SME risks take centre stage at European banks

Anyone looking at the loan portfolios of European banks would be hard-pressed to find any sign of a crisis. Default rates have yet to reflect the economic toll of the pandemic. Outside of a few hard-hit sectors, most blue-chip corporate clients appear to be in fine fettle.

But it may not be the goliaths of the business world that banks should be worrying about. A recent survey of lenders by the European Banking Authority found that 58% expect their loans to small and medium-sized entities (SMEs) to deteriorate over the next year. A McKinsey poll of SMEs in France, Germany, Italy, Spain and the UK found that 55% expect to shutter by next September if their revenues do not recover from their current, pandemic-impaired levels. One in five fear they might default on their loans.

Large, multinational banks should be able to absorb losses from SME loans without too much trouble, since these portfolios make up a small part of their overall exposures. At Deutsche Bank, for example, SME loans make up just 14% of its corporate loan book.

But smaller, regionally-focused firms could struggle if their small business borrowers collapsed en masse. At the UK’s Lloyds, SME loans make up 44% of total corporate exposures; at Denmark’s Danske Bank, 51%. If 20% of Lloyds’ performing SME loans default, that’s £2.1 billion ($2.3 billion) of exposures – equal to 7% of its core equity capital.

That’s why policy-makers’ efforts to support SMEs through the pandemic are as important to the financial sector as they are to the real economy. At the outset of the crisis, many European Union governments imposed payment moratoria for certain loans. SMEs were one group that benefited. Spanish bank Santander said 7% of its SME and corporate loan book benefited from payment holidays, though many of these have now expired.

The reprieve saved banks from having to downgrade heaps of loans in the midst of the crisis. If these had to be classified as non-performing, lenders would have been forced to divert earnings into loan-loss reserves instead of their capital buffers, weakening their ability to withstand shocks later on.

The question is what happens when all these payment holidays expire. If governments continue to support SMEs through targeted relief, they may be able to keep up the repayments on their loans. If not, they could rapidly default.

Certain banks are already building up loss provisions in case those loans emerging from moratoria do start to crumble. Dutch bank ING, for instance, said part of a €552 million ($655 million) provision overlay taken over Q3 was to cover these kinds of exposures. Other banks are likely to add overlays of their own if government support for the private sector starts to wane while the pandemic continues to rage.

This means that bank earnings could stay crimped for some quarters to come.