Restoring Financing and Growth to Greek SMEs JUNE 18, 2014

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1 Restoring Financing and Growth to Greek SMEs JUNE 18, 214 The length and severity of Greece s economic and financial crisis has had profoundly negative effects on bank liquidity, capital and credit conditions Greek SMEs account for large shares of employment and value added and have been hit hard given their dependence on banks and focus on the domestic market Confidence is now firming amid signs that the business cycle has begun to turn, but loan demand remains constrained given continued tight credit conditions Facilitating an increase in SME financing after a two-thirds drop from the 29 peak will require stronger and better coordinated efforts by the Greek authorities, the Troika and the European Commission s technical assistance mission, the Task Force for Greece These efforts will need to entail more effective action to remove restrictions on the use of EU funds, strengthen SME equity and reverse the upward trend in expected losses on new bank lending, including by bolstering collateral recovery and creditor rights Jeffrey Anderson SENIOR DIRECTOR European Affairs janderson@iif.com Jessica Stallings RESEARCH ASSOCIATE European Affairs jstallings@iif.com Small and medium-sized enterprises (SMEs) have been at the forefront of the economic and financial crisis in Greece, experiencing marked declines in new credit from banks and sharply tightened borrowing conditions (Charts 1 and 2). To look more closely at the reasons, this report follows the framework used in the October 213 report published jointly by the IIF and Bain & Company entitled Restoring Financing and Growth to Europe s SMEs. Focused on France, Ireland, Italy, the Netherlands, Portugal and Spain, that report identified four sets of impediments to SME finance: Information about SME creditworthiness and potential is costly and difficult to obtain SMEs face many disincentives to scale and financial health Banks are less able to shoulder credit risk than before the crisis Alternative funding is less available Chart 1 New Lending to Businesses in Amounts < 1 Million 1 billion, 12-month totals Defined maturities; Source: Bank of Greece. Chart 2 Availability of Bank Loans, 213H2 percent SMEs reporting receiving all credit requested DE AT FI FR BE IT ES IE PT NL GR Source: ECB SAFE Survey; IIF. iif.com

2 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 2 Based on those findings, the October report recommended that the European Council invite interested member states to establish national task forces of key stakeholders among lenders, investors, borrowers and officials to develop tailored, technically-oriented action plans to address each of these impediments to SME financing. The report also recommended that the European Council call for the establishment of regular EU-level reporting on progress addressing these impediments in the different member states that would support the work of the national task forces by disseminating information about good practice policies adopted to address each impediment. Good practice policies should include well-targeted schemes to support SME financing, especially initiatives best able to leverage additional financing from private lenders and investors, assuring the most effective use of each euro of official financial resources. In Greece s specific circumstances, resolving ongoing barriers to the effective use of EU funds will require stronger and better coordinated action by the EU, especially via the European Commission s technical assistance mission, the Task Force for Greece (TFGR). More effective action will be needed, too, by the Greek authorities and their Troika partners to deliver the steadier macroeconomic and financial environment, buttressed by more secure creditor rights, needed to moderate loss expectations on new credit extended by banks and other lenders. This report is based on more than 25 interviews in Athens with banks, SME associations, officials and providers of alternative funding. The discussions confirm the existence in Greece of the same four impediments highlighted in the October report. The negative effects of the crisis for banks and borrowers have been much more debilitating in Greece, however, playing a much larger role in curtailing credit and the tightening of credit terms.

3 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 3 A DEVASTATING CRISIS The harsh downturn experienced since 21 presents a stark backdrop against which to assess impediments to SME finance in Greece. GDP fell by more than one-fourth in real terms from 29 through 213 and by nearly as much in current prices. Nonfinancial companies were hit hard by the marked contraction of the internal market, on which most firms still depend. In nominal terms, domestic demand decreased by 28%, contributing to a 24% fall in gross value added among nonfinancial companies (Chart 3). External competitiveness improved as large reductions in both wages and employment lowered wage costs and boosted profit shares (Chart 4). In euro terms, however, profits declined, although less than value added, compensation and other costs. 1 SMEs are likely to have been hit harder during the downturn than larger firms given their dependence on contracting domestic demand. A sample of individual loan files assessed by BlackRock found that turnover among SMEs that had received bank credit declined by almost 3% on average from 21 to 212. That was nearly double the 17% drop in gross value added seen among corporate borrowers as a whole. From 29 to 213, between 33, and 37, Greek SMEs are estimated to have closed. 2 Their high shares of value added and employment exacerbated the effects of the downturn for Greek SMEs (Table 1). 3 Chart 3 Nonfinancial Corporation Value Added and GDP 28=1 11 Chart 4 Competitiveness and Profit Share 25=1 percent value added Nominal GDP NFC Value Added 1 Operating Surplus Relative Unit Labor Costs Source: Eurostat Source: Eurostat; AMECO The gross operating surplus of nonfinancial corporations reported officially, equal to 61.8% of gross value added in the four quarters through the third quarter of 213, is half again more than the Euro Area average. The high level is due in part to the large share of firms with fewer than 1 employees, which amounted to 35% of value added in 211, compared with 22% for the EU as a whole. Owners account for a significant share of employees among these smaller firms and are compensated more via profits than wage payments, on which social insurance taxes must be paid in addition to personal income tax. Official data also include the income received by the selfemployed, whose share in employment is considerably larger than elsewhere in Europe. These factors complicate comparisons among countries but are unlikely to invalidate the conclusion that profit shares have increased even as profits have declined in euro terms. 2 According to data from the National Confederation of Hellenic Commerce. These figures may include numerous self-employed who discontinued registration with the tax authorities in response to higher taxes. 3 Semi-annual surveys of Greek SMEs by the National Bank of Greece report that only one third were export-oriented in 212 or only one fourth generated most of their turnover from foreign sales.

