Philipp Grein University of Bern

Small business banking and financing: a global perspective, Cagliari

The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective

Philipp GreinUniversity of Bern

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Agenda

1. Introduction2. Characteristics of a lending relationship3. IFRS versus German Commercial Code4. Prior research on IFRS-adoption5. The model

1. General assumptions2. Information structure3. Sequence of events4. Equilibria for discrete strategies

6. Conclusion

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1. Introduction

> German SMEs primarily financed by relationship lenders due to their size and informational opaqueness.

> Long-term lending relationships help to overcome financing

constraints but relationship lender gains monopolistic position

> Possible solution: Increased disclosure by adopting IFRS

> Question:• Can a SME really reduce its dependence from relationship

lenders by adopting IFRS?• Does an IFRS-adoption reduce the cost of debt for a SME?• Is an IFRS-adoption always beneficial for an SME with regard to

the financing situation?

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2. Characteristics of a lending relationship

> Lending relationships are of long-term nature:• Relationship lender accumulates information over time

> Relationship lender:• has access to private information, which is of soft nature• provides largest share of debt capital of a debtor• assists debtor during times of financial distress

> Access to private information decisive factor for the existence of a lending relationship:• Competition on loan market is reduced

Problem of time inconsistency solved inter-temporal contracts possible Relationship lender is able to earn an information rent

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3. IFRS versus German Commercial Code

> German Commercial Code:• Influenced by tax accounting rules• Prudence principle very dominant

• assets cannot be valued higher than at their historical costs• internally generated intangibles assets cannot be recognized

creation of hidden reserves • Relief for smaller and medium firms with regard to the notes

(§326, § 327 HGB)

Main accounting purpose:• Determination of distributable income and capital maintenance• Provision of information only of subordinate importance

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3. IFRS versus German Commercial Code

> International Financial Reporting Standards (IFRS)• Not influenced by tax accounting rules• Prudence principle less dominant:

• valuation at fair value of certain assets possible• broader definition of assets • internally generated intangibles assets can be recognized

less creation of hidden reserves• greater number of mandatory notes

• No relief for smaller and medium firms

Main accounting purpose:• Provision of decision useful information (true and fair view)

> IFRS-adoption increases amount and quality of disclosed information

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4. Prior research on IFRS-adoption

> Disclosure and cost of capital across different accounting standards• Till now: evidence only for cost of equity capital • Ambiguous results (e.g. Leuz/Verrecchia and Daske)

> Accounting quality and cost of capital• Negative relationship for cost of equity capital as well as for debt capital

(e.g. Francis et al, Bharat/Sunder/Sunder)

> Accounting quality of different accounting standards• IFRS exhibit a higher quality than German GAAP

(e.g. Gassen/Sellhorn and Daske/Gebhardt)

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5. The model

5.1 General assumptions

> Model with two time periods> 3 Players:

• Owners of an owner managed firm either of type G or of type B • Relationship lender• Outsiders

> Investment program:• Owner can run two consecutive investment projects, initial investment

of I each: • Project 1: starts in t=0, pay-off 0 or X in t=1• Project 2: starts in t=1, pay-off 0 or Y in t=2

• Probability of success: π with πB < πG

• Both projects only for type G positive net present value

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5. The model

5.1 General assumptions

> Financing:• Only debt financing possible• Outsider and relationship lender simultaneously offer an interest

rate

• Relationship lender incur relationship building costs cHB if chosen as financier

• Financing of both types in t=0 and t=1 is associated with a loss

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5. The model

5.2 Information structure

> Sequence of events, pay off structure of investment projects, and ex ante probabilities are common knowledge

> In t=0 only entrepreneur observes his true type

> If relationship lender is financier of first investment project, it can observe true type of entrepreneur after completion of first project

> Outsiders rely only on publicly observable information

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5. The model

5.2 Information structure

> In t=1 entrepreneur chooses either information systems HGB or IFRS

> If IFRS is chosen and entrepreneur is type G:IFRSG ΦG

IFRSS 1-ΦG

> If IFRS is chosen and entrepreneur is type B:IFRSS ΦS

IFRSG 1-ΦS

IFRS as verifiable signal on type of entrepreneur

> Assumptions:1. IFRS is informative: ΦG>0,5 and ΦS>0,52. German GAAP no information content, no signal sent

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5. The model

5.3 Sequence of Events

0 1 2

Relationship lender or

other lenders provide I

Entrepreneur starts project

one

Return from project two:

0 or Y

Loan is repaid if possible

Owner chooses an information

system, IFRS or HGB

Owner starts

second project

Relationship lender or outsiders provide I

Return from project one:

0 or X

Loan is repaid if possible

Relationship lender observe owner’s type

If owner chooses IFRS, outsiders

observe signal on owner’s type

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5. The model

5.4 Equilibria for discrete strategies

> Assumption:• Relationship lender offers either rmax or rd

• Outsiders offer either rd or make no offer

> Without information system:• Outsiders never make an offer• Relationship lender earns information rent by financing second

project with rmax

• Information rent exceeds losses from first project

Relationship lender is willing to finance project in t=0

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5. The model


> With information system two types of equilibria in t=1, separating or pooling

> Pooling equlibria:1. Both types choose German GAAP

same equilibrium as in situation without information system outsiders have sceptical expectations

2. Both types choose IFRS (assumption: no cost of adoption)• Very high information quality: relationship lender offers rd, outsiders

offer rd if signal indicates good type

• High information quality: equilibrium in mixed strategies• Medium information quality: relationship lender offers rmax,

outsiders offer rd if signal indicates good type

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5. The model


> Separating equilibrium (cost of adoption equals b)• Type G entrepreneurs adopt IFRS, Type B entrepreneurs keep

German GAAP

• Type G entrepreneurs receives financing in t=1 at rmax

• Type B entrepreneurs receive no financing in t=1 Equilibrium holds only if cost of adoption is sufficiently high but

not too high

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5. The model


> Equilibrium of entire game depends on outcome of second stage

> If information rent is significantly reduced, relationship lender is not going to invest in a relationship depends on information quality of IFRS, on adoption

costs and on relationship building costs

Both entrepreneurs do not receive financing in t=1

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6. Conclusion

> Effects of an IFRS-adoption for the financing of SMEs depends on information quality of IFRS

> If IFRS of sufficient information quality:

Mitigation of hold up problem possible

Cost of debt financing reduced

> But: Relationship lenders looses ability to earn information rent• Nature of existing lending relationships alter: willingness to provide assistance during financial distress declines• Banks may no longer be willing to establish lending relationships

Credit availability for very young SMEs declines

Documents

Philipp Grein University of Bern