1. Small business banking and financing: a global perspective, Cagliari The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective Philipp Grein University of Bern

2. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 2 Agenda 1.Introduction 2.Characteristics of a lending relationship 3.IFRS versus German Commercial Code 4.Prior research on IFRS-adoption 5.The model 1.General assumptions 2.Information structure 3.Sequence of events 4.Equilibria for discrete strategies 6.Conclusion

3. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 3 1. Introduction > German SMEs primarily financed by relationship lenders due to their size and informational opaqueness. > Long-term lending relationships help to overcome financing constraints but relationship lender gains monopolistic position > Possible solution: Increased disclosure by adopting IFRS > Question: Can a SME really reduce its dependence from relationship lenders by adopting IFRS? Does an IFRS-adoption reduce the cost of debt for a SME? Is an IFRS-adoption always beneficial for an SME with regard to the financing situation?

4. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 4 2. Characteristics of a lending relationship > Lending relationships are of long-term nature: Relationship lender accumulates information over time > Relationship lender: has access to private information, which is of soft nature provides largest share of debt capital of a debtor assists debtor during times of financial distress > Access to private information decisive factor for the existence of a lending relationship: Competition on loan market is reduced  Problem of time inconsistency solved  inter-temporal contracts possible  Relationship lender is able to earn an information rent

5. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 5 3. IFRS versus German Commercial Code > German Commercial Code: Influenced by tax accounting rules Prudence principle very dominant assets cannot be valued higher than at their historical costs internally generated intangibles assets cannot be recognized  creation of hidden reserves Relief for smaller and medium firms with regard to the notes (§326, § 327 HGB)  Main accounting purpose: Determination of distributable income and capital maintenance Provision of information only of subordinate importance

6. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 6 3. IFRS versus German Commercial Code > International Financial Reporting Standards (IFRS) Not influenced by tax accounting rules Prudence principle less dominant: valuation at fair value of certain assets possible broader definition of assets internally generated intangibles assets can be recognized  less creation of hidden reserves greater number of mandatory notes No relief for smaller and medium firms  Main accounting purpose: Provision of decision useful information (true and fair view) > IFRS-adoption increases amount and quality of disclosed information

7. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 7 4. Prior research on IFRS-adoption > Disclosure and cost of capital across different accounting standards Till now: evidence only for cost of equity capital Ambiguous results (e.g. Leuz/Verrecchia and Daske) > Accounting quality and cost of capital Negative relationship for cost of equity capital as well as for debt capital (e.g. Francis et al, Bharat/Sunder/Sunder) > Accounting quality of different accounting standards IFRS exhibit a higher quality than German GAAP (e.g. Gassen/Sellhorn and Daske/Gebhardt)

8. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 8 5. The model 5.1 General assumptions > Model with two time periods > 3 Players: Owners of an owner managed firm either of type G or of type B Relationship lender Outsiders > Investment program: Owner can run two consecutive investment projects, initial investment of I each: Project 1: starts in t=0, pay-off 0 or X in t=1 Project 2: starts in t=1, pay-off 0 or Y in t=2 Probability of success: π with π B < π G Both projects only for type G positive net present value

9. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 9 5. The model 5.1General assumptions > Financing: Only debt financing possible Outsider and relationship lender simultaneously offer an interest rate Relationship lender incur relationship building costs c HB if chosen as financier Financing of both types in t=0 and t=1 is associated with a loss

10. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 10 5. The model 5.2Information structure > Sequence of events, pay off structure of investment projects, and ex ante probabilities are common knowledge > In t=0 only entrepreneur observes his true type > If relationship lender is financier of first investment project, it can observe true type of entrepreneur after completion of first project > Outsiders rely only on publicly observable information

11. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 11 5. The model 5.2Information structure > In t=1 entrepreneur chooses either information systems HGB or IFRS > If IFRS is chosen and entrepreneur is type G: IFRS G  Φ G IFRS S  1-Φ G > If IFRS is chosen and entrepreneur is type B: IFRS S  Φ S IFRS G  1-Φ S  IFRS as verifiable signal on type of entrepreneur > Assumptions: 1. IFRS is informative: Φ G >0,5 and Φ S >0,5 2. German GAAP no information content, no signal sent

12. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 12 5. The model 5.3Sequence of Events 012 Relationship lender or other lenders provide I Entrepreneur starts project one Return from project two: 0 or Y Loan is repaid if possible Owner chooses an information system, IFRS or HGB Owner starts second project Relationship lender or outsiders provide I Return from project one: 0 or X Loan is repaid if possible Relationship lender observe owner’s type If owner chooses IFRS, outsiders observe signal on owner’s type

13. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 13 5. The model 5.4Equilibria for discrete strategies > Assumption: Relationship lender offers either r max or r d Outsiders offer either r d or make no offer > Without information system: Outsiders never make an offer Relationship lender earns information rent by financing second project with r max Information rent exceeds losses from first project  Relationship lender is willing to finance project in t=0

14. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 14 5. The model 5.4Equilibria for discrete strategies > With information system two types of equilibria in t=1, separating or pooling > Pooling equlibria: 1. Both types choose German GAAP  same equilibrium as in situation without information system  outsiders have sceptical expectations 2. Both types choose IFRS (assumption: no cost of adoption) Very high information quality: relationship lender offers r d, outsiders offer r d if signal indicates good type High information quality: equilibrium in mixed strategies Medium information quality: relationship lender offers r max, outsiders offer r d if signal indicates good type

15. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 15 5. The model 5.4Equilibria for discrete strategies > Separating equilibrium (cost of adoption equals b) Type G entrepreneurs adopt IFRS, Type B entrepreneurs keep German GAAP Type G entrepreneurs receives financing in t=1 at r max Type B entrepreneurs receive no financing in t=1  Equilibrium holds only if cost of adoption is sufficiently high but not too high

16. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 16 5. The model 5.4Equilibria for discrete strategies > Equilibrium of entire game depends on outcome of second stage > If information rent is significantly reduced, relationship lender is not going to invest in a relationship  depends on information quality of IFRS, on adoption costs and on relationship building costs  Both entrepreneurs do not receive financing in t=1

17. 25.05.2007 The impact of an IFRS-adoption on relationship lending for German SMEs – An economic perspective 17 6. Conclusion > Effects of an IFRS-adoption for the financing of SMEs depends on information quality of IFRS > If IFRS of sufficient information quality:  Mitigation of hold up problem possible  Cost of debt financing reduced > But: Relationship lenders looses ability to earn information rent Nature of existing lending relationships alter:  willingness to provide assistance during financial distress declines Banks may no longer be willing to establish lending relationships  Credit availability for very young SMEs declines