The Impact of Basel II on Small and Medium sized Enterprises in Germany

Table of contents

List of abbreviations

List of figures

1 Introduction
1.1 The current problem and the papers objectives
1.2 Methodology

2 Small and Medium Sized Enterprises in Germany
2.1 The qualitative aspect
2.2 The quantitative aspect
2.3 The economic importance of SMEs in Germany
2.4 How do SMEs fund their investments?
What is their capital structure like?

3 Banking regulation and the Basel Accords
3.1 Regulation and banking supervision
3.1.1 Why regulate financial Markets
3.1.2 Exhibit: The Asia Crisis
3.2 From Basel I to Basel II
3.3 The Basel Committee and its first Capital Accord
3.4 The current accord’s weaknesses and consequences
3.5 The New Basel Capital Accord
3.6 Two options for a bank’s credit risk calculation
3.6.1 The Standardised Approach
3.6.2 Internal Ratings-Based Approach

4 Rating
4.1 Definition
4.2 External rating: importance, agencies, procedures & notations
4.3 Internal ratings: procedure, example & importance
4.4 Impact on the rating grades on terms and conditions of loans
4.5 Impact on SMEs, how well are they prepared for rating?

5 Conclusion
5.1 Consequences and scenarios
5.2 Outlook for the future

Glossary

Appendix 1 Job creation and job losses

Appendix 2 Capital sources of SMEs and its use

Appendix 3 Duration of bank loans in Germany

Appendix 4 Formulas for risk weight calculation (IRB approach)

Appendix 5 Necessary conditions for rating agencies to be recognised by BaFin

Appendix 6 German companies that are externally rated

Bibliography

List of abbreviations

illustration not visible in this excerpt

List of figures

Figure 1: Newspaper headings concerning Basel II

Figure 2: New SME definition applied by the IfM Bonn, in €

Figure 3: Key figures of the German SMEs

Figure 4: SMEs provision with own funds Own funds as a % of balance sheet total

Figure 5: Implication of banks for the finance of ‘Mittelstand’ enterprises
What % of the debt capital comes from banks? P. 10

Figure 6: Current capital requirements in a bank’s loan portfolio

Figure 7: Development of enterprise insolvencies 1993-2003

Figure 8: Time scale of capital regulation

Figure 9: The New Capital Adequacy Framework

Figure 10: Risk weights due to external rating (Standardised Approach)

Figure 11: Capital requirements according to the IRB-Foundation Approach

Figure 12: The three leading rating agencies

Figure 13: ‘Bottom – up’ external analysis procedure

Figure 14: Rating scales and implications

Figure 15: Cumulated PDs according to S&P over 20 years

Figure 16: BVR-Rating System

Figure 17: Combination of two key figures

Figure 18: Calculation of expected loss

Figure 19: Quick rating test

Figure 20: Income and expenses of Western German companies

1 Introduction

1.1 The current problem and the paper’s objectives

“SMEs in Germany fear that Basel II will create enormous difficulties for them in finding adequate sources of financing and that many of them will be driven out of business. If that prediction comes true, the immediate result will be the opposite of what Basel II had in mind” (Bartels 2002). For more than two years the development and implementation of new guidelines for banks regulatory capital, called Basel II (or New Capital Accord), is of major discussion to representatives of banks, industry groups, the finance and business media. In 2002, in the year of the German government elections, it even became a matter in the election campaign of the two main political parties. The Economist (10.11.2001) wrote “Mr Schröder: Basel 2 is unacceptable to Germany”. Other headlines and quotes from international financial and economic newspapers included e.g.:

Figure 1: Newspaper headings concerning Basel II

illustration not visible in this excerpt

So does Basel II imply the ruin of the German SMEs or ‘Mittelstand’? Can Basel II be understood as a danger or as an opportunity? Is Basel II a revolution in the way SMEs will be financed in the future? Will the majority benefit from Basel II? This paper aims to find answers to these questions.

Furthermore it is important to clarify what exactly Basel II is and what its predecessor Basel I is and why financial supervision and regulation is important for an economy. What do terms like the German ‘Mittelstand’/ SMEs mean and is it really important for the German Economy? Why is there a connection between Basel II and the way SMEs in Germany are financed?

