How do better financing conditions affect a firm’s investment? Does a firm respond more to lower interest rates or lower collateral requirements? And does it depend on the kind of firm or investment project?
These are key policy questions, in particular for an institution like the European Investment Bank, which aims to stimulate investment with a high social and economic impact through improved access to finance. But there has been no theoretical or empirical research to analyse the preferences firms have for the specific characteristics of their financing.
So we conducted an experiment with 1,126 firms to see what financing conditions would promote the most investment.
The results showed that even small changes in access to finance can double the likelihood that a firm will invest. That’s very important information at a time when interest rates are low and the options for monetary policy seem limited.
Here’s why we conducted our experiment and what we found.
Lack of research on financing conditions
The question of how firms finance their business and investment activity is long-standing in academic literature and policy circles. The availability of sufficient and adapted sources of funding is at the heart of the functioning of market economies.
The leading theories on the optimal financing mix are:
The overwhelming majority of empirical analyses attempt to explain the proportions of debt and equity instruments in a firm’s total liabilities. To the best of our knowledge, however, almost no theoretical or empirical work analyses:
- the preferences of firms for specific characteristics of debt financing, such as for example collateral requirements, maturity or fixed versus floating interest rate
- the pass-through of these preferences to real investment decisions
- and how these decisions translate into real activity.
The financing conditions knowledge gap
This knowledge gap is surprising. After all, it’s vital that we understand how specific firms at different stages of development value different financing options and how loan characteristics relate to their investment decisions. This is of crucial relevance for:
· economic modelling
· the design of loan offers by private or promotional banks (such as the European Investment Bank)
· central banks, which must evaluate the functioning of the monetary policy transmission channel through interest rates (especially at the zero lower bound).
From the central bank perspective, in the current low interest-rate environment, a policy that extends financing maturities might almost be as effective in stimulating investment as a policy that aims to lower interest-rates even further.
Pick your financing conditions
As part of the EIB Investment Survey in 2016, we analysed responses from 1,126 firms (of which around 80% were SMEs). About one third of these firms were active in manufacturing, another third in the infrastructure sector, and the rest were more or less evenly split into service and construction firms. Here’s what we asked:
- Each firm was asked whether it was currently considering putting into place a specific investment project, and, if so, what type of project this would be. We asked about the size of the project as well as how much external finance they would like to raise for this project and with what ideal maturity.
- Next we asked the firms to choose between pairs of randomly drawn hypothetical financing offers. Financing offers differed in terms of their amount and maturity (distributed around firms’ preferred amount and maturity), amortisation, interest rate (distributed around a market mid-rate according to the European Central Bank), interest type, level of seniority and collateral requirements, as well as whether or not there would be a fee for early repayment.
- Finally, firms were required to state how likely they would be to carry out their favourite investment project, given the financing offer that they had chosen in the second step.
All firms were shown eight screens like this one.