SME lending: Capital rules, asymmetric info drive bank competition
A Bank of England working paper analyzes how risk-based capital requirements influence competition and credit allocation in the UK unsecured SME lending market. The study finds that regulation interacts with information processing and costs to shape pricing and credit allocation.
Modeling information asymmetry in SME credit
Small and medium-sized enterprises (SMEs) are central to economic activity but face persistent difficulties accessing external finance due to asymmetric information.
Lenders find it costly to assess SME creditworthiness, unlike large corporations with verifiable financial histories.
While banks traditionally dominated, non-bank lenders with distinct screening technologies and cost structures have become increasingly important.
This competitive landscape is shaped by differential regulation, as banks are subject to risk-based capital requirements that affect incentives for risky loans, while non-banks operate outside this framework.
This paper develops a structural model to quantify how capital requirements affect competition between banks and non-banks, and the implications for credit pricing, composition, and availability for UK unsecured SME lending.
Demand, supply, and screening precision
The model features a demand side where borrowers vary in default probabilities, influenced by observable characteristics and private unobserved risk.
Loan size reflects endogenous finance needs.
Borrowers choose from lender-specific offers, derived from each lender's risk belief.
On the supply side, banks and non-banks compete with heterogeneous screening precision and cost structures.
Bank lending costs incorporate balance sheet capacity linked to risk-weighted assets, reflecting capital buffer preferences.
Lenders assess borrower risk using requested loan size as a public signal, refined by private screening.
The model is estimated to match key empirical moments, including pricing, repayment outcomes, market shares, and loan size.
Regulation's unseen hand in SME credit
The study provides a crucial quantitative framework for understanding the complex interplay between capital regulation, information asymmetry, and competition in SME lending.
Its findings underscore that non-bank growth isn't just about regulatory arbitrage but also their comparative advantages in screening technology.
For policymakers, this means regulatory interventions must consider these nuanced dynamics to avoid unintended consequences for credit availability and market structure.