Are SME Loans Less Risky than Regulatory Capital Requirements Suggest?

Abstract

This article addresses firm size as a driver of systematic credit risk in loans to small and medium-sized enterprises (SMEs). Key contributions are the use of a unique dataset of SME lending by more than 400 German banks and relating systematic risk to the size dependence of regulatory capital requirements. What sets this sample apart is its comprehensive coverage of the particularly rich and well-developed credit market for SMEs in Germany. The authors estimate asset correlations as the key measure of systematic risk from historical default rates. The results suggest that systematic risk tends to increase with firm size, conditional on the respective rating category. They also compare the size of this effect with the capital relief that has been granted in Basel II for SMEs relative to large firms. The asset correlation estimates suggest a significantly larger relative difference from the corresponding values for large firms than reflected in the regulatory capital requirements in two cases: first, for SME loans in the corporate portfolio of the internal ratings–based approach, and second, for SME loans treated under the revised standardized approach of Basel II. <b>TOPICS:</b>Fixed income and structured finance, developed