Month: November 2011

 

Securitised SME Loans, More Competition, Support Financial Services Innovation – Hurrah for NESTA!

Originally published in Entrepreneur Country, 25 November 2011.

NESTA, the National Endowment for Science, Technology and the Arts, (www.nesta.org.uk) in collaboration with Sam Gyimah, MP for Surrey East, today published the long awaited report proposing recommendations to help improve British SME’s access capital.

The key recommendation of the paper is the set up of a British Industry and Enterprise Bond scheme. Bonds issued by the government, predominately to institutional and also retail investors, that pay interest based on an underlying pool of securitised SME loans.
The proposal is a good one. The paper addresses the mechanics; rather than the securitisation occurring at the bank level, the Government should purchase the loan portfolio’s from banks then securitise and sell this asset backed bond to investors, providing guarantees beyond a level of default on the underlying portfolio to insure against the catastrophic impact of mass distress/default on the loans. We have seen the consequences of mis-management of these types of assets before –they are part of the family of Asset Based Securities (ABS) that includes Mortgage Backed Securities (MBS).The paper touches on some of the obvious concerns of such a scheme. Will the scheme stimulate more lending by the banks? Potentially, as it frees up the balance sheet of the banks, compelling them to lend to SMEs as the continued Government purchase of the portfolio will deliver a source of funding for the banking operations – liquidity is one of the biggest concerns of the banks due to the issues in sovereign debt markets, their traditional source of raising cash.

What about Moral Hazard? If the banks know they can offload the loan portfolio to the Government, will they be more gung-ho in their assessment of risk when providing loans to SMEs? NESTA and Mr. Gyimah suggest that the banks be made to buy portions of the bonds themselves, across all tranches of risk (for a detailed description of how securitisation works, I would rather you refer to Wikipedia), thus continuing to be exposed to risk themselves.

The argument is a little weak in reasoning and one of my few criticisms of the report; banks have being doing this for a long time with ABS; it does not work as effectively as one might think. ABS bonds have a considerably higher credit rating than the underlying loans, especially with the Govt guaranteeing against default on those loans, as proposed in the paper. Thus the capital charge for holding the Bond is much much lower, regardless of the tranching that occurs. So, offloading the high risk to Govt, being forced to purchase low risk bond tranches, still promotes hazard and gives more capital for the banks to gamble with. The government, and thus the tax payer, will bear the brunt of any problems that occur. Fair dues to the authors who state:

“The issue of asymmetric information and the possible passing off of bad loans would be one of the main tasks of the managers of the new entity”.

The paper suggests using Experian to measure the credit worthiness of the underlying loan. Mmmm, I must confess to a little giggle when reading this section. xperian, Equifax and other business data/credit agencies have come in for a great deal of criticism in the press recently around the disparate methodologies and ratings of SME risk. Further, a 3rd party has no real vested interest (skin in the game) to do a good job, reputational risk aside. I would like see a group of specialists employed by the Government perform the risk assessment, with 3rd parties, such as Experian being used as auditors of the process. Another one for the managers of the scheme to resolve!

The expansion of securitisation beyond a unilateral Government scheme is discussed with supporting data from an intelligently administered survey through MORI. The suggestion that specialist non bank commercial lending institutions with a trusted reputation in SME lending, be permitted to also issue securitised bonds for investors provides a breadth to the recommendation that is applaudable. Free market forces, supported by the Government, the right processes and market structure, will inevitably lead to a better, more robust product then the Government acting alone.

Credit Easing and the potential establishment of a state controlled bank are considered and dismissed – well thought through and pragmatic arguments are presented that demonstrate the ineffectiveness of either solution to resolve the immediate pains being felt by SMEs while toeing the line of proposed regulation.

The other major proposal of note is one of “soft” (private sector led) structural reform of the financial sector; looking at new innovations and new models of lending that enable greater competition and/or focus banks on core capabilities (risk management), to better deliver services to consumers. Direct Bond Issuance, championed by Will King of King of Shaves fame, an unexpected but amiable figurehead for SME capital as a result of his “shaving bonds”, is put forward as a solution for larger firms.

Innovation in financial services is accelerating, the sector is unlikely to look the same in 10 years time. Matching those with Capital to those that need it, leveraging technology, new business models and focusing on specific strands of the financial services value chain, will evolve the industry for the better. Solutions such as Funding Circle (mentioned in the report), our own EuroTRX, MovenBank, Crowdcube, Zopa…will hopefully be the big names we all, business and retail alike, turn to for our financial needs in the future.

The UK’s SMEs have been crying, pleading, for a legitimate solution to their lending issues for several years. “Beyond the Banks” presents a well thought through and viable resolution that should give SME’s reason to cheer. Execution is key – Will the government act, and if so, how soon? We wait with baited breath for George Osborne’s statement next Tuesday; fingers crossed that he follows through with some of the report recommendations and provide the spark for the light at the end of the tunnel.

