Literature Review: SME’s facing difficulties in Europe
Definition of SMEs varies depending on individual nation and their financial institutions. (Beck ,2013) notes the differentiation relating to various aspects as number of employees, capital, sales and turnover. SMEs take a significant role in the economic development of the nation as it has a critical role in shaping the economy of any nation through job creation, social stability, foster economic growth, generate low income for people, and development of firms. Therefore, financial services are significant in creating vibrant environment for SMEs. Nonetheless, access to the financial services has always been a hindrance for SME’s and this report will extensively discuss such difficulties which are being faced by SME’s in Europe.
Well known economic researcher, Beck has indicated that the age and size of SME’s largely affect the competition and obstacle which the SME’s face in access to financial services. The study shows that young SME organization face a greater challenge compared to the old enterprises.
SMEs has a significant role in the economic development of the nation as it has a critical role in shaping the economy. Nonetheless, there are a number of barriers that exist regarding SMEs. These barriers make it difficult for SMEs to access finance. Additionally, developing SMEs faces competition with the access to finance. It can provide alert in the focus for financing SMEs. These situation results affect the development of an economy (Roman, 2011). In a study by (Beck; Pemirguc-Kunt and Laeven and Maksimovic ,2004), it is concluded that the age and size of the enterprises affect the financial method of the SMEs. The study shows that young SME organization face a greater challenge compared to the old enterprises. This is very similar to what Beck concluded in another research work that banks prefer lending to larger organization than to a SME and this is a direct indication relating to financing problems being faced by SME’s. In a research conducted by the European Central Bank, SME’s has also reported the financial problems as their third most operating issue after Finding Customers and Competition. From the point of the most pressing problem that face SMEs during the period between April- Sep 2011, the report indicates that access to finance slightly dropped marginally by 1% from 17% in the first half of 2009 to 16% in the period (April – Sep 2011)
Access to finance continued to be a very affective obstacle that SMEs face regarding to Oct 2013- March 2014 report. The European countries that recorded the highest percentage in this aspect are: Greece; Italy; Spain and Portugal with 66%; 52%; 45% and 43%, respectively. (European Central Bank, 2014) The graph below will provide a better insight over the issue:
However, why exactly SME’s face such problems in obtaining finances for their organization has been a source of though for many economists. As per Roman, 2011, barriers that SMEs face arise due to various reasons which include:
- Legislative Frameworks
- Lack of information
In terms of legislation and frameworks, there are regulations and legislation that lead to conflicts between capital and enterprises. Due to lack of information, SMEs face barriers regarding capital and enterprises. Additionally, lack of historical information, which relates to lenders and enterprises are some of the barriers regarding SMEs and on account of this, Financial Institutions take time before making decision to lend to SMEs and many a times, reject their loan application because of insufficient information relating to their credit history. (Roman, 2011).
Furthermore, economists have also started to blame the recent financial crisis that has largely affected the SME financing. The financial crisis, as the world knows, shook the roots of the banking sector and it had a negative impact on the credit strategies of the banks. Following the restrictive credit policy, the banks avoided any kind of risks and in order to maintain enough liquidity, they started to avoid any kind of loans to the SME’s .
Now in the era where SME’s are largely dependent on external financing, restrictions over the credit policies have largely affected the SME’s development. (Paulet et al, 2014). A report by (OECD ,2006) also confirms that although the banks are the leading sources for SMEs financing, nonetheless, there are routines, which can hinder banks from lending the SMEs. Conversely, (OECD ,2006) indicates that the barriers existed before the SMEs started. This can be shown by the financing that financial institutions had in relation to the SMEs needs. Additionally, lack of skill and information, which SMEs suffers from, makes the barriers stronger, and cannot be assumed. The graph below indicates the sources of external financing for the SME’s in the Euro area and how it changed from the year 2009-2011:
In the chart above SMEs show that their needs of bank loans almost remain stable since the second half of 2010, while the overdraft and credit lines increased to reach the peak in the second half of 2010 with 42%. Further, the demand for leasing; hire- purchase and factoring decreased marginally from the second half of 2010 to the first half of 2011 after an increase recorded by 8% between the first half of 2009 and the second half of 2010 (European Central Bank, 2011).
As for the external financing requirements of SMEs in Euro area, an increase was recorded for bank loans and bank overdrafts in France and Italy while this high demand for these sources of finance referred to low profit that they had and the lack of liquidity. On the other side, SME’s based in Germany recorded a decrease in their requirement for external financing which may be related to sufficient internal financing provided by the firms (European Central Bank, 2014).
