Eurozone Credit Crunch: a disease still waiting for stronger remedies

The debate on how to tackle the SME credit crunch should not deflect EU focus from resolving structural imbalances and weaknesses within the Eurozone banking system. The calm EU debate over how to improve the economies in the Eurozone does not reflect a sense of urgency, an urgency which dire economic conditions throughout Europe would otherwise suggest.

The relative tranquility in European markets seems to have provided solace to European leaders, to the point of hiding the scent of burning with a strong whiff of complacency.   A recent statement from French President François Hollande regarding the end of the Euro crisis is emblematic in that respect.

Regardless of the Euro-leaders’ lack of meaningful resolve to tackle the dismal Eurozone economy (six consecutive quarters of economic contraction), a generally shared view is that Small & Medium-sized Enterprises (SMEs) seem to be suffering the most from the current conditions.

Growth is still elusive, not only because of widespread austerity measures put in place by European governments, but also because of insufficient credit available to SMEs.

A dearth of bank lending, noticeable even in countries outside the EU such as the UK, seems in strident contrast with the loose monetary policies adopted by central banks, precisely to facilitate the transmission of credit into the economic system.

ECB Chairman Mario Draghi, over the course of the last year, has issued statements in support of lending, with an emphasis on SMEs.  In his view, special attention to SMEs is required, due to the fact that they account for about 75% of employment and some 60% of economic output. Not only that, access to wholesale markets (for example via bond issuance) is hardly an easy option for them.

Recent research from J.P. Morgan, nonetheless, argues that evidence about SME problems and their underlying causes are not self-evident. Their conclusion seems to suggest that SMEs probably don’t deserve preferential treatment vis-à-vis large corporations or households.

According to the Markit PMI data, a number of economic indicators on the biggest economies, indicates that SMEs in Spain and Italy are not obviously under-performing larger firms. In fact, employment and output indices do not show much difference between those two groups. Rather surprisingly, in these two countries small firms are not faring relatively worse than their peers in Germany or France.

On the financing side, the most recent ECB lending survey does not show stricter tightening of lending standards towards SMEs rather than households or large corporations. In terms of funding costs, MFI interest rate statistics highlight that banks in the Eurozone periphery countries charge higher rates than core countries on all loans. However, the spread between small loans and large loans is very high, only in Spain. Access to finance varies across different countries, with strong evidence that in Spain, SMEs are more penalized than large corporations, if compared to the rest of the Eurozone, while in Italy this applies as well, but to a lesser extent.

This study does raise an interesting point with regards to why the ECB should focus on SMEs rather than other categories.  On the other hand, I think drawing the conclusion that SMEs might not deserve more attention than other economic sectors, purely on the basis of a relatively limited statistical data may miss the scope of Draghi’s point of view.

SMEs are inherently riskier borrowers and credit access is structurally more difficult for them to obtain than for larger corporations, who may have access to alternative funding, other than traditional banks loans.

Furthermore, SMEs tend to have a very strong connection with the local territory, probably more so than large corporations. In the last 20 years, the consolidation of the banking industry may have reduced the role of local banks when it comes to the financing of SMEs.

Given current economic conditions, large national banks have to look after their P&L and (especially in the Eurozone periphery) carefully manage their balance sheets, while new EU banking regulations are curbing leverage.

Therefore, given the deleveraging at large banks, without a more coordinated set of policies in favour of SMEs, it could be difficult to mitigate the double wham of weak demand and difficult access to credit.

Draghi’s approach also makes sense when we consider that SMEs are usually more labour intensive than large corporations. Given the size of small ones, supporting them will go a long way towards helping households too, improving overall employment and private consumption.

Nonetheless, having identified a target such as SMEs to focus on does not necessarily provide a straightforward solution to the problem of growth and employment in the Eurozone.

The recent gathering held in Rome last Friday with high ranked Labour and Finance ministers discussing such issues, seems at least to have identified a shared view on several measures to adopt.

While no concrete measures have yet been finalized, discussions revolved around how to improve long-term credit to SMEs, together with the European Investment Bank (EIB) and national state development agencies, such as Italy's Cassa Depositi e Prestiti, France's Caisse des Depots and Germany's KfW.

The 10 billion euros capital increase which took place at the EIB last year could be leveraged to as much as 60 billion euros using its balance sheet as a lending facility. With that in the background, European governments are evaluating several proposals, including issuing special "mini bonds" and securitized loans backed by state members or the EIB.

Other measures are already available to help SMEs, such as loan guarantee programs, but their efficacy could be further enhanced if AECMs (European Association of Mutual Guarantee Societies) were more localised and were provided with additional financial firepower, going forward.

Eurozone state members face a daunting task of promoting alternative access to funding, increasing liquidity and reducing SMEs dependence on traditional bank loans, while at the same time sticking to Germany-led austerity (albeit more relaxed than in previous years).

State members should focus their activity in several directions, in cooperation with all economic entities.

For a start, there should be a coordinated effort between banks and mutual guarantee societies to provide long-term credit facilities to SMEs. Easing funding charges for banks, who provide increased lending to SMEs at cheaper rates would go a long way towards re-connecting the banking system with its customers.

The private sector could benefit from new regulations, which enable the issuance of new capital and incentivise inter-company borrowing. Wholesalers and large traders could leverage their funding by lending to their own customers. The new rules could also include promotion of Venture Capital and the issuance of corporate debentures.

Public administrations in Europe should also tackle the delay of payments to the private sector (Italy’s abysmal record of about 63 bn euros stock of trade credits and advances payable, springs to mind), improving liquidity for many SMEs in a meaningful way.

Clearly, these are only a few examples of specific measures for SMEs, but by no means, the only ones. While they are obviously important, they cannot replace the fundamental role of banks to kick-start economic growth.

I cannot stress enough the importance of the EU delivering sooner rather than later on broader issues regarding the banking industry.

Reforms aimed at restoring trust in the banking system, improving risk evaluation, recapitalizing banks in difficulty and introducing a regulatory framework for supervision of large institutions at the ECB are still lagging.

The timeline for these reforms is still somewhat hazy, due to the difficulty of overcoming political resistance, mainly from Germany, to undertake more courageous measures.

Recent statements from Germany and France seem to hint at delaying direct bank aid from the ESM (European Stability Mechanism). The Finnish Finance minister Urpilainen has also been on record saying that the second phase in banking union will not be easy, highlighting also that the joint EU deposit guarantee is a not a timely issue.

Such inaction speaks volumes on how difficult it is to further advance political integration inside the EU.

 ‘Virtuous’ countries seem to be pushing harder on each state member to adopt pro-growth initiatives and reforms, shunning any increase in the financial burden for the ECB (or its supranational agencies for that matter) necessary to support such policies.

Without a more substantial coordinated effort at the EU level to resolve some of the critical issues which plague the credit system, it is unlikely that small doses of several different medicines will be sufficient to cure the Eurozone credit crunch.