4 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 4 Table 1 SMEs in the Economy percent share Number of enterprises Number of employees Value added Greece EU-27 Greece EU-27 Greece EU-27 Micro Small Medium SMEs Source: European Commission, 213 SBA Fact Sheet, Greece. Data refers to 29 statistics, the latest available. NEW BANK LENDING TO GREEK SMES HAS FALLEN SHARPLY The government s abrupt loss of bond market access in April 21 had sharply negative consequences for bank funding. Market funding from foreign lenders dried up as confidence dissipated amid growing concerns about counterparty risk and Greece s ability to retain the euro. Domestic deposits fell for similar reasons, and as households and firms drew down balances to meet pressing liquidity needs as incomes contracted, payments delays multiplied and access to credit tightened. Net repayments to foreign lenders amounted to 6 billion through mid-212. Stabilizing thereafter, domestic deposits declined by 77 billion over the same period. Taking both sets of outflows together, banks lost funding equivalent to 43% of the outstanding of deposits and foreign funding at the end of 29, 66% of credit outstanding to companies and households and 77% of GDP in 29. Against this backdrop of crippling liquidity constraints, offset only in part by increased borrowing from the Eurosystem 4 and in response to a severe drop in borrowing demand from creditworthy firms, the outstanding stock of credit to nonfinancial corporations fell by 24% from the end of 28 through April 214. Credit to individuals and private nonprofits fell by 21% over the same period. How much of the decline in credit to nonfinancial firms was accounted for by SMEs is less than clear, however, from the official data. Data published by the central bank register a decline in outstanding credit to SMEs of 11% from August 21 through April 214, net of a small amount of writedowns and large, unexplained upward reclassifications. 5 Data on new business volumes for smaller loans point to a sharper decline. New loans in amounts of less than 1 million fell to just 4.5 billion, or 2.5% of GDP, in the 12 months through April 214, a drop of two-thirds from a pre-crisis peak in August 29 of 14.1 billion, or 6.1% of GDP (see Chart 1). Roughly three-fourths of the decrease in new lending occurred during 21 and Deposit outflows and net repayments to foreign lenders were offset only in part by increased borrowing from the Eurosystem. Borrowing by Greek banks from the national central bank, most of which was financed in turn by borrowing from the Eurosystem, rose from 5 billion at end-29 to a peak of 136 billion in June 212 before easing again to 62 billion at end-april The decline after August 21 follows, however, a seemingly implausible 12% jump from June 21, the first month data were reported. 6 Data on new lending volumes for nongovernment borrowers as a whole, including households and larger companies, registered a marked increase before the crisis, rising from 35 billion during 23 (excluding overdrafts) to 58 billion during 28. Those volumes were consistent with increases in credit outstanding averaging 17% a year from 21 through 29. Credit to nonfinancial corporations registered increases averaging 1% a year during the period, considerably less than households, credit to which rose from a small base.

5 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 5 REDUCED CREDIT SUPPLY HAS CONTRIBUTED TO THE DROP IN LENDING... Findings from the ECB s survey on Access to Finance for SMEs (SAFE) show tighter supply constraints in Greece than any other European country (see Chart 2). Unlike their peers in Italy, Spain and Portugal, which cite overly high interest rates and insufficient collateral or guarantees as the largest obstacles to financing, Greek SMEs report the limited availability of financing to be most important (Charts 5 and 6). Credit supply has tightened in response to liquidity constraints but also because of a marked deterioration in credit quality. While Greek corporate debt peaked well below the levels seen in Ireland, Spain and Portugal (Chart 7), sharply reduced turnover has left many firms unable to sustain timely debt service. Including loans to households and individuals, nonperforming loans (NPLs) owed Greek banks rose to 32% of the total at end-213 from 5% in early 29 (Chart 8). Mortgage arrears account for a significant portion of overall NPLs and a startling 26% of overall mortgage loans, which is very high in comparison with other European countries. 7 NPL ratios are even higher for SME loans, amounting to 4% at end-june 213 versus 29% for the whole of credit portfolios reviewed in the recent BlackRock assessment. Payment delays by suppliers and the public sector have contributed to SME payments difficulties, elevating uncollected accounts receivable and leaving many firms unable to make timely payments on their own liabilities. 8 According to both banks and business associations, banks have become more conservative in the credit assessment process and have increased requirements for Chart 5 Largest Obstacles to Financing, According to Greek SMEs percent responding 1 Chart 6 Largest Obstacles to Financing, According to SMEs, 213H1 percent responding 1 Other Other 75 5 None Collateral 75 5 None Ownership Collateral Interest Rates Interest Rates 25 Financing Not Available 25 Financing Not Available 211H1 Source: ECB SAFE Survey; IIF. 213H1 Greece Ireland Italy Portugal Spain Source: ECB SAFE Survey; IIF. 7 Bankers note that NPLs on housing credits have risen in part because of the moratorium on home foreclosures instituted in 28. NPLs on housing credits in Spain and Portugal were reported by their central banks to have not exceeded 6% and 3%, respectively. 8 Data from Intrum Justitia reports average payment delays of 35, 43 and 19 days for payments from consumers, other businesses, and public authorities, respectively. The average payment delays from public authorities improved from 114 days in 212, likely due to the 5.5 billion in arrears clearance payments made by the government. Recently announced measures will provide debt relief to SMEs by allowing them to offset debts to the state with debts owed by state entities.

