Credit risk mitigation and SMEs bank financing in Basel II : the case of the Loan Guarantee Associations

Abstract

The objective of this paper is to analyse the impact of the techniques foreseen in the Basel Agreement II (BII) for mitigating the risk of default on bank loans to small and medium enterprises (SMEs). In particular, we will conduct an analysis of the effect of the guarantees that the Loan Guarantee Association (LGA) offer to the SMEs on the assignment of capital requirements of the financial entities under BII. At the same time, the study will examine the effect of this guarantee on the credit risk premium that the financial entities should charge their clients, and whether this foreseeable decrease in the interest rates applicable to the SMEs is compensated by the cost of the guarantee. The results show that, considering that the cost of the LGA guarantee in Spain is around 0.68%, it will be advantageous for an SME with the annual sales of less than or equal to €5 million to request this guarantee whenever the probability of default (PD) of the LGA is <1.1%, if the approach utilised by the financial entity is the Internal Ratings-Based (IRB) and the SME is considered as corporate; however, if the SME is included in a regulatory retail portfolio, then the limit for the PD of the LGA decreases to 0.71%. On the other hand, when the approach utilised is the Standardised one, then will be profitable for an SME treated as retail to request this guarantee whenever the PD of the LGA is <3.35% (3.95% for corporate exposures).