Banks must study their books to pass UK regulator’s tests

FSA urges banks to scrutinise property loanbooks when setting capital reserves, writes Lauren Parr 

The Financial Services Authority (FSA) has published guidance on the standards it expects from banks when it comes to working out capital requirements for real estate. The Basel capital regime allows for the use of internal ratings models to produce capital requirements for some types of exposure. But the FSA sees income-producing real estate as a particularly difficult asset class for which to build rating systems to determine probability of default. So it has developed further guidelines for calculating regulatory capital for property, to help banks that are struggling to comply.

The FSA’s response to the financial crisis in terms of real estate was summarised in its latest Prudential Risk Outlook (PRO), published in February. Its key message to lenders was that they must ensure that they fully understand their loanbooks’ composi-tion; in particular the strength of cashflows. Lenders and auditors must ensure that their provisioning practices reflect realistic estimates of future cashflows and that they have workable exit strategies for all of their commercial real estate loans.

“Where they are deciding to extend loans or maybe to waive breaches of covenants, such as LTVs, they need to be consistent with their strategy for maximising repayment of the loan,” says David Rule, head of the FSA’s macro prudential department. “They must be realistic about the extent to which loans will be repaid and make provisions if they think they are not going to get repaid in full.”

PRO analysis shows banks are extending loan maturities and waiving covenants in the hope of finding alternative refinancing later. It cites De Montfort University research which estimated that £54bn – or 20% – of outstanding UK loans were in breach of covenants or in default as of June 2010.

The FSA wants to know that banks recognise impairment to their loans when they extend them, rather than doing it because they can’t think of anything else to do, and that they are adequately provisioned. The FSA’s approach broadly requires major UK banks to hold a minimum amount of capital as a percentage of their risk-weighted assets. This is after imposing severe stress tests on assets, which assume a world recession and a further 36% fall in UK commercial real estate values, plus rising unemployment and falling GDP growth.

The FSA has been toughest on the bank lending areas that pose the biggest risks. “We have some concerns about commercial real estate exposure, because there has been a fall in values and there is a lack of willing new lenders in the market to refinance exposure,” Rule says. “Also, there is a large concentration on a number of UK banks’ books to commercial real estate.” All this suggests that losses in the sector are going to be high.

Securitising players pay the price of having ‘skin in the game’

No measure will have a greater impact  on the securitisation industry than the European retention rules, which require  originators to retain 5% of CMBS issues. The measure, introduced this year as part of the EU Capital Requirements Directive, aims to align investors’ and originators’ interests, and includes new disclosure and due diligence requirements.

“The cost of securitisation will rise because more of banks’ balance sheets will be tied up,” says Charles Roberts, a finance partner at Paul Hastings. “This cost will be passed on to the borrowers, who will have to pay higher margins. It could make it harder for those loans to compete. But it’s  hard to say when new lending is limited.”

The rules apply to future securitisations and existing ones where new exposures are added or substituted after 2015. “If you have revolving programme deals that were set up before this year and are adding in assets, you will be caught after 2015,” says one legal expert who specialises in banking.

Originators must retain at least 5% of a securitisation on an ongoing basis. There are several ways this can be done: they can hold a vertical slice, no less than 5%, of the nominal value of each tranche sold; retain a random selection of securitised exposures; or hold the first-loss piece.

“If you retain an interest you’re going to make sure better quality assets are in the pool in the first place, and you’ll service them properly,” the legal expert adds. The originator must also disclose its risk retention level to investors, and ensure that prospective investors have all the data on  credit quality and performance, cashflows and collateral backing the deal, plus any data needed to conduct rigorous stress tests on cashflow and collateral values.

Investors must also take responsibility for understanding their securitisation investments. “It doesn’t really encourage better behaviour,” says Roberts. “Nobody should be investing just because originators keep a percentage of a securitisation. They should be underwriting their own deals, frankly.”