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.

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