Too Small to Fail : SMEs as a Key to Europe’s Recovery

Written by | Monday, September 15th, 2014

About 99 percent of all non-financial companies in Europe qualify as small and medium-sized firms (SMEs). This means companies that have turnover of less than 50 million euro annually and employ less than 250 workers. Such firms are lifeblood of the European economy, accounting for 66 percent of job creation thanks to their dynamic nature compared to large corporations, and 58 percent of value added. Because SMEs play a crucial role in the domestic market, they are also more reliant on it, as well as on bank lending.

As such, SMEs have been literally battered since the beginning of the euro crisis and no wonder that the European economy effectively remains stagnant, despite occasional positive figures of economic indicators. Nir Klein of the International Monetary Fund recently pointed out that there was no doubt about the connection between the prevalence of SMEs in the European economy and its economic development. For many SMEs in developed countries, the continuous slowdown means a battle for survival. As Hugh Sturges of Berry Bros & Rudd, a British wine and spirits seller, put it, “the challenge is to continue to make a profit in the downturn”. The European Commission has been trying to help SMEs for years but with vague results. Although it has pumped about €1.1 billion into the eurozone economy to help mobilize €15 billion of capital for SMEs only since May last year, the problems with funding remain stark. The main reasons behind the failure of EU programs to boost SMEs seem to be great diversity within the group, insufficient incentives provided to banks to boost their funding as well as lack of SMEs’ interest in alternative sources of funding, which the EU fails to sufficiently promote.

As a result, Europe now has a bunch of successful German SMEs that have been doing comparatively rather well despite a latest economic slowdown, French SMEs that were provided with plenty of public support in addition to low interest rates, and there are also peripheral countries whose SMEs finally admit that access to finance has improved somewhat but remains very costly. Furthermore, the approach that the EU has used to make banks lend more focused on cheap funding and guarantees, which certainly helped but not as much as initially hoped for. Yet, many financial institutions oppose the EU strategy arguing that the so-called “cheap funding” is really cheap only for the SME but still very expensive – and hardly a profitable business – for the banks. Undeterred by the relative lack of success, the ECB is about to draw on the EU’s approach by providing additional €400 billion from this month on.

In this situation, the two alternatives – or really more sort of complements – should be taken into consideration. First, insurance firms, pension funds, asset managers and unconventional new players such as P2P networks are slowly stepping into the territory of buying SME loans off banks or purchasing tradable securities that are covered by loans issued by banks. These actors usually have long-dated liabilities and some of them are less vulnerable to a financial panic than banks. However, on the flipside, for example insurance companies will have to keep enough capital to secure themselves against possible losses, just like banks do. Therefore, at the end of the day, insurance companies might find it as difficult to provide loans to SMEs as banks. Then other financial institutions might face difficulties in garnering confidence of European clients, who are traditionally more conservative in terms of funding than their American counterparts. Second, private-debt funds, hedge funds, and venture capitalists also increase their activities towards financing SMEs. Currently, such options constitute about 10-15 percent of external financing of small and mid-sized companies but generating volume in this case is not encouraged on the grounds that they are seen as too risky. Here again, European firms are not too familiar with such options and their trust in conventional banking might not be easily overcome.

Few believe that such “alternatives” could replace or at least tangibly complement traditional bank lending in Europe. In the United States, where the reliance of SMEs on the bank sector is much lower, diversification of the financial sector including funding options for smaller businesses has been gradually developed for many years in part also owing to the existence of a more hospitable regulatory environment. Therefore, the role of the EU should be two-fold: long-term and short-term. In short-term, the key priority must be to focus bank lending on helping SMEs to sustain their role as the crux of the European economy. In the long run, however, an emphasis should be put on diversification of funding options so that Europe’s SMEs get more flexible especially if another similar economic and financial crisis was again to hit the EU in the future.

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