The Small and Medium-Sized Enterprises - Essay Example

? Mind the Gap Mind the Gap This report outlines a brief of ‘the small and medium sized enterprises’ that are found within the European Union. Four major issues relating to financing of ‘small and medium sized enterprises’ have also been outlined and they include effects of financial crisis on SMEs’ capital structure; the sovereign debt crisis impacts on bank’s credit standards, credit margin, and funding conditions; and the effects caused by comprehensive regulatory changes on policies dealing with bank lending activities. The report also focuses on how these major issues have been addresses by FSB, a corporation that represents SMEs in the financial market, with the help of Bank Lending Survey. It is recommended that cooperation between FBS and Bank Lending Survey need to be established in order to identify issues affecting SMEs. Table of contents Abstract 1. Introduction 2. ‘The Small and Medium- sized Enterprises’ 3. Financial crisis on SMEs’ capital structure 4. Sovereign debt crisis which affects the bank’s credit standards, credit margin, and funding conditions 5. Regulatory changes on policies that deal with bank lending activities 6. “The Federation of small Businesses” 7. Recommendation 1) Introduction “The Small and Medium- sized Enterprises” abbreviated as SMEs is defined by the European Commission as “an enterprise employing not more than 250 employees; having an annual turnover of not more than €50m and balance sheet assets of €43m; and that has less than 25 per cent of its capital.” However, SMEs are defined using three concepts and they include small, local, and single. They are small in nature when considering the number of employees, capital and assets, and turnover. They are also owned by a single owner who could only be the sole employee. SMEs are also local in nature because their markets are usually based on local areas or places of residence (Fielden, 2003). In the European Union, Small and Medium- sized Enterprises faces a number of issues in term of financing. These issues include effects of financial crisis on SMEs’ capital structure; the sovereign debt crisis impacts on bank’s credit standards, credit margin, and funding conditions; and the effects caused by comprehensive regulatory changes on policies dealing with bank lending activities. However, “The Federation of small Businesses” abbreviated as FSB, has come to rescue these SMEs by representing them in the issues for financial market (Ministry of defence, 2013). Its functions revolve around practices dealing with financial lending “of the small and medium-sized Enterprises.” 2) “The Small and Medium- sized Enterprises” The SMEs have been recognized as the key contributors of the economy in the European Union, due to the way they have changed the union into a market oriented economy. Currently, statistics shows that 96% of the registered firms are recognized “as small and medium sized firms,” with SMEs accounting for approximately 82%. These small businesses actively contribute to 25% of the annual Global Domestic Product of the European Union (Villa, 2011). Despite their great contribution, SMEs are faced with financial crisis, cause by various factors hence affecting the capital structure. The financial sector within the European Union is characterized by a system based bank where SOCBs or state owned commercial banks play an important role. SOCBs provide 78 % of the overall loans in the economy, with half of its credits being channeled into SOEs. This, therefore, makes it difficult “for the small and medium size enterprises” to access bank loans. 3) Financial crisis on SMEs’ capital structure However, there are a number of factors which leads to financial crisis that affects the SMEs capital structure. The first one is firm growth. It is suggested that firm’s growth is relatively negative to its capital structure. A SMEs’ information asymmetry may demand an extra premium for it to raise external funds, despite the true quality of its investment project. If it happens to issue debt, then the extra premium is revealed in the higher expected yield. SMEs may, therefore, find it too expensive to depend on debt in order to grow financially. A higher growing SME may have many options for investing in future as compared to the low growing SME. Thus, highly leverage SMEs has a high likelihood of disseminating profitable investment opportunities, because the investment may transfer wealth from the SME’s owner to its debt holders. This, therefore, leads to the SME with high growth potential failing to offer debt; the leverage is expected to negatively relate with the growth opportunities. However, the solution for this financial issue is that long term debt can be replaced with short term debt. In this case, the ratio for short term debt becomes positively related to the rate of growth, if the flourishing SME have its long term financing being substituted with short term financing (North, 2009). The second factor that leads to financial crisis is business risk. The theory of financial distress suggests that businesses which take high risks have high probability of financial distress (Kon, 2003). Businesses should, therefore, tradeoff between bankrupts and tax benefits (Wilson, 2007). This foretells a negative relationship between leverage and business risk. It also suggests that, SMEs have a likelihood of experiencing higher business risks as compared to large firms. The third factor is profitability where a number of theories suggest that, many SMEs utilize retained earnings as investment funds, and consequently move to new equity and debt only if necessary. In this case, a negative relationship between leverage and profitability becomes evident. Although, tax model proposes that profitable firms need to borrow more money in order to take tax advantages, the theory behide the argument of profitability totally disagree because, SMEs in the European Union face a lot of challenges in acquiring access to credit. Furthermore, SMEs’ owner do not like losing their property but instead prefer to make use of retained earnings to fuel the operation of their SMEs. The last factor is lack of relationship with banks. The ability of SMEs to access loans is affected by banking practices. Establishment of close relationship with the bank eliminates liquidity constraints for borrowers and reduces the asymmetric information. Lack of close relationship with the bank hinders great opportunities and