- The amount of state aid embedded in a public guarantee is the difference between the market rate of the premium and the premium, if any, that is actually charged.
- The market rate of premium reflects the risk borne by the guarantor, which in turn reflects the credit rating of the beneficiary and the value of the collateral, if any, that it can pledge.
- The market rate of premium for guarantee scheme must also include the cost of capital that is necessary to absorb any losses.
Introduction
When state aid is provided in a form other than a grant, it becomes necessary to calculate the gross-grant equivalent [GGE] of state aid embedded in the measure in question. The de minimis regulation [Regulation 2023/2831], allows Member States to grant public guarantees under certain conditions without charging any premium, provided that, among other things, the guaranteed amount does not exceed EUR 2.25 million over five years. Then, it is presumed that the GGE of the aid embedded in the guarantee remains below the threshold of EUR 300,000 per three-year period per undertaking. If the amount is greater, or if the duration of the guaranteed loan is longer or if the beneficiary is a large undertaking with a credit rating lower than the prescribed B-, then Member States must use an appropriate methodology that must have been previously notified to and approved by the Commission. Given that for larger amounts and longer periods the GGE would exceed the de minimis threshold of EUR 300,000, it is also necessary for the granting authority to charge an appropriate premium in order to ensure that any difference between a market premium and the premium that is actually charged results in a GGE that remains below EUR 300,000.
For example, an SME with credit rating BB that seeks to obtain a guarantee for a loan of, say, EUR 20 million with duration of one year would have to pay a market premium of 2%. The 2% rate is the safe-harbour rate derived from the table in the Commission’s 2008 Notice on state aid in public guarantees. According to the Notice, the guarantee may not exceed 80% of the underlying loan. Therefore, the guaranteed amount would be EUR 16,000,000. A market rate of premium of 2% would require payment by the borrower of EUR 320,000 [= EUR 16,000,000 x 0.02]. This exceeds the de minimis threshold. However, if, for example, the granting authority charges a premium of 0.2%, the borrower would have to pay EUR 32,000 [= EUR 16,000,000 x 0.002]. Therefore, the GGE would be EUR 288,000 [= EUR 320,000 – EUR 32,000], which can be granted as de minimis aid.
Recently, there has been a flurry of notifications by Member States of various methodologies for estimating the GGE of state aid in the form of guarantees. Here are some of the recent measures that have been approved by the Commission:
- 110155: Spain: Methodology for calculating market-conform guarantee premiums for the modernization of the merchant fleet of Spanish shipowners.
- 113219: Belgium: Methodology to calculate the aid element in agricultural guarantees.
- 118719: Denmark: Calculation method for the guarantee scheme SA.109413 in the agricultural sector [the originally approved measure was SA.29974 of March 2010].
- 119003: Latvia: Guarantee methodology for large undertakings.
- 119113: Finland: Methodology for calculating market-conform state guarantees premiums for agriculture.
The variety of the measures above indicates that the chosen methodology needs to reflect the particularities of the undertakings or sectors to which the guarantee in granted.
Guarantees free of state aid
For a guarantee to be free of state aid, the premium charged must be at the appropriate market rate. Section 3.2 of the Commission’s 2008 Notice on guarantees lays down the following four cumulative requirements:
- The borrower must not be in financial difficulty.
- The extent of the guarantee can be properly measured when it is granted. This means that the guarantee must be linked to a specific financial transaction, for a fixed maximum amount and limited in time.
- The guarantee must not cover more than 80% of the outstanding loan or other financial obligation.
- A market-oriented price must be paid for the guarantee.
The art and science of determining the appropriate premium for a guarantee is the calculation of the probability of default. This is the risk borne by the guarantor. This is because if the borrower defaults on its loan, the guarantor has to pay the lender the guaranteed amount. The probability of default is mainly determined on the basis of historic data and is based on the implicit assumption that future events resemble past events. The more comprehensive the data, the more accurate the assessment of risk. The default rate of start-ups is considerably higher than the average in any sector of the economy. By contrast, companies acquired by third parties normally exhibit a much lower probability of default, possibly because acquired companies are either healthy or are restructured and turned around by their new owners.
