Loath to loan

By Yan Barcelo
Illustration: Jean-François Martin

Can Canadian banks meet the challenges of improving relations with the small business sector, which feels ignored?

“My bank is a necessary evil,”says Jean Julien, president of Montreal-based computer consulting firm Exprocom. Though banks are not his enemy, he insists, his links to them still take the form of a “typical love-hate relationship.”

And Julien’s attitude is a common one throughout the business community, particularly among small business enterprises (SBE) such as Exprocom, which specializes in IP telephony and employs 20 consultants. A 2003 study conducted by the Canadian Federation of Independent Business (CFIB), Banking on Competition, is highly critical of Canada’s banks. The study’s most significant finding concerns the loan rejection rate for federation members: between 2000 and 2003 it rose by a striking 50%, climbing to 16% from 10.5%.

 Admittedly, it was a troubling time for the economy and for a number of banks, many of which withdrew from entire sectors such as high tech, steel and retail. But this isn’t enough to explain the trend. Another study by Industry Canada, Financing SMEs in Canada, describes an even more problematic situation. The study, which is dated 2002, focuses on 2000, a year in which the economy was booming; and yet, of the 23% of small and medium-sized businesses that applied for loans during this period, 18% were refused. “Many of these companies were able to make a few changes to their applications and obtain at least something,” says Peter Webber, director of the small business financing policy branch at Industry Canada in Ottawa. However, he can’t say what percent of them did in fact receive something or just how much they eventually got.

From the CFIB’s perspective, it is clear that banks are systematically withdrawing from the small business market. Its study indicates that loans of less than $200,000, which are intended for businesses with less than 50 employees, have remained stable over the past few decades: “What’s more, if we adjust the data to take inflation in- to account, we find that small loan activity has been declining since the 1980s, while the number of larger loans has been increasing.”

For some observers, these statistics are a clear indication that banks are quitting the critical SBE sector. “Twenty-five years ago, small businesses made up 25% of the economy,” says Doug Bruce, CFIB director of research in Toronto. “Today, they represent 50% and generate 75% of jobs.” In short, even though SBEs have doubled their economic weight, banks are granting them fewer loans.

And while there are a number of factors for this decline, the main one is that the relationship between SBEs and their banks have become impersonal and problematic. For example, many banks have transferred their business loan operations from branches and centralized them in regional offices. For small business owners who are often pressed for time, the distance has complicated their relationship with their bank and means they meet their account manager less frequently. At the same time, banks are opening more and more ATMs, which is definitely no way to increase service to small businesses.

But the main problem is that a higher turnover rate among account managers and the automated loan evaluation systems have made relations between borrowers and banks increasingly impersonal. “Twenty percent of our members have noted a higher turnover rate among their account managers,” says Bruce. The percentage varies from one bank to the next, from a low of 10.3% for savings cooperatives and credit unions to a high of 25% at TD Canada Trust. And for a business in search of financing, when the account manager changes, loan conditions are more likely to deteriorate. “Long-term understanding of the company and its owner suffers, which makes it even more complicated for SBEs to obtain adequate financing,” says Bruce. “This probably explains why the rejection rate is so high. It’s a disturbing trend.”

More than one way to the money If you’re an SBE out looking for a lender to finance your next project, take heart. There are ways to get what you want: Don’t be satisfied with just one financial supplier. Too many entrepreneurs put themselves at the mercy of just one bank. By doing that, they’re in for a big surprise the day the bank decides to tighten the purse strings. Doing business with different suppliers will give you some leverage to negotiate when your bank starts to take you for granted. Shop around for financial services. Banking institutions don’t offer the same services. For example, while a number of banks neglect the garment and export sectors, the HSBC specializes in these two industries. Above all, make sure you don’t just rely on the banks: institutions such as the BDC, Investissement Québec and many others could finance all or some of your projects. The federal government’s Strategis site at www.strategis.ic.gc.ca/sources can help you in your search. Cultivate your relationship with your banker. Many businesses simply open a business account and don’t bother to get to know their account manager. Try to meet him or her at least once a year. Be clear and transparent. You have only one chance to make a good first impression. Present your project clearly and articulately and don’t try to hide past problems. By concealing any difficulties, you could create a climate of distrust. If you are open about them and acknowledge them, a banker will be more likely to find a way to help solve or surmount them.

Another inevitable trend, which has been emerging for some time, has also had an impact. “In 1950, most credit decisions were made by an individual or a team of individuals,” says Jean Roy, finance professor at HEC Montréal. “The first change came with the introduction of computerized, score-based evaluation systems for credit cards. All employees had to do was file a data report, which the computer then evaluated. This system was later expanded to apply to automobile loans and mortgages and finally to small business loans.”

