Although non-financial corporate debt (bond issues and privately issued debt) has become more common in the past 10-20 years, bank loans are still the prime source of business finance, especially for small and medium-sized enterprises (SMEs). As a consequence, banks’ ex-ante assessment of the riskiness of loan applicants and the resulting decision to grant credit (or not) at some risk-adjusted interest rate, is of great importance for businesses. Bank regulators increasingly lean on the risk assessments made by banks: in the Basel Committee’s proposal for new capital adequacy rules, the so called Basel II Accord, internal risk ratings produced by banks have been given a prominent role.

Unlike previous regulation, the rules of Basel II will make the size of the required buffer capital contingent on a bank’s appraisal of ex-ante individual counterpart risk. It will be up to each bank to characterize the riskiness of the counterparts and loans in its portfolio by means of a relatively small number of risk categories or ”rating classes”. A special feature of the new regulation is that retail credit and loans to SMEs will receive a different treatment than corporate loans and will require less regulatory capital for given default probabilities. The main reason for this differential treatment is the supposedly low correlation between small business loans. Their risk is generally thought to be largely of an idiosyncratic nature.