THE UNIVERSITY OF BIRMINGHAM

FINANCING PROBLEMS OF SMALL FIRMS:

EVIDENCE FROM TURKEY

A DISSERTATION SUBMITTED TO

THE FACULTY OF SOCIAL SCIENCES

IN CANDIDACY FOR THE DEGREE OF

MASTER OF SCIENCE IN ECONOMICS

DEPARTMENT OF ECONOMICS

BY

GIZEM KEDICI

BIRMINGHAM, UK

SEPTEMBER 2003

ABSTRACT

This paper analyses the financial problems of small firms in Turkey by over viewing

the problem from both firm owner’s and bank’s point of views, exploring the policy issues,

and making use of the survey results of 39 firms in Ankara, in comparison with results of

State Institute of Statistics. These empirical analyses suggest that the fragility in the financial

markets and lack of competition for small firm financing are the key factors creating the

external finance difficulties of entrepreneurs. The financial restructuring era that Turkey is

experiencing will promote competition in credit markets; ease those problems of small firm

owners and endorse higher growth.

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TABLE OF CONTENTS

PAGE

CHAPTER I: INTRODUCTION:.................................................................1

1-1 The Definition of SME.................................................................2

CHAPTER II: FINANCING SMALL FIRMS: .............................................4

2-1 Sources of Finance........................................................................5

2-1-1 Asset Based Finance......................................................5

2-1-2 Debt Finance..................................................................6

2-1-3 Equity Finance...............................................................7

2-2 Financial Management of the Small Business..............................8

2-2-1 Moral Hazard................................................................10

2-2-2 Adverse Selection..........................................................11

CHAPTER III: SMALL ENTERPRISES IN TURKEY:...............................12

3-1 Macroeconomic Environment of Enterprises...............................13

3-1-1 Effects of Financial Liberalisation on SME’s...............14

3-1-2 Effects of Crises on SME’s...........................................15

3-2 Structure of Small Establishments in Turkey...............................16

3-3 The Bank- Borrower Relationship................................................18

3-3-1 Bank’s Perspective........................................................18

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3-3-2 Government’s Perspective.............................................23

3-3-3 Small Firm’s Perspective...............................................24

3-4 Empirical Results..........................................................................25

CHAPTER IV: CONCLUSION........................................................................29

REFERENCES..................................................................................................31

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LIST OF ILLUSTRATIONS

LIST OF FIGURES:

Figure 3.1 The contribution of SME’s to GNP of countries………………………….…13

Figure 3.2 The usage of bank credit in small firm finance in a sample of countries........19

Figure 3-3 Total credits of Halkbank for the last three years. …………………………..21

Figure 3-4 Percentages of types of credit given by Halkbank, 2002 …………………….21

LIST OF CHARTS:

Chart 3.1 Application process for a small enterprise.........................................................24

LIST OF TABLES:

Table 3.1 Distribution of manufacturing employment by establishment size,

selected countries...………………………………………………………………............12

Table 3.2 Number of small sized manufacturing industry establishments by financial

decision makers......…………………………………………………………….......…....16

Table 3.3 Number of small sized manufacturing industry establishments by the

source of finance....…………………………………………………….........……..........17

Table 3.4 Number of small sized manufacturing industry establishments by the

reasons that effect using credits...............…………………………………………...........25

Table 3-5 Statistical summary of survey results………………………………………....26

Table 3-6 Result summary of small enterprise survey in Ankara, 2003…………………26

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I - INTRODUCTION:

In early studies of industrialisation, the large-scale industries have been the center of

discussion and research, which continued until late post-war period. However, during the last

two decades the importance given to smaller enterprises has been gradually increasing

especially in the developing economies. It became the subject of enduring academic and

political debate. The main reason was the economic crises in the 1970’s and 1980’s and the

striking resistance and vitality of small and medium sized enterprise’s (SME)’s in many

sectors. The second reason was the fact that the inefficient production schemes large

enterprises and their inabilities in promoting employment. (Cınar, Evcimen, Kaytaz, 1988)

How to induce small industries to produce for exports and how to fit their developments more

adequately in the large development plans of national governments were the practical

questions that are dealed with by international lending institutions.

The importance of SME sector was also recognized in Turkey and a number of

organizations were established in order to develop and suggest policies for the improvement

of the sector. These institutions have been mainly operating in order to deal with the financial

disadvantages of SME’s because of their size and the current problems of banking sector after

2001 financial crisis. It will be shown that these problems repel small firms from taking bank

credit, which is the most common source of finance. As small firms are seen an employment

generating institutions, this dampens their plant improvement and consequently slows down

the growth of the nation, in macro sense. The bids to prevent this problem are found to be

insufficient since the government designates solely one government owned bank, Halkbank,

which makes credit taking extremely difficult because of formal procedures and high interest

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rates. If this monopolistic power were removed, the private banks would supply greater

amount of credit to entrepreneurs together with lower rates.

The study aims to enlighten these financial problem of small firms by considering the

matters from both bank’s and firm’s point of views. The paper is organized as follows; the

first section reviews the definition of SME’s within international comparisons, the second

section mainly describes different sources of finance and their usage. It also explains the

asymmetric information existing in financial markets, which makes finding sources of finance

even harder. The third section is based on verification of these facts by a close look at Turkish

economy. This will be followed by a field survey conducted in the capital of Turkey, Ankara.

The last part of the article states the most important conclusions of the survey.

1 – 1 THE DEFINITION OF SME:

The term small business generally refers to an enterprise which, mostly operates with

labour intensive production and lower level of capital. They have the advantage of easy

decision-making and source shifting, so as low management costs. The firm owner is usually

the manager of the firm. There is not any strict classification for small firm since it differs

from country to country in accordance to the lack of homogeneity of size and economic

structure between country economies. Another reason is that these firms are supported by

different purposes in each country and the definition will determine who will benefit from

SME support schemes. (Palas and Oguzkurt, 1997) Therefore, the definitions used by

different institutions are inconsistent. Even in the same country, they may change from sector

to sector.

