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WorldNovember 1 2013

No quick fix to European SME financing conundrum

Politicians worrying about the supply of credit to small and medium-sized businesses see capital markets as a possible solution, but the lack of standardised loans in the sector is making securitisation difficult.
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No quick fix to European SME financing conundrum

Small and medium-sized businesses (SMEs) are widely considered to be the backbone of the economy of the majority of countries in the world. In Europe, they account for 99.8% of all companies and provide more than two-thirds of employment in the region. But many of these firms have been struggling since the financial crisis and a common complaint is lack of finance.

Traditionally, European companies have turned to their banks for funds and such financing remains their principal source of capital. But it is in short supply. Banks’ balance sheets are constrained and they are significantly more cautious than they were pre-crisis. The situation has attracted concern from policy-makers and regulators across Europe. Now, many of them are considering other options.

Risky business

A glance across the Atlantic is illuminating. In the US, traditional bank financing accounts for just 20% of real economy funding, while the bulk is provided by non-banks and capital markets. In Europe, traditional bank financing is behind 80% of real economy funding so when banks batten down the hatches, the impact can be felt across the economic spectrum.

The past few years have highlighted the consequences of this reliance on bank debt. Concerned by the depth and breadth of the financial crisis, regulators have been determined to create a lending framework where banks’ balance sheets accurately reflect the risks they are undertaking.

Lending to SMEs is considered risky, as are longer-term loans, so it is more expensive than ever before for banks to issue SME loans of about five to seven years (the typical term for this sector). As a consequence, banks are less willing to lend to this asset class than previously, and even if they are prepared to lend, the margins they charge are far higher than they were pre-crisis.

For policy-makers in search of a solution to this problem, institutional investors would appear to provide at least part of the answer. These institutions are flush with cash and are actively looking for assets that provide long-term sustainable returns.

“The regulatory environment is designed to squeeze risk out of the banking sector. [This is] going to mean less lending [unless] non-banks... step in and fill the gap. Pension funds and insurers have long-term liabilities and they have pools of money that they need to invest. If you can bring together the people who need the money with the people who have it, that would seem both logical and beneficial,” says James Nixon, chief economist at financial services trade body TheCityUK.

Standardisation challenge

The argument seems logical and it leads straight to securitisation and covered bonds. Securitisation issues allow banks package up loans, divide them into tranches of varying degrees of risk and sell them on to investors. This frees up banks’ balance sheets so they have a greater capacity to lend.

Covered bonds are also originated by banks from pools of loans but investors have a preferential claim to the underlying assets in the event of default. The level of cover gives them a particular kudos in the capital markets so they attract keen pricing which should mean that the borrowers of the underlying loans benefit from cheaper credit.

However, while authorities such as the European Commission have been hoping these types of instruments will unlock the European SME funding conundrum, banks themselves are less confident. “Securitisation and covered bonds can help as part of a wider solution, but they are not the magic bullet,” says David Kim, head of covered bond structuring at Barclays.

Fabrice Susini, global head of securitisation at BNP Paribas, shares this view. “There is no magic wand that someone can wave to make this market happen,” he says.

A securitisation risk?

The level of issuance speaks for itself. There has been precious little of it. Overall securitisation issuance levels have dropped from about €450bn in 2006 to little more than €80bn today. SME issuance is a tiny fraction of that total. For many bankers, the very nature of SME lending poses challenges around securitisation.

“Banks have been securitising assets such as mortgages, auto loans and trade receivables for almost 30 years. These are far more standardised assets than SME loans and they are well understood by investors. Given the diverse industries, collateral packages and servicing terms inherent in SME loans, they are a less homogeneous asset class and thus have not been as readily securitised historically,” says Jim Ahern, head of securitisation at Société Générale Corporate and Investment Banking.