A private guarantor would charge a premium that covers at minimum the cost of the risk it assumes. For an individual guarantee, the quantification of the risk for one year is given by the following equation:
Cost of risk [individual guarantee] = (loss given default x probability of default)
The loss given default depends on the quality of the collateral. For example, if a guarantee covers 80% of a loan of 100 and the borrower can pledge collateral whose value is 50, then the loss given default is 30 or in percentage terms 37.5% [= 30/80]. Hence, if the probability of default is, say, 5%, the amount of expected loss is 1.5 [= 30 x 0.05]. Alternatively, the expected loss for every euro guaranteed is 1.9% [= 0.375 x 0.05] which for a guaranteed amount of 80, the expected loss is also 1.5 [= 80 x 0.019].
For a scheme, it is necessary to add the cost of capital that absorbs losses:
Cost of risk [scheme] = (loss given default x probability of default) + cost of capital
Normally, it is assumed that capital must cover at least 8% of the guaranteed amount and be remunerated at 4%; i.e. the cost of capital per euro guaranteed is 0.32% [= 0.0032 = 0.08 x 0.04]
To the premiums of both individual guarantees and guaranteed schemes, the cost of administering the guarantee must be added and this exercise has to be repeated for every year that the guarantee covers the remaining principal of the loan.
State aid embedded in guarantees
A guarantee is deemed to contain state aid, if the premium charged is lower than the corresponding market rate. Section 4.1 of the 2008 Notice explains that “the state aid element will be deemed to be the difference between the appropriate market price of the guarantee provided individually or through a scheme and the actual price paid for that measure.”
“The resulting yearly cash grant equivalents should be discounted to their present value using the reference rate, then added up to obtain the total grant equivalent.”
The 2008 Notice further explains that when calculating the aid element in a guarantee, the Commission pays special attention to the following four factors:
- Whether undertakings in financial difficulty are excluded.
- Whether the extent of each guarantee can be properly measured when it is granted.
- Whether the guarantee covers more than 80% of each outstanding loan or other financial obligation.
- Whether the specific characteristics of the guarantee and loan (or other financial obligation) have been taken into account when determining the market premium of the guarantee, from which the aid element is calculated by comparing it with the premium actually paid.
A relatively simple model for determining the GGE of state aid in public guarantees
The methodology approved by the Commission for the original Danish measure in SA.29974, which was later modified by SA.118719, was probably the simplest.[1] It applied only to SMEs with higher risk, which were not able to secure a loan according to normal banking rates and practice.
The GGE was calculated as the difference between the outstanding sum guaranteed, multiplied by the market premium, and any amount of premium actually paid. Expressed as formula, the GGE is:
GGE = (G x Pm) – Pa, where
G = guaranteed amount
Pm = market rate of premium [for the relevant risk class]
Pa = actual amount of premium paid, if any.
On the basis of the above calculation and given that the guaranteed loans are depreciated linearly over their lifetime, the average aid element of the guarantees for undertakings in the agriculture and fisheries sectors would be 15.23 % and the worst case scenario would produce an aid element of 19.02%.
The conditions that were taken into account are listed below [values are in DKK]:
- Discount rate: 88%
- Expected total loan volume: 2352 million
- Total guarantee volume [75% of loans]: 1764 million
- Expected default rate: 20% [based on past experience]
- Initial premium paid by borrowers: 2%
- Yearly premium paid by borrowers: 25%
- Maximum loan amount per borrower: 10 million
- Expected income from premiums: 130 million
- Administrative costs: 23 million [or 1.3% = 23/1764]
- Expected payments on loan defaults: 353 million [i.e. 1764 x 0.2]
- Capital cost: 56 million [i.e. remuneration at 4% for required capital of 8% for 1764 million = 0.04 x 0.08 x 1764 over ten years]
- Total costs: 432 million [i.e. 23 + 353 + 56]
- Total required market premium: 49% [i.e. 432/1764]
The conditions defined above mean that in the first year a loan of, say, EUR 10 million would have a guaranteed element of EUR 7.5 million [= 75% of the principal of the loan]. The borrower would pay an one-off premium of EUR 150,000 [= EUR 7.5 million x 2%] plus an annual premium which in the first year would be EUR 93,750 [= EUR 7.5 million x 1.25%], i.e. a total of EUR 243,750. However, the market premium for that guarantee was would be EUR 407,974 or 5.4% of the guaranteed amount.
