Response to discussion Paper and Call for Evidence on SMEs and the SME Supporting Factor
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Therefore, based on this breakdown, which provides as well the Risk-Weighted Asset (RWA) information pre and post the application of the supporting factor, it would be easy to calculate the capital relief by simply adding the amounts relieved in each portfolio.
In addition to these COREP reports, banks usually follow the variations on credit exposure by asset class for internal credit risk management purposes and thus they can control the impact of the SME SF.
- The SF keeps SME capital requirements closer to those of Basel II. The EBF has long argued that SME lending was not at the core of the crisis and that imposing overly conservative requirements on SME finance would unwarrantedly increase SME credit spreads.
- More importantly, the allocation of capital among asset classes has become a critical factor in banks management after the financial crisis. Without the SF, SME lending would be put at a disadvantage compared to other lending alternatives. Banks’ lending business is driven by margins. Therefore any capital relief has a direct business-boosting impact. Specifically, the SME factor has an impact on the pricing as the cost of capital is reduced, whereas the credit decision is still very much linked to the risk assessment of the SME. However, two features of the SME supporting factor have made full use of it challenging. Firstly, the design of the SME supporting factor results in cliff effects. When the customer breaches the exposure or turnover cap an increase in capital requirement amounting to the SME supporting factor is imposed.
However, it should be noticed that there are multiple other definitions used for other purposes. No reconciliation of the internal definitions of SMEs to the definition used for the SF is performed because there is no business imperative or benefit from such reconciliation.
Nevertheless, we would like to note that the exposure limit of €1.5 million for eligibility for the SF seems too low. The range of business size covered should be more ambitious and include a wider range of SMEs.
There are a number of different SME definitions used for internal, risk and regulatory reporting. For example the COREP reports also include splits for Retail SME and Corporate SME asset classes. Having one consistent definition would simplify reporting and reduce the potential for misunderstanding.
An issue that EU policy makers will have to resolve is the relative size of SME in different EU countries. The country’s GDP, the number and concentration of SMEs, the productivity and other factors should be considered when fixing a threshold based on size.
- These risk indicators, although useful from a credit management perspective, are largely cyclical and backward looking by design which hinder any risk assessment system from predicting SME risk of insolvency and allowing issues to be resolved and measures to be put in place before risks materialise. How to assess them objectively. Many of the proposed risk drivers are based on accounting conventions that are not yet globally harmonised. Depending on the country jurisdiction there are small companies which are not required to publicly file any accounts, and some other countries that although having the obligation to comply, this information may be prepared up to nine months after the financial year end. Therefore, in order to be able to comply with these measures of SME riskiness on a current value basis it would be necessary to change the small business accounting conventions. However, this might not be enough to identify and anticipate the SMEs risk-profiles. The main difficulty faced by banks when lending to SMEs is the accuracy, volatility, and availability of the financial information provided by SMEs.
- A “one size fits all” approach is too imprecise to do justice to the heterogeneity of the SME sector. A differentiated analysis making a distinction between sectors or clusters of sectors (i.e. trade, manufacturing industry, services) and countries is therefore required.
- Debt Service Coverage Ratio (EBITDA / Capital Repayments + Interest)
- Debt / EBITDA
- Overall size of the business
- Life stage of the business
- Consolidation risk in the case of lending to finance mergers and acquisitions
- Ownership and financial position of natural person(s) behind the company
- Quality of management (competences, professional experience and perspectives about the succession)
- Quality of financial information
- Competitive position of the customer in the specific market; diversification of customer base; diversification of supplier base; number of competitors in market.
- Maturity of customers products in terms of life cycle and diversification / concentration of customers products
- Value of collateral offered
- Sensitivity to economic environment and interest rate changes
- Payment behavioural information
- Financial debt and behaviour in the financial system
- The stable relationship with the institution, measured, for example, by the costumers’ history or by the percentage of the business activity performed with the entities
- Indicators should be estimated both at a given time and with a past and forward-looking perspective
- Some specific indicators for individual entrepreneurs and self-employed, as for example:
o Turnover (except if it is included in the overall size of the business indicator)
o Taxes
VAT
Income tax
o Financial Assets Statements
As a conclusion, several studies show that a close bank-firm relationship has a positive effect on bank lending.
