Historical Financing of Small- and Medium-Size Enterprises Robert

Historical Financing of Small- and Medium-Size Enterprises Robert Cull, World Bank Lance E. Davis, Cal Tech and NBER Naomi R. Lamoreaux, UCLA and NBER Jean-Laurent Rosenthal, UCLA

Question: To what extent are the small numbers of SMEs in developing countries a result of the problems they face in obtaining external funding—that is, of financing constraints imposed on them by underdeveloped financial systems?

Average Employment by Establishment in Selected Countries at the Beginning of the Twentieth century France United States Britain Germany All firms in the censuses 26 67 Firms with more than 20 workers 109 117 Firms with more than 50 workers 185 176 64 14 N. A. 53 N. A 154

Findings about Historical Finance of SMEs • Most equity came from internal sources or through personal connections—rarely from the securities markets. • Most external finance took the form of debt—supplied mainly by small-scale institutions that were able to tap into local, informal sources of information. • These institutions emerged endogenously and wherever there was significant demand by SMEs for finance. • Responses to the demand for finance took very different forms, depending on local circumstances and institutions. • Role of government was generally marginal.

SMEs Raised Equity Informally • Formal markets not important for them, in part because the size of their issues was too small to sustain trade or make it worthwhile for traders to invest in overcoming information asymmetries. • More importantly, owners of SMEs most often chose organizational forms that did not permit tradable shares, such as partnerships, limited partnerships, or private limited liability companies.

New Multi-owner Firms in Paris 1833 -2003

Sources of Credit for SMEs • SMES have little collateral: –Assets are small and often have limited residual value. –Access to credit depends on the wealth or reputation of their owners. • Institutions to leverage either wealth or reputation were diverse. –They were also abundant where SMES were numerous. • Lets look at some examples of this diversity

Example 1: Notaries • Recorders of private contracts so have very good local information • Notaries’ primary economic roles – loan (asset) brokers. – informational intermediation. • When demand high ‘stray’ into more risky activities – securities underwriting (Paris and big cities). – short term debt (Southern France). • Implication: bankruptcies, call for sanctions – But Government intervention delayed until alternatives in place. Not banks, but quantitative magnitude of market is large—in 1840, 650, 000 loans, outstanding loans=25% GDP.

Example 2: RG DUN • In most countries, the rise of information providers occurs late (illegal in some countries) • In the US, credit reporting agencies arise early and allow for the large scale development of commercial debt. • Credit reporting agencies are not very reliable, but the government does not create severe sanctions for errors Implication: facilitates the rise of trade credit and to some extent competition among banks.

Example 3: local banks • The rise of a large manufacturing sector in a given locality is closely associated with the rise of local banks. – In the UK and the continent these are proprietorships or partnerships. – In the US they are most often corporations. – Everywhere they are small. • Have very good information because they are imbedded in the local economy.

Digression: Insider Lending • In most places each bank had a limited number of industrial enterprises it supported. Thus early commercial lending was most often insider lending. • Insider lending was an important mechanism to reduce the cost of information to banks. • In the North Atlantic core, the small scale of banks and the relative ease of entry led to a rapid growth in the number of banks and hence to access to banking services.

Example 4: Savings Institutions, Pawnshops and credit cooperatives • Two roles • Increased savings – In all cases these institutions target middle class savers and encourage asset accumulation. – Do so by having either the state or the local elite absorb administrative costs. • Increased supply of capital. But to whom? – – – In France, the state In Belgium, the Société Générale In Germany , much of it goes to SMEs In the US, mostly to the real estate sector In the UK, a bit more of a mix.

Implications of Local Finance • Limited interregional flows does not allow returns to equalize – This problem is large in frontier economies like the US, but less of an issue in long settled ones where there is a lot wealth. • Intermediaries prone to local shocks – Correspondent networks reduce but do not eliminate these problems – Central banks don’t have the information to intervene until much later • Most likely rationing prevails – Tempered by low entry barriers • But we do get growth.

Financial Deserts • Even in the North Atlantic Core, where financial intermediaries were most abundant, their geographical distribution is extremely uneven. • Looking at regions that are under served can help us understand whether demand plays an important role. • On the whole it seems that financial institutions followed demand. Something that is less obvious outside the core. • Example the Massif Central

France Without Paris Southern Massif Central Ratio Large bank Branches In 1898 18. 6 12. 2 0. 65 Bank of France Discounts 1898 245 MF 69 MF 0. 28 Credit Foncier de France, all loans 1853 -98 Number of loans 1651 1534 0. 92 Value of loans 44, 5 MF 23. 1 MF 0. 52 Savings banks in 1898 Branches 15. 4 15. 19 0. 98 Accounts 171, 000 67, 000 0. 39 Value of accounts 93 MF 34. 3 MF 0. 47 All Bank branches In 1829 18. 3 10. 26 0. 56 In 1840 32. 4 21. 9 0. 68 In 1898 70. 7 64. 5 0. 91

Beyond the core • The number of financial institutions seems to be an order of magnitude smaller – To be sure, less wealth => less finance – To some extent more inequality => less finance (because the rich make rather than buy financial services) • Government bears much of the blame in some places • This is particularly hard on SMEs

Conclusion • Key Role of demand. – Institutional innovation helps but even simple private banks can play a key role. – Government support alone does not create demand for financial services • Key role of institutional diversity – Must resist the temptation to seek out the optimal form. It is probably better to adapt local forms…because the first order effects are probably available with any set of institutions. • Difficulty of government intervention for SMEs – administrative burden of dealing with plethora of firms. – Local information not the government’s comparative advantage. • Potential perverse effects of government intervention. – Increase supply of funds to a few successful firms to reduce administrative burden – Impose uniform solutions so as to provide ‘transparency’ but at the expense of local solutions. – Regulation can be the first step to expropriation.