In July, Europe’s first certified credit rating agency for small and medium-sized enterprises (SMEs) was launched, holding out the promise that as many as 25 million SMEs across Europe may be able to obtain corporate ratings, which have traditionally been reserved for larger, publicly quoted companies.
The new agency is a commercial joint venture between two fintechs. Wiserfunding, founded in 2016 by professor Edward Altman and Gabriele Sabato, uses financial history and a range of publicly available structured and unstructured data to assess the creditworthiness of SMEs across Europe. It will work together with a competitor in the same field, modefinance, which was founded in 2009 by Mattia Ciprian and Valentino Pediroda to develop artificial intelligence solutions for the assessment and management of credit risk.
Pediroda, chief executive of modefinance, says: “Financial technology has opened up new opportunities for SMEs, in particular through the expansion of financing methods and access to credit. With this new bond rating initiative aimed at European SMEs, we are helping a sector that has suffered greatly in recent years while on the hunt for credit to support their growth.”
Gabriele Sabato, Wiserfunding
Sabato, chief executive of Wiserfunding, explains how the two companies will work together: “The idea is to use our SME Z-score score as a key input in the ratings process. But we are not a ratings agency and we have been unable to fulfill requests from some large banks who use our service. We were looking to partner with a ratings agency and found a connection with modefinance, a young company like us and heavily focused on technology.”
In 2015 the European Securities and Markets Authority (ESMA) approved the registration of modefinance as a ratings agency and the new joint venture will apply this wrapper to credit assessments based on Wiserfunding’s credit score.
Sabato tells Euromoney: “Ratings analysts will take that initial credit score and then apply a judgement which also takes account of the economic outlook for the market in which a company operates and its likely prospects. But that judgement cannot diverge markedly from our score.”
The ratings scale will include 21 classes, ranging from the highest rated A1 down to C3. “If our credit assessment classes a company as a B2 credit, the ratings analysts cannot assign it a C3 rating,” says Sabato.
The process of applying for a rating from one of the larger agencies can be long drawn out and costly, ranging from weeks to months, which puts it beyond the resource of most SMEs. And lack of ratings is likely to hurt these companies increasingly.
Bank regulators struggle to admit that they have impeded SMEs’ access to credit in the avalanche of post-financial crisis reforms, despite all the evidence of reduced supply – which they try to blame on reduced appetite to borrow. In June, the Financial Stability Board (FSB) put out a consultative paper designed to mark its own homework. The headline conclusion was that: “The analysis thus far does not identify material and persistent negative effects on SME financing in general.”
The wordy style – ‘thus far’, ‘material and persistent’, ‘in general’ – betrays the lack of confidence in this assertion that regulation has not reduced the availability or increased the cost of lending to SMEs. In the very next breath, the authors concede: “There is some evidence that the more stringent risk-based capital (RBC) requirements under Basel III slowed the pace and, in some jurisdictions, tightened the conditions of SME lending at the most ‘affected’ banks (ie those least capitalized ex ante).”
They later admit that these most affected banks “have increased loan rates charged to SMEs relatively more” and insisted on more collateral. Most SMEs have no such collateral to post.
Banks that have spent large sums developing internal risk-based models have managed to avoid the worst impacts by calculating their own measures of probability of default and loss-given default on their SME loan portfolios. But from 2022 the new system of input and output floors will limit how far banks can diverge from the standardized approach, which typically applies a 100% risk weighting to unrated corporate loans.
In Europe, where SMEs rely much more heavily on bank lending than in the US, the Capital Requirement Regulation introduced a supporting factor (SF) to offset some of the impact of higher Basel III regulatory capital requirements on loans of up to €1.5 million for SMEs of below €50 million annual turnover. But there is no evidence this has stimulated lending to SMEs. The FSB points to a 2018 study that finds that “the SME SF alleviates credit rationing for medium-sized firms, but not for micro/small firms or if all SMEs are analyzed together.”
Sabato tells Euromoney: “What is happening now with Basel III is that no matter how low a bank’s own assessment of its regulatory capital requirement goes under the advanced internal ratings based approach, it will not be able to diverge far from the standardized approach that will be the basis to calculate the output floor.”
The implication is clear, he says: “Basel III rules will further reduce the availability of credit to SMEs and output floors will raise the cost of capital for banks making such loans and so increase the cost of credit for borrowers.”
Banks are now shifting their focus from internal models to lowering their standardized capital requirements. “And there is only one way to do that,” Sabato says, “get as much as possible of their loan books rated.” He adds: “Obviously, most SME loans will be unrated.”
The revenue model for the joint venture is that banks will pay for ratings, not the borrowers. This seems a good approach. The financial crisis proved that investors should always be suspicious of ratings that issuers themselves have paid for.
Sabato says the process will be fast and lower cost than ratings from the larger ratings agencies, essentially requiring automated retrieval of data, most of which has already been collated in making an initial credit risk assessment.
“We can reduce the time to a few hours,” he says. “That means that banks with thousands of SME loans could get them all rated. One day, we would like to see every company have a rating from a regulated and licensed rating agency.”
That might in turn increase the flow of funds to SMEs from non-bank providers, which may not be subject to the same regulatory capital requirements as banks but are suspicious of buying diverse portfolios through securitizations.
“The problem for investors with securitizations is that they depend on the original lenders’ own assessments of the underlying loans, whereas we would be independent,” Sabato points out.
The new joint venture is already running three pilot programmes with European banks – one in the UK, one in the Netherlands and one in Italy – all top five banks in their countries. Although modefinance’s ESMA licence as a rating agency only extends to Europe, the venture could look beyond the region eventually, perhaps partnering with other ratings agencies.