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/ REX/264
EU-Turkey Joint
Consultative Committee

Brussels, 31/10/2008

25th meeting of the EU-Turkey Joint Consultative Committee

Paris, France

18-19 November, 2008

REPORT

Access to financing for SME's in the EU and Turkey

RAPPORTEUR

Peter KORN

Member of the European Economic and Social Committee – Group I (Employers Group)

Former Head of the Representation of the Federation of German Chambers of Industry and Commerce (DIHK) to the EU

Rapporteur´s expert:

Alexandra BOEHNE

  1. Conclusions and recommendations

1.1Access to finance is a crucial prerequisite for the creation, expansion and development of firms in the EU.SMEs in EU member states differ widely in their structure, especially in their average size, number of employees and kind of activities. Financial needs also vary substantially.Hence there exists no Single SME market in the EU.

1.2Financial problems are an important issue which constrain the development of firms during their whole life-cycle. Especially young enterprises and start-ups have to cope with manifold difficulties to get access to appropriate financial sources.

1.3Currently the financial turmoil has created anew uncertainty about the future access to finance. So far SMEs in Europeare affected in different ways by the crisis of the financial system: apart from the economic slow-down in most European countries, they are faced with negative impacts with regard to the credit supply – but these differ widely.

1.4Not every consequence the banking crisis in Europe and worldwide will put on SMEs and their access to finance can be identified or assessed already today. Very much it will depend on how successful the rescue packages for banks will be and how quickly the financial sector can start their consolidation process.

1.5Furthermore the planned regulation reforms will have an impact on the future access of SMEs to finance. Therefore it is important to retain the Small Business Act principle “Think small first”: Changes in regulation or new regulation rules will always have an impact on access to finance of companies. Better regulation can lead to higher transparency and quality of financial products, but it will also raisethe cost of capital if it results in over-regulation.

1.6 While SMEs are strongly depending on loan financing by banks a too rigid or over-regulation may constrain the scope of the future credit supply. This will strike those who have not been responsible for the financial crisis. And it will also hamper financing innovative firms.

1.7As a – thoroughly positive – result of the crisis, banks are more reluctant of financing higher risk projects. But this can also hinder the access to finance substantially. Therefore the right balance between better regulation and over-regulation is essential when SMEs shall not suffer of new burdens.

  1. Introduction

2.1SMEs play a crucial role in creating employment and boosting the economic growth in Europe. 23 million SMEs (99 % of the European enterprises) create 75 millionjobs.

2.2Access to finance is of crucial importance for the creation, expansion and development of firms. Often there is an equity gap for SMEs in their seed, start-up and expansion stages. A lack of financial sources is often an important obstacle for high-innovative companies, which impede important innovations, investment and growth in Europe.[1]

2.3Besidesthis the financial needs vary at different stages of SMEs life cycle. This may often involve debt finance, private equity or venture capital.

2.4SMEs can only grow if they have appropriate access to suitable forms of funding. Different to larger companies, SMEs still meet obstacles when they are looking for loans for investment projects: 21 % of European SMEs have a restricted access to financial sources.[2] In 2005 47 % of European SMEs feel that access to loans granted by banks is difficult, whereas the regional variation between European countries was large.[3]

2.5 The environment for corporate finance is subject to structural changes. SMEs have undertaken great efforts in the last years to implement the necessary adjustments to the changing financing structures and practises.

2.6 In additionto these challenges the tightening of the US mortgage crisis and itsconsequences for several European banks create uncertainty about the impact on access to finance in the future – especially for SMEs.

3. Specific Remarks

3.1 Development and changes in the recent years

  • Banks and initial funding remain the leading source of funding for SMEs. Changes in the finance sector in the recent years influence the relationship between banks and SMEs:[4]

-The increased competition and restructuring process in the banking sectors lead to more automatisation and a standardisation of business processes in banks.

-The rapid technological progress in information and communication technology changes the access to finance.

-New capital adequacy rules (Basel II) for financial institutions were implemented.

  • Changes in the financial regulatory framework, such as the Capital Requirements Directive (CRD)[5], have led to a more risk sensitive behaviour by banks and to a standardised risk assessment by the credit sector.
  • Basel II has put the traditionally close credit relations between SMEs and their principal banks to the test. SMEs have been confronted with requests for detailed information about business situation and rating and credit scoring systems. Therefore enterprises have to adapt themselves strategically to the fact that the path to a principal bank loan will be more formal and, in many cases, more laborious. Enterprises with a low credit standing have problems to fulfil banks requirements. Particularly SMEs of weak equity capital have had more frequent-than-average problems accessing credits.[6]
  • The growing automatisation in the business processes of the banks lead to less personal contact between enterprises and banks on one side, but it offers an easier access to information and a better B2B relationship on the other side.
  • More than that the technical progress and innovative financial instruments created more competitive environment for the credit sector. The competitive environment led to a much more return oriented business for corporate lending. Therefore SMEs with lower credit worthiness are less attractive for banks.
  • But the new structures of the financial sector can also be in their favour. The new information- and communication technology increases the transparency of financial markets where SMEs can benefit from. This more competitive environment will lead to lower capital credit costs for enterprises. SMEs are more willing to search for better offers. The fast growing markets for foreign capital and equity get more interesting for a wider range of enterprises – likewise for SMEs.[7]