Since the definition for SME comes from the classification, we can observe the criteria

used in two components;

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i- Quantitative criteria:

These criteria are measurable and statistically meaningful magnitudes for the firms

which are mainly comparing the number of workers, profits and fixed assets, machinery park,

amount of investment per worker and physical technology level. Generally, the most common

source of classification is the number of employers.

ii- Qualitative criteria:

These can be summarized as shares of effort and capital used in production, satisfying

required conditions to provide credits, use of machine equipment and marketing power of the

firm. Although these firms reflect the qualitative characteristics more evidently, in practice it

is easier to classify them by quantitative criteria in order to make more explanatory definition.

iii- The European Union definition:

Since it is necessary to use a common definition to describe SME, it is examined by

the number of people engaged, amount of turnover and balance sheet aggregation. In

accordance with this, having at most 250 employers, turnover level below ECU 40 million or

annual balance sheet not exceeding ECU 27 million are small and medium sized whereas the

small enterprise is defined as having maximum 50 workers, and ECU 7 million turnover or

balance sheet aggregation below ECU 5 million.

iv- The definition in Turkey:

Although the definition differs due to the institution referred, the meaning can be

generalized as having less than 50 employers and fixed assets less than 50 Billion Turkish

Liras (20 thousand GBP) (Palas, 2000)

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II- FINANCING SMALL FIRMS:

Major problems that small enterprises generally experience can be grouped under

some topics. First of all, firms face law and regulation problems, since these are set same for

all kinds of establishments. However, they should be disconnected from the regulations of

larger size establishments and smaller sized firms should be subsidized by contributions,

funds and exemptions. This is also true for tax regulations since tax management system does

not operate efficiently; it is hard to evaluate tax ratios by taxable capacity and structure of

obligors. So tax system should be simplified by making declarations concerning all

establishments clearer.

Another problem that small enterprises face is administrative, which underlines the

special characteristics of these firms that firm owners are most generally the managers and the

financial analysts of the firm. The SME survey of Turkey by SIS 1 shows that, the percentage

of firms, which have an administrative staff other than owners and participants, which is only

2.49 % for small, sized and 5.70 % for medium sized establishments. This fact leads to

difficulties in solving problems of the small sized firm.

Finally, the finance and credit problems, which create the basis of arguments of the

project, should be considered. As many of the topics above are arising from financial

difficulties the small firms face and effect their and the nations growth, more attention must

be paid on this subject. Finding the initial source of finance is known to be the basic financial

problem for small enterprises all over the world. However this problem is even more critical

when we consider developing countries like Turkey, as the per capita income is lower, and the

high level of inflation which dilutes the own capital even faster worsens the problem of initial

investment. Inflation leads to continuous rise in the prices of the raw materials, which cannot

1 State institute of statistics survey of SME’s in 1991 which was done by a questionnare given to 2458 firms in order to receive detailed information about the situation of SME’s and their problems. The survey wasn’t repetaed after 1991.

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be compensated, by the rise of firm’s product prices. Therefore, the ability of an entrepreneur

to provide sufficient capital is very problematic (Halkbank Report 2003)

Finding other sources of finance is also challenging because of the macroeconomic

structure of the country, going through three serious financial crises in 10 years and facing

challenges to rebuild the banking system so that they can coordinate requirements of SME’s.

These make taking credits from private banks difficult since the banks prefer less risky

investment. At this point, the issue of asymmetric information gains importance, because the

banking system, which does not have standard credits, is not good at collecting sufficient

information about firms who are applying for credit to initiate a business. These issues show

the obscurities in finding sources of finance, which will be explained in more detail in

subtitles.

2 - 1 SOURCES OF FINANCE:

2 -1- 1 PERSONAL ASSET BASED FINANCE:

The typical source of finance, which is the type most commonly used, is asset-based

finance where the entrepreneur uses his own wealth as the initial capital when starting a

business. Especially small firms rely on this basic internal source since other sources of

finance are challenging to achieve and the high interest payments the financial institutions

charge lowers demand for external sources even more. The asset based financing can be in the

form of re-mortgages or money raised from family or previous business. Since providing

capital for initiating a small firm is not considered so high, people try to provide their own

personal probabilities, which encourage the individual savings of the country.

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2 -1 - 2 DEBT FINANCE:

In general, small firms also use basic external sources like trade and bank credit or

leasing, hire purchase or factoring. The banks still have overwhelming importance while a

gradual shift towards technology orientated banking delivery mechanisms, such as telephone

and Internet banking (Reid, Jacobsen 1998). Trade credit taken from suppliers can be an

important source of finance with stocks and flows of credit being twice the size of bank credit

in most countries. Some sectors like retailers and others who are dealing with public may

benefit from this. (Bank of England 2002) The trade credit can be used as initial capital or for

increasing plant. Credit can also be helpful in the time of market failures or unexpected

requirements. Nature of competition, firm characteristics like size or position in the value

chain, the nature of customer, supplier relationships based on frequency of purchase can be

named as factors affecting the supply of credit given to small sized firms. If imperfections in

credit markets result having an unsatisfied demand for finance then the firm is likely to

possess both trade and bank credit even when the trade credit rates exceed comparable bank

rates states Wilson, Summers and Singleton. (Wilson, Summers and Singleton 1997).

Fundamentally, firm prefers trade credit when it is relatively cheap or when it is offered as a

total package of different bank services.