The Need for Industry Innovation to Improve SME Financing

Originally published in Entrepreneur Country, 23 November 2011.

Credit/lending to SMEs continues to catch the headlines. The banks’ promises under Project Merlin are still not being met, though the situation has improved. Interestingly, the proportion of lending through various means of asset based finance has apparently risen, with ABFA’s recent press release specifically highlighting the growth of invoice finance over the past year.

ABFA (http://www.abfa.org.uk) do a stellar job of promoting the industry with the limited budget they have, but I believe more can be done.

Looking at ABFA’s own statistics: 48,172 companies used factoring or invoice discounting at the end of 2008 – a figure which has fallen to 41,486 by 30th June 2011.  They also claim that,

“the latest figures show invoice finance clients are (again) choosing not to access all of the funds available to them. Total available funds this quarter were £22.2bn, with £6.5bn of finance available but not drawn.”

Can it be that the majority of clients are “choosing not to access all of the funds available to them?” I believe the truth is more likely to be that the figures are rendered somewhat meaningless by the 496 companies with annual turnovers in excess of £50m who represent 1.2% of clients by number but one third of the turnover in ABFA’s statistics.

The reality is that as far as the SME sector is concerned, the invoice finance industry, dominated by our well known and creaking high street banks, is running fast in the same spot, and has been for the past few years.

With the state of the traditional lending to SMEs being what it is, the window of opportunity for independent, non-bank firms within the asset based finance industry is tremendous. An opportunity to be the good guys, an opportunity to help the economy, resuscitate business, play a key role in getting the Economy growing again. They can work to change the perceptions of asset based finance and specifically invoice finance – make access easier for business and demystify the perceived complexity. Bolster marketing, re-position, innovate.

Sadly this is not happening, well, not to the extent it should be. Some claim (the banks) that the British Banker Association statistics for company borrowing continue to show that demand for debt from companies, specifically SMEs, is not there, and that the continued fall in net borrowing is a result of companies paying back loans to wipe debt off their books in these gloomy times.

Certainly, reduced confidence in growth and the economy as a whole does make SMEs cautious in their ability to continue to service debt. But in this lies the solution and enlightenment; traditional debt finance requires continued interest payments, impacting a firm’s cash flow and further straining working capital – the cash available to a business to service its monthly operations. Injecting capital through Invoice Finance does not. To simplify: Cash in from debtor, repayment out to financer, debt closed.  Eureka!

The incentives for selling invoice finance to SMEs are just not strong enough. If an invoice finance salesperson is trying to grow their loan portfolio by 10 percent, they are more likely to get there by making fewer larger sales than a whole lot of smaller ones, particularly as the time taken to sell the facility to a larger firm relative to a smaller one is still marginal compared to the potential return.

Many small businesses have lost faith in the banking sector and are looking at other means of finance. Research firm BDRC recently published a survey that found that bank refusals on borrowing applications/renegotiations have increased since the 2008.  The mere fact that SMEs are turning to other forms of finance – Peer to Peer lending networks, retail bonds even pawnbrokers, suggest there is still a demand for capital. Asset based lenders should seize the opportunity.

Having spoken to many in recent months, I also believe that other non-banking financial firms, those that do not currently compete in the asset based finance arena, can add considerable value.  There is a demand to access the market from a variety of firms: hedge funds, family offices, alternative investment advisors, private banks. These firms, more streamline in their operations with lower overheads, can deliver more competitive funding rates for business while still turning a decent profit on the risk they are taking. They are very interested in investing in new and alternative asset classes to diversify their portfolios and exposures.

It was interesting to read the following in the interim report by the Independent Commission on Banking Reform, published in April 2011,

“…..reforms that stabilise the UK banking system may also raise its costs. This may cause some activities to move to non-banks, foreign banks, or capital markets………. Non-banks may well be better-placed than banks to conduct some financial activities, and limiting the implicit government guarantee for banks may also encourage some activities to move out of the banking system. To the extent that shadow banks can safely remove risk from the banking system, an increased role for them will be positive for financial stability.”

The issue for non-banks is one of sourcing – they have no capability in this area nor in the area of due diligence. Sourcing and relationship management is a heavy cost even to existing participants in the industry and, coupled with consumer perceptions, makes client acquisition far from easy.

What is the solution? We all have an opinion, here is mine. Fragment the industry value chain. Narrow the focus of firms within the industry to a small set of core capabilities that they can excel at, let others take over the management of marketing, sales and distribution; going beyond the “lifestyle” brokers that proliferate the industry. Put more emphasis on consumer needs in the delivery of financing, make them more comfortable with the solutions provided. Leverage a new breed of innovative services that use technology to deliver massive scalability in terms of clients, services that demonstrate competency in marketing and sales and are driven by volume rather than deal size.

