Address by Deputy Governor, Cyril Roux, to Chartered Accountants Ireland, Leinster Society

SME Lending and Arrears

Chairman, Ladies and Gentlemen, Good Afternoon.

Many thanks to the Leinster Society of Chartered Accountants for inviting me to address you today.  It is my pleasure to be here with such a distinguished audience of professionals from both industry and practice on the topic of SME lending. 

Given the range of professional services provided by chartered accountants to the financial services and other sectors, you are already familiar with the dynamics of the Irish economy and its businesses, with the difficulties which business borrowers and their lenders have faced over the course of the past seven to eight years, and with the recent return to economic and lending growth. 

These dynamics are also very familiar to us at the Central Bank. Indeed commercial lending is a core area of work for the Central Bank, in three main strands.

First, the Central Bank is part of the Eurosystem which, as a monetary authority, aims for an effective transmission of its monetary policy, so that non-financial corporations may avail of the bank loans they need to function and to grow without extraneous impediments. Over the past number of years the Eurosystem has furnished Eurozone banks, including Irish banks, with a suite of ample refinancing operations which have played a decisive role in ensuring the continuous flow of banking credit throughout sometimes choppy market liquidity conditions. By taking over the additional responsibility of supervising the banks in the Eurozone, the ECB looks to ensure that the banking system is everywhere in a sound position to perform its economic function towards businesses and in particular able to finance SMEs.

Second, the Central Bank is a centre of study and knowledge of the Irish economy, collecting data on individual and corporate finances, and publishing a stream of research and statistics. We continuously monitor lending data and publish regular SME Market reports.  We have also conducted last year the Irish component of the Eurozone wide Bank Lending Survey (BLS). Just yesterday, the Central Bank published data on Trends in Business Credit and Deposits, which I will mention later.

Third, The Central Bank acts as the domestic banking supervisory authority. In that capacity, we monitor banks’ lending practices, which cover risk appetite, risk mitigation and governance. Although I am personally responsible for this third strand only, I will be addressing today our overall work at the Bank.

I will focus first on the importance of the SME sector to the economy and the emerging trends in its financing. I will then expand on how the Central Bank drives non-performing loan resolution. Finally, I will consider emerging issues in new lending and mention our work in relation to the Code of Conduct for Business Lending to SMEs.

SMEs in the Irish economy

Creating the right environment for SMEs to prosper is of vital importance to the economy given that SME businesses account for so much of the private sector workforce in Ireland.

SMEs employing less than 250 persons, account for 99% of active enterprises, employs over two-thirds of the business sector workforce and over 50% of turnover.

However employment in SMEs fell by two hundred thousands between 2007 and 2012, with construction and industrial sectors most heavily impacted.  Even in sectors where there has been continuity of employment, many employees have experienced significant reductions in their net take home pay. 

Indeed the impact of the twin property and banking crises has been felt across the SME community:

• Excessive and frequently property related debt overhang has impacted on viability and potential to grow;
• Sharp falls in property prices from peak levels in 2007, combined with reductions in income have resulted in unsustainable property related debt causing a significant drag on SME’s core business, and
• Turnover has declined in many sectors, reflecting stalled consumer spending as disposable incomes were squeezed and consumer confidence receded.

While I acknowledge that SMEs have experienced tough times, the business environment has recently started to improve.   We have also seen the number of start-ups increase.

Financing SMEs

The issues in the banking sector are well documented, and are not intended to be covered in any detail today, suffice to say that the growth in property related lending (including to SMEs) resulted in Irish banks becoming virtually mono-line businesses and that the aftermath of the collapse of this business model and the related banking crisis had far reaching effects on the ability of banks to lend and the capacity of SMEs to service their debts and sustain new borrowing.

Despite new and welcome initiatives to diversify sources of funding, SMEs cannot but rely on banks to provide the credit they seek to function and expand. Like most EU countries, banks are the main source of financing, particularly for SMEs in Ireland. The difficulties experienced by the banking sector, which have constrained its lending capacity, highlight the importance of developing alternative sources of finance. Let me list these alternatives:

• The issuance of marketable securities is a main source of funding for large corporations but indeed it requires a bigger size than that of most SMEs. Recent experiences abroad to offer retail investors SME bonds have been fraught.

• Peer to peer lending is active mostly in the microcredit space. Rules around the protection of investors that have been painstakingly developed in the markets, securities and fund industry are missing and so are time and tested processes and procedures to assess the creditworthiness of borrowers, to ensure professional collection, and to devise and implement workouts of non-performing loans. Peer to peer lending is likely to stay at best a marginal source of funding for the economy for some time.
• A more promising source of non-bank lending is the fund industry. Ireland is at the forefront of opening the door to direct commercial lending by investment funds. After having developed and issued the domestic regulation of loan originating funds last year, the Central Bank has authorised the first such fund earlier this year. Time will tell the place it will take in the market for SME lending.

§ Finally, investment vehicles such as the Ireland Strategic Investment Fund and the Strategic Bank Corporation of Ireland are welcome additions to the funding mix.

