CORPORATE
EXPOSURES
SUMMARY
The
main changes introduced by the Basel IV revisions can be summarised
as follows:
SME’s:
A separate risk weight of 85%, lower than the 100% risk weight
applicable to large unrated corporates, is applied to unrated
exposures to SME’s. Small and Medium Enterprises are defined
as corporates with a maximum turnover of € 50 million. This
aligns the treatment of SME’s to their treatment under the
IRB.
The
risk
weights
associated with external ratings are recalibrated .
The recalibration facilitates the access of standardised banks to
some of the lower risk weights, which it brings more in line with
the IRB risk weights.
If
banks are incorporated in jurisdictions that do not
allow
the use of external ratings for regulatory purposes, they are
permitted to assign a 65% risk weight to the corporates that they
identify as “ investment
grade ” .
Three
categories of “Specialised
lending”
(Object finance, Commodity finance and Project Finance) are
“imported” from the IRB Approaches.
If
the exposure is a claim on a corporate but “ related
to real estate”
then new, separate rules apply, which will be covered in a future
article. Commercial real estate does not have a separate treatment
under the current SA rules. The 100% risk weight applies.
DETAILED
REVIEW
Current
Basel II rules- a refresher
Under
Basel I all
corporate exposures were assigned the same 100% risk weight.
Since
the minimum amount of capital required by Basel I ( and Basel II-III)
is equal to 8% of the risk weighted assets of the bank, this meant
that for a loan of 100 million to a corporate, a bank had to allocate
an amount of capital of at least 8 million : 100 million x 8% x 100%
= 8 million.
The
main innovation of the existing Standardised Approach was to allow
banks to use external ratings (i.e. the ratings of credit agencies
such as Moody’s, S&P etc.) to access the lower risk weights
associated with high(er) credit ratings, as shown in the table below.
This
means, as an example, that the capital required for a loan of 100
million to a company rated AA, which was 8 million under Basel I as
shown above, is now 100 million x 8% x 20% = 1.6 million.
Because
of the lower risk weight of 20%, the capital requirement is divided
by 5 and, accordingly, the return on that loan is multiplied by 5.
Basel
II, again to encourage banks to move away from the Standardised
Approach and use the IRB Approaches instead, deliberately set the bar
very high: only exposures to corporates rated A- or better (there are
not that many of these) enjoy a risk weight lower than 100%.
Even
exposures to BBB- to BBB+ corporates, which are
investment grade, are still risk-weighted 100%.
And
so are unrated exposures, which of course, on a worldwide basis,
vastly outnumber the rated ones. This is particularly true of
emerging markets, where the pool of rated companies is limited.
Basel
IV
In
order to “enhance the credit risk sensitivity of the
Standardised Approach”, the corporate exposure class now
differentiates between “General corporate exposures” and
“Specialised lending exposures”.
General
corporate exposures
There
are now in effect 3 different regimes:
A.
Jurisdictions where the use of external ratings is allowed.
Banks
incorporated in a jurisdiction that allows the use of external
ratings
must assign risk weights according to the table below, which is
extracted from the Basel IV Revisions.
What
has changed is the recalibration of the risk weights. Contrary to the
current table discussed above, exposures to corporates rated BBB- to
BBB+, which are investment grade, are assigned a 75% risk weight
instead of the current 100%.
This
risk weight is also more closely aligned to the risk weight produced
by the IRB Risk Weight Function for a credit of similar quality,
which of course was the objective.
B.
Jurisdictions where external ratings are not allowed
For
corporate exposures of banks incorporated in jurisdictions that do
not
allow
the use of external ratings for regulatory purposes, banks must
assign a 100%
risk weight to all corporate exposures, with the exception of
exposures to corporates identified by the bank as “investment
grade”
in which case the risk weight is 65%.
The
Revisions define an investment grade corporate as: “a corporate
entity that has adequate capacity to meet its financial commitments
in a timely manner and its ability to do so is assessed to be robust
against adverse changes in the economic cycle and business
conditions. When making this determination, the bank should assess
the corporate entity against the investment grade definition taking
into account the complexity of its business model, performance
against industry and peers, and risks posed by the entity’s
operating environment.
Moreover,
the corporate entity (or its parent company) must have securities
outstanding on a recognised securities exchange.”
In
other words, apart from the stock exchange listing requirement, all a
bank has to do to qualify for this treatment is to be able to conduct
a well informed and argued credit analysis to justify its decision.
Nothing
extraordinary here. Banks, standardised or not, should, indeed must,
be able to conduct proper credit analyses.
Nevertheless,
this is the first time banks using the Standardised Approach are
allowed to use their own judgement to rate a corporate.
What
you may find intriguing, or even disappointing, about this new
provision however is its limited scope of application.
Why
indeed restrict it to jurisdictions where the use of external ratings
is not
allowed?
Unrated
exposures vastly outnumber rated ones even where external ratings are
allowed,
so why not apply this provision to all unrated exposures, wherever
they are? And why create a different treatment solely for “investment
grade” corporates and not a scale of several risk grades, good
and bad?
More
broadly, how does this limitation reconcile with the Basel
Committee’s stated policy to grant more discretion to banks in
the revised Standardised Approach?
Looking
at the consultations that preceded the publication of the Basel IV
Revisions, I think that the discretion granted to banks by this
provision is less an example of a change in policy than the
confirmation of the BCBS’ capitulation on that front.
