By forcing banks to carry a disproportionately higher amount of capital against such loans, Basel can unintentionally harm lending to small private firms. It generates perverse incentives for finance institutions that flee to other asset classes where loans originated are less expensive to hold. Additionally, it could encourage more financing in the organization loans instead of in small company economy.
As explained in Basel Committee on Banking Supervision (2005), in preparing the administrative centre regulation, Basel could use historical data on corporate loans but had no usage of historical information on small company loans. Regulators made a decision to ignore this inconsistency and for the organization loans they estimated the regulatory formula predicated on the available historical data. Confronted with too little historical information on small company loans, regulators calibrated the formula for small company capital requirement so that it fit the administrative centre levels banks held before the regulation. In so doing, Basel regulators created precedence where one asset class (small company loans) is treated differently from others. This may have dire consequences for access of small company to finance.
We wish to advocate a larger vigilance in the regulation and policymaking. Given the now improved usage of information on small company lending, regulators could acquire data on small company loans and repeat the exercise to calibrate the administrative centre requirements to the historical loan data for all asset classes rather than as done currently by mistreating small company loans. We think that this will stimulate an improved usage of finance for smaller businesses and equally provide incentives for lending to large corporate firms also to small businesses.
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Ang, A, R Hodrick, Y Xing, and X Zhang (2009), “High Idiosyncratic Volatility and Low Returns: International and additional U.S. Evidence”, Journal of Financial Economics 91, 1-23.
Basel Committee on Banking Supervision (2005), “An explanatory note on the Basel II IRB risk weight functions”, Bank for International Settlements.
Bams, D, M Pisa and C Wolff (2015), “Credit Risk Characteristics folks SMALL COMPANY Portfolios”, CEPR Discussion Paper No. DP10889.
Udell, G F (2009), “How Will a MARKET MELTDOWN Affect SMALL COMPANY Finance?” FRBSF Economic Letter, 2009-09, Federal Reserve Bank of SAN FRANCISCO BAY AREA (March 6).