This being said, SMEs and banks are to remain economic bedfellows. The Central Bank’s SME Market Report aims to give an up-to-date picture of developments in the SMEs credit market.

The Report provides information on credit demand, credit access, loan terms and conditions, loan default, interest rates and credit market concentration and is released twice yearly.

Data used to populate this report comes from a wide range of sources including data from banks and surveys of SMEs, particular on their demand for credit.

Policy Response from the Central Bank

While there has been a great deal of public attention and media focus on our ongoing work in relation to distressed mortgage borrowers, we have not seen as significant a public focus on distressed commercial and SME loans. Although this is understandable given the difficult and personal borrower issues involved in mortgage arrears, the scale of the issues in the banks’ commercial lending books are significantly larger than the amounts at stake in mortgage lending,. Indeed two thirds of all distressed loan values are attributable to commercial lending.

The Central Bank drives the banks to resolve their non-performing loans, not only to repair their own balance sheets but also to ensure that the banking sector is fully able to finance the wider economy.

Our approach is similar for both mortgage and commercial debt. Our approach reflects our mandate and our high level goals – financial stability, effective regulation, resolution of financial difficulties. These are consistent with the economy’s needs.

The Central Bank seeks to navigate a balanced course, recognising both the need to manage the capital that has been provided to the banks and the need for borrowers to be dealt with in a fair and realistic manner. In effect in many cases these two goals are complementary.

From 2011 onwards, following the recapitalisation and consolidation of banks, we increased our focus on the banks’ abilities to resolve the unprecedented volumes of non-performing loans. We have ensured that the strategies and actions taken by banks would curtail losses and, over the long term, strengthen their balance sheets to enable them to, once again, support the economy.

Central Bank Initiatives

As with mortgage arrears, our approach to distressed commercial and SME debt has been multi-faceted, and, over the past several years, quite interventionist. Our increased assertiveness reflects tardiness and the ad hoc nature of the banks’ initial approaches.

In the early days of the crisis, the banks’ resolution strategies tended to be aspirational and the featured a host of operational problems:

• Insufficient staff and inadequate skills across all banks;

• Little segmentation of risk, an inappropriate “one size fits all” approach was very much in evidence;
• Light touch or non-existent customer contact strategies; and
• A narrow set of loan resolution options, insufficient for the scale of the challenge at hand.

Our approach has therefore required banks to fix their operational capability and address the strategic shortcomings, which we are broadly satisfied has now been done.

Since 2010, we have undertaken capital assessment reviews, stress tests, distressed credit operation reviews, balance sheet assessment exercises and on-going, intensive supervisory engagement with the banks. While until 2014 we set blanket public targets for the resolution of mortgage arrears, we took a differentiated approach for the ‘workout’ of distressed commercial loans, an approach that we have now also extended to retail loans.

In 2013, SME loan resolution bank specific targets were set for AIB and Bank of Ireland, reflecting the need to take account of the respective capabilities of banks. The targets required the banks to develop strategies, at borrower level, to resolve their non-performing loans. While banks were targeted to make substantial progress in 2013 and 2014, we appreciated that the overall timeframes for commercial loan resolution will extend over a considerable workout period, and certainly over the next three to five years

The three to five year outlook for Non-Performing Loan (NPL) Resolution

I would like to look to the future now and our outlook for three-to-five years. Irish banks are now pursuing three primary avenues to resolve distressed commercial loan portfolios:

• A return to growth

Businesses that have weathered the worst of the storm, which have cut their costs and have gotten “fit”, are well-placed to take advantage of the recent, if fragile, improvement in trading conditions and economic outlook.

• Restructures

Approximately two-thirds of loans have good prospects of returning to viability – but, and here’s the key point, it will take time. Many businesses have excessive property-related debt tied to a core business that is viable , for example take the case of a chemist in the high street of a midlands town who decided to build apartments in the back yard – the property ‘play’ has proven disastrous but the core business is viable. Restructure strategies now typically involve a level of incentivisation to give, in this instance, the beleaguered chemist a reason to get up in the morning. The resolution of this loan requires, to the extent possible, the separation of the viable business from the legacy property debt. This may require disposal of the property and involve concessions being made over a three or five year workout period subject to achievement of agreed milestones such as the sale of certain non-core assets within target timelines and growth in turnover.

• Consensual exit or enforcement

Where a loan is not viable or where the borrower is not cooperating, the ultimate resolution will arise either through consensual agreement or through legal recourse.

Central Bank’s latest assessment on NPL resolution

Following on from our three to five year outlook, I would like to briefly mention our latest assessment on non-performing loan resolution.

The level of distressed business loans is falling and is set to fall further over the rest of 2015, albeit from very high levels. Given that trading recovery and asset sales take time, workout of Commercial NPLs will extend over several years. Where loans are not sustainable, or where agreement cannot be reached, recourse to court or insolvency systems is inevitable.

Helped by the improving macroeconomic environment, the overall level of arrears, as well as the incidence of new cases, has fallen significantly. In the course of our work we have noted material improvements in the banks’ distressed debt operations and a related increase in the sustainable restructure of distressed debt.

