Are Capital Requirements on Small Business Loans Flawed?

Abstract

We explore an inconsistency in the Basel Committee’s Internal Ratings Based (IRB) rules: the IRB rules on corporate loans were calibrated to loan-level data, while the IRB rules on small business loans were calibrated with little, if any, information on small business loans. We argue that the resulting IRB rules do not put small business and corporate loans on a level playing field. In order to treat both asset classes – small business and corporate loans – proportionately to their correlated credit risk, the IRB rules should require 45% lower capital requirements for small business loans than what the Basel Committee currently prescribes. This lowering of capital requirements on small business loans goes in the same direction as the SME Support Factor introduced by the European Commission in the current installment of the Basel regulation.

Keywords: Small business credit risk, capital charges, default correlation, factor models

JEL Classification: C51, G32, E44