European banks need to offer suitable small and mid-size enterprise financing in order to grow and take advantage of the business opportunities

• New Roland Berger study: Small and mid-size enterprises (SMEs) are still the backbone of the European economy: In 2010, about 21 million SMEs were active in the EU
• Yet restrictive bank lending policies because of the Basel III requirements are dampening growth, not just of SMEs, but of the banks themselves
• Banks have to adapt their business models to the requirements of SMEs and expand their product portfolios
• Four levers offer considerable potential: individual cash products, financing solutions that tie up little equity; partnerships with other investors and SME loan securitization

Small and mid-size enterprises still serve as the backbone of the European economy. In 2010, the European Union boasted about 21 million SMEs, which created 85% of all new jobs in the EU between 2002 and 2010. But as lending policies were made stricter in the wake of Basel III, banks have become a lot stingier with financing for SMEs. This limits the growth for Europe's SMEs as well as its financial institutions. For this reason, banks should adapt their product portfolios to meet the needs of SMEs. These are the results of a new study by Roland Berger Strategy Consultants for its think: act CONTENT publication series, entitled "Fueling engines of growth". Based on the study, the experts at Roland Berger have identified four ways to breathe new life into the SME financing market: develop individual cash products, sell products that tie up less equity, set up partnerships with other investors and offer SME loan securitization.

"The new Basel III lending requirements are bad news for corporate financing. Yet this is exactly where banks generate a significant portion of their revenues," says Cécile André, Partner at Roland Berger Strategy Consultants. "Banks can't afford to neglect the potential in this area and have to develop appropriate strategies in response."

Regulations put a damper on SME financing

Tougher equity and liquidity requirements, like those laid down by Basel III, make it harder for banks to grant loans – especially to SMEs. This opinion is shared by about a quarter of Europe's SMEs, according to a study conducted in March 2012 by the European Central Bank. For 17% of those surveyed, the lack of financing presented the biggest hurdle to growth.

As capital requirements were toughened up and financial markets became more volatile in recent years, banks started to target mainly large companies to achieve higher earnings. In doing so, the major growth potential and profitability of numerous SMEs have been underestimated. "Banks should position themselves as partners to SMEs and support them with appropriate financing services," explains Roland Berger Partner Christophe Angoulvant. "By offering such financing solutions, banks can tap key sources of income."

Individual cash products and new financing solutions for SMEs

SMEs, along with large corporations, need individual products and solutions to make investments and manage cash at home and abroad. In developing products suited for small and mid-size businesses, André recommends that banks segment their clients, not by sales, but by financing demand, organizational structure and business complexity: "A retailer has different financing needs than a plant construction firm. A bank can't offer an optimal financing mix with a sensible maturity structure unless it's familiar with its clients' short- and long-term liquidity needs."

In doing so, however, banks need to pay careful attention to the profitability and liquidity requirements of their product portfolios. That's because the new requirements have different effects on the individual financial products. For example, the equity requirements for non-collateralized financing such as loans are much higher than for leasing financing. "Banks should develop an optimal product mix to efficiently use equity and avoid cash outflows," says Angoulvant. "Many financial products became too expensive and require too much liquidity under Basel III; banks therefore have to offer alternative products such as factoring or leasing." Other products, including advisory services, insurance or private banking offers for SMEs, could also open up promising business opportunities for banks in the coming years.

Partnerships with more investors and securitization of SME loans- more flexibility is needed

In the banking sector, partnerships with other investors are an unusual but sound alternative, particularly in SME financing. By collaborating with private equity funds, business angels or public institutions, banks can offer more flexible financing solutions for small and mid-size businesses. For instance, Oséo in France, KfW in Germany and the European Investment Bank (EIB) support SMEs on the local and international level with loans and bank guaranties. In 2010, 130,000 SMEs profited from EIB guaranties to the tune of nearly EUR 2 billion in total.

In addition, banks can improve their funding profiles by securitizing loans to small and mid-size businesses and then selling them to institutional investors. "There's a lot of catching up to do here, since this investment option has thus far been little used," says André. The European market for SME loan securitization amounted to EUR 37 billion in 2010 – that's equivalent to 10% of the total securitization market.