The government has announced a loan guarantee scheme for bank lending to Irish SME’s to help them emerge from the economic shutdown associated with the pandemic. The proposed program provides a lending bank with a guarantee giving 80% pari passu (proportional sharing) loan loss protection for eligible loans to Irish SMEs impacted by the pandemic shutdown. There is also a portfolio cap on the guarantee so that each bank can only claim 80% loss coverage on 50% of its covered loan portfolio. This effectively shrinks the “tail risk” coverage (if the bank’s SME loan portfolio performs disastrously) to 40%. The guarantee is offset by a 50 basis point fee payable to the government. The budgeted €2 billion loan guarantee program equates to 0.58% of 2019 GDP. Policymakers still have a few weeks to best calibrate the program for maximum effectiveness before a prospective Dáil majority coalition passes the enabling legislation. Given the calamitous economic impact of the pandemic shutdown there is no guaranteed best strategy.
It is useful to compare the proposed Irish program with some of the existing programs. Spain has already opened a €100 billion 70-80% pari passu guarantee program; the budgeted magnitude equates to 8.02% of 2019 Spanish GDP. The French €300 billion loan guarantee program equates to 12.4% of French 2019 GDP. It has 90% pari passu loan coverage for lending to firms with 2019 revenues of €1.5 billion or less; 70-80% pari passu for larger firms. Most generous in the EU is the program of Germany, which has announced a loan guarantee program of €500 billion + which corresponds to 14.6% of 2019 GDP. The “plus sign” here denotes that the German government has explicitly committed to increasing the loan guarantee budget to however much above €500 billion is needed. It is not clear whether such an increase is pre-approved by the EU Commission or alternatively whether an increase will require subsequent vetting. The EU amended state aid rules require “the aid is granted on the basis of a scheme with an estimated budget” so it is ambiguous whether the German government can formally make this unlimited commitment within these newly amended rules. The German program pari passu loss coverage ranges from 100% for the smallest firms down to 80% for the largest eligible (the program covers both SMEs and larger firms, but the very largest German corporations are dealt with separately). The German program also offers fast-track approval and dispersal of funds for smaller loan amounts.
The UK is no longer bound by EU strictures regarding state aid rules and monetary financing rules and this flexibility is reflected in its SME lending aid programs. For small loans the UK government offers 100% loss coverage; 80% for larger loans, with no fee for the guarantee. For small firms (less than £41 million 2019 revenues) the government will pay the first six months of loan interest in addition to providing the guarantee, so the implicit “insurance fee” for the guarantee is negative. The small-loan Bounce Back Loan program has had a fast and successful start, whereas the Coronavirus Business Interruption Loan Scheme (larger loan amounts) which requires more vetting and paperwork has had less quick take-up. The UK budgeted amount for its loan guarantee programs is not fixed beforehand. The UK plan originally had a portfolio cap (as in the proposed Irish plan) but they have dropped it. The very successful joint programs of the US Fed / US Treasury involve 95% outright loan purchases (equivalent to 95% pari passu loss coverage) with no fee payable. One of the two US schemes (the Paycheck Protection Loan Plan, see my earlier blog entry) has a large subsidy component since the loan amount due is partly or entirely forgiven if the loan proceeds are spent on retaining staff that otherwise would have been made redundant. Unlike the US or UK, Ireland has the prospect of a eurozone sovereign debt crisis looming in the background, shrinking the available fiscal space for bold giveaway programs to save jobs. Ireland also must navigate through the state-aid restrictions of the EU Commission.
The economic rationale for these loan guarantees is fundamental and needs to be understood clearly. To encourage a quick macroeconomic recovery, countries need their banking sectors to engage in this lending which, in the absence of a loan guarantee, is not in their financial interest. Sector risks are substantial in this new SME lending since no one knows for sure which currently impacted sectors will remain closed or deeply troubled. For example, there will be likely be considerable SME lending demand from Irish hotels. Should banks be willing to lend to hotels in Ireland, to allow them to reopen? In the absence of a government-funded loan guarantee, the correct answer is no. Commercial banks earn their value by “being boring,” that is lending to low-risk activities, with unsystematic risks which diversify across individual businesses and sectors, resulting in a modest and predictable realised default rate. In exchange the banks earn a relatively small but dependable interest margin over funding costs. The very uncertain prospects for SME lending outcomes in the post-pandemic period, with large systematic sector risks, are too exciting to be a sensible activity for commercial banks in the absence of a government loan guarantee.