Transaction costs: Another theoretical explanation for the use of trade credit is the

concept of transaction costs. Firm’s preferences to use trade credit in order to obtain

efficiencies in cash management underline the importance of transaction costs, as converting

asset to liquid for short notice is very costly. Because of this, firms prefer to hold

precautionary cash for emergencies. The role of trade credit at this point is to allow holding

smaller cash balances by allowing the firm to accumulate invoices and forecast the urgent

cash requirements during uncertain delivery schedules. By this way the small firm can reduce

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the number of transactions made with the local bank who is trying to achieve income from

charges and fees apart from margins of profit and balance its cash-asset ratio independently.

The biggest advantage of credit from banks is that it doesn’t require a search procedure as

equity finance, which may dilute the initial capital of the firm owner, since it is easier to reach

the bank manager of the preferred bank to apply for finance. In addition, trade credit can be a

tool for buyers, signaling the performance of the firm and the confidence in the quality of the

product marketed. In spite of those advantages, bank finance is still not a very preferred

source of finance. The grounds of this argument will be explained in the bank relations’

section.

2 – 1- 3 EQUITY FINANCE:

Another source of finance is venture capital, which has the drawback of requiring high

rates of return, since they are assumed to take higher risk than the banks do. So the considered

firm should be high a growth firm with certain capabilities, making enough profits to be able

to achieve very high rates of return to corresponding fund that is supplied. That is why

venture capitalist more often considers funding a firm in the early stages and prefers

technology-based entrepreneurial firms to traditional industries. (Bank of England 1999) The

role of both formal and informal venture capital is crucial for these businesses, many of which

require risk capital from the seedcorn stage.

Recent literature on venture capitalists show that the growing number of this type of

capital is given in the form of Management Buy Outs (MBO’s) 2 or Management Buy-ins

(MBI’s) which limits the availability of the fund. This is because venture capital companies

take the risk of project of the small firm being successful as they supply equity capital, not

2 MBO: Current management purchases equity of the outside shareholder and the purchase is funded by issuing debt. Management keeps all profits of company, and then has a stronger incentive o raise the value of the company.

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debt capital. So they have to monitor the performance of the firms in the funded period which

is tough and costly. This monitoring problem creates moral hazard in the market, which

means that the venture capitalist would be willing to involve in the management of the

venture. One method, which the venture capitalist tries to monitor the value of the small firm,

is through non-executive director (NED) who builds a long-term relation with the

entrepreneur. However, the NED system is still in the development stage, which makes the

monitoring of operations of the small firm, still a problem for the capitalist. In this sector it

can be observed that less than 5 % of the venture capital applicants are able to take the

funding, which results from the above reasoning.

2 - 2 FINANCIAL MANAGEMENT OF THE SMALL BUSINESS:

The financial gap (unwillingness on the part of suppliers of finance to supply it on

terms and conditions required by small firms) in the funding market makes financial

management of the small firm more important. This gap arises because the demand for credit

is greater than the willingness of institutions to supply credit.3 (Deakins 1999) Insufficiency of

financial sources creates “credit rationing”, follows the lead of Stiglitz, (1981) who claims

that although the excess demand for credit increases the price of credit- interest rate or

collateral amount- until equilibrium, the excess demand for loan-able funds always exists.

Since the aim of the firm is to have low-risk borrowers, the expected profit of the firm may

decrease when the interest rate exceeds a limit. That is why the bank prefers credit rationing

instead of raising the rates more.

As it has been mentioned in the introduction, as a result of financial limitations the

owner of the firm is usually also the finance manager, deciding which sources of funding to

3 Finance gaps have been recognized for almost 60 years and they were first highlighted by the MacMillan Report of 1931 and subsequently termed as “MacMillan Gap”.

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use. He builds personal relation with the institutions of finance, mostly banks in order to

achieve credit for the business. He also determines the ratio of the different sources of finance

that are classified above to build the financial structure.

This economic analysis has been made by the Nobel Prize winning article by

Modigliani-Miller in 1958, which proves that the capital structure of the firm does not affect

financial decisions of the firm. (Modigliani and Miller, 1958) Therefore, the entrepreneur

would be independent of the decision of debt-equity ratio of the firm when targeting value of

the firm. The argument was supported by the fact that the returns going to the equity holder is

risky and when value of equity declines the two effects are offset so the value of the firm

remain independent. It was assumed that the capital market has symmetric information, no

distortion, is perfectly structured and the only distortion is the tax effect. Therefore, control

aspects of shares are ignored and are treated as percentage of firms profit stream. However,

when the unrealistic assumptions behind this theory are relaxed what Modigliani- Miller

theorem claims does not hold. Today asymmetric information exists in the capital market and

leads to moral hazard and adverse selection problems. So it is more accurate to say that that

there is a concave relationship between a firms value and its debt- equity ratio. (Reid and

Jacobsen 1998)

The problem of asymmetric information is endemic to small business lending and it

compounds concerns about the principal (bank) and the agent (firm) relationship. The main

issue is the ability of the lender to control the borrower. In most cases, the borrower takes

high risks for sake of high returns, knowing that all capital gains will accrue to them as

owners. Meanwhile the lender remains with the downside risk of writing-off the loan that is

not compensated by the prospect of gain if the business performs well. (Storey 1994 ) To

some extent, monitoring is possible for the banks but its costs are generally independent of the

size of the loan. Consequently, we would expect the bulk of initial financing come from the

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owner. While the savings of the firm owner remains to be the most common source of

finance, as our survey will verify, in most developed countries, the development in the

financial institutions shows an improved ability to monitor and control new business lending.

(Hamilton and Fox 1998)

2 - 2 - 1 MORAL HAZARD:

Moral hazard may occur when the asymmetric information in the credit market makes

the banks not having full information about the business, supplying credit. The problem may

get worse when the level of debt and the probability of bankruptcy rise. Because debt

financing at the early stages of establishment can add value to the firm but too much debt

making increases the risk disproportionately. (Reid and Jacobsen 1998) Once an entrepreneur

raises the loan, there is no guarantee that they will act in the best interest of the bank.

