SMES must learn to work with each other to keep loan wolves at bay

Small- and medium-sized enterprises (SMEs) struggle to get financing even in the best of times. Now with Europe in what is arguably the worst of times, small businesses and entrepreneurs are facing even more difficulties in getting extra euros out of their reluctant bankers.

When the debt crisis unfolded in Europe, European banks were asked to rebuild their capital as part of the financial restructuring for Basel III norms, which also means decreasing riskier assets. Unfortunately, the loans to small- and medium-sized businesses are exactly the kind of risky asset that lenders want to avoid. As a result, business owners are facing hikes in interest payments, account charges and other regulations, just as their incomes are dropping.

The outcome of a tight financing environment in Europe is however different in China. A squeeze on SME lending by major lenders in 2011 saw many Chinese entrepreneurs and small businesses turning to the private lending market for sustenance. When credit was tightened further, this contributed to the Wenzhou crisis and some entrepreneurs ran into difficulties.

In Europe, the private network is limited as wealthy individuals or companies with excess cash generally invest the funds in the capital markets through investment institutions, rather than in the private lending market. If they want to back SMEs, it is most likely to be through angel investment, which means taking high-risk equity stakes rather than lending at high interest rates. As a result, when bank loans run out, SMEs often become bankrupt - around 1 million companies have stopped trading in Europe during the last downturn in 2009 and similar numbers are expected this time round.

This means that the government is trying to take action, as the importance of SMEs to both China and Europe is similar, even if their financing is different. SMEs account for an estimated 80 percent of new jobs in Europe and almost 60 percent of the total economic value added.

There are several initiatives to channel funds to SMEs which have been given greater urgency during the European economic crisis. This includes giving a 75 percent risk weighting to SME loans for banks, trying to give greater market and financial information to small companies, and encouraging pan-European rules and regulations for venture capital and angel investment. These measures have mixed success in increasing funds, however, and may not actually address the main problems.

As a result, one method gaining popularity is getting companies either to work with each other through mutual guarantee institutions or the EU providing backing directly through its Loan Guarantee Facility for SMEs as this reduces the risk of individual loans.

Mutual guarantee institutions work in similar ways to micro-finance in that it pools borrowers into larger groups. These then act as collective guarantors for the loans - if one member of the scheme fails to repay the loan, then all suffer, creating a powerful incentive to cough up.

Companies in the guarantee scheme get easier access to bank financing and, in turn, will assist other companies so that they do not have a bad debtor in their group - creating a one-for-all and all-for-one dynamic.

While not an answer to every business, it does make SME financing more attractive to banks and other investors rather than dealing with individual entrepreneurs and their individual corporate idiosyncrasies.

The author is head of research at the London-based China Policy Research.