Basel II: capital concerns

Basel II has forced banks, long the mainstay of lending to European corporates, tore-evaluate the amount of money they lend. However Alan McNee reports that far from leading to a huge drop in bank lending, Basel II may actually have the opposite effect

The new Basel II bank capital adequacy accord represents perhaps the biggest change to banking regulation since 1988, when the current Basel I accord was endorsed. The new framework aims to tie bank regulatory capital more closely to the real risks banks face. Yet there is very little information on how the new rules will affect how much credit risk – both loans and bonds – banks hold. Just as uncertain is how the accord will affect the supply and demand of corporate bonds and credit derivatives.

The most important change is that the capital charge of lending to high investment-grade borrowers could decline by as much as 60%, making such lending much more capital-efficient for banks. At the other extreme, retail – including medium-sized companies small enough to count as retail – and mortgage clients will also benefit. Those worst hit will be the bigger non-investment grade SMEs.

But while Basel II means that higher-risk credits will attract higher regulatory capital requirements, it is not simply the case that banks will offload these riskier exposures. Otto Dichtl, senior credit analyst at BNP Paribas, says the complexities of Basel II mean that “you cannot simply predict that there will or will not be a big sell-off. Even if there is a higher capital charge for low-rated credits, the spread you get for holding that credit may cover your higher regulatory capital costs.” The problem is that as yet no one has examined fully how Basel II will affect the cost of borrowing and so whether companies – particularly lower-rated ones – will continue to be able to afford bank funding.

Scott Bugie, managing director of European financial services at Standard & Poor’s, agrees Basel II is unlikely to result in widespread asset disposal. He says that, while some asset classes are treated more favourably or less favourably than others under the new regime, “it’s hard to see an area where the treatment would be so negative that it would lead to sell-offs once Basel II is implemented.” In Bugie’s opinion this includes the larger non-investment grade SMEs. However Bugie cautions: “In relative terms, though, we may see a switch in emphasis from areas such as mid-market lending towards more high-end corporate lending, if the latter enjoys more favourable capital treatment.”

Back to the banks

The introduction of these new rules could have a regressive effect on the capital markets: more reliance by corporates on bank lending and less on borrowing via the capital markets. Under Basel I, all corporate borrowing had a risk weighting of 100%, but the new accord means that banks using the IRB (internal ratings-based) approach can assign risk weights as low as 10% to the highest-rated borrowers. This will allow banks to charge high-rated companies lower premiums, and this in turn could well encourage those borrowers who currently use the capital markets to return to banks for financing.

Similarly, weaker borrowers who find themselves having to pay far higher premiums could find that their access to the capital markets is made easier by investors hungry for high-yielding credit. European bond markets could eventually look very different as a result of Basel II. European investor appetite for the lower end of the corporate credit spectrum is a relatively new phenomenon but a booming one nonetheless. If weaker borrowers look to the capital markets as a result of Basel II, they could find themselves pushing at an open door with the institutional investors behind it keen to lend to borrowers who offer better returns. However some companies, particularly those rated low investment grade, may find it more efficient to improve their rating and return to using banks for funding.

Jackie Ineke, European bank analyst at Morgan Stanley, says one impact of the new rules could be the reintermediation of banks when it comes to extending credit to large corporate borrowers who have turned to the capital markets. “Corporate borrowers are getting rid of their minimum 100% risk weighting, so we’ll see tighter pricing to the big, strongly rated [by agencies, or the banks themselves] corporates on the part of banks,” she predicts. Conversely, lower-rated borrowers could increasingly find that their access to the capital markets improves.

“The banks will always be there as providers of credit to smaller, unrated corporates – it’s their job to manage risk, and so long as it’s properly priced they will stay in that market,” says Ineke. “But they will be pricing credit to higher-risk borrowers at much higher margins, and this could lead to a shift towards the capital markets on the part of those borrowers.” It is still unclear to what extent the price of funding will rise. Meanwhile, if the supply of stronger corporates issuing in the capital markets dries up, investor demand for credit may mean that lower-rated names are increasingly able to issue. The vast population of European borrowers currently unable to access the capital markets directly could find that Basel II finally opens the door for them – giving credit investors a wealth of high-risk, high-return issuers to choose from.

A carrot for consolidation It is possible that Basel II could lead to consolidation among European banks; indeed, one interpretation of Banco Santander’s bid for UK mortgage provider Abbey is that it is driven by a desire to be better placed for the start of Basel II compliance. Having a larger portfolio of mortgage assets gives regulatory capital advantages that might help to offset the more stringent capital requirements for some of Banco Santander’s higher-risk Latin American exposures. But a recent report by UBS – Will Basel II change the competitive landscape for banks? – suggests that while the new accord could be a catalyst for M&A activity, “it is more likely that Basel II will be a driving force to realign business models and strategies, with portfolio swaps rather than comprehensive buying and selling of banks.” Robert Motyka, executive director at UBS Investment Research and the report’s author, says that while straight portfolio swaps may take place on a bilateral basis between banks, these will probably entail the use of credit default swaps and total return swaps to gain protection. “Basel II expands the use of different forms of collateral, giving a greater incentive for banks to use these products to offset counterparty credit exposure,” he says.

Basel II: a beginners’ guide The new Basel II framework for bank capital adequacy was finally published in June by the Basel Committee on Banking Supervision after years of consultation, review and discussion. Unlike in the US, where only banks with over $250 billion in assets will have to comply, the new accord will be mandatory for banks throughout Europe. It will replace Basel I, the regulatory capital regime in place since 1988. Basel II is intended to come into effect in stages from late 2006, although 2007, or even 2008, is widely considered a more realistic deadline. The new framework is fiendishly complicated, but its main thrust can be summed up as follows: Basel II is intended to align regulatory capital more closely to the real risks banks face. In other words, the less credit, market and operation risk a bank is exposed to, the less regulatory capital it will need to hold, and vice versa. The framework is based on the ‘three Pillars’ of minimum capital requirements, supervisory review and market discipline. Pillar One – minimum capital requirements – allows banks to choose between three different approaches to calculating their regulatory capital requirements; standardised, foundation internal ratings-based (IRB) and advanced IRB. The standardised approach is fairly close to the current Basel I system, but whereas under Basel I, risk weights for credit exposures were assigned to one of four ‘buckets’ (governments, banks, mortgages and corporate lending), the Basel II approach assigns risk weights to a whole spectrum of risk, and uses credit ratings. The IRB approaches allow banks to use their own internal risk measurement data for capital calculations. Since the IRB approaches are more risk-sensitive, or in the eyes of regulators better, banks are given capital incentives to progress to these more sophisticated methods. In contrast to the existing Basel I capital accord, Basel II is more sensitive to the credit quality of the borrower, as determined by the rating agencies or a bank’s internal ratings. In addition, potential recovery value of a loan in the event of a default – loss given default (LGD) – is another key factor in the determination of Basel II capital requirements. The higher the recovery rate, the lower the requirement. Once a bank has worked out which of the three approaches it will take for Pillar One, it is faced with the twin hurdles of Pillar Two, supervisory review, and Pillar Three, market discipline. Supervisory review refers to the discretion that national banking regulators will be allowed in adjusting the capital amount for the banks they regulate. Market discipline refers to the reliance on greater disclosure of risk positions by banks, and the reaction to it by the market – a reaction that would affect the cost of a bank’s funding.