Consulting » BANKING AND FINANCE – New Basle capital rules will make banks rate corporate debt by risk

Under the current rules, for every #100 of loans a bank has to hold #8 of capital, regardless of the rating of the corporate it is lending to.

The revisions to the 1988 Basle Accord, which set the minimum levels of capital banks need to hold, shift the focus to credit risk. In future, credit ratings will determine the weightings banks have to take for accepting bonds issued by corporates.

“The changes will improve the attractiveness of corporate bonds for banks,” says John Tattersall, chairman UK regulatory practice, PricewaterhouseCoopers “This will encourage corporates to obtain ratings, particularly in Europe, as in the US most bonds are already rated. The disincentive for banks to hold them is taken away and potentially it will add greater liquidity to the market.”

As distortions caused by the present rules are removed borrowers should see their cost of debt relate more closely to their credit rating. In theory, the higher a corporate is rated the lower the credit charge against its paper, hence the lower the cost of issuing bonds. Jim Claire, portfolio manager at US fund manager Evergreen Investment Management, believes this will lead to an increase in the number of buyers of corporate paper.

The new proposals will also provide a strong incentive for corporates to go out and get a rating. Under the present formula all companies, regardless of their size or soundness, are assigned a 100% risk weighting. Lending to banks is treated more leniently, as OECD-based financial institutions are given a 20% risk weighting. However, in a 1999 draft, the Basle Committee suggests a maximum weighting of 20% for corporate debt rated AA- or higher, which is the same as that for a similarly rated bank. The rating incentive this brings applies mainly to second and third tier companies, since the 80 or so European companies assigned AAA to AA- are by definition big enough to issue bonds without having to spend much time worrying about the terms.

The proposed increase in the risk weighting for low-grade debt could also lead to more bond issues as companies in this category encounter stiffer penalties on their borrowings in the lending market than in the bond market.

“If you are a corporate rated B- or lower your capital weighting goes up to 150%, and this will affect a large number of companies,” explains Graham Bishop, an adviser to Schroder Salomon Smith Barney. “If a company rated BB is downgraded, its bank needs to put up 50% more capital and this is likely to raise the price on lending. This should promote growth of the high yield market, as companies will get better financing from the bond market than from banks that have to put up 12% of their capital against a loan (8% times the 150% risk weighting).”

The assumption is that if low or unrated corporates cannot obtain loans they will be pushed into the bond market. George Grodski, a credit analyst at Credit Suisse First Boston, says, “I foresee increased supply and a stronger tiering of medium and low-grade spreads, with higher grade spreads tightening.” However, it should be kept in mind that for a corporate with a rating potential of B- or below that is planning to issue in the capital markets, it might be best to avoid the cost and bother of approaching the agencies altogether. An unrated corporate attracts a 100% rating and as such it would be likely to obtain better borrowing terms than as a company rated B-.

The rating of corporate credit, particularly in Europe, throws up a question of public policy. There is a reluctance in Europe to use the two big US agencies, Moody’s and Standard & Poor’s, as this would in effect allow them to set economic conditions in Europe. In the case of the banks, the losers would be those that are unable to obtain AA- (S&P)/Aa3 ratings or better. They would face disadvantageous pricing and terms of business in their dealings with other banks and corporate clients. The alternative now under discussion is to allow at least the large international banks to use their own internal rating systems. This would be of special significance in Europe where relatively few corporates are agency rated.

“It is important for corporate customers to understand the new proposals and their impact on banks, says Philip Middleton, head of global banking strategy at KPMG. “If a bank has a sophisticated risk measurement model it may provide some competitive, and even some funding advantages. For financial directors of non-financial institutions, hopefully it means they will be dealing with soundly managed banks.”

Jules Stewart is a freelance journalist.