Europe grapples with legacy Covid-19 SME loan default risk
European governments have yet to resolve the challenge of legacy Covid-19 era loans to support SMEs and large corporates through the acute liquidity crunch caused by pandemic lockdowns. European Union member states provided generous State guaranteed bank loans, particularly for SMEs, which were starved of revenues due to lockdowns stalling the circulation of money that prevented normal operations.
Policymakers’ response during the crisis was swift. Public funds allocated to these emergency lending programs were exceptionally large in Germany and Italy, where the government’s guaranteed loan schemes had a maximum budget of €757 billion and €400 billion representing 20% and 25% of GDP, respectively. In Spain, the protection was much lower, with budgets of €140 billion, representing 7.4% of GDP, while Greece extended more than the self-employed and households, representing 22.8% of GDP. In total, these programs distributed more than €1 trillion in emergency loans, mostly to SMEs.
With interest and principal payment holidays now expired, the number of defaults has started to increase. Governments relied on the banking system and national development banks to act as conduits of government-backed liquidity and extend public credit guarantees on private bank loans. However, during the initial phase of the Covid-19 shock, the economic environment was extremely uncertain while corporate demand for liquidity was high. Banks were ultimately responsible for emergency loan lending decisions, but with time of the essence and government guarantees ranging between 60% and 100%, many loans issued with unusually lax due diligence. In some cases, loans were issued across Europe to borrowers with inaccurate and incomplete information, poor credit history and high existing corporate leverage, which increased the default risk. Many European governments are concerned that banks may hastily exercise the government guarantees which would jeopardise companies’ ability to remain operational and have significant implications for national public finances.
In this article, we will examine the programmes across four selected European markets – Italy, Germany, Spain and Greece – and explore how these nations are managing the problem of legacy Covid-19 era emergency loans.
Italy’s government underwrote €277 billion in Covid-related corporate debt across 2.7 million SMEs. Italy introduced various loan schemes to support SMEs, including state guarantees and subsidised loans. The two main programs were:
- “Relaunch Decree” (Decreto Rilancio) which included loan guarantees provided by the Italian government through SACE (Società per l’Assicurazione del Credito all’Esportazione), part of CDP group, to support SMEs. Government guarantees were between 70% and 90% on loans and credit facilities to large corporations and SMEs
- the “National Guarantee Fund” (Fondo di Garanzia) was expanded to provide guarantees on new bank loans for SMEs. Government guarantees were between 80% and 100% on loans and other credit to SMEs and mid-caps.
For all schemes, the maximum guaranteed amount must not exceed 25% of the borrower’s revenues. There were no fees and no credit checks.
For many firms, capital repayments began in June 2023 prompting the first significant test of their ability to repay debts. Italy’s Guaranteed Loan Active Management (GLAM) programme, introduced by previous government led by Mario Draghi and managed by AMCO, aimed to prevent banks from too hastily calling on State guarantees.
Under the original legislation, banks had a 90-day window to exercise the guarantee in full and transfer the loan to the GLAM programme if a borrower misses a payment. The GLAM proposal allowed banks to transfer SME loans at risk of default to a separate vehicle with AMCO leading the recovery efforts. However, the Italian government has yet to sign off on the proposal, as triggering State guarantees can jeopardise borrowers’ ability to remain in business as well as having significant implications for Italy’s public finances. The Italian government has now paused the scheme designed to deal with State guarantees, as part of a review into how the nation is managing Covid-19 era guaranteed loans in the event borrowers’ default, Reuters reported. It remains unclear what path the Italian government will take to balance its legal commitment to banks which extended loans with government guarantees.
It is important to note that Italy’s stock of state-backed Covid-19 corporate loans is almost double the equivalent in France and Spain, and nearly five-fold larger than the €57 billion = underwritten by Germany, the region’s largest economy.
On 27 March 2020, the German government announced €756 billion in funding to back loan guarantee schemes (including bank loans, promissory notes, overdrafts, invoice finance facilities, etc), which was later reduced to around €550 billion. This funding was split into two loan guarantee schemes:
- €400 billion was earmarked to support finance large corporations. Guarantees of up to 90% were directly issued by the Minister of Finance (Bundesministe-rium der Finanzen, or BMF).