Obviously, the rationale behind these developments is economic. “Administrative costs are about the same for a $500,000 loan as they are for a $50,000 one,” says Louise St-Cyr, chair of small and medium-size business development and succession at HEC Montréal. “The bank has to open a file, interview the person, evaluate the risk and ensure followup. Because the $50,000 loan will of course be processed through the automated system, the entrepreneur won’t get the same treatment as in the past.” The computer system is programmed to process only those files that strictly correspond to the criteria selected, whether they are broad or narrow. “And managing exceptional cases simply isn’t profitable,” Roy says. “It’s much easier to hit the reject button.”

But there’s another explanation for why banks are becoming more distanced from their customers — securitization, a process that consists of selling blocks of debt on the market in the form of bonds. With this market model, which is common at CIBC, the bank transfers responsibility for the loan to the market and acts as a loan broker that receives remuneration. “To some degree, this model has had a paradoxical effect,” says Roy. “It has the advantage of allowing the bank to grant more loans because the responsibility is transferred to the market, but it has an adverse impact on customer relations.”

The banks’ withdrawal has strongly affected rural areas, to such an extent that Bruce talks about two Canadas: one urban, one rural. “In recent years, we have seen decisions being centralized in Montreal,” says Anne-France Thibault of Quebec’s Rouyn-Noranda region, where she is president of the chamber of commerce and runs her own distribution business, Legault Gaz Soudures. “But the person in Montreal who makes the final decision isn’t familiar with the people involved or with local business cycles. If the banks were closer to the regions,” she says, “they would know who has the business potential plus the network of contacts to back it up, and who doesn’t.”

Some critics feel banks just aren’t making any effort. “They seem to be more interested in charging transaction fees than in making loans,” Thibault says. “They do not do business with entrepreneurs and especially not with startups. In fact, some banks return startup files without even opening them. Yet local entrepreneurs are extremely important. If we don’t help them get started, there will be nobody left in the regions.”

And a number of industry observers would argue that banks don’t fulfil the economic and social responsibilities that should go along with the quasi-monopolies they enjoy through their federal charter. “Up to a certain point, I think it’s immoral that banks make such huge profits and then say that all Canadians benefit through their pension plans,” says one close collaborator with banks who wishes to remain anonymous.

Nevertheless, since 2001, banking regulators, aware of the need to remind the banks of their social and economic responsibilities, have required banks to file an annual report on their public responsibility. They have even specified the format of these reports, which must present a detailed breakdown of all loans less than $5 million — and most of those are relevant to SBEs.

But not everyone is impressed with this initiative. Some observers point out that banks can say just about anything in these reports. For example, one bank announced it was establishing a small business research chair in Vancouver as its contribution. These critics say it would be more beneficial for banks to fulfil their economic responsibilities and finance the SBEs most in need by lending them the money they rake in from savings account holders.

The other side of the coin
But not everyone is jumping on the bandwagon to blame the banks for all the ills. Jean Robillard, a specialist in business recovery and president of Raymond Chabot Inc., a subsidiary of Raymond Chabot Grant Thornton in Montreal, thinks SBEs have an antiquated view of banks. “Banks aren’t shareholders. That was the role they played 20 years ago, and they didn’t even demand the same return as a shareholder. Of course, this situation was advantageous for businesses; they only had to pay 5% interest to the bank instead of 15% of their profits to an actual shareholder.”

However, such a paternalistic attitude had its downside. “Twenty years ago,” Robillard says, “if a company was in trouble, as its only partner, the bank called in its loan and wound it up.” While he acknowledges that automated systems have made relations more impersonal, he believes they also make it easier to monitor a business once a loan has been granted. “Air Canada would have been closed down in a flash 15 years ago,” he says. “Today, banks participate in a whole range of business recovery services. Problems come to light much earlier and teams of special creditors can get involved and turn things around before disaster strikes. Less than 1% of companies resort to insolvency laws. So things don’t seem to be all that bad.”

Roy points out that banks operate under considerable constraints, such as those imposed by the Canadian Deposit Insurance Corporation. “On the one hand, a government office asks them to grant more loans to businesses, but on the other hand, another office tells them if they take more risks they’ll have to pay higher insurance premiums.”