The
original intention of the Basel Committee was in fact to eliminate
the use of external ratings altogether. They had become unpopular
after the financial crisis and, perhaps more importantly, were
perceived as too much of a mechanical substitute for credit analyses.
All
valid concerns.
So,
the proposal was to replace them with 2 metrics: revenues (Turnover)
and a leverage ratio (Assets to equity), which the Basel committee
thought had predictive value, at least statistically.
Perhaps
surprisingly the feedback from the industry was negative, on the
grounds that the calculation of the metrics by banks would have
created inconsistencies between jurisdictions.
Given
the very basic nature of the calculations in question, I doubt very
much it would have been the case, at least not to the extent of
disrupting the comparability of ratings and risk weights.
The
Standardised Approach might have taken a different turn and ended up
looking very different but what prevailed in the end, with some
irony, is the pretty dim view banks seem to take of their own
analytical abilities.
Comparability
and uniformity won the day and the pendulum swung all the way back to
external ratings, except in jurisdictions that could not/did not want
to use them.
C.
SME’s
For
unrated exposures to corporate
SMEs
(defined as “corporate exposures where the reported annual
sales for the consolidated group of which the corporate counterparty
is a part is less than or equal to
€50
million
for the most recent financial year”), an 85%
risk weight
will
be applied.
Under
the IRB Approaches, the same SME’s enjoy a specific Risk Weight
Function (RWF), which generates lower risk weights than the RWF used
for large corporates. This favourable treatment is now replicated in
the SA.
Note
that the new rules applicable to retail exposures specifically allow
banks to include these exposures, which are corporate
exposures,
in their “qualifying retail
portfolios”,
provided the qualifying criteria are met. These criteria are reviewed
in the article dedicated to retail exposures.
Qualifying
retail exposures are assigned a 75%
risk weight ,
better than the 85% “normal” SME risk weight.
Specialised
lending exposures
These
categories are similar to the IRB Specialised Lending categories,
which are “imported” into the Standardised Approach.
Currently
these exposures are treated as corporate exposures, which means that
unless they take the form of an investment in an instrument (E.g.
bond) with an issue-specific
external rating, the applicable risk weight is 100%.
Categories
Specialised
lending cannot be related
to real estate, which
is treated separately under Basel IV.
The
exposure is typically to an
entity
(often a special purpose vehicle (SPV)) that was created specifically
to finance and/or operate physical assets; the
borrowing entity has few
or no other material assets or activities, and therefore little or no
independent capacity to
repay the obligation, apart from the income that it receives from the
asset(s) being financed.
Specialised
lending comprises the following three subcategories of specialised
lending:
(i)
Project
finance
refers to the method of funding in which the lender looks primarily
to the revenues generated by a single project, both as the source of
repayment and as security for the loan.
(ii)
Object
finance
refers to the method of funding the acquisition of equipment (e.g.
ships, aircraft, satellites, railcars, and fleets) where the
repayment of the loan is dependent on the cash flows generated by the
specific assets that have been financed and pledged or assigned to
the lender.
(iii)
Commodities
finance refers to short-term lending to finance reserves,
inventories, or receivables of exchange-traded commodities (e.g.
crude oil, metals, or crops), where the loan will be repaid from the
proceeds of the sale of the commodity and the borrower has no
independent capacity to repay the loan.
Treatment
If
external issue-specific
ratings are allowed and available, the
Table 10 (See above) used
for general corporates
applies.
This
provision only clarifies the current regime.
If
external issue-specific ratings are not allowed or not available:
This
new provision in fact changes nothing.
130%
during the pre-operational phase
100%
during the operational phase
80%
for operational phase and deemed to be high quality
“ Operational
phase” is defined as the phase in which the entity that was
specifically created to finance the project has (i) a positive net
cash flow that is sufficient to cover any remaining contractual
obligation, and (ii) declining long term debt.
A
“high quality” project finance exposure refers to an
exposure to a project finance entity that is able to meet its
financial commitments in a timely manner and its ability to do so is
assessed to be robust against adverse changes in the economic cycle
and business conditions.
ASSESSMENT
Overall,
the Basel IV rules on corporate claims do what it says on the tin:
the Standardised Approach looks more like the IRB Approaches and
their respective capital outputs are more closely aligned.
The
treatment of exposures to corporate SME’s makes sense and the
option to include them in qualifying retail portfolios, a somewhat
confusing issue under the current rules, has been clarified.
The
recalibration of the risk weights associated with external ratings
also goes in the right direction although its impact is limited as it
only affects corporates rated BBB- to BBB+.
A
different, separate treatment for real estate exposures is also a
positive development. As history has shown time and time again,
commercial real estate can be a disproportionately large asset class
for many banks and a risky, even dangerous one. This asset class will
be reviewed in future articles.
Some
of the new provisions, however, are less convincing:
First,
there doesn’t seem to be much point in creating new special
lending categories like Object and Commodity finance, if it is to
treat them exactly as before.
There
is, in the IRB Approaches, a ready-made supervisory scale for these
exposures that could have been imported.
Then
there is the capitulation of the Basel Committee on the use of
financial metrics, which were sacrificed on the altar of uniformity.
I
think it is regrettable. Potentially hiding exposures to highly
geared corporates behind a 100% risk weight is a major weakness of
the Standardised Approach, and if banks are unable to “calculate”
a company’s turnover or leverage, maybe they shouldn’t be
in banking at all.
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