The New Basel Capital Accord and Sme Financing the New Basel Capital Accord and Sme Financing Smes and the New Rating Culture

The Centre for European Policy Studies (CEPS) is an independent policy research institute in Brussels. Its mission is to produce sound policy research leading to constructive solutions to the challenges facing Europe. As a research institute, CEPS takes no position on matters of policy. The views expressed are entirely those of the author. Acknowledgments: The author would like to thank Els Desmet, Ortwin Volcke and Karel Lannoo for their constructive comments and suggestions along with all those who contributed to the finalisation of this report by responding to the CEPS survey on the Basel II Capital Accord and SME financing. CEPS gratefully acknowledges financial support for this study from CRION, a member of Aon Trade Credit. The report, however, is the responsibility of the author and any conclusions should not be attributed to CRION. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the Centre for European Policy Studies. As the negotiating period for finalising the new Basel Capital Accord (hereafter 'Basel II') drew to a close, there were serious apprehensions among industry members that the likely high capital charge would discourage banks from granting loans to small-and medium-sized enterprises (SMEs), thereby triggering a shortage of finance for this sector. It was thought that this situation would damage the EU economy since SMEs, which are known to be the most important source of growth and employment creation in the EU, already suffer from financing problems. These concerns were partially assuaged when the Basel Committee introduced a more favourable treatment of SME portfolios under pillar 1, based on empirical evidence suggesting that SMEs have a lower default correlation than large enterprises. This finding in turn suggests that the lower the default correlation among SMEs, the fewer the number of firms in this sector that are affected by the same macroeconomic factors and the more the default is related to idiosyncratic or firm-specific risks. Nevertheless, the more risk-sensitive pricing introduced by the internal ratings-based approaches under pillar 1 of Basel II will certainly entail variation in capital adequacy, depending upon the individual quality of the SME. Indeed, a poor-quality (low-rated) SME will force the bank to hold more regulatory capital compared to a high-quality (highly rated) SME. This situation does not curtail loan …