Lender Capital, Funding Costs & Balance Sheet Constraints

While much attention is given to SME borrowing, the other side of the equation is equally critical: the lenders themselves. How much they can lend, at what price, and under what conditions is fundamentally shaped by their own capital, funding costs, and balance sheet constraints.

In a rising interest rate environment, lending is not simply a matter of demand. Deposit rates rise, wholesale funding becomes more expensive, and regulatory capital buffers limit the ability of banks to expand. Meanwhile, non-bank lenders face their own funding cost pressures that affect product pricing and appetite. Understanding these mechanics is key to assessing credit availability and potential bottlenecks for SMEs.

1. Capital and Regulatory Constraints: The Core Limiters

Banks operate under strict regulatory frameworks designed to ensure stability. Two key mechanisms shape lending capacity:

Capital adequacy requirements

Under Basel III rules, banks must hold sufficient Tier 1 and Tier 2 capital relative to risk-weighted assets. Lending to SMEs increases risk-weighted assets, so expanding credit requires either:

• Increasing equity (expensive and slow)
• Offsetting risk elsewhere on the balance sheet
• Absorbing lower returns on riskier loans

Liquidity coverage ratios (LCR) and net stable funding ratios (NSFR)

These rules require banks to hold high-quality liquid assets to cover potential outflows over 30 days (LCR) or to maintain stable funding for one year (NSFR). Excessive lending can strain these ratios, particularly in sectors with volatile cash flows.

Key takeaway: Even if demand from SMEs is strong, banks may limit lending to maintain compliance with regulatory ratios.

2. Funding Costs: The Price of Credit

The cost of capital for lenders directly affects SME credit pricing and availability. Funding comes from multiple sources:

• Customer deposits
  When rates rise, banks pay more to attract and retain deposits, increasing the cost of lending.
• Wholesale funding / bond markets
  Banks and non-bank lenders often borrow in capital markets. Rising interest rates increase bond yields, pushing up funding costs.
• Equity financing
  Raising capital to expand lending is expensive and dilutive, especially in periods of market volatility.

Implication: Higher funding costs reduce lenders’ margins, causing them to tighten credit terms or reprioritise lending towards lower-risk, higher-yield segments.

3. Trading Off Return vs Risk

Lenders constantly balance return on capital against credit and operational risk:

• Riskier SME loans may generate higher interest income, but they consume more capital due to regulatory risk weights.
• Conservative lending maximises portfolio quality and regulatory compliance but may leave unused lending capacity.
• In rising-rate environments, lenders may prefer short-term lending or secured facilities to maintain capital efficiency.

Non-bank lenders face similar trade-offs but often have more flexibility in structuring products. They are sensitive to wholesale funding costs and investor appetite for debt securities, meaning their lending capacity can expand or contract more quickly than banks’ but at a higher pricing sensitivity.

4. How Balance Sheet Pressures Affect SME Lending

When funding costs are high and capital is constrained:

• Credit growth slows
  Lenders may prioritise refinancing over new lending, reducing the net availability of new credit.
• Pricing becomes more selective
  SMEs may face higher interest rates or stricter covenants to compensate for balance sheet consumption.
• Product innovation may be limited
  Longer-term or unsecured facilities are more expensive for lenders under these conditions, curbing product diversity.
• Sectoral and risk segmentation emerges
  Lenders may favour low-risk or collateral-rich borrowers, while higher-risk SMEs may face reduced access.

5. Forecasting Potential Easing: Rate Cuts and Bond Yields

The supply of credit is highly sensitive to changes in market conditions:

• Easing in bond yields or central bank rate cuts
  Could reduce wholesale funding costs, lower deposit pressures, and free up capital for new SME lending.
• Structural caution may persist
  Even if funding becomes cheaper, lenders may retain a conservative posture following recent volatility, regulatory scrutiny, or sector-specific losses.

Scenario analysis:

• If rates fall modestly in 2025–2026, we might see moderate expansion in SME credit, particularly in sectors deemed resilient.
• If lenders maintain a cautious stance, balance sheet constraints could continue to limit lending growth, even if economic conditions improve.

6. Strategic Takeaways for SMEs

For businesses seeking finance, understanding lender constraints can improve planning:

✔ Engage early

• Pre-emptive discussions with lenders before peak borrowing periods increase the likelihood of securing credit.

✔ Consider facility type and structure

• Short-term or asset-backed facilities may be easier to obtain under tight balance sheet conditions.

✔ Monitor market signals

• Bond yields, deposit rates, and central bank guidance provide early indicators of potential easing in lending constraints.

✔ Build lender relationships

• Long-standing relationships and transparent financial reporting can improve access even when balance sheet capacity is tight.

Conclusion: Lending Capacity is Not Infinite

SME borrowing does not exist in a vacuum. Lender capital, funding costs, and balance sheet constraints are fundamental determinants of how much credit is available and on what terms. Rising rates, higher deposit costs, and regulatory buffers can restrict lending, while rate cuts or falling bond yields may create room for expansion.

The key for SMEs is understanding that credit supply is as much a function of lender balance sheets as borrower demand. Strategic planning, early engagement, and flexible facility design are critical to navigating a constrained lending environment in 2026.