Governments around the world annually spend billions of dollars in attempts to plug
perceived debt and equity ‘gaps’ - situations where the finance markets are claimed to
be unduly restrictive in supplying capital to firms wanting to set up or expand. The
alleged victims of such market imperfections are typically small, young and sometimes
high-tech firms – and the supposed loss is to society as a whole in the form of less
innovation, slower growth and fewer new jobs.
But do these funding gaps really exist, and if so, what if anything should be done about
them? A symposium in the latest edition of the Economic Journal, edited by Professor
Robert Cressy of City University Business School, comes up with some clear
conclusions:
· The case for funding gaps is much overstated and that there is little ground for
government intervention of the kind we have seen over the last two decades.
· Governments should definitely not subsidise finance for small and medium-sized
enterprises (SMEs) in general.
· While there may be a case for selective intervention towards finance for high-tech
SMEs, this is probably not advisable for the Western Europe and the United States.
· Nevertheless, there is some sense in providing support of a different kind than
finance: for example, mimicking the evaluative style of the private sector (Lerner);
restricting entry to self-employment (de Meza); breaking down barriers to flotation
(Carpenter and Petersen); and supplementation of boards of directors of young
companies with experienced personnel (Cressy).
The basis of debt gaps - where firms cannot borrow enough for viable projects -
appears to be the bank’s shortage of information on business activities. A market-led
solution to this problem discussed by Professors Allen Berger and Gregory Udell
(respectively of the Federal Reserve and Indiana University) seems to lie in the
development of long -term banking relationships with entrepreneurs. This tends to
reduce the chances of the banks rationing credit to otherwise anonymous borrowers.
Berger and Udell’s research shows that the typical banking relationship for a small firm
in the United States is a surprisingly long 9.4 years. But they also point to problems
associated with relationship banking when the bank manager becomes too close to the
entrepreneur wanting to borrow and his standards get compromised in the process.
Such imperfections may thus result in overlending to smaller firms. On the other hand,
these relationships take a while to build up and entrepreneurs just starting out may still
find it difficult to raise money.
Professor David de Meza of Bristol University finds that there are good theoretical
reasons for markets not only to provide enough finance, but perhaps also to swamp
firms with money. The dominant academic literature argues for the existence of funding
gaps on the grounds that banks will have no incentive to reduce any ‘excess’ loan
demand by raising i nterest rates. To do so would attract worse quality applicants
prepared to pay the higher rates – questionable applicants that if offered funds would
probably go bust at the expense of the bank. De Meza’s fascinating conclusion results
from analysis in which high quality borrowers are attracted into the market in response
to a raised price of credit.
Moving away from debt and towards equity funding, Professor Josh Lerner of Harvard
University suggests that governments can and do respond to potential equity market
deficiencies by studying private sector ways of doing things and transferring these best
practices into their own domain. This may be achieved for example by studying the
behaviour of venture capitalists in evaluating and monitoring investments.
Venture capital is a form of equity finance where the investor buys shares in an
unquoted firm rather than providing it with a loan. The venture capitalist hopes thereby
to make a capital gain on a future sale of the firm’s shares. Venture capitalists who fund
fast-growth start-ups are regularly involved in the selection of investments and in the
day-to-day running of the investee businesses. In the process, they acquire skill and
knowledge about their quality and functioning. By meticulous study of these operations,
governments can and do gain skills in both selecting and monitoring investments.
These in turn may be transferred to the public sector to address market deficiencies
such as the absence of follow-on funding for fast-growth businesses that have been
able to raise an initial tranche of funds from the private sector.
Finally, empirical work on funding deficiencies by Professors Carpenter and Petersen
(respectively University of Maryland and Washington University) takes a new look at the
role of the stock exchanges in providing funds to the high tech sector in the short and
long run. Market imperfections might suggest a prejudice against small, young entrants.
What they find is that while the newly quoted firm does expand dramatically after
flotation (tripling its size when its shares are first sold to the general public), there is
very little additional supply of funds once the honeymoon period is over. This might be
an argument for the existence of a funding gap and a call for government intervention to
plug it. But the authors point out that there are real costs involved in supplying such
funds when information is one-sided (for example, the costs of monitoring a firm’s
behaviour), and these are not circumvented by government intervention
ENDS
Notes for Editors: ‘Funding Gaps: A Symposium’ edited by Robert Cressy is published
in the February 2002 issue of the Economic Journal. Cressy is Professor of Finance
at City University Business School, London.
For Further Information: contact Robert Cressy on 0207-477-8774 (email:
R.C.Cressy@city.ac.uk); or RES Media Consultant Romesh Vaitilingam on 0117-983-
9770 or 07768-661095 (email: romesh@compuserve.com).