In addition, it would be important to note that the analysis presented in the Discussion Paper does not take into full consideration the following aspects:
- By definition, the SME group includes the new businesses (start-ups) which are more prone to failure due to the less stable and robust source of revenues which penalise the access to credit. So, the SME data on default may be biased by the higher weight of new business, which are more likely to default than the universe of large corporate. In this sense, a kind of “vintage” analysis of SME defaults making distinction between new SMEs vs. established SMEs could be useful for the purpose of the discussion paper;
- SME usually have shorter loan maturities hence being more prone to refinance risk at times of prolonged crisis;
- Further consideration should be given to the conclusion presented on paragraph 31, by pointing out, as a major factor for riskiness, the importance of the type of activity performed instead of firm size;
- Though the data focus on riskiness of SMEs no analysis is performed on the riskiness of portfolio composed of Large Corporates and SMEs. In the end that is what matters for capital requirements as stated on paragraphs 32 to 35 of the discussion paper “asset correlation increase with firm size”. So, it seems appropriate to have in place a SME supporting factor in order to incentivise the more diversified banking portfolios that may turn out to be more robust in a crisis scenario.
- The EBA should cover all EU countries rather than only the euro area countries.
- The definition of “New Lending” as ‘loans other than revolving loans and overdrafts…’ is a flawed definition which undermines the statistical data. These products are a key source of funding for SMEs. Indeed, for many businesses whose activities are confined to trading, such as those involved in wholesale or retail distribution overdrafts and revolving exposures are frequently the most significant source of funding. This impacts the analysis contained in the section entitled “Lending trends”. By contrary Paragraph 3 in section 4.1 incorporates both overdrafts and loans within the definition of “banking financing”.
- Finally a necessary caveat is that SMEs trends are proxied by loans < 1M€.
It can be argued that banks could have changed their policies to the detriment of SME lending if the SF had not been introduced. The SF must have partially offset the disadvantaged position where SME lending was left as a result of the wider regulatory reform
The overall impact of the regulatory reform leaves SME lending worse-off than other asset classes in spite of the fact that SME lending was not at the core of the crisis. In particular, the combined effect of enhanced capital requirements and liquidity rules put SME lending at a disadvantaged position compared to other assets. The stricter capital requirements lead to deleveraging whilst the liquidity rules force banks to invest a considerable part of their resources in qualifying assets, mainly government bonds. The stringent scenario is compounded by the overly restrictive conditions for SME loan securitisation.
The original intention was to maintain the capital requirements of Basel II as SME lending was not at the core of the assets that gave rise to the financial crisis.
Please refer to the annex for further evidence on the effect of the SME SF.
However, we believe that given the diversity among the SMEs, it is necessary that regulators establish the right balance between complexity and risk sensitivity.
In order to adequately reflect the SME risk profiles, we consider that is necessary a different treatment according to the type of product, geography, etc. SMEs show a clear different behaviour depending on their jurisdiction. SMEs treatment should be calibrated in order to reflect the specificities of the sector and geography where these companies are located. These two components are critical for this segment, highly influenced by the local business culture and the local rules. For instance, some SMEs are not required to publish financial statements according to the local accounting standards.
Q1: Do you have systems in place to track the reduction in capital due to the application of the SME Supporting Factor (capital relief)? Yes/No. Please explain and provide evidence.
Though the question seems to be addressed to individual institutions, the EBF can presume that banks at large are able to calculate the impact of the SME Supporting Factor (SF). The capital relief due to the application of the SME Supporting Factor can be monitored through the COREP reporting templates (EU Regulation 680/2014 of 16 April 2014). These reports include a breakdown of “Exposures subject to SME Supporting Factor” under the Total Exposure caption.Therefore, based on this breakdown, which provides as well the Risk-Weighted Asset (RWA) information pre and post the application of the supporting factor, it would be easy to calculate the capital relief by simply adding the amounts relieved in each portfolio.
