The Basel III accords set out a far stricter regulatory capital framework for banks, to increase the resilience of the global financial system after the unprecedented events of the 2008 credit crunch. At the time Basel III was debated, a number of technical commenters expressed concerns that it could overcorrect the mistakes of its discredited predecessor Basel II, in particular by being punitive on lending to small firms – which are often described as the engine room of economic growth.
Now, a few years on from Basel III, in our white paper “Small business finance: Life after the overdraft”, we have carried out a UK survey to see if Basel III is indeed showing a negative impact. Worryingly, we have found that, in the UK at least, bank overdrafts to small firms are indeed falling at a dramatic rate, with severe knock-on effects for small and medium enterprises (SMEs) all over the country. The UK is fortunate to be perhaps second only to the USA in terms of the diversity and maturity of its alternative finance market, which has likely cushioned the effects of this withdrawal of bank lending to SMEs. Our findings could have far-reaching implications for those parts of the world that don’t have the luxury of an equally diverse alternative finance market to cushion the blow of Basel III and its effect on bank lending.
A hazy future
While Basel III introduced a number of revisions to its predecessor, one key difference is capital requirements. Compared to Basel II, Basel III requires banks to hold more capital – often twice as much. Generally, holding more capital in readiness for stress is wise at a macroeconomic level, particularly in the wake of the financial crisis.
However, while appearing sensible on a global macroeconomic scale, such measures were clearly not ideal for SMEs. Indeed, at the time that the Basel III accords were formulated, contemporary commentators such as the ACCA, a prominent global accountancy body, anticipated negative consequences for small and medium-sized businesses, noting in July 2011 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.”
While contemporary opinion anticipated problems for SMEs, nobody really knew what would happen specifically. In the same report, the ACCA admitted that “Policymakers still know little about the potential impact of Basel III on lending to SMEs” — in 2015, the impact is becoming clearer.
A capital offense
Basel III’s capital constraints have led to a few unintended but predictable consequences for SMEs. On one hand, new capital requirements might have encouraged the banks to acquire more capital to sustain the same level of risk — but on the other hand, they could also choose to reduce their lending to retain the same level of capital.
For large institutions looking to reduce their exposure rather than find more capital, SME lending is the obvious area to be reduced — it’s generally higher risk, lower return, and requires significant resources to process each case. Basel III has encouraged the banks to turn down risky propositions, and take a one-size-fits-all approach — so in turn, bank lending to SMEs has been hugely reduced.
The death of the overdraft
The way Basel III categorises overdrafts has also had bad consequences for SMEs. The banks have to consider them the same way as drawn down loans, or in other words, they have to hold enough capital to cover the possibility of overdrafts being withdrawn simultaneously — even though this is incredibly unlikely to actually happen. That means it’s no longer attractive for banks to offer large overdrafts, and sure enough, they’ve been declining ever since.
In fact, recent research by Funding Options revealed that in the UK business overdrafts have been reduced or removed at a rate approaching USD $8million per day since 2011, with almost a third of UK firms saying this has happened to them in the last two years. Access to working capital is critical for small businesses with unpredictable trading cycles, and the bank overdraft was traditionally the go-to source of such funding.
The opportunity for AltFi
With the rise of alternative finance, there are many other options out there for rejected businesses. The trouble is, businesses turned down by the banks often don’t know about or don’t understand the options open to them — and the most likely outcome is they give up. Access to lending is a strong predictor for growth, so even the businesses that survive a lack of funding are being starved of the opportunity to grow and innovate.
Our research shows there’s still a huge knowledge gap, and many business owners simply don’t know about the options available, don’t understand them, struggle to access them, or all three. While the in-vogue peer-to-peer lending (latterly ‘marketplace lending’) has gone some of the way to increasing awareness of alternative finance, it represents a fraction of the market in terms of lending volume — and while perfect for some firms, it don’t work for many others.
What can be done to solve the problems of Basel III?
In the UK, government initiatives like a bank referral scheme, whereby businesses turned down for finance will be signposted to alternative providers, show that policymakers have recognised this knowledge gap exists and needs to be addressed. As well as the government, there is a variety of stakeholders who all need to play a part in improving SME understanding of alternative finance, including: small business owners themselves; their trusted advisors like accountants or business mentors; and mainstream banks, alternative lenders, and marketplaces alike.
In the UK, alternative finance is already matching 45% of the volume of bank lending — a much better situation than just a few years ago — but with the right measures, we can close the knowledge gap entirely and make ‘alternative’ lending well and truly mainstream. If that future is realised, the effects of Basel III will no longer be felt so painfully by SMEs all over the world.
By Conrad Ford, Chief Executive, Funding Options.