Debt Capital Markets – the answer to Europe’s funding needs?Russell Schofield-Bezer, EMEA Head of Debt Capital Markets and Corporate Treasury Solutions, HSBC Holdings plc

The post-crisis reform agenda has presented European regulators and banking authorities with a major dilemma: how to get much needed funds to corporate borrowers, while at the same time ensuring banks deleverage, shrinking their balance sheets and re-pricing the cost of credit. Small- and medium-sized enterprises (SMEs) have been the most vulnerable to the unintended consequences of these policies.

As banks are constrained by regulation, it is logical to expect that Europe’s corporate financing model will become more reliant upon the debt capital markets. For Europe’s debt markets to grow the necessary scale and reach, a more integrated approach is required to promote capital market financing.

European debt markets remain fragmented, with legal and fiscal frameworks operating on a national basis, and notable distinctions in business culture and practice. Monetary union has not of course addressed issues of fiscal harmonisation. Different corporate tax rates and stamp duties apply across the Eurozone. This fragmentation limits Europe’s ability to capture the economies of scale and efficiencies that a single capital market could potentially deliver.

The task of getting funding to SMEs sometimes seems almost insurmountable. In the face of political and legal challenges, and when monetary policy appears to have lost its capacity to engender change, markets and lawmakers must resolve this stalemate if we are serious about jump-starting flagging European economies.

The Challenges

Although the vast pool of liquidity provided by extraordinary measures such as the European Central Bank’s (ECB) Long Term Repo Operations (LTRO) looks propitious on the surface, it appears that money is still not flowing to the critical SME

sector. Record low interest rates mean strong investment-grade corporate borrowers can obtain funds below 2% for up to 10 years. Frequent issuers have already taken advantage of this flood of liquidity in the market. One might well expect other non-traditional users to follow suit, moving down the credit spectrum into high yield, unrated or private placement issues.

Yet cheap financing is not making inroads by flowing beyond the traditional ‘blue chip’ borrowers into crucial SME territory. Policymakers appear to be aware of the problem. Speaking to the European Parliament in July, new Commission President Jean-Claude Juncker said, “SMEs are the backbone of our economy, creating more than 85% of new jobs in Europe, and we have to free them from burdensome regulation.”*

So what is going amiss? A core problem is the material rise in the cost of traditional bank lending which, measured by capital held against assets, has doubled overall since 2007. Banks won’t lend unless loan returns either match or exceed the cost of equity. However, they are increasingly unable to lend to unrated SMEs, because they are constrained by the increasing burden of capital.

Regulated solutions

ECB president Mario Draghi is attempting to free up bank balance sheets with his plan to invigorate the moribund EUR 1.5 trillion European Asset Backed Securities (ABS) market (about 1/5th the size of the US securitisation market). On 4 September, Draghi announced the ECB would start to buy high quality ABS from banks, in an effort to unblock their balance sheets, and boost lending to SMEs. The ECB also proposes to underwrite guaranteed mezzanine risk

in ABS, to allow banks to focus on recycling certain risks, including SME loans, on their balance sheets. Although the details of the ECB’s ABS Purchase Plan are still to be determined, the ECB strategy to facilitate funding and risk transfer through securitisation is clear.

Meanwhile, the capital charges under Solvency II, the EU directive that harmonizes the insurance industry, have been eased. New rules, effective from 1 January 2016 at the latest, change the weightings required for securitised debt to make it less punitive for insurance firms to hold senior, low risk tranches of ABS. But, more needs to be done. The International Organisation of Securities Commissions (IOSCO) is expected to release further improved capital requirements for high quality ABS. Similarly, proposed Basel III risk weights for ABS on European bank balance sheets are being reviewed.

The European Banking Authority’s recent discussion paper on ABS proposes specific preferential treatment for ABS which is simple, standard and transparent. The authorities clearly hope to create a kind of conveyor belt to promote liquidity for banks, which will facilitate SME lending. Insurers were significant buyers of ABS before Solvency II was introduced and US insurers, who are not subject to Solvency II, remain active in the securitisation market. Basel III needs to ensure that banks remain supportive of the market. But, more can be done to further develop a vibrant investor base for ABS.