The term ‘rating’ is always mentioned in context with Basel II and in context with German SMEs (see newspaper headings in figure 1). Why is this so and what does the term ‘rating’ mean?

“That will become brutal if credit institutes will be extremely cautious in granting loans to SMEs” (Kaufmann and Wolff 2002, p.7). Is that a possible scenario or is it exaggerated?

Or are the problems with Basel II nearly solved? “Will Basel II be the key driver for innovation in all sectors?” (Bartels 2002). Why is there resistance towards Basel II?

Who is able to keep an overview with so much contrariety? Because the arguments in this discussion are often accompanied by emotions, the objective of this paper is to find a balance between the interests of the German SMEs and the banks through factual and realistic arguments.

It is necessary for the enterpriser to reveal the details/basics of the risk adjusted loan policies before any possible changes in interest rates for loans due to Basel II will be discussed.

The importance of the SMEs for the German economy will be clearly demonstrated so that possible strategies of banks, which are directed at eliminating credit risk, will be difficult to implement.

1.2 Methodology

To achieve these objectives firstly the German ‘Mittelstand’ (SMEs) will be defined qualitatively and quantitatively to explain the economic importance of the SMEs for the German economy. To immediately implicate the SMEs with the New Capital Accord, it is then outlined how these enterprises fund their investments and it is further analysed what their capital structure is. Before describing Basel I and Basel II, the need for financial regulation and supervision to reach financial stability within an economy is explained. To demonstrate its importance, an exhibit about the Asian financial and economic crisis is given. Capital adequacy in this context is given as one reason for financial stability.

The Basel Committee and its first Capital Accord will then be analysed and its weaknesses will be outlined. It will be explained why a change is needed. The New Basel Capital Accord (Basel II) will then be described in detail and the different approaches a bank can choose to determine their capital requirements. An overview about the history of the development of Basel II is given before the connection between the new guidelines and ‘rating’ are made clear. The different types of ratings, its procedures, its importance and its implications are outlined to find out the impact on terms and conditions for loans and what impact they will have on small and medium sized enterprises (SMEs) in Germany. Therefore the current situation of SMEs is assessed and suggestions are made how they can prepare for the approaching rating process. In the concluding chapter different scenarios, mainly brought up by the international finance media (see figure one) are briefly described and then evaluated by the author of this paper.

This report involved the collection and analysis of secondary research only. Primary research was not conducted because many SMEs will not be able to comment on Basel II until it has been implemented and. Therefore future research after Basel II introduction would be appropriate. Gathering primary research from banks is difficult. Data is usually highly confidential and unlikely to be released to an external source.

2 Small and Medium Sized Enterprises (SMEs) in Germany

“In most countries the Term ‘Small and Medium Sized Enterprises’ (SMEs) is confined to describe a statistically sizeable part of the overall economy. This is not so in Germany. Here, politicians, researchers or the press refer to the term ‘Mittelstand’ when they focus on specific (broader) aspects of the SME-sector” (Hauser, 2001, p.1).

Although it is constantly used in context with the current discussion about Basel II there is no legitimate definition of the term ‘Mittelstand’ or SMEs (IHK Osnabrück, 2002). Therefore it is important to question what exactly is meant by the term SMEs /’Mittelstand’. Not only does it describe Germany’s SMEs in a quantitative way, like annual turnover and number of employees, but also in a qualitative way, for example the identity of enterprise ownership or the personal responsibility for the enterprise’s activities. According to Hauser (2001, p. 1) “the German term ‘Mittelstand’ comprises economic aspects as well as social and psychological ones. Deriving the ‘Mittelstand’s’ significance only from statistics would lead into the wrong direction because it neglects that the ‘Mittelstand’ is also characterised by its basic convictions and attitudes in the socio-economic and political process”. The international financial and economic press increasingly pays attention to this characteristics and avoids translating the term ‘Mittelstand’. Therefore the term needs to be defined qualitatively and quantitatively. Both the terms ‘SMEs’ and ‘Mittelstand’ are used in this paper to refer to definition given below.

