The flow of capital to small-scale businesses through private equity and the debt markets is likely to be influenced significantly by changes in the macroeconomic climate, including fluctuations in the financial or real sector or changes in government policy. Because of the opacity of information and the lack of transparency, small businesses are likely to be a significant portion of the loss of funds in the event of a market failure. This section will look at several research areas that relate to this risk, such as the impact of market disruptions in public equity and changes in public policy regarding the transfer of money into venture and angel capital markets, as well as the impacts of monetary policy changes or credit crunches as well as an increase in the size of the banking sector to the movement of money to small-scale businesses in the banking markets.
5.1. The flow of money into venture capital markets
General economic conditions could affect the flow of money in the debt and private equity markets. The flow and price of private equity are heavily dependent on the equity markets of the public. The prices of angel finance and venture capital during the beginning stage are primarily based on the forecasts of the value at the exit. One of the primary methods for valuing a company is taking the market’s actual price/earnings ratios and then applying these to projected earnings at the time of exit. The behavior ex-post of the market will determine the exit time via its IPO or subsequent offers and the valuations accompanying the offerings. Therefore, when stock market prices fall, it can trigger an inverse chain reaction, where the volatile IPO market ceases to function, reducing the flow of capital into private venture capital and angel finance equity markets.
It was found that the high returns realized in venture capital due to current stock prices are likely to result in increased investment in venture capital fund capital ( Gompers & Lerner, 1997; Gompers, 1998). Gompers (1998)argued that the high valuations of stocks could result in an “overheating” of the primary venture capital market. He also concluded that the increase in the amount of money that is pumped into venture capital seems to be correlated with various changes to the contracts for venture capital, such as an increasing proportion of profits kept by fund general partners as well as less restrictive partnership contracts; the shift to more advanced stage investments; and a growing interest in international investment.
The flow and ebb of capital to venture capital raises the issue of why venture capital’s principal markets seem skewed and prone to a wave of optimism and optimism. We do not know the answer other than to note that evidence from anecdotes suggests that the same kind of myopia appears to be present in the traditional market for stocks, real estate markets, and the credit market. For example, waves of optimism and pessimism could also be the reason for the price of commercial loans, as credit standards change throughout business cycles.
The venture capital market is not a new phenomenon, but as an intermediary business, it could be susceptible to the same type of crises that impact the commercial banking sector. For example, confident institutional investors could severely reduce their venture capital when they experience losses elsewhere in their portfolios. As we have mentioned before, public and corporate pension funds and endowments make up more than half the capital needed for limited partnerships in venture capital. This type of recession is similar to the decrease in lending by banks that took place during the credit crunch in the 90s (discussed below), which is partly due to losses in the commercial actual property portfolio. These questions of fluctuation in venture capital investment are fascinating and present complex challenges to future research.
The considerable significance of institutions as investors in the US venture capital market is of significance in and of itself. Before the 1980s, US pension funds had been prohibited from making any significant venture capital investment because of prudent man’s rules. In 1979, however, the Department of Labor reinterpreted the Employee Retirement Income Security Act (ERISA) to allow pension funds to invest in venture capital as long as it did not threaten the portfolio in general. These changes and others in the regulatory framework caused a dramatic growth in the flow of funds to venture capital. As pension funds, patient investors, endowments, and life insurance companies are best suited to invest in venture capital.
Today the vibrant formal venture capital firms are mostly only available in the US and the UK. The US experiences suggest that other nations may be interested in policies that promote the creation of pension funds and their regulatory ability to invest in venture capital investments. 30 But the absence of well-developed equity markets for public investors across continental Europe and other regions has hindered the growth of venture capital businesses. One distinctive feature in the US financial market that makes venture capital investment so appealing is the availability of well-developed markets for public equity, especially for small-cap stocks, such as NASDAQ, that provide an upward-facing exit option to venture capitalists.
5.2. The impact of bank shocks on the sector of small business financing
In the last few years, there have been numerous financial crises that have resulted from problems with capital, failures and regulatory changes or other issues in several countries, including Japan, Korea, the Scandinavian countries as well as the US, as well as others which were followed by periods of recession or a slowing of growth in the economy. The mechanism for transferring financial distress to decreased macroeconomic performance has yet to be understood entirely. However, it could result in reducing banks’ credit to small companies.
