Capital requirement regulations have been extended to infrastructure finance, but need tweaking to be fully effective.
The financial crises that have occurred over the past two decades have typically been caused by issues related to credit supply. Subsequent regulation has focused on ensuring the resilience of banks and their support for non-financial firms.
On top of their main objective of maintaining the stability of the financial system, regulators have concentrated on ensuring the continuity of credit during periods of recession and sought to stabilise the business cycle, in accordance with the correlation between the contribution of bank credit supply and real GDP.
These goals, however, are not always compatible with each other.
In financial crises, industrialised countries typically see a decrease in credit supply led by a tightening of loan and finance criteria.
Structural differences in economic systems can be an obstacle to effective decision-making – and the EU is a case in point.
EU member states have a high degree of heterogeneity, particularly in relation to the contribution of small and medium-sized enterprises (SMEs) to turnover – ranging from 47% in Germany to 69% in Italy.
Regulator reaction
Given that SMEs generally have lower credit quality than large firms, compliance with capital constraints typically squeezes banks that do the most business with this customer segment.
Supervisory authorities’ response to these concerns was the introduction of a ‘SME supporting factor’ to offset the tightening of capital requirements as a result of Basel III.
The regulatory measure – introduced by Capital Requirements Regulation 575/2013 (CRR) – seeks to ensure an adequate flow of credit; and allows credit exposure to SMEs to neutralise the new capital requirements introduced with the Basel III reforms.
The rationale for the SME supporting factor is based on two assumptions:
1) it is important to support a socially-relevant sector that has been badly affected by the crisis and can struggle to access credit; and
2) a portfolio composed of SMEs has lower risk because a diverse mix of small businesses will react differently to a negative external event, mitigating its effects.
During the Covid-19 crisis, European regulators have introduced a final revision of the CRR, increasing the capital discount for exposure to SMEs and strengthening essential public services.
The regulatory measures adopted do not eliminate the problems associated with companies’ size.
According to EU Regulation 2020/873 of June 24, 2020, the application of these measures “in the context of the Covid-19 pandemic would incentivise institutions to increase much-needed lending. It is therefore necessary to advance the date of application of the two supporting factors so that they can already be used by institutions during the Covid-19 pandemic.”
This revision is expected to come into force on June 28 this year.
A question of effectiveness
The regulatory measures adopted, however, do not eliminate the problems associated with companies’ size.
Indeed, banks’ credit risk is also affected by how correlated their exposures are: for example, how much they move together, especially in response to unpredictable events, measured by asset correlations.
And the intensity and direction of these movements can vary depending on the size and cyclicality of the economy.
In two papers written with my colleague Pietro Vozzella, we addressed the issues of the adequacy of international rules governing banks' capital requirements and the suitability of the ‘SME supporting factor’ to cope with the rationing of credit to small firms due to increased capital requirements.
We found that asset correlations increase with company size, and that large companies face significantly more systemic risk than SMEs. Moreover, we found that bank regulation does not adequately account for the diversification effect in SME portfolios, especially those of better credit quality.
Our analysis shows that the SME supporting factor does improve small companies’ access to credit in certain respects; but empirically, the likelihood that companies’ access to credit is rationed by banks depends more on their correlations with other borrowers and the stage of the cycle.
This is why economic and financial policy decisions aimed at reinforcing infrastructure investments should add to the supporting factor a revision of the criteria for calculating banks’ risk-weighted assets and consider empirical market correlations, which often prove to be lower than those provided for by regulation.
This revision would supply a better incentive to build highly diversified portfolios and steer bank business models towards this market segment.
We are observing this process in consumer banking, with the entry of players such as JPMorgan Chase. A review of the regulatory framework could also direct banks’ strategic choices towards retail clients and support the financing of borrowers, functions which are vital to economic recovery.
Giampaolo Gabbi is professor of risk management practice at the SDA Bocconi School of Management in Milan.
