Basel’s unlikely victim: venture capital

Changes to credit risk framework could block alternative path for EU banks to finance SMEs

  • Changes made to the Basel Committee on Banking Supervision’s standardised approach for credit risk in December 2017 will significantly increase the amount of risk-weighted assets European banks generate on exposures to funds that invest in small and medium-sized entities.
  • Banks and industry sources say the risk weights could restrict equity financing made to SMEs through funds and venture capital firms.
  • US banks should be unaffected by the risk weights as the Volcker rule bars them from investing in venture capital firms.
  • The European Banking Authority found exposures to equity and equity investments in funds produced the largest increases in capital for large European banks under the credit risk framework set out in Basel III.

Every politician and government would want you to know they support the real economy. Banks have the financial firepower, but they are not well suited to the task of funding small and medium-sized enterprises (SMEs). In particular, technology driven companies that do not have easily transferable property or machinery to mortgage struggle to access bank debt directly and need equity instead.

“Banks are the principal form of funding for SMEs in Europe, but, increasingly, they’ll find it difficult to lend to modern SMEs, which don’t have collateral to offer, so they need to add equity investments as an option and use these mechanisms to finance higher-growth SMEs,” says James Chew, global head of regulatory strategy at HSBC.

Direct investing by banks in SME equity carries a high risk of companies defaulting. Instead, the use of investment vehicles to provide equity financing to SMEs has been gaining traction among banks as an alternative route for SMEs. These vehicles or funds enable banks to share the risk with other investors and spread their exposure to a diverse selection of companies – and venture capital firms are simply better adapted to the hands-on management style required to make a success of SME investing.

However, the next wave of bank regulations designed by the Basel Committee on Banking Supervision could close down even this indirect and diversified route for supporting SMEs. In Europe, where banks remain the major avenue of financing for SMEs, capital requirements on exposures to venture capital firms could be more than doubled, and the implications are potentially serious. Banks have responded by asking lawmakers to narrow the scope of the new Basel rules (see box: Defining risk).

“Whilst many governments have a clear growth policy aimed at supporting SMEs and their ability to access finance, they, at the same time, [consider putting] risk charges on banks which create economic disincentives to provide equity finance to SMEs in the first place, thereby undermining the benefits of such growth policies,” says Gianluca Riccio, a director of credit and portfolio management at a UK bank, speaking in his capacity as vice-chair of the Business at OECD (Organisation for Economic Co-operation and Development) finance committee, which provides banking sector input to the multilateral body.

“So the question is: what is the overarching strategic objective?” he asks.

First-mover disadvantage

European lawmakers will need to answer that question imminently. Once the new European Parliament convenes after elections in May, and a new European Commission is appointed, one of their first tasks will be to prepare a large legislative package to implement the set of standards published by the Basel Committee in December 2017.

These Basel III rules included updates to both the standardised and internal ratings-based (IRB) approach used by banks to calculate credit risk-weighted assets (RWAs) in their banking books. Banks will now be barred from using IRB to calculate the default risk inherent in equity exposures and must use the standardised approach.

In the December 2017 update, the standardised approach imposes a 250% risk weight for most equity holdings and a 400% risk weight for “speculative unlisted equity exposures”, which would include most SMEs. That is equivalent to holding €1 of capital for every €3 of exposure.

It is pretty critical where this ends up in terms of the cost of capital for these vehicles. If legislators set a high amount of capital for these investments then they are going to restrict the amount we can invest in the market
James Chew, HSBC

If implemented in Europe, this would replace a standardised risk weight of 150% under the existing capital requirements regulation (CRR). Currently, banks are also allowed to use the IRB, where the inputs include the probability of default, loss given default and exposure-at-default of the underlying exposures, together with a scalar of 190% to 370%, depending on the level of diversification in the fund. Sources say the mid-point of IRB outputs is roughly in line with the standardised approach – so a fund invested in relatively high-quality companies would end up with a risk weight of less than 150%.

The new treatment applies not only to direct investments in equity, but also to investments made through funds. To calculate RWAs on fund investments, banks are meant to rely purely on the standardised risk weights for the underlying exposures. Hence, attempts by banks to mitigate default risks through diversified fund investments will receive no capital benefits.

US banks are unlikely to be unaffected by the new risk weight, because the local Volcker rule has already barred them from investing in venture capital firms.

In Europe, by contrast, banks and industry sources warn the 400% risk weight under the standardised approach will deliver a significant increase in the capital held against the investments they make in venture capital initiatives, which would then deliver a blow to equity financing of SMEs.

In a quantitative impact study published in March, the European Banking Authority found equity investments in companies and funds delivered the largest increase in capital for 44 banks in Europe from the credit risk framework. The EBA does not disclose which banks these are, but all banks in the study have more than €3 billion ($3.4 billion) in Tier 1 capital and are active internationally.

“It is pretty critical where this ends up in terms of the cost of capital for these vehicles. If legislators set a high amount of capital for these investments then they are going to restrict the amount we can invest in the market,” says Chew.

Big, friendly fund

In the UK, a key vehicle set up to allow banks to support SMEs is an investment company called the Business Growth Fund (BGF), which is owned by four UK banks – Barclays, HSBC, Lloyds and RBS (Standard Chartered also has a smaller stake).

BGF invests in SMEs across the UK and Ireland, and it has already invested £1.9 billion ($2.4 billion) in capital provided by the banks. BGF disclosed in March 2018, within its response to an EC consultation on transposing Basel III into CRR, that at least two of its investing banks assign the standardised 150% risk weight to their exposures, while the remaining banks use the IRB approach with the scalar set at the lower bound (190%).

