The Consequences of the New Basel Capital Accord (Basel II) for Bank Lending to Corporate Borrowers
The central problem and resulting question of this thesis was: 'Will Basel II make credits in the Mittelstand more expensive?' In view of the previous analysis on possible capital requirements and changes in credit conditions for German small and medium-sized enterprises, the answer to this question can be adequately answered: On average, Basel II does not make credits in the Mittelstand more expensive. Basel II has an influence on the amount of regulatory capital the banks have to hold. The costs of this scarce factor are included in the risk premium which is part of the borrowers credit rent. Therefore, the credit rent would ceteris paribus be higher if capital requirements rose.
However, it has been shown that for about 90% of German companies, capital requirements will even be lower in Basel II. This is because these companies will belong to the retail segment in Basel II where there is a reduction in regulatory capital (compared to the current 8%) up to a high probability of default between 7% and 8%, which would apply to a company in default or bankruptcy.
Additionally, capital requirements for small and medium-sized enterprises can be further reduced due to the extended recognition of collaterals. Basel II has introduced types of collaterals that small and medium-sized companies are more often able to deliver, namely account receivables and real estate. It can therefore be concluded that a possible future increase in average credit rent levels for German small and medium-sized enterprises must have other reasons than the banks costs for regulatory capital.
Jede Wirtschaft beruht auf einem Kreditsystem, das heißt, auf der irrtümlichen Annahme, der andere werde gepumptes Geld zurückzahlen (Kurt Tucholsky, 1931)
Kreditinstitute spielen eine besondere Rolle in modernen Volkswirtschaften. Sie sind nicht nur Mittler zwischen Kreditnehmern und Einlegern, sondern stellen darüber hinaus vielfältige nicht bilanzwirksame Finanzdienstleistungen zur Verfügung. Dabei ist der professionelle Umgang mit Kredit-, Markt-, Liquiditäts- und anderen Risiken eine der wichtigsten Leistungen von Finanzintermediären. Solche Risiken dürfen jedoch nicht zu Instabilitäten im Finanzsektor führen. Über die eigene Risikovorsorge der Institute hinaus wurden deshalb besondere Aufsichtsregeln für Kreditinstitute geschaffen, unter denen die Eigenkapitalregeln eine herausragende Rolle einnehmen.
Im dynamischen und […]
Table of Contents
List of Formulas
List of Figures
List of Tables
List of Abbreviations
1 The Development of Basel II
1.1 The Third Consultative Document
1.1.1 Pillar 3 – Disclosure
1.1.2 Pillar 2 – Supervisory Review Process
1.1.3 Pillar 1 – Minimum Capital Requirements
1.2 Central Problem
1.3 Line of Proceeding
2 Credit Risk in Basel II and its Impact on Credits to German small and medium-sized Enterprises
2.1 Regulatory Capital for Credit Risk in Basel II
2.1.1 Standardised Approach
2.1.2 IRB Approach
2.1.3 IRB Risk Weight Formulas for the Retail and the Corporate Segment
2.1.4 Minimum Requirements and Disclosure in the IRB Approach
2.1.5 Credit Risk Mitigation Techniques in Basel II
2.2 Small and medium-sized Companies in Germany
2.2.1 The quantitative Aspect
2.2.2 The qualitative Aspect
2.2.3 Current Situation in the “Mittelstand”
2.2.4 Financial Structures in the “Mittelstand”
2.2.5 German small and medium-sized Enterprises and Rating in Basel II
2.3 Regulatory Capital Requirements for German small and medium-sized Enterprises
2.3.1 Capital requirements for German small and medium-sized Enterprises
2.4 Impact of Regulatory Capital Requirements on Credit Conditions
2.4.1 Changes in Credit Rents for German small and medium-sized Enterprises
3 Conclusion and Outlook
3.1 Basel II causes structural Changes in Credit Pricing
3.2 Structural Crisis of Banks and Credit Pricing
3.3 German small and medium-sized Enterprises have to take Action
3.3.1 Capital Base
Appendix A: Common Framework of the IRB Formula for Risk Weights
A.4 Calculation of Risk Weights
A.5 Supplementary Information on Volatility and Variance
A.6 Supplementary Information on Expected and Unexpected Loss
Appendix B: Calculation of IRB Risk Weights in Practice
B.1 Example Calculations
Summary in German
1 The Development of Basel II
Credit institutions play an important role in modern economies. They act as intermediaries between borrowers and depositors on capital markets and offer traditional financial products such as credits. Bank credits play an important role for companies’ investment financing and day-to-day business activity. However, the nature of banking business entails a number of risks that have to be adequately managed by banks. Such risks are, for example, credit risks, market risks, interest rate risks and also operational risks (see also Bessis 1998, pp.5-15). These risks must not be allowed to lead to instabilities in the financial sector. Over and above the institutions' own risk provisioning measures, specific regulation has therefore been laid down for credit institutions. Regarding the design of such banking regulation, the Basel Committee on Banking Supervision has made several proposals which have mostly been incorporated into the national law of many different countries.