“So SME securitisation should be part of the mix for re-establishing economic growth, but it is not the only answer. There should be more encouragement given to traditional securitisation. An invigorated securitisation market for traditional asset classes such as mortgages, equipment loans and trade receivables would enhance bank sources of liquidity and capital, which could then be re-deployed to increase SME finance.” 

Julia Hoggett, head of financial institutions group flow financing, covered bonds and short-term fixed-income origination for European, Middle East and Africa (EMEA) at Bank of America Merrill Lynch, believes a similar argument applies to covered bonds.

“Over the past year, the European Central Bank has been trying to foster funding for the SME community across Europe and there have been suggestions that covered bonds could help. But covered bonds are traditionally secured by mortgages or public sector debt, which are easy to evaluate from a credit perspective and also to compare across jurisdictions. Covered bonds are defined by legislation and they benefit from a high degree of regulatory acceptance in terms of risk weights, repo haircuts and single counterparty exposures among other things, which all go to making them highly cost-effective for issuers and indeed for investors,” says Ms Hoggett.

“SME loans are very different from mortgages because they are so diverse and the credit analysis around them is much more complex. Investors would have to do far more work, which would affect the price they would be prepared to pay and the level of cover that they would be comfortable with.” 

Choosing collateral

The level of cover is a key issue. In covered bonds, the value of the cover pool invariably exceeds the value of the total bond issue, but the amount of excess required by regulators and investors depends on the nature of the underlying assets. If assets are deemed to be relatively low risk, such as mortgages, the cover pool can be smaller. But SME loans are considered to be rather risky so the cover pool would need to be much larger, making the whole exercise less cost-effective.

In addition, under many current covered bond legislative codes, SMEs are not eligible for inclusion in covered bond pools. “And it is hard to see how they might be, unless changes were made to covered bond legislation and there was a greater degree of regularity, consistency and transparency in the way in which SME loans are structured and reported,” says Ms Hoggett.

For most bankers, the very diversity of SMEs makes it difficult to see how they could fit into a securitisation or covered bond structure.

“From an investor perspective, the key obstacle is the lack of information. Companies with a turnover of €200m are one thing but when companies are turning over €5m or €10m, it is much more difficult to understand how they work. A butcher in Rouen is very different from a plumber in Lancashire, for example. Retail banks have a better grasp of these businesses due to their proximity and long-lasting presence, but for external investors or new entrants in this market, it can be very challenging,” says Mr Susini.

When investors sense a challenge, they expect a greater return and this calls into question the very economics of securitisation and covered bonds, particularly in the current environment.

“Institutional investors are interested in the SME loan sector and securitisation could work to give them access to exposure in this asset class. They cannot be expected to originate SME loans themselves. But, at the moment, SME loan securitisation is not cost-effective,” says Lynn Maxwell, managing director of structured finance at HSBC.

“As a bank, you look at all your funding opportunities and you seek out where you can raise capital most cheaply. Northern European banks have plenty of access to funds right now from deposits, the capital markets and from central bank programmes. These funds are cheaper than could be procured from SME securitisations.” 

Early adopters

That is not to say there have been no SME securitisations in Europe since the financial crisis. Lloyds Banking Group issued several SME securitisations under the brand name Sandown Gold between 2010 and 2012, but the group admits the deals were done when its funding options were more limited.



“Back then, when there was limited appetite for unsecured paper at a reasonable price, Lloyds Bank did a number of credit card and mortgage securitisations. When investors began to fill up on these asset types, the bank looked at SME securitisations. These deals brought in different investors but the spread paid on these deals was higher than the credit card and mortgage-backed debt. From a pure cost perspective, these SME deals would not have been the bank's first choice, but it did allow the bank to diversify its investor base at a price that was still cheaper than unsecured funding rates of similar tenor,” says Robert Plehn, head of asset-backed securities (ABS) at Lloyds Bank Commercial Banking. 

SMEs have been used in a covered bond structure too. Early in 2013, Commerzbank launched a €500m, five-year issue, which was enthusiastically taken up by investors. However, the programme took two years to arrange and the deal benefits from Commerzbank’s position as the leading provider of finance to German SMEs.

