At the end of June, UK Finance, the trade body of the UK banking industry, unveiled a survey of 18,000 small and medium-sized enterprises, which produced the happy finding that most are succeeding in accessing finance from banks, with 80% of applications being approved by lenders.
That’s supposed to be the good news. But it might be the bad.
These companies have more than access to credit on their minds. Stephen Pegge, managing director, commercial finance at UK Finance, admits: “This survey suggests many small businesses across the country are increasingly concerned about the ongoing uncertainty over Brexit.”
Concern extends to the worsening economic climate and is highest among small firms in London, the north east and west midlands.
They should take courage, though. Pegge says: “The banking and finance industry is ready to support viable businesses whatever the outcome.”
That may be nice for them to hear, but Fitch is worried about some banks being too accommodative. “UK challenger banks may be more vulnerable than more established banks to late-cycle and Brexit-related risks,” Fitch Ratings found in a report published on the same day as UK Finance's survey results.
This echoes the recent findings of a review by Melanie Beaman, director of UK deposit-takers supervision at the Prudential Regulation Authority, that fast-growing lenders with a limited track record could be underestimating potential losses on their loan portfolios.
Beaman reports that most such fast-growing firms (FGFs) that the PRA recently tested were “overly optimistic about the potential impact of a stress scenario on their business”. Beaman says: “This was most apparent in their assumptions about stressed impairment rates that could emerge and their ability to raise capital, dispose of parts of their business, or widen their margins in the context of a market-wide stress.”
Challengers want to build share and hope to convince backers that any downturn is the time to do so.
Worryingly, however, Beaman says: “Many FGFs did not demonstrate an understanding of the stress drivers for their business, were unable to explain the assumptions made in their stress testing models, and/or to analyze the sensitivities of their business models to these assumptions.”
In that case, the PRA has much work to do.
In fact, UK policymakers should look to their own contribution to the build-up of risks in the system. They have sought to boost provision of credit to SMEs through the so-called alternative remedies package: an unusual scheme cooked up between the UK government and the European Commission to reduce RBS’s share of the SME lending market following its state bailout 10 years ago and subsequent failure either to float Williams & Glyn or sell the subsidiary to a smaller competitor.
This had been a requirement of the European competition authorities and the fumbling of it was a big embarrassment to the UK government. RBS complained it could not hope to sell off Williams & Glyn due to the aversion of investors to UK bank stocks thanks to Brexit.
That aversion was entirely rational.
However, an agreement was struck in 2017 instead to distribute £833 million, some through incentivized switching, with £425 million pooled in four disbursements mostly to UK challenger banks. This is now almost complete, with the biggest beneficiaries of the largest pool A being Metro Bank, which received £120 million, Starling Bank (£100 million) and ClearBank (£60 million). From pool B, Nationwide Building Society took £50 million, while Investec Bank and Co-operative Bank received £15 million each.
|Gabriele Sabato, Wiserfunding|
In June, five much smaller grants of £5 million each from pool D went to fintechs seeking to commercialize technology relevant to SMEs. In mid-August, four final grants of £10 million each from pool C will be announced by Banking Competition Remedies (BCR), the independent body administering the scheme.
A lot has been written about the mechanics of these grants, most of which ignores a simple but fundamental question: is this money going to the right institutions best placed to support the economy by funding SMEs? Or is it likely to be wasted?
At about the same time buyers for Williams & Glyn were falling away, the former head of risk appetite portfolio decisioning at RBS, Gabriele Sabato, was preparing to co-found a fintech providing risk management tools focused on SMEs.
The other co-founder of Wiserfunding was Edward Altman, emeritus professor of finance at the Stern School of Business and author in 1967 of the Z-score formula for predicting likelihood of default. This looks at ratios to total assets of working capital, retained earnings, earnings before interest and tax and annual sales, as well as at market value of equity to total liabilities.
As European policymakers focused on boosting finance to SMEs, the Italian stock exchange had approached Sabato and Altman to build an underwriting model for a new channel to sell mini-bonds from such companies to institutional investors that might not know these issuers.
“SMEs have traditionally been the missing middle, not well covered either by bank risk models that focus more on retail or larger, listed corporates or by rating agencies,” Sabato, chief executive of Wiserfunding, tells Euromoney. “The models we have built work on both structured data – companies’ published accounts, latest macroeconomic statistics – and unstructured behavioural data, including governance and the experience, background and connections of company directors. We have invested in new technology to connect to all the relevant databases through APIs and so automate speedy collection of this data and enable fast decision-making.”
This is not replacing credit underwriters, rather arming them with efficient access to essential data inputs for risk models dedicated to SMEs with annual turnover of anywhere from €1 million to €150 million.
“The SME segment has enormous potential but is immensely complex, because individual companies tend to have idiosyncratic risks and yet are quite correlated with each other,” Sabato says. Wiserfunding still partners with the Italian stock exchange but has retained ownership of its model and extended it across Europe.
