Fresh scrutiny for Europe’s SME capital carve-out

A controversial European let-off for banks lending to smaller companies may be a waste of time, the Financial Stability Board has concluded.

In a new consultation, the FSB finds Basel III’s tougher post-crisis capital standards have not reduced lending to small and medium-sized enterprises (SMEs), and that Europe’s decision to diverge from those standards appears to have had no clear benefit for borrowers.

Speaking today at a press conference to launch the consultation, Klaas Knot – the FSB vice-chair and president of the Dutch central bank – urged conformity with international standards and noted that governments already had a wide range of policy tools to support the financing of the real economy, including government guarantee schemes on SME loans.

“We would caution [against] using capital requirements as a public policy instrument to foster SME lending,” he said.

The EU’s supporting factor for SMEs has been a source of regulatory and political contention.  

When the Basel Committee branded it a “deviation” from the international standards in December 2014, members of the European Parliament – who had lobbied in its favour – issued a press release stating that: “A large majority of MEPs cannot accept that the Basel Committee calls into question the tools to finance the economy, especially SMEs and corporate organisations.”

In Article 501 of the EU’s capital requirements regulation (CRR) that took effect in 2014, lawmakers introduced a discount factor of 0.7619 to Basel risk weights for SME lending, known as the SME supporting factor. It applies to all companies with less than €50 million ($56.7 million) in annual revenue as long as the bank has an exposure of less than €1.5 million to the company.

However, the FSB’s consultation paper states: “Studies on the effectiveness of the SME supporting factor do not find clear significant results.” The FSB cites the most recent study on the subject, published in the Journal of Financial Intermediation in October 2018 by two researchers at the Banco de Espana, that suggested medium-sized firms had enjoyed some improvement in the availability of credit, but not small firms. The FSB notes there was no overall impact “if all SMEs are analysed together”.

Based on this evaluation, at the level of the FSB I do not anticipate any revising of the current rules

Klaas Knot, FSB vice-chair 

The FSB’s report concludes the post-crisis reforms slowed SME lending slightly, but only temporarily during the implementation phase, and mainly in countries that were suffering economic recession at the same time. The consultation suggests it has not been possible to identify “material and persistent negative effects on SME financing in general,” making it unlikely the FSB will recommend any major changes to regulation.

“Based on this evaluation, at the level of the FSB I do not anticipate any revising of the current rules,” said Knot.

However, he also noted that changes with similar goals to the supporting factor were made to Basel III when the package was updated and finalised in December 2017.

“In the new Basel III revisions, there is actually a similar approach incorporated at the global level to this EU supporting factor. So there is more global sympathy for having such a factor in the global agreement,” said Knot.

This appears to be a reference to a new risk-weight treatment for SMEs that lack a credit rating. Smaller companies generally do not want the expense of seeking an external credit rating.

The original Basel II framework from 2004 imposed a 100% risk weight on unrated corporate exposures under the standardised approach, but also included a discounted 75% risk weight under the standardised approach for exposures classed as “regulatory retail”. To qualify, these need to be less than 0.2% of the total portfolio for each exposure, and must also meet certain product criteria such as credit card or leasing contracts – criteria that explicitly exclude mortgages or bond instruments.

The 2017 package included a new standardised approach category for unrated SMEs that do not meet the regulatory retail criteria. This category – assigned an 85% risk weight – applies the same €50 million revenue ceiling as the EU’s SME supporting factor.

As these reforms have not yet been implemented nationally, it is too early to assess what benefit – if any – this easing will have.

The European Commission has agreed it will introduce new legislation to implement the Basel III credit risk rules by June 30, 2020, which would be the moment to reconsider the SME supporting factor. However, the measure was originally introduced by members of the European Parliament during the debate on the 2014 CRR, and is likely to remain politically sensitive when the revisions are tabled next year.

Knot sought to discourage jurisdictions from using opt-outs from the Basel rules during the press conference. He said rules agreed internationally should be “implemented in a consistent and coherent fashion across the globe”, though he recognised there can be national specificities when Basel standards are transposed into local rules.

“Any deviation, in and of itself, we watch with some concern. We also know that… national legislative frameworks differ, so it is inevitable that, at the end of the day, you have some differences. But it is not always clear whether the differences are truly inevitable,” said Knot.