However, the principal accepts the project, since he expects that the proposal will end up with

maximum profit for both parties. The risk averse agent tries to choose an action which

maximizes firms profit, while the principal is risk neutral and tries to maximize expected

profit. (Deakins 1999) In a moral hazard environment, the shareholder does not care about

earnings in the event that the firm bankrupts. The bondholders only care earnings in the event

of bankrupt and the probability of bankrupt. Therefore, they will try to anticipate and demand

higher returns from firms with high levels of risk. The most important consequence of the

situation is that the burden falls on the small firm, bearing the high levels of interest rate

demanded.

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2 - 2 - 2 ADVERSE SELECTION:

If the manager of the small firm is better informed than the market about future

prospects of the firm, then the adverse selection problem arises. When uncertainty is also

added to the picture, the risk averse bank may either provide finance for a venture capital

which subsequently fails or refuses finance for a venture that would have been successful. It

may occur because the bank does not have all the available information or the information is

imperfect. In other words, the high quality borrower with low probability of default faces

difficulty in convincing the bank to take credit so he can bare an interest rate same as a “bad

borrower” with high probability to default. In this case, the bad borrower may even be the one

taking the credit in expense of the other. (Weinberg 1994) To prevent this situation the bank

may improve the monitoring facilities to forecast the outcomes of the investment better but

this process is costly and time-consuming. If the small firm demanding credit is new in the

business, the bank will have no record of the past performance of the firm. Hence, if one

looks at the cross section of firms, one might expect deviations from the benchmark of

finance to be inversely related to a firm’s age and experience. The banking system should

reduce both types of errors since they have the skills and the resources necessary to do so.

This problem of asymmetric information is easier to be controlled by the banks than the moral

hazard problem.

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III - SMALL ENTERPRISES IN TURKEY:

Turkey is often characterized as a newly industrializing country. In such a developing

economy, the share of SME’s in the manufacturing industry is expected to be high. Benefits

of small industries to Turkish economy can be summarized as creating employment;

promoting entrepreneurship, supplying products to larger industries by sub-contracting, and

creating product differentiation.

Table 3.1 presents data on the distribution of manufacturing employment by

establishment size in a selected group of developed countries. Although there are some

differences among the definitions of establishments in between countries, as mentioned in the

introduction, it would still a comparison of position of Turkey with others.

Table 3.1 Distribution of manufacturing employment by establishment size, selected

countries

CountryNum of Emp.

(000)

Distribution by size % 

     0-9 10--49 50-99

Australia 962 11 22 12Canada 1540 4 19 13Holland 949 11 20 11Germany 6929 13 23 9

Japan 11156 12 29 13Portugal 989 15 26 14Sweden 749 1 16 12

Switzerland 868 12 22 28Austria 580 2 16 14Turkey 150 35 12 6Source: Palas, 1996

From this table we can see that the share of small sized industries is 35%, which is

much greater than the developed economies where the percentage of medium or larger sized

establishments is smaller. In addition, the following chart illustrates contribution of small

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industries to the GNP of nations where Turkey has a percentage not lower than developed

countries.

Figure 3.1 The contribution of SME’s to GNP of countries,

Source: Halkbank 2003 Report

These properties stress the higher importance that must be given to small sized

industries in Turkey. Before exploring the situation of small enterprises in Turkey, a brief

overlook at the current economic atmosphere would help us to understand the topic intensely.

3 - 1 MACROECONOMIC ENVIRONMENT OF ENTERPRISES:

Turkish economy has recently passed unstable stages through the last decade. Great

fluctuations in production and capital flow have been experienced and high levels of inflation

continued to dampen the economy. In addition, with the rising level of foreign debt, started

suffering from fiscal problem, which were reflected in the monetary system by the

government. After the 2000-1 financial crises high interest payments worsened the

government budget external debt surpassing 100 million $. Also the loss of confidence in the

international markets were experienced, thus a steady cash-flow to the country was almost

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dried up. (ICC 2001) Expenses for the reconstruction of the banking system increased the

public debt- GNP ratio to 101% in 2001. Moreover, there has been great depreciation of

Turkish Lira after returning to floating exchange rate regime after February 2001.

After the crises, Turkey gave a start to the new stabilization program (by the credit

taken from IMF and World Bank), which aims to solve the internal debt problem, increasing

the prime surplus in the budget, lower inflation and provide a transition to stable growth.

Current stabilization efforts also include strengthening financial fragility and increase controls

over the banking sector. Regarding the large amounts of domestic and foreign debt,

restructuring financial markets is crucial to recover from financial crisis. Banking system with

12% bad debt in the total credit requires further attention. (ICC 2001) This result is quite

paradoxical since the duty of supporting SME’s given to some state-owned banks by

government, (together with agricultural support schemes) mostly contributed to the 12 % bad

debt before the crisis. These promoting credits were not controlled intensely so worsen the

financial structures of State-owned banks. This led to sharply rising interest rates. In this

environment state banks could not operate, resources required to restructure banking system

worsened public debts.

Solutions for the state-owned banks are as follows; increasing capital amounts of these

banks, limiting their support to non-governmental institutions like SME’s, consolidating

Emlak Bank and Sümer Bank, establishing an independent institution to control consolidated

banks.

3 – 1 – 1 EFFECTS OF FINANCIAL LIBERALISATION ON SME’S:

In order to create an independent and efficient financial system, financial markets

were liberalized in June 1980. Reforms eliminated interest rate controls on deposits and loans,

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eased entry to financial markets and permitted formation of new financial institutions.

