European companies are voicing concerns over increased funding costs after the Basel Committee on Banking Supervision (BCBS) announced plans to curb banks' use of internal models to calculate credit risk capital requirements.
If Basel's March 24 proposals are adopted, banks will be pushed off the internal ratings-based (IRB) approach for the largest corporates, defined as those with total group assets exceeding €50 billion ($55.8 billion). Regulators estimate this threshold will capture only 200 corporates and exposures to them would be subject to the standardised approach to credit risk. All credit exposures to other financial institutions will also be moved to the standardised approach, including trade finance letters of credit that count as exposures to other financial institutions.
Banks will be allowed to continue using the IRB for corporates below the €50 billion asset threshold, but they will be forced to use a simpler approach for those with revenues exceeding €200 million. Known as the foundation IRB, this only allows banks to estimate an institution's probability of default (PD), removing the option to model exposure at default (EAD) and loss-given default (LGD), as is the current practice under the advanced IRB.
As a result of a less sophisticated approach, corporates are concerned banks will either reduce their exposure to the sector or increase the cost of funding to corporates assigned a higher risk weight, forcing banks to hold more capital. There is particular confusion as to why Basel would want banks to apply higher capital charges to borrowers with some of the largest and strongest balance sheets.
"I don't understand why they're effectively suggesting a stricter treatment through limiting internal models for the highest-rated clientele. We're talking about the most creditworthy and transparent debtors. If the less sophisticated models have to be used for them, it is clear [that] capital requirements will rise, which, of course, will raise customer prices, again," says one senior treasurer at a European non-financial corporate.
We're talking about the most creditworthy and transparent debtors. If the less sophisticated models have to be used for them, it is clear [that] capital requirements will rise
Senior treasurer, European non-financial corporate
"On existing loans, banks would not be able to change conditions retroactively so easily – depending on the terms, of course. As European corporates to a large degree depend on loan financing instead of bonds – the smaller players, that is – this might have a huge economic impact."
Figures gathered by Risk back up the claim of potential increases in costs. Even where banks will still be permitted to use the advanced or foundation IRB, the model parameters may be subject to a floor. For example, regulators propose flooring PDs for corporate exposures and mortgage portfolios at five basis points, compared with 3bp previously. At Barclays, the 5bp corporate floor would have applied for up to £11 billion ($15.5 billion) of exposures as of the end of 2015, all of which had a PD of less than 0.05%. Deutsche Bank would have had to potentially raise the PDs attached to up to €10.3 billion of corporate credit exposures.
The Basel Committee's justification for reducing the scope of IRB for large corporates and financial institutions is a lack of data regarding previous defaults, which casts doubt on the reliability of modelled estimates. The ultimate aim is to reduce variation in risk-weighted assets (RWAs) following the controversy surrounding banks' internal models, which were called into question after the crisis as huge discrepancies emerged in RWAs.
But the senior treasurer at the European non-financial corporate disagrees with the Basel Committee's reasoning. "I noted [the point on limited data], but it's a ridiculous argument to me," he says.
"How can you say banks should use the less sophisticated models on those that are least likely to default? Why punish the solid players with higher capital requirements – read costs? I also disagree on the idea that it would be too hard to judge both probability and impact of a default – that's exactly what sophisticated models are there for," he adds.
Stephen Baseby, associate policy and technical director at the Association of Corporate Treasurers in London, says this may lead banks to direct their capital to other areas that are less costly.
"We're concerned this will end up with a change of appetite in lending and will change the nature of the banks, which in itself will lead to a loss of competition. We're seeing that already in some areas where bankers are trying to withdraw from certain types of products," he says.
Official estimates suggest 70% of exposures will still be measured using the IRB approach, even after removing large corporates and banks. For the other 30%, John Jackson, group treasurer at Severn Trent, says it remains to be seen whether loan prices will rise, but he attributes to the regulatory environment a change in banks' willingness to lend to corporates.
Just because an organisation is large does not necessarily mean it's more risky
John Jackson, Severn Trent
"Just because an organisation is large does not necessarily mean it's more risky. I guess [regulators] are worried about systemic risk, but even so it seems a rather strange way of going about things. But I think it will be difficult to measure the correlation between capital requirements and end-user pricing. Generally, from an end-user perspective, the regulatory landscape looks terribly confusing at the moment. And that really is very much present in how varied banks' appetite is for credit and how they price that credit," says Jackson.
Christophe Salmon, chief financial officer of commodity merchant trader Trafigura, says the bank regulatory framework seems to be paying less attention to the risk mitigation provided by secured lending, such as the self-liquidating transactional finance frequently used by merchant traders. The proposed constraints on LGD inputs and the switch of bank letters of credit to the standardised approach reinforce this trend.
Salmon fears a rerun of the fight to salvage trade finance, which happened during the early drafting of the Basel III leverage ratio. Initial proposals in 2010 would have required banks to fully capitalise trade finance as on-balance-sheet activity, threatening the economics of a business that is supposed to be low risk and low margin.
"The structural benefits of safe, secured lending are being capped relative to the earlier Basel framework, and I think we need to do more to educate regulators about the good recovery expectations on this type of credit. We should point out the positive experience of collateral liquidation and enforcement on the security, and backtest the LGD rates of this specific asset class," he says.
The Basel Committee's revised standardised approach to credit risk, published in December 2015, would assign a flat 120% risk weight to commodity-backed credit exposures.
Additional reporting by Philip Alexander.