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Within a couple of years, banks
will be subject to new capital
adequacy rules which will affect
their cost of funding loans. The
new system will be particularly
complex in relation to lending
against property and it is
inevitable that that the nature of the transaction, and
of the bank’s method of calculating capital, will lead to
greater variation in capital “costs” than is currently the
case. How will banks react to these changes? How will
borrowers be affected?
What is capital adequacy?
Capital is often described as “risk capital” or, in plain
English, money that you might not get back. Equity
investors expect to receive dividends plus return of
their original investment if the business is wound up,
but their rights rank behind other legal obligations of
a company.
When a bank lends money, in theory it uses the
money from its depositors to fund the loan. If the
loan were not repaid then, absent capital (or
“prudential”) requirements, the bank would be unable
to repay the depositors. To protect depositors, capital
requirements dictate that a portion of the bank’s
funding, minimum 8%, should be in the form of
equity or equity like-funding, eg subordinated debt,
so that in the event that one of the bank’s loans is not
repaid, it is the equity investors who will bear the
burden, rather than the depositors. Given the risk
that equity investors bear, they tend to “require” a
higher rate of return than they would get if they
simply placed their money in the bank. This
“requirement”, of course, has no legal force.
However, absent a reasonable rate of return, share
prices will probably deteriorate and an institution may
be forced into a merger or takeover. For this reason,
the requirement for equity funding (with its higher
expected level of return) is seen as more costly than
funding by deposits (deposits or inter-bank lending).
Basel Capital Accord
In 1988, a committee of the Bank for International
Settlements, known as the Basel Committee,
established a set of standards for capital requirements.
The Committee established the basic 8% capital
requirement, but it also set out a set of standards to
modify the 8% requirement, depending on the nature
of the borrower and certain aspects of the loan. For
instance, a loan to a credit institution incorporated in
an OECD country would be risk weighted at 20%, ie
[amount of loan] x 8% x 20%. Thus a £1,000,000
loan to such a credit institution would require
£16000 of the finance for the loan to be funded by
equity, only 20% of the capital required for a loan to
a corporate entity (which is currently risk weighted at
100%). Lending secured on residential property is
risk weighted at 50% of the original value, reflecting
the value of the security in the event of default.
Basel II
The view arose that the Basel system was not sensitive
enough to the credit quality of the borrower or other
features of lending and, in 2004, the second Basel
Capital Accord (Basel II) was finalised. This aim was to
introduce a more sensitive system and also to
incentivise banks to introduce more sophisticated risk
management systems. The new system will be more
complicated than the existing one, particularly in
relation to property finance.
Basel II permits two approaches to calculating capital
requirements: the Standardised approach and the
Internal Ratings Based (“IRB”) approach. The
Standardised approach is intended for less
sophisticated banks, but the intention is that more
sophisticated banks will move towards the IRB
approach. The risk weightings calculated by either
approach will be scaled back slightly to allow for a
new “operational risk charge”, which will reflect the
lending bank’s operational competence. The
European Union has issued a draft implementing
Directive and the Financial Services Authority has
already issued a draft Handbook with the text to
implement the measures in the UK.
Standardised approach
Under the Standardised approach, entities will be
assigned a risk weighting on the basis of their credit
quality, along a seven point scale. Sovereigns will
attract risk weightings ranging from 0% for a triple-A
rating to 150% for a sovereign rated C or below.
Bank and corporate risk weightings will range from
20% to 150%. If a borrower’s credit rating changes
during the life of the loan, then the capital
requirement will change accordingly. During
consultation, it became obvious that the new system
would be disadvantageous to small borrowers, which
are almost invariably of low credit quality. Therefore,
the new system makes provisions for a 25% reduction
in the risk weighting of credits that qualify for
inclusion in a regulatory retail portfolio, provided that the total exposure (including residential mortgages)
does not exceed one million euro.
Currently, a reduced risk weighting of 50% is allowed
where a loan is collateralised by residential real estate.
