Determinants of the Low SME Loan Approval Rate in Croatia Dario Czira ´ky Sanja Tisˇma Anamarija Pisarovic` ABSTRACT. The paper proposes a new methodological framework for investigating consistency in loan assess- ment decisions and determinants of loan approval based on structural equation modelling and covariance structure analysis. We focus on a governmental SME loan pro- gramme in Croatia and investigate possible reasons for low loan approval rate that occurred in spite of interest rates subsidisation and sufficient supply of the loan funds. The novelty of the methodological approach taken is that it enables simultaneous investigation of the determinants of the loan approval and testing for consistency in the loan assessment decisions, which need not be assumed. We test several hypotheses about consistency in the loan approval decisions and lending preferences in Croatia. The empirical findings reject overall consistency of criteria but indicate a preference toward smaller loans. Among all SME loan requests, banks preferred smaller firms that requested smaller loans. The results suggest that individ- ual banks differ in their criteria and in their loan-size pref- erences and that there is no positive correlation between the bank’s size and its loan-size preference. KEY WORDS: commercial banks, credit rationing, latent variable models, loan assessment, small and medium enterprises. JEL CLASSIFICATION: C31, C51, C52, G21, H81. 1. Introduction Small and medium enterprises (SMEs) play an important role in transitional economies and have high relevance for their economic policy (Bagnasco and Sabel, 1995; Levitsky, 1996; Scase, 1997; Bateman and Lloyd-Reason, 2000; see also Tybout, 1983 for an analysis of a non-transitional developing country). In Croatia, the SMEs com- prise over 96% of all business entities, thus mak- ing the SME sector a dominant part of its national economy. Nevertheless, their access to credit and loan funds is still rather limited (Boogearts et al., 2000; Barlett et al., 2002). Over the last several years, the Croatian SME sector had a mean annual employment growth of 5% while, in the same period, the employment in the large businesses sector decreased for over 30%. In addition, the SMEs currently produce over 55% of the Croatian GDP. However, the obstacles to economic development are numerous and one of the most serious is a very low SME loan approval rate in the commercial banks. Before 1998, the main obstacle to SME financing in Croatia was insufficient supply of SME credit funds (see e.g. Pissarides, 1998). By 1999, and especially in 2000, Croatian commercial banks no longer lacked funds and low loan approval rate emerged as the primary obstacle to efficient SME finance. Access to financial markets for SMEs is often problematic even in western economies (see e.g. Mullineux, 1994; Cressy et al., 1997; Assel- bergh, 2002) and SMEs are often forced to look for alternative means of financing (e.g. Hamilton and Fox, 1998). The SME financing in Croatia is further complicated by a weak banking system and a lack of expertise in commercial banks for dealing with the SME clients (Kraft, 2000, 2002) 1 . Final version accepted on 5 February 2004 Dario Czira ´ky Department of Statistics, London School of Economics Houghton Street London WC2A 2AE U.K. E-mail: D. Civaki@lse.ac.ok Sanja Tisˇma Anamarija Pisarovic´ Resource Economics Department IMO, Zagreb Ul. Farkasasˇa-Vukotinovic´a 2, 10000, Croatia Small Business Economics (2005) 25: 347–372 Ó Springer 2005 DOI 10.1007/s11187-004-6481-0