How SME funding risk is allocated

Giorgio Barba Navaretti, Giacomo Calzolari, Alberto Franco Pozzolo 18 November 2015



In recent years, the debate around small and medium-sized enterprises (SMEs) and how to finance them has become a crucial policy concern. SMEs account for a very large share of employment and GDP in all economies and, as most great things start small, they are key ingredients of growth prospects everywhere (e.g. WEF 2015). At the same time, they are risky and, in the aggregate, they sum up to a large fraction of banks’ lending. Finding the right balance between supporting SMEs and their expansion and at the same time containing and efficiently spreading the risk of financing them is difficult. It has been even more so during the long years of the financial crisis and the consequent tightening of financial regulation and prudential requirements. In the second issue of European Economy - Banks, Regulation and the Real Sector several authors discuss how to deal with this complex trade-off.

The starting question is of course why there is a need for financing SMEs and why this is so sensitive from the point of view of policy. There is a static and a dynamic approach to this question. The static one is about the existence and the survival of a large share of the domestic economy in all countries. More than 99% of all firms in the EU are SMEs and they account for 66.9% of total employment (Figure 1). SMEs are also a pretty heavy load on banks’ balance sheets – new loans to SMEs were around 27% of new loans to non-financial corporations in the Eurozone, with peaks at around 40% for Italy and Spain (Figure 2). The dynamic perspective is about favouring the reallocation of resources towards fast-growing enterprises. For example, start-ups plus fast-growing young firms historically have accounted for about 70% of gross US job creation annually (Haltiwanger 2014). But if most large firms start small, not all firms become large – about 50% of private firms born in the US in 2009, and about 30% of US firms that were already five-years old in 2009, had exited the market by 2014 (DeYoung et al. 2015, De Young 2015).

Figure 1. SMEs role in selected European countries

Source: European Commission, Annual Report on European SMEs. According to the EU recommendation 2003/361, firms with less than 250 employees and an annual turnover not exceeding 50 million € (or a balance sheet total not exceeding 43 million euros) are classified as SMEs.

Figure 2. New loans to SMEs as a share of total new corporate loans

Source: ECB Statistical Data Warehouse. 12-month moving average of the value of new loans to SMEs (new business, of value up to and including 1 million €) to total new loans to non-financial corporations.

If SMEs are crucial both in static and dynamic terms, financial market imperfections hinder their ability to survive and expand. The keyword (a well-known one, but frequently elapsing in policy propositions advocating unlimited and unconditional support for SMEs) is market failure – if financial markets were functioning adequately, we would not have an SME issue. Asymmetric information between financial institutions and firms restricts financing opportunities and the matching between demand and supply, especially for SMEs which are more opaque than large firms. Moreover, the implications for financial markets are quite different depending on whether we consider smallness as a persistent or a transient state of affairs – younger firms, that tend to be smaller for obvious reasons, are even more opaque for banks. In fact, signalling profitability and riskiness takes time, making adverse selection stronger for younger and thus smaller firms.

Market failures cannot not only generate an inefficient amount of financing, but also a wrong allocation away from the most deserving borrowers – SMEs have no right to funding just because they are such. Solving market failures precisely means finding ways for being efficiently selective, for example nurturing young and small firms with fast growth opportunities. Many proposals and best practices have been discussed for fostering and supporting SMEs, but no all-encompassing optimal solutions exist (Barba Navaretti et al. 2015).

These concerns become even more critical under severe negative systemic shocks. SMEs became especially topical in the long years of the financial plus sovereign crisis. Indeed, several indicators show a higher level of distress for these companies, particularly at the peak of the Global Crisis – a much higher share of non-performing loans over total loans (Figure 3), faster decline in profitability, and an increased number of these firms declaring a funding gap between their needs and the actual availability of funds.

Figure 3. Non-performing loans by firm size

Source: EBA, “Discussion Paper and Call for Evidence on SMEs and SME Supporting Factor”, 2015-02. Data refer to end of 2014.

Capital requirements for lending

The policy reaction to this shortfall was massive – capital requirements for lending to SMEs through the so called ‘supporting factor’ were lowered in the EU; many European governments and finally the EU set up funds entirely or partially financed with taxpayers money directly investing in SMEs or providing credit guarantees; and several interventions increased the viability of the packaging and securitisation of loans to SMEs.

Both the reduction of capital requirements for lending to SMEs through the ‘supporting factor’ and public credit guarantees aim at expanding lending to small and medium enterprises by reducing its cost in terms of capital absorption. There are theoretical arguments and mild empirical evidence supporting the view that the particularly high capital absorption for loans to SMEs, reinforced in the transition from Basel II to Basel III, might constrain lending to this group of firms (Clerc 2015, Udell 2015). Also, if well designed, public guarantee funds can certainly address part of the market failures arising from SMEs lending because they target market failures more directly than other policies.