However, financial distress in real sector combined with extremely high real interest rates

caused by deregulation led to unsustainablity of the liberalisation process. (Denizer 1997) So

the government continued to control the market through the following decade. The main

reasons behind the failure of the program, which resulted successfully in many other

developing countries, is the public debt pressure. The rates and disponsibility ratios were

determined due to the deficit in the government budget. So the market could not find the

environment to operate independently. This kept the rates always high and financial market

remained fragile (Kedici, 2001).

3 - 1- 2 EFFECTS OF CRISES ON SME’S :

Small firms are vulnerable in the financial markets because of their dependencies on

financial institutions for external funding. As a result shocks to the banking system in as

country may adversely affect the small firms because of the fall in the supply of credits. This

result proved itself when the government decided not to finance state-owned banks, including

Halkbank, after the crises. Then the banks had to take responsibility of their own profits and

had to pay for the failing credits. After that, as expected the unique bank serving SME’s

lowered the amount of credit and raised the interest rates up to 65%. Therefore, disequilibria

in financial markets worsen already existing funding problems of small businesses. (Berger

and Udell 2002)

The policy makers appropriated both small and medium sized establishments a 400

Trillion Turkish Liras (170 Million GBP) fund to cover their losses from the crises. (Treasury,

2001) With the help of this fund, these institutions are able to lower the adverse effects of

massive rise of interest rate of the credits taken from Halkbank.

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3- 2 STRUCTURE OF SMALL ESTABLISHMENTS IN TURKEY:

In Turkey, small enterprises generally concentrate on a single industrial site, create

externalities of production (sharing capital equipment and expertise) and facilitate division of

labor between stores. This loose integration helps them to increase quality of production and

lower costs. In addition since they generally use own raw materials, they are not adversely

affected by the changes in the exchange rate like large scale firms4.

The State Institute of Statistics made the survey about small establishments only in

1991. The results of this survey may help us to compare their structure with general outlook

that was given in the second section.

First, the following table verifies the statement claiming that owners and the partners

rather than special managers mostly control these firms.

Table 3.2 Number of small sized manufacturing industry establishments by financial

decision makers.

Industry groups TotalBoard of Directors

Accounting Manager Owner

Owner and Shareholder

Director of Finance Other

Total 100 36,83 2 27,21 31,51 1,51 0,94Food, Beverages and Tobacco 100 37,77 0,47 29,3 31,16 0 1,3Textile and Leather 100 33,69 2,47 32,39 29,55 1,33 0,67Wood and Furniture 100 26,8 2,06 25,77 45,36 0 0Paper, Printing and Publishing 100 34,84 0,45 33,48 27,6 3,62 0Chemicals, Petroleum, Coal and Plastic 100 41,25 2,81 13,31 31,02 3,14 2,48Non-Metallic products 100 30,97 0 22,35 45,58 1,11 0Basic Metal Industries 100 44,74 6,14 20,18 26,32 2,63 0Machinery, Transport and Scientific Equipment 100 39,62 2,67 25,11 29,54 2,02 1,07Other manufacturing 100 46,67 0 33,33 18,33 1,67 0

Source: SIS 1991 Survey

4 The modern sector relies on imported technology and inputs, so after the financial crises, when the Turkish Lira devaluated highly, large-scale firms in Turkey are adversely affected and especially many firms having debts in foreign exchange have bankrupted.

21

Due to these results, the owners manage 58.725% of the total number of small firms

alone or together with shareholders. High percentage of firms also has board of directors’

management that is 36% as a total; the rest is accounting manager and director of finance,

which do not make a ratio higher than 2 percent. The limited source of finance and magnitude

of their total revenues lead to this fact. The sectors, which have relatively higher profit

margin, like chemical or metal industry manufacturing seems to have greater budget for

financial management. This can be seen from the percentages of those sectors, for director of

finance and accounting manager.

Second statement to verify is the source of finance these small businesses generally

use, which can be shown by Table 3.3.

Table 3.3 Number of small sized manufacturing industry establishments by the source

of finance.

Industry groups TotalBank Credit

Commercial Credit

Own Net Asset Leasing Other

Total 100 17,94 12,7 65,43 2,51 1,43Food, Beverages and Tobacco 100 19,89 10,56 65,85 1,58 2,11Textile and Leather 100 17,4 13,36 66,3 1,47 1,47Wood and Furniture 100 26,26 4,04 63,64 6,06 0Paper, Printing and Publishing 100 17,19 24,22 51,56 3,91 3,13Chemicals, Petroleum, Coal and Plastic 100 19,34 10,43 65,14 3,05 2,04Non-Metallic products 100 17,37 14,83 65,68 2,12 0Basic Metal Industries 100 12,5 10 74,17 3,33 0Machinery, Transport and Scientific Equipment 100 16,64 13,76 65,66 3,01 0,92Other manufacturing 100 11,11 11,11 59,26 11,11 7,41

Source: SIS 1991 Survey

The table proves our statement about the barriers to find a finance source to their

businesses discourage firms from taking bank or commercial credit (The percentages are

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17,94 % and 12,7% as total, respectively). These firms prefer using own net asset,

significantly in all types of industry groups not only because it is easier to reach but also

because by insider financing the owner of the firm have the most control over the firm. The

equity finance is included in the other source of finance section with an average of 1,43 %.

When industry groups are separately considered it can be seen that wood and basic metal

industries do not use any venture or other types of capital funding. In particular, small firms

with high growth potential have access to equity markets. Therefore, the traditional, labour

intensive production firms are more typically bankable. (Carpenter and Petersen, 2002) The

following section will explore the bank relations to have a well understanding.