2.1 The Qualitative Aspect

To be considered as an SME in Germany a company has to fulfil qualitative criteria. The central qualitative characteristic of the SMEs is a strong linkage between enterprise and owner (Hauser 2001, p.1). This includes personal responsibilities for the enterprises’ activities and personal liability for the enterprises’ financial situation (Hauser 2001, p.1). Additionally an autonomous economic activity, which notably requires complete or virtually complete independence of any larger economic entity is a prerequisite (Deutsche Bundesbank 10/2003). According to the European Commission’s definition, this condition is met if the “capital interest held by a large firm in an SME is below 25%” (Deutsche Bundesbank 10/2003, p.31).

2.2 The Quantitative Aspect

For economic analyses and political discussions of the SMEs in Germany it is essential to structure the stock of enterprises by size classes. The Bonn-based Institute for SME research has defined SMEs which is agreed upon all over Germany and shown in figure 2 below (IfM 2003). With respect to turnover size classes the Institute for SME research^[1] now follows the SME definition applied by the European Union. Accordingly small enterprises are said to have up to nine employees and a maximum annual turnover of one million Euros. Medium-sized enterprises are defined to have between ten and 499 employees and an annual turnover between one and 50 million Euros. Large enterprises have 500 and more employees and an annual turnover of 50 million Euros and more (IfM 2003).

Figure 2: New SME definition applied by the IfM Bonn, in €

illustration not visible in this excerpt

Source: Institute for SME research homepage, www.ifm-bonn.org/dienste/daten-en.htm

In the case that an establishment matches two different size-classes, e.g. a company with an annual turnover of more than € 50 million and less than 500 employees, the annual turnover is of higher importance and thus the enterprises’ size is considered as large.

2.3 The economic importance of SMEs in Germany

“The SMEs are the carrying pillar of the German economy” (Paul and Stein, 2002, p.9). In general the ‘Mittelstand’ uses labour intensive methods of production and does extensive vocational training activities. Approximately 20 million employees work for SMEs which are 52.7% of the labour force in Germany. The ‘Mittelstand’ accounts for nearly 83% of all apprentices (Hauser, 2001, p.26). In 2002 there were 3,374,000 SMEs which is a share of 99.7% of all enterprises producing a turnover subject to VAT of 42.1% and a value-added subject to VAT of 48.8% of the German economy (IfM 2003). According to the Institute for SME research (2003) SMEs carried out 46% of gross investment in 2002. In the same year there were 452,000 start-ups and 389,000 closures leading to a positive balance of 63,000 enterprises in this sector (IfM 2003)^[2]. Strikingly the SME sector has the biggest job growth potential, especially the medium-sized establishments with 10 to 499 employees which created 1,633,300 jobs in the period 1990 to 1994^[3]. According to Paul and Stein (2002) the SMEs are the warranty for employment in Germany.

In 1998 exports of German enterprises amounted to more than € 485 billion. SMEs accounted for 30% of total direct exports (Hauser 2001, p.31). Compared to large establishments, export ratios (exports over turnover) are much lower in smaller establishments. One explanation for SMEs’ smaller share in exports can be seen in their function as suppliers for larger (exporting) enterprises (Hauser 2001).

At the same time the SMEs, their owners, associates and managing directors are an important factor for the aggregate demand in the economy: “they demand products and services, invest, and are an important target group for marketing- and advertising campaigns” (Paul and Stein 2002, p.9). The ‘Mittelstand’ is considered to be very innovative. 75% of all patents are being developed here (Ehlers 2003, p.1). According to the Deutsche Bundesbank (10/2003, p.32) in 1999 more than 10.4% of staff in firms with less than 100 employees were engaged in research and development. This figure is actually higher than in larger enterprises with over 5,000 employees, in which “only” around 8% of staff were engaged in research and development. Figure 3 on the following page gives an overview of the key figures of the German SMEs.

Figure 3: Key figures of the German SMEs

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* Western Germany without West-Berlin, Eastern Germany including all Berlin.
** Only those enterprises are covered whose annual (taxable) turnover exceeds € 16.617
*** Insolvencies in 2002 per 1000 enterprises according to VAT statistics (estimated)
**** This percentage share is not comparable with previous values as many privatised (formerly state owned) enterprises are now counted as large (private) enterprises, thus reducing the share of SMEs in overall value added.