SMEs have traditionally been the missing middle, not well covered either by bank risk models that focus more on retail or larger, listed corporates or by rating agencies- Gabriele Sabato, Wiserfunding
“It became clear we needed different models for each country and even for industry sectors within those countries,” Sabato says. “Right now we have 43 models across eight countries and we are now working on new models to launch outside Europe over the next 18 months, notably for India, China and the US.”
Who takes the offering?
“Most are alternative, non-bank lenders – leasing companies, P2P lenders, insurers – some incorporating it into their relationship management tools to check if it is actually worth the effort and cost to acquire of engaging potential new clients. We do have two smaller banks using our tool and several corporates also using it to assess the credit of suppliers and customers.”
And this is where Sabato sees potential problems ahead. His analysis is that the alternative remedies scheme has boosted the supply of credit to SMEs when, despite the experience of OakNorth and iwoca, overall demand to borrow is depressed thanks to Brexit, a slowing economy and faltering confidence. “More than 60% of UK SMEs would rather slow their growth than borrow money to speed it up,” he says.
But recipients of alternative remedies funds have made undertakings to extend loans and may fall into the trap of adverse selection, being so desperate to attract new customers that they end up lending to weak credits.
“I see banks struggling to find SMEs that want to borrow. Many creditworthy ones have withdrawn from the funding market and rely on retained earnings and internal resources. The competition between lenders and the price to onboard new SME clients is out of control at this point,” Sabato says.
“What is needed now is not new money but rather a mix of incentives for entrepreneurs to found new companies, education around debt for start-ups so they are prepared for managing it when they take it on, and a compelling proposition that might tempt more creditworthy, established SMEs back. However, only the smaller Pool D grants focus on this.”
I see banks struggling to find SMEs that want to borrow... What is needed now is not new money but rather a mix of incentives for entrepreneurs to found new companies [and] education around debt for start-ups- Gabriele Sabato, Wiserfunding
Even while default rates look encouraging for now, thanks to low interest rates, this is a moment to be wary. Sabato says: “If you look back at the crisis in 2008 and 2009, banks’ biggest losses on SMEs came from loans extended in the two years immediately prior to the crisis when they were all trying to grow fast. Since 2017 we have seen a constant reduction in credit quality of UK SMEs mainly thanks to exogenous factors such as Brexit. If there is any sort of market correction in the next 24 months, which is reasonable to expect, then all this leverage is going to downgrade very fast and lead to some very bad outcomes.”
Who will suffer the biggest hits?
Sabato suggests: “Smaller alternative lenders look more risk-aware to us, while the medium size and larger challengers need to meet growth promises made to their backers and may be relaxing lending criteria to do so.”
It’s hard for challengers that have promised growth to venture capitalists and, in some cases, public investors to change tack. In July, Funding Circle reported half-year results and slashed revenue growth forecasts for 2019 from 40% to 20%. It is finally facing up to reality.
Samir Desai, chief executive and co-founder, explained: "The uncertain economic environment has reduced demand from small businesses and led us to proactively tighten lending criteria. As a result, revenue growth will be impacted. We recognize that this is a change from our previous guidance, but we are taking the prudent course of action for the long-term growth and development of our business."
How did investors reward this new-found prudence? The share price, which had stood at £2.50 on June 20, fell to £1.15 on July 2, declining nearly 30% on the day of the announcement from the previous close. There it rested, nearly 74% below the price at which Funding Circle floated in October 2018.
If prudence becomes the new watchword instead of growth, what should SME lenders be doing?
Wiserfunding claims a 90% accuracy ratio for its models in discerning one year in advance which SMEs might default.
One of the regular claims of challenger banks and fintechs now targeting SMEs is that they have all built new and better credit underwriting algorithms that incorporate gee-whiz technology working on non-standard data such as analysis of business activity and customer ratings on merchant platforms like Amazon and eBay.
That’s not what Sabato finds, though. He tells Euromoney: “I have been surprised over two years of business development. I go to some of the big new lenders expecting them to say they already have a better system than ours for assessing credit risk but instead they tend to say, ‘this is exactly what we need.’”
Where does SME credit risk modelling go next?
Sabato says: “The new frontier is continuous underwriting, which will come if we can connect directly with SMEs’ accounting software and, subject to their permission, take regular, perhaps monthly, updates.”
It has come as a surprise to many that open banking has been slow to take off, but there seems to be a different feeling around accounting software which might be a source of much more useful information than a current account.
“One of our lending clients has permission from 70% of its SME clients to access their accounting software,” Sabato reports. “SMEs can see that giving such permission might bring better service or pricing. So, on financing against invoices, for example, the lender might give a decision within 24 hours at zero cost to a company when it has access to accounting software, instead of taking three days for clients where it doesn’t have access and charging even if it doesn’t advance funds.”
Such small, fintech initiatives might be useful in the long run for creditworthy SMEs in a more robust economy. Right now, regulators should be on high alert and investors wary, especially of lenders re-packaging SME loans recently put on in an effort to demonstrate growth to their venture capitalists for securitization.