How to tackle problem loans in Europe’s small businesses

Six years after the global financial crisis, Europe continues to be weighed down by high levels of corporate debt and millions of nonperforming loans. Small and medium-sized enterprises (SMEs) bear a disproportionately heavy burden. Their nonperforming loan ratios are on average more than double those of their larger corporate cousins. This is worrisome. SMEs are the lifeblood of the European economy, comprising 99 percent of all businesses and employing nearly two of every three workers in Europe. Given the importance of smaller businesses to the economy, addressing their problem loans could lay the foundation for a more robust and sustainable economic recovery.

Small businesses, big obstacles

SMEs in Europe are defined as employing fewer than 250 people and having annual sales of less than € 50 million. Unfortunately, their small size often makes it harder for them to resolve their distressed loans. Large loan volumes, limited financial data about SMEs, and concentration of talent in a few key people for SMEs (management, shareholders, and employees) are serious obstacles.

Generally, smaller businesses are more likely to suffer from lack of expertise in restructuring, costly or complex insolvency regimes, and higher costs of distressed financing. Strict insolvency laws often dampen entrepreneurial spirit by denying the owners of failed businesses the opportunity to start afresh. On top of these unique difficulties, small businesses share the same challenges as bigger corporations in the current environment: cash-strapped banks, weak insolvency systems and inadequate legal enforcement tools.

Help is on the way

European governments have taken measures, particularly to reform insolvency regimes, for example through out-of-court workouts. Some countries — such as Cyprus, Greece, and Ireland — have strengthened supervision of problem loan management in banks. The new Single Supervisory Mechanism, led by the European Central Bank, is expected to harmonize nonperforming loan management oversight throughout the Eurozone.

Governments have created tax and other economic incentives for small and medium-sized enterprises to restructure debt, as well as to facilitate access to financing. The European Commission is also lending a hand, creating targeted programs for SMEs and taking the first steps to provide legislative guidance to member countries.

Despite these efforts, the pace of resolving small business problem loans remains too slow. Governments and banks need to do more. IMF staff recently published a paper, collating experience and attempting to provide some practical policy solutions.

Time for more action

Governments need to devise a comprehensive, coordinated strategy that provides both macro and microeconomic support including through insolvency reforms and enhanced banking supervision. They should consider introducing simpler, more cost-effective insolvency procedures for small firms. Time is money. While creditors deliberate, the value of a business goes down. It is like arguing on how to divide a melting ice cream.

International experience has shown that “enhanced” out-of-court workouts, including some judicial elements or mediation, are essential to restructure debt more quickly and more cheaply. Combined with other reforms, this could give entrepreneurs of failed ventures a chance to shed unsustainable debt and make a fresh start, subject to reasonable safeguards.

As banks are in most cases the main creditors, tougher banking supervision would provide more incentives for banks to tackle their problem loans such as by exiting quickly nonviable firms and assisting in the restructuring of viable, but distressed firms.

Europe’s entrepreneurs and smaller businesses could be the backbone of the European recovery, but too many are currently hobbled by problem loans. Resolving this situation would free up precious resources to help healthy SMEs flourish and new ones emerge. It’s time to make small beautiful again.

This article is published in collaboration with IMF Direct. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Yan Liu is Assistant General Counsel in the Legal Department of the International Monetary Fund, heading the Financial Integrity Group. Kenneth Kang is an Assistant Director in the European Department of the International Monetary Fund, heading the Advanced Economies division. Dermot Monaghan is a financial sector expert in the Monetary and Capital Markets Department of the International Monetary Fund. Wolfgang Bergthaler is senior counsel at the International Monetary Fund’s Legal Department