The SME loan guarantee programs of EU countries include a 20-100 basis point loan guarantee fee paid to the national government so that each program can be ruled to not violate the EU rules against individual member state aid to industry. It does not make sense if the guarantee fees payable for these programs are market-value based fees which fully compensate for the value of the risk capital. Charging a market-value-based fee for the guarantee defeats the purpose of the program: to give powerful incentives for otherwise-too-risky lending to SMEs in vulnerable sectors.
Patrick Honohan (2020) overviews these loan-guarantee programs internationally and expresses his concern that these loans may impose too much debt on troubled firms and generate prolonged financial distress. Such a concern is particularly pertinent for Ireland, with its extremely slow and cumbersome non-performing loan (NPL) resolution framework. Honohan also worries that many of these government-guaranteed loans may effectively transform into subsidies via non-payment; this is particularly relevant in the case of Ireland given its political-business culture regarding NPLs. Honohan suggests adding an equity-conversion feature to the loan guarantees, but this might be a bit too complicated in the Irish case.
In terms of the Irish proposal, the 80% guarantee coverage is on the low side relative to comparable nations. 90% coverage would be better; imposing a 20% risk exposure on the banks might slow take-up substantially. Getting a fast and high take-up rate requires that the program is administratively easy to access and well-incentivised for both the SMEs and banks in terms of risk-reward acceptability. The €2 billion budgeted amount seems very low. The guarantee fee (which is counterproductive) should be pushed as low as the EU commission will allow. It would be good if the smaller loans at least could have some sweetener attached, linked to payroll or job retention.
Clifford Chance (2020). Coronavirus – Guarantee Scheme in Spain. [online] cliffordchance.com. Available at: https://www.cliffordchance.com/briefings/2020/03/covid-19-_-spanish-guarantee-scheme.html [Accessed 7 May 2020]
Department of Business, Enterprise and Innovation (2020). Credit Guarantee Scheme for COVID-19 FAQs. [online] dbei.gov.ie. Available at: https://dbei.gov.ie/en/What-We-Do/Supports-for-SMEs/COVID-19-supports/Credit-Guarantee-Scheme-COVID-19-FAQ.html [Accessed 7 May 2020]
European Central Bank (2020). ECB announces new pandemic emergency longer-term refinancing operations. [online] ecb.europa.eu. Available at: https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200430_1~477f400e39.en.html [Accessed 7 May 2020]
European Commission (2020). Temporary Framework for State aid measures to support the economy in the current COVID-19 outbreak. [online] ec.europa.eu. Available at: https://ec.europa.eu/competition/state_aid/what_is_new/sa_covid19_temporary-framework.pdf [Accessed 7 May 2020]
European Commission (2020). State aid: Commission approves German measures to support economy in Coronavirus outbreak. [online] ec.europa.eu. Available at: https://ec.europa.eu/commission/presscorner/detail/en/IP_20_653 [Accessed 7 May 2020]
Financial Times (2020). State-backed SME lending picks up pace too late for many. [online] ft.com. Available at: https://www.ft.com/content/9b5c3d0a-4960-4654-b8d5-c4b6697c43c5 [Accessed 7 May 2020]
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Financial Times (2020). Loan guarantees: what funding will be available to UK businesses? [online] ft.com. Available at: https://www.ft.com/content/626de1f8-69b4-11ea-800d-da70cff6e4d3 [Accessed 7 May 2020]
Financial Times (2020). More than 100,000 apply for ‘bounce back’ loans. [online] ft.com. Available at: https://www.ft.com/content/ad74d6ff-f9cf-4218-9563-c511681f5acb [Accessed 7 May 2020]
Patrick Honohan (2020). Pandemic loans to firms: Postponing the evil day? [online] Peterson Institute for International Economics. Available at: https://www.piie.com/blogs/realtime-economic-issues-watch/pandemic-loans-firms-postponing-evil-day [Accessed 7 May 2020]
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Bruno Robino (2020). Capped Portfolio Guarantee. European Investment Bank. [online] Available at: https://www.fi-compass.eu/sites/default/files/publications/Bruno_Robino_How_does_a_Guarantee_scheme_work_0.pdf [Accessed 11 May 2020]
Shearman and Sterling (2020). Updated – Covid-19 France: State Guarantee Scheme for New Money Loans. [online] shearman.com. Available at: https://www.shearman.com/perspectives/2020/04/covid-19-france-state-guarantee-scheme-for-new-money-loans [Accessed 7 May 2020]
The Telegraph (2020). Germany’s 100pc guarantees highlights shortcomings of UK loan scheme. [online] telegraph.co.uk. Available at: https://www.telegraph.co.uk/business/2020/04/08/germanys-100pc-guarantees-throw-spotlight-ailing-uk-loan-scheme/ [Accessed 7 May 2020]