The financial crisis in the banking sector can affect short-term lending as banks reduce their size, lessen their credit risk exposure, and attempt to improve their equity capital ratios. Furthermore, the bank’s failures could result in an expense over the long term due to the loss of relationships with banks and the data accumulated by contact over time, which makes it difficult for some lenders to keep funding investment that has positive net present value (Slovin et al., 1993). This is likely to affect small-scale businesses that are opaque to information. They depend on banks and need help in obtaining financing from other sources. Additionally, this decrease in investment might cause more macroeconomic and regional difficulties ( Bernanke, 1983). The supervision and regulation of banks in order to ensure that they remain secure and sound is usually justifiable due to the possibility of a crisis in the system that could decrease the availability of credit for small, bank-dependent businesses.
5.2.1. Monetary policy shocks
“Credit channels” and “credit channels” of monetary policy transmission are two distinct theories that monetary policy shocks could be disproportionately detrimental to small-scale business financing. These mechanisms – built on the flaws in the private debt market – are in sync with the conventional “money view” channel in which monetary policy is governed by changes in interest rates that influence the actual spending preferences of economic players.
In”the “bank lending view,” the decline in bank reserves due to the tightening of monetary policy results in banks having to reduce their loan supply. This decrease in loan availability makes some borrowers cut back on their spending, which can slow the macroeconomic process because other funding avenues are not available or cost prohibitive, at the very least, for the near term ( Bernanke & Blinder, 1988). If the bank lending theory holds, monetary policy shocks could cause disproportionately significant effects on those dependent on banks and have no other funding sources. This could be particularly true for small enterprises – or, at most, the majority of which take loans from banks.
The research on empirical evidence generally supports the two principal evidences of the view that banks lend that a tight monetary policy decreases the amount of bank loans available and that a decrease in bank lending can slow the macroeconomic system (see Kashyap and Stein, 1997 for a study). In addition to the overall evidence, the majority of the overall slowdown may be due to the alterations made that small companies make. One of these findings is that policy on monetary matters has a more significant influence over small banks than larger ones ( Kashyap & Stein, 1995). This will likely work in a way that is disproportionately affecting small companies because small banks focus on lending to small businesses. Another observation is that policy changes affect the expansion and investment of small manufacturing companies more than large companies ( Gertler & Gilchrist, 1994; Bernanke et al., 1996).
Based on the second credit channel, which is the “balance sheet channel” or “financial accelerator,” the tightening of monetary policies works partly because higher interest rates reduce the collateral value or decrease the value of a few borrowers, making their credit worthier and reducing their capacity to get money. Of course, this method could “accelerate” the effects on the macroeconomics of any event which reduces collateral values and net worth (e.g., the oil price rise or the crash of the real estate market) and amplify the impact on the macroeconomics by accelerating the existing contracting issues based on information between lenders and borrowers. Balance sheet channels are expected to impact small-sized businesses that can borrow from financial institutions significantly. These are shown in Table 2 above to be able to pledge collateral on over 90 percent of the loans. The balance sheet channel is different from the banking channel in that it suggests a decrease in the need for credit from good-credit borrowers from all lenders and not a decrease in the availability of credit provided by banks due to the tightening of monetary policy. Numerous empirical studies confirm this channel in the balance sheet and its significant impact on small-sized businesses, such as research that links monetary policy with changes in the strength of balance sheets as well as findings that link balance sheet positions to actual spending choices (see Bernanke and Gertler 1995; Bernanke et and. 1996for summaries).
5.2.2. The credit crunch
The beginning of the 1990s in the US was referred to as an economic crisis due to the drop in lending to businesses by US banks. Between the end of 1989 and the close of 1992, US banks’ real domestic industrial and commercial (C&I) loans dropped 23.2 percent, a decrease in dollars between $596.7 billion to $458.2 billion. Estimates based on extrapolation from the STBL found that the percentage decrease in small-business lending (loans to borrowers who have bank credit of less than one million dollars) was much higher, with an estimated drop of 38.5 percent between $143.7 billion to $88.4 billion in dollars in 1994 ( Berger et al., 1995). The analysis of other data sources included those from the NFIB ( Dunkelberg & Dennis, 1992) and the NSSBF ( Avery et al., 1998). Also, it was apparent that credit from banks was more challenging for small-sized firms at the beginning of the 1990s than in the latter part of the 1980s.