6 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 6 Chart 7 Corporate Debt percent GDP Spain Greece Germany Ireland Portugal Italy Source: European Commission. Chart 8 Nonperforming Loans percent loans outstanding 5 collateral. Bank of Greece data show that the percentage of new loans with collateral or guarantees has risen to 89% from an already high 79% in 21H2 (Chart 9). 9 Falling real estate values, meanwhile, have made it increasingly difficult for SME owners to meet collateral requirements. 1 Bankers, moreover, noted the adverse effect of real estate taxes on the volume of transactions, on prices and on the value of collateral. Assessments based on historical rather than recent prices have contributed to the weakness of real estate demand, as have uncertainties with respect to the tax itself and its application. One result was a 68% drop in the volume of residential property transactions involving bank credit intermediation between 29 and 213Q1, 11 which led to the effective freezing of the property market during the first months of Overall NPL Ratio Business Loans Mortgage Loans Consumer Loans Source: Bank of Greece. BUT REDUCED CREDIT DEMAND WAS LIKELY MORE IMPORTANT Tighter credit standards have been accompanied by a marked drop in borrowing demand, according to survey data and discussions with bankers, officials and business associations. Demand for new financing is reported to have declined to extremely low levels among those SMEs that have survived. The SAFE survey records only 16% of responding firms reporting that they applied for a new loan or renewal in 213 compared with 4% in 29 (Chart 1). This decline reflects in part discouragement among many potential borrowers given high borrowing costs, tough collateral requirements and doubts that their applications would be approved. Interviewees agreed, however, that credit demand had also declined because viable firms were likely using internally-generated cash flow to pay down debt. Bankers and SME associations agree with survey findings that the overwhelming majority of applications for new loans 9 The volume of new lending in amounts of 1 million or less without collateral or guarantees slipped to.4 billion in the 12 months through March, or only.2% of GDP, from 1.2 billion in June Q1 residential property prices registered a decline of 35% from the peak in 28Q3, according to data from the ECB. 11 The average time to market in the housing market increased from about five months in early 29 to nearly one year over the same period.

7 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 7 Chart 9 New Loans to NFCs up to 1mn with Collateral/Guarantee percent H2 11H1 11H2 12H1 12H2 13H1 13H2 Source: Bank of Greece. Chart 1 Credit Contraction for SMEs: Demand and Supply percent, yearly average Loan Rejections Demand for Loans Source: ECB SAFE Survey; IIF. Chart 11 Investment by NFCs and Needs Reported by SMEs 21Q1=1 net Source: European Commission; ECB SAFE Survey; IIF. have been for working capital. 12 Demand for investment financing has fallen sharply given the marked contraction of domestic demand and ongoing uncertainty about both the economic outlook and domestic politics (Chart 11). Survey data from the National Bank of Greece for the second half of 213 report a strong preference among SMEs, particularly smaller ones, for the low-interest loans backed by EU funds. These could only be used for investment until changes last year that allowed them to be used for working capital as well (Chart 12). Non-financial Corporations Gross Fixed Capital Formation Reported Increase in Investment Needs, SMEs Chart 12 SME Preferences for Financing Tools percent SME segment Pre-payment of Trade Credit Credit Risk Insurance Guarantees Management of Receivables¹ NSRF Loans Size 1² Size 2-5 Size 6 Source: National Bank of Greece. ¹ Includes factoring, discounting, pre-financing of receivables. ² Size 1 turnover is up to 1K, Size 2-5 turnover is 1K- 5mn, Size 6 turnover is 5-1mn. INTEREST RATES REMAIN HIGH AND SPREADS WIDE Central bank data report that interest rates on new SME loans have declined significantly from their early 212 peak, at least for shorter maturities. Even so, reported rates remain higher than during much of the pre-crisis period and significantly higher 12 One bank economist noted that outstanding loans to nonfinancial corporations with maturities of up to one year had fallen much more since 21 than outstandings of loans with maturities of more than five years, suggesting this gives little evidence of a shift to the shorter maturities characteristic of working capital finance.

