Basel's New Balance

A new accord may soon help banks lend more for less.


Corporate borrowers, take heart. An effort by global banking authorities to change the way financial institutions reserve capital against their lending activities could pare costs for some types of borrowing, and ultimately give companies more flexibility in funding their capital structure.

The Basel Committee on Banking Supervision, an arm of the Basel, Switzerland-based Bank for International Settlements, has been working for several years to refine the guidelines that govern how much capital banks in its 13 member countries, including the United States, must hold in reserve. One of the committee's principal goals is to make the rules more sensitive to the varying degrees of risk presented by different types of lending to different types of borrowers. For example, under the current rules, which have been in place since the committee implemented its original Basel Capital Accord (Basel I) in 1988, U.S. banks must hold at least the same amount of capital against loans to AAA-rated commercial borrowers—8 percent—as they do against loans to BBB-rated borrowers. Meanwhile, the banks argue that they aren't allowed to make meaningful capital allowances for loans secured by collateral versus loans that aren't secured.

The new accord—Basel II—is scheduled to be implemented in 2006. It won't eliminate the 8 percent minimum ratio of capital to assets at risk, but it will give banks more flexibility in weighting those risks by providing several new options for calculating credit and operational risks. The bottom line? Less-risky loans should require less capital.

Cheaper Credit?

The amount of capital that banks are required to set aside can have a profound effect on their lending behavior. Todd Thomson, CFO of global banking giant Citigroup, says the amount required by the first Basel accord didn't always make economic sense. "While it was an improvement over the previous system, Basel I prevented a lot of very rational and sensible lending to Corporate America," he says.

In part to address the economic constraints of Basel I, banks invented a variety of new banking practices, causing new sectors of the financial-services industry to grow rapidly. In the consumer-lending arena, for example, many banks stopped holding mortgages rather than saddle their balance sheets with low-risk, high-reserve products. Instead, they became mortgage originators, packaging those loans for resale into what became a burgeoning secondary market, often to insurance-company buyers in the form of private placements or to institutional investors that weren't bound by Basel I. The first accord also spurred the growth of the credit-card securitization market and, on the corporate side of the business, the loan-syndication market.

"Because Basel I was so risk-insensitive, anything that really required less capital—credit-card loans, a mortgage (especially a prime mortgage), or lending to high-to medium-grade borrowers—was actually pushed out of the banking system," says Eric Aboaf, head of capital allocation and deployment at Citigroup. "It just wasn't cost-effective to keep those things on the balance sheet." One obvious victim was the corporate borrower whose business model didn't lend itself to securitization. "There are many corporate borrowers that have not been able to cost-effectively get loans from banks," says Aboaf. "It's not been the junk-debt borrowers, either, but the high-grade borrowers. The only way they can get funding is to go to the capital markets and issue commercial paper."

To the extent that Basel II reverses those developments, as now seems likely, finance chiefs may be able to rethink their capital structures. "I'd be looking at my needs and asking what kinds of maturity structures I would really like to have, as opposed to being told by my bank I can only have a 364-day backup line of credit," says Aboaf. (Under Basel I, backup lines of less than a year do not require reserves.) "Maybe what I would really like is a two-year backup line, or structured loans, or bullet loans. I would also be thinking about what kind of collateral I might be able to put into a capital structure that would make the bank more favorably disposed to doing that kind of lending."

"What Basel II will do, if done correctly," says Thomson, "is create a much more risk-sensitive framework for lenders, with the result that products that truly are less risky should become cheaper."

Among the most obvious candidates for better pricing are loans to highly rated borrowers and loans backed by collateral. But does that also mean that loans to lower-rated borrowers will cost more under Basel II? Not necessarily, says David Fanger, senior vice president and credit analyst at Moody's Investors Service. "The fact is, the larger and more-sophisticated banks have already moved beyond Basel I in deciding how to allocate their economic capital, as opposed to their regulatory capital. Basel II really just reflects the rules on regulatory capital catching up with what banks are already doing in terms of allocating economic capital."

Where corporate financing costs might go up, Fanger says, is in those areas where Basel II would tighten loopholes that have allowed banks to avoid holding regulatory capital against off-balance-sheet vehicles, such as commercial-paper conduits. In fact, he notes, banking regulators in the United States have already anticipated Basel II by floating a proposal to increase capital charges against asset-backed commercial paper.

