Small and medium-sized enterprises account for 75% of employment in the eurozone, according to data from the European Commission, making them the engine house of the European economy. As a result, banks and other financial institutions have faced constant pressure to provide loans to revive SMEs ever since the beginning of Covid-19.
Beyond pure economics, the survival of SMEs has been an important cause for regulators, traditionally those leaning to the left of centre.
While all kinds of government resources and private market funding mechanisms have been deployed to help SMEs, securitization is one of the most efficient — yet overlooked — means of funding.
There are two main types of SME securitizations that market participants use: synthetic risk transfer deals and private or public term ABS — both of which have helped shore up and transfer liquidity to where it is most needed.
From SRTs to private deals
Synthetic risk transfers enable banks to continue extending loans to SMEs without breaching their capital limits. The mechanism works by allowing banks to sell the risk from loan portfolios to investors, thereby freeing up space for new loans. Because SME loans are not the easiest asset class to securitize in a cashflow structure, synthetic risk transfers have been the preferred route for many market participants.
“You are not raising new cash against them or moving anything from the balance sheet,” says Richard Hopkin, managing director and head of fixed income at the Association for Financial Markets in Europe. “An integrated strategy of synthetics combined with cash securitization is probably the optimal strategy that we would expect most of our bank members to use.”
The European Investment Fund (EIF), majority owned by the European Investment Bank, has played a crucial role in using synthetic risk transfers to help SMEs, especially through working with smaller European banks in Italy, Spain and Greece. As a government entity, the EIF has the role of guaranteeing the junior loans in a given portfolio, so banks can hand off the guaranteed loans to investors. In theory, synthetic risk transfers are designed to improve the economy because, through the risk offloading mechanism, businesses can receive loans from banks more easily, as well as at better rates.
Since 2015, the EIF has guaranteed more than 60 deals totalling around €9bn, according to Giovanni Inglisa, structured finance manager at the EIF. The bulk of the EIF’s deals related to SMEs have been synthetic securitizations.
“We have been a truly countercyclical investor,” says Inglisa. “As the market was freezing up in 2020, private investors, hedge funds and issuers were looking at this market wondering what could be done with SMEs, and we were able to jump in to help.”
The EIF is working on opening up new markets for SME synthetic risk transfers, particularly regional banks or areas that are underserved by the general private investor market, says Inglisa. For example, Romania is one of the newer markets the EIF is looking to help.
Another helpful tool, though less widely used, is traditional securitization deals, both in private and public form. Throughout the pandemic, fixed income law firm partners have been involved in discussions with European multilaterals to figure out ways to bring greater financing into the market. One answer to that has been the classic securitization deal backed by SME loans, sources say.
However, after countries come out of the lockdown, a good number of multilateral organisations will have to get involved in securitizations to reassure and draw in bank participants because banks lack experience in pricing the risks in this type of financing.
“Private investors won’t come in without some understanding that multilaterals will enter,” adds one law firm partner.
In terms of investor appetite, demand is still strong for synthetic risk transfer SME risk, mostly from private market investors.
“From the private financing side, my feeling is the credit tone is quite strong and pricing is tight,” says Andrew Scourse, managing director, securitization at Santander. “There is a significant credit appetite to invest in various risk transfers as well.”
Issuer appetite for synthetic risk transfers also remains strong. The EIF, for instance, has found that there are more opportunities versus resources, so their pipeline always fills up very quickly.
“Issuer appetite remains the same,” says Inglisa, “Our 2021 pipeline is already very busy and we hope to shortly access additional resources to take up further opportunities for transactions.”
What the ‘quick fix’ doesn’t do
As of April, synthetic risk transfer deals are eligible for the simple, transparent and standardised securitizations (STS) framework. The changes came as a part of what was called a “quick fix” to the securitization framework by the European Parliament, aimed to help put the economy back on its feet.
The amendment makes synthetic risk transfers a purely risk-moving or hedging tool, rather than something to gain profit from. More specifically, the rule makes changes to the synthetic excess spread, the amount left over in a deal when investors have been paid. The new excess spread amendment ensures that there is “skin in the game” for investors as well and prevents them from charging excessive premiums.
Overall, market participants believe the amendment is helpful. For one, the quick fix is a sign of the European government’s understanding of what securitization can do for SMEs, seeing it as a part of the solution, not the problem. Otherwise, the European Commission would not have made those changes, sources say. Traditionally, a part of the problem has been that regulators are doubtful over securitization as a financing tool in the European Union.
Regulators have tended to minimise the role of securitization, viewing it as a trivial yet complementary tool to use along with state support. As a result, securitization was not able to be effectively applied across Europe. However, as regulators saw they were lacking solutions to bring businesses back to life, they began looking at securitization in a more favourable light.
“My slight pessimism is that securitization is understood well in the US, but not enough in Europe,” says Debashis Dey, a partner at White & Case. “In Europe, it has been hard to get the levels of funding we need versus pre-crisis. If we did have those things, we could have offloaded the risks banks were worried about. We can create SME funding platforms. The EU regulations had not previously been supportive in that regard.”
Though not the final solution, the combination of bank appetite and regulatory changes is a great first step forward to extending more help to SMEs.
“I think it’s premature to say securitization has played a huge role in helping SMEs, but with the regulatory changes we may see the impact of securitization even more,” says Dennis Heuer, partner at White & Case in the Frankfurt office.
On the other hand, some market participants are worried that the new rule takes away the economic benefit synthetic risk transfers used to have, because risk transfers are now supposed to be a purely de-risking mechanism. Since risk transfers take up a lot of time, money and effort to structure, issuers may not be incentivised enough to keep doing them if they are not allowed to obtain monetary gain from it.
“The key problem remaining is the capital treatment. If there are no economic benefits, you may ask yourself the question: will I invest time and effort?” says Hopkin. “Nonetheless, the Commission is going in the right direction and we welcome the support from regulators.”
If banks begin to think the new rule is too much and there is little capital benefit, synthetic risk transfers may become a tool not worth bothering with. That would make many parts of the SME funding market no longer viable.
“The beauty of securitization is that if you can achieve risk transfer and free up the balance sheet, you can recycle capital,” says Hopkin. “And if you can’t do that because of overly strict prudential requirements, then you are just not going to do it any more. Banks will have to stop.”
Another slight annoyance that market participants are complaining about is the long form they must fill out about their synthetic risk transfer deals, even when the deal is private. The requirement is meant to inject transparency into the SME funding market, but adds another hurdle for private investors to have to deal with.
What worked and what didn’t
Some regions get more help than others depending on how their markets are set up and how transparent the jurisdictions are. Scandinavian countries, for example, are not typically markets where you see securitization, so naturally there are not a lot of securitization deals that have been done to help SMEs.
On the other hand, Germany and Spain are very active securitization destinations and have an established SME banking infrastructure even outside of securitization.
“I don’t think it’s easy yet to pick out clear outperformers and underperformers. However, it is possibly easier to look at it by sector,” says Scourse. “Sectors like travel and hospitality, with some exceptions, are difficult areas, whereas some other industrial segments have functioned pretty well even with the restrictions.”
Other types of risks that may not be every issuers’ first choice include highly seasonal businesses such as vacation homes, outdoor businesses or holiday-related enterprises.
In the future, fintechs may rise as new players that can funnel liquidity to SMEs that need it most, using the rich pool of data they have gathered over the past few years.
“Thinking positively, I believe the economy coming back to life opens up almost a new window for new SME financings to come to life,” says Dey. “What I am seeing more of is digital lenders who operate via platforms using all kinds of digital data they collect. They are reaching out more and more to SMEs and I think that can create a lot more volume for SMEs.”