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European Banks: Regulations Continue to Sweeten SME Lending

by internationalbanker

By Nicolas Charnay, Senior Director and Cihan Duran, Associate Director, S&P Global Ratings




The European Union’s (EU’s) 25 million small and medium-sized enterprises (SMEs) are the backbone of wealth and growth in the Member States. These hidden champions account for 99 percent of all EU businesses, half of its gross domestic product (GDP) and two jobs out of three. Despite their relevance to the European economy, SMEs can find it difficult to access finance given their small size, opacity and somewhat weaker profitability than larger firms. They, therefore, heavily rely on bank financing and have generally refrained from accessing the capital markets by issuing bonds or other securities. With its Capital Markets Union (CMU) project, the EU aims to limit this overreliance on bank funding and broaden SMEs’ access to market-based sources of financing.

At the same time, the EU is also finalizing the implementation of Basel III rules for banks, and a question has emerged about its impact on European SMEs’ access to bank funding. We think that the revised capital-requirement framework will not lead to tighter bank-financing conditions for SMEs and could even be a positive. This is because European policymakers have introduced or maintained several preferential regulatory treatments for banks’ exposures to SMEs, which will make these types of financing less capital-intensive than under the initial Basel proposals. Some of these measures are temporary until 2032, but we expect policymakers to continue with their “pro-SME” stance, at least until SMEs have made substantial progress in diversifying their funding bases.

Financing conditions have improved for SMEs in recent years—but the war in Ukraine clouds the outlook.

In the past seven years, European SMEs’ financing conditions have strongly improved. The large financing gap between funding needs and funding availability during the European debt crisis in 2011 and 2012, which was pronounced for micro-enterprises, has been closed (see Figure 1). This has been largely due to the accommodative monetary policy conducted by central banks and, since the COVID-19 pandemic, the massive fiscal support granted by EU governments. Today, European SMEs are financed through banks at historically low rates—even negative in real terms.

Russia’s invasion of Ukraine in February 2022 has not led to an immediate stress event for the European financial system. The European Central Bank’s (ECB’s) composite systemic stress indicator has not reached the levels seen during the global financial crisis or the eurozone debt crisis by far. However, due to the energy-price shocks and supply-chain disruptions, the economic spillovers from the war will have a bearing on the economic outlook and affect several corporate sectors. What’s more, by driving up the price of agricultural commodities and ultimately food prices this year and beyond, leaving inflation higher for longer, the ECB will likely be prompted to raise the policy rate from zero to a neutral level sooner than expected. Early indications (see the most recent ECB’s Bank Lending Survey) point to an expectation by banks that credit standards for loans to firms (including SMEs) will tighten considerably in the second quarter of 2022. Although there is significant uncertainty about the economic outlook, we expect that the negative economic effects of the war will play out over one to two quarters and that governments and central banks will intervene to avoid negative feedback loops due to excessively tightened funding conditions.

From a banking-regulation perspective, support for bank financing to SMEs has been consistent over the years and is unlikely to be deterred by Basel III finalization.

Looking beyond the current uncertainties raised by the war in Ukraine, we believe European policymakers will continue to apply preferential capital treatment for banks’ financing to SMEs, and the recent draft proposal from the European Commission (EC) to implement Basel III rules in Europe is further evidence of that. We think this policy stance will continue for the foreseeable future, at least as long as market-based financing remains underdeveloped in Europe for SMEs.

The SME Supporting Factor (SF) was introduced in the Capital Requirements Regulation (CRR) in January 2014 for all EU countries except Spain, which had introduced it in 2013. The purpose of the Supporting Factor, a notable divergence from the Basel Accords, was to reduce the potential adverse impact of introducing the countercyclical capital buffer between 2016 and 2019 on SME lending. In April 2020, the EC introduced its “quick fix” amendments to EU banking rules amid the pandemic and updated the Supporting Factor. This lowered capital requirements by up to 25 percentage points for loans granted to SMEs with an annual turnover not exceeding €50 million. These SME-specific measures lowered capital costs for banks and consequently reduced the borrowing costs that banks charge to SMEs as part of the price of loans.

On October 27, 2021, the EC published its draft directive and regulatory proposals to implement the Basel III regulatory framework into EU law. This directive, also covering capital requirements for SME exposures, would finalize the implementation of the global revisions to Basel III (published in 2017) that aimed to reduce disparities in how global banks calculate credit, operational and market risks—notably through their use of internal models. Already the result of intense lobbying, the proposal faces further political debate and potential tweaks before it is completed and transposed into national laws. Originally targeted for implementation in January 2022, then delayed to 2023 after the pandemic hit, the revised rules will likely take effect in the EU from January 2025, with a five-year phase-in period, meaning that the framework will be fully in place by 2030 at the earliest (see Figure 2).