Under the new regime, the FSA is proposing to apply
a 35% weighting up to 80% of loan-to-value (“LTV”),
with a marginal risk weighting of 75% for the
remainder. It is also proposing that firms could either
determine their LTV at origination or use a current LTV
which could be estimated using a house price index.
Commercial real estate has always been a contentious
issue. Certain EU countries, such as Germany, have
allowed a 50% weighting for loans collateralised by
commercial real estate, although the UK has never
adopted this treatment. Regulators will still be able to
permit this treatment, but the FSA has indicated that
it will not adopt it. However, the FSA will allow UKauthorised
firms lending into countries that allow the
reduced risk weighting to calculate their exposure in
those countries at that reduced level, while EU lenders
lending into the UK will be obliged to use the UK
treatment.
Internal Ratings Based approach
Under the IRB approach, capital requirements for
individual loans will be set using data for a number of
variables including Probability of Default, Loss Given
Default, Exposure at Default and Maturity. The EU has
published its proposed formula in the draft Directive.
Under the Foundation IRB approach, banks will be
expected to have sufficient internal historical data to
input the figures for Probability of Default, while the
regulatory authority will provide the other data. If
banks have sufficient historical data available, then
they will be able to use the Advanced IRB approach,
under which they may provide all, or nearly all, of the
figures for the calculations.
The estimates of Loss Given Default will, by their
nature, reflect the loss-reducing effect of any
commercial or residential real estate security.
However, there will be minimum levels of Loss Given
Default for secured portions of exposure: 35% for
senior claims, and 65% for subordinated claims.
Banks will have to report IRB lending under five asset
classes: sovereign; corporate; bank; retail; and equity.
Loans falling within the retail asset class will have to
meet criteria relating to the nature of the borrower
and the number of exposures in the class. Within the
retail asset class, there will be a sub-class relating to
“exposures secured by residential properties”.
The broad element of the corporate asset class will be
used for general corporate loans. However, the
corporate class will have four specialised lending subclasses,
namely: project finance; income producing
real estate; object finance; and commodity finance
(the FSA is not proposing to implement the Basel
Committee’s fifth category of high volatility real
estate). Specialised Lending is lending which
possesses (either in legal form or economic substance)
the characteristics that the exposure is typically to an
entity that was created to finance and/or operate
physical assets; the borrowing entity has little or no
other assets; the terms of the obligation give the
lender a substantial degree of control over the assets;
and consequently the primary source of repayment is
the income generated by the assets.
Income producing real estate (“IPRE”) is funding to
finance real estate (office buildings to let, retail space,
multifamily residential buildings, industrial or
warehouse space and hotels) where the prospects for
repayment and recovery of the exposure depend
primarily on the cash flows generated by the asset
(primarily lease of rental payments or the sale of the
asset). The distinguishing characteristics of IPRE versus
other corporate exposures collateralised by real estate
is the strong positive correlation between the prospects
for repayment of the exposures and the prospects for
recovery in the event of default, with both depending
on the cash flows generated by a property.
If banks do not have sufficient internal historical data
for specialised lending calculations, then they must
use the pre-set figures, which can give rise to a very
much higher weighting for a weak (rated B to C-)
transaction.
Implications
Loans to borrowers with high credit rating will attract
a lower risk weighting under the new system, while
loans to poorly rated borrowers will attract a higher
risk weighting. Loans secured on residential property
will attract a reduced risk weighting under both the
Standardised and IRB approach. However, loans
secured on commercial property may only attract a
reduced risk weighting under the IRB approach
(through being reflected in the reduced assessment of
Loss Given Default). However, if the lending falls
into one of the specialised lending categories, then
IRB banks could find that they are required to allocate
a much higher amount of capital than a Standard
approach bank would require.
It will be interesting to see to what extent the above
considerations will cause the lending practices of
banks to align with their method of calculating
capital, so that Standardised approach and IRB
approach banks each gravitate to certain types of
lending. Borrowers, too, will undoubtedly be
watching to see whether the way that banks calculate
capital affects the interest costs that they must pay.
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