While there are encouraging signs, it is important not to be complacent. Commercial loans still make up the sizable majority of distressed loans in Ireland and will take time to work through, even with an improving economic outlook.

Through our inspection programmes, which assess the quality of progress, we continue to see room for improvement and I will give you some insights on this next.

Emerging Issues in the SME Sector

In 2013, there was an upturn in new lending for the first time in several years. In 2014, we undertook a thematic review, conducting a preliminary analysis of new lending activity. Our motivation centred on monitoring developments in order to position ourselves to make early interventions where needed. We approached this work cautiously, keen to avoid unintended consequences such as inappropriately curtailing supply or demand.

Ultimately, we formed the view that the risks associated with new lending practices in 2014 were relatively low from a prudential viewpoint. However we resolved to increase our focus on the increase in new lending activity following several years of exclusive focus on distressed loans.

Supervisory approach under SSM

As part of our preparation for the implementation of the Single Supervisory Mechanism (SSM), we re-organised Banking Supervision within the Central Bank and created a Division dedicated to the performance of on-site inspections on an ongoing basis. From 4 November 2014, this Division commenced the performance of inspections in accordance with the SSM Supervisory Manual. We have created teams with expertise in specific risk areas and, while we have had a team dedicated to credit risk for a number of years, this team has grown with the implementation of SSM.

We have also assigned resources with particular expertise to perform inspections on specific risk areas such as governance and business model. In this regard, a programme of credit risk and other inspections has been developed and will be independently performed by this new Division. We expect that the inspection teams will be on-site in our largest credit institutions throughout the year with targeted inspections taking place in other institutions based on our risk assessment.

Onsite inspections of new lending

Aligned to our strategy to ensure that banks provide credit appropriately, we have recently conducted a number of inspections of new lending. These inspections consider factors such as risk appetite, governance arrangements, management oversight and control, risk, compliance and audit functions.

In respect of audit, we have required the banks and their auditors to provide assurance regarding the effectiveness of the governance arrangements in place regarding new lending. We will receive first reports from this work in the coming months.

We also assess the broader operating environment to assess risks arising from credit culture, remuneration arrangements and concentration risk.

Overall, we are satisfied that governance and underlying standards are much improved relative to the crisis. However, there are still areas where improvements are required. These include:

• Improvement in stress testing of downside scenarios, considering falls in turnover, increases in interest rates;

• The conduct of due diligence, including better assessment of repayment capacity;

• Instances of too many loans being approved outside credit policy and the need for better oversight thereof.

We at the Central Bank are determined to ensure that new lending is conducted appropriately and we will take the necessary steps to ensure that banks comply with our expectations in this area.

Review of the Code of Conduct for Business Lending to SMEs

Before I conclude, I would like to say a few words on an active policy issue.

In our Strategic Plan 2013-2015, we announced our intention to complete a Review of the Code of Conduct for Lending to Small and Medium Sized Enterprises (SME Code). The SME Code was originally introduced in 2009 and provides protections for SMEs across a range of areas. 

A Consultation Paper and draft Regulations to replace the SME Code were published on 11 January 2015. 

We are proposing additional and enhanced protections to strengthen the existing SME Code.  To inform the review, we engaged with a wide range of stakeholders, including representative bodies, advisers, Government departments and agencies and lenders.  We also carried out a themed review on the operation of areas of the SME Code in practice and considered issues highlighted in reports by the Oireachtas Joint Committee on Jobs, Enterprise and Innovation ‘Report on Access to Finance for SMEs’ and Red C Credit Demand Survey carried out on behalf of the Department of Finance.

Following the public consultation process and a period to analyse any responses received, we expect to publish revised Regulations by the end of 2015 or early 2016.

Concluding remarks

SMEs are central to the Irish economy and their proper financing is a prerequisite for a sustained return to growth.

Our approach to SME lending is consistent with this state of affairs.

While there are fledgling new avenues of non-bank lending, Irish SMEs will rely on banks to function and to grow for many years to come.

The Central Bank has a role to play to ensure commercial banks do so appropriately.

The Eurosystem acts both as a monetary authority and as a banking supervisor to ensure that the Eurozone banking system is soundly managed, well capitalized and properly refinanced so that non financial firms can avail of the banking credit they need. We know firsthand how important.

In Ireland, over-indebtedness has had a debilitating effect on banks and SMEs and thus we have been driving the banks to resolve the legacy of over leverage, property related debt overhang, and NPLs more generally , which is in the interests of the borrowers, the banks, and the wider economy.

While much progress has been made, workout takes time and in many cases a number of years, so it will continue to be a focus.

We have also turned our attention onto new lending, cognisant of our responsibility to ensure that the mistakes of the past are not repeated, particularly in a climate where banks’ business models remain challenged.

Early signs of improvement in the fortunes of the SME sector and their access to credit are picked up by the Central Bank, and we will continue to monitor closely economic developments in this regard and publish our findings.

I hope that you this update has been relevant and informative and gives you some insights into the past, the present and hopefully the future of SME financing in Ireland and I wish you and the businesses you support every success in 2015. 

Thank you for your time.