8 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 8 Chart 13 Interest Rates on New Loans to NFCs, 1mn, 1 Year percent Portugal Greece Chart 14 Interest Rates on New Loans to NFCs, 1mn, >1 Year percent Portugal Greece 5 5 Italy 4 Italy 3 Spain Germany Source: European Central Bank Spain Germany Source: European Central Bank. than those charged competitors in the Euro Area core. Discussions indicate that offered interest on credit without official guarantees are typically at interest rates of 8-9% rather than the 6% officially reported for maturities of less than one year or the somewhat higher rates reported for Ionger-term loans (Charts 13 and 14). Spreads vis-à-vis competitors in the core, accordingly, are more on the order of 5-7 bps than the 3-4 bps indicated by the ECB data. 13,14 Bankers also shared the view that the overall deterioration in asset quality may have led to a compression in credit spreads between borrowers of stronger and weaker credit quality. In order to avoid exorbitant interest rates that would further worsen the financial circumstance of less creditworthy SMEs, some lenders are thought to have charged higher rates to more creditworthy SMEs than their better credit standing might otherwise have implied. 15 Bankers indicated that cost-of-risk estimates made by banks to cover past and expected losses have continued to rise, moreover, along with increases in NPL ratios, boosting breakeven margins between lending rates and funding costs. 16 The latter have declined, but less than elsewhere. Average rates on deposits, which account for most funding, remained just shy of 3% through April (not including overnight accounts). This compared with rates around 1% in Germany and % elsewhere in the periphery. 13 Discussions with banks and borrowers in the other Euro Area member states reviewed in the October IIF-Bain report also suggested wider spreads on offered credit in Italy, Spain, and Portugal vis-à-vis loans to competitors in the Euro Area core than were reported by the ECB on extended credits. The former appeared from those discussions to be 45-6bps, compared to the 15-25bps indicated by ECB data. The smaller differences reported by the ECB likely reflect marked differences from country to country in composition, with credit actually extended limited in the periphery to borrowers of better relative credit risk, with narrower margins. In addition, larger shares of credit are with official guarantees, with narrower margins due to capital relief, and at shorter maturities, which can be funded at narrower spreads visà-vis the Euro Area core in line with narrower sovereign spreads than further out the yield curve. 14 Interest rates on loans with collateral were reported to range from 8 to 11% in the July 213 report of a working group of representatives of banks, borrowers and officials entitled Access to Finance for SMEs in Greece. Interest rates on loans without collateral were reported to range from 11 to 14%. 15 Some bankers suggested that few credits are likely to have been offered at interest rates above 9% even though credit quality and funding costs might have suggested rates at that level or higher may have been needed to adequately compensate for credit risk and preserve bank capital. 16 The end-213 aggregate NPL ratio was 31.9%, of which only about half was accompanied by loan-loss provisions.

9 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 9 FAMILIAR IMPEDIMENTS The severe effects of the economic and financial crisis notwithstanding, interviews confirmed that the same four sets of impediments to SME finance elsewhere in the Euro Area are present in Greece. Well-crafted policies will be necessary to ease these and to restore financing and growth to Greek SMEs. Absent good quality, timely information about SME creditworthiness, banks and other lenders face difficulty making good credit decisions. New entrants, including alternative providers, face barriers to competing in credit provision. Central credit registries can be important in helping lenders to assess potential exposures against a borrower s total debt. Data on debt outstanding can be supplemented by information on the timeliness of payments reported by banks, other lenders, tax authorities and credit insurers. Few credit reporting firms or rating agencies find it feasible to cover small firms, however. This leaves traditional relationship banking, based on branch managers knowledge of each company s current account transactions, cash flows, business prospects, managers, and owners, as the most cost-effective way to assess the creditworthiness and potential of most SMEs. BANKS CAPACITY FOR CREDIT RISK ASSESSMENT HAS BEEN REDUCED Consolidation amid crisis appears to have considerably shrunk the aggregate capacity of Greece s banking system to carry out traditional credit assessment. That reduced capacity coincides, however, with a marked increase in the need for it, given the severity of the contraction in economic activity and the resulting increase in uncertainty about the financial health of most firms. Mergers, acquisitions and interventions by the state have cut the number of commercial banks from 19 to 5 and cooperative banks from 16 to 1. The banks that have remained, meanwhile, have cut the number of their branches (and branch managers) by 3% (Chart 15). As in other Euro Area member states, especially Spain, consolidation has left acquiring banks reluctant to sustain exposures to individual borrowers, even those of higher credit quality, where such exposures were increased by bank mergers or acquisitions. At the same time, reductions in the number of banks and branch closures by those that remain have disrupted the flow of information generated by tracking SME current account transactions at the branch level. Credit assessment, as a result, is likely to have become more difficult, despite efforts by acquiring banks to retain key information on client credit histories after mergers. At the same time, a number of borrowers affirm that relationships with their creditor banks remain strong and ongoing despite the strains caused by the crisis. Chart 15 Consolidation of Banking System End-28= Branches Employees Source: Hellenic Bank Assoc.

