with $350 million to provide equity finance to KBI firms.
Macdonald & Associates reports that, in total, the banks committed an additional $740 million to their venture capital funds and an additional $150 million to private venture funds between 1994 and the end of 1997. During 1997, bank venture capital funds invested $129 million, mainly in first-time financings.
Some concern was expressed to the Task Force that many of these equity initiatives have yet to make extensive investments. The Task Force recognises that the context of venture capital with the attendant risk profile requires review of a large number of proposals to find projects with sufficient potential for investment. The Task Force does wish to encourage the banks to aggressively pursue the new opportunities available to them to invest in Canada’s KBIs. Their success is a national priority.
Task Force Recommendations
106)In order to better understand the financing needs of knowledge-based industries, the SME Finance Group should give priority to the adoption of a common definition of "knowledge-based industries" for purposes of data collection and analysis of the sector.
107) The Task Force urges financial institutions to pursue their recent KBI initiatives, with a focus on seed and venture capital, and to ensure a vigorous rate of investment in innovative KBI firms, subject to appropriate due diligence and prudential constraints.
108) The Industry Committee of the House of Commons should hold annual hearings on the state of KBI finance, at which the chief executive officers of the major banks would be invited to appear and update the Committee on the progress being made by their institutions to support the industries of the "new economy."
Views of Witnesses
The Committee received very little testimony on knowledge-based industries. The President of the Canadian Federation of independent Business indicated the problems faced by many small firms.
We … would be the first to acknowledge that the small firm sector is not an easy one to lend to. It is quite challenging. It takes special expertise. The major banks have taken quite a while to understand the needs of the market. They are still facing challenges with the knowledge-based sector and some other sub-segments of the market. (Catherine Swift, November 5, 1998)
Conclusions
The Committee has heard a great deal about the general lack of understanding of the financing needs of knowledge-based firms in its hearings on small business financing in the past. The Committee supports the Task Force recommendation for substantive research to be undertaken on this subject.
7. Provision of Credit by Financial Institutions to Aboriginal Individuals and Institutions
Background
One area of SME financing where specific problems exist is the financing of aboriginal businesses. The indigenous people of Canada are increasingly active in the Canadian business community. First Nations government structures and economic activities are changing rapidly and are directed toward achieving self-sufficiency and self-reliance. In recent years, considerable steps have been taken to support the financing of aboriginal businesses. (Task Force Report, Background Paper # 4, pp. 68-70).
Several financial institutions have a special focus on the banking needs of aboriginal communities. There are a number of First Nations credit unions. Peace Hills Trust Company is a native-owned trust company with branches in three provinces. The First Nations Bank of Canada was incorporated in 1997 as a joint venture of the Saskatchewan Indian Equity Foundation and the Toronto-Dominion Bank, with the intent that it will ultimately be owned entirely by First Nations people.
Many other Canadian banks have taken initiatives directed at providing financing to aboriginal bands, businesses and individuals. For example, banks have established special lending units or programs to serve the emerging needs of these communities.
Indian bands and individuals have established businesses, some large and many smaller, in important sectors of the economy. As they continue to do so, they are increasingly dealing with financial institutions and, like other Canadians, they will rely on them to provide financing.
The Task Force met with representatives of some of the aboriginal financial institutions and discussed aboriginal financing issues with representatives of the banks. The Task Force also reviewed the report of the National Aboriginal Financing Task Force (the "NAFTF Report"), which was tabled in 1997. The NAFTF Report made a number of recommendations to aboriginal community leaders, governments and private-sector financial institutions, all designed to provide aboriginal people with better access to capital. Among those recommendations were the following:
The NAFTF Report identified Section 89 of the Indian Act as an important impediment to access to capital for aboriginal small business. This section prohibits the seizure of on-reserve real and personal property, thereby preventing its use as collateral. Although the NAFTF Report noted differences among aboriginal people as to whether land should be available as collateral, it proposed that community leaders should support changes to the Indian Act, the Small Business Loans Act (SBLA) and the Farm Credit Act to permit movable personal property to be used as security.
The NAFTF Report urged financial institutions to participate, through the provision of loans and preferred share investments, in the financing of aboriginal capital corporations, which would be providers of capital to aboriginal enterprises.
Finally, the NAFTF Report noted the lack of sufficient data on how much capital was now being accessed by aboriginal people from financial institutions. It recommended that, as a part of its SME data collection program, the CBA compile information on the banks’ financing of aboriginal businesses and governments.
The attention of the Task Force was also directed to security difficulties encountered by financial institutions because of legislative restrictions on the assignment for security of treaty entitlement monies and other funds payable by the federal government to Indian bands.
It is important that aboriginal communities and individuals have the necessary tools, including access to capital, to participate fully in the Canadian economy. In some regions of the country, where there are large aboriginal populations with a considerable land and economic base, First Nations are and will continue to be important factors in economic growth and employment.
