VoxEU Column Financial Regulation and Banking

Basel regulation: Friend or foe of small business lending?

Small businesses are the engine of innovation and job creation, and Basel regulation acknowledges their special role and discounts the capital requirements for loans to small firms. This column argues that the Basel requirements overstate the riskiness of small businesses, and that retail exposures are a much safer investment than previously thought. By forcing banks to hold a disproportionately higher amount of capital against such loans, Basel can unintentionally harm lending to small private firms.  

Small businesses: A friend?

Small businesses are the engine of innovation and job creation and therefore are of special interest to policymakers. Basel regulation acknowledges their special role and discounts the capital requirements for the loans to small firms. For example, the internal rating-based (IRB) capital requirement amounts to 5.54% for a corporate loan with a 5% probability of default, 20% of loss given default, and effective maturity equal to 3. If classified as a small business (retail) loan, that same loan with 5% probability of default and 20% of loss given default has 2.36% capital charges.

This is a much welcomed discount, especially in the view of current research by Baker and Wurgler (2015) showing that greater capital requirements imposed by regulators increase bank’s cost of capital and potentially harm investments and growth. Higher capital charges in general mean that banks have a higher share of equity financing and, as Admati and Hellwig (2013) argue, are safer. Despite being viewed as safer, such banks do not enjoy cheaper access to equity financing. In fact Ang et al. (2009) document a “low risk anomaly” in which low beta stocks earn greater returns. The low risk anomaly is weaker in the debt markets, which justifies banks’ persistent lobbying to have lower capital requirements and rely more on the debt financing rather than on equity financing.

Figure 1 shows that banks with a large share of small business lending (as a ratio of the outstanding amount of loans to small businesses with original amount below $100,000 to the total value of C&I loans) do indeed enjoy lower capital requirements. In 2005 the top 25% of banks with most small business loans enjoyed a 2.1% lower Tier 1 leverage capital ratio than the bottom 25% of banks. This reduction in capital requirements does not necessarily mean that those banks are more vulnerable during a crisis. During the Global Crisis, only 54 out of the top 25% of banks with most small business loans failed, comparing to 101 failed banks in the bottom 25%.

Banks enjoy various benefits from lending to small businesses, such as lower capital charges, lower cost of capital, and lower failure rate of the banks during the Global Crisis. Despite these benefits, studies such as Udell (2009) observe that in recent years, the credit crunch subjected many small businesses to shortage of funding. For example, Figure 2 shows that – whether still operating or failed in the aftermath of the Global Crisis – most US banks tend to have low exposure to small business lending. In particular, three out of four banks report less than 35% of their C&I loans are to small businesses. So, why don’t we observe more small business lending?

Small businesses: An enemy?

It seems necessary to critically evaluate the Basel capital adequacy framework for small business loans. We take a much needed step towards this direction in our recent paper (Bams et al. 2015), in which we examine the validity of Basel IRB capital requirements in portfolios of loans to small firms. Basel regulators, motivated by the importance of small businesses, discount the capital charges for small business loans with the intention to make lending to small firms more attractive. However, we show that the discount is inadequate as the credit risk in those loans is primarily idiosyncratic, and therefore in principle losses on small business loans should be covered largely by loan pricing and provisioning rather than by capital requirements. If pricing and provisioning of those loans is done properly, banks should be required to hold only a small required capital against those loans.

Figure 1. Categories of banks which lend to small businesses

Notes: Four equally populated groups of banks categorized with respect to their exposure to small business loans. The exposure to small business loans is computed for year 2005 and is a share of C&I loans to small business with original amount of $100,000 or less.

Figure 2. Share of small business lending in banks’ commercial and industrial (C&I) loan portfolios in 2005

Notes: Whether still operating or failed in the aftermath of the financial crisis, most U.S. banks tend to have low exposure to small business lending. In particular, 3 out of 4 banks report less than 35% of their C&I loans are to small businesses and with original amount of $100,000 or less.

  • We find that Basel IRB formula significantly overstates the asset correlation and thus capital requirement for small firms.
  • Importantly, this is not the case in other asset classes, i.e. in portfolios of large corporate loans.

By forcing banks to hold a disproportionately higher amount of capital against such loans, Basel can unintentionally harm lending to small private firms. It creates perverse incentives for financial institutions that flee to other asset classes in which loans originated are less costly to hold. Additionally, it can encourage more financing in the corporate loans rather than in small business economy.

As explained in Basel Committee on Banking Supervision (2005), in preparing the capital regulation, Basel was able to use historical data on corporate loans but had no access to historical information on small business loans. Regulators decided to ignore this inconsistency and for the corporate loans they estimated the regulatory formula based on the available historical data. Faced with a lack of historical information on small business loans, regulators calibrated the formula for small business capital requirement such that it fit the capital levels banks held prior to the regulation. By doing so, Basel regulators created precedence in which one asset class (small business loans) is treated differently from others. This might have dire consequences for access of small business to finance.

Next steps

We would like to advocate a greater vigilance in the regulation and policymaking. Given the now improved access to information on small business lending, regulators could acquire data on small business loans and repeat the exercise to calibrate the capital requirements to the historical loan data for all asset classes and not as done currently by mistreating small business loans. We believe that this will stimulate a better access to finance for small businesses and equally provide incentives for lending to large corporate firms and to small businesses.

References

Admati, A R and M Hellwig (2013), The Bankers’ New Clothes, Princeton University Press, (Princeton).

Ang, A, R Hodrick, Y Xing, and X Zhang (2009), “High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence”, Journal of Financial Economics 91, 1-23.

Basel Committee on Banking Supervision (2005), “An explanatory note on the Basel II IRB risk weight functions”, Bank for International Settlements.

Bams, D, M Pisa and C Wolff (2015), “Credit Risk Characteristics of US Small Business Portfolios”, CEPR Discussion Paper No. DP10889.

Udell, G F (2009), “How Will a Credit Crunch Affect Small Business Finance?” FRBSF Economic Letter, 2009-09, Federal Reserve Bank of San Francisco (March 6).

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