Basel II and the survival of the SME: are lenders and borrowers ready to comply with Basel II? (International Affairs Section).(Basel II Accord on capital adequacy, small- and medium sized companies)

The Basel II Accord on capital adequacy has triggered a fundamental change in the attitude of banks towards borrowers, especially small- and medium sized companies (SMEs). Banks are reviewing their portfolios today along the lines of the criteria laid down by Basel II, although the accord will not go into effect before 2005. The criteria will be in the form of a bank internal rating, which is designed to permit a more accurate assessment of the true risk of a loan. At issue is that firms, which are to be rated, are not familiar with the new formal rating process. Bank or credit managers do not always have good insights into the economics of SMEs to be able to accurately rate these firms objectively based on the criteria laid down by Basel II. This applies especially to soft facts, such as the market position of a firm, the competence of its management, the degree of operating leverage and the resulting impact of demand variability.

SMEs fear that Basel II will create enormous difficulties for them in finding adequate financing and many of them may be driven out of business. If that prediction comes true, the immediate result will be the opposite of what Basel II had in mind. Not only will Basel II result in more non-performing loans short term, but it will also cause problems for trade creditors. The problem seems to be especially acute in Germany where the debate has now become a political football. The general tenor being that Basel II is detrimental to the German 'Mittelstand.' The term 'Mittelstand' can be defined as the nucleus of small- to medium-sized privately held entrepreneurial companies that represent the mainstay of Germany's economy, exports and employment. These businesses generally have a low capital base (less than 20 percent) and are heavily dependent on bank financing.

The Basel Committee on Bank Supervision has recommended an update of capital adequacy rules for banks. The proposal commonly known as Basel II is a revision of the 1988 Basel Capital Accord, a global standard by which the financial soundness of banks is assessed. The Basel II Accord is designed to create a more competitive, albeit safer banking world. It is based on three pillars: the first pillar deals with improved capital adequacy, the second pillar focuses on better bank supervision and the third pillar envisions the use of a greater market discipline. It is the first pillar that causes great consternation amongst clients of banks and SMEs in particular. The first pillar deals with improved capital adequacy and a greater refinement of the system of risk weightings. The objective is to achieve a better correlation between a loan portfolio's true risk and capital. The assessment of the true risk would be based either on an external or internal credit assessment, i.e. a rating.

For the majority of SMEs, a bank internal rating will apply, since external rating agencies are not in a position to rate such companies. The debate now focuses on the criteria itself and the process of a bank internal rating, because (a) SMEs are unfamiliar with formal rating processes and (b) the majority of SMEs are ill prepared in terms of documentation on strategy, market position/potential and the use of the instrument of controlling. Financial statements are generally geared towards a tax avoidance ...