As Lawrence Kryzanowski, holder of the Ned Goodman chair in investment finance at Concordia University’s John Molson School of Business, says: “The banks need to have $20 in leverage for each dollar of capital. They incur a tremendous financial risk and have to offset it by cautious management. If they can make huge profits by managing this risk competently, why subsidize small businesses and not give money back to the shareholders?”

But just what is the banks’ mission? Is it to make high-risk loans or safeguard depositors’ savings and shareholder returns? Do they have the right balance between depositors, shareholders and the needs of the economy? Such questions surface regularly and some may say that people may be asking banks to do things that aren’t part of their mandate.

And as for the principal players, the banks themselves don’t deny there’s a problem. The Royal Bank and TD Canada Trust say they are aware of the complaints of many SBE stakeholders. Guy Roy, vice-president for small and medium enterprises at the Royal in Montreal, had a copy of the CFIB report on his desk when he was interviewed. “When I took this job three years ago, all these complaints constituted a challenge for us to improve relations with SBEs. Five years ago, we weren’t really paying attention to these businesses,” he says, “and for a very simple reason: because loan applications for $20,000 and $800,000 were processed by the same person, the $20,000 applications tended to be neglected.”

Roy, whose employer has the largest SBE loan portfolio in Canada, insists the Royal has instituted major organizational changes to more effectively meet the needs of small businesses. First, account managers are no longer responsible for approval decisions, except those involving small amounts. They are still mandated to recommend or refuse a loan, but only the central office evaluates the risk involved. 

The decision to rotate employees in charge of approvals was intended to prevent account managers from becoming too familiar with their loan applicants. But relieving them of their decision-making responsibility eliminates this risk and the need for job rotation. Finally, the Royal plans to educate its account managers about the economic conditions specific to various SBE sectors. “These changes have meant that we now tell our account managers to develop a closer relationship with customers so that they can better advise them,” says Roy.

Like the Royal, TD Canada Trust claims to have renewed its interest in the SBE sector, since 1996. From 1980 to 1995, “the banks were more focused on large corporations, but all that has changed in the past five years,” says Nick Stitt, vice-president of small business banking with TD Canada Trust in Toronto. “I think that’s because of a new awareness of the importance of this market.” Although the bank previously had only 60 centres specializing in business loans, it is in the process of offering loan services to SBEs in 1,000 of its branches and now has more than 260 specialists in place and 65 others who travel between branches.

The reason for this shift is simple. According to the Royal and the TD Canada Trust, admittedly, concentrating on large accounts brings in more money in the short term, but granting loans to SBEs is the best way to recruit new customers and “stock up” for the future. “If you have the correct systems in place, you don’t have to spend as much time with small businesses, so the bank can make money from these, too,” says Roy.

HEC Montréal’s Roy believes that banks are serious in their desire to make this shift for the simple reason that they don’t have a choice. “Given that a number of large and medium-sized businesses meet their financial needs in the markets, the banks have to fall back on SBEs,” he says. They’re also influenced by government pressure to focus more on this sector’s needs.

Josée St-Pierre, professor of finance and director of the business performance research lab at the Université du Québec à Trois-Rivières, has studied SBE financing and prepared a report for Industry Canada. While she believes the banks are sincere, she doesn’t think their intentions and initiatives will result in actions that are advantageous for SBEs. And the entire sector could suffer.

“Small businesses have been poorly served by the banks and things aren’t going to get any better,” she explains. One reason is that under the Basel accords — a framework that set minimum risk-based capital requirements for internationally active banks and will be implemented in 2006 — banks will have to evaluate their lending risk much more frequently. “That could mean a lot more work, especially for small transactions, which could cause the banks to limit their loans,” she says. Another reason is more important and more cultural in nature: “The system evaluates financial factors only, whereas the true risk elements lie elsewhere,” says St-Pierre. “The new economy is moving very fast. The performance of any business now depends on its ability to innovate, not only its products, but also its processes. Because it has to regularly change the way it operates, financial ratios become unstable. That’s why these ratios are becoming less and less relevant to assess a company’s value. Its true value is tied to a multitude of intangible factors that aren’t reflected in the financial statements.”

But is there an effective and inexpensive way to determine the true risk value of a small business? St-Pierre believes there is and that’s why she developed, with Canada Economic Development (a branch of Industry Canada for Quebec), evaluation software that explores a company’s position and the risks inherent in the project it is contemplating. This software, which is parameter adaptive, can evaluate some 100 risk factors in half an hour, or an hour tops, she says. The model has been tested in several bank branches. In her view, “If a financial institution served this need in the market, entrepreneurs would be beating a path to its door.”