The BGF-style strategy has gained traction in other countries, with a Canadian Business Growth Fund making its first investment in October 2018, and the current Australian government laying plans to launch its own version.

Matt Reed
Matthew Reed

“The banks have proven to be excellent long-term supporters of our mission,” says Matthew Reed, chief operating officer of BGF. “However, if legislators are going to double the regulatory capital required for them to continue on a permanent basis then, clearly, it is going to make it more difficult for them to maintain equity holdings. Critically, the unintended outcome of that situation could be less capital available to SMEs at a time when there is growing demand.”

The increase will not be immediate, because the Basel Committee allows jurisdictions to phase in the risk weight over five years – beginning with a 100% risk weight and increasing by 60 percentage points at the end of each year – but the transition does nothing to ease the pain of the end-point.

“A 400% risk weight is a pretty big leap from today,” says Chew of HSBC. “There is a phasing-in period, but the problem is that equity investments in these companies are not things you can buy and sell every day, so the phasing-in period may well just be used to decide whether we continue to invest or not.”

Constance Usherwood, a director at the Association for Financial Markets in Europe, warns if Europe was to implement the risk weight in its upcoming review of the CRR, it could worsen the struggle for SMEs to access financing and undermine the European Commission’s proposed capital markets union, which is designed to foster a more integrated market for financing corporates across the European Union.

“A lot of the focus of the capital markets union has been how to increase equity financing in Europe’s SMEs, as it is not as advanced as other jurisdictions,” says Usherwood. “I think the European Commission has to consider the dampening effect that the risk weights may have in advance of Basel III being implemented.”

Scrapped plans

The jump in risk weights has already led to talk of projects being abandoned.

BGF revealed in its response to the EC consultation that a plan for a pan-European fund had been dropped since the publication of Basel III. BGF declined to give further details on the cancelled project for this article.

I would expect any project that is in its initial stages to be abandoned until there is further clarity
Gianluca Riccio, Business at OECD

Two sources not directly involved in the project say it would have been similar to the BGF, with one of them adding it would have also focused on environmentally friendly investments.

“I would expect any project that is in its initial stages to be abandoned until there is further clarity on the regulatory treatment of these investments,” says Riccio of the OECD advisory panel. “The projects that are already deployed will continue running and reassess when there is more clarity, but it is hard to see how new money will be committed if capital requirements will jump.”

It has not completely put the brakes on new initiatives, however, with the Canadian Business Growth Fund making its first investment in October last year – 10 months after Basel III was announced.

Banks and industry sources are unsure why the Basel Committee has increased risk weights by so much. Riccio believes the standard-setter perceives the investments as high risk and wants to disincentivise banks from taking that on.  

“The Basel Committee twice consulted on proposed minimum requirements for speculative unlisted equity exposures, and small- and medium-sized exposures,” says a spokesperson at the Basel Committee. “In both cases, it conducted careful quantitative impact analyses. Achieving appropriately prudent and risk-sensitive treatments was an important objective of the committee’s work, and it believes the minimum capital requirements set out in its December 2017 publication have achieved that goal.”

Defining risk

When Europe implements the new Basel standards, banks want the capital requirements to consider the benefits of venture capital firms, and funds having diverse portfolios that are invested in multiple companies across different sectors and geographies.

“We invest in all sectors of the UK economy except for financial services,” says Matthew Reed of BGF. “Our investment committee keeps an eye on our sector concentrations to make sure we have a good spread. They also make sure we are not overly invested in any one sector.”

Gianluca Riccio of the OECD advisory panel says that once a fund has invested in a wide variety of entities, the risk of the whole portfolio’s value falling to zero is vanishingly small because the underlying companies would not all default simultaneously.

Other lobbyists want legislators to tighten the definition of “speculative unlisted equity exposures” and “venture capital” used in Basel III.

“The Basel definition for speculative investments is quite broad and does not clearly define what constitutes a speculative investment,” says James Chew of HSBC. “It leaves some room for argument and could be applied quite widely if we’re unable to make the case that some initiatives shouldn’t be in scope.”

The UK government has already signalled it is in favour of a change to the definition in a response to a consultation launched by the European Commission back in March 2018. The consultation is the start of the process for the EU to incorporate Basel III into its bank capital laws.

“One of the few areas in the standardised approach where RWAs are being raised materially is for speculative investments in equity,” HM Treasury stated in its consultation response to the EC.

Not clearly defined

“Basel does not clearly define what constitutes a ‘speculative’ investment of this type. Therefore, further work is required to determine an appropriate definition which will not compromise real-economy financing, particularly as non-bank equity investment is still an underdeveloped market in Europe relative to other parts of the world,” HM Treasury added.

At the moment, definitions of venture capital used in EU law could capture a wide range of investments by banks. All those exposures would then be subject to the highest 400% risk weight.

“The current definition of venture capital in EU regulations is also drafted quite broadly because they wanted it to be inclusive,” says Chew. “[The definition] says venture capital covers any company that employs fewer than 250 people with annual turnover not exceeding €50 million or total assets of less than €43 million.”

That means even funds investing in relatively long-established companies could be deemed high risk and face the 400% risk weight.

As an alternative, Constance Usherwood of Afme proposes using a definition of venture capital set out in recent EBA guidelines, published in January, which list exposures deemed high risk under the EU’s current bank capital laws.

“The definition of venture capital is quite broad and so we have been looking for a clarification on that in line with guidelines issued by the EBA in 2019,” says Usherwood.

The 2019 EBA guidelines refer to high-risk venture capital as providing funding to newly established enterprises; for example, funding the development of new products and related research. Using that definition would limit the scope of the new Basel risk weights to start-up and early-stage companies.

Editing by Philip Alexander

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