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German Banking Industry Committee

Please refer our general comments in the attached document.

The effect of the application of the SME Supporting Factor in reducing capital can be calculated from the supervisory reporting system (COREP). In the COREP templates (Commission Implementing Regulation (EU) No 680/2014 of 16 April 2014), for example, the exposure value must always be given before and after the SME Supporting Factor.

In paragraph 17 EBA DP, the EBA comes to the conclusion that – at least for the banks in its sample – the SME Supporting Factor has no more than a negligible impact on the amount of capital required. We do not share this view.

The following table (the proper display is given in the attached document on page 5) shows the capital relief (as a percentage) attributable to the SME Supporting Factor for the private-sector German banks as at 31 March 2015:

Size of banks
Exposure class Total Total Assets > EUR 10 bn Total Assets EUR 1 –10 bn Total Assets < EUR 1 bn
Banking book 0.6% 0.5% 1.4% 2.2%
Corporates 0.4% 0.3% 0.6% 1.3%
Retail 2.0% 1.6% 3.7% 5.3%
Secured by mortgages 1.8% 0.2% 3.2% 1.3%
on immovable property

A similar analysis was made for the 415 German Savings Banks, taking into account COREP data as at 31 March 2015. The following table (the proper display is given in the attached document on page 6) shows the capital relief (as a percentage) attributable the SME Supporting Factor:

Size of banks
Exposure class Total Total Assets > EUR 10 bn Total Assets EUR 1 –10 bn Total Assets < EUR 1 bn
Credit Risk 4.1% 2.8% 4.3% 5.8%
(incl. all exposure classes)
Corporates 2.8%
Retail 9.5%
Secured by mortgages 5.3%
on immovable property

This shows clearly that the allegedly low level of relief within the private sector German banks (0.6%) only holds true for an analysis of aggregated figures across all institutions. A similar pattern can be observed for the German Savings Banks, where the capital relief is even higher due to their business model.

Rather, it is the case for all banks included in both analysis that the capital relief effect is greatest in those exposure classes in which SMEs naturally account for a high proportion. For example, considerable capital savings can be demonstrated in the “Retail” and “Secured by mortgages on immovable property” exposure classes. By contrast, the effect appears to be lower for the “Corporate” exposure class – however, because of the definition that applies here to SME loans (exposures of max. EUR 1.5 million), the proportion of SME loans compared with the total corporate loan portfolio is likely to be lower than in the other exposure classes.

Because of their business model, smaller banks would probably suffer disproportionately if the SME Supporting Factor were to be abolished. However, the SME Supporting Factor also plays a significant role at mid-sized and large institutions because of their substantial exposure to SMEs.

As a result, a conspicuous level of capital relief is evident in the exposure classes with strong SME participation.

Furthermore, promotional banks grant loans to SMEs that are extended via other institutions as intermediaries (pass-through loans). These loans are of public interest as they implement public policy objectives. Multilateral, national and regional development institutions often conduct their business by lending via (one or more) intermediate banks. For these pass-through loans, the SME Supporting Factor is used to promote SME financing at the level of the intermediary institutions.
One factor that needs to be particularly stressed is that institutions cannot be considered being in a position to make reliable business policy decisions because of the temporary limitation currently defined for the SME Supporting Factor in Article 501 of the CRR. As the financing environment of Germany and possibly those of other Member States as well are dominated by long-term loans, the uncertainty associated with the review clause tends to result in decisions being subject to conservative assumptions. Moreover, lending practices by the banks depend on a range of additional factors. These include demand for and supply of credit, the bank’s own capital resources and its business model.

It should also be considered that the requirements of the CRR, including the SME Supporting Factor, have only been in force since 1 January 2014. In combination with the current economic environment, which is characterised – among other things – by the persistently low level of interest rates and greater competition for SME loans because of regulatory factors, no significant effects on SME lending can realistically be expected. The result of this overall situation is that it is not currently possible to empirically isolate the effect of the SME Supporting Factor on lending practices because of the wide range of, in part, offsetting factors that affect the situation.

