Asymmetric information and capital regulation in SME lending: a structural model of bank and non-bank competition

A new research paper from the Bank of England examines how the growth of non-bank lending to small and medium-sized enterprises is changing the dynamics of the business credit market and creating new challenges for financial regulators.

The paper, published as a staff working paper, builds a structural model of bank and non-bank competition in the SME lending market. Its central finding is that non-bank lenders are able to compete effectively with banks because they are not subject to the same capital requirements, allowing them to offer lower interest rates to creditworthy borrowers. But this competitive advantage comes at a cost: non-bank lenders are less able to assess the creditworthiness of borrowers than banks, which have long-standing relationships and access to transaction data that non-bank lenders lack.

The result is a market in which the best borrowers are increasingly served by non-bank lenders, while banks are left with a pool of borrowers that is riskier on average — a dynamic that could make the banking system more fragile while concentrating risk in a less regulated part of the financial system.

The paper's findings have significant implications for financial regulation. The authors argue that capital requirements for banks should be calibrated to take account of the competitive dynamics of the markets in which they operate, and that regulators should develop a framework for monitoring and, where necessary, regulating non-bank lending to ensure that risks do not accumulate outside the regulatory perimeter.

The paper is part of a broader programme of research at the Bank into the implications of the growth of non-bank finance, which now accounts for approximately half of global financial assets and which has transformed the structure of the financial system over the past two decades.