When looking deeper into capital-requirements rules under the proposed EU directive, we don’t expect a negative impact on SME lending. We rather find that it might have a mildly positive effect considering:

  • Some relaxation, relative to current rules, of risk weights of corporate and SME exposures for certain rating classes; and
  • European policymakers’ proposals to reduce the impacts of the output floor for internal models for unrated corporates and SMEs by introducing a discount factor until 2032.

In what is a net positive for banks’ required size of regulatory capital and, therefore, funding costs for SME lending, the new directive allows banks to use the standardized or the internal ratings-based (IRB) approach for corporate and SME loans.

Standardized approach

Many banks that fund SMEs use the standardized approach for loan exposures to calculate credit risk-weighted assets—one component of the denominator of regulatory capital ratios. For example, the Deutsche Bundesbank estimates German banks use the standardized approach for up to 70 percent of loans granted to SMEs. Figure 3 shows the risk weights of the existing standardized approach under Basel II and the new Basel III rules. Under the Basel III standards, standardized risk weights were lowered to 75 percent from 100 percent for SMEs rated BBB+ to BBB- for jurisdictions allowing the use of external credit ratings. While for unrated corporate SMEs (those with turnovers of less than €50 million), the risk weight was reduced to 85 percent from 100 percent previously. For Europe, the SME Supporting Factor under the EC’s “quick fix” effectively already implemented the lower risk weights of 85 percent for SME exposures (with turnover higher than €2.5 million) and even introduced a lower bracket for SMEs with turnover below €2.5 million (76-percent risk weight).

Internal ratings-based approach

Some banks use internal models for their SME portfolios to calculate capital requirements. These models allow banks to estimate relevant risk parameters, such as the probability of default for loans and loss given default (LGD) if a borrower is unable to pay back the loan, to infer capital requirements to cover potential credit losses in the future. The revised Basel III rules introduce some “input floors”, which will set minimum values for the parameters banks use to calculate their capital requirements under the IRB approach, resulting in increased capital requirements. What’s more, and a significant change from the previous Basel standard, an “output floor” will be introduced and restrict some of the beneficial effects from internal models to make these models globally more comparable. As such, the new output floor limits how much banks can reduce their capital requirements for loans relative to the standardized approach.

To smooth the impact of introducing the output floor, the EC has proposed phasing it in over five years. Starting from 50 percent of calculated credit risk-weighted assets (RWA) under the standardized approach in 2025, the output floor will increase gradually toward 72.5 percent in 2030 (see Figure 3 above). Considering the relatively large RWA impact from the output floor—particularly for exposures to unrated corporates and SMEs—the EC’s proposed transitional rule would avoid a negative impact on credit supply and give banks more time to adapt. In addition, banks would be allowed until the end of 2032 to apply a preferential risk weight of 65 percent for their exposures to corporates and SMEs with a probability of default of less than or equal to 0.5 percent when calculating the RWAs for the output floor.

Equity investments in corporates and SMEs

Under the Basel rules, the IRB approach is no longer applicable for calculating RWAs for equity investments in corporates and SMEs. Banks have to use the standardized approach, which would lead to higher RWAs—for example, 250 percent for standard corporate-equity exposures and 400 percent for speculative-equity investments. To somewhat offset this tightening, European lawmakers have also proposed to reduce the impact by carving out equity investments deemed as “long-term strategic” from the 400-percent classification, to bring it back to 250 percent, and by introducing a transition phase of five years for both the 250-percent and 400-percent exposures.

In implementing the Basel rules, European policymakers have continuously sought to avoid the negative consequences of tightening banking regulations on SME lending. We expect this policy stance to continue in the future, at least until SMEs have managed to diversify their funding bases substantially.



European Central Bank (ECB): “April 2022: The euro area bank lending survey,” (for the first quarter of 2022), April 12, 2022.

S&P Global Ratings: “Financing Faster Growth For Europe’s SMEs,” March 22, 2022.

New Financial: “A New Vision for EU Capital Markets,” Panagiotis Asimakopoulos, Eivind Friis Hamre and William Wright, February 2022.

European Central Bank: “Survey on the access of finance to enterprises,” November 24, 2021.

S&P Global Ratings: “Basel III Bank Capital Rules In Europe: Delayed And Diluted,” October 28, 2021.

European Commission: “Capital markets union 2020 action plan: A capital markets union for people and businesses,” September 24, 2020.


Cihan Duran is an Associate Director on S&P Global Ratings’ Financial Institutions team. Prior to his current post, he was at the European Systemic Risk Board, covering topics concerning macro-prudential policy and financial-stability risks. And he was also a Strategy Consultant at Boston Consulting Group.

Nicolas Charnay is a Senior Director on S&P Global Ratings’ Financial Institutions team. He is a Sector Lead for European Financial Institutions and is based in Frankfurt, Germany. Before joining S&P, Nicolas was an adviser in banking supervision at the European Central Bank.


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