- Following Commerzbank’s hybrid SME
covered bond in February, speculation has mounted over
whether the deal would spark the dawning of a new asset class
- But statutory shortcomings and SME
loans’ credit risk means it will be a niche
instrument issued by strong issuers in well-established
- Regulators had called on the market to look at
capital market innovations, including SME loan-backed
investment vehicles, to help plus the funding shortfall
plaguing Europe’s economic
- But market participants note that if a SME
covered bond sector does emerge, it will not be for some
time, meaning more immediate funding solutions are
Covered bonds backed by loans to small and medium-sized
enterprises (SME) will remain a niche product of established
issuers from mature markets.
Regulators have urged the market to innovate capital market
solutions to fill the SME funding gap plaguing
Europe’s recovery. But industry participants have
made clear that, in addition to structural and asset quality
challenges, the amount of time needed to establish an SME
covered bond sector means it is not an immediate funding
SME covered bonds have been a hot topic since
Germany’s Commerzbank unlocked the sector with
its €500 million ($679 million) deal in February.
"I agree the structure is very smart and I can imagine other
issuers in the core countries using it, but I
wouldn’t think about such a structure issued out
of peripheral countries," said Pimco covered bond portfolio
manager Timo Boehm, speaking at the Association for
Financial Markets in Europe’s covered bonds
conference in Berlin on Friday.
With €1.5 trillion of outstanding SME loans in Europe,
some query whether the covered bond market is missing a
But while panellists agreed it would remain an area to watch
in 2014, they do not expect it to amount to a new segment of
The major obstacle is that the vast majority of covered bond
legislation across Europe, including in countries amounting for
the greatest volumes, is firmly geared towards mortgages and
public sector loans. This means that other types of assets,
including SME loans, cannot be included in cover pools.
Commerzbank’s landmark deal sidestepped this
problem through the use of a contractual structure, which
replicated the parties’ rights and obligations
As such, many – including investors –
believe it is a misnomer to call them covered bonds.
"We are clearly in the camp that we are talking about
structured covered bonds," said Boehm. "We generally
acknowledge the product and new investment alternatives, but we
don’t want to have such a product on an existing
covered bond law."
According to Ralf Grossmann, head of covered bond
origination at Société Générale
Corporate & Investment Banking, the key features of any SME
deal must be dual recourse, a high level of transparency, and
There was discussion in
France earlier this year about legislating for SME covered
bonds, but this was not expected to be formalised into a
bill anytime soon. Spain is now contemplating changing its law
to make SME loans eligible as cover pool assets.
For less developed covered bond markets, however, SME-backed
deals are not likely to feature any time soon. Oliver Koepke,
head of treasury at Poland’s BRE Bank, said this
new breed of covered bond would be difficult from a legal and
tax perspective under the country’s legislation,
and so other ways to improve SME funding would be considered
It should be noted that Turkey is an anomaly in this regard.
Its 2007 covered bond law makes SME loans eligible cover pool
a number of banks have issued such bonds over the past 18
Statutory shortcomings aside, SME covered bonds face
Issuing banks must be happy to take the credit risk, which
can be substantial given that SMEs’ default rate
is significantly higher than traditional cover pool assets.
How investors assesses these deals could also prove an
obstacle, with their focus moving away from the cover pool and
towards the credit of the issuing bank.
"We must keep in mind the asset quality is completely
different [to mortgages]," said one buyside panellist, noting
that Commerzbank’s rating would have contributed
significantly to the February deal’s success.
Nonetheless, panellists agreed that such instruments would
be interesting to sophisticated investors. "Given low interest
rates will remain for some time, some large investors would
significantly benefit from access to a more developed set of
investment vehicles and opportunities related to SMEs," said
the European Central Bank’s (ECB) Philipp
Hartmann, (speaking in his own capacity) delivering the
conference’s keynote address.
Holistic SME funding
Grossman and Boehm agreed that SME covered bonds are not an
immediate solution to Europe’s funding
"We are just at the starting point and it would take a long
time to develop this [market]," Grossmann said. "So it is not
something to help SMEs right away; it would take some
As such, there are more pragmatic ways to arrange cheaper
and quicker funding for the sector.
But Hartmann noted that as the ECB cannot intervene to
directly resolve the problem, market-based solutions forcing a
shift from today’s reliance on bank lending
towards capital markets is needed.
"The ECB can only do so much in this regard, we quickly
reach our limits, so we need a holistic approach to address
this," said Hartmann. "Some are closer to your business and
some are closer to ours….innovation in the capital
markets is really called for in that regard."
"I have read about reservations about the role of covered
bonds here, and what is possible on the ABS [asset-backed
securities] side," he said. "But I do think a flexible
financing system that can shift between different sources of
financing, and a greater role of capital market financial
instruments does play an important role here."
"This is up to market innovation to a large extent, with
some support of public authorities on the fair regulatory
treatment and maybe offering other types of supports including
the treatment of other types of support, such as the debt
treatment in our collateral framework," he added.
In addition to the ECB’s collateral programme
and inclusion of SME loans in covered bond pools or
securitisation structures, Hartmann’s recommended
holistic approach to SME funding includes:
- implementation of the banking union, to help stop the
funding discrimination faced by SMEs in stressed countries
(due to their being associated with the sovereign);
- enhanced data transparency for SMEs to help structure
pooled investment vehicles consisting of small loans which,
today, are hard to verify credit standing;
- fostering joint efforts of development banks in different
- more private equity and venture capital initiatives;
- fostering a stronger private placement market;
- mini bonds; and,
- exchanges for small cap companies.
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