ESRI: Loan demand from SMEs 'suppressed' by higher interest rates and lack of banking competition

Lack of competition in Irish banking seen as reason for the high cost of credit

The ESRI report found credit demand by SMEs across the eurozone peaked following the financial crisis and has been on a downward trend ever since.

High borrowing costs compared to other eurozone countries and limited competition in the Irish banking sector has led to demand for credit from small and medium-sized enterprises (SMEs) being “suppressed”, which can limit investment in long-term growth, a new report from the Economic and Social Research Institute (ESRI) has found.

According to the report, credit demand by SMEs across the eurozone peaked following the financial crisis — likely reflecting firms seeking emergency working capital — and has been on a downward trend ever since.

While the report acknowledges this trend was mirrored in the data for Ireland, there are two clear differences between Ireland and other countries.

“Irish firms have a higher demand for trade credit and a lower demand for bank loans than that found in other countries,” it said.

Even with the strong economic recovery since the crash, the demand for bank loans from SMEs has “not risen substantially” and, in fact, “bank loan demand in Ireland is significantly lower in a eurozone context”.

The report noted a number of factors influencing this trend.

Interest rates charged to SMEs in Ireland remain above the euro area average, reflecting low competition — among other factors — in the banking sector.

The report found “loan demand has been suppressed by higher interest rates and low competition in Ireland relative to other countries”.

In addition, Irish SMEs demonstrate a heavy reliance on trade credits — an agreement whereby a business will pay for goods at a later date — which may limit investment in long-term growth.

“The weak competition and the high price for credit manifest not as credit denial but as credit priced at levels that suppress demand, with SMEs substituting toward trade credit as an alternative, and typically less efficient, form of financing characterised by shorter maturities and smaller amounts.” 

Policy recommendations

In its policy recommendations, the report said existing measures such as credit guarantees and State-backed lending schemes primarily target the availability of credit and policymakers should place greater emphasis on reducing borrowing costs, increasing competition in the banking sector, enhancing direct lending options, and potentially providing targeted supports for young and micro firms.

 “Alternative approaches, such as exploring a greater role for State-backed agencies in direct lending, may merit further consideration, in particular if a benchmarking exercise relative to other European countries shows such a gap in provision,” the report added.

The ESRI said the findings “raise concerns about investment and productivity”, as limited access to affordable bank finance may constrain firms’ ability to invest in innovation, capital expansion, and long-term growth.

Co-author of the report, and chief economist at the Department of Enterprise, Tourism, and Employment, Dermot Coates said the pursuit of sustainable growth in the Irish indigenous SME sector would “require that we build-up the capacity of this sector”.

“But as the report makes clear, access to finance remains a barrier and there is an ongoing need to address both the cost and availability of finance”.

The research was funded by the Department of Enterprise, Tourism and Employment.