Capital reserve rules will further squeeze banks’ lending ability and raise costs, writes Lauren Parr
With legacy loan books to manage and a raft of refinancing ahead, banks remain selective in their lending. They are also starting to battle with the impact of forthcoming Basel III regulations govern-ing banks’ capital reserves. This is further restricting the level of capital lenders can deploy towards the debt market.
From a capital adequacy perspective, Basel III will have a big impact on property lending. It demands more and better quality tier-one capital – the money a bank must put aside to support the risks it takes. This makes everything a bank does more costly.
The regulation will largely do away with hybrid capital, the complex instruments that straddle both debt and equity and have been a big part of European banks’ tier-one capital in recent years, but did not prove to be loss- absorbing in times of stress.
This will hit the German Landesbanks particularly hard, as the hybrid capital they rely on, called silent participations, will no longer be considered up to scratch. The definition of tier-two capital is also being rewritten. This was traditionally categorised as ‘sub debt’ that counted as capital on the basis that it would protect depositors in the event of a bank going bust something regulators now acknowledge cannot be allowed to happen.
Tier two in its new form will be an instrument that can be converted into equity if necessary. Between now and 2013, banks must complete a massive exchange to substitute new qualified tier-two funds for their outstanding tier-two capital. Listed lender Commerzbank is conducting a capital raising, partly through a large rights issue.
But most German banks are not listed. “Banks have to raise multi billions of euros to do the same amount of business as before – where will that money come from?” asks Jürgen Fenk, head of commercial real estate lending at Bawag.
Basel lll already biting
Although the regulation will be phased in over six years from 2013, it is already affecting banks’ behaviour. “If you look at banks’ results for this year, somewhere near the front of analysts’ questions was: ‘are you Basel III compliant yet – if not, how soon will you be?’” notes Simon Gleeson, a partner at Clifford Chance specialising in regulation.
No bank is yet compliant, though they are jockeying for position. “There is a lot of pressure from banks’ chief executives saying: ‘I don’t care what the theoretical implementation timetable is’,” adds Gleeson. “Banks are being measured today by how far off the Basel III target they are. An awful lot is going on internally to enable banks to put their hands up and say ‘hey guys we’re fully Basel III compliant. We got there before our competitors, aren’t we stable?’” This is driving very fast implementation of the changes, Gleeson says.
One respondent to the Pricewaterhouse-Coopers/Urban Land Institute Emerging Trends in Real Estate survey, published in February, noted: “A regulation race is going on to make banks whiter than white, and there is nothing we can do to stop it.”
Basel III applies a metric of requirements, rather than simply the 8% capital adequacy rule required by Basel I. There are three main parts to the new legislation: a capital requirement, a leverage requirement and a liquidity requirement.
Some banks, like Barclays, say they are well in the lead in terms of hitting all three of those. Gleeson says retail-focused banks that have accumulated large volumes of low-risk assets, such as retail mortgages and diversified personal loan portfolios, will “have real problems with the leverage ratio”.
Generally, banks are some way off being liquidity compliant, a requirement they have little enthusiasm for. “No sane bank would maintain the liquidity levels Basel III says they should, for the good and obvious reason that what Basel III requires is set at the worst possible liquidity crisis ever and then some,” says Gleeson. “But it’s going to have to happen sooner or later.”
Basel III differs from Basel II in three ways. First is the change from a single requirement to a set of requirements, the liquidity and leverage ratios being totally new. Secondly, banks now have to hold enough capital not just to cover expected losses, but expected losses in a crisis. This means the total amount of capital needed rises for every asset on a bank’s balance sheet – “the rising tide that lifts all boats” as Gleeson puts it.
The third big change is that Basel III contains a positive disincentive for banks to have exposure to other banks, turning on its head the premise of Basel I and II. Basel I presumed that exposure to other banks should get favourable capital treatment, because banks were regulated, so were safer than non banks. Basel II dismissed the bank versus non bank notion, focusing on credit alone.
Penalties for inter-bank exposure
Basel III threatens penalties for exposure to banks, as opposed to exposure to non banks, because in a crisis all banks fail together. While the regulation imposes minimum standards on all European banks, some countries may raise the bar to address risks particular to their national markets.
This is happening in Germany, where only a fraction of the state’s bailouts have yet been repaid. National banks are allowed to apply surcharges to individual banks. In the UK, this month’s Independent Commission on Banking draft report recommends a 10% core tier-one equity ratio for the retail banking operations of systemically important banks.
It is possible that Basel III will affect banks that have similar credit exposures in different ways, because the regulation takes into account how the bank is structured, as well as the nature of particular assets. If banks lend to special-purpose vehicles, for example, they pick up a big regulatory capital cost compared to direct lending.