Source: Institute for SME research homepage, www.ifm-bonn.org/dienste/daten-en.htm

2.4 How do SMEs fund their investments? What is their capital structure like?

With reflection on the requirements of Basel II^[4] it shows that the major problem for SMEs will consist of raising long-term loans and equity capital. Large enterprises are able to make use of the capital markets in issuing shares or securities in contrast to SMEs. The interest charges for long-term bank loans do not describe a major problem. It is rather the lack of sufficient availability of equity and debt securities (Paul and Stein 2002) which are usually prerequisites for a long-term bank loan.

“Public companies in Japan and Germany have traditionally relied more on debt than on equity, so their gearing^[5] has typically been twice or three times as high as that of Anglo-American” (Edwards and Fischer 1993, p.21). Public limited companies only represent a minority of the SMEs in Germany. According to Paul and Stein (2002, p.10) they make out around two percent. The majority, about 80 percent, are private limited companies and sole proprietors. However, comparisons of the gearing ratio with other industrialised countries, undertaken by Edwards and Fischer (1993), consistently suggest that the debt-equity ratio of non-financial enterprises (all sizes)^[6] in Germany is significantly higher than that in the UK. But it is difficult to compare this ratio internationally because of e.g. the correct measurement under inflationary conditions^[7]. Bartels (2002) argues that historically high tax rates have hampered German SMEs in building up adequate capital cushions. As a consequence of this they are heavily dependent on bank financing for working capital and investments. Furthermore their financial statements are generally designed towards a tax avoidance strategy rather than a business and investment strategy. The Deutsche Bundesbank (10/2003 p.39) also states that there is a “relatively large share of bank loans in SMEs’ financing”. Figure 4 below shows the SMEs’ provision with own funds in comparison with large enterprises.

Figure 4: SMEs provision with own funds.

illustration not visible in this excerpt

Own funds as a % of balance sheet total.

Source: Deutsche Bundesbank Monthly Review (10/2003)

Figure 4 shows that the percentage of equity of SMEs is significantly lower than those of large enterprises. However, the own funds-ratio of the corporations within the SME sector was 16.5% in 2001. Those of the non-corporations^[8] was 0.5% in 2001 and explains the low ratio of all SMEs.

Due to the low equity-ratio and debt securities SMEs face difficulties in receiving loans and less favourable terms and conditions (e.g. provision of collateral required and mark-ups on the rate of interest) . The Mind-Study^[9] (2001) is based on more than 1,000 interviews with SME representatives (owners, managers) about which sources of finance have been used during the last three years to cover their capital needs. According to Mind (2001 p.19) the major source of finance is of an internal nature. This major source consists of the retention of profits on the one hand and the finance of depreciation and reserves^[10] on the other hand. The third most important source of finance according to the survey is bank loans and overdrafts^[11]. 30% of all interviewed SMEs mentioned the use of bank finance. It is impossible for the Deutsche Bundesbank to quantitatively confirm this self-assessment of the SMEs by means of balance sheet analysis. When considering the accounting standards it has to be distinguished between inner and open self-finance. The inner self-finance does not become apparent in the balance sheet because it arises from either undervaluation of assets or overvaluation of liabilities (Paul and Stein, 2002).

The finance of SMEs by bank loans is rather at a low level. According to statistics of the Deutsche Bundesbank (03/2000) in 1999 the part of liabilities towards credit institutes amounted to 21% measured by the SMEs’ balance sheet total. The role of banks in Germany is of much higher significance in comparison to credit institutes e.g. in France. In France liabilities of SMEs towards banks are on average between ten and eleven percent of the SMEs’ balance sheet total (Paul and Stein 2002).

Figure 5 shows that approximately one third of all SMEs are being provided with 50 percent or more of their debt capital by banks. Another one third of all SMEs’ are being provided with less than 50% of their debt capital by credit institutes. Three out of ten companies said that they do not make any use of debt capital.

Figure 5: Implication of banks for the finance of ‘Mittelstand’ enterprises
What % of the debt capital comes from banks?

illustration not visible in this excerpt

Source: Mind-Study (2001) „Mittelstand in Deutschland“

With examination of the different lengths of capital provided by banks^[12], the 1,000 surveyed companies have answered as follows:

- long term loans with a duration of four years and more amount to 43%.
- medium-term loans with a duration of between one and four years represent 36%
- short-term loans with a duration of less than one year amount to 21%.