- €150 billion was allocated to provide liquidity for SMEs, subdivided into four categories to cater for different types of firms. Kreditanstalt für Wiederaufbau (KfW), the national development bank, was responsible for loan distribution across the four schemes:
- KfW Instant loans (100% guarantee);
- KfW Entrepreneurial loans;
- ERP start-up loans; and
- direct participation for syndicate financing
Between March 2020 and July 2021, KfW pledged €58.6 billion across all loan schemes, just above one-third of the German government’s assigned budget.
Of these four schemes, KfW Instant Loans was the most generous. KfW covered 100% of credit risk, backed up by a guarantee from the German Federal Government. Credit approval was relaxed and did not require risk assessment by participating bank or KfW to allow for quick disbursement. Despite the generous terms, take-up was relatively low at €8.1 billion (as of August 2021). KfW launched two additional programs with a partial guarantee of 80% to 90% and higher maximum loan amounts. The maximum loan amount was €100 million. Total take-up across both programs was €34.1 billion as of August 2021.
The Spanish government launched two loan guarantee schemes with a combined budget of €141 billion to support SMEs and self-employed workers. The loan schemes were administered by the Instituto de Crédito Oficial (ICO), Spain’s national development bank, alongside the Ministry of the Economic Affairs and Digital Transformation. The schemes were:
- the ICO Líneas Avales “Liquidez” COVID 19 was introduced to support businesses’ liquidity (working capital) needs.
- the ICO Líneas Avales “Inversión y actividad” provided guarantee lines to fund new investment projects by SMEs.
The loan schemes endorsements allowed to reach up to €141 billion in loans, with more than 98% subscribed by SMEs (particularly micro-SMEs) and self-employed across more than 1.2 million facilities. Total guaranteed amount is €107 billion. The terms were less generous terms than the Italian and German loan guarantees schemes, covering 80% of new loans, 70% for renewals to SMEs and self-employed. For bigger companies, the guarantee covers 70% of new loans and 60% of renewals. Additionally, regional governments in Spain implemented their own loan programs to support SMEs.
By type of activity, tourism and culture amounted 36% of the total volume, followed by transportation and automotive industry (23%), distribution of food and drinks (19%), trade activities (13%) and textile, fashion and trade (10%).
Greece’s Ministry of Finance provided in financial support to households and businesses affected by the pandemic across two mortgage subsidy programmes:
- GEFYRA 1 program extended €247 million to 75,666 beneficiaries; and
- GEFYRA 2 program extended €256.3 million in of 18,773 loans to 10,533 SMEs and self-employed beneficiaries
Banks and loan servicers have been closely monitoring the behaviour of these loans, amid concerns about the impact inflation, on reduced household disposable income, and increased borrowing costs impacting SMEs and homeowners’ ability to service debts. Apart from increasing short-term collections for banks, the Gefyra programs helped foster a healthy payment culture as borrowers that received government guarantees are under “probation” for up to 18 months, having to stay current in order to avoid having to return the subsidy to the government.
Managing troubled Covid-19 loans
In many EU jurisdictions, there are strong limitations and restrictions on selling Covid-era state-backed loans to investors. These restrictions were designed to prevent potential exploitation of the guarantee schemes. Restricting the sale of these loans was supposed to allow governments to maintain control over the distribution of funds and ensure intended beneficiaries received required support and protect viability of their business. However, for banks issuing government backed loans, without an ability to sell on the loans, calling in the guarantee is the only viable exit.
Banks processes for managing defaulted SME loans are typically not designed to the scale of troubled loans that may emerge over the coming one to two years. As defaulted loan volumes increase, banks concerns will rise over the cost, risk, and management time these loans are absorbing.
Without clear guidance, or where compliance with the government guarantee procedures is too expensive, banks may lack incentive to restructure or extend new credit to SMEs operating at edge of corporate survival. In this scenario, more SMEs may fail than current projections suggest. This outcome is not inevitable, but it is possible.