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What is an SME?

19 October 2018
Richard Kemmish

European secured notes - covered bond like structures - based on loans to small and medium sized enterprises have to answer three questions: what is an SME? What is a loan? And are they any good? None of these questions is trivial.


An SME is - like pornography according to the ruling in ‘Jacobellis Vs the State of Ohio’ - difficult to legally define but you’ll know it when you see it. There is of course an official EU definition, written in 2003 and based on employee numbers and turnover and balance sheets. But even EU legislators admit that the definition is imperfect, later legislation tells you that its ok to ignore the turnover and balance sheet bits and focus on the number of employees. They then go further and say that you don’t have to focus on the employees if you really don’t want to for policy reasons.

Thank you for that carve out. Plenty of countries have created their own definitions as a consequence.

Which is all utterly academic for the purposes of European Secured Notes – covered bond like structures secured on loans to SMEs. Bank IT systems just aren’t up to it. No bank records the number of employees of the companies that they lend to. Only in one country (a country with control-freak tendencies) did I meet banks who can actually say, with auditable certainty, that they can tell me which of their exposures are to SMEs and which to companies which are larger than the official definition (and I’m not sure that I totally believed them).

Never mind, we can use loan size as a proxy. If a loan is to a company and for less than €1.5mn then it is probably safe to say that it is a loan to an SME…most of the time.

I use the word ‘loan’ loosely. Exposures (better word) to SMEs take many forms, most of which are strikingly country specific. In some countries almost all of the exposures are short term, revolving exposures to fund working capital. In others most are in the form of leases to fund capital equipment (you will find out which countries on 1st January next year when IFRS 16 comes into force, the impact of this seems to have been totally ignored by most people; wrongly so. But I digress).

The wonderful, vibrant diversity of European bank’s exposure to small businesses means that it will be utterly impossible to define the form of the exposures that would be eligible to back ESNs. At least impossible to agree a definition that will be widely accepted in all countries. Whereas there are some things that it is best not to legislate, the implication for the ESN market’s development are very significant: there will be a lot more diversity of assets and structures than we currently see in the traditional covered bond world.

Then there is the matter of defining what a good exposure is. In mortgage land loan-to-value may be a crude measure of credit with significant national variations in it’s power to predict defaults but it is easy to understand and easy to harmonise. No such metric exists for SMEs. Attempts to define them (with reference to balance sheet ratios for example) invariably fail.

But all of the predictive power of a bank’s credit assessment is captured in their risk model if they have been given permission by their supervisor to move to the ‘internal ratings based’ approach for capital allocation. Banks that have passed this test represent about 65% of the total lending to the SME sector in Europe (took me ages to work that number out). If an IRB based minimum credit quality were to be used it would be credible, signed off by regulators and cover most of the sector. It would also provide an incentive to banks to move to more sophisticated risk management systems.

SME loans as eligible collateral will always be more difficult to define and measure than residential mortgages. That doesn’t mean that they are impossible to use.

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