This hasn't been a good year for anyone, but it has been especially bad for small business. Trapped between declining demand in a shrinking economy and extremely tight lending conditions, many have gone to the wall in the last 12 months. Job losses doubled in 2009 when compared to the year before and SMEs took a lot of the pain. The deadly combination of a recession and a banking crisis has spelled disaster for small businesses, which rely on both the domestic markets and domestic banks to keep them afloat.

Unfortunately for SMEs, bankers and their business customers are still talking past each other when it comes to lending. SME owners have consistently complained about the declining availability of finance, tougher terms and conditions and overall frostier relationships with the banks. The banks insist they are open for business and continuing to supply credit to viable enterprises across all sectors.

Both perceptions are somewhat accurate. Banks are indeed lending, but fewer companies are meeting their criteria because the economic environment is so poor. This gives businesses the impression that lenders are hoarding while the banks protest that it makes no sense to lend to businesses that are not creditworthy.

Supply of credit contracted

Without anyone really planning it, the supply of credit contracted enormously, leaving many businesses without sufficient overdrafts or access to working capital to supply inventories or tide them over while waiting for their own customers to pay up. This vicious circle just spiralled down and down in 2009.

Average payment time pushed out to 75 days this month, according to Isme statistics, with nearly half of firms experiencing payment delays.

"The major issue is that SMEs are finding it very difficult to get paid, which leads to problems when they go to a bank looking for working capital," said Isme head of research Jim Curran. "Cashflow problems are particularly difficult in this environment. SMEs' backs are to the wall – they have cut as much as they possibly can in wages and employment."

There was some hope early in the year that the collapse in SME lending could be arrested by government intervention. In February, finance minister Brian Lenihan demanded, as a condition of the €7bn state recapitalisation, that AIB and Bank of Ireland increase funds available to SMEs by 10% in 2009.

But immediately gaps emerged between 'availability' and 'approvals', not to mention 'drawdowns'. The money was theoretically there, but either businesses chose not to seek it out, got rejected when they did or baulked at taking it when approved.

The big two banks both announced targeted lending packages for the SME sector in response to mounting criticism from lobby groups and politicians that they were choking the economy by withholding credit from the economy.

AIB pledged €1bn for new investment and working capital in December 2008 along with a €200m start-up fund. Bank of Ireland put €250m into a business-support fund. Both banks also instituted flexible payment and restructuring options, too.

But the banks reported very early on that applications were falling off as businesses went into defensive mode and the pool of creditworthy borrowers dried up. Even Isme, the small-business lobby group, admitted in the spring that members stopped looking for fresh funds as the depth of the downturn became apparent.

When the European Investment Bank (EIB) gave €350m in April to AIB, BoI, Ulster Bank and Bank of Scotland Ireland to lend to small businesses, a small bit of optimism poked through the prevailing gloom. These funds – though relatively small in the context of overall business lending – were still not fully disbursed by the end of the year.

According to the banks, the restrictions on lending the money were so strict, it was impossible to find viable candidates that met the borrowing criteria.

Yet it was not just those funds with special rules attached which businesses were finding hard to get. It was any funding at all. The watchword became 'viability'.

'It all goes back to viability'

"It all goes back to viability. Do they have orders in place? We will supply working capital to support that," Damian Young, head of small business lending at Bank of Ireland told the Sunday Tribune. "We look at a business that is providing revenues and get a list of their debtors: Who owes them? How much? For how long?"

An independent survey conducted earlier in the year by consultants Mazars bore this out. Mazars found that banks' decisions to decline credit were usually reasonable in the context of normal commercial criteria. In other words, the banks avoided bad credit risks – and there were a lot of bad credit risks out there.

And supply was not the only problem. Pricing tightened up as well. Even in a low interest rate environment where the ECB base rate fell to just 1%, businesses complained of getting gouged as banks looked for margins of 5% or more.

The problem behind the problem here was the Irish banks persistent struggle to raise funds from deposits and capital markets and competitive prices. Because the banks have had to pay so much to get money in, they have had to charge more on the way out. Businesses, not personal customers, traditionally carry this kind of margin burden because it is assumed they can pass on the difference to their customers. In a deflationary world, though, that is a very hard sell. Until the banks have healthier balance sheets, the woes for SMEs are likely to continue.

One of the selling points of Nama was that removing the bad property loans from the banks and replacing them with clean bonds for funding purposes would get lending flowing again. But the bankers themselves have been anxious to rein in expectations that Nama will create a credit watershed. With the outlook for both the banks and the economy still uncertain, the banks have every reason to be cautious about lending.

Isme is predicting another bad first quarter for small businesses, with bankruptcies and job losses in January and February as cash runs out.

"Business optimism has increased," said Isme's Jim Curran. "But the business trends behind that optimism have not changed."

The new credit review system on business lending, announced by Brian Lenihan in his budget speech earlier this month, appears designed to coax the banks out of their reluctance by submitting them to an appeals process that can ultimately force them to lend. Details on the process are still scant, but SMEs which are refused credit will now have a right to appeal once the bank's own internal process is complete.

Grounds for appeal will include slow responses, onerous terms and conditions, and other forms of "constructive refusal". The system will also review the credit policies and practices of the banks in general, and provides for a "name-and-shame" analysis of appeals and their outcomes.

The risks of moving from moral suasion to government intervention are obvious, as the banks could simply 'turn Japanese' and lend uneconomically to politically-favoured sectors, thus storing up more bad loans for the future.

On the other hand, the review system might reveal what has become clear over the last year: there is little demand and less supply for business loans in the Irish market. Until the recession ends, this fact is unlikely to change.