10 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 1 Bankers acknowledged, all the same, that the management of large portfolios of NPLs will consume a great deal of management and administrative effort at a time when credit assessment needs have shifted to discounted cash flow analysis and projection from the collateral valuation that was frequently more important before the crisis. Judgments regarding credit risk assessment have become more complex, meanwhile, given the ongoing uncertainty in the business environment, the weakness of investment-related credit demand and the shift of credit demand related to working capital from financing growth and expansion to meeting sharply intensified liquidity needs, including loss financing for financially weakened firms. NEEDED INFORMATION IS NOT OFTEN NOT AVAILABLE Greece currently lacks a public credit registry, although the central bank has plans to begin collecting data on a loan-by-loan basis in 216 as part of a comprehensive Euro Area effort by the ECB to underpin asset-backed securities. Local chambers of commerce operate a general commercial registry, the operation of which may be jeopardized, according to the chambers, if membership is no longer mandatory, as the Troika has proposed. There are two oft-cited private sources of information on companies operating in Greece. Tiresias, which operates as a credit bureau owned jointly by banks, is widely used for credit information on private individuals. It also collects both positive information about individual SMEs, including approvals for loans, overdrafts, company cards, factoring, leasing, fixed assets and working capital, as well as negative information about payments delays. According to its own estimates, Tiresias s information covers companies that account for only about 3% of outstanding credit to SMEs and is reported to be available only to those lenders who participate in providing data. Another privately-owned company, ICAP, provides financial data and credit ratings for larger firms, including midcaps and some medium-sized companies, but does not cover smaller companies. Restrictions due to privacy laws are less significant than in other Euro Area countries as regards the retention and distribution of data on company finances. Positive data may be held for 5 years and negative data for 1 years, longer than in other EU member states. The Hellenic Data Protection Authority implements laws governing privacy, but these are mostly related to personal rather than company data. Personal data, however, can be important as regards the collateral and personal guarantees that underpin most SME lending. Progress improving the availability and reducing the cost of good quality information about the creditworthiness of individual SMEs will require action on a number of fronts, including the establishment of a robust central credit registry incorporating timely information on outstandings and payments. Simplified and digitized data on company financial performance such as that provided by Standard Business Reporting in Belgium

11 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 11 and the Netherlands would better support creditworthiness assessments at lower cost by banks and other lenders, reaching a broader range of potential borrowers. Finding ways to integrate digitized big data and algorithmic credit scoring by specialized providers and rating agencies could also help to spur the emergence of new entrants in credit provision to SMEs. These new entrants ought to include microfinance lenders as well as crowd-funding providers, such as Funding Circle in the UK and Lending Club in the US. SMEs have been more vulnerable to the recession in Greece in part because their small size makes them more dependent on the domestic market, except perhaps for firms serving tourism. Smaller firms lack the scale and financial resources needed to find new customers abroad or pay the high fixed information costs needed to tap market financing. Their financial health has also been worsened by delays in payments from suppliers, including in the public sector. Efforts to pay down these arrears have reduced the total stock of general government arrears from over 8 billion at end-212 to a still substantial 4.5 billion at end-march 214. FISCAL AND REGULATORY DISINCENTIVES MAY NOW IMPEDE LESS Microenterprises, with 1 or fewer employees, and smaller firms predominate in Greece, as in other countries in the Euro Area periphery (Chart 16). This seems likely to reflect cultural preferences to remain small and retain control, at least in part. Views differed on fiscal and regulatory disincentives to scale. Some argue that these have been reduced by reforms enacted under the EU-IMF program. Others contend that lax tax enforcement and widespread evasion have resulted in less financial discipline among smaller firms, enabling more to survive in Greece than in other countries, both before the crisis and since. One business association indicated, however, that surprise audits are now more likely among small companies as the authorities have strengthened efforts to address tax evasion and limit scope for clandestine employment. One disincentive to scale has been eliminated with the abolition of strict regulation that used to require the recording of transactions by larger companies. External audits are still required for companies with assets above a certain threshold, but business associations suggest that few firms consider this requirement to be a genuine disincentive to expansion. One disincentive that was cited involves corporate income tax rates. These increase from 26% to 33% (on income over 5,) for very small firms that lack the resources or