Task Force Recommendations
109) The Task Force endorses the recommendation of the National Aboriginal Financing Task Force that, subject to reasonable consensus within the aboriginal community, changes be made to federal legislation so that movable personal property situated on reserves may be used as security, thereby facilitating the provision of credit by financial institutions to aboriginal individuals and institutions.
110)The Task Force urges financial institutions to continue to pursue initiatives which are supportive of the economic development initiatives of aboriginal peoples and, for that purpose, to establish and maintain tailored, innovative financing programs.
111) The data collection programs to be undertaken by Statistics Canada and Industry Canada should include detailed information gathering on aboriginal financing issues to fill the void in data identified by the National Aboriginal Financing Task Force.
Views of Witnesses
The Committee heard from the CEOs of two aboriginal institutions who explained why their institutions were created. The CEO of the First Nations Bank also explained how his bank operates.
The First Nations in Canada are at a point where we perceive a need for a financial institution to grow and merge and flourish with our emerging economies. In essence, our economies are not a lot different from the economy of Canada in 1867. We are the base level, we are beginning to grow, beginning to develop, beginning to diversify. This institution we see as an important step towards the economic self-sufficiency of aboriginal people, and we see economic self-sufficiency as a major step toward political self-determination. So that is the philosophy behind our bank. That is why our founders wanted us to establish a national chartered bank that would serve aboriginal people.
The history of how it was formed has a bit of a background as well. In 1982 the Federation of Saskatchewan Indian Nations established the Saskatchewan Indian Equity Foundation, which was the first Aboriginal Capital Corporation in Canada. This was established because they saw a lack of capital to develop and expand First Nations businesses. The First Nations people had no credit rating, very little equity, no history in business operations and very little experience with financial institutions. So at this time we were starting to get control of our own economies, get control of the finances at the First Nations level, and we had very little ability to develop the businesses that served our communities. The stores were being run by people from outside of the community. The buses were being bought by Indian Affairs and run by Indian Affairs. There was very little ownership of any business enterprises on our First Nations….
We know that lending on First Nations a lot of people, a lot of the banks say, "Well, we cannot get security in a house in northern Saskatchewan so we cannot put a mortgage on that community." We do not see ourselves as being in the real estate business. We see ourselves as being in the loaning of capital and recovery of that money and paying our shareholders and operating a financial services network within the community. So we use a lot of community structures to allow for that: the band council basically backing individuals or we have established a housing authority on communities, where individuals can become part of a larger housing authority that retains a base of capital to back mortgages of individuals, and we are piloting that project in northern Quebec right now. We use a lot of the community's need to be part of the economy. If you want to protect your assets from encroachment or security, then you have to recognise that you are going to have less access to capital. So Saskatchewan Indian Equity Foundation established that right from the beginning, they told the people that they were talking to and lending to that "you are not just a borrower here, but you are the owner of this institution", and it was the Saskatchewan Indian Equity Foundation, and we established the same relationship as a First Nations Bank. We expect a lot of the major communities that we do business with to also be investors in the bank, and it is not in their best interests to walk away from loans. So we use a lot of those processes to ensure.
… The Business Development Bank has tried to become more and more active in First Nations markets. They have got some capital to do some loans and do some business services. Our problem is the same problem we have with a lot of banks that want to get into our market. They have no history with aboriginal people. They do not know the culture. They do not know the communities. They do not know the inherent risks or the inherent opportunities. There are maybe pockets of success, but we do not see them as being the best way to serve our communities. We have got a structure of aboriginal capital corporations if we are talking about the development fund. We have got a structure of aboriginal capital corporations that are run by the communities and for the most part have been successful. When we took over the lending processes when we created the Saskatchewan Indian Equity Foundation from the government, the government's loan loss ratio was like 80 per cent. People just didn't see it as part of the community. They saw it as a grant, not a loan, and we do not see those kinds of institutions as serving our communities. They have to make the people responsible for their own affairs. That is what we see our institution doing or our institutions doing. (Keith Martel, October 27, 1998)
The Chief Executive Officer of Peace Hills Trust Company described his institution:
It is a full service, federally chartered national trust company founded in 1980. Its head office is in Hobbema, Alberta, located on the Samson Cree reservation. It was formed to deal with a need of First Nations communities' lack of access to capital due primarily to certain interpretations of the Indian Act and lack of understanding by some of the major financial institutions in this country in dealing with the development of their communities.
It was initially capitalised in the amount of $7 million for the Samson Cree nations' oil revenues. Its present capital has grown to in excess of $40 million. The company assets are in excess of $400 million. (Warren Hannay, November 3, 1998)
Conclusions
The First Nations Bank and Peace Hills Trust Company are examples of the type of entrepreneurship that the Committee seeks to encourage in the financial services sector. These two institutions have been established to serve a well-defined market niche. Their progress should be monitored and lessons for public policy in (1) financing aboriginal communities, and (2) encouraging entry into the financial services sector, developed.