With a plan by the UK government to provide support for smaller businesses through the bond market short on detail, covered bonds backed by SME loans could be in the mix. However, market participants disagreed as to how welcome any such development could be in a debate taking in French, German and Turkish developments.

UK Chancellor George Osborne

UK chancellor George Osborne announced last Monday (3 October) that the government will help provide more loans for small businesses, partly through bond purchases, as part of a “credit easing” plan.

Richard Kemmish, head of covered bond origination at Credit Suisse, said that Osborne’s remark was “one of those small throwaway comments by a politician that opens a huge can of worms”.

Further details are expected to be announced in the chancellor’s autumn statement on 29 November.

Proposals for covered bonds backed by loans to small and medium sized enterprises have been floated several times in developed covered bond markets, and the first Turkish covered bond, launched by Şekerbank in July, was backed by such collateral. A plan to introduce legislation for SME covered bonds was debated in the French parliament in 2010.

Kemmish added that SME loan backed covered bonds had also been considered in Germany and the US, as well as France.

“I think this actually makes a lot of sense,” he said. “There’s huge political incentive to do it in a market like this.

“Historically, SME securitisations have been the ugly duckling compared to the swans of the RMBS market,” added Kemmish. “It’s always been not particularly fashionable, not particularly large or interesting in the market, but it would make a huge amount of sense in the covered bond market, at least in theory.”

Frank Will, senior analyst at RBS, said that in theory it would be possible for a UK issuer to put together a covered bond backed by SME loans.

“There have been some ideas of doing this, but it’s still uncertain,” he said. “If the UK were to launch SME backed covered bonds, it would probably have to be in the form of structured covered bonds.”

Other market participants agreed that if UK financial institutions were to launch SME backed covered bonds, they would have to be structured covered bonds.

“You couldn’t call them covered bonds under the current legal framework, which does not allow SME loans as eligible collateral,” said Georg Grodzki, head of credit and research at Legal & General Investment Management. “Hence you wouldn’t get the regulatory advantage,” he said, adding that as a result, they might be more difficult to market.

“For example, SME backed structured covered bonds would not qualify for a liquidity buffer for banks under Basel III,” he said. “They would also not qualify for any special treatment under Solvency II.

“The buyer base would therefore be quite limited, almost regardless of rating and pricing.”

Kemmish said that as the key UCITS criteria do not mention assets, the product could be, in theory, UCITS compliant, if a regulator were to allow it.

“This brings up the question of what should be a covered bond for regulatory purposes,” he said. “Should it be the narrower definition of CRD IV or of the more general UCITS definition?

“It’s up to the European Banking Authority to decide whether it will be eligible for regulatory purposes or not,” he added.

He said that the market for the product would be easier to develop in jurisdictions like the UK, where securitisation technology is better established than somewhere like Germany.

Will at RBS said a problem would be that as soon as SME loans were included in cover pools, investors would probably demand a minimum diversification and a certain level of granularity given the potentially high correlation risk between SME loans from the same country.

“At this stage, it seems unlikely that such a product will emerge anytime soon,” he added.

Grodzki at LGIM also said that too much collateral would have to be eaten up by overcollateralisation requirements, making it more expensive for the issuer.

“Even if you only target a double-A rating, instead of a triple-A, it would still eat up a lot of collateral,” he said, “because SME loans have different characteristics than mortgages, including a higher loss given default rate.

“Everybody is invited to try, but the collateral costs could be so significant that they could drive a truck through the economics.”

Grodzki added that while anything could be sold at the right price, he thought issuers should stay away from this instrument “as much as possible, no matter what the price”.

Kemmish at Credit Suisse disagreed.

“I can understand why a lot of people believe this is dilution of the brand,” he said, “because the brand has always been strongly protected, gold-plated, but I really believe the banking sector has to change.

“The RMBS market is shrinking,” he said. “I heard that for every three euros of RMBS maturing only one euro is reinvested in that market. The covered bond market has to pick up a lot of the slack, and we can’t fund the whole banking sector, so we have to find solutions.”

Patrick Artus, Natixis chief economist and member of a French prime ministerial advisory body, last month made a similar argument, calling for banks’ funding capacity to be increased by an expansion of the range of assets eligible as covered bond collateral to include corporate loans.

Kemmish added that large corporates are increasingly accessing the bond market directly, but small and medium sized corporates did not have that option.

“And with unsecured wholesale funding for banks either non-existent or very expensive, the business model has to change,” he said. “Allowing banks to raise cheaper covered bond financing based on SME loans would help achieve that.”

If an issuer does decide to proceed, he said, it should not take more than a couple of months.

“It’s just a matter of someone making the decision to go for it,” he said.

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