12 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 12 choose not to maintain double-entry accounting. Intended as an incentive to greater financial transparency, the provision arguably has the effect of giving microenterprises with income below the 5, limit an incentive to stay below it. 17 Recent reforms to the business environment and labor market regulations have helped ease some regulatory disincentives. A concerted effort to facilitate market entry has prompted measures to ease licensing and administrative procedures, including the establishment of a one-stop shop to register new companies. Tax payments can now be filed electronically. Changes in collective bargaining practices and rules governing the termination of employment contracts have increased labor market flexibility. A less restrictive definition now applies to mass redundancies, which must still be approved by the labor ministry. Despite these actions, however, interviewees argue that greater flexibility is still needed, particularly as regards working hours for some sectors, including information and communications technology (ICT). EFFECTIVE RESTRUCTURING MECHANISMS ARE NEEDED... The economic and financial crisis has resulted in large numbers of SMEs that are no longer viable. Many viable firms, meanwhile, have been left with excessive debts and are in need of significant restructuring. Sizable sums of bank liquidity, collateral and capital, potentially, are tied up in such credits, limiting banks ability to provide the credit needed to support the current activity and future expansion of less indebted companies with greater promise and more potential. Overleveraged firms include viable firms that invested heavily in real estate and became trapped by falling property prices. Bankers acknowledged that the restructuring of relatively small amounts of debt could restore the health of balance sheets for many SMEs and dramatically accelerate growth. To support more effective restructurings, however, banks remain in need of assurance that collateral can be recovered within a reasonable period of time. Allowing loan loss provisions and writedowns to be charged off against tax liabilities could provide better incentives for banks to be more active in addressing problematic loans. Discussants repeatedly cited the lack of adequate, timely and fair insolvency framework mechanisms as a key impediment to renewed financing by banks or restructurings that could support a return to greater creditworthiness by overindebted but still viable firms. Procedures are lengthy and costly, viewed by many as a black hole. Changes in the corporate bankruptcy code in 27 and its amendment in 211 allow for the possibility of second-chance restructurings, but very few restructurings have actually occurred. 17 The SMEs concerned would have to determine that the additional costs entailed in keeping double-entry accounts would not be covered by additional after-tax proceeds on income above the threshold.

13 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 13 A thorough review of corporate bankruptcy procedures would entail moving to a clear definition of a reasonable length of time and ensuring adequate protection for creditors and debtors. Additional thoughts shared by interviewees included the following: Requiring lawyers involved in bankruptcy procedures to possess specialized skills could enhance the efficiency of the proceedings, as would developing training for insolvency practitioners and establishing clear-cut procedures. Incentives are said to be skewed because of the super-priorities of certain employees wage claims and the state s interests in discharging debt. Greece s bankruptcy law was reformed in 27 to provide for reorganization as an alternative to liquidation. Amendments in 211 introduced provisions to allow majorities to overrule minorities, subject to court approval. Reorganization procedures are viewed as taking too long, however, requiring no less than two years in most cases and too much judicial involvement. A quicker out-ofcourt process is needed to facilitate more progress realizing collateral and facilitating the exit of nonviable firms. Bankruptcy procedures and debt restructurings for SMEs will be governed in part by further legislation enacted in late 213 that established a Government Council for the Management of Private Debt to oversee the establishment of permanent mechanisms for the resolution of non-performing debt of individuals, legal entities and businesses. 18 A code of conduct to be finalized soon by the central bank will clarify definitions to guide courts and banks in assessing debt repayment capability. Together with provisions lifting the moratorium on residential property foreclosures, these definitions should help to restore a stronger payment culture, reduce moral hazard and bring an end to strategic defaults by mortgage borrowers. All of this will be important in strengthening creditor rights and reducing expected losses going forward. Draft versions of the code circulated earlier this year set forth resolution procedures and clarify alternatives that include short-term restructurings to reduce installments, grant temporary grace periods or defer principal repayments, as well as permanent arrangements that cut interest rates, switch to fixed from floating interest rates, and extend maturities. Permanent solutions envisaged also include signing over property to lenders and sale-and-leaseback provisions. Not included in the instruments under consideration, reportedly, are provisions to facilitate the conversion of debt to equity. ALONG WITH MORE EQUITY IN SME BALANCE SHEETS Measures to support debt restructuring need to be accompanied by actions to facilitate more equity on SME balance sheets. Targeted tax incentives, such as the Allowance for Corporate Equity enacted in Italy, could help to strengthen the equity in SME balance sheets by reducing the relative tax advantage of debt. 19 Scope is limited for banks to 18 European Commission, The Second Adjustment Programme for Greece, Fourth Review, April The Allowance for Corporate Equity enables Italian SMEs below a certain threshold to deduct 3% of any new equity raised since the end of 211 from taxable income.

14 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 14 convert to equity debts owed by firms in promising sectors such as fisheries given high capital requirements for equity holdings (up to 5% under Basel III). For owners with financial resources to strengthen equity themselves, stronger creditor rights would be needed, along with supporting legal procedures in and out of court, to make credible the likelihood that ownership stakes and collateral would be transferred in a timely fashion to lenders should borrowers fail to make timely payments. Stronger creditor rights would also be needed to strengthen interest from potential buyers of distressed debt. Progress easing disincentives to scale and improving the financial health of SMEs will require stronger efforts by the government to clear existing payments arrears and prevent the emergence of new ones. Efforts to improve tax compliance will remain key to preserving and reinforcing hard-won financial stability. Implementation needs to be well-calibrated to assure that sensible focus on larger taxpayers does not result in higher effective tax rates for firms that are able to grow. Tax compliance, at the same time, remains key, along with an effective insolvency regime, to strengthening financial discipline sufficiently at the firm level to facilitate greater consolidation of microenterprises into small and then medium-sized firms, a process that should lead over time to a broader range of creditworthy companies with healthier potential. Tax incentives favoring equity will be needed to reinforce a shift in corporate financing away from overreliance on debt financing. The further reform of bankruptcy procedures will be needed as well, strengthening effective creditor rights while giving due consideration to the needs of viable but over-indebted firms. Appropriate action by supervisors and regulators may well be needed, along the lines of compromises recently reached in Spain s new insolvency law, to assure adequate incentives for the conversion of debt into equity by lenders. Those incentives will need to include appropriate accounting treatment for restructured debt, tax treatment for released provisions and capital requirements for new equity positions resulting from debt conversions. Chart 16 Microenterprises in European Economies percent share Employment Value Added Greece Italy Spain Portugal Ireland Germany Source: European Commission. Chart 17 ETEAN/TEMPME Guarantees million Issued Claimed Source: ETEAN/TEMPME financial statements; European Mutual Guarantee Fund (AECM).