The orientation of the debt-relationship towards medium- and long-term loans is a central part of the current discussion about the impact of Basel II on the SMEs in Germany. From the banks’ point of view it is to say at this stage of the paper, that according to the above findings the SMEs’ appropriate provision with equity and less favourable terms and conditions for loans illustrate the major problems for SMEs to date.

3 Banking regulation and the Basel Accords

3.1 Regulation and banking supervision

Recent appraisals of East Asian banking systems have commented on a number of serious common weaknesses, although with differing severity, throughout much of the region. Among others these include low capital-adequacy ratios, unduly lenient provisioning rules for non-performing loans and weak supervision (Crafts in Oxford Review of Economic Policy, Autumn 1999).

This part of the chapter outlines the importance of regulatory capital and banking supervision as a part of regulation of a financial system to ensure financial stability of an economy. According to Avgerinos (2003) this includes the need to achieve microeconomic objectives such as transparency in the market, consumer protection and promotion of competition.

3.1.1 Why regulate financial markets?

Money is “an asset that is accepted by people in exchange for goods and services because they expect that others will, in turn, accept this asset for other exchanges” (Benston 1998, p. 28). According to Woelfel (2001) a bank is an organisation engaged in receiving, transferring, paying, lending, investing, dealing, exchanging and servicing money. Customers trust banks and deposit their money (savings) at banks. An important reason for financial regulation is the protection of consumers from the loss of their investments, fraud and misinterpretation, unfair treatment and insufficient information (Benston 1998).

Chorafaras (2000) outlines the importance and the role of regulatory capital: “It reduces the probability of an institution’s insolvency to an acceptable level and provides for an orderly wind-down in case this becomes unavoidable, without creating systemic risk”. This definition underlines the impact of insufficient regulatory capital. It therefore becomes distinct how carefully new regulations have to be elaborated and that the development and implementation process involves extensive interaction with banks and industry groups.

One component of financial stability is the ability to absorb loss. In banking, loss is absorbed by capital reserves, which are set aside against untoward events (The Banker 11/2002). “The financial stability of a major bank is critical to its customers, but the financial stability of the international banking system overall is critical to everyone. To oversimplify somewhat the Basel Committee on Banking Supervision (hereafter referred to as the Basel Committee) sets standards for the key banks in major countries with that global stability in mind” (Geer 2002, p.12). During the last three or four years international bankers have been calling on the Basel Committee to change its formula for calculating how much capital institutions need to hold back as a cushion against credit risk^[13].

In the last few years, the international focus on banking crises has increased. As with many other economic phenomena, increased vulnerability to financial crisis can be traced down to two overarching trends that have swept the world: liberalisation and globalisation (Caprio et al 1998). Where liberalisation is important for governments for faster growth, globalisation^[14] increases the international effects of domestic financial crises.

The Basel initiatives were generally intended to cover only the participating industrial countries, and did not cover banks in developing or transition economies^[15]. As recent events demonstrate, emerging markets could also benefit from more stringent rules. According to Caprio et al (1998) such rules could also improve international financial stability. The following exhibit briefly describes the Asian financial and economic crisis to demonstrate the importance of financial regulation and minimum capital requirements.

3.1.2 Exhibit: The Asia Crisis

“The Asian economic and financial crisis has brought untold economic and social damages and political instability to the countries in trouble” (Van Hoa 2000, p.14). It started in July 1997 in Thailand and spread quickly to other East Asian economies with devastating effects. Economically, financially, socially and politically. Strong economies such as Hong Kong, Taiwan, Singapore, China and Japan have also been affected “by the contagion of this major turmoil” (Van Hoa 2000, p.14). Countries that are far away from Asia like Russia, Brazil, Argentina, the U.S. and Germany have all experienced the damages the Asian meltdown has generated. The main characteristics of this crisis were a downturn in economic growth and a recession accompanied by huge falls in the regional stock markets. According to Van Hoa and Harvie (2000) these were caused by a massive outflow (up to 40%) of its foreign investment capital from Thailand and secondly, Thailand’s currency was devalued under sustained international pressure.

