Change to bank capital rules could result in £44bn drop in SME lending

A report by Oxera commissioned by SME lender Allica has found that proposed changes to UK bank capital rules could result in a £44 billion drop in lending to SMEs.

The research suggests that the Prudential Regulatory Authority (PRA) could put up to £44 billion of SME lending at risk. In November 2022, the PRA published a consultation paper outlining its proposed approach to implementing the final elements of the Basel international banking standards, known as Basel 3.1. The consultation contains proposals to materially increase the level of risk-weighting banks would need to apply to SME lending.

Oxera’s detailed analysis of the PRA’s proposals has found that: the risk weighting for secured SME lending would be higher than for unsecured lending to SMEs – this is illogical and incentivises riskier lending which is not aligned to the PRA’s own objectives to make capital rules more risk sensitive. Challenger banks, using the so-called Standardised Approach to measure their capital requirements, would see an increase of over 30% in the risk weighting that must be assigned to loans made to SMEs.

Whilst the overall effect of the increase in risk weighting, assuming no change in either the level of capital held by banks or the capital-risk-weighted asset ratio with which they operate, would be a reduction in SME lending of up to £44bn from the banking sector.

Research published by the British Business Bank in February showed that challenger and specialist banks accounted for 55% of gross lending to small firms in 2022 – a record share compared to the traditional ‘big 5’ banks – demonstrating the vital role challenger banks now play in providing finance to SMEs across the UK. The UK’s c.5.5 million small businesses make up more than half of private sector employment, half of GDP, and have created double the number of jobs compared to large companies.

While Allica believes the SME Support factor could be removed for new lending, it has proposed that a more risk-sensitive capital regime should be implemented than the PRA is currently proposing, including the removal of the PRA’s proposed 100% minimum risk weight floor for SME business loans secured on property – this would be substantially higher than international standards and would mean unsecured SME loans would have lower risk weights than secured loans, potentially incentivising banks to favour riskier lending.

Introduce a new risk weight for equipment and invoice finance lending to SMEs at 69%, which is equal to the current average of the SME Support Factor and also the PRA’s own benchmark risk weight for SME lending in its Pillar 2A guidance.  Put unsecured SME lending in line with the current proposals, applying 75% risk weights for smaller loans and 85% risk weights for larger loans to SMEs.

Allica believes this approach could achieve the PRA’s over-arching objectives, while also implementing a fully risk-sensitive basis for capital requirements, without materially increasing the capital required which could cause substantial damage to the SME economy.

Richard Davies, CEO of Allica Bank said “Over the past decade, the PRA has been instrumental in helping establish a more diverse and competitive banking market – and non-systemic challenger banks now account for more than half of all new lending to small firms across the economy.”

“This transformational change in the UK banking market has helped to create a more robust, diverse and responsible SME finance market for Britain’s army of small business owners, the engine room of our economy.”

“With a more risk-based approach to new capital rules, aligning the PRA’s proposals to the actual risks associated with lending, the regulator could avoid a really negative impact on the SME economy in the next two to three years.”

“It’s really a golden opportunity to continue to cement the gains made in increased competition in the SME banking market while meeting the PRA’s prudential objectives.”

Writing introductory forewords in support of the new analysis, both the Federation of Small Business (FSB) and the National Association of Commercial Finance Brokers (NACFB) have called for the PRA to provide a more detailed assessment of how their proposals could impact the SME finance market and real economy.

Martin McTague, National Chair of the Federation of Small Businesses, said “The PRA have an opportunity to pursue their secondary objectives in terms of supporting the UK’s economic growth and competitiveness, and encouraging competition in the financial sector, without compromising on their primary objective of ensuring financial stability. We would welcome the PRA publishing empirical evidence and cost benefit analysis specific to SME lending, as it isn’t clear that the proposed changes are justified.”

Paul Goodman, Chair of the National Association of Commercial Finance Brokers, said “Market plurality and competition are central tenets of what has become a vibrant SME lending community, and now is not the time to hinder smaller players and hold back their evolution.”

“The NACFB supports calls for a greater examination of the potential unintended consequences that the proposals framework will likely bring and encourages the Bank of England and the PRA to show their workings by releasing supporting data ahead of any implementation.”