Many theories of the slowdown in the credit market have been analyzed as well as the effect on the Basle-Accord’s implementation risk-based capital standards that generally increased capital requirements for commercial loan (Haubrich and Wachtel 1993; Berger and Udell, 1994; Hancock and Wilcox, 1994a; Wagster, 1997) the effects of regulatory capital measures in relation to the leverage rates (Berger and Udell 1994; Peek and Rosengren, 1994; Peek and Rosengren 1995a, Hancock and Wilcox, 1994a; Hancock et al. 1995) (depletion of bank capital due to the loss of loans in the latter part of the 80s (Peek and Rosengren 1994 1995a, Hancock and Wilcox, 1994a, Hancock and Wilcox, 1997) and increased regulatory scrutiny that includes tightened examination requirements as well as loan loss reserve policies and formal measures (Bizer 1993; Peek and Rosengren, 1995b; Wagster, 1997) decisions to use lower risk profile by bank managers (Hancock and Wilcox in 1993; Hancock and Wilcox, 1994b) decreased demand for loans due to regional or macroeconomic receding markets (Bernanke and Lown 1991, Hancock and Wilcox, 1993; Hancock and Wilcox, 1997) or a general decline in need for loans from banks as a result of the increase in alternative credit sources (Berger and Udell 1994). While this literature is not in the realm of consensus in its findings, empirical evidence generally does not support risk-based capital as the primary cause of the slowdown in lending; however, they provide the basis for many other theories.
A study that was able to study the impact of fluctuations in the capital of banks as well as loan delinquency rate and other variables not just on lending by banks however, but also on the health of small companies located in the same area during the credit squeeze ( Hancock & Wilcox, 1998). Hancock and Wilcox found that the loss of capital at a small institution reduced C&I lending by more than a decrease of one dollar at a central bank. Additionally, they observed that the reduction in the capital of tiny banks during the financial crunch resulted in economic and statistically significant decreases in the number of employees and the payroll of small companies in the state. These findings underscore the significance of lending by banks to small businesses and suggest a significant contribution to capital problems at small banks during the national and regional slowdowns in the 1990s.
5.3. Rationing of credit for small-sized businesses based on the rate of interest and credit risk cycles
The theories about credit rationing ( Stiglitz and Weiss 1981 and others) indicate that adverse choice and moral risk issues that are associated with borrowers who are not transparent could be made worse when interest rates in the open market rise. The lenders may need to be able to increase the interest rate of this borrower in line with the rates for government securities for fear of attracting less-qualified borrowers or triggering risk shifting. This results in “sticky” loan interest rates and credit rationing in equilibrium. It is probable that if a significant amount of rationing from banks happens, it will significantly impact the access to credit for small-sized firms.
Numerous empirical studies showed that the rates of bank loans for business are high and provide some evidence to support the concept of equilibrium allocation ( Slovin & Sushka, 1983; King, 1986; Sofianos et and. 1990). However, one study utilized personal loan information from STBL and discovered evidence that the stickiness of this loan was not a sign of significant credit rationing. The amount of stickiness was roughly equal for new loans with commitments safe from rationing and new loans not under commitment. Additionally, it was found that the proportion of noncommitment loans to commitment credit did not increase significantly when open market rates were high. This could be the case if noncommitment lenders were subject to rationing ( Berger & Udell, 1992). Nonetheless, another study using a different data set on the stock of bank loans found that the commitment/noncommitment loan ratio did rise substantially when monetary policy tightened (Morgan, 1998).
Another explanation for the rates of loans that are stuck aside from credit rationing could be that some banks offer implicit interest-only insurance to specific relationship customers. Banks can smooth out loan interest rates by granting loans at interest rates below market for those who have a risk-averse relationship in times of high market rates and compensate with rates that are higher than market rates for the same borrowers when rates are low or in conjunction with more expensive rates on various financial services ( Fried & Howitt, 1980). This could be made possible through the existence of core deposits that also have low rates of interest ( Berlin & Mester, 1997). Similar to other benefits of relationship loans mentioned above, the supply of insurance on interest rates could be made possible by the bank possessing market control over the data acquired by the relationship. The potential future rents to be earned through access to the information could motivate the bank to loan at an expense in the short run.
A few empirical studies support the concept of insurance for interest rates. Specific loan interest rates listed by the STBL were lower than those of the US Treasury rate for comparable timeframes when Treasury rates were huge ( Berger & Udell, 1992). These loans are not expected to yield positive economic returns. They cannot only be justified in a way concerning the expected profit from other sources within the scope of an association. Another evidence of stickiness or smoothing of STBL small-business loans has also been discovered, and the stickiness was correlated with higher profitability due to the presence of an interest rate policy which indicates effective contraction ( Berlin & Mester, 1998).