Asset correlations and capital requirements for SME in the revised basel II framework

This article reviews the final changes in the Benchmark Risk Weight Function of the Basel II proposal as of June 2004. A special focus is directed to the impact of the proposed changes to the segment of Small and Mid-Sized Enterprises (SME). One of the main objectives of the recalibration of the IRB approach was to relieve capital requirements for these institutions. We review the changes in the revised Basel II framework and compare the regulatory approach to empirical results on the relationship between asset correlations, probability of default (PD) and firm size. Empirical findings suggest asset correlations in the market to be lower than those assumed in the capital accord. In a final case study we investigate the implications of changes in regulatory capital on credit spreads for SME. Our findings suggest that as a result of the new capital accord credit spreads will decrease for companies with higher ratings while there will be an increase in interest rate and spread for companies with non-investment grade ratings.