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Crunch time for small businesses
by Edward Russell-Walling

Could the sub-prime loans crisis hit small firms all over Europe?

When credit markets took fright this summer, few in Europe were as apprehensive about the outcome as the small-to-medium enterprise (SME) sector. SMEs know—because they have seen it all before—that when credit turns sour, small companies usually find themselves in the front line. Are they right to tremble?

As the European Commission likes to remind us, SMEs are very important to the EU's economy. They account for half of all its new jobs and considerably more than half of its GDP, giving their collective health a distinct bearing on EU and eurozone economic performance. If a credit crunch made it harder or more expensive for SMEs to borrow money, this could cramp their growth and so accelerate a European slowdown, at worst tipping its economy into recession.

That's the theory, at least. Ask the banks themselves, and they will tell you that they are not turning the screws. Deutsche Bank, for example, says that the outlook for its domestic economy remains favourable and insists that it continues to regard SME borrowers as an attractive client group.

But even in Germany, where the economy has come back to life after languishing for six years, the cost of money for smaller companies may become more selective. "What we might see is that the interest rates—the risk premium—will be more differentiated according to the 'rating' of the individual company," says a Deutsche Bank spokesman.

In Sweden, small businesses are holding their breath in the hope that local banks don't get into a panic. The last time they panicked, during the Swedish banking crisis of the early 1990s, they began calling in small company loans—an easy target—and many businesses went to the wall.

In the UK, where the credit cycle operates at least partly in its own microclimate, there is already anecdotal evidence of a hardening in lending criteria. Instead of directly increasing the cost of borrowing, this effectively reduces the amount of credit available to less favoured borrowers. But there are subtle differences this time around, according to Henry Ejdelbaum, who, as managing director of ASC Finance for Business, advises small UK companies. "Last time, in the early 1990s, it was based on high interest rates and very tight lending criteria. Now it's different. In the last month or two we have seen a tightening of secondary lending criteria-which still means that fewer people get less money."

Ejdelbaum cites a lender who undertakes to lend up to 80 per cent of the value of an investment property. That's the headline criterion. But by stipulating rental cover of 115 per cent, the small print reduces the possible loan amount. And by raising the rental cover to, say, 125 per cent, as some lenders are now doing, they are restricting the available loan amount even further.

"There is no point singling out one bank because all commercial lenders are using these types of 'soft' tools," Ejdelbaum says. "Another method is to insist on monthly instead of annual management accounts. It's not raising interest payments but it is taking more money out of your pocket."

A survey of eurozone bank lending published quietly by the European Central Bank last month suggests that, whatever they may say in public, banks are inclined to squeeze harder than they did earlier this year. The Euro Area Bank Lending Survey for the third quarter of 2007 shows a net tightening of credit standards for loans to business compared to the quarter before.

It doesn't provide hard data, but logs answers from eurozone banks to a stock list of questions and charts the net percentage difference between them. In this way, it records a net tightening of 31 per cent for July-September, compared with a net easing of three per cent in April-June.

"This follows a long period where credit standards remained basically unchanged or were slightly eased," the report observes. How did banks tighten these credit standards? They "widened their margins" on both "average" loans (11 per cent, up from 19 per cent in the previous survey) and on "riskier" loans (37 per cent, up from two per cent).

The survey also tracks the difference in bank attitudes towards large companies and SMEs. While a balance of 36 per cent says the recent turmoil has contributed somewhat to a tightening of standards for large companies, only 19 per cent says the same for SMEs. "It's only my theory but, whereas big company loans tend to be handled by the corporate banks, loans to small companies come from the retail banks, which find it very difficult to fine-tune credit conditions," says Stephane Deo, chief European economist at UBS.

Deo doesn't offer too much immediate comfort for SMEs, however. While large listed companies have very low leverage, SMEs are highly dependent on bank lending. "Listed European companies are in a very healthy position," he says. "However, our research suggests that the rest of the economy is not—so SMEs are very exposed to the credit tightening that is now under way."

The European economy is past its peak—on that most observers agree. "Add to that a credit crunch and the risk is that the slowdown will be more pronounced than expected," says Deo. "SMEs are a very important part of the European economy. If they find it difficult to finance themselves, they will start to reconsider their hiring and investment plans." And that, he concludes, could have a significant impact on the European economy in general.