3.2 Actual Development: Financial Turmoil and impact on SMEs

  • The tightening of the financial crisis in September 2008 led to the fall of three major US-investment-banks, which also affected several European banks seriously. This led to a strong lack of confidence in interbank-lending.[8] The Euro Area countries agreed on a concerted European action plan to coordinatenational efforts to prop up banks and protect depositors and to increase the flow of credit. According to the plan, national governments would buy into banks to boost their finances and temporarily guarantee bank refinancing to ease the credit squeeze.[9]
  • As the ongoing financial crisis affects several European banks seriously the access to finance for companies has become a more important question yet.
  • During the last month a tightening of credit conditions could be monitored. The results of the ECB Lending Survey[10]for the 2. Quarter 2008 show that the net tightening of credit standards continued to be stronger for larger firms than for SMEs. While the level of net tightening was, however, broadly unchanged for SMEs, it was less severe for large enterprises than in the previous chapter. The impact on the turmoil on credit standard was especially strong for loans for financing MAs and corporate restructuring. The impact on loans to finance fixed investment or inventories and working capital was more limited. Additionally there is a difficult environment for securitisation. 80 to 90 percent of the responding banks reported that the access to securitisation was hampered.
  • The recent DIHK Business Survey shows for 3.500 German enterprises a worsening of credit condition because of the financial turmoil. But there is no credit crunch so far. Only few credit demands have been rejected (2 per cent). The results are nearly the same for industry, service sector, trade and construction.[11]
  • So far European SMEs are affected by the financial crisis mainly by the lower economic growth. But a worsening of the profit situation of enterprises may have a negative impact on the credit conditions and the access to finance for SMEs in the future.
  • Probably SMEs with lower creditworthiness and/or high innovative enterprises with risky projects will face a more difficult access to finance because banks react with higher risk awareness on credit demands.
  • On the request on the European Union Finance Minister the European Investment Bank (EIB) will now make EUR 15 billion over the period 2008-2009 available as loans to small firms to make up for a shortfall in credit supply.[12]
  • Financial stability is a precondition for culture entrepreneurship and with it growth and employment in Europe. Therefore it is important that financial markets will reassure and that confidence restores in the financial markets. It is also important that banks can return to normal business – also to avoid a stronger tightening of credit lending for SMEs in the EU. The concentrated action by European countries has been a crucial confidence-building measure for the financial sector.
  • The financial crisis has created a public discussion about the functioning of financial markets and their developments in the last years, but also of the social and ethical dimension of financial institutes.[13]The EU-Commission has announced stronger financial market regulation to avoid financial turmoil in the future and to strengthen market and institutional resilience:[14]

-ECOFIN Roadmap of October 2007: (i) enhancing transparency, (ii) improving valuation standards, (iii) reinforcing prudential rules and risk management in the financial sector, (iv) improving market functioning

-upgrading of valuation methods by the Basle Committee and the International Accounting Standards Board (IASB)

-changes to Capital Requirement Directive (CRD)[15]

-regulation of credit rating agencies

-financial services supervision

  • The Committee on Economic and Monetary Affairs and the Committee on Legal Affairs put forward recommendations to the Commission on hedge funds and private equity and on transparency of institutional investors.[16]
  • These proposed amendments have no instant impact on the current situation – apart of the amendments of accountancy rules - because the revisions will only come into force in the years to come. Hence it is important to react with the right quantity and not under the pressure of the crisis. Particularly the crisis has manifold reasons, i.e.:

- lending practise in the US,

- failure of rating agencies,

- expansive monetary policy in the US,

- rapid growth of innovative financial instruments,

- originate-to-distribute-model etc.

