SME lending returns lower for UK banks due to costs, not capital
Analysis of large UK banks by the Bank of England reveals that SME lending yields the lowest return-on-equity compared to retail and large corporate lending. This is primarily due to higher impairment rates and operating costs, rather than capital requirements.
Costs, not capital, depress SME returns
Based on analysis of large UK banks' published disclosures, SME lending has the lowest average return-on-equity (RoE) compared to retail and large corporate lending.
The Bank of England's analysis suggests that capital requirements are not the primary driver of this lower RoE for SME lending relative to other corporates.
Instead, the key differences are attributed to significantly higher impairment rates and elevated operating costs associated with small and medium-sized enterprise exposures.
These factors collectively reduce the profitability of SME portfolios for large UK commercial banks, influencing their capital deployment decisions.
The study highlights that understanding these underlying cost structures is crucial for improving the economic viability of SME financing.
Capital rules play minor role
While capital requirements, driven by risk weights, are a significant determinant of equity held against exposures, they play a minor role in the estimated RoE gap between SME and large corporate lending.
The analysis indicates that differences in risk weights between these segments mean higher average capital requirements contribute only marginally to the RoE disparity.
This is partly due to SME loans attracting lower risk weights for a given probability of default and loss given default under the IRB approach, reflecting their diversified, firm-specific risk profiles.
Furthermore, the SME support factor, soon to be replaced by a similar firm-specific adjustment, reduces risk-weighted assets by 15% to 24%, further lowering required capital for eligible SME lending.
Digitalisation: The path to profitable SME lending
The findings underscore that improving the economics of SME lending hinges on addressing high delivery and monitoring costs.
Investment in digitalisation and automation can materially reduce these operational and impairment expenses, making SME portfolios more attractive.
Such efficiencies could foster increased lending to UK SMEs, supporting broader economic growth and offering diversification benefits for banks.