Lending is a risky business

The third consultative paper on capital adequacy will replace the 1988 Basel Accord, the first global attempt to set minimum levels of capital that banks need to hold against their core base. The focus for determining capital adequacy will now shift to credit risk, taking into account the numerous and often spectacular financial disasters that have taken place since the original proposals were drawn up. Under the final draft agreement, credit ratings come to the fore, as this is the yardstick by which banks will determine the level of risk involved in granting loans and accepting bonds issued by corporate customers.

Under the current rules, for every £100 of loans granted to a corporate borrower, a bank must hold £8 of capital, regardless of the customer’s rating. That is, all corporate loans are currently 100% risk-weighted.

“The trend set by Basel II is that the capital which banks have to put aside for loans to corporates will vary according to riskiness rather than the status of the borrower,” says John Tattersall, a partner at PricewaterhouseCoopers and chairman of its UK financial services regulatory group. “Companies that are a good risk and highly rated will have lower capital requirements and a lot will depend on relationships. This sort of company will find it easier to borrow from its banks. Conversely, any adverse development or downgrade will increase the cost of borrowing. As distortions caused by the present rules are removed, borrowers should see their cost of debt relate more closely to their credit ratings.”

This obviously puts a more prominent role on preferred banking relationships and a greater attachment to credit ratings. Banks will assign a more generous rating on companies they know and trust, and this applies, in particular, to the more sophisticated banks that will be allowed to use their own internal risk management systems rather than relying on external ratings agencies.

While all corporate borrowers are now rated 100%, going forward, this will vary according to the level of risk, moving from 30% to 150%. The amount of capital a bank has to hold against will decrease significantly for better rated corporates.

“The whole thrust of Basel II is to make lending more risk-sensitive,” says Ian Linnell, head of credit policy Europe at Fitch rating agency.

“This will lead to greater polarisation between the haves and have nots.

That is, poorly rated companies can expect to see their cost of borrowing go up and this will entail a potential undermining of traditional banking relationships. On the other hand, these relationships are likely to be strengthened for companies with higher ratings.”

There is, however, a curve ball in that scenario. Linnell points out that in spite of the new regulations, subsidised pricing will remain a prominent feature for companies considered large enough to provide banks with spin-off capital market business. The syndicated lending market is riddled with banks giving away money at uneconomic margins in the hope of winning over mandates to underwrite rights issues, IPOs and advise on M&A activity.

Another off-shoot of Basel II will be a boost for the corporate bond market, particularly in Europe where corporate issuance has lagged behind the US. The higher a corporate is rated, the lower the credit charge against its paper, hence, the lower the costs of issuing bonds. The proposed increase in the risk weighting for low-grade debt could also lead to more bond issuance as companies in this category pay a higher premium on their borrowings in the lending than in the bond market.

Corporates rated B- or lower by the three major ratings agencies will see their capital weighting go up to 150%. This affects a large number of mid-cap corporates in the UK and Europe. For instance, if a BB-rated company slips and is downgraded, its bank needs to put up 50% more capital and this will raise the price on lending. This should promote some growth of the high-yield market, as corporates in this category 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 versus a much more attractive 2.4% capital requirement for loans made to the best-rated companies.

Basel II could usher in a credit squeeze for corporates falling into the 150% bucket. This, in turn, could lead to a period of transition, coinciding with economic recovery as companies shop around for banks willing to help fund expansion plans coming out of the prolonged slump.