All participants, old and new, supporting service providers and potentially most importantly, businesses, will win– innovation at the industry level, not just at the product and process level, delivers the greatest rewards.

Misleading Data – The Truth Behind Project Merlin Figures

Originally published on Entrepreneur Country, 15 November 2011.

Following a period of discussion between the Government and the major UK banks, known as ‘Project Merlin’, a statement was made by the banks on 9 February 2011.As part of that, the banks stated a capacity and willingness to lend £190 billion of new credit to business in 2011, with £76 billion of this lending capacity allocated to small and medium-sized enterprises – 40% of the total lending target.

The Q3 2011 Project Merlin figures released today show that the major banks have once again failed to meet their quarterly targets. Banks lent a total of £57.4m to non-financial corporates, with £18.8 billion of that figure going to SMEs. The SME lending target for Q3 was £19 billion.

Some may argue that the numbers still look good – a shortfall of £200m is not too bad. Couple this with the banks’ insistence that demand from SMEs for debt is low and the numbers looks almost rosey.

However, some serious cracks appear when we dig a little deeper, cracks that cast concerning hazards for business on the road to recovery.

The obvious first: the amount lent to SMEs in Q3 is 8.3% less than the previous quarter. Considering seasonality, demand for capital tends to increase in Q3 and Q4, principally as the business machine gets back into gear after the more relaxing summer months, gearing up for year end.

Proportionately and logically, given the intrinsic incentives of proposed capital adequacy regulation under Basel III and the Vickers report, it is clear that banks are shifting their lending strategy to more reliable credits: larger corporations. The proportion of lending to SMEs as a percentage of total lending in each quarter is Q1:35%, Q2: 38%, Q3: 32%.

Now the crunch: lending numbers reported by the BOE are on a GROSS basis – i.e. inclusive of existing facilities that are rolled over. Considering the onus on stimulating the economy and the widely repeated statement by senior politicians and economists that SMEs are the lifeblood of the stimulus, one would be fair to assume that more new money is being lent each quarter than is expiring as facilities are closed. WRONG.

Simple math: Previous quarter’s lending + new lending – expired lending = current quarter gross lending.

For Q3: £20.5 billion (Q2 gross to SMEs) + new lending – expired lending = £18.8 billion

New lending – expired lending = -£1.7 billion

Expired lending exceeds new lending by £1.7 billion!

For clarity: Banks did not make £18.8 billion of NEW money available to SMEs in Q3. In fact, they lent less new money to SMEs then was paid off by SMEs; £1.7 billion less, 9% of total lending for the quarter.

Without question, a reasonable percentage of facilities will have been rolled over. For illustration, let’s assume £10 billion for simplicity, though I hazard a guess that number is far greater. That would mean expired facilities totalled £5.25 billion while new lending equalled £3.55 billion.

Certainly, reduced confidence in growth and the economy as a whole does make SMEs cautious in their ability to service debt. This is further expounded by the perception, recently corroborated by the Federation of Small Business, that banks may pull credit lines at short notice or change the terms of lending agreements. SME facilities will be the first to be impacted should banks need to shore up capital themselves due to issues in other areas of the bank.

The banks are no longer the most effective means for SMEs to access capital. A number of new innovative services are coming to market to help address the pain felt by SMEs. These services seek to positively disrupt the industry by providing more power to and better meet the needs of the SME consumer.  Services such as Funding Circle (www.fundingcircle.com ), MarketInvoice (www.marketinvoice.com ) and Zopa (www.zopa.com , consumer loans), have all made a splash. Recent figures suggest that as much as 10% of consumer lending in the UK may be facilitated by P2P services. Businesses, particularly SMEs should take note.

However, with this first wave of innovation, imperfections are inherent and there is undoubtedly room for further refinement of service to provide the best fit solution for SMEs. We, at EuroTRX, have sought to identify the gaps in order to shape a more robust and sustainable solution for SMEs. We don’t believe alternative loans are the answer. We believe that the predominant need is for working capital, and that an invoice exchange, delivered in the right way, will best fulfil the need.

Invoice financing in its current guise accounts for less than 5% of business funding in the UK; a criminally low percentage considering the relative benefits of invoice finance to traditional debt finance such as loans and overdrafts. No interest to pay that further impacts cash flow, more effective use of balance sheet assets, inherent security for funders (invoice buyers) thus nurturing more demand, and generally improved financials and ratios for the business borrower (invoice seller). The barrier has always been the complexity of the delivered service, the unnecessarily high cost and the lack of awareness of invoice finance. EuroTRX, when we launch, will change these dynamics for the better, delivering a more transparent, lower cost, sustainable and flexible service to SMEs by connecting them with non-traditional non-banking sources of finance in a user friendly online auction platform. We are determined to deliver the right solution for UK businesses.