Financial regulations in Europe (and beyond) will make lending for small businesses more difficult.
In 2011 the European Commission unveiled its proposals for the Capital Requirements package commonly referred to as CRD IV, which will, among other things, implement Basel III (the new global framework for bank capital and liquidity regulation) in the EU member states.
We have long championed the cause of more and better capital for banks and realises that there is a trade-off to be made between economic growth and financial stability. In calibrating the provisions of CRD IV the stakes are very high. European SMEs are more dependent on bank lending than their US counterparts and in turn EU banks are more exposed to SME loans. In 2012 Europe's SMEs will need to finance around €646 billion worth of investment in fixed assets alone and unless banks play their part much of the growth we’re all counting on will never materialise.
Changes CRD IV can bring
The European Commission has conducted an SME test on the potential impact of CRD IV, however, we believe that the evidence cited misrepresents the impact on lending to SMEs. Under CRD IV, lending to SMEs will be substantially discouraged in ways that the policy makers do not fully understand.
CRD IV will change not just interest rates but entire business models leaving little room for SME lending. In fact since the first Basel accord was implemented in the early 1990s lending has been marginalised as a banking activity, and lending to SMEs even more so. The Commission has claimed that this isn't the case, citing evidence from the adjustment to higher capital requirements among European banks in Q4 2010 and Q1 2011. However, these two data points don’t represent the amount of time during which banks have known about and begun to prepare for the likely provisions of CRD IV, and moreover discuss loan volumes, which are unlikely to be the primary channel through which the impact of the new requirements reaches SMEs in the short term.
The Commission has also argued that SMEs transact more with smaller banks which are better capitalised and more liquid and will therefore be less affected by CRD IV. This claim is not only false but also a dangerous generalisation. It’s true that smaller banks are usually better capitalised than larger banks and it is almost certainly true that SME lending represents a larger portion of their business. However, research by CapGemini suggests that small businesses account for 46% of the risk adjusted assets of global retail banks: the combined SME loan portfolio of Europe's large banks is larger for the purposes of CRDIV than regulators realise; besides, as we have since found out, CRDIV is even more ill-suited to small lenders than it is to large ones.
Thirdly the Commission has argued that the benefits of financial stability are greater for SMEs than for large businesses and that the market will demand capital adjustments similar to those under CRD IV anyway as investors and bondholders need to be reassured of the solvency of European banks. These arguments are not unreasonable – however we would argue that if the capital adjustments were to be demanded anyway then there would be no need for further regulation. Even if the rate of recapitalisation and/ or deleveraging were left purely to the market the Commission would still be considering support for SMEs as it did in the financial crisis of 2008/2009. If so, then it is best to build in some support for SMEs in to or alongside CRD IV from the outset rather than wait for a new credit crunch.
One thing the market would not arrive at spontaneously is the set of risk weights that CRD IV applies to different bank assets, nominally derived from estimates of operational, market and credit risks. However, these are not the risks that the legislative package is meant to prevent. In effect CRD IV is double-penalising mundane risks while ignoring the systemic risks, meaning that SMEs across the European Union are going to take a hit that should have been reserved for the true authors of the financial crisis.
It is clear that further work is needed to understand the impact of CRD IV. In addition to a second SME test for CRD IV, no later than 2015, we would like to see a business support package to mitigate the early effects of CRDIV and an adjustment of its unrealistic risk weights.
If this does not happen, Europe's SMEs, businesses that are vital to every economy across the EU, could end up paying dearly for CRDIV and missing out on the financial stability promised in return.
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