Basel and the march to conformity

The latest proposals from regulators on risk weighting may not be flexible enough for lenders’ liking.   Regulation: a word that tends to make bankers shudder. Since the Global Financial Crisis, lenders have had to get used to the scrutiny of regulators striving to ensure that they set aside enough capital to off-set risks. Asked […]

The latest proposals from regulators on risk weighting may not be flexible enough for lenders’ liking.  

Regulation: a word that tends to make bankers shudder. Since the Global Financial Crisis, lenders have had to get used to the scrutiny of regulators striving to ensure that they set aside enough capital to off-set risks.

image006Asked about pressures on their business, real estate bankers will usually list increased regulation in amongst market conditions, economic threats and political matters. Rising capital requirements coupled with borrowers’ expectations of cheap debt mean that margins are being squeezed to unworkable levels, goes the argument.

The latest regulation to land on their plate is a Basel Committee proposal intended to standardise risk weighting. Rumours that the committee would no longer recognise the use of internal ratings-based (IRB) models of allocating risk-weighting in specialised lending (including income-producing real estate) had started to circulate late last year.

The debate is how best to ensure that capital requirements are proportionate to lending risk in a business where each loan is secured by properties with unique strengths and weaknesses. It is a challenge that the Basel Committee on Banking Supervision is grappling with via a series of painstaking revisions to the international committee of banking supervisors’ 2010 Basel III accord.

What the Switzerland-based committee is essentially proposing is that banks be universally subject to the same risk assessment model rather than be allowed to use their own clever instruments to determine capital allocations along a sliding scale. Specialised loans including real estate must instead be subject to the “standardised” method first unveiled by the initial Basel accord in 2001.

That one is hardly a sophisticated method. Under the Basel I standardised approach, most real estate loans are subject to a 100 percent risk-weighted allocation, allowing no leeway for the circumstances of the individual loan.

The Basel Committee itself recognises that some nuance is needed and has recently proposed that the standardised approach become a little less homogenous. Rather than an automatic 100 percent allocation, such loans will be graded from 80 percent to 130 percent under the revision.

The other method which Basel would recognise is ‘slotting’, already used by UK banks at the behest of the Financial Conduct Authority since 2013. A bit less rigid than the standardised approach, slotting puts loans into four distinct buckets depending on their loan-to-value ratio (with separate treatment for defaulted loans). Capital weightings range from 50 percent to 250 percent.

Whether it’s slotting or some yet-to-be determined standardised measure, the direction of travel is heading towards more rather than less uniformity.

UK banks might have griped about slotting at first, but they seem to have got to grips with it. US investment banks tend to operate on the standardised approach, but their originate-to-distribute model keeps their balance sheets lean anyway. The institutions that will be most alarmed by the latest Basel pronouncement are those continental European banks – mainly German – which have set aside time and money to fine-tune their own IRB-based systems which help them to maintain low costs of capital.

Some might argue that, as IRB-based systems were only introduced by Basel II in 2007, they didn’t have a chance to either prove or disprove their value before the credit crisis hit. However, the capital requirements debate will most probably centre on the nitty gritty of Basel’s standardised approach and the need for it to reflect the individual nature of each real estate loan.

Peter Cosmetatos, chief executive of CREFC Europe, commented that greater consistency in the capital treatment of banks has to be a good thing. However, he warned: “The fact that it is a levelling of the playing field up instead of down means that the cost of credit for real estate businesses is likely to get higher and the availability of finance lower.

“The most important challenge for regulators is to ensure that very low risk and very high risk exposures attract appropriate risk weights; neither slotting nor the standardised approach as proposed will achieve that.”

Anecdotally, some in the market say that the proposed minimum capital weighting under either the standardised approach or slotting does not provide enough leniency for strong, risk-averse loans. Conversely, they say, the maximum capital weighting is not sufficiently stringent on risky lending.

Then there is the subject of development finance. Under the new proposals, all development finance loans will be subject to 150 percent weighting, be they loans to fully pre-let core office schemes or speculative residential schemes in unproven locations.

The Basel Committee has invited comments on its proposals by 24 June. Real Estate Capital would also like to hear your thoughts at basel@recapitalnews.com.

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