benefits such as good rates and terms when required; assurance of fund availability; and knowledge of client needed by the bank. Financial crisis can also be caused by market failure where the financial market fails to offer the expected financial resources to the small businesses. Financial failure usually happens when owner manager fails to acquire financial resources due to weaknesses found in the business case that they put forward. Therefore, even when there is a good market progress, there is likelihood for businesses to have unsatisfied demand for finance. Sovereign debt crisis which affects the bank’s credit standards, credit margin, and funding conditions SMEs are also faced with the issue of sovereign debt crisis which affects the bank’s credit standards, credit margin, and funding conditions. The bank funding conditions are usually affected through two direct ways. The first one is the ‘direct contact to sovereign debt’ which weakens the bank balance sheets, accelerate their riskiness, and make funding more difficult and costly to obtain. The second one is ‘value of sovereign collateral’ which is reduced by the higher sovereign debt risk. This, therefore, makes it difficult for banks to offer wholesale funding for SMEs. During the subsiding financial tension of 2013, in most market segment, the Bank Lending Survey indicated that the sovereign debt crisis was held accountable of the subsiding financial tension in 2013 as compared to the 4th quarter of 2012 (Bhaird, 2010). In 2012, the euro area banks of about one percent, reported that the sovereign collateral and their direct exposure to sovereign debt, made it easier for them to access fund. In addition, other factors such as financial contagion indicated a slight change in the effect of sovereign tension. For instance, decrease by 1 per cent from 15% to 14% in the 3rd quarter of 2012. According to these results, it is evidence that the negative impact on the bank’s funding conditions caused by the sovereign debt crisis, retreated during the 4th quarter of 2012. It, therefore, represented a significant improvement in relation to the crisis situation found in the 2rd quarter of 2012. However, as compared to the previous quarter, the effect of the sovereign tension also receded strongly on bank’s credit standards, at euro area in the 4th quarter of 2012. This change was pronounced across channels of transmission and lending categories (Hsu, 2004). Concurrently, banks revealed that the impact caused by the sovereign debt crisis on credit margins of the banks, was much stronger as compared to that of their credit standards. 4) Regulatory changes on policies that deal with bank lending activities Another issue facing the SMEs is the comprehensive regulatory changes on policies that deal with bank lending activities. The Bank lending Survey reveals that the survey questionnaire conducted in January 2013 included two ‘bi annual questions.’ The main objective of these questions was to assess the level at which the new regulatory instruments affected the banks’ lending policies, through the potential impact on the credit standards applied to loans and their capital positions. These new instruments covers all regulations found in the extra measures of the EBU or The European banking Authority in “CRD IV” proposal; and any other national regulations dealing with bank’s capital ratios. These national regulations are predicted to be approved in the future. 19 per cent of the euro area banks reported that they would put strict measure on credit standards for loans in large enterprises. The cause of this action was due to the new laws and regulations. 15 per cent of the banks in the same regions also made a similar report for loans ‘to small and medium sized enterprises’ (Hall, 2000). The new regulatory instruments also affected the household’s loans. For instance, 11 per cent of the banks indicated that there was a tight credit standard on household loans while 8 per cent indicated a tight consumer credit. During the 2rd half of 2012, 32 per cent of the euro area banks indicated a decrease in the risk weight assets when they attempted to comply with the emerging regulatory requirements. This is different as compared to the 1st half of 2012 which account for 40 per cent. It also shows that there are more ‘riskier loans’ than the ‘average loans’ which accounts for 38 per cent and 26 per cent respectively. They, therefore, remains unchanged from the 1st half of 2012. The Bank Lending Survey shows that, due to regulatory measures on bank’s capital positions, 24 per cent of euro area banks reported an improvement in their capital position in the past 6 months. This is different as compared to the July 2012 Bank Lending Survey which account for 36 per cent (Mason, 2004). However, few euro area banks plan to minimize their risk weighted assets during the 1st half of 2013, for instance, 20 per cent down from 32 per cent in the 2rd half of 2012. All together, the capital position of the banks is expected to be increased by their percentage share, more than the 2rd half of 2012, that is, 39 per cent up from 24 per cent in the 2rd half of 2012. Besides, the banks’ retained earnings are expected to play an important role in improving their capital position, as compared to the share issuance. 5) ‘The Federation of small Businesses’ “Small and Medium sized enterprise” are seen to be the most vulnerable business in the harsh economic sector. “The Federation of small Businesses” has, therefore, intervened in the economic sector in order to assist the SMEs (Susman, 2007). It is recognized as a leading business organization that represents the owners of small businesses at all levels; at European, regional, local, and national levels. It is unique in the way it represents the interests of genuine small business. However, in order to ensure improvement of SMEs, FSB has attempted to concentrate on the financial lending practices. The official data covering practices of lending SMEs in the European Union, shows the lend stock to have fallen by around 4 billion Euros in the 3 months toward November. This shows a negative annual growth rate of the stock lend to SMEs in the 3 months. The contraction of the overall lending stock to businesses was shown a cross all firm sizes, with a negative annual growth rate for SMEs being noticed over that period. In the past 3 quarters, there was also a fall in both the gross lending and repayment in all firm sizes. Large companies usually have