Europe’s main economic engine — small and medium-size businesses — desperately needs attention if the Continent’s nascent recovery is to gain momentum. To provide a boost, policy makers and the private sector must resolve the systemic problems that impede the flow of information, limit access to capital, and contribute to burdensome regulations that stifle growth and employment.
In France, for example, there are roughly 60 percent fewer companies with 50 employees than with 49 employees. Why? All things being equal, you would expect a normal distribution of companies by employee size, with no significant difference in the number of firms with 48 employees, 49 or 50. But, because of the regulations triggered by reaching 50 employees, a huge number of businesses deliberately do not exceed 49. Adding one more job involves coping with 34 more regulatory requirements — such as creation of a works council, a hygiene and security committee, and mandatory profit-sharing. That raises a company’s costs by the equivalent of 4 percent, on average, of total payroll.
Small and medium enterprises, or SMEs, provide two of every three jobs in Europe and account for 58 percent of business activity. They range from tiny startups to small family-run firms to medium-size concerns supplying major manufacturers. For Europe to fully recover, policy makers need to understand what is blocking financing to such enterprises, find solutions and quickly implement them.
Consider the size of the challenge: New bank lending to small and medium enterprises in the euro zone as a whole (using loans of less than €1 million as a gauge) has declined by 36 percent since the April 2008 peak. This falloff was steepest from 2008 to 2010, but the decline has continued since 2010. With a heavy dependence on domestic markets, these businesses have been coping with a sharp slide in demand from consumers, other firms and governments.
To gain a clearer picture of what’s hindering this critical sector, the Institute of International Finance and Bain & Co. conducted more than 140 interviews with a broad cross-section of small business associations, bankers, venture capitalists, academics and public officials in France, Ireland, Italy, the Netherlands, Portugal and Spain, and at the European level. What emerged are four major sets of impediments to financing.
The first is the lack of easy access to low-cost information about creditworthiness. Such information often resides in too many places; Ireland and the Netherlands, for example, have no credit registry run by a central bank that would allow other banks to check their own exposure against a small firm’s outstanding aggregate debt. Other regulations actually prevent the easy sharing of information to those that need it most. In Portugal, restrictions on accessing historical information about potential new clients hamper the ability of banks and investors to judge risk.
The second impediment consists of tax, legal and regulatory disincentives that hinder SMEs from achieving greater scale and financial health. That, in turn, limits their creditworthiness, because smaller firms are more susceptible to economic swings than larger ones. In Spain, for example, auditing regulations unintentionally stifle growth, notably through a requirement to have an external audit when a firm reaches annual revenues of €6 million.
The third and fourth impediments prevent banks and alternative sources of financing from fully serving demand, especially once European growth accelerates. Banks now can shoulder less credit risk than before the crisis, and they’re in the midst of significant deleveraging. Even so, better credit guarantees and broader use of credit insurance could spur more lending.
Beyond banks, some countries lack the funding sources that firms should be able to tap at different stages of maturity, whether they are high-potential startups or firms that need to restructure. Britain and Italy have comparable populations and economic output, but British venture capital and private equity firms provide 20 times more funding than their Italian counterparts. Italy and other countries where small firms play a more prominent role, like Portugal, Greece and Spain, also suffer from weak supporting ecosystems of legal, accounting and regulatory participants.
Many initiatives throughout Europe have begun to help reduce these impediments. We found, however, that a best practice in one country was not necessarily well-known elsewhere. For instance, Standard Business Reporting, or SBR, a common, simple, digital language for business-to-government reporting, has worked well in the Netherlands since 2008. It allows a Dutch firm to submit its financial accounts to tax authorities, business registers and banks as an input to credit applications. If adopted elsewhere, SBR could significantly reduce information costs.
France offers another example via the impressive central credit registry run by the Banque de France, which also provides credit ratings on nearly 280,000 firms, most of them small and medium enterprises. Similar information in other countries could do a lot to lower the cost and improve the availability of information on creditworthiness.
We found equally promising initiatives in Italy, Ireland, Portugal and Spain involving credit guarantees, tax incentives for equity investments and bankruptcy restructuring.
So how can each country address these impediments? Most of the effort should be led at the national level. The solutions will be complex and require coordination across different groups. We recommend the establishment of technocratic, nonpartisan national task forces with participants from small business, the public sector, banks and providers of alternative financing, so that each task force can craft solutions tailored to its national environment.
This process won’t be easy, but we believe it can succeed. Most of the potential solutions have already shown promise in one country or another. During our interviews, we heard enthusiasm for learning about what works abroad and how it can be adapted at home.
Europe needs small and medium-sized businesses that are globally competitive, highly productive and able to seize the benefits of the single market. Focused national task forces and better sharing of innovative processes will get Europe on the path to stronger job creation and economic growth.
Jeffrey Anderson is senior director for European Affairs at the Institute of International Finance in Washington. John Ott is a senior partner at Bain & Co. in London.