In addition to these COREP reports, banks usually follow the variations on credit exposure by asset class for internal credit risk management purposes and thus they can control the impact of the SME SF.
Q2: In your experience, is the reduction in capital requirements due to the application of the SME Supporting Factor (capital relief) being used to support lending to SMEs? Yes/No. Please explain and provide evidence.
The perception of EU banks is that the SF has positively influenced SME lending patterns. In particular:- The SF keeps SME capital requirements closer to those of Basel II. The EBF has long argued that SME lending was not at the core of the crisis and that imposing overly conservative requirements on SME finance would unwarrantedly increase SME credit spreads.
- More importantly, the allocation of capital among asset classes has become a critical factor in banks management after the financial crisis. Without the SF, SME lending would be put at a disadvantage compared to other lending alternatives. Banks’ lending business is driven by margins. Therefore any capital relief has a direct business-boosting impact. Specifically, the SME factor has an impact on the pricing as the cost of capital is reduced, whereas the credit decision is still very much linked to the risk assessment of the SME. However, two features of the SME supporting factor have made full use of it challenging. Firstly, the design of the SME supporting factor results in cliff effects. When the customer breaches the exposure or turnover cap an increase in capital requirement amounting to the SME supporting factor is imposed.
Q3: Is your internal definition of SMEs in line with the definition of SME exposures subject to the SME Supporting Factor? Yes/No. If no, how are you reconciling the internal definition of SMEs with the definition of SMEs subject to Supporting Factor? Please explain and provide specific examples.
Our members are fully aware of the definition of SMEs as set out in the Commission’s recommendation 2003/361/EC of 6 May 2003 as well as the clarifying consolidated guidance set out by the EBA in Annex 3 of its Discussion Paper. This SMEs definition is the one used for the purpose of identifying those exposures which benefit from the SF criteria set out in the CRR.However, it should be noticed that there are multiple other definitions used for other purposes. No reconciliation of the internal definitions of SMEs to the definition used for the SF is performed because there is no business imperative or benefit from such reconciliation.
Q4: In monitoring the total amount owed to you, your parent and subsidiary undertakings, including exposures in default, by the borrower and its group of connected clients (as defined in CRR Article 4(1)(39)), what reasonable steps do you take to ensure that amount does not exceed EUR 1.5 million in accordance with Article 501(2)(c)?
Banks will be responding to EBA on an individual basis should they choose to do so.Nevertheless, we would like to note that the exposure limit of €1.5 million for eligibility for the SF seems too low. The range of business size covered should be more ambitious and include a wider range of SMEs.
Q5: Do you see merits in having a harmonised definition of SMEs for reporting purposes? Yes/No. Please explain and provide specific examples.
Yes. Harmonised definitions can be beneficial as they would ensure a uniform application across all EU member states. In addition, harmonisation promotes transparency and simplicity of the regulatory framework. Moreover, taking into account the next steps in relation with the Capital Markets Union a harmonised definition of SMEs will become a matter of level playing field.There are a number of different SME definitions used for internal, risk and regulatory reporting. For example the COREP reports also include splits for Retail SME and Corporate SME asset classes. Having one consistent definition would simplify reporting and reduce the potential for misunderstanding.
An issue that EU policy makers will have to resolve is the relative size of SME in different EU countries. The country’s GDP, the number and concentration of SMEs, the productivity and other factors should be considered when fixing a threshold based on size.
Q6: Do you agree with the proposed measures of SME riskiness? Yes/No. Are some of these measures more relevant than others? Yes/No.
Whilst the five factors identified may very well be suitable proxies of SME riskiness, it should be taken into account some key issues highlighted by our members:- These risk indicators, although useful from a credit management perspective, are largely cyclical and backward looking by design which hinder any risk assessment system from predicting SME risk of insolvency and allowing issues to be resolved and measures to be put in place before risks materialise. How to assess them objectively. Many of the proposed risk drivers are based on accounting conventions that are not yet globally harmonised. Depending on the country jurisdiction there are small companies which are not required to publicly file any accounts, and some other countries that although having the obligation to comply, this information may be prepared up to nine months after the financial year end. Therefore, in order to be able to comply with these measures of SME riskiness on a current value basis it would be necessary to change the small business accounting conventions. However, this might not be enough to identify and anticipate the SMEs risk-profiles. The main difficulty faced by banks when lending to SMEs is the accuracy, volatility, and availability of the financial information provided by SMEs.
