Study based on £56bn of assets monitored by IPD finds FSA’s system of property risk weighting for lenders is “potential threat to financial stability”
An independent study by Investment Property Databank has questioned the validity of slotting, the risk-weighting regime that the Financial Services Authority is requiring banks to apply to their commercial real estate lending. It concludes that the current method of slotting is not sufficiently sensitive to provide a detailed analysis of the risk in real estate loans.
“As such, the use of slotting, as outlined by the Bank for International Settlements, is a retrograde step in risk management and a potential threat to UK financial stability,” the report says. Using performance data from £56.6bn of real properties, IPD has simulated how a hypothetical portfolio of loans originated in 2007 would have behaved during the last market cycle.
It found that, as currently constructed, slotting requires banks to hold more risk capital than they would need to cover their losses on defaulting loans in a downturn. This, it noted, could cause the amount of lending to UK real estate to shrink, which, in turn, could undermine property values.
Moreover, slotting provides “perverse incentives” that could skew bank lending towards higher-risk slots, according to IPD. This is because the criteria for debt service cover ratios are not consistent with interest cover ratios. It means that stricter underwriting would be required for less risky amortising loans than for interest-only ‘bullet’ loans and it also favours shorter-term lending.
In addition, IPD found that the FSA’s criteria on lease lengths are out of step with the market norm. If it was applied, almost all the loans in IPD’s simulation – 80% by number and 67% by value – would be classified as ‘weak’, regardless of conservative loan-to-value levels, debt service cover ratios and the quality of assets. The FSA guidance indicated that any loans with less than 10 years left on the lease of the underly-ing collateral must be categorised as weak.
However, UK lease lengths have fallen over the past two decades; the average unexpired term is now 10.2 years and 76% of new leases signed in 2011 were for less than five years. When IPD ran a simulation using lease lengths that were more in keeping with market reality, only 54% of loans – or 33% by value – were classified as ‘weak’.
The FSA’s criteria, used by IPD, appeared as guidance published in June 2011 but was subsequently withdrawn in the face of concern from banks. However, nothing has appeared yet to replace it. “We are in stasis at the moment,” said one banker.
IPD has submitted its study, The Slotting Approach to Investment Property Real Estate Risk Weighted Capital: A UK Simulation Study Using IPD Data, to the UK regulators. It has not been released, but Real Estate Capital has seen a version circulated among UK banks.
IPD intends to carry out further research into an alternative slotting methodology. “We do see ample potential for a more risk-sensitive UK slotting regime that would provide capital cost incentives to lend in a stabilising manner,” the study concludes.