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Effects of the New Basel Capital Accord on Bank Capital Requirements for SMEs

Published: 2005
Journal of Financial Services Research, Vol. 28, Issue. 1-3
By Edward I. Altman, Gabriele Sabato
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Abstract

Using data from three countries (US, Italy and Australia) and surveying related studies from several Other countries in Europe, we investigate the effects Of the New Basel Capital Accord (Basel II) on bank capital requirements for small and medium sized enterprises (SMES). For each country, we analyze different possibilities that banking organintions have in considering SMEs, as either retail or as corporate, with a special discount linked to the firm's sales size. We find that, for all the countries, banks Will have significant benefits, in terms Of lower capital requirements, when considering small and medium sized firms as retail customers. But they Will be obliged to use the Advanced IRB approach (providing their own estimates Of probability Of default (PD) and loss given default (LGD) for each counterparty and to manage them on a pooled basis. For SMES as corporate, however, the results show that capital requirements will be slightly greater than under the existing Basel I Capital Accord. We believe that most eligible banks will use a blended approach (considering some SMEs as retail and some as corporate). Through a breakeven analysis, we find that for all Of our countries, banking organizations will be obliged to classify as retail at least 20% Of their SME portfolio in order to, at a minimum, maintain the current capital requirement (8%). Moreover, we show that the percentage Of SMEs to be classified as retail increases to at least 40% if banks will want to enjoy lower capital requirements by implementing the Advanced IRB instead Of the Standardized approach. Since one Of the main goals Of the new Basel Capital Accord is to improve the efficiency of banks risk management systems, we conclude that a likely impact will be an additional motivation for banks to consider and manage their SMEs clients as retail customers.

Introduction

Small and medium sized enterprises (SMEs) play a fundamental role in the economy of many countries all over the world. For OECD members, the percentage of SMEs out of the total number of firms is greater than 97%. They are a continuing source of dynamism for the economy, producing three-fourths of the total jobs and often more than one-third of the country's GDP- Thanks to the simple structure of SMEs, they can respond quickly to changing economic conditions and meet local customers' needs, growing sometimes into large and powerful corporations or failing within a short time of the firm' s inception. Many public and private financial institutions, such as the World Bank or Governments themselves, launch each year plans in order to sustain this essential player of nations' economy. Borrowings, however, especially from commercial banks*, remain undoubtedly the most important source of external SME financing.

Concerns have been raised that the new Basel Capital Accord (Basel II) will change the way banks analyze credits, introducing new credit risk management techniques and possibly reducing the lending activity toward SMEs. This is due to banks' potential perception that SMEs carry higher risk and, hence, higher capital requirements than under Basel L Many SME associations in different countries have publicly complained about the new rules and many governments are now concerned. To reduce these concerns, the European Commission published a report in which the SMEs access to finance, for non-start-up companies, was analyzed The report concluded that only 13% of European SMEs consider access to finance as a major barrier. Approximately of them had at least one established credit line. However, this study's conclusions did not eliminate SME's concerns about their future under the new Basel Accord.

From the beginning (1999) of the capital adequacy reform process, the Basel Committee paid particular attention to the SME segment, mainly by having changed the formulas to calculate risk weights linked to SMEss three times. In the last version (June 2004, par. 232 and 273), banks are able to consider small and medium sized enterprises as retail or as corporate entities, primarily based on their total exposure to this entity. If total exposure is under e I million, SMEs can be classified as retail, but another important qualitative requirement must be followed: the credit must be managed as a retail exposure. This means that "the exEH»sure must be one of a large pool of exposures which are managed by the bank on a pooled basis". On the other hand, if SME credits are classified as corporate, a special "discount" in the asset correlation calculation is ensured for exposures to firms with under €50 million in sales. Both approaches specify "haircuts" which are based on the assumption that smaller firms credit risks are less correlated as to default risk than larger corporates and less sensitive to the business cycle. We also expect that the benefits shown for SMEs have been motivated by nations' concerns about lessening credit possibilities and the importance that SME owners and employees have on voting results.

In this paper, we use data from three different countries (US, Italy and Australia), considering the SME structure of each economy, in order to quantify the expected effect on the bank capital requirements when considering a small firm as either retail or corporate.

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