  • The regulative changes have to be a precise reaction to the current problems. The proposals might help to increase transparency and to restore confidence – especially in the securitisation market. But there is also a negative impact on bank lending and access to finance for enterprises. A tighter regulation will increase the price of foreign capital which will have a negative influence on the access to finance of SMEs in the future. Therefore the legislative proposals should be in accordance with the main objective of the Small Business Act to improve access to finance.
  • SMEs benefit from innovative financial instruments: The interaction between loan and capital markets offers new finance opportunities for SMEs, because securitizations gives banks the opportunity to extend their relationships to customers independently of balance sheet constraints.[17]
  • The overemphasise of the pros – ability to hold or to transfer risks, improved funding possibilities and capital efficiency and more flexibility in reducing credit risk concentration - in the recent years of the originate-to-distribute model neglect the cons, which partly led to the current financial disturbances.
  • But policy proposals should also be aware of the benefits for SMEs.[18] Securitisation of SME loans is an instrument which can lead to a higher supply of SME loans in the primary market. The increased access to finance is thereby of high importance for SMEs.[19]
  • The transfer of credit risks by banks is part of the Competitiveness and Innovation Framework Programme (CIP). The programme will provide support for banks to package and sell off portfolios of SME loans, thus releasing lending capacity.[20]The regulative reaction should not counteract the efforts and achievements which have been undertaken in the past to foster a more capital-market based lending for SMEs. The impact on bank lending of SMEs should also be an aspect, which guides the discussion of new financial markets’ regulation. Because higher or tighter regulation will necessarily rise the cost of finance and hence the obstacles for access to finance. This in the end means higher market entry costs for SMEs.

3.3 Different Financial Needs for SMEs

The different financial needs often depend onthe position of an enterprisein its business life-cycle.

  • SMEs face an equity gap during their seed, start-up- and expansion phase. Especially innovative firms have financing problems, because their projects represent higher risk than other SMEs or larger companies.
  • Private equity and venture capital are very important financial sources for a high-innovative company. Due to high transaction costs and low returns given the risks incurred investors are often reluctant to invest in innovative enterprises. Private equity and venture capital investments can fill this gap. It is also a crucial financial source because companies with private equity or venture capital investments are characterized by higher growth rates and more employment.[21]
  • While the upward trend of the last years in private equity investments in Europe documented the increasing relevance of private equity investment the markets feel now the financial turbulence, because banks are more reluctant.[22]
  • One of the main concerns of external equity financing for SME owners is that they can not retain control over the company. The demand for external equity by established SMEs is often restrained, because of the possible co-determination of the private equity investor.[23]
  • Currently the venture capital market in Europe is fragmented: Innovative high-growth companies suffer from problems in raising capital – especially in those parts of Europe where venture capital markets is less developed. The fragmentation of the European venture capital market hampers cross-border venture capital investments, because funds often need separate registrations.[24]
  • An alternative finance source is Mezzanine capital as a complementary source of debt and equity finance. It can be helpful in financing start-ups, the expansion of SMEs, innovation and business transfers. The market for Mezzanine financing varies across Europe. Mezzanine finance can be helpful in financing the start-up, and expansion of SMEs, innovation and business transfer. Mezzanine has been gaining in importance, but remains little used compared to loan financing. Mezzanine finance provides some challenges for SMEs. SMEs are often not aware of the opportunities and the requirements of Mezzanine products. Low- and middle-tier SMEs often have difficulties to obtain Mezzanine capital because there are many requirements to meet – i.e. in regard of transparency. Nevertheless Mezzanine finance is more expansive than debt finance.[25]
  • During their seed- and growth phase external financing becomes necessary, when initial funds have been exhausted. Therefore entrepreneurs have to obtain external financing to develop their business. Financing by banks is besides equity financing the main financial sources for SMEs.[26] But often banks are confronted with asymmetric information when SMEs want access to finance. Financial players are unwilling to take the risks of small and middle-sized young enterprises without credit history and insufficient collateral and in regard to the new capital requirements for banks (Basel II).
  • Banks need more information about their client firms to estimate the risks – especially since Basel II has been implemented. Enterprises can improve their bank relationship by improving their information policy with and input to the banks.[27] The problem of insufficient collateral information can be overcome by guarantees given by public or private guarantee or mutual guarantee institutions. Loan guarantees lower the risk of bank lending and can be counter cycling.[28]

3.4 EU contribution to SME financing

  • The role of SMEs in the European economy has been acknowledged at the highest political level. The EU placed the needs of SMEs at the heart of Lisbon Growth and Jobs strategy.[29] The Small Business Act aims to improve the overall approach to entrepreneurship, to anchor the “Think Small First” -principle in policy-making and to promote SMEs growth. The European Union has pointed out in there initiatives the importance of improving SMEs’ access to finance.[30] Under the Small Business Act it is Principle VI, which aims to facilitate SMEs’ access to finance.
  • Intervention of the EU for improving SMEs’ access to finances stems from different concepts:[31]

-Presence of market failure.[32]

-Presence of market gaps.[33]

-Underdeveloped supply of finance for SMEs.[34]

-Institutional and cultural factors.

  • To improve the access to finance the EU attempt various initiatives:[35]

-The EU Commission has organized “Round Tables between Banks and SMEs” to facilitate a better relationship.[36]

-In the past the EU-Commission has organised a series of conferences toinform SMEs about the impact of the Basel II accord. In addition to that the Commission has published a guidebook aimed at giving SMEs practical advice on how to adjust proactively to the ongoing changes in the credit process.[37]