What if we put local banks at the heart of Europe’s sustainable growth?

According to the European Commission, SMEs represent 99% of all businesses in the EU, employ around 100 million people and account for more than half of Europe’s GDP.  All over Europe, local banks play a pivotal role in the financing of small and medium-sized enterprises – or SMEs –, which, in turn, are the main drivers of regional development. What if we put local banks at the heart of Europe's sustainable growth? This is the question at the centre of episode 1 of season 2 of the European Democracy Lab podcast by the Institute of European Democrats (the podcast is available in English, French and German).

A problem of information asymmetry

Compared to larger companies, SMEs can adapt swiftly to changing economic conditions. Obtaining a loan, though, can become a real challenge. And this is linked to a particular problem that in economic literature goes under the name of asymmetric information. 

Bernhard Herz, professor of Economics at the University of Bayreuth, Germany, explains this concept: “Issuing a bank loan is something very difficult. The point is that a creditor and a debtor have different information at hand. Those who need a loan know the investment project really well. But the bank, on the other hand, has only limited knowledge and needs to understand if the project is valuable.”

So how can small enterprises compete? This is when local banks step in. Professor Herz is co-author of a research paper released by the Institute of European Democrats titled “Cooperative Banks and Municipal Saving Banks: Which Effects do Local Banks have on SMEs?”. This study shows that local banks are crucial for sustainable regional development in Europe and are in a better position to solve the “information asymmetry problem'' when the business asking for a loan is a SME.

“When SMEs and regional banks are geographically close to one another, banks can more easily define how a given SME is structured, how good its business actions are and, therefore, its investments. Sometimes knowledge stems from personal relationships. As a consequence, the bank can evaluate the safety of a loan. The credit is given away earlier and the risk is lower”.

Nonetheless, the big financial institutions seem to have embraced the local dimensions as well, by establishing networks of regional branches that reach across European countries. Why is it so important to be just a local bank then? According to Professor Herz, “the whole loan issuing process is concentrated in regional administrative structures that are as distant from local realities. The decisions are taken in the headquarters. It’s all a question of corporate governance. And so, we are back to square one, to the disadvantages SMEs face”.

An example of cooperative banking

Laboral Kutxa, a Basque credit union located in Mondragón, is a clear example of how a local and cooperative banking model can play a pivotal role in the development of a given European region. Susanna Andres, commercial director of Laboral Kutxa, explains the ins and outs of a regional banking business: “We have a very prominent role in the business of families, freelancers and small companies. And we can say that our cooperative banking is a benchmark in the financial world of our environment and as a consequence, our relevant agent in the development of the territory”.

The history of Laboral Kutxa is rooted in the Basque cooperative movement, started in 1955 by the visionary young priest José María Arizmendiarrieta and based on the idea of workers' democracy. This soon led to the foundation of the first cooperative financial institution Caja Laboral, aimed at serving the needs of families and small businesses. With a workforce of two thousand people, more than a million and a hundred clients and more than two hundred and eighty-five branch offices, its business philosophy is all about knowing the ins and outs of the local territory.

Despite the crucial role played in regional economic growth, according to Susanna Andres there is not enough recognition of the role of local cooperative credit institutions and “the dominant line of opinion has boosted banking concentration with the larger entities, with the argument of greater solidity and efficiency”. On the top of that, she argues, “an extraordinary regulatory and supervisory capacity has been developed, which requires entities an enormous amount of resources to be able to respond to it, resulting in a disproportionate burden for small entities such as credit cooperatives”.

A different model for a European Banking Union

Over the past few years, the establishment of the European Banking Union has been widely greeted as a major step forward in the process of European integration. The European Banking Union brought about a number of regulatory requirements in terms of rules and internal structuring which also local banks need to fulfill. Although the latter development aims at tackling the risks created by financial institutions that are 'too big to fail’, they also limit the freedom of institutions like Laboral Cutxa.

Susanna Andres argues that “local specificities have not been taken into account. There is a tendency to regulate more and more financial activity and with a higher level of complexity which entails a disproportionate cost of compliance for entities of our size. It's true that European regulations handle the criteria of proportionality, but on many occasions, when it comes down to reality and to the day to day life of the entities, it's not enough to adapt to the reality of the smallest entities”.

Just as Susanna Andres, professor Herz pledges for a more diversified banking regulation system that takes into account differences between regions across Europe: “The key point should be that we need more space for regional and national exceptions within the banking system. This is important in light of what the financial crisis taught us. Namely that regional banks worked as stabilisers of the economy.”.

Opening up a debate on the role of local and cooperative banks could help us in achieving a better balance between regulating those who are too big to fail, on the one hand, and spurring the business of those who risk becoming too small to thrive, on the other one. “It's essential to promote reflection on the importance of complementing the current trend – to establish a single banking model which will lead us to have a few large corporations in the medium term – with a more social banking model rooted in the territory represented by credit cooperatives, which allows the generation of more sustainable and balanced societies”, Andres concludes.

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