Determinants of SME Loan Contracts

Abstract

This chapter incorporates major theoretical works on loan pricing, collateral determination and the value of relationships in loan contracting. Findings from this chapter reveal that the determinants of risk premium on SME loans are largely connected with factors that underline the opacity and riskiness of SMEs and are also connected with lender factors such as cost of funds and administrative expenses associated with loan appraisal and disbursement. Banks generally charge higher differential interest rates to younger SMEs than to older, larger and more established customers, due to the former’s relative opacity, perceived risks and uncertainties and high failure rate. Customers with longer relationships with their bank tend to benefit from lower interest rates than first-time customers, supporting the notion that relationship lending generates valuable information about borrower quality. What determines the likelihood of requesting collateral from SMEs is significantly related to the borrower’s risk characteristics, such as firm size, firm’s age or opacity. Loan size, firm size and borrower’s credit rating tend to also determine the likelihood that a bank will request full or partial collateralisation. Finally, the determinants of loan contract terms are also influenced by external and business environment factors such as the business cycle, monetary policy and the level of bank competition.