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What do SMEs look like?

11 June 2014
Richard Kemmish

1: Covered bonds are a good thing.
2: SMEs are a good thing.
3: Therefore...

Funnily enough it’s not as straightforward as that. I’ve always been a supporter of the idea in general but there are plenty of you out there who oppose the idea in general. Enough of the general, maybe we need to look at a few specifics.

Firstly, what is an SME? There are official Europe wide definitions but as ever they hide significant diversity across Europe. When a German bank refers to an SME they are typically referring to the Mittlestand, larger, higher tech, highly capital intensive businesses. Whereas an Italian bank’s SME book more often contains ‘micro’ businesses, often in stable but low growth, low capital industries. Over 40% of Italians are employed in businesses with 10 or fewer employees, compared to less than 20% in Germany. Across Europe smaller business have been harder hit by the downturn than larger businesses as they are less able to cut costs and more reliant on the domestic economy.

What is the SME using the funds for? Pre-crisis it would have been much more about capital creation – therefore a big asset to take security over. Now that the Eurozone has excess capacity, less money is required to buy that big shiny new machine and more is required to fund regular working capital, this can be a good thing – looking into new markets – or a bad thing, ‘my customers are paying their invoices later’. Either way it undermines the ability of banks to analyse the credit and to take security.  
The ability of banks to make the credit decision has often been impaired by the restructuring of the banking sector. It is the medium sized local banks who have both historically been the biggest lenders to the sector and who have been most hit by restructuring, cost cutting and balance sheet shrinkage.
Then of course there is the nature of the loans themselves. Loans to SMEs are more complex, more frequently amended – including their maturity date - and generally more heterogeneous than, say mortgages. In the event of a distressed SME credit, many countries are introducing schemes to amend the loans (the Irish for example are looking to copy their Mortgage Resolution model).

So what? You can start to make a few conclusions about what an SME covered bond should look like:

Given the lack of security and poorer credit information, it is more likely to come from countries with good SME guarantee schemes (such as Portugal with the SME Invest programme) and/or good information about credit (such as France where the Banque de France operates a thorough credit scoring system for SMEs). 

With the economics of the underlying loans comes a greater need for credit enhancement and more flexibility with regard to pay downs (either conditional pass throughs or extendible structures).

Pools will need to be more dynamic to reflect the ever changing nature of the underlying assets. Whereas a mortgage portfolio exhibits very little month-to-month change, an SME portfolio will need far more amending. Fortunately a strength of the covered bond market, dynamic pools being far more difficult in the securitisation market.

None of which say that SME covered bonds are good or bad, its just time to start thinking a bit more about what they actually are.

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