Nevertheless, the SME Supporting Factor is a lever that can influence bank lending in the overall context:

- The SME Supporting Factor reduces own funds requirements and thus cuts the cost of capital (see also Q1). This is all the more important the higher interest rates climb, because customer price sensitivity then also increases. If interest rates are expected to rise, cost of capital is thus likely to become more important.
- A lower cost of capital increases profit margins and makes SME loans more attractive.
- Many institutions stipulate minimum margins when they lend money. Capital relief is therefore likely to have the effect of enhancing their business.
If institutions or their subsidiaries are managed using limits (corresponding to capital allocation), the SME Supporting Factor reduces the extent to which limits are used. This in turn increases the scope for SME lending.
- All other things being equal, capital relief due to the SME Supporting Factor leads to a greater range of options based on the pricing tools used by numerous credit institutions.
As a rule, the criteria in Article 501(2) of the CRR are used to apply the SME Supporting Factor. The criteria are checked automatically by the IT systems. If the criteria are met, the SME Supporting Factor is applied to the calculation of the regulatory capital requirements.
Different institutions use different procedures to group borrowers. For example, this can be done using standard “Group partner numbers” in a similar fashion to the collective item used in the large exposure regime. This ensures on a group-wide basis that exposures to SMEs do not exceed the EUR 1.5 million limit.
A harmonised definition should be based on Art. 501 (2) CRR.
To allow any focused discussion of the topic of “riskiness of SMEs”, this concept must be defined clearly and unambiguously. This is the only way to ensure that all contributions to the debate on this topic are based on the same understanding of the concept.

The definition stipulated in connection with the supervisory own funds requirements is that only unexpected losses are to be regarded as risks, and therefore also have to be backed by capital. For this reason, the term “riskiness of SMEs” should also be based solely on these losses, while expected losses in particular should be disregarded. Unexpected losses represent an adequate indicator of portfolio granularity. If this risk measure is used, a lower risk level relative to the Larger Corporates portfolio is shown through the higher granularity of the SME portfolios.

In contrast to expected losses, only unexpected losses that represent a negative deviation of losses from the expected (mean) losses represent risks as far as a bank’s risk management is concerned. The expected losses due to credit losses are offset on average by an equal level of income from lending transactions, because these expected losses are priced into the lending conditions and are thus matched by corresponding income from lending transactions. Expected losses do not therefore represent a risk in terms of a bank’s risk management and may not be included in the concept of riskiness. The supervisory own funds requirements also follow this interpretation.

Based on the above definition of riskiness, it can be established that the level of non-performing loans cannot be a proxy for riskiness, because such a measure is not based on unexpected losses and can be seen more as an indicator of expected losses.

As far as an evaluation of financial ratios is concerned, these are also not proxies for riskiness, but merely offer an indication of expected losses. If the composite index derived from the financial ratios produces worse figures for SMEs than for large enterprises, the only conclusion that can be drawn from this is that SMEs should exhibit higher default rates. All other things being equal, this allows the conclusion to be inferred that expected losses are likely to be higher for SMEs.

The issue of how to calculate an optimum composite index for SMEs is based on the implementation of a rating to determine PD as a risk parameter in the IRB rating systems. There is a broad knowledge base for this in the literature. In addition, all institutions with approved IRB rating systems for SME loans have corresponding documentation that describes in detail the calculation of an optimum composite index. These documents can be provided at any time on request. No exhaustive descriptions of the calculation of an optimum composite index for SMEs are presented in this consultation because they would not shed any light on the topic of riskiness in the sense that this term is used in the EBA DP.

A link to the concept of riskiness can only be made in the context of statements about the cyclicality over time of the composite index. However, this needs to be qualified by noting that no evaluations are given that would demonstrate the way in which a change in the composite index over time would be accompanied by a change in default rates or losses. The many years of experience of those responsible for developing rating procedures for SMEs show that a change in the credit quality of borrowers determined on the basis of a composite index (and hence on the basis of financial ratios) can only be used to a very limited extent as a measure of the cyclicality of default rates or losses, and hence of the riskiness of SME loans.
Please refer to our answers to questions 6 and 8. We would like to point out again in this context that any discussion of the topic of riskiness should be based on a definition of the concept of riskiness that only encompasses unexpected losses.
SME loan default rates are less cyclical than loans to large enterprises. In fact, the cyclicality is considerably lower than is currently already assumed by the Basel own funds requirements.

The volatility of default rates over time is regularly used to determine the cyclicality of loan default rates and the riskiness (in the sense of unexpected losses) to be derived from this cyclicality. All other things being equal (given constant loss levels), this allows the volatility of losses in the credit portfolio to be derived whose negative deviation from the expected loss value represents the unexpected losses that have to be backed by capital.

Asset correlation is used as the measure of the volatility of default rates over time. This measure of cyclicality is also the measure used in the Basel own funds requirements to determine the level of own funds requirements to be derived from cyclicality. Measuring asset correlation is therefore the equivalent of measuring cyclicality (of default rates). Under the Basel own funds requirements, measurement of the asset correlation can then be used to determine the optimum level of supervisory risk weights that correspond to the riskiness of the loans.

