Here is the submitted text for an article in this week’s SBP on SME debt, the state of the banks and this year’s stress tests for eurozone banks. It continues below the fold.
Should we fear an SME loan meltdown?
In 2007 Prof. Morgan Kelly identified the likely 50 per cent fall in Irish house prices. He set out the implications this would have for construction employment but suggested that the larger banks were “well-capitalized” with unemployment and “macroeconomic dislocation” being the main problems that would emerge. The analysis was incredibly accurate on house prices and the consequences for employment and it wasn’t long before the impact on the banking sector also became clear.
The underlying factor to the most recent warning is not property price falls but the banks calling in loans provided to small and medium enterprises (SMEs) and in the event of their inability to repay the banks would foreclose on the businesses. Again the threat is to employment but it is not limited to 300,000 construction jobs; it is to SME employment across the entire economy.
The 1.9 million people currently in employment in Ireland can roughly be broken down as 350,000 self employed, 350,000 in the public sector, 400,000 in large enterprises and 800,000 in SMEs. SMEs are the largest source of employment in Ireland.
The Irish SME sector is carrying a significant level of debt. Figures from the Central Bank show that there was €56 billion of credit extended to SMEs at the end of 2013. As SMEs are the largest source of employment in the economy the debt burden needs to be resolved but not at a cost to viable employment. This will involved the banks foreclosing and repossessing on loans relating to business properties and premises.
Of the €56 billion SME debt, €31 billion is to property-related sectors such as property development, construction, land and commercial property. Some of these are the development loans which were in the non-NAMA banks such as Ulster Bank or in the NAMA banks but below the transfer threshold of €20 million. Employment in construction has already been wiped out. Many of the loans are also likely tied to the commercial premises used by the SME sector. Around two-thirds of these loans are non-performing.
The remaining €25 billion can be roughly broken down as €4 billion to agriculture, €2 billion to manufacturing, €8 billion to the wholesale and retail trades, €5 billion to hotels, pubs and restaurants, €2 billion to business services, €1 billion to health and €2 billion across transportation and storage, information and communication, education and other miscellaneous sectors.
The biggest providers of credit to non-property related SME sectors are Bank of Ireland and AIB. Between them they provide €19 billion of lending to SMEs. Both banks are subject to the ECB stress tests that will completed by the end of this year but there is nothing to suggest that the stress tests will have any uniquely negative consequences for Irish SME lending.
The purpose of the stress tests to is establish the strength of bank balance sheets by checking whether they are adequately capitalised now through an Asset Quality Review and whether they can absorb the impact of a negative economic shock in the future – the stress test.
Ireland has already carried out a form of asset quality review through the Balance Sheet Assessment undertaken by the Central Bank last autumn. This looked at the balance sheet of the banks to determine whether they were appropriately valuing their assets.
The main asset of banks are customer loans and one of the biggest problems the Irish banks face is that many of their customers are in arrears. The purpose of the asset review is, among other things, to assess whether the banks have adequately provided for the likely losses they will incur from their impaired loans. This is done in advance of the actual default or foreclosure on the loan and means the bank has already set aside provisions to deal with the loss.
AIB, Bank of Ireland and PTSB have issued about €150 billion of loans to customers in Ireland across all areas; mortgages; SMEs, corporate, property and consumer. Of these, around €60 billion are non-performing. However, over the past few years the banks have made over €30 billion of provisions against these loans to cover likely losses. They were required to further increase this after the Balance Sheet Assessment which drove some of the losses announced by the banks in their recent 2013 annual reports.
Even with these losses recent losses the banks still maintain capital ratios of over 11 per cent. Under the ECB’s Asset Quality Review, banks will require a capital ratio of 8 per cent and under the stress test scenario the capital ratio will be required to stay over 6 per cent.
The Irish banks are in a strong position going into the ECB’s stress test and will pass them. This is not because their assets are performing well; it is because they have provided for the likely losses on their non-performing loans. It is possible that over the next few years will see the Irish banks engage in reverse-provisioning, that is removing the provisions for losses that did not materialise.
The Irish banks will also be boosted by the recent strong performance of Irish government bonds, which is in part the result of ECB actions and words, as they hold significant amounts of them as well as NAMA bonds.
The ECB’s stress tests will not be about micro-managing non-performing SME loans. The most recent figures show that across all non-property business lending (SME and corporate) the arrears rate is around 25 per cent. The banks have a further 25 per cent of loans on “watch” meaning that in total 50 per cent of business loans are described as “vulnerable”.
However, loan arrears tells us nothing about the underlying profitability of the business. We are now six years into the crisis and many unprofitable businesses will have shut down and their loans will be dealt in the standard manner.
For businesses that are generating trading profits foreclosure makes no sense. If the business is profitable that bank can recoup its money from the value of the premises and the future profit stream. If the bank forecloses all that is available is the premises.
A process needs to be established to allow the business to continue but to strip away the loans relating to property and premises. In many cases small business owners will have bought the properties in an attempt to create an income in retirement. There were also tax advantages in doing so but these investments have no [correction: now] gone sour.
The business owners will have to lose ownership of the premises and suffer a financial loss. The advantage of this is that the business will be able to continue and there will be no loss of employment because of bank actions. The owner’s pension will be a problem for another day. If the business is trading profitably foreclosure makes no sense and such actions are not part of the ECB’s stress tests.