15 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 15 Sharply reduced liquidity and large losses on credit extended to government and private borrowers have cut into banks capacity to bear credit risk more sharply in Greece than in most other countries since the start of the global financial crisis. Stronger emphasis on capital by the supervisor and the Troika has been evident in multiple asset quality reviews and stress tests under the country s EU-IMF programs, of which the comprehensive ECB assessment now underway is only the latest. That emphasis has been reinforced by pressure from financial markets and shareholders, who have suffered large losses and been heavily diluted in successive recapitalizations. As a result, banks now manage capital with a much greater sense of scarcity than before the crisis, notwithstanding capital injections from the state and from private shareholders since 21 that now exceed 5 billion. STABILITY NEEDED... While deposits have broadly stabilized since the June 212 elections, bankers stressed the need for confidence in the economic and political environment to be sustained going forward. Deleveraging is thought likely to continue for some time as banks keep lending prudent and creditworthy borrowers shy away from uninviting credit terms. With funding costs and banks cost-of-risk still elevated, banks remain constrained to keep offered lending rates high, credit standards tight and collateral requirements tough in order to limit losses and preserve capital. Official credit guarantees ought to have played an important role in facilitating credit extension under these circumstances. EU funds, indeed, have been made available to finance the officially-guaranteed portion of new credits at zero cost. Backed by the cash proceeds of EU funds, the guarantee itself has reduced risk weights and lending margins, with expected losses on new credit covered in part by the guarantee. AND FEWER STRINGS ON EU FUNDS Despite government success accelerating drawdowns of EU funds, take-up of Greek government credit guarantees has dwindled markedly since an exceptional 4.1 billion were extended in New guarantees on SME loans appear to have amounted to only 4 million in 213 after slipping to just 5 million in 212 from 2 million in 21. Outstanding guarantees, meanwhile, dropped to just 33 million by the end of 213 from 3.5 billion at the end of 29 (Chart 17). 21 Weak borrowing demand may have been principally responsible for the inability to make better use of the available credit guarantees. Restrictive conditions governing the 2 European Mutual Guarantee Association, various annual statistics reports. 21 National Fund for Entrepreneurship and Development (ETEAN), various annual financial statements.

16 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 16 use of EU funds played a role as well. These include requirements that EU funds be used only for new credit rather than to refinance existing loans and that EU funds drawn for credit guarantees be allocated only according to quotas set for individual regions within Greece, without provisions to reallocate unused funds from low-demand regions to those with greater take-up demand. Adjustments have been made since 212, however, to allow funds to be used for working capital, which led to increased take-up during the latter half of 213. Financing from the European Regional Development Fund (ERDF) is still required to be used to finance SME business expansion rather than refinance existing credit, with applications subject to expensive and time-consuming compliance verification. Borrowing demand, moreover, has been concentrated in Attica and Central Macedonia, leaving untapped funds that have been allocated to the 11 other regions. The principle vehicle for official guarantees, the National Fund for Entrepreneurship and Development (ETEAN), offers first-loss protection up to 7% for investment loans and 8% for working capital credits. Interviewees agreed that ETEAN guarantees have been helpful in securing credit for SMEs that have struggled to meet collateral requirements. (Collateral requirements remain in most instances for those parts of credits not covered by ETEAN guarantees.) The Entrepreneurship Fund, which operates as part of ETEAN and has both an onlending program and credit guarantees, has seen greater take-up. Some interviewees noted, however, that its documentation process is lengthy. The on-lending program has been in heavier demand, with roughly 2 million in loan applications during the final quarter of 213, because it can be used for working capital as well as investment and is funded at zero interest for 5% extended by ETEAN, with near zero margins as well for that portion of the credit, for which ETEAN assumes the risk. Several interviewees saw the need for information campaigns to bolster awareness among SMEs about the credit guarantee programs the government has put in place. 22 A government website that consolidates information about available funding programs should streamline processes and support greater take-up. National schemes are reinforced by initiatives from the European Investment Bank (EIB), which has agreed 65 million in loan facilities, including for trade financing, and the European Investment Fund (EIF), which operates risk-sharing guarantee programs with local banks that provide for working capital as well as investment financing. The EIB has also established a Guarantee Fund for Greek SMEs, plans for which call for using 5 million of unutilized EU funds to provide a 5% risk-sharing guarantee and low cost funding for 1 billion of loans local partner banks are trying to extend to Greek SMEs before the end of Other guarantee schemes are targeted at letters of guarantee extended by banks for very small firms, island tourism, and manufacturing and loan restructuring and for credits to households for energy efficiency upgrades, take-up of which has been much stronger.

