OFFICE:FMA DEVEX Explainer: For SMEs, access to finance isn't the problem. Lending is.

This article, by OFFICE:FMA Partners Steven Zausner and Andrew Haimes, originally appeared on DEVEX.

Explainer: For SMEs, access to finance isn't the problem. Lending is.

A female entrepreneur visits a bank in Vientiane, Laos. Photo by:  Stanislas Fradelizi / World Bank  /  CC BY-NC-ND

A female entrepreneur visits a bank in Vientiane, Laos. Photo by: Stanislas Fradelizi / World Bank / CC BY-NC-ND

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.

Basel III

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.

Banks exist on leverage. The higher the leverage they can get, the better returns they can generate. As such, the lower the capital requirements for an asset, the more capital they can deploy. This dynamic leads to banks making a choice between two ends of a spectrum: Either holding more capital to sustain the same amount of lending, or keeping the gross amount of capital and reducing risk. Most banks leaned towards reducing risk by cutting loans to riskier assets. SMEs became an easy target: High risk, lots of person-power needed to process loans and, with a higher capital requirement, now a guaranteed lower return.

Pretty simple, right? No? Okay, here's a sample problem.

XYZ Bank in Taxastania has the choice of the following investment options, yielding:

Treasuries: 5 percent
Investment Grade (IG) Corporates: 10 percent
Unrated SMEs: 15 percent

And assuming that the cost of processing/managing these investments was the same (which it is not), what would be the best investment. Easy, right? The SMEs.

Ah, but here's the rub. Under Basel, each of these instruments has a different capital requirement. Again, somewhat broadly, say they were required to hold the following percentages of capital against each of these investments:

Treasuries: 2 percent
IG Corporates: 5 percent
Unrated SMEs: 10 percent

As such, leverage for each is:  

Treasuries: 50 times
IG Corporates: 20 times
Unrated SMEs: 10 times

Meaning investment return would be, assuming no defaults and linear payment (two huge assumptions):

Treasuries: 50 x 5 percent = 250 percent
IG Corporates: 20 x 8 percent = 160 percent
Unrated SMEs: 10 x 10 percent = 100 percent

So, what looks like a no-brainer, actually, generally, becomes a no-go.

Given their size, SMEs tend to be very dependent on bank credit, as other financing sources, such as wholesale debt or intra-firm funding are not available. As such, Basel III rules disproportionately affect SMEs access to capital.

At the time that the Basel III accords were formulated, contemporary commentators such as the Association of Chartered Certified Accountants, a prominent global accountancy body, anticipated negative consequences for small and medium-sized businesses, noting that: “... the credit crunch and economic slowdown that followed it have hit smaller enterprises hard. Although Basel III is often described as a recipe for mitigating and perhaps even avoiding future financial crises, its effects on lending to small businesses are generally expected to be disproportionately negative.”

The result of Basel III on SME lending has, indeed, been disproportionately negative. In May 2016, the European Banking Authority released a report trying to analyze the effect of Basel III on SME lending. One conclusion: “SME lending remained below its pre-crisis level.” The United States Treasury recently released a report that reached similar conclusions.

The way Basel III categorizes overdrafts also has bad consequences for SMEs. One of the key ways SMEs meet working capital needs is through bank overdrafts, which occur when money is withdrawn from a bank account and the available balance goes below zero. Under Basel III, banks have to consider overdrafts the same as draws on loan facilities. In other words, they have to hold credit risk capital on overdraft facilities, which are typically considered to be simple short-term liquidity products, instead of loans. Structurally, loans and overdrafts are different and should be treated differently under regulatory capital rules. This all means it’s no longer attractive for banks to offer overdrafts.

Know Your Client and the decline of correspondent banking  

Through correspondent banking relationships, banks can access financial services in different jurisdictions and provide cross-border payment services to their customers, supporting international trade and financial inclusion.

Large global banks have traditionally maintained broad networks of correspondent banking relationships, but this situation is changing, rapidly. In particular, some banks providing these services are reducing the number of relationships they maintain and are establishing few new ones. As a result, many correspondent banks, especially in emerging markets, are at risk of being cut off from international payment networks. This implies a threat that cross-border payment networks might fragment, and that the range of available options for these transactions could narrow.

Bank of England Governor and Chairman of the G-20 Financial Stability Board Mark Carney recently highlighted the risk, writing: “So-called ‘de-risking’ in correspondent banking relationships has threatened the ability of some emerging market and developing economies to access the international financial system, and it risks driving flows underground.”

Rising costs and uncertainty about how far customer due diligence should go in order to ensure regulatory compliance and to what extent banks need to know their customers’ customers — the so-called Know Your Client — are cited by banks as among the main reasons for cutting back their correspondent relationships. In fact, “90 percent of bank officers surveyed by the International Chamber of Commerce in 2016 cited the cost or complexity of compliance requirements relating to anti-money laundering, Know Your Client and sanctions as a chief barrier to the provision of trade finance.”

A further 77 percent cited Basel III specifically as a significant impediment to trade finance. To avoid penalties and related reputational damage, internationally active banks have developed an increased sensitivity to the risks associated with this business. This sensitivity has particularly hurt SMEs, which encompassed 58 percent of rejected trade-finance proposals, despite forming only 44 percent of submissions.

As a consequence, they have cut back services for correspondent banks that: (i) Do not generate sufficient volumes to overcome compliance costs; (ii) are located in jurisdictions perceived as too risky, i.e., emerging and frontier markets; (iii) provide payment services to customers about which the necessary information for an adequate risk assessment is not available; or (iv) offer products or services or have customers that pose a higher risk for anti-money laundering/combating the financing of terrorism and are, therefore, more difficult to manage. The Middle East is often cited as being particularly vulnerable to this risk.

For first time participants in the financial sector — oftentimes SMEs that are graduating from the “grey economy,” a large segment in emerging markets — the intrusive nature of the expanded due diligence and regulations can be an insurmountable barrier. Most of these firms will not have ready, or sufficiently-prepared access to all of the financial information, historical data and   other sources required by their counterpart at a financial institution. Adding the sometimes overlapping and excessive number of touchpoints to provide and recertifying key data can often lead to slow, tedious and inconsistent relationships between financial institutions and SMEs. This increases the opportunity and actual cost to a given financial institution, which can seemingly justify their reticence to lend to SMEs.

A recent WTO report on Trade Finance and SMEs found that superfluous and not harmonized regulatory requirements were seen as a serious impediment to trade finance, as detailed in the below chart.

Source: ICC

Source: ICC

Billy Evans, managing director of operations for Barclays Africa, summed it up nicely in a recent interview on how anti-money laundering, KYC and other regulations in Basel III have proliferated   rapidly, with many inconsistencies or even incongruities, which can dramatically increase the time and expense needed to be compliant. Beyond highlighting the general burden of these regulations, he emphasized how most of this must be completed pre-deal: “You cannot do deals or conduct trade finance, for example, without having these things in place,” he said. “The onerous regulations really do lengthen the time between interest and execution on a loan or form of credit, which can hurt SMEs in particular, given their lower levels of free capital.”

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