Therefore, the GGE the state aid would be EUR 164,224. If the loan were just for one year, the aid could be considered to be de minimis. However, for an eight-year loan, the total amount of the annual state aid, discounted to the date of the granting of the guarantee, would be about EUR 1,142,515 which is far above the de minimis threshold. In that case, the guarantee would need to be linked to an investment undertaken by the borrower. For example, the borrower could use the loan of EUR 7.5 million to finance an investment project with eligible expenditure of at least EUR 7.5 million. Then an amount of state aid of EUR 1,142,515 would correspond to aid intensity of 15.23% [= 1,142,515/7,500,000]. Investment aid of such rate of intensity could be granted, for example, to a small enterprise under Article 17 of the GBER or to an SME investing in an assisted region under Article 14 of the GBER.
A more complex model
One of the most recently approved methodologies is that of Latvia for guarantees granted to large undertakings, as approved by the Commission in SA.119003.[2]
The Latvian scheme provides guarantees for amounts up to a maximum of EUR 25 million, with the maturity of the guaranteed loans not exceeding 20 years. Unlike other guarantee schemes where the state bears the full loss up to 80% of the underlying loan, losses in this scheme are sustained proportionally and in the same way by the lender and the guarantor. This is because, the guarantees are provided by ALTUM – Latvia’s state-owned financial development institution – to banks which offer the loans.
In order to determine the appropriate guarantee premium, the Latvian methodology requires the calculation of the following three amounts for each individual exposure:
- The risk based premium.
- The effective interest rate premium.
- The CDS premium.
Then ALTUM establishes the applicable guarantee premium for each individual exposure by adopting the highest amount among the three calculations so that:
Guarantee premium = the highest of the risk based premium or the effective interest rate premium or the CDS premium.
Risk based premium
The risk based premium is composed of three components: the risk of expected losses [EL], administrative cost [AC], and annual capital remuneration [ACR].
Expected losses are calculated according to the formula:
EL = LGD x (((1 – (1 – PD))WAL/WAL), where
LGD = loss given default, which depends on the quality of collateral
PD = one-year probability of default
WAL = weighted average life of the exposure, expressed in years.
The one-year default probability for the most secure class is [0.25%- 1.00%] while for the least secure class it is [3.00%- 5.00%].
Administrative costs are calculated as an average of historical data of the costs incurred since 2016, and they are [0.20%-0.60%]. Administrative costs cover the initial risk assessment as well as risk monitoring and risk management and encompass both direct costs associated with servicing of guarantees and a portion of indirect costs that support overall operations, which are not directly linked to the servicing of guarantees. The allocation of indirect costs is based on the number of full-time employees [FTEs] engaged or forecast to be engaged with respective financial instruments relative to the total number of FTEs.
The annual capital remuneration varies between 1.25% and 1.85%, depending on the class of risk to which it corresponds. Borrowers are allocated to one of five different classes of risk.
Effective interest rate premium
Because the guarantees are provided to banks, the measure in question seeks to prevent banks from charging a higher rate of interest on the loan they grant. That is, the measure seeks to minimise any advantage to banks .
As explained in the Commission decision, “(36) the EIR methodology is designed to assess the interest rate applied by the financial institution to the loan, from which the implied credit spread – representing the premium required for the borrower’s credit risk – is derived. By ensuring that the price of the guarantee is aligned with the price of the loan, the methodology prevents the financial institution from deriving undue benefit from a guarantee granted at a subsidised or below-market rate. Where the interest rate charged is excessively high, the resulting credit spread will likewise be high, thereby diminishing the attractiveness and effectiveness of both the guarantee and the loan.”
The guarantee premium [GP] that is based on the effective interest rate method [EIR] is defined as follows:
GP > (EIR − F – (G ∗ CDS))/(1 – G) where,
EIR = effective interest rate charged
F = funding cost of the bank
G = guaranteed amount (80% <)
CDS = credit default swap of the bank.
[1] The text of the Commission decisions SA.29974 & SA.118719 can be accessed, respectively, at:
https://ec.europa.eu/competition/state_aid/cases/234247/234247_1083038_22_1.pdf, and
https://ec.europa.eu/competition/state_aid/cases1/20263/SA_118719_41.pdf
[2] The text of the Commission decision can be accessed at:
https://ec.europa.eu/competition/state_aid/cases1/20264/SA_119003_73.pdf