3-3 THE BANK-BORROWER RELATIONSHIP:

3 - 3 - 1 BANK’S PERSPECTIVE:

Private banking is almost a new phenomenon in developing countries. Through 50’s

until end of 70’s financial system of those countries were dominated by state-owned banks

and foreign-owned private banks. This was also true for Turkey; the state-owned banks

promoted economic development priorities like agriculture, mining or textile by building

special financial institutions like Ziraat Bank, Sümer Bank, Halkbank5. Commercial banks

have nearly been absent in small firm financing in Turkey. However, cross-country studies

shows that importance of bank lending is greater in developed countries. The following chart

confirms this argument. Banks in Turkey has the lowest contribution with only 4% while

developed countries like France and Japan has 48 and 50% respectively.

5 Ziraat Bank is agricultural, Sümer Bank is textile supporting and Halkbank is enterprise supporting banks. In between Ziraat Bank is the oldest and the largest one.

23

Figure 3.2 The usage of bank credit in small firm finance in a sample of countries:

Source: Halkbank Report, 2003

.

The main reason banks are discouraged from lending to the small firms is the riskiness

of the sector. There are two different types of risk involved in the small business sector. The

first one is the business risk, which is likely to be much greater than comparable large

enterprises in the same market. It follows that the returns expected from a small enterprise

vis-à-vis a comparable large business will be reflected by the higher returns demanded by the

investors. This will result in a significantly greater cost of capital for small business.

The second type of risk is financial risk, where a firm with a high debt to earnings

ratio will be taken as a more risky investment than others. It is widely recognised that small

firms have higher debt ratios so the bankers perceive small businesses as bad credit risk. The

perception is that small clients do not have stable and viable business for which to borrow and

from which to generate repayment. Moreover, these firms lack collateral to guarantee their

loans. Finally, they do not have lending methodologies, which makes bad credit inescapable.

Amount of non-performing loans (arrears), mostly depend on the lender’s image and

credit methodology. Ratio of arrears to total amount of loans can be explained by average

loan term and average nominal interest rate. The loan term or the repayment schedule can

affect the ability of borrower to pay his loan back. The shorter terms and frequent payment

24

schedules increases the probability of repayment because longer terms make control of the

loans harder for the bank. In addition, it has been widely accepted that micro and small

enterprises are capable of borrowing at commercial banks rate. Increase in the interest rate

over this rate will imply higher cash burden on the small firm, so higher chance of default of

debt.

Second reason why banks do not prefer lending to small firms is the amounts of credit

demanded are small and terms are very short so the bank operations will be inefficient and

costly. Finally many banks claim that education levels and socio-economic conditions of

small firm owners does not allow them to build personal relations with bank managers easily.

Halkbank, established in 1933, and became responsible for enterprise financing in

1984, aiming to contribute to the national saving of the country, and transferring these sources

to finance SME’s and operate as the economic force behind them. The share of SME credits

within the balance sheet of Halkbank can give an idea of the importance of this bank in the

sector. Due to the following chart, SME’s sector is the main sector the bank finances and the

proportion of other types of credits have been decreasing. The percentage of SME finance has

risen to 76% last year from 63% and the commercial credit fell to 16% from 29% during the

last three years.

25

Figure 3-3 Total credits of Halkbank for the last three years.

Source: Halkbank

Halkbank provides three types of credits to SME’S; cooperative, industrial and

funding credits. Industrial credits include tourism, machinery, high-tech, computer

programming and export credits. The cooperative type of credit is mainly service machinery;

vehicle and employment support credits. Finally fund credits is medium or long-term foreign

exchange credits. Throughout the years and especially after financial crises, there has been

significant decreased. Mr.Cebeci, (member of Halkbank, responsible from credits) stated

that stagnation in financial markets, leading to rise in the interest rates of Halkbank credits

was the main reason behind this change.

Figure 3-4 Percentages of types of credit given by Halkbank, 2002

Source: Halkbank

26

Banking law numbered 4603 states that the banking system restructuring should be done by

privatisation of state-owned banks, which gave great amounts of bad debts after the financial

crises. It is also stated that the privatisation process will enable a modern banking system

operating in a competitive environment. The intuition is that if many banks compete to

finance small firms, then small firms will have to option to switch lenders. (Ocak, 2002)

These changes will also allow lower interest rates, which will promote growth, transparent

balance sheets, and covering short-term debts.

Meliha Koyluoglu, manager of Isbank, explained me that Isbank has started

agreements to become the first private bank, financing small business sector. Their aim is to

increase the competition and lower the interest rates to provide a larger amount of credit

supply to the owners of small sized enterprises. She stated that the financial crises of 2000-1

reduced the confidence on Halkbank as the single provider of small business credit. So, the

firm managers decided to apply for credit to a bank, which has a good reputation in Turkey,

Isbank, although they have announced loss after the crises. Moreover, the bank was suffering

from the bad debts of large institutions with long-term debts whose balance sheets seemed

credible when they were accepted for the fund. This encouraged the bank to create a special

funding regime for the small firms with low returns and insufficient collateral amounts.

As the bank managers knew that this new credits will also be quite risky, they adapted

control strategies6 like requiring monthly payments of both principal and interest payments

and discriminate interest rates in order to diversify the risk. The idea is if 10% of the loans

turn out to be failing, the bank will still benefit from the rest. The fluctuating interest rates

allow them to keep the rates at low levels, while Halkbank insists on 50-55% interest rates.

These reforms may create the question that was not Isbank already financing a small

firm applying for credit with a credible balance sheet and cash flow. Of course, it was but this

6 These strategies are accepted with agreement of 13th of November 2002 and the policy is being applied since 17th of May, so the bank does not have the rate of success of credits given. However the monthly controls are optimistic.

27

was included in commercial credit account of the bank. However, after last year’s agreement,

the bank-small enterprise relation became formal and restricted with certain rules to reduce

the existing risk. In other words there wasn’t any special offers and promotions created for the

small businesses applying, it was only the competition for this sector increasing and allowing

more firms to benefit from credits.

