What is Basel III?
It is a new agreement formed by the members of the Basel Committee on Banking Supervision. It is developed to plug the holes in the financial regulation deficiencies that led to the global financial crisis. Basel III will raise the banks’ capital reserve depending on how much they are lending out, so that the global financial sector can be more resilient to future shocks. The agreement specifically requires banks to hold 4.5% of common equity and 6% of Tier I Capital by 2015, up from 2% and 4% respectively, and an optional buffer on top of that.
Why will Basel III affect SME lending?
Although small and medium-sized enterprises (SMEs) did not cause the financial crisis, the subsequent credit crunch has severely limited their credit availability. With Basel III, banks will have to hold extra cash in reserve, meaning that they will be able to lend out less money compared to pre-crisis levels. With SMEs producing half of the private sector output and employing 63% of private sector workers, SMEs are going to be negatively affected by the Basel III regulatory restrictions.
How will Basel III affect SME lending?
When Basel III is enforced, according to the ACCA, banks can be roughly classified into two categories: credit pricing and credit rationing. Banks in the former category will generally set a higher price for firms to obtain credit due to the reduced credit supply, and the banks in the latter category will simply ration off the money that they are able to lend out. Small businesses would suffer more if more banks drop into the second category, as they will no longer be able to obtain credit even if they could pay the price.
When Basel III is fully effective in 2015, banks may demand additional security in order to comply with the reduced risk allowance. This means banks may require personal guarantees for SME borrowings or even switching away from lending to SMEs.
Moreover, smaller businesses have less bargaining power against a bank, so they are likely to face higher credit cost in the future. But as other alternative methods of financing have been made available recently, coupled with this rise in credit cost, small firms are now expected to turn towards other sources of credit. The extent of how much more small companies have to pay will depend on the market competition.
A way to get around the reduction of supply is to create securitisation for small business loans, but as seen in the financial crisis, the loss of information between investors and the banks may foster another round of "irrational exuberance" among investors, a term coined by Alan Greenspan. If such a bubble gets busted, small firms will be hit even harder compared to the current credit crunch.