Banking contraction behind SME credit woes, ESRI finds

The lack of competition in Ireland’s post-crash banking sector may be a key reason why firms are finding it so difficult to access credit.

New research by the Economic and Social Research Institute (ESRI) suggests a direct link between bank market competition and access to finance by small- and medium-sized enterprises.

The study – entitled Does Bank Market Power Affect SME Financing Constraints? – assessed the financial constraints faced by 118,000 SMEs in 20 European countries between 2005 and 2008.

It found that as "market power" increased, in other words as banking competition fell, SMEs faced higher financing constraints.

Morgan Kelly

The research feeds into economist Morgan Kelly’s stark warning that stress-testing of Irish banks will further tighten lending conditions here, potentially wiping out many SMEs who are burdened with debts from the property boom era.

It also comes in the wake of a report earlier this week which found the lending refusal rate by banks to small businesses had risen to 54 per cent in the first quarter of this year.

The ESRI study said the impact of the financial crisis on domestic banking sectors across Europe had led, in many cases, to "a retrenchment towards domestic activity".

This had resulted in extensive, albeit necessary, state intervention to provide banking sector support and restructuring. "If such restructuring significantly lessens competition between financial institutions, our findings suggest this will lead to an increase in financing constraints for SMEs."

Foreign bank exit

The research has particular relevance to Ireland, which has seen a massive contraction of its retail banking sector since the crash, with considerable market exit by foreign banks as well as the consolidation of domestic entities.

At the height of the boom, there were more than 10 retail banks operating in the State, now there is about half that number.

This has substantially lessened competition for business credit in Ireland, the study, which was co-authored by the ESRI's Conor O'Toole, Trinity College economist Robert Ryan and Fergal McCann of the Central Bank, said.

“This reduction in competition poses serious questions regarding the ability of the financial system to transmit credit to SME borrowers in a recovery scenario,”the report said.

“If competition between financial institutions in Ireland is lacking, the risk of increased SME credit constraints heightens.”

The report said policy measures to restore competition in the banking sector were required.