high opportunities of accessing adequate fund as compared to smaller companies; a category where SMEs falls in. Therefore, there is a need to secure lending across the smaller companies. According to data issued by the major European Union lenders, the endeavor to secure smaller companies for three months, led to the overall increase in gross flow of protected lending as compared to the previous months. Gross lending between mortgaging and house purchase, were also included by the data showing a slight increase in that period. Apart from securing the lending stock, FSB has also increased the way SMEs access the bank finance (Schmid , 2001). To achieve this, it has concentrated on analyzing decision making by bank managers, when dealing with debt funding applications in The European Union. The analysis is done through interviewing the bank managers and the entrepreneurs. For instance, an interview survey can be done on entrepreneurs who are found complaining for having difficulties in accessing bank finance. The interview use verbal protocol analysis containing valid business funding proposal in order to give insight in the process of decision making. There are a times when the entrepreneurs are faced with challenged due to bank managers being unable to skillfully use standard decision making models. For instance, entrepreneurs may have problems in matching the required information by the bank. This can be as a result of financial modeling process and diligence, understanding and timing of their businesses. The bank managers may, therefore, spend a lot of time in understanding the nature of entrepreneur’s business before coming up with a financial solution. This suggests that entrepreneurs are greatly affected by banks’ informational requirement and protocol. This scenario is found especially in situations involving new technology, new products, and diversification. Lending SMEs is one of the most crucial services undertaken by the banks. These services enable SMEs to generate greater wealth in the economy, obtain more employees, and grow competitively in the market. However, for these banks to continue offering their services to SMEs there is a need for them to earn a return. This return is, therefore, acquired from loan pricing. It is good to note that loan pricing is usually determined by the market and is the most competitive area for SMEs. “The Federation of small Businesses” has assisted the SMEs in issues dealing with loan pricing in a number of ways. The first one is influencing banks to pay SMEs a certain amount of money that is in form of interest. The second effort is influencing the bank to hold deposits for a lengthy period of time once it has lend some amount of money to SMEs. The third one is proposing to banks on increasing security and confidence of SMEs by holding their capital at higher levels. The last one is influencing the Banks to improve the way they set up facilities, provide documentation, monitor and control facilities, and regulate information (North, 2010). The overall cost of bank finance given to a SME, can be decomposed into the fees required by the lender in order to provide loan services, ‘spreads over a specified reference rate’ used to offer loans, and the established level of that rate. The ‘spreads over the reference rate’ has been discussed by the ‘trends in lending’, since the beginning of financial crisis. It is revealed that an elevation of ‘spreads over reference rate,’ leads to increased ‘repricing risk’ and ‘credit risk on lending’. At the same time, these spreads have a likelihood of reflecting the relative cost of increasing longer term funding (Kon, 2003). According to the European Union lenders, there was stability in conditions for the longer term funding markets in 2012. However, these conditions improved in 2012 as at the lenders report in October 2012. Most of the European Union lenders discovered that the stability of the recent conditions were as a result of the liquidity supplied through the central bank actions, especially, that of the Bank of England and European Central Bank. In the European Union, SMEs usually face low spreads for longer term wholesale funding, due to inadequate issuance by banks. This is evidence when many European Union lenders predicted the modest fall of these long-term wholesale funding spreads in the year 2013. There are three types of loan pricing and they include mortgage pricing, corporate loan pricing, and consumer credit pricing. Mortgage pricing is the rate of interest alleged on a mortgage and is usually determined by the lender and can either be fixed or variable. Mortgage pricing can rise and fall hence drastically affecting the buyers. For instance, in The European Union, many SMEs reported that the bank’s quoted fixed rate for mortgages fell in the year 2012 with 17 per cent and 90 per cent loan to value ratio. This led to the spreads over swap rates for the fixed rate products, narrowing down over the quarter due to unchanged relevant swap rates. In three months time, the fixed mortgage rate had fallen by 30 points. In the consumer credit pricing the credit conditions survey shows that lending of spreads on credit card, remained unchanged despite the tightening of other unsecured lending. In addition, the spreads between bank rate and effective rates, remained larger as compared to that of 2008. In corporate loan pricing, a reduction in spreads was discovered. It was said to have been caused by the increased competition between banks and the Funding for Lending scheme. The fee and commissions were also reported by the credit conditions survey, to have fallen ‘for small and medium sized enterprise.’ 6) Recommendations In order for the ‘small and medium sized enterprises’ to be well represented in the financial market, ‘the Federation of small Businesses’ need to carefully identify the key factors or issues facing these businesses. The identified issues should, therefore, be analyzed and classified in a manner that makes it easier to derive effective measures and solutions. At this stage of analysis, ‘ the Federation of small Businesses’ need to work hand in hand with the Bank Lending survey in order to track how the identified issues affect the SMEs in the financial market. This, therefore, assists the FSB in coming up with effective solutions. In addition, the Bank Lending survey also reveals other factors affects SMEs that were not identified earlier by the FSB. 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