In a research conducted by Udell, et all in 2009, they raised the concern of SME’s based in Spain and compared the finance availability to the firms based in US and UK. Their research concluded that, unlike Spain, US and UK have better credit policies for the SME. Moreover, the availability of SMEs information is significant in lending the funds to these organizations. (Udell et al. ,2009) also opine that lending relationship is directly linked to the power of the organization in the market which indeed is a problem for SME’s.
An exclusive research was also conducted by Herna´ndez-Ca´novas and Martı´nez-Solano in 2008, where they disclosed as how a relationship between a SME organization and bank can affect the lending practices. The researchers concluded that the trust between the banking institution and the borrowing SME is the main factor behind successful loan application and can also result in reduction of cost of borrowing for the SME organization. Further, the study indicates a relating proof and the monopoly of power, which encourages the continuing of the single relationship and few engagements with few banks. This can have an impact on the representation of the high interest rates for SME funding and a possible source of drawback for SME’s.
Continuing their research to find out as, how the relation between SME and banks affect the SME funding, the researchers compared SME enterprises based in China that were having relationship with two banking institutions to those that were having relationship with only one single bank. They concluded their research and found that the SMEs that have relationships with two banks can get the minimal interest costs. Additionally, the study indicates that developing a relationship with the financial institution relies on trust. This has the benefits of creating the financing and diminishing the borrowing cost.
O’Toole et al conducted a study on the relationship of SMEs and banks in Ireland, in relation to other European nations such as Czech Republic, Estonia, Germany, Greece, Hungary, Latvia, Lithuania, Portugal, Slovakia, Slovenia, Poland and Spain. The study covered banks, which offered funds to Irish SMEs between 2005 and 2012 and time frame was divided in two intervals, i.e. before the financial crisis and after the financial crisis. It considered the period prior and after the financial crisis.
Results indicated that Irish SME’s take a significant position after Germany in borrowing from banks in Europe. However, the number of enterprises that use banks to get access to finance has decreased over the period by 50 percent. Additionally, Irish SMEs mostly depend on internal financing and this indicates the funding preference of Irish SME’s to use internal financing to support their investments as against external financing like banks or any other external financial institution.
According to research conducted by Herna´ndez-Ca´novas and Martı´nez-Solano during 2008, house banks are the leading creditors that have the best assimilation to huge information and warranty compared to other financial institutions. In Germany, it was found that house banks are the best sources that provide financing to enterprises and even lend their funds to SME’s at the time of financial crisis or economic unrest. This situation is very much different from the other financial institutions, which reduce their financial services in the same periods (Elsa and Krahnen, 1998). Additionally, (Machauer and Weber,1998) noted institutions offer additional warranties to the house banks. This relates to the appraisal benefits that link to the assets assessment and selection. Further (Harhoff and Körting ,1998), based their study on Germany SMEs in which it was concluded that focusing on improving the relationship between the banks and the SMEs offers advantage to SME’s as itt leads to a decrease in the borrowing costs and required warranties that are needed during borrowing.
Income and Debt Situation of SME’s based in Europe:
In relation to turnover, 50% of SMEs in the euro area recorded decline in their turnover, which is higher than what was observed in relation to large firms which indicate 44% of decline. That was reverted to the decrease in profit which was a nature consequence of the economic deterioration during the period between Jan- June 2009. Based on the percentages shown, it is clearly illustrate that SMEs were the most affected by the economic situation (European Central Bank, 2009).
Later during 2010-2011, it had been reported that there were an increase by 6% from 3% recorded in the second half of 2010 up to 9% based on the period April to Sep 2011. This referred to the good economic position in that period (European Central Bank, 2011). Whereas the report that covered the period from Oct 2013- March 2014 based on 7,520 firms, has indicated a drop in the turnover by 1% compared to that period. More specifically, a positive achievement in relation to turnover in Germany was witnessed, while it was only a vice-verse situation in Italy and Spain. On the other hand, large firms informed a raise in their turnover by 11% from 20% in April – Sep 2013 to 31% in the period (Oct 2013 – March 2014). The comparative between SMEs and large firms gives a sign of better financial position for the latter one rather than the former (European Central Bank, 2014).
In reference to the leverage percentage (the ratio of debt to assets), the figures raise attention to the real financial situation of SMEs which has a direct effect on SMEs financing. The report (Jan- June 2009) observed that 6% and 10% of micro and the rest of firms respectively have no debt, whereas 3% of SMEs notified increasing in their leverage (European Central Bank, 2009). An increase recorded by 2% in SMEs leverage from 4% in the second half of 2010 to 6% in April- Sep 2011. This actually related to the SMEs needs of debt. On the other hand, large firm recorded decline from 10% to 7% which confirm that the general financial position of large firms better than SMEs for the period from the second half of 2010 to April-Sep 2011 (European Central Bank, 2011). The leverage of SMEs in all euro area recorded decline or stable position during the period from Oct 2013 – March 2014 (European Central Bank, 2014).