3 – 3 – 2 GOVERNMENT’S PERSPECTIVE:

Government in Turkey has always been an active force in small firm financing, like in

all aspects of the national economy. After the importance of small sized firms is being

recognized, several state organisations have been established to protect and support them.

The primary institution established in 1990 is KOSGEB (Small and Medium Industry

Development Organisation of Turkey), which aims firms to rapidly changing technological

improvements in production and increase economic contributions. This institution gives

education, information and documentation services together with EIC (Euro Info Centre)7.

KGF (Credit guarantee fund) is another government institution established with

assistance of Germany in 1995, to support small enterprises financially. They are

collaborating with Halkbank and KOSGEB. The objective of this institution is to help the

firms applying for credits without enough collateral. The guarantee amount should not exceed

80% or 4000,000 €. Other prerequisites are having a promising project to be financed,

sufficient net assets, enough assets deposited in the relevant bank and an efficient financial

management. Experts control these conditions and the decision to support the considered

company is given by board of KGF. The following diagram explains the procedures of

7 EIC operates in 36 countries with 250 institutions since 1992. They have been operating together with KOSGEB since 1993. The educational programs of the institution helps the firms to learn European Union activities and prepare them so that their structures comply with EU decisions.

28

applying to KGF for collateral. So the applications rejected by Halkbank because of

insufficiency of assets are sent to KGF for evaluation for certain criteria that are mentioned

above. If the firm complies with those principles the application for credit is accepted and the

required collateral is supplied by KGF, otherwise the firm can not receive credit from the

bank.

Chart 3-1: Application process for a small enterprise

3 – 3 – 3 SMALL FIRM’S PERSPECTIVE:

The fragility Turkish financial markets together with procedures and obstacles while

demanding debt or equity finance keeps the firms away from finding sources of finance both

in the early stages of establishing and for the ongoing investments. The Small Firm Survey of

SIS can give an outlook to the main reasons affect using credits:

29

HALK BANKCredit Application

Small Enterprise

Evaluation

Incapable KGF

Rejection

Acception with collateral

Position of the firm is evaluated by KGF

Col

late

ral

und

erta

ken

Acception

Table 3.4 Number of small sized manufacturing industry establishments by the

reasons that effect using credits.

Industry groups TotalHigh cost of Credit Formalities

Samll number of creditors

Adequacy of own resources

Performance of Commercial debts

Inadequacy of gurantee Other

Total 100 77,89 1,45 0,65 12,63 2,69 1,29 3,41Food, Beverages and Tobacco 100 75,76 0,92 0,55 14,84 2,49 1,01 4,42

Textile and Leather 100 77,35 1,42 1,34 10,83 2,48 1,56 5,02

Wood and Furniture 100 87,11 3,09 0 4,12 1,55 2,06 2,06Paper, Printing and Publishing 100 77 0 0 14,5 5,5 0 3Chemicals, Petroleum, Coal and Plastic 100 83,89 0 1,3 10,56 0,74 2,22 1,3

Non-Metallic products 100 69,98 3,78 0,24 17,02 5,2 0,24 3,55

Basic Metal Industries 100 79,41 1,96 0 9,31 5,39 1,96 1,96Machinery, Transport and Scientific Equipment 100 78,4 1,76 0,09 13,96 2,46 1,23 2,11

Other manufacturing 100 90,57 0 0 9,43 0 0 0

Source: SIS Survey, 1992

It is clearly seen that the most common reason why small firms avoid credit is the high

costs of credit. The main hypothesis of small firm borrowing states that as the amount of

collateral or rate of interest rises, amount of credit demanded decreases. This result is not

surprising when the competitive structure of the banking system that is serving small firms is

considered. Therefore, the firms shift to internal sources for financing as the cost of external

financing exceeds opportunity cost of internal financing when the transactions costs or the

costs arising from asymmetric information are considered. (Carpenter, Fazzari, Petersen,

1995)

3 – 4 EMPIRICAL RESULTS:

30

The small firm survey has only been done in Turkey by State Institute of Statistics in

1991. Since it is a costly and tough process to interview the small firms, this survey has not

been repeated through the last decade. This survey includes financing problems of 39 small

enterprises in Ankara. In order to be consistent the interviews have been made to the firms

with similar rates of return and operate in the same economic area. However, the sectors these

firms operate are very diverse; ranging from food to textile, construction to health. The

summary of results can be seen from table 3-5 and 3-6.

Table 3-5 Statistical summary of survey results:

  Mean Median Max Min

Age of the firm 8,642857143 5,5 29 1Num. Of Workers 12,35714286 7,5 35 3

Table 3-6 Result summary of small enterprise survey in Ankara, 2003:

Sources of Finance Total Asset Finance Credit Finance Equity Finance

Percentage 100 76,92 23,07 0Asset Finance:Sources from ex-business 76,92 35,49 * *Sources from family 76,92 29,58 * *Sources from Chamber of Commerce 76,92 11,84 * *Credit Finance: Collateral - Guarantor 23,07 * 5,76 *Balance Sheet Check 23,07 * 8,65 *Relationship with Bank Manager 23,07 * 8,65 *

This table summarizes results of choice of finance for the firms participated in the

survey. The results matches the SIS results given in section 3-2 in the way that the greatest

percentage of choice of finance is own asset based as it was 65,43% in SIS survey and

76.92% in this survey. This is made up of sources transferred from previous business that the

owner, which is 35% of total asset based finance, from family or chamber of commerce.

