LONDON, April 3 (Reuters) - Forcing banks to set aside more capital in case loans to small and medium-sized companies turn sour would hit Britain's economy, banking industry body UK Finance said on Monday.
The Bank of England is deciding how to implement the final leg of Basel III, a suite of tougher bank capital rules introduced after many lenders were bailed out by taxpayers in the 2007-09 global financial crisis.
It has proposed ending the preferential capital treatment for loans to small businesses, known as the SME supporting factor.
"The SME support factor should not be completely and suddenly removed," UK Finance said in a statement.
"Without it the cost of lending to a critical component of the UK economy will increase and lending appetite reduce."
If the BoE does go ahead, capital reduction should be maintained on loans already made, the capital hit to secured loans should be less harsh, and a transitional phase-out period should be introduced, UK Finance said.
The BoE has said no final decision has been taken on the SME supporting factor.
UK Finance also opposed a BoE proposal for preferential capital treatment on loans for infrastructure investments, saying it would make it harder for banks to back Britain's climate objectives.
Basel introduces an "output floor" to avoid big banks who use their own models to calculate capital buffers from having an advantage over small lenders, who must use more conservative criteria set out by regulators.
Britain should bring the floor into line with other countries to avoid a competitive disadvantage, UK Finance said.
The European Union is also finalising how it will apply the remaining Basel rules, and may ease the impact of the output floor on big banks in some areas of activity.
The BoE plans a simpler capital regime for smaller UK lenders, and UK Finance said the central bank should apply it to subsidiaries of foreign lenders operating in Britain as well.
