Few people like talking — or reading — about regulation. It's boring.
While frequently mind numbing, if ignored, regulation can often lay waste to the best-laid plans, especially when it comes to accessing financing for small and medium-sized enterprises. As it stands, there are two regulatory challenges that are causing major headwinds for SME lending and capital formation: Basel III regulatory capital requirements and Know Your Client guidelines, which has severely impacted correspondent banking.
The Basel Committee on Banking Supervision developed Basel III as a result of the lessons learned after the crash of 2008. The new, more stringent, regulations included changes to capital controls, leverage ratios and liquidity requirements. Compared to Basel II, Basel III requires banks to hold more capital. For SMEs, often twice as much. Basel-compliant countries use the committee’s standards to tailor laws and rules for their specific jurisdictions. For decades, the Basel framework sought to make international banking stronger and better able to withstand exogenous, macro-related shocks. Generally, holding more capital to withstand stress is wise, particularly in the wake of a financial crisis. It is, however, not ideal for SMEs.
Most importantly, or detrimentally, for SMEs, capital adequacy rules assign a risk weighting to each of a bank's assets that is meant to be proportionate to the credit and market risk that the asset in question represents. Under Basel III, loans to SMEs are assigned a relatively high risk rating. As such, banks have to hold more capital against SME loans than against, for example, government securities. In addition, banks struggle to measure the ex-ante riskiness of SMEs, which suffer from higher mortality — bankruptcy — rates, lack of credit information and scarce collateral.