The Financing of Small Firms Public Disclosure Authorized in Germany Public Disclosure Authorized Christianharm
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F PolicyResarch 'WORKING PAPERS Fnancial Policyand Systems CountryEconomics Department The WorldBank Public Disclosure Authorized May 1992 WPS 899 The Financing of Small Firms Public Disclosure Authorized in Germany Public Disclosure Authorized ChristianHarm In Public Disclosure Authorized Germany,small banks finance small firms. Active govern- ment support and a sophisticatedrefinancing network effec- tively overcomefinancial market imperfections. PolicyRsearch WorkingPpersdisserminate the findingsof workin pogress andencourage the edxange of ideasamong Bank staff and dl othemintested in developmcntissues. Thes cpms.distributed by the Research Advisory Staff, cany the names of the authors,rdlect onlytteirviews.nd tshou bousdBndi ited cardingly.thefindinga, itman ouionsent, dcorc usionsamtertc hot'oweIbeyshould noitbe sttributed to the Wolid Bank, its Board of Dimcors,its management, or any of itsrnember counuries. PolicyReserch FnancdalPolicy and Systems WPS 899 This paper- a product of the Financial Policy and Systems Division, Country Economics Department- is part of a larger effort in the department to study the role and functions of financial institutions. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Wilai Pitayatonakam, room N9-003, extension 37664 (May 1992, 35 pages). In Germany, small firrns are financed chiefly by institutioni benefits almost exclusively the small banks, which are grouped into two sys- entrepreneur who would otherwise have been tems: the savings banks (Sparkassen) and the rationed out of the market. Banks benf-fit only to credit cooperatives. The government actively the extent that overcoming such rationing brings supports the financing of investments in small them new business. Therefore, subsidies are not industry - especially business start-ups. Harm exploited beyond an intended level. explains how small firms are financed in Ger- many. - Harm points out that small banks, which are part of a decentralized market structure, over- Harm contends that small and medium-size come imperfections in the financial market by firms contribute a lot to the Germany economy. building institutions that supersede the market Small firms are not subject to the control institu- mechanism. The savings bank and credit tions - such as supervisory board seats, proxy cooperative systems have each developed an votir.,,, and equity holdings - that shape the internal capital market, not unlike those within relationships between large firms and large large banks operating nationwide. Only central banks. institutions participate in the domestic money market, to place the system's excess liquidity or Government prograns - whether loans to raise funds to cover the system's deficits. from government banks or credit insurance from Also, the funding programs of the government subsidized credit-guarantee institutions - are all banks can be seen as a refinancing mechanism administered through the banking system. The that especially helps small banks. The same is government funds or insures selected projects, true for rediscountable trade bills. but the banks assume the role of the monitor and credit analyst in return for compensation. Harm stresses that the nonmarket means for allocating funds have developed only to counter The operations of government banks do not market imperfections. Market incentives provide have a subsidy component beyond profits the framework for economic decisions. The forgone. Their loans carry low interest rates but system is balanced to the extent that the scope not to the extent that they allow profitable for perverse allocation of funds is minimized by arbitrage with financial investments. The mandating joint decisions of potentially conflict- subsidy associated with the credit-guarantee ing parties. The PolicyResearch Working Paper Series disseminates the rmdingsof workunder way in theBank. An objectiveof the series is to get these findings out quickly,even if presentationsare less than fully polished.The findings,interpretations, and conclusionsin these papersdo not necessarilyrepresent official Bank policy. Producedby the PolicyResearch Dissemination Center OUTLINE 1. Introduction ............................................................ 1 2. Theindustrial environment of German Banks ............................ 2 2.1. Size distribution .................. *. **........................... 2 2.2. Legalincorporation ....... ................................... 3 2.3. Governance structures for smail firms ....... ............................ S 3. Ofidal support for business start-upsand small businessesin Gemany ........... 7 3.1. Statistical notes on entrepreneurial activity ................. .... ..... 