17 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 17 CREDIT INSURANCE HAS BEEN SUSTAINED Interviews with banks elsewhere in Europe suggested a greater readiness to extend credit on easier terms to SMEs in their home markets that also insured their accounts receivable with one of the major European credit insurers. As was the case elsewhere, however, relatively few Greek SMEs did so, perhaps reflecting in part the expense involved. For those SMEs who did insure their claims, coverage remained available during the crisis through public and private insurers. Euler Hermes recently increased its ownership stake in its Greek subsidiary from 8% to 1%, while the public export credit agency, Export Credit Insurance Organization (ECIO), is increasing its financing limits from 5, to 1 million. However, as the crisis intensified, credit insurance became increasingly difficult to obtain for imports into Greece, with many firms having to provide cash in advance in order to insure the debts owed by Greek businesses. Addressing the scarcity of private insurance cover, the European Commission temporarily allowed public sector support for shortterm export insurance. Progress enabling banks to lend more with existing capital will require stronger efforts by the government and the EU to lessen conditions that have constrained the use of EU funds. Most urgent, perhaps, would be a waiver of the requirements that EU funds be used to support new credit rather than the refinancing of existing loans. Provisions should also be made to allow regional funding allocations to be redirected to meet existing demand for credit guarantees, even if that requires establishing procedures to compensate low credit demand regions later with an offsetting re-diversion of funds. Redoubled efforts by the Greek authorities and their European partners will be needed, including a greater risk appetite perhaps by EU lending institutions, to bring the lending and investing activities of Greece s new development finance institution, the Institution for Growth (IfG), on line sooner and with greater effect. Further actions by the Greek authorities and the Troika to assure more secure creditor rights on new credit extended by banks and other lenders would moderate loss expectations. Larger amounts of alternative funding are needed, especially equity, to broaden access to finance among Greek SMEs. Scope for banks to lend more on their own, indeed, would be improved if more equity financing was available to help lower debt equity ratios and strengthen balance sheets among SMEs. Greater access is also needed to funding sources appropriate to differing stages of SME maturity, sources which populate the funding escalators for small and growing firms that exist in countries with more developed financial markets (Chart 18). Those different sources can do a better job of addressing financing needs as firms evolve from seed to startup to early and then sustained growth. This kind of alternative funding, moreover, requires the support of an ecosystem that aligns the interests and incentives of many different actors, including fund managers, accountants, lawyers, stock exchanges, brokers, analysts and investors, in

18 RESTORING FINANCING AND GROWTH TO GREEK SMES JUNE 18, 214 page 18 Chart 18 Funding Escalator for SMEs Other structured finance Supply chain finance Export credit Securitization Public debt market (including institutional investors) Invoice discounting Asset financing Inventory financing Public equity Peer- to-peer/ Crowdfunding Business angels Venture capital Private equity Microfinance Friends and family Private debt placement Seed Start- up Early Growth Sustained Growth Source: Restoring Financing and Growth to Europe's SMEs, IIF and Bain & Company, 213. addition to the SMEs themselves. Tax incentives may be needed to broaden interest among private investors in equity investments targeted at SMEs and the numbers of fund managers able to incentivize SME managers and help assure needed operational restructuring. GAPS IN THE FUNDING ESCALATOR ARE SIGNIFICANT Interviewees confirmed that important providers of alternative finance have survived the crisis but that significant gaps have developed, especially as regards the capacity to meet an immense need for growth capital. Private equity firms, many of them belonging to banks, first began operating in Greece in the early 199s and met with some success before the onset of the global financial crisis. Available OECD statistics on venture capital investment show a decrease of almost half the investment from 29 to 211, the latest available data, to less than.5% of GDP (Chart 19). Traditionally, Greek banks have provided little in the way of start-up finance; available seed financing has come mostly from family and friends. A handful of public funds exist to invest in startups, but these have been subject to a high degree of regulation and state control. RECENT INITIATIVES Recent efforts have targeted some key funding gaps facing SMEs. EIF: As a fund of funds, the EIF has committed 48 million in equity to Greek firms through the JEREMIE initiative, which uses EU structural funds, to four seed and early stage VC funds. These commitments, in turn, have attracted an additional 21 million from private investors. While there are some views that the allocation of the JEREMIE funds could be enhanced, many interviewees acknowledged that the EIF s role has provided a solid structure for injecting equity and would like to see these efforts expanded and extended to mezzanine financing that can be converted from high yield debt to equity The EIF made a 3 million equity investment in a mezzanine fund focused on Greece during the final quarter of 213.