Basel regulators hope for SME solution by mid-June

Global banking regulators are optimistic they can resolve by mid-June the vexed question of the treatment of lending to small to medium-sized enterprises (SMEs) under the proposed Basel II bank capital adequacy Accord.

The politically sensitive issue has dogged the development of the risk-based Accord and caused its delay until at least late 2006 – three years later than originally intended.

The German government, which faces parliamentary elections in September, threatened to veto the Accord if it penalised bank lending to the country’s SMEs, known as mittelstand, which are regarded as a vital component of the German economy. Other countries, including Japan, Italy and Spain, also want special treatment for SMEs.

Regulators said last week’s Amsterdam meeting of the key Capital Task Force sub-grouping of the Basel Committee on Banking Supervision, the architect of Basel II, put the seal on two months of major progress on the SME issue.

“We certainly don’t have a final proposal at the moment, but we probably should have by mid-June when the Task Force next meets ahead of the early-July meeting of the full Basel Committee,” said one regulator who declined to provide more precise details.

But regulators said they were concentrating on the threshold problem, namely what criteria to use to define SMEs. The mathematics of the risk-weight function of curve that might be used for measuring the risk of lending to SMEs was less of a problem.

Basel II aims to align regulatory capital with economic capital – the capital banks allot according to their own assessment of the risks they face.

Regulators now appear to accept the argument that while the failure rate of SMEs is higher than that for larger companies, it is less volatile and more predictable and fits more into the category of expected losses rather than unexpected losses.

Bankers and regulators believe lending to SMEs should be treated similarly to lending to the retail sector that will attract lower capital charges under Basel II because loss rates are fairly predictable.

The main question facing regulators is what sort of threshold to use to define an SME. A figure of €2 million ($1.8 million) is under discussion, but it has still to be decided whether the figure should apply to a firm’s turnover, balance sheet value, or exposure to SME risk. Another question is whether there should be different thresholds for differently sized economies.

Meanwhile, regulators continue to work on the treatment of asset securitisation under the Basel II credit risk proposals.

This technical, but less contentious, issue has also helped to delay the Accord. Regulators plan to publish a progress paper on October 1, the day they intend issuing their third quantitative impact study (QIS3) that will seek to assess the impact of Basel II on banks.

They plan to issue a third, non-technical document describing progress with the whole Basel II Accord on October on the same date.