- A “one size fits all” approach is too imprecise to do justice to the heterogeneity of the SME sector. A differentiated analysis making a distinction between sectors or clusters of sectors (i.e. trade, manufacturing industry, services) and countries is therefore required.
Q7: Are other aspects relevant in your assessment of the creditworthiness/riskiness of potential SME borrowers? Yes/No. If yes, please provide a list of those aspects and explain how you measure SME riskiness.
Yes. Other key risk indicators used to assess the riskiness of SME borrowers include:- Debt Service Coverage Ratio (EBITDA / Capital Repayments + Interest)
- Debt / EBITDA
- Overall size of the business
- Life stage of the business
- Consolidation risk in the case of lending to finance mergers and acquisitions
- Ownership and financial position of natural person(s) behind the company
- Quality of management (competences, professional experience and perspectives about the succession)
- Quality of financial information
- Competitive position of the customer in the specific market; diversification of customer base; diversification of supplier base; number of competitors in market.
- Maturity of customers products in terms of life cycle and diversification / concentration of customers products
- Value of collateral offered
- Sensitivity to economic environment and interest rate changes
- Payment behavioural information
- Financial debt and behaviour in the financial system
- The stable relationship with the institution, measured, for example, by the costumers’ history or by the percentage of the business activity performed with the entities
- Indicators should be estimated both at a given time and with a past and forward-looking perspective
- Some specific indicators for individual entrepreneurs and self-employed, as for example:
o Turnover (except if it is included in the overall size of the business indicator)
o Taxes
VAT
Income tax
o Financial Assets Statements
As a conclusion, several studies show that a close bank-firm relationship has a positive effect on bank lending.
Q8: In your experience, are SMEs as cyclical or more/less cyclical than large enterprises?
Generally SMEs tend to be more cyclical than large enterprises, but this largely depends on the sectors, companies and their risk. Different industries and sectors may be impacted to a different degree, and with a different timing, through an economic cycle. The default rates and increases in the PDs produced by the models during the financial crisis align with this view; and with the view of the Discussion Paper.In addition, it would be important to note that the analysis presented in the Discussion Paper does not take into full consideration the following aspects:
- By definition, the SME group includes the new businesses (start-ups) which are more prone to failure due to the less stable and robust source of revenues which penalise the access to credit. So, the SME data on default may be biased by the higher weight of new business, which are more likely to default than the universe of large corporate. In this sense, a kind of “vintage” analysis of SME defaults making distinction between new SMEs vs. established SMEs could be useful for the purpose of the discussion paper;
- SME usually have shorter loan maturities hence being more prone to refinance risk at times of prolonged crisis;
- Further consideration should be given to the conclusion presented on paragraph 31, by pointing out, as a major factor for riskiness, the importance of the type of activity performed instead of firm size;
- Though the data focus on riskiness of SMEs no analysis is performed on the riskiness of portfolio composed of Large Corporates and SMEs. In the end that is what matters for capital requirements as stated on paragraphs 32 to 35 of the discussion paper “asset correlation increase with firm size”. So, it seems appropriate to have in place a SME supporting factor in order to incentivise the more diversified banking portfolios that may turn out to be more robust in a crisis scenario.
Q9: Do you agree with the proposed methodology to assess the own funds requirements in relation to SME riskiness? Yes/No. If no, please provide alternative methodologies or indicators, if available.
We do not believe there is sufficient information to evaluate the proposed methodology on own funds requirements robustly. EBF members look forward to the publication of the results of the EBA empirical project.Q10: Did the arrears and loss experience in 2009/2010/2011 exceed an (internal) limit? Yes/No. Were (expected/unexpected) losses adequately covered by loan loss provisions? Yes/No. Please explain and provide specific figures.
