A mass of evidence indicates that potential entrepreneurs are often unable to obtain loans to start a new business unless they post considerable collateral or provide substantial self finance. This suggests a market failure resulting in many potentially worthwhile projects going unfunded.
What’s more, the evidence is used to justify government policies aimed at encouraging more small businesses to be established, such as those announced in the latest Budget. But according to new research by Professors David de Meza and David Webb, published in the latest issue of the Economic Journal, such conclusions do not follow at all. If anything, under laissez faire, there is a tendency to overlending. Banks cannot easily distinguish good prospects from poor and so offer similar terms to all. Hence, low quality entrepreneurs obtain excessively cheap finance and, were they charged a rate appropriate to their quality, some would not proceed.
Collateral requirements help avoid the problem for, as the entrepreneur has a significant stake in the success of the business, fewer of those with low-quality projects seek funding. Moreover, these researchers demonstrate, collateral disciplines the borrower, counteracting a tendency to excessive risk-taking and insufficient effort once the loan is made. Even so, the systematic tendency for funding terms to reflect average performance makes it too easy for applicants with below average projects to get funds. The problem of overlending is further exacerbated by a well documented propensity to over-optimism by entrepreneurs, as discussed in earlier research in the Economic Journal (”The Borrowers” Curse”, March 1996) by Professor de Meza.
”Wealth, Enterprise and Credit Policy” by David de Meza and David Webb is published in the April 1999 issue of the Economic Journal. De Meza is at the University of Exeter; Webb at the London School of Economics.
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