Regulators, therefore, may be prepared to take some of the sting out of holding ABS, but at the same time they are taking on added risk. Yet, is this a long-term solution for SME lending? While ECB-supported funding may be sustainable in the short term, they are only keeping Europe on life support. Policies to facilitate the further growth of capital markets are essential to produce viable, long-term solutions. Governments should consider how to promote private investment in European growth.

As another top-down initiative, Juncker announced his vision of an EU capital markets union, which would, “cut the cost of raising capital, notably for SMEs, and help reduce our very high dependence on bank funding.”** The aim appears to be to mobilise capital markets to bridge the funding gap, but as always the devil remains in the detail. What exactly does capital market union mean in practice? Is the focus on greater transparency in terms of understanding corporate risk? Is it an attempt to spur the rating agencies towards better performance in analysing SMEs and small companies?

Private solutions

As long as the current conditions prevail, particularly fragmentation of existing markets and regulation that inhibits progress, a fresh approach is needed. In the context of today’s patchwork, alternative funding solutions are beginning to evolve, such as peer-to-peer lending and crowd-funding. But, these lack scale and their potential to grow may be limited. One potential path is that of the shadow funding system, which may include a host of instruments and players, from private placements and insurance companies, to pension funds and a variety of asset managers. Fund managers, private equity firms and hedge funds may be better positioned to circumvent the challenges facing the market. Right now, fund managers still tend to invest largely in securities to meet their needs for liquidity. Private Equity and hedge funds are playing an important role providing equity for asset pools, including SME loans originated by banks. With bank

leverage, these financial sponsors can achieve required returns and provide a valuable route for banks to recycle capital. Today, financial sponsors in Europe are largely dependent on cheap leverage from banks to generate their required equity returns. The market needs to take over the provision of this leverage, particularly if central banks want to wind down their liquidity programmes.

In this environment, what is the outlook for the future of the European capital markets? Most likely, as a more formalised private placement market develops, Europe will begin to look more like the US, where banking financing is used primarily to fund short-term working capital and around 70% of term funding comes from the markets. Historically, Europe’s model has been the opposite: with the majority of longer-term funding, particularly for smaller borrowers, coming from bank lending, in part due to diversity of local conditions, insolvency rules and legal systems. Banks, it is argued, already possess the necessary local knowledge and relationships to support this model.

While that pattern may change, as institutions move closer to the American model, banks in Europe will nevertheless continue to perform their traditional functions like clearing, wholesale banking and foreign exchange. They may also still be capable of acting as intermediaries in capital market underwriting, and will carry on lending to the larger corporations they have historically served. But their ability to service the SME segment may remain uncertain, particularly for truly small business. An SME’s relationship bank continues to be best placed to understand local business and proprietor risks. The shadow banking system and capital markets are not able, efficient or interested in underwriting small loans. Faced with this, banks need to continue to support small business growth, notwithstanding capital constraints.

In conclusion, several key pillars are needed for capital markets union to support an alternative debt platform for SMEs. At the moment, fiscal and legal barriers to free movement of capital are impeding the development of capital markets for small borrowers. It is also essential to create a more transparent flow of information and associated infrastructure, currently lacking at the SME level. An EU credit risk database, for instance, has been suggested as a potential tool to connect SMEs to capital markets. Fiscal incentives for private investment to support SME lending would incentivise fund managers and pension funds to allocate larger pools of capital to invest in SME loans and related ABS. Certainty that banks can recycle SME exposures into the market is also essential. A more vibrant SME securitisation market allows this. Also, equity support from unregulated shadow providers is valuable whilst bank capital is constrained. In considering the implementation of some or all of these initiatives, Europe could show that it is serious about creating a capital markets union for growth.

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*http://ec.europa.eu/about/juncker-commission/priorities/01/index_en.htm**http://ec.europa.eu/about/juncker-commission/priorities/04/index_en.htm