Still Tweaking

The Basel Committee itself does not actually have any authority to impose capital-reserve requirements on the world's banks; instead, it formulates broad supervisory standards and recommends best practices, which it then turns over to regulatory authorities in its 13 member countries for implementation. Many nonmember countries also seek to comply with its recommendations. In the United States, the Federal Reserve has indicated that only the 10 largest and most-complex U.S. banks will be required to comply with Basel II, although it won't say exactly which banks meet those criteria. The Fed also expects the next 10 largest banks to opt in, partly for competitive reasons and partly because Basel II is expected to offer a better, more-sophisticated methodology than Basel I. In Europe, by contrast, the European Union Commission has decided to apply the capital-adequacy directive to all financial institutions, including brokerages and broker-dealers.

Basel II compliance also will require changes to banks' public disclosures and the regulatory review of their capital adequacy. With banks set to gain more control over how they assess their risks and reserve for them, the Basel Committee wants to make sure that regulators' judgments of risk and capital adequacy are based on more than an assessment of whether a bank complies with minimum capital requirements. Under Basel II, banks will subject themselves to stress tests of their own design. Regulators will then evaluate the tests and recommend changes if banks are not holding a sufficient capital buffer. The committee also has stressed it will be more important than ever for banks to provide key information about their risk profiles and capitalization levels to market participants.

Until the remaining details of Basel II are hammered out and implementation is under way, it is difficult to say exactly how prices might change for different types of corporate credit. "We have a good idea of what the framework of Basel II looks like, but the various elements of it are still being tweaked," says Fanger. "So it's not exactly clear how much impact there will be on pricing, or how the market's competitive dynamic will factor into the equation."

At a minimum, Basel II should result in a broader array of funding sources. "I think some of the lending activities that got forced out of the banking system are going to become economical again for banks," says Aboaf.

That, of course, is good news not only for banks, but also for companies. More financing choices are always better than fewer.

Randy Myers is a contributing editor of CFO.

Accord Discord

The Basel Committee on Banking Supervision includes representatives of central banks and banking regulators from 13 developed countries (see below). Although it began working toward a second Basel accord in 1999, reaching a consensus on the myriad details — the latest draft numbers 226 pages — has been a slow process. As recently as October, German bank regulators warned that Basel II could collapse because of demands by their U.S. counterparts that only unexpected loan losses — not expected losses, as proposed by Basel II — be backed by capital reserves. Bankers in the United States complained that expected losses are already covered either by a loan's pricing, an insurance policy, or income. At the time, some banking regulators suggested the scheduled implementation of the new accord, originally slated for year-end 2006, would be pushed back to year-end 2007.

The accord was rescued, for the time being, at a meeting in Madrid later that month, when the committee capitulated to the demand to excuse expected losses from the capital requirements, and also announced that it would drop a controversial and complex "supervisory formula" for determining capital backing for securitized assets that they admitted was too difficult to understand.

There remain some sticking points. As currently written, Basel II proposes unused lines of credit on credit cards be treated like actual outstanding balances on those cards, raising howls of protest from credit-card issuers. "The reality is that credit-card lines aren't contractually committed; banks can cancel or re-price them at any time," says Todd Thomson, CFO of Citigroup, the largest credit-card provider in the world. Many bankers also have pushed the Basel Committee to reduce capital charges on assets for which lenders have purchased insurance, and require lower reserves for banks whose loan portfolios are broadly diversified, rather than concentrated among a few types of borrowers or industries. If the Basel Committee and banking regulators become comfortable with the methods that sophisticated banks use to quantify risk mitigated through credit-risk insurance, corporate borrowers are likely to benefit, since banks would be more willing to make loans to riskier borrowers and more willing to make larger loans to smaller borrowers.

Following the October meeting in Madrid, the Basel Committee, chaired by Jaime Caruana, governor of the Bank of Spain, announced that the committee will revisit the credit-card and credit-insurance issues, among others. He also said the committee expects to have all outstanding issues resolved by midyear 2004, with implementation of the new accord still targeted for year-end 2006. —R.M.

The Basel II Participants

The Netherlands
United Kingdom
United States


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