45,45% of the firms using sources form previous business is operating in the same sector as

31

before. The rest, which changed the sector they function, are mostly from food sector. The

reason behind this fact is that the increasing number of supermarkets opened in the cities

caused the small food markets bankrupt. Each firm in the survey was a member of chambers

of commerce corresponding to its sector. However, none of them was receiving any support

from these institutions even though they were paying annual fees to be supported. The bank

managers also pointed this matter; they were claiming that these payments should be used as

collaterals to private banks in order to solve asymmetric information puzzle in the small firm

market. By this way each chamber can act as a guarantor for the firm which they receive

annual payment and lower the monitoring costs of banks.

The second major type of finance is credit finance which is in the form of either bank

credit or commercial credit. Most of the small firms in this survey were using bank credit, as

it requires fewer formalities, generally collateral or a guarantor working for government

sector. While the banks usually require balance sheet controls when giving commercial credit

in order to reduce the asymmetric information in the credit markets. The ones not paying

revenue taxes fully do not want their annual returns to be controlled so they apply for personal

credit, as the owner transfers these personal sources to firms account.

It can also bee seen that none of the firms reported that they have used equity finance

in the survey, which requires strict control of the firm performance8. As it is mentioned,

enterprises in Turkey generally do not prefer to be monitored closely. This situation is

worsening the moral hazard problem9.

Another type of borrowing is renting of supplies and materials, which is called

leasing. Almost half of the firms in the survey have used this, especially small manufacturing

companies. Less number of formalities and conditions make this type of borrowing easier for

firm owners when compared to taking credit from banks. Only disadvantage involved in this

8 See section 2-3 Equity finance.9 See section 2-4-1 Moral Hazard

32

is that it requires high rates of return as venture capital, since the initial payments of leasing

are higher than interest payments. However, when total payments are compared leasing

payments are easier to pay.

Another topic the survey aimed to find was the reasons discouraging firms from taking

credit. The survey showed that many firms preferring internal finance are the ones who have

already applied for credit from banks but were rejected. The rejection was because of lack of

collateral and guarantor. The ones who have not tried to take credit from banks gave their

reasons for doing so. The results were same as survey of SIS where the greatest percentage of

the firms, around 65% stated high cost of credit and around 27% reported adequacy of their

own sources as the main reasons.

For example, the owner of a stationary shop called Denge complained about the high

cost of taking credit because of collateral. The bank he applied asked for his house which is

worth of 30 Billion Turkish Liras (12,000 GBP) as a collateral. However the credit amount

the entrepreneur asked for was only 3 Billion TL. (1200 GBP) So he did not want to risk his

asset for a small amount of credit and got financial help from his family as many others do.

Finally, the results also matched the SIS survey in financial management topic, except

these results were extreme. In the survey of 1991 only 58% of the firms were found to be

managed by owners or shareholders but in this survey, 96,1 % of the firms are found not to

have a special finance manager. The rest is employing accounting or finance managers to

control budgetary activities.

As a summary, these results show that the financial situation of small businesses in

Turkey has not proved to be improving over the last decade. Turkey is still the country having

the lowest percentage of bank credit among developed countries. It is not the lack of

willingness of entrepreneurs to take credit (as many internal financers are the ones rejected

33

from banks), it is mostly the lack of supply and advantageous conditions of today’s credit

market in Turkey.

IV- CONCLUSION:

This paper first tries to understand the meaning and importance of small firms in the

economy and then tries to explore their problems. Since the main problem this sector faces is

financial, the paper concentrates on finding solutions to this problem. In order to find the right

solutions the situation should be overviewed from all points of views. So difficulties of

finance are analysed from bank’s, government’s and small firm’s point of view by doing

interviews and surveys.

The banks admit that small firm was not a preferred sector to give credits, as it was

costly to monitor performances or manage the risk in the fragile credit market caused by

asymmetric information. For many years, government has been trying to support

entrepreneurs by Halkbank credits. However, prerequisites and rates of state-bank finance,

which was a monopoly, discouraged small firms from external finance. Nevertheless, after the

financial crises Halkbank gave large amount of losses like many other state-owned banks and

the entrepreneurs lost confidence in government support. At that point, the largest private

bank, Isbank, decided to create a special funding regime for small firms and lowered the

interest rates. This was a step for changing the monopolistic market structure for small firm

credits. It is expected that the other large private banks try to adapt this policy in the short-

term in order to compete with Isbank. While the private banks are raising profits the small

firm will have the chance to access to credit more easily. This might end up with the

MacMillian Gap10 lessening and supply of credit for small firms becoming sufficient.

Government has adapted new policies to restructure the banking system, cover the

losses of state-owned banks, and even privatise most of them. Recently government has also

10 See Section 2, page 8

34

been considering merging the state-owned banks and consolidating their losses. As this would

increase the influence of Halkbank on SME’s, if the state legislates this law, the financing

problems would even worsen. So instead of merging state-owned banks, the state should

privatise them and in that way promote competition. This way the risk involved in this sector

would decline since consolidating budget of the state-owned bank would induce a riskier

market. Therefore, the unique duty of the government for this aspect would be to command

the chambers of commerce to support them as a guarantor with the annual payments they

receive from small firms.

These improvements are promising for small firms owners as the empirical research

has highlighted that greatest percentage still use internal finance and that the high costs of

taking credit is the main reason for not using debt finance. The survey has also proved that the

problems of these entrepreneurs has been continuing through the last decade since the survey

results of 1991 were very similar to today’s survey results. This means that the small firm

sector of the economy could not improve to contribute more to growth within ten years. That

makes this restructuring period of Turkish economy even more important, because if the

government attempts to privatise state-owned banks and the new funding plans of Isbank,

(hopefully other private banks are expected to adapt the strategy) become successful. This

will promote their production and sales plans. These policies will be beneficial not only for

the banks and the firms but also for the government. A stronger financial market, recovering

from crises will increase confidence for the state and this confidence will endorse growth of

the nation.

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35

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