These led to a closure of one third of the country’s banking and financial institutions (Van Hoa and Harvie 2000). Van Hoa (2000) lists as main reasons for the shift of short term capital to other countries a failure in government fiscal and monetary policy, a lack of good governance, and more importantly for this paper the immaturity of the financial markets (which includes insufficient capital adequacy measures) in the economies in crisis. He further argues that “the lack of trustworthiness of the financial system for local and international creditors has caused a fast deterioration of asset quality and a systemic risk of insolvency of the financial institutions and vice versa” (Van Hoa 2000, p. 22). According to him the insolvency of financial institutions was caused by their highly leveraged structure: a high debt-equity ratio resulting in the high costs of financial distress. Woo and Sachs (2000) point out that the claim is correct that the Asian Pacific economies had imperfect economic institutions, for example inadequate banking regulation and supervision. These include e.g. over expansion of bank lending without proper credit assessment and lending into unproductive sectors such as property and the equity markets. According to Carse (1998) in a number of economies banks were ordered or persuaded by the government to lend heavily to particular industries. In addition banks failed to recognise bad debts, in other words systems for loan classification and provisioning have been inadequate. “Political interference in banks policy lending and pressure on supervisors not to take actions against well-connected owners of banks” (Carse 1998, p. 3) were reasons for failure in banking supervision and regulation.

However, Woo and Sachs (2000) also point out that it is incorrect to claim that these flawed economic institutions ignited the region wide economic crisis. Neither does the author of this paper claim that with adequate economic institutions such as banking supervision the crisis would have been prevented. But weak financial systems with inadequate banking supervision are one reason, among others, for the cause of the crisis. The Basel Committee has produced a set of core principles that are intended to provide a set of minimum requirements for effective banking supervision. These supervisory standards can be applied to every country.

3.2 From Basel I to Basel II

Besides their role as a mediator between debtors and depositors credit institutes offer a variety of other financial services. One of the most important tasks of banks is to manage different kinds of risks including credit-, market price-, liquidity- and other risks^[16]. These risks can become a major threat (in the worst case) to the banking and finance sector in an economy. Therefore, besides their own provision against risks (calculation of standard risk cost against the expected loss), credit institutes are committed by special supervisory regulations to build up adequate risk cushions. “Among these regulations, the regulations on capital assume a prominent role” (Deutsche Bundesbank, 04/2001, p.15).

The 1988 Capital Accord of the Basel Committee forms the basis of the corresponding German supervisory regulations (principle 1 of the Banking Act).

[...]

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^[1] Institute for SME research is the translation for “Institut für Mittelstandsforschung” (IfM), Bonn

^[2] see figure 3

^[3] see appendix no. 1

^[4] explained in the next chapter ‘Banking Regulation and the Basel Accords’

^[5] see glossary for definition

^[6] It was not within the reach of this report to gather specific information on gearing ratios by company size. Therefore it is assumed by the author that the high debt-equity ratio relates to each company size equally.

^[7] In the UK buildings are periodically revalued while in Germany all assets are valued at true historic cost with no revaluations (Edwards and Fischer 1993).

^[8] which are sole proprietors and partnerships

^[9] The Mind-Study is a cooperative project of the Dresdner Bank AG, the business magazine ‘impulse’ and the Institute for SME research, Bonn (IfM). It is a diverse and deep structured research project and is a “rich source” for an up-to-date image of the ‘Mittelstand’. It can be downloaded from: http://www.impulse.de/spe/mind/studie.html

^[10] reserves are a company’s accumulated, retained profits (Lines et al, 2000, p.244)

^[11] see appendix no. 2

^[12] see appendix no. 3

^[13] see glossary for definition

^[14] Globalisation in this context is a concept associated with the evolution of financial markets and institutions to the point where geographic boundaries do not restrict transactions and other activities. Globalisation applies to the increasingly international characteristics of banks and other institutions (Woelfel 2001).

^[15] For detailed information on participating and non-participating countries the see the Bank for International Settlements homepage: http://www.bis.org

^[16] All defined in the glossary of this report