This part of the investigation discusses the relevant key theories for SME financing. It is often difficult to identify the relevant theories that impact SME access to finance in management and SME finance research. These include agency cost, signalling, credit rationing, pecking order and discouraged borrower theories. Economists and management scholars developed these theories to explain small business financing behaviour and financial institution lending to SMEs. An economic theory considered in relation to SME financing is the agency cost theory (Ross, 1973). This theory is derived from the theory of agency and embraces the concepts of information asymmetry, moral hazard and adverse selection (Jensen and Meckling, 1976). Previously, economic models of decision-making processes were largely based on the assumption of perfect information (Stiglitz, 2002) or when minor information imperfections are present in markets, the market would still behave similarly to markets with perfect information (Stiglitz, 2000). The information asymmetry (IA) research, however, suggests that the borrower may have more superior information over the lender about their business (Saridakis et al., 2008). Lenders are risk averse and more so in the period of the financial crisis (Saridakis et al., 2013). As a result, they engage in protective and preventive measures to limit their risk. These measures are not without cost implications and agency cost is the sum of monitoring costs, bonding costs and residual loss (Jensen and Meckling, 1976). Thus, as lenders engaged in financial risk management after the credit crunch, they incurred agency costs and this is regardless of the success or failure of the transaction.
Moreover, in signalling theory, lenders are able to make an assessment of potential borrower information to determine the potential borrower behaviour to inform lending decision. Thus, the potential borrower information reduces IA between the two parties (Spence, 1973). For example, in signalling research, the human capital of owner-managers of the business can act as a positive indication of potentially good
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performance (Colombo and Grilli, 2005; Saridakis et al., 2008). Whilst Weiss (1995) also discussed the relevance of human capital as a signalling effect in labour economics, Ross (1977) revealed the role of incentive-signalling in the determination of corporate financial structure. There are limited but growing researches in the human capital area indicating that the experience (Gruber et al., 2012) and education (Saridakis et al., 2008, 2013b) of the owner-manager can have a positive signalling effect on lenders in SME access to finance and business lifespan. A notable example is the human capital signalling effect of owner-managers on venture capital funding (Hsu, 2007). Moreover, business registration with limited liability status can improve IA (Klapper et al., 2006). Thus, limited liability status acts as signal of improved IA and encourage lenders to lend. A good legal system can act as signal of improved financially developed environment (La Porta et al., 1998; Levine, 1999).
Economists have also argued that uncertainty and IA may lead to credit rationing (Saridakis and Storey, 2009). Simply we can say that there is a critical level of interest rate where any further increase in interest rate reduces loan supply. This is due to moral hazard and adverse selection problems discussed in Saridakis and Storey (2009). It can be argued, for example, that using high interest rate to determine lending can be counter-productive because on the one hand if the borrower is ill- informed, it may opt for the high interest loan with no regard for high premium interest rate and on the other hand, it may discourage low-risk businesses (Kay et al., 2014; Besanko and Thakor, 1987; De Meza and Webb, 2000; Mattesini, 1990). The concept of credit rationing was introduced by Stiglitz and Weiss (1981) who showed that borrowers who are willing to pay high interest rate may exhibit the propensity for high risk as they may not be able to honour the repayment of the loan. Credit rationing reduces the credit finance available for SMEs and it can be affected by uncertainties in the business environment (such as the financial crisis) and the non- availability of collateral. Earlier review by Storey (1994), however, suggests that credit rationing does not exist on a major scale in the UK and a more recent work by Kremp and Sevestre (2013) shows that French SMEs have not been significantly affected by credit rationing since the recent economic/financial crisis. Moreover, Cowling et al. (2012) used the UK longitudinal dataset spanning the crisis period to show that credit rationed firms in the UK peaked in 2009 as 10% of small businesses were refused.
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Another theory that emerges as a result of the presence of IA problems, such as moral hazard and adverse selection in financial markets, is the pecking order theory (Frank and Goyal, 2003). Myers (1984) suggests that pecking order theory is the hierarchy of financing pursuit of SMEs where owner-managers prefer debt finance over equity. The pecking order theory allows owner-managers to determine their financing option and keep full control of their business (Holmes and Kent, 1991) as well as reduce transaction cost (Lopez-Gracia and Sogorb-Mira, 2008). According to the pecking order theory, owner-managers of small firms consider internal sources of business financing before external sources. Lopez-Gracia and Sogorb-Mira (2008) considering a large sample of Spanish SMEs over a 10-year period found that SMEs follow a funding source hierarchy. Therefore, this can be likened to the UK SMEs as the UK and Spain are in the European Union with somewhat related business environment.
Finally, in condition of imperfect information and positive application costs, creditworthy borrowers who fear credit rejection may not apply for any credit and according to Fraser (2008) and Kon and Storey (2003) this group of borrowers is described as discouraged. This brings the recently developed theory of discouraged borrowers to the forefront in SME research. It has been estimated that 4.2% and 4% of US and UK businesses respectively are discouraged borrowers at any one time (Fraser, 2004; Levenson and Willard, 2000). Han et al. (2008) using US data found that riskier borrowers have higher probabilities of discouragement, low risk borrowers are less likely to be discouraged in concentrated markets than in competitive markets. Also, Han et al. (2009) argued that good borrowers may not apply for a loan fearing rejection. Hence, this identifies another dimension in the theory of discouraged borrowers. It has been revealed that good and bad borrowers can be discouraged thereby creating a self-rationing credit device (Kon and Storey, 2003). Interestingly, the number of owners not applying for a loan increased over the economic crisis (Fraser, 2008). Discouragement may point to discrimination in the market for SME finance (Blanchflower et al., 1998; Cavalluzzo et al., 2002). However, Cowling et al. (2012) does not believe that discrimination is relevant, especially in the period of the financial crisis. To this end, it can be said that the financial crisis impacted the theory of discouragement as good and bad borrowers could not easily be exempted from being discouraged in their credit application rejections. Financial constraints and SME
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borrower discouragement affect greater proportion of small firms than larger firms (Kay et al., 2014).