Basel III implementation and SME financing: Evidence for emerging markets and developing economies

In 2018, the Financial Stability Board launched an evaluation of the effects of G20 financial reforms on the financing of small and medium-size enterprises (SMEs). According to FSB (2019), reforms such as the Basel III bank regulatory framework shall boost financial stability and systemic resilience in the long term. But they may be associated with some short-run costs. The global community is interested in learning if any such short-run costs may be incurred by SMEs — the main job providers and conduits of shared prosperity. Because banks provide SMEs most of their external finance, the main transmission mechanism from the reforms to SME growth could work through bank credit provision to SMEs (FSB 2019). 

In a recent paper, we examine whether Basel III capital requirements, the first and most prominent regulation of the Basel III package, had any short- to medium-term effects on SME access to finance in emerging markets and developing economies (EMDEs). Access to finance as a constraint reflects the firm’s overall perception of difficulties in accessing financing and is tracked before and after the Basel III implementation for matching firms. This subjective measure of access to finance has been used by, for example, Beck, Demirgüç-Kunt, and Maksimovic (2004) and Beck et al. (2006).

As in FSB (2019), we assume that the main channel through which Basel III implementation affects SME access to financing is the availability of bank credit. In principle, the Basel III package focuses on increasing the quality and quantity of capital and liquidity at banks. Banks may need to strengthen their capitalization and adjust their balance sheets to improve their short-term liquidity and secure stable funding. Reducing credit to SMEs — one of the riskier lending categories (asset classes) — could represent one adjustment mechanism through which a bank can improve its capitalization in response to stricter capital regulation.

The strength with which the Basel III implementation affects SME financing may depend on the degree of financial inclusion of SMEs — for example, whether firms have a bank account, bank loan, or both  — and firm risk characteristics, such as size, age, or financial performance.

Indirect effects and the role of expectation could co-determine how Basel III implementation ultimately affects SME financing. The indirect effects could work through the response of buyers and suppliers of SMEs as well as the property (collateral) markets to Basel III implementation. Expecting Basel III implementation in their country, SMEs may change their perception about future credit availability and preemptively adjust their borrowing strategy. The transmission mechanisms depicted in chart 1 will work on the back of the country context, which can include the level of economic development, sharing of credit history information, strength of contract enforcement, and so forth.

Chart 1: Conceptual framework for the effect of Basel III on SME financing

To properly gauge the effect of Basel III on SME financing, we employ the difference-in-differences method in a regression setup to control for confounding factors and address possible sample selection issues. We use firm-level data of repeated cross-sections and panel samples covering 32 EMDEs before and after Basel III implementation, with only some countries exposed to the treatment (Basel III implementation) and others not. To tighten the identification, we also form a panel of matched firm-bank data to isolate the supply-side factors of the SME finance market.

We find that Basel III implementation had a moderately negative effect on SME assess to finance in EMDEs (figure 1, blue bars). Interestingly, SMEs that were initially on the fringes of financial inclusion could have been affected more adversely than SMEs already using bank credit. Moreover, the Basel III effect on SMEs that already used credit could have been insignificant (figure 1, estimates for the panel of firms, gray/insignificant bar). This finding dovetails with practitioners’ view that once SMEs have an established relationship with a bank, they typically do not face problems in renewing credit.  One channel for the negative effect of Basel III could arise because of banks shifting toward more unsecured (presumably short-term) lending and, on secured lending, banks requiring much more collateral from SMEs.

Figure 1: Estimates of Basel III’s effect on SME access to finance

Source: Fisera, Horvath, and Melecky 2019.

The economic effect of Basel III implementation on SME access to financing in EMDEs can range between negative 0.244 and negative 0.593. The SME access to financing variable has a mean of 3.43 in our sample of EMDEs and a standard deviation of 1.31. These values imply that Basel III implementation could, on average, increase the access to finance constraints by about one-third of the standard deviation. Although this effect could be less economically important for countries such as Turkey and the Philippines, with the best financial access in our sample (values of 4.3 and 4.2 out of 5), it may be more important for countries such as Kenya and Ghana, with the worst access (2.4 out of 5). For instance, Basel III implementation could, keeping other things constant, push Peru (3.8) back to the level of Ukraine (3.4), or it could push Thailand (3.4) back to the level of Argentina (3.0). On economic significance, we thus assess the short-run effect of Basel III implementation on SME financing in EMDEs as moderately negative.  

We also find that financial crises curtailed the progress in easing SME access to finance across the board. In contrast, SMEs in countries with better contract enforcement saw their access to finance ease significantly more. The analysis suggests little support for varying Basel III effects across firm size and age, or bank capitalization and liquidity positions. And the adjustment cost for SME access to finance is not smaller if countries transitioned to Basel III from Basel 2.5 as opposed to Basel II.

The policy implications of the discussed study are threefold. One, well-capitalized and provisioned banking systems could be more successful in improving SME access to finance  and, in turn, cushion any short-term, moderately negative effect of Basel III implementation on SME financing. Two, successful macroprudential management that helps avoid financial crises can help advance SME access to financing, by ensuring a stable and risk-tolerant environment in which banks continue providing credit and financially including SMEs. Three, improving contract enforcement could help avoid situations in which banks preemptively restrict lending when faced with growing risk and uncertainty.

References

Beck, T., A. Demirgüç-Kunt, and V. Maksimovic. 2004. “Bank Competition and Access to Finance: International Evidence.” Journal of Money, Credit and Banking 36 (3): 627–48.

Beck, T., A. Demirgüç-Kunt, L. Laeven, and V. Maksimovic. 2006. “The Determinants of Financing Obstacles.” Journal of International Money and Finance 25 (6): 932–52.

Fisera, B., R. Horvath, M. Melecky. 2019. “Basel III Implementation and SME Financing: Evidence for Emerging Markets and Developing Economies.” Policy Research working paper; no. WPS 9069. Washington, D.C.: World Bank Group.

FSB (Financial Stability Board). 2019. “Evaluation of the effects of financial regulatory reforms on small and medium-sized enterprise (SME) financing.” The Financial Stability Board. November 2019.