The literature contains several approaches for determining the cyclicality of SME loan default rates compared with loans to large enterprises, and these are also cited in the EBA DP. In particular, we would like to draw attention to the paper by Düllmann und Koziol (2014) that is also cited in the DP. This paper revealed that the relative risk weights of SME loans derived from asset correlation measurements, compared with loans to large enterprises, are far lower than those stipulated by the formulas for determining risk weights. The own funds requirements for SME loans are only adequate, in the sense of reflecting riskiness, when the SME Supporting Factor is included.

The next objective of the study of SME loan riskiness should therefore focus on continuing to verify the results of the Düllmann and Koziol study, and in particular on an examination of the extent to which these results can be transferred to other countries and data time series with longer histories.

Based on the methodology for determining SME loan riskiness and hence of the optimum level of own funds requirements (and risk weights) used by Düllmann and Koziol in their study, analyses were conducted internally using the data resources of the German savings bank finance group. These analyses used a data history of more than one million loans over a period of eight years. The results of the analyses confirm the results of the Düllmann and Koziol study that the SME Supporting Factor leads to adequate own funds requirements for SME loans that reflect the riskiness of the loans.
We agree with the methodology for deriving the own funds requirements from the riskiness of the SME loans as also used in the Düllmann and Koziol study.
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Please refer in this context to our remarks on Q4. From a business policy perspective, we can say that the SME Supporting Factor is reflected in the own funds requirements and thus in the extent to which limits are used. Lower own funds requirements increase the scope for lending and the attractiveness of lending to SMEs.

However, we remain critical of the EUR 1.5 million limit on SME loans stipulated in Article 501 of the CRR. This restriction means that equity and thus loan pricing are not significantly reduced for many SMEs. We therefore propose that this requirement be eliminated, so that the annual turnover limit of less than EUR 50 million would be a sufficient requirement for an application of the SME Supporting Factor.

As an example, GBIC would like to refer to the development of the banking sector of a German federal state, in which loans to corporate clients increased from € 37,396 million (31 December 2013) to € 40,293 million (30 June 2015). These figures attest that the introduction of SME-correction factor has proved to be absolutely correct and necessary. To strengthen the regional banking industry SMEs correction factor must be maintained absolutely. Otherwise, we anticipate appreciable negative effects. In addition, a study is made of this sector to loans which are SME-enabled shows that the quality of these loans - as measured by the percentage distribution within the so-called IFD marks - has significantly improved over the period 30.06.2004 to 31.12.2013. (Project of the Bundesbank on the review of the SME factor (§ 501 CRR)) Thus, the proportion (IFD Note I) increased in the category of the best rating of 21.97% in 2004 to 43.23% in 2013, at the same time there was no significant negative change recorded in the category of the worst credit rating (IFD grade VI). The values increases only from 3.27% in 2004 to 4.04% in 2013. This data underlines the thesis that SME loans have a high stability and a lower equity cost is justified.
The decision whether certain types of transaction will be prioritised depends on a range of factors. In principle, the following factors should be mentioned here:

- How are loans treated for supervisory purposes? Are there any preferential treatments? Are there additional capital requirements, e.g. because of the countercyclical capital buffer?
- What is the market environment, what is the competitive situation?
- How and at what conditions can the transactions be funded?
We refer to our general comments in this respect.

It should be emphasized that a potential effect of the SME supporting factor cannot be isolated due to the wide range of newly introduced regulation under the CRDIV and CRR package.

In addition to extensive regulatory changes, current economic conditions are marked by persistently low levels of interest rates and a sharp rise in the equity base of German SMEs. German medium-sized companies have increased their capital ratios in recent years continuously up to a current average of 22.3%. This inevitably leads to increased internal financing capacity, which is at the expense of loan demand as a whole. At the same time it should be noted that SMEs become more attractive and that competition between banks in this segment has significantly increased mainly due to the above-mentioned extensive regulation introduced with the CRD IV and the CRR.
The SME Supporting Factor feeds into the pricing calculation of a loan via the cost of capital. A positive effect arises in particular if banks manage lending using minimum margins: application of the factor increases the margin, which results in transactions being entered into that would not have been considered without a sufficient margin.
In light of the aim of ensuring as simple a regulatory regime as possible, we do not see any need for further differentiation. Any such differentiation would further increase the already undesirably high complexity of the regulatory requirements.
Michael Engelhard
+49 30 20225 5331