Arbitrage in SME lending

One of the big concerns of the aftermath of the Covid-19 crisis is that the recovery might take much longer because many firms, particularly small and medium (SMEs), will have closed down for good. From the very beginning, different actions by governments and central banks tried to make sure that SMEs did not suffer a reduction in credit. For instance, the Bank of England put in place a Term Funding Scheme (TFS) to provide cheap funding to banks, and the amount that banks can borrow from this scheme is proportional to the amount of lending that they provide to SMEs. The idea is then that banks can borrow very cheap from the central bank if they in turn provide credit to SMEs.

But of course there are limits to this policy. Even if banks keep lending to SMEs, these firms will suffer losses—many of them are temporarily closed—and hence the risk that they are unable to pay back the credit, even when this credit stays constant, increases as the lockdown remains. Banks have to consider these risks: their provisions and capital should go up to cover the increase in potential losses. This has been a source of concern at the Bank of England.

Nevertheless, the UK government has introduced a different scheme, Bounce Back Loans. These loans provided by banks but fully guaranteed by the government—if firms cannot repay, the government will. Given the maximum size of the loans, £50,000, they are designed for small firms. These are, hence, additional incentives for banks to lend to SMEs.

How do both schemes interact? Well, in the last days the Bank of England has provided some interesting information on this regard. First, bounce back loans can have a maturity up to six years, while, originally, the maximum term in the TFS was four years; the Bank of England has announced that it will be possible to extend the funding to match the maturity of the bounce back loans.

This way, banks can borrow very cheaply from the Bank of England scheme and provide bounce back loans to small firms. But what about capital requirements? There is a part of capital regulation that covers credit risk mitigation, which is the situation where the borrower obtains guarantees from a third party to repay the loans. Exactly as bounce back loans. Again, here the Bank of England has clarified that this can be done and hence banks can provide these loans at essentially zero risk weights; in other words, these loans carry no capital requirements.

Yet the 2007-08 financial crisis showed the limits of risk-based capital regulation; for this reason, policy makers around the world introduced the leverage ratio, a capital regulation that does not depend on the riskiness of bank’s assets, only on its size. I have talked about it extensively (here, here, here, here). Even if risk weights on these loans are zero, they would still affect the leverage ratio. However, the Bank of England has announced that these loans will be exempt from this regulation; more precisely, these loans will not be added to the “Leverage Exposure Measure”, which is the denominator of the leverage ratio.

Therefore, banks have a fantastic arbitrage strategy that consists on providing loans to SMEs with the full guarantee of the government and fund these loans using funding from the Bank of England just slightly above the Bank Rate (at the moment, the Bank Rate is at 0.1%). The only limit to this strategy is the amount of eligible collateral of the bank. Other than that, capital and leverage requirements are not binding, and from the point of view of liquidity requirements, this strategy is also neutral (the funding is quite long-term).

What are the risks? For the banking sector, none, as long as the UK government maintains its solvency. And this is key. The current framework assumes that the main problem of non-financial corporations is liquidity, not solvency. But this is not at all clear. For sure, liquidity is an issue, but so is solvency, especially for some sectors. What happens if a big part of these guarantees end up realising? The government debt would increase even more. It is not unthinkable that the UK might lose the double-A credit rating in the near future. And all this while negotiating the new deal with the EU.

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