The Art of Transformation: Future Role of Banks in SME Corporate Lending.

van Rik Gent, Yorick Hallers, Mitch Vis

February 2017

In recent years, the banking sector had to face ever more pressure on their business model. A recent study by Capgemini (2016) documents the trends in the banking sector and points out several trends that are potentially disruptive to the business model of the sector. Chief among these disruptive trends is the entrance of non-traditional players in financial markets. Tech companies are increasingly targeting banking services such as payments, personal finance management and lending. In this blog, we will focus on the latter segment and explore the challenges that banks face especially in the SME Finance.

SME companies are the backbone of any country's economy. The SME sector is significant for economic growth and employment. In Europe, more than 21 million SME companies employ nearly 90 million people, which is 67% (Lopez de Silanes Molina et al., 2015) of the employed populace. Problems in this sector should thus be taken seriously by governments, as these problems may affect the economic stability. One problem documented by an ECB survey is that SME companies are still finding it difficult to obtain financing. European Central Bank (2016).

It is important to note that a company is classified as a SME in Europe when it has less than 250 staff members and either a turnover of less than, or equal to, €50 million or a balance sheet total of less than, or equal to, €43 million (European Commission, 2003). SMEs are a very diverse group of companies and thus cannot be classified as one specific type of company. Moritz et al. (2015) used sector, country, existing financing instruments and the level of innovativeness to classify SMEs into six different types. These types are mixed-financed, state-subsidized, debt-financed, flexible-debt-financed, trade-financed and finally internally-financed SMEs. Each type of class has different growth expectations and are using different instruments to finance its business. In Europe, the largest part of SMEs is financed with debt from commercial banks (Demary et al., 2016). In the wake of the Great Financial Crisis (GFC) of 2008, the SME sector faced a financing gap (Figure 1). A plausible cause for this is that the European banks were reluctant to provide capital because they were deleveraging and reducing the risks on their balance sheets.

We will zoom in on two causes of the finance gap for SME's in Europe namely:

1. Mismatching of financing

2. Bank regulation

Figure 1: Financing gap for The Netherlands, Germany, France and the United States of America in 2013. The financing gap is expressed as a percentage of the GDP of the country. Data from (Lopez de Silanes Molina et al., 2015)

Mismatching of financing

The first of the two factors relates to the parties that operate on the supply side of the European SME financing market and their risk preferences. SME financing are riskier compared to larger enterprise financing (Lopez de Silanes Molina et al., 2015), because of the following three factors:

1. SME's are less transparent than larger enterprises

2. SME's are more vulnerable to economic conditions than larger enterprises

3. Investments in SME's are less liquid than money used to finance larger enterprises

In Europe, most corporate lending is supplied via bank loans (see Figure 2). There however seems to be a mismatching of the assets (SME's) and the liabilities (loans and invested equity) (Lopez de Silanes Molina et al., 2015). We know that SME financing is riskier than large enterprise financing. The opaqueness of SME's and the illiquid nature of SME financial instruments, require high rates of returns on SME financial instruments. This is not the case in the SME sector as bank loans supply a large part of the financing demand. This creates a mismatch in the required rate of return versus the risk of the financial instruments.

Figure 2: Financing structure in Europe and USA (in %). Retrieved from Lopez de Silanes Molina et al., 2015

From Figure 3 we see that the size and the degree of information availability of a firm determines the form of financing for that firm. For SME's we expect that the financing need is supplied from internal cash flows, limited owners financing and to some degree via short-term commercial loans and venture capital (UK Institute for Employment Studies, 2016). These latter two forms of financing should have a high rate of return, which matches the risk profile of the SME's assets.

Figure 3: Match of supply and demand in finance. Retrieved from Carey et all, 1993.