7 3.2.1. Direct subsidies to entrepreneurs . ............................. 9 3.2.2. The banks of the federal government ................. .... ... 9 3.2.2.1. The Kreditanstalt ur Wiederaufbau .................. ..... 10 3.2.2.2. The Deutsche Ausgieichsbank . ............................ 13 3.2.3.TIe credit guarantee institu.3ns ....... .............................. 14 3.2.3.1. The structure of credit guarantee instdtutions ................... 15 3.2.3.2. Business Volumeand Loss Experience ....................... 16 3.2.3.3. Who receivesthesubsidy? ......................... ,..... 16 3.2.4. Performance of supported vs. non-supported entrepreneurs ............. 19 3.2.5. The finandal structure of new ventures ..... ..................... 19 4. Issuesin thefinandng ofsmall firms ........... ................................. 22 4.1. Market segmentation: small banks flnance small firms ................... 22 4.2.The refinandng medunism of small banks ..... .. .................... 24 4.2.1. Rediscountable trade-bills.......... .................................. 25 4.2.2.The refinandng by goverment banks .......................... 26 4.2.3. "Internal" money markets ......... .. .... .* ...... ^ . 26 4.2.4.The decentralization of monitoring bank activity .... ................ 27 4.3.Trade credit, and tade credtinsurance ............................. 29 S. Suivar and 1Snal Analysis ........................................... 31 1. Introduction The purpose of this paper is to familiarizethe reader with the mechanismsof financingsmall and medium-sizedindustry in Germany. The main issue, however, is not merely size per se, but it is the scope of control that banks can exert over their client firms in their monitoring activities. The two papers on banks' relationshipswith smalland large' industry then symbolize the altogether different scopes of control. While the companion paper on the relationshipbetween banks and large industry focuses on the cliche view of German banking, i.e. that banks own and control industry, the purpose of this paper is to demonstrate how the banking system is involved in the financing of the larger fraction of German industry without having access to these means of control. Hence, this paper aims at dispelling the myth that the relationshipof a few large banks with a few large firms is characteristic of German banldng. We will start out in iapter two to provide some statistics that reflect the degree of decentralizationof German industry. The chapter is supposed to provide an intuition on the nature of the banks' market, as it influences the nature of the demand for financial services as well as the organizationalstructure of the banking system. It will be seen that the largest firms contribute about half of the revenues in the economy, and that moreover the corporate charter allowing for the said means of bank control is not very typical in Germany. This motivatesa closer look at the nature of financingof small industry. in chapter three, we will focus on the government's support of entrepreneurialactivity, which explains to some extent the decentralizationof German industry. We shall discuss and analyze the worldngs of the two banks of the federal govemment, KfW and DAB, as well as the activitiesof the state-wideoperating credit guarantee institutions. Chapter four will describe the financingof small firms in more detail, focussing on the refinancingof the lending banks. On top of a literature survey, the research was supported by numerous interviews with representativesof the various banking groups, and managers of different size firms. See Harm (221. 1 2. The industrialenvironment of German Banks When describing the structure of German industry, we mean to define characterstics of the environment- or the market - of German banks. Primarily, the banking system has to adapt to this environnient, althoughit undoubtedlyalso takes its share in shaping the industriallandscape. First of all there is the issue of size. Germany's industrial landscapeconsists to a large extent of small firms - the so-called "Mittelstand"- which has obvious consequencesfor the financing: limited or no access to capital markets, greater transparencyof the firm's operations, but greater risks due to lacking diversificationand greater dependence on managementskills. The legal form of incorporationis likewise important for the financingof a firm. German "Kapitalgeselischaften'feature limited liability,while in "Personengesellschaften"there is always at least one investor liable with his private wealth. The "Kapitalgesellschaften"are further split into AG's (Aktiengesellschaftn) with tradeable shares, and GmbH's (Gesellschaften mit beschrinkter Haftung), where the trading of the shares is usually restricted in the companies' charters, and even