Availability of external financing for Euro based SME’s:
According to the or deterioration of external financing availability, the report of the first six months of 2009 indicated 33% of SMEs had a decrease of bank loans provided for them. Further, micro and large firms had the same situation on decrease bank loans with 38%, 41% for micro and large firms respectively. The decrease in the availability of external financing is related to many aspects such as: the creditor policies; the firms’ financial situation and history (European Central Bank, 2009).
In relation to availability of external financing, SMEs reported a raise by 5% from 9% in the second half of 2010 to 14% during the period April- Sep 2011. Further, no deterioration in formed in the other external financing sources. The increase in the availability of the external financing may be a sign of easier policies that provided by the lenders or an improvement in the firms’ financial position (European Central Bank, 2011).
A decline was reported in bank loans that were provided to SME’s in the period Oct 2013 – March. Further, a huge progress that recorded in Spain regards to the availability of bank loans, while Greece had the completely opposite direction. In addition, drop also recorded in other external financing provided such as: bank overdrafts. On the other land, it had been noticed that the large firms were progressing better in the bank loans and bank overdrafts provided for them (European Central Bank, 2014).
The difference that indicates between the external financing needed and the financing provided is known as the external financing gap. Further, this gap reported a decrease during the period (Oct 2013 – March 2014).
In relation to the factors that affect the external financing, general economic position showed a positive impact of it on Germany and Ireland external financing. Further, there were a reduction on the negative impact of it in Greece; Spain; Italy, while remained stable in France (European Central Bank, 2014).
Real financing scenario of SME’s:
Furthermore, in relation to the actual loan application submitted by SME’s, during April- September, 2011, a drastic change was witnessed in the applications for the external financing where only 22% of the SMEs had submitted applications for bank loans, whereas 51% did not apply relating their decision to the adequate internal financing. In addition, the percentage of the firms did not apply for rejection reasons reduced by 1% from 7% in the second half of 2010 to 6% in April – Sep 2011. SMEs confirmed the success of their requests for external financing with 63% that get entire fund they asked for (European Central Bank, 2011).
A report issued by the European Central bank in 2014 indicates that 25% of Euro area SMEs applied for bank loans. In addition, availability of sufficient internal funds prevent 47% of the SMEs from applying for bank loans while 6% did not apply because of rejection concern. In particular, the highest country applied for bank loans was France with 31%, then 29%; 26%; 15%; 14%; 12% for Italy; Spain; Greece; Ireland and Netherlands respectively. Moreover, based on the sufficient internal funds, Austria reported as the highest European country that its SMEs have their financing with 70% while the lowest country is Greece with 28% (European Central Bank, 2014).
Regards to the success of the applications, 66% of SMEs in Euro area had the full fund they asked for and a rejection of 11% of SMEs while 10% received a part of the amount they applied for (European Central Bank, 2014). Micro firms received the full fund they applied for with 53% which was the lowest percentage comparing with medium-sized which recorded 72%. Regards to the firms that get part of the funds they asked for the report indicated 17% of SMEs, while disapproval faced some of small; medium and large firms with 9%; 7% and 5% respectively France (European Central Bank, 2009)
Literature view over impact of removing obstacles for SME’s:
Demirgüc-Kunt and Maksimoric in their report referred that, developing SMEs finance can provide a positive indication to the diminishing impact of the financing barriers which at present is restricting the SMEs growth. Additionally, (Diamind ,1984 and Stein ,2002) show that SME’s have opportunities to access finance due to various reasons. For Instance, Fixed investment recorded as the highest factor has an impact on the needs of external financing with 8% of SMEs.
(Beck ,2008) notes SMEs can belong to the same socio-economic process. This can be a good strategy for the SMEs and their creditors. Therefore, there is no need of offering more information to the lenders. Nonetheless, relationship between SMEs and just one bank can lead to problems (Sharpe, 1990 and Rajan, 1992). As such, SMEs should maintain the relationship with given banks as this can offer the best opportunity for SMEs to receive finance from banks at cost effective rates. (Thakor, 1996 and Thadden, 1995). Moreover, as enterprises expand, the number of banks that have relationships with the SMEs increase and the size of SMEs can determine the number of banks that relate to a given firm (Smith, 2000). (Ferri and Messori ,2000) note that the relationship of SMEs and banks can also depend on location as most SMEs are located in rural area. SMEs, in most instances depend on the external financing, which ought to be the banking institutions and thus, SME’s should focus on building a relationship with banks so as to obtain loans at low rate of interest and also to ensure sufficient financing availability from the banks as and when required. (Petersen and Rajan, 1994; Sapienza, 2002)