Background to loan financial instruments
A market perspective
Debt financing in the real economy
Bank lending remains the prevalent form of external financing in almost all jurisdictions. However, banks' lending capacity has been negatively affected by the European banking sector's implementation of Basel III reforms (requiring a 25%-30% increase in capital). Additionally, the increased interest rates since 2022 have impacted banks' ability to extend loans to SMEs, leading to higher borrowing costs, reduced loan demand and pressure on profitability margins.
Market failures, like information asymmetry and transaction costs associated with small-scale loans, hinder SMEs from securing bank lending. Banks often struggle to assess the risk of highly innovative SMEs, making financing difficult even at high interest rates. Additionally, small-scale borrowing can lead to disproportionately high interest rates due to transaction costs, posing a significant barrier for SMEs.
Regulatory requirements related to capital adequacy ratios have reduced lending, especially to higher-risk businesses. Economic fluctuations and liquidity issues in financial markets further exacerbate challenges of SME financing.
Debt instruments, especially loan co-financing arrangements, can provide a stable source of funding, mitigating liquidity risks for banks and ensuring a more consistent flow of credit to SMEs. Additionally, debt instruments contribute to building a robust funding ecosystem that supports the higher-risk spectrum of the economy, including emerging sectors that may otherwise struggle to access traditional financing avenues.
Loans provide the main source of finance for energy efficiency and renewable energy investments, providing long term finance for projects tailored to the needs of different final recipients. Long-term, low-cost loans, often in combination with grants can provide a financing solution whereby the annual cost of finance is equal to or less than the savings made by the final recipient.
Energy efficient residential building in Lithuania
Financial instruments, in combination with grants, have been used by Lithuania’s Ministry of Finance and Ministry of Environment to fund loans to support investment in energy efficiency in apartment block buildings in Lithuania. The financial instruments have supported the development of a single product for homeowners known as the ‘Modernisation Loan’ which forms the centerpiece of the Lithuanian government’s programme to improve energy efficiency in residential properties.
Seed loans typically finance individuals or young innovative SMEs in their seed, pre-seed and/or start-up phase, where the risk is the highest, and where the resources to finance the investments are difficult to find. Financed projects could include, for example, market feasibility studies, development of prototypes and beta versions, filing of patents, etc.
Loan instruments vs. other financial products
Figure 6 Comparison of financial products
Loan vs. Guarantee
Both funded and unfunded types of financial instrument have advantages and disadvantages compared to the other. Funded products such as loans require more initial resources than unfunded products such as guarantees. The leverage potential of loan instruments is lower than that of unfunded instruments and they are less adequate if the market failure to address is related to the low risk appetite of the banks.
On the other hand, loan instruments could be the instrument of choice for managing authorities if scarce liquidity or required capital adequacy ratios are more of an issue for the banking sector. In such cases, the funded nature of the product allows to increase the lending capabilities of the banks and thus improving access to financing for the targeted final recipients.
Loan instruments are more advantageous than guarantees in terms of the revolving effect as well. The reflows, in line with the predefined repayment schedule of the loans, become available for re-investment sooner than in the case of unfunded products.
Loan vs. Equity
In comparison with equity/quasi-equity products, loan financial instruments offer a lower return. Equity funds also tend to provide non-financial support to the businesses they support through mentoring, participation in board meetings and strategic decision making and developing a network of customers and suppliers.
On the other hand, loan financial instruments have the potential to reach a far greater number of final recipients and are well understood products attractive to different types of final recipient. In particular, whilst equity/quasi-equity finance is suitable for financing companies with high growth potential, loan financial instruments can support businesses of all types, providing accessible finance that does not dilute the ownership structure of the final recipient.