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Stavros Theophilou explores SME lending in Commercial Broker

May 2023

Director Stavros Theophilou examines how changes to Basel 3.1 will have a wide-reaching impact on the SME lending market, in Commercial Broker.

Stavros’ article was published in NACFB’s Commercial Broker, 9 May 2023, and can be found here.

The Basel 3.1 standards are a set of amendments to the Basel framework that the Basel Committee expected its members to apply by 1 January 2023. The UK’s implementation of the Basel 3.1 standards will require wide-ranging alterations to the existing prudential framework for banks, building societies and designated investment firms (the lenders). The UK authorities’ aim is for the measures implementing the standards to come into force on 1 January 2025.

The risk proposals are likely to result in a substantial change to the competitiveness of the lenders. They will require banks and building societies to reconsider their strategy and portfolio mix to ensure optimal use of capital and to maximise profitability. At the same time, robust and efficient operational capabilities will be required to achieve compliance cost effectively.

Some of the key changes that Basel 3.1 will bring to UK banking regulations include:

  1. Higher capital requirements: lenders will be required to hold higher levels of capital to absorb potential losses, particularly in times of economic stress.
  2. Improved risk management: lenders will need to improve their risk management practices, particularly with regards to the measurement and management of operational risk.
  3. Greater transparency: lenders will be required to provide more detailed information about their risk exposures, capital levels, and liquidity positions.
  4. Changes to the treatment of certain assets: Basel 3.1 introduces changes to the way certain assets are treated, including securitization exposures and the treatment of sovereign debt.

The proposals impact the capital allocation and management across the industry, markedly the rebalancing of risk weights across portfolios. The changes may open a number of lower risk areas of lending to challenger banks where they were normally not competitive, whilst established lenders may pursue higher-risk lending.

In theory, one would expect that the market structure shifts from a model where high street lenders focus on low-risk lending and challenger banks to one where they focus on areas of high risk, to a more varied market model, leading to a greater sense of equilibrium in the market.

Overall, although the implementation of Basel 3.1 is expected to make the UK banking system more resilient and better able to withstand future economic shock, it will undoubtedly increase compliance costs for lenders and lead to major changes in the way they do business.

The higher capital requirements under Basel 3.1 will likely impact the availability and cost of credit for borrowers. Lenders, as a result, will be more cautious in their lending practices and may require higher levels of collateral or stricter loan covenants, which will make it more difficult for commercial brokers to secure financing for their clients. In turn, this could lead to higher borrowing costs for buy-to-let landlords, as lenders may require higher levels of collateral or stricter loan covenants to offset the additional risks they face in the buy-to-let sector.

Moreover, the increased focus on risk management and transparency may require commercial brokers to provide more detailed information about their clients and their financial positions. This could require more extensive due diligence and documentation, the knock-on effect being that there will be an increase in time and costs associated with brokering deals, largely hindering the need for borrowers in urgent need of liquidity.

The intended changes to the treatment of certain assets may impact the types of deals that commercial brokers are even able to facilitate. For example, if securitisation exposures are subject to more stringent capital requirements, it may be become far more difficult for commercial brokers to arrange specific debt deals for their clients.

Commercial brokers should begin preparing to adapt to the new regulatory environment and adjusting their business practices accordingly sooner rather than later. This could involve investing in new systems and processes to comply with the new regulations, as well as working closely with their lender partners to ensure that they are able to secure the best possible financing options for their clients. Lenders should also look to work proactively with their trusted commercial brokers in cases where market-wide information may be necessary that commercial brokers can readily obtain from their clients.

With all that said, it is important to note that the regulations are aimed at creating a more stable and resilient banking sector, which could ultimately benefit the property market and the wider economy in the long run.