Banks will be responding to EBA on an individual basis should they choose to do so.Q11: Do you agree with the above interpretation of statistical data on lending trends and conditions? Yes/No. If no, please explain.
In relation to the statistical data on lending trends and conditions analysis our members would like to point out the next comments:- The EBA should cover all EU countries rather than only the euro area countries.
- The definition of “New Lending” as ‘loans other than revolving loans and overdrafts…’ is a flawed definition which undermines the statistical data. These products are a key source of funding for SMEs. Indeed, for many businesses whose activities are confined to trading, such as those involved in wholesale or retail distribution overdrafts and revolving exposures are frequently the most significant source of funding. This impacts the analysis contained in the section entitled “Lending trends”. By contrary Paragraph 3 in section 4.1 incorporates both overdrafts and loans within the definition of “banking financing”.
- Finally a necessary caveat is that SMEs trends are proxied by loans < 1M€.
Q12: Since 1 January 2014, have you changed your SME credit lending and assessment policies and procedures, specifically as a result of the introduction of the Supporting Factor? Yes/No. If yes, please explain and provide specific examples.
Since January 2014, banks do not seem to have changed significantly their SME credit lending assessment policies and procedures. The risk assessment rather than the cost of funding the transaction in focus is crucial when the decision to grant a loan is taken. The cost of capital does, on the other hand, has an impact on pricing.It can be argued that banks could have changed their policies to the detriment of SME lending if the SF had not been introduced. The SF must have partially offset the disadvantaged position where SME lending was left as a result of the wider regulatory reform
Q13: Have changes to your SME credit lending and assessment policies and procedures been driven by other factors (e.g. competition from alternative sources of SME financing as described in section 4.1)? Yes/No. Please explain and provide specific examples.
No comment at aggregate level.Q14: In your experience, is there an impact of the SME supporting factor on the volume of SME lending compared to other loans? Yes/No. Please explain and provide evidence.
Although there is a wide range of factors influencing lending conditions in the market place, the cost of capital is a decisive factor. Therefore, to a certain extent, the SME SF reduces the cost of SME lending. Otherwise, banks could arguably be forced to deleverage their SME portfolios.The overall impact of the regulatory reform leaves SME lending worse-off than other asset classes in spite of the fact that SME lending was not at the core of the crisis. In particular, the combined effect of enhanced capital requirements and liquidity rules put SME lending at a disadvantaged position compared to other assets. The stricter capital requirements lead to deleveraging whilst the liquidity rules force banks to invest a considerable part of their resources in qualifying assets, mainly government bonds. The stringent scenario is compounded by the overly restrictive conditions for SME loan securitisation.
The original intention was to maintain the capital requirements of Basel II as SME lending was not at the core of the assets that gave rise to the financial crisis.
Please refer to the annex for further evidence on the effect of the SME SF.
Q15: In your experience, is there an impact of the SME supporting factor on the pricing and overall conditions of SME lending compared to other loans? Yes/No. Please explain and provide evidence.
Although this question could be answered with previous response to Question 14, we could complement it by adding that the SME SF is included in calculation of lending rates via the cost of capital. Banks usually set minimum margins for credit transactions and the application of the SME SF allows for a wider range of SME transactions to meet the minimum margin target.Q16: Do you consider SMEs are a consistent group when it comes to access to credit or should a distinction be made between different types of SMEs (e.g. micro, small and medium ones)? Yes/No. Please explain and provide specific examples.
Given the diversity among SMEs, namely on size, sector and market, we acknowledge that further regulatory differentiation might be challenging considering the complexity involved.However, we believe that given the diversity among the SMEs, it is necessary that regulators establish the right balance between complexity and risk sensitivity.
In order to adequately reflect the SME risk profiles, we consider that is necessary a different treatment according to the type of product, geography, etc. SMEs show a clear different behaviour depending on their jurisdiction. SMEs treatment should be calibrated in order to reflect the specificities of the sector and geography where these companies are located. These two components are critical for this segment, highly influenced by the local business culture and the local rules. For instance, some SMEs are not required to publish financial statements according to the local accounting standards.