SME Credit Risk Analysis

Definition

SME Credit Risk Analysis is the specialization of Credit Risk Analysis to the particular context of SME Lending.

General Requirements

General requirements for the analysis of SME Credit Risk are set in

Institutions should assess the borrower’s current and future ability to meet the obligations under the loan agreement. Institutions should also analyse the loan application of the Borrower in order to ensure that the application is in line with the institution’s Credit Risk Appetite, policies, credit-granting criteria, limits and relevant metrics, as well as any relevant macroprudential measures, where applied by the designated macroprudential authority.

Institutions should carry out the Creditworthiness assessment in relation to the specificities of the loan, such as nature, maturity and interest rate.

For assessing the borrower’s ability to meet obligations under the loan agreement, institutions should adopt suitable methods and approaches, which may include models, as long as these guidelines are met. The selection of the suitable and adequate method should depend on the risk level, size and type of loan.

Components of Creditworthiness Assessemtn

When carrying out the creditworthiness assessment, institutions should:

1. analyse the financial condition and Credit Risk of the borrower, as set out below;
2. analyse the Business Model and Business Strategy of the borrower, as set out below;
3. determine and assess the borrower’s Credit Scoring or internal Credit Rating, where applicable, in accordance with the credit risk policies and procedures;
4. consider all the borrower’s financial commitments, such as drawn and undrawn committed facilities with institutions, including Working Capital facilities, credit exposures of the borrower and the past repayment behaviour of the borrower, as well as other obligations arising from tax or other public authorities or social security funds;
5. when relevant, assess the structure of the transaction, including the risk of structural subordination and related terms, e.g. covenants, and, if applicable, third-party guarantees and Collateral structure.

Cash Flow versus Collateral

Institutions should consider that Cash Flow from the ordinary business activities of the borrower and, when applicable within the purpose of the loan agreement, any proceeds on the sale of the assets are the primary sources of repayment.

When assessing the creditworthiness of the borrower, institutions should put emphasis on the borrower’s realistic and sustainable future income and future cash flow, and not on available Collateral. Collateral by itself should not be a predominant criterion for approving a loan and cannot by itself justify the approval of any loan agreement. Collateral should be considered the institution’s second way out in case of default or material deterioration of the risk profile, and not the primary source of repayment, with the exception of when the loan agreement envisages that the repayment of the loan is based on the sale of the property pledged as collateral or liquid collateral provided.

Connected Clients

If the borrower is a member of a group of connected clients, institutions should carry out the assessment at individual level and, where relevant, at group level, in accordance with the EBA Guidelines on connected clients, especially when repayment is reliant on cash flow emanating from other connected parties. If the borrower is a member of a group of connected clients linked to central banks and sovereigns, including central governments, regional and local authorities, and public sector entities, institutions should assess the individual entity.

Cross-Border Elements

For lending activities with cross-border elements (e.g. Trade Finance, Export Finance), institutions should take into account the political, economic and legal environment in which the foreign counterparty of the institution’s client operates. Institutions should assess the buyer’s ability to transfer funds, the supplier’s capacity to deliver the order, including its capacity to meet the applicable local legal requirements, and the supplier’s financial capacity to handle possible delays in transaction.

ESG Factors

Institutions should assess the borrower’s exposure to ESG factors, in particular environmental factors and the impact on climate change, and the appropriateness of the mitigating strategies, as set out by the borrower. This analysis should be performed on a borrower basis; however, when relevant, institutions may also consider performing this analysis on a portfolio basis.

In order to identify borrowers that are exposed, directly or indirectly, to increased risk associated with ESG factors, institutions should consider using heat maps that highlight, for example, climate-related and environmental risks of individual economic (sub-)sectors in a chart or on a scaling system.

For loans or borrowers associated with a higher ESG risk, a more intensive analysis of the actual business model of the borrower is required, including a review of current and projected greenhouse gas emissions, the market environment, supervisory ESG requirements for the companies under consideration and the likely impacts of ESG regulation on the borrower’s financial position.

Analysis of the borrower’s financial position

For the purposes of the analysis of the financial position within the creditworthiness assessment as specified above, institutions should consider the following:

• both the current and the projected financial position, including balance sheets, source of repayment capacity to meet contractual obligations, including under possible adverse events, and, where relevant, capital structure, working capital, income and cash flow;
• where relevant, the borrower’s leverage level, dividend distribution, and actual and projected/forecasted capital expenditure, as well as its cash conversion cycle in relation to the facility under consideration;
• where relevant, the exposure profile until maturity, in relation to potential market movements, such as exposures denominated in foreign currencies and exposures collateralised by repayment vehicles;
• where applicable, the probability of default, based on credit scoring or internal risk rating;
• the use of appropriate financial, asset class-specific or product type-specific metrics and indicators, in line with their credit risk appetite, policies and limits set out in accordance with Sections 4.2 and 4.3, including considering metrics in Annex 3 to an extent that is applicable and appropriate to the specific credit proposal.

Institutions should ensure that the financial projections used in the analysis are realistic and reasonable. These projections/forecasts should be at least based on projecting historical financial data forward. Institutions should assess if these projections are in line with the institution’s economic and market expectations. When institutions have material concerns about the reliability of these financial projections, they should make their own projections of the borrowers’ financial position and repayment capacity.

If applicable, institutions should assess the financial position when granting loans to holding companies, both as a separate entity, e.g. at consolidated level, and as a single entity, if the holding company is not itself an operating company or institutions do not have guarantees from the operating companies to the holding company.

When assessing the borrowers’ financial position, institutions should assess the sustainability and feasibility of the future repayment capacity under potential adverse conditions that are relevant to the type and purpose of the loan and may occur in the duration of the loan agreement. These events may include a reduction in income and other cash flow; an increase in interest rates; negative amortisation of the loan; deferred payments of principal or interest; deterioration in the market and operating conditions for the borrower; and foreign currency exchange rate changes, when relevant.

Analysis of the borrower’s business model and strategy

Institutions should assess the business model and strategy of the borrowers, including in relation to the purpose of the loan.

Institutions should assess the borrower’s knowledge, experience and capacity to manage business activities, assets or investments linked to the loan agreements (e.g. specific property for a CRE loan).

Institutions should assess the feasibility of the business plan and associated financial projections, in line with the specificities of the sector in which the borrower operates.

Institutions should assess the borrower’s reliance on key contracts, customers or suppliers and how they affect cash flow generation, including any concentrations.

Institutions should assess the presence of any potential key-person dependency with regard to the borrower and, when necessary, identify, together with the borrower, possible mitigation measures.

Assessment of guarantees and collateral

Institutions should assess any pledged collateral that is used for the purposes of risk mitigation against the requirements for collateral set out in the institution’s credit risk appetite, policies and procedures, including the valuation and ownership, and check all relevant documentation (e.g. whether property is registered in appropriate registers).

Institutions should assess any guarantees, covenants, negative pledge clauses and debt service agreements that are used for the purposes of risk mitigation.

When relevant to credit decisions, institutions should assess the borrower’s equity and credit enhancements, such as mortgage insurance, take-out commitments and repayment guarantees from external sources.

If a loan agreement involves any form of guarantees from third parties, institutions should assess the level of protection provided by the guarantee, and if relevant, conduct a creditworthiness assessment of the guarantor, applying the relevant provisions of these guidelines, depending on whether the guarantor is a natural person or an enterprise. The creditworthiness assessment of the guarantor should be proportionate to the size of the guarantee in relation to the loan and the type of guarantor.

See Also

• EBA Guidelines on Loan Origination and Monitoring