“When we started the exercise, senior unsecured debt was much more expensive and covered bond programmes were much more efficient. We thought we would use an SME covered bond to attract new investors as it had a higher yield than ordinary pfandbriefe [mortgage-backed covered bonds],” says Christopher McMullen, head of securitised products at Commerzbank.

The idea worked, as the deal attracted interest from 64 different institutions. But Commerzbank also benefited because it had already devised a sophisticated credit scoring system for SMEs.

“We asked investors to invest in our knowledge of the asset base. For this approach to work, you need to be confident in your internal assessment mechanism, the rating agencies have to be confident in it and you need to be able to identify and replenish the asset pool. We had already done the work elsewhere so it was less arduous for us,” says Mr McMullen.

For most Northern European banks, however, this type of preparation would be arduous and possibly not worthwhile. As Mr Plehn explains: “All UK banks now have plenty of access to cheap liquidity from multiple sources. There may be a place for SME securitisation for funding purposes in the UK market but it will not happen until the market costs of using this funding tool are cost competitive with other funding tools that banks have at their disposal.”

Regulatory obstacles

In peripheral Europe, where funding costs are much higher than elsewhere, securitisation could prove more cost-effective. Banco Popolare di Vicenza issued a €1bn SME securitisation in July of this year, for example. But those close to the deal said investors commanded a significant premium, such that it would only work for a bank whose alternative funding costs were relatively steep. Across Europe, however, banks agree that the single greatest obstacle to SME securitisation is the approach of the regulators.

“Regulators want to promote more securitised issuance for SMEs, but they are also saying that banks need to hold more capital against these assets and reduce their leverage. However, until we have more clarity, these could be viewed as conflicting messages,” says Mr Kim.

Such conflicting messages are also affecting investors. “An example of a regulatory threat facing securitisation is Solvency II, where the proposed capital treatment for an institutional investor of ABS would be up to 10 times that of a like-rated sovereign, corporate or covered bond. Fortunately, the timing for Solvency II implementation has been postponed and we are hopeful this will allow for constructive discussions with the regulators,” says Mr Ahern.

Essentially, securitised assets are still suffering from the pall cast over the sector after the financial crisis. Although this related primarily to the inappropriate securitisation of US subprime mortgages, the damage was so pervasive that regulators remain extremely wary.

“Regulators now want banks to have skin in the game, but the risk weighting for SMEs is so high that it is cheaper for banks to lend directly to them than to securitise the debt. And on the investor side, regulators have been keen to ensure that capital requirements are appropriate but they have been calibrating those requirements with reference to subprime mortgages. What we need now is a level playing field where securitisation is capital neutral,” says Mr Nixon.

Easing the flow

Discussions are ongoing but policy-makers and central bankers remain convinced that securitisation could ease the flow of funds to SMEs. Some experts suggest that securitisation and covered bond issuance could be facilitated if SME loans were standardised in some way.

“SME loan standardisation would be a practical and complex challenge but it would allow funds to reach the SME sector,” says Oldrich Masek, head of EMEA ABS origination at JPMorgan.

Mr Susini says: "If we say that SME loans are more diversified, this would not prevent us from reflecting best practice and defining certain criteria that would only make certain categories of loan eligible. This has happened for mortgages as all are not eligible indiscriminately.” 

Others believe government guarantees could prove useful. “You could see a scenario where governments set up a vehicle similar to Fannie Mae or Freddie Mac, where banks contributed SMEs loans and received capital relief from those sales. Standardisation is a big challenge when it comes to SMEs but a government guarantee would help and therefore drive down costs,” says one banker.

Broadly speaking, however, while bankers believe SME securitisation may play a role in economic growth, they do not see it as a panacea. As Ms Hoggett suggests: “Everyone is right to focus on it. It is the current and the next big banking conundrum. But it may require a range of solutions.” 

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