RBA exposes ‘intertwined nature’ of SMEs and mortgages

The 257-page research paper, titled Small Business Conditions and Finance, was released this week, detailing the RBA’s 2015 conference, which was focused on SME finance solutions.

The RBA noted that, other than bank credit, the most common form of finance used by small businesses is housing equity.

The RBA’s Ellis Connolly, Gianni La Cava and Matthew Read presented an examination of the use of housing equity in small business finance in Australia.

One of the key drivers behind their section of the report, titled Housing Prices and Entrepreneurship: Evidence for the Housing Collateral Channel in Australia, was to gain a better understanding of how interest rate setting can impact the broader economy.

“For instance, lower real interest rates typically lead to higher housing prices; if the housing collateral channel is operating, then expansionary monetary policy may lead to more entrepreneurial activity, such as the formation of new businesses,” the report said.

“Furthermore, it is generally believed that new businesses contribute disproportionately to employment and output growth, implying that this channel of monetary policy transmission could be quite strong.”

In addition, the report noted that if there is a housing collateral channel, then it could mean that some entrepreneurs are credit constrained, which has implications for the design of policies aimed at improving entrepreneurs’ access to finance.

The RBA conducted a series of interviews with SME finance experts at a range of Australian lenders.

“The lenders widely acknowledged the intertwined nature of the entrepreneur’s business and personal finances, particularly for sole traders and family businesses,” the report said.

“In response to this, the lenders actively seek to analyse the finances of their small business customers on a consolidated basis, including their personal finances.

"Some lenders speculated that a share of their home loans to self-employed borrowers, and home equity loans for ‘investment purposes’, could be used in part to finance small businesses,” it said.

The RBA noted that the distinction between borrowing for business purposes and personal purposes has been made clearer since the introduction of the NCCP.

According to the central bank financial institutions are effectively required to separately identify lending for personal, as opposed to small business, purposes given the additional consumer protections that apply to personal lending.

“The lenders implement this by asking customers the purpose of the loan when they make a loan application or seek a redraw on a home loan,” the report said.

“However, once a borrower has indicated that a loan is for a non-business purpose and the funds have been lent, it is not feasible for lenders to determine the extent to which the funds are used for business purposes.”

The Reserve Bank’s interviews with Australian lenders highlighted that the provision of housing collateral by small business borrowers has some influence on the lending decision, and has a significant effect on the terms of the lending.

“Most of the small business finance experts identified housing collateral as being relevant to the framework they use when making lending decisions, although few considered it to be the most important element,” it said.

However, the central bank’s research found that there was some divergence regarding the importance of the collateral provided by the borrower, particularly in the form of residential housing.

“Some lenders downplayed the importance of collateral, arguing that it was just a ‘backstop’ that could reduce the loss for the lender in the event of default, without affecting the probability of a default occurring,” the report said.

“In addition, some emphasised how costly and ‘undesirable’ it was to take possession of a business owner’s home upon default.

“These lenders viewed taking possession of the home as a third and final line of defence, after the borrower’s capacity to repay has been exhausted, and after any other collateral, such as commercial property or equipment, has been sold to recover the value of the debt.”

Australian lenders have acknowledged the difficulty that new businesses face in accessing finance, regardless of their housing collateral, the RBA concluded.

The central bank said it would be worthwhile examining the effect of housing collateral over the life cycle of a small business.