This paper was a submission to Financial System Inquiry.

Throughout the world the funding for small and medium business enterprises1 (SMEs) has become increasingly constrained through long-term structural changes in credit markets. Consolidation of banks, and centralised credit assessment has increased the distance between borrowers and lenders, both geographically and in terms of relationships. With distance comes an increase in information asymmetry, resulting in higher transaction costs as larger credit corporations struggle to deal with very small but complex loans, and higher search costs for SMEs as they seek out avenues of funding (Mills and McCarthy, 2014).

Cyclical factors have also accelerated this long-term structural change. Economic conditions surrounding the global financial crisis (GFC) have seen lenders become more risk averse, impacting negatively on the availability of credit for SMEs. The price of credit has increased due to defaults and business failures, and at the same time many SMEs have become less credit worthy due to weaker sales (especially in the retail sector), and a reduction in the value of collateral. Increased capital requirements on lending, introduced in the re-regulation period that followed the GFC, have also restrained credit growth.
While it is recognized that in a competitive capital market it is not optimal for all potential entrepreneurs or businesses to receive financing, as funds should flow only to those businesses that are expected to generate an adequate return of capital, restricting the flow of funds to the SME sector can have a detrimental impact on the economy. In Australia, for example around 2 million SMEs account for 68 percent of all industry employment and 56 percent of industry gross value added. As explained in the following sections of this report, there are a number of factors that suggest that structural impediments for small business credit may be acting as barriers to the financing of economic enterprises in Australia.