www.dcu.ie/dcubsDCU Business School

Financing of businesses in Ireland before and after the 2007-09 credit

crunch

Valerio Potì

Lecturer in Finance and Director of the Master in Finance & Capital Markets, DCUBS

DCU Business School

Plan

• Main focus on SMEs• Some facts and figures, key

developments• Implication for businesses/policy

DCU Business School

Wealthy DaysIs available financing sufficient to see projects through?, 2005 EOS Gallup

SMEs Survey)

DCU Business School

Fast forward to 2009

• Unfortunately, no recent Gallup survey available• Mazar’s report shows significant fall in loans to

SMEs, but also in applications for loans• Central bank data shows fall in lending across

the economy (-3.6% yoy), especially dramatic in certain sectors (e.g., construction -28% yoy, manufacturing -18% yoy), but part of this is due to valuation effects (write-downs)

• No such falls in countries already less awash with credit (e.g. Italy and Germany) before 2007-09 ‘credit crunch’

DCU Business School

Background / big picture

• Three crucial developments:– Transition to Basel II/CRD3– Long-term trend towards recapitalization

of banks– Burst of asset pricing bubbles

DCU Business School

Basel II

• A much more risk-sensitive framework– Incentives to strongly discriminate across

financed units based on measurable creditworthiness

– Adverse effect mitigated by recognition of the diversification benefit afforded by lending to SMEs

– Difficult to predict the final net effect, but better rated banks will be able to maneuver more

DCU Business School

Banks replenishing capital cushions

DCU Business School

Long-term view on capitalization

DCU Business School

S&P500

DCU Business School

(Re-)Emerging financing gap

• SMEs financing is naturally ‘problematic’ – They exhibit more volatile returns (distress risk) and there

is a so-called “lemon problem” (information asymmetries + adverse selection), compounded, in the case of ISMEs, by lack of collateral

• Impact of these problems on both cost and availability of credit is exacerbated (relaxed) when banks need/want to hold more (less) capital as a cushion against risk

• The asset price bubble, and resulting credit bubble, simply concealed these problems for some time

DCU Business School

‘To-do list’ for SMEs

• Understand Basel II/CRD3, in certain cases cost of finance might actually decrease

• Effective communication with providers of capital, to reduce ‘opacity’

• Manage working capital and volatility of cash flows– cash flows stabilization is a key tangible signal when

negotiating creditworthiness

• Engineer liabilities in ways that minimize ‘lemon problem’, opportunity for financial engineering to rehabilitate itself

DCU Business School

Possible policy measures

• Financial support and incentives to banks that lend to SMEs, e.g. EIB loans

• Schemes that facilitate credit to SMEs with risk-sharing, e.g. KfW in Germany, and an element of mutualism, e.g. the ‘Confidi’ funds/coops in Italy

• In Ireland, main focus has been on provision of seed and venture capital to “innovative” firms (ISMEs)

• Re-run survey like Gallup (money well spent)

DCU Business School

Conclusions

• Because of long-term trend in bank capitalization, businesses will have to adjust to operating with lower levels of debt and higher levels of risk capital (own funds + arrangements that limit downside)

• If a growing SMEs sector is a policy aim, measures to close the likely widening ‘financing gap’ will have to be devised

• All the more important if the aim is to expand the indigenous business sector (without credit, typical option to finance growth for ISMEs is MNCs buy-out of entrepreneur)

DCU Business School

End

• Merry Christmas!