Yet these two instruments have different implications in terms of the distribution of the risk of lending to SMEs. A reduction in capital requirements concentrates this risk on banks’ balance sheets (and eventually on resolution funds and taxpayers in case of default), as capital buffers facing these risks are reduced. Public guarantees instead lift away this risk from banks’ balance sheets and spread it to taxpayers.  

Nowadays these instruments are still in place, nurturing and supporting the economic recovery of the EU and several countries outside of the EU. The key question at this point is whether they should be preserved once recovery has fully stabilised. In other words, are the market imperfections that have justified these measures during the Crisis structural and still relevant in a better phase of the cycle? Or should these measures gradually be phased out towards a return to SME lending at market conditions? Here, the jury is still out. As for capital requirements, the prudential drive of the regulatory reforms in the past years has not always carefully factored in the trade-off between the impact of capital absorption on lending and the reduction in financial risks. There is therefore a structural issue in the design of capital requirements that should be addressed directly and explicitly rather than being tackled through compensatory exceptional measures like the ‘supporting factor’. As for guarantees, we need convincing arguments for why spreading the risk of lending to taxpayers may solve structural market failures. As argued, these measures can be effective in this respect, but the devil is in the detail – the design of these schemes is crucial for generating sustainable financial and economic additionality (Gozzi and Schmukler 2015).

Vibrant markets

Anyway, the ultimate objective of any action for SME support should be the restoration of a vibrant market for SME lending, where the distribution of risks is efficiently dealt with by the market. In our view, improving the information set is the key strategy for making SME lending more efficient and selective. The principle that only firms able to provide qualified and certified information can have access to funding – i.e. “I fund you only if you are transparent” – should permeate the governance and the culture of SMEs in their relationship to potential funders (Di Noia et al. 2015). This might help expand the role of non-bank forms of funding – from specialised finance, to equity, to securitisation. This market space may expand both in the high and the low end of the financing business. The high end involves the access of SMEs in market segments generally conceived for large firms, through an evolution of the corporate culture and investments in providing broad and accurate information on their business conditions. The low end involves lending technologies that are either asset-based (i.e. where funding is guaranteed through non-opaque assets), or based on verifiable performance records (as in crowdfunding) or on high interest, not capped by regulatory ceilings and sufficient to compensate lenders against very high risks.


SMEs are risky, and when they are so important for the well-being of any economy, someone must bear the risk for funding them. Through better information and calls for greater transparency, it is possible to make them less risky and their financing more efficiently selective, but only partially. This special (and structural) combination between high risk and a key economic function makes this issue a critical test for regulatory reforms, and calls for a deep, systematic and balanced assessment of their impact.


European Economy, “Who Takes the Risk for Funding SMEs”, Issue 2/2015, available at

Barba Navaretti, G, G Calzolari, A F Pozzolo (2015), “Is Special Treatment for SMEs Warranted?”, European Economy. Banks Regulation and the Real Secto 2.

Clerc, L (2015), “Higher Capital requirements for GSIBs: Systemic Risk vs. Lending to the real Economy”, European Economy. Banks Regulation and the Real Sector 1.

DeYoung, R, A Gron, G Torna, and A Winton (2015) (forthcoming), “Risk Overhang and Loan Portfolio Decisions: Small Business Lending Before and During the Financial Crisis”, Journal of Finance.

De Young, R (2015), “How Relationship can Reduce Risk in Small Business Lending”, European Economy – Banks, Regulation, and the Real Sector 2.

Di Noia, C, A D’Onofrio and A Giovannini (2015) “Matching demand and supply in SMEs Financing”, European Economy – Banks, Regulation, and the Real Sector 2.

Gozzi, J C and S Schmukler (2015), “Public Credit Guarantees and access to Finance”, European Economy. Banks Regulation and the Real Sector 2.

Haltiwanger, J (2014), The Decline in Business Dynamism in the U.S, University of Maryland WP.

Udell, G F (2015), “Issues in SME Access to Finance”, European Economy – Banks, Regulation, and the Real Sector 2.

World Economic Forum (2015), “Why SMEs are key to growth in Africa”, 4 August, available at



Topics:  Frontiers of economic research Microeconomic regulation

Tags:  SMEs, lending, growth

Professor of Economics at the University of Milan and Scientific Director of the Centro Studi Luca d’Agliano

Professor of Economics, Bologna University ; Research Fellow, CEPR

Professor of Economics at the University of Molise

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