“That’s the sort of thing nobody bothered with until now, as the credit analysis was the same and in the old days that was all you cared about,” says Gleeson. “It is true that apparently very similar banks could end up with very different calculations because of differences in the way in which they operate.”
German pfandbrief lenders could suffer more than others, because the type of low risk-weighted assets pfandbrief lenders invest in, i.e. public-sector loans, face the same leverage limit as riskier assets. So pfandbrief banks will be treated in the same way as other less prudent lenders.
“Pfandbrief is a highly liquid instrument not on an equal footing with other similarly risky assets,” says Bernhard Scholz, Deutsche Pfandbriefbank’s board member responsible for real estate. “It has been more liquid and stable than many other government bonds. Therefore it’s not fair to discriminate against pfandbrief.”
Basel III is an immediate concern for banks because today’s deals will be on their books when the rules come into effect. “A lot of loans will be for five years, within which time they will have to account to Basel III,” says Philip Cropper, an executive director in CB Richard Ellis’s real estate finance team.
“The idea behind the delay in implementation was to help the banks in the short term so their legacy books do not absorb their limited capital rather than new business. With any new lending, banks will start thinking about the impact it is going to have on their balance sheets when the phased implementation has elapsed.”
Nicholas Voisey, a director at the Loan Market Association, says the liquidity cover-age ratio, which comes into force in 2015, and the net stable funding ratio, which comes into force in 2018, could have the biggest impact on loan products.
Hiking the cost of lending
The liquidity coverage ratio requires 100% liquidity coverage for liquidity facilities. “If you’ve got an uncommitted facility that is potentially used as a standby line, for example to support a commercial paper programme, you’re going to have to allocate 100% of that amount to a liquid asset account – a high percentage of which has to be either cash or sovereign debt,” he says.
This will increase the cost of lending and, by virtue, the cost of borrowing. “The net stable funding requirement could have an even greater impact, because loan maturities greater than a year have to be funded by stable funding, which is either capital or funding itself in excess of a year,” Voisey adds. “Banks normally fund loans for the short term through the interbank market, using Libor as the reference rate. Therefore the regulation, which will require them to fund a greater proportion for a longer term, will drive up banks’ cost of funding.”
Any sort of structured credit – particularly lending to non-first-rate clients – will become significantly more expensive. This is likely to shrink banks’ aggregate credit portfolios, which will focus on the best borrowers. As banks cluster round borrowers with the best rating, the cost of funding for AAA borrowers is falling. But for those outside this bracket, margins are rising steadily. This trend is expected to continue, given that banks’ model is to work backwards from a return on equity target. If a bank’s cost of equity rises, it will try to ease the situation by increasing the spreads on its loans.
A research note by The Institute for International Finance shows that bank bond spreads have risen 100bps in the past four years. Passing this through to bank lending rates would result in a rise of 39bps in the US and 18bps in the Euro area. However, this is across the entire portfolio, and “since a chunk of it won’t move at all, if that’s the average rise in spread across the entire portfolio, at the most liquid end that becomes really quite painful”, says Gleeson.
But Basel III’s impact is not yet driving margins, partly because the rules were only finalised late last year. “Banks have broadly finished their first cut; they know roughly where they are, as against where they have to be,” he adds. “They are looking at portfolios on an asset-by-asset basis to work out what needs to go up and what needs to go down. Most of them have a lot of work to do.”
Getting to grips with regulation
One banker at an Italian bank stresses the importance of getting to grips with Basel III: “Typically, an accountant would have handled this area in the past. Overall, it’s the group treasurer’s job to make sure the bank is Basel III compliant. But you cannot accurately price a loan or achieve profitability without understanding Basel III. More teams are becoming aware of risk-weighted assets.” The regulation will make banks far less enthusiastic about using their balance sheets to provide financings. They are expected to step back from lending and try to turn what were previously bilateral or multi-lateral financings into securities issuance, thus dis-intermediating their balance sheets. Real estate lenders could also be blasted by rules limiting concentration to one sector when regulators revisit the subject of large exposures next year. Today, banks can lend all their loan book to borrowers in the same broad business line, if no more than 25% of their equity is exposed to any one borrower.
If this changed, banks’ ability to act as pure real estate lenders would be undercut. “Next year it’s likely that a rule will be implemented against sectoral concentration, just as you have a rule today about individual loan concentration,” says Gleeson. Many believe that for banks to feel more comfortable with real estate lending, the securitisation market needs to reopen, so banks can sell on some real estate exposure. The reality is that real estate finance will be badly affected by the changes in banks’ capital regulations. Banks are moving into a world of scarce capital and this sort of lending will chew up more capital than other business that might generate similar returns.