The fact, however, is that banks have supplied a large part of the financing needs of SME's in Europe in the past (see Figure 2) via debt. Banks have decreased the amount of approved loans to SME's after the financial crisis and regulatory changes (ECB, 2016). Therefore, SME's sought financing suppliers in debt-suppliers with higher risk preferences and in the venture capital sector. A problem with direct lending from loan-suppliers with higher return and risk preferences is that there is still a problem with the degree of opaqueness in SME's. Banks can play a role here. A framework, where the bank becomes an intermediary between the supply and demand of capital in the SME sector, is already in place in the United States of America (see Figure 2).

Bank regulation

In the wake of the GFC, regulatory scrutiny for financial institutions has become more pervasive. Stricter regulation for banks (Basel III) are under construction or are already put in place (Basel Committee on Banking Supervision. 2016). The aim of these regulations is to make financial institutions resilient to shocks in financial markets. This is done by regulating the required capital- and liquidity buffers. These regulations however change the incentives for financial corporations, certain investments become more attractive than others.

Figures 4 show the trend for some bank assets, we see that banks are divesting their holdings of corporate loans. Holdings of mortgage loans however, are steadily increasing. This move is not surprising when we consider the significant difference in capital charge, under the Basel III regulatory framework. Loans to non-financial corporates are much more expensive in terms of capital requirements than retail mortgages. Table 1, shows that loans to typical clients of commercial banks, non-rated corporates and SME companies, have a high capital charge.

Loans to investment grade firms are still attractive for banks from a capital requirement point of view. However, these firms generally have good access to the capital markets and can easily finance themselves with publicly listed bonds. Smaller companies can generally not afford a rating and get lower ratings because of the risks associated with their size. SME companies are therefore increasingly less attractive customers for banks.

Figure 4: Financial assets held by European banks, data from European Central Bank (2017).
Table 1: Capital cost in bps. Source Thibeault & Wambeke (2014)

European capital markets union

The European union is working on regulation that should increase the availability of financing for companies by 2019 (European Commission, 2015). The first aim of the European capital markets Union is to create an integrated financial market is Europe where funds can flow over national borders more easily. Secondly, financing in Europe should become more market based. Contrary to current system where banks dominate the financing of European corporations.

The European Commission places particular emphasis on expanding the financing options for SME firms. Two initiatives in particular help to achieve this goal. An initiative to lower the barriers to entry of financial markets is well underway. A revision of the current prospectus regime for financial instruments will contribute to this effort. A barrier to entry for investors in SME firms is the limited availability of reliable financial information for small companies. To broaden the investor base, the European commission is sponsoring initiatives to develop a common minimum set of comparable financial information European commission (2015).

Future of bank role in SME finance

We have seen that the banking sector has come under a lot of pressure in recent years and that SME financing has suffered as a consequence. Banks, under regulatory pressure, have shifted their investments to less capital intensive assets like mortgages.

The banking sector, in the future, will have to show some flexibility to cope with new competitors and regulatory pressure. One way banks can adapt to this changing environment is by using their valuable knowhow on credit assessment as intermediaries for private- and institutional investors. Banks could add value for their corporate clients by finding the investor with the right risk reward preferences for their loan. Both investors and corporate clients can benefit from the extensive network and credit assessment expertise that banks have.

The focus of banking activities in the commercial loans market would shift from investing for own account to linking investors and corporate clients directly and assisting them in the investment process. This requires a new way of thinking for banks, but the shift should not be difficult because the banks already possess all required skills and assets. The impact of this particular transformation would be substantial; the business is much less capital intensive and the profits would be much more dependent on fees and commissions rather than earned interest.

One way in which this could happen is when banks set up SME-Loan funds for Private- and institutional investors to invest in. Today we already see banks moving in this direction. ABN Amro in the Netherlands for example has set up an SME loan fund in close coordination with Dutch Insurance firms ABN Amro and Verbond van Verzekeraars (2014). It is our belief that bank regulation, the development of the Capital markets union, and market circumstances will eventually push banks towards these kinds of services.


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