The Basel Committee on Banking Supervision was established at the end of 1974. The Committee’s members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States (see also Basel Committee 2001a). Countries are represented by their central bank (e.g. Deutsche Bundesbank) and also by the authority with formal responsibility for the prudential supervision of banking business where it is not the central bank (e.g. in Germany the German Financial Supervisory Authority called BAFin). The Basel Committee (in the following text referred to as “the Committee”) has its seat at the Bank for International Settlements (“BIS”) in Basel. Since 1975, the Committee has been holding meetings several times a year. The Committee has the fundamental objective “to strengthen the soundness and stability of the international banking system” (Basel Committee 1988, p.1) by establishing a regulatory framework that “should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks” (Basel Committee 1988, p.1).
The Committee’s proposals are in principle only directed at international active banks. Usually they are implemented almost unaltered into European law by the European Commission in form of an EU directive. The member countries are then obliged to transfer the EU directive into national law. In Germany, the Basel proposals are implemented by alterations or extensions of the German Banking Act, the principles of the BAFin or bylaws. That way, the Basel proposals are also legally binding for small credit institutions with less complex activities compared to international banks.
The cornerstone in the Committee’s work is a framework for minimum capital requirements for internationally operating banks commonly referred to as the “Basel Capital Accord” or, simply, “Basel I” (see also Basel Committee 1988). In July 1988, Basel I was approved by the G-10 governors and has been introduced not only in member countries of the Basel Committee, but in virtually all other countries with international active banks by 1993 (see also Basel Committee 2001a, p.3). The basic concept of Basel I is that banks have to hold a regulatory minimum capital buffer for the risk that credit losses might be higher than expected, i.e. credit risk. At least 50% of this capital buffer has to be Tier 1 capital where the rest can be Tier 2 capital. Tier 1 capital is the institution’s core capital, consisting of equity capital (both common and noncumulative preferred) and “disclosed” reserves from post-tax earnings. Tier 2 capital is the institution’s supplemental capital, compromising general loan-loss reserves and other hidden reserves and revaluation reserves (see also Katz 2001). The amount of the capital buffer should be at least 8% of the so-called “risk weighted assets”. These are simply the bank’s “risky” assets weighted in accordance with their relative credit riskiness. To determine these risk weights, assets are classified in broad categories. Each category has its own risk weight, varying from 0% for loans to OECD governments to 100% for loans to corporates. The regulatory capital charge for corporate loans is therefore a uniform 8% (100% of 8%) of loan face value, regardless of the financial strength of the borrower or the quality of any collateral.
Basel I was originally directed at the assessment of capital in relation to credit risk (see also Ong 1999, p.3). In the 1996 amendment of Basel I, the initial requirement for credit risk was extended to include risk-based capital adequacy for market risks arising from banks’ open positions in foreign exchange traded debt securities, equities, commodities and options (see also Basel Committee / Bank for International Settlements 1996).
Although Basel I has functioned reasonably well, it has not been totally free of criticism. Above all, it has been criticised that banks have to hold the same amount of regulatory capital for corporate loans of very different degrees of credit risk. Regulatory capital is a cost factor for banks that is included in the risk premium of the borrower’s credit rent. As the bank’s cost for regulatory capital is the same for all credits, low-risk borrowers actually subsidise high-risk borrowers because they pay too high risk premiums and the others too low risk premiums. Due to this lack of differentiation, regulatory capital has not been used for high quality borrowers in the first place resulting in a misallocation of banks’ capital. Furthermore, the uniform capital charge created the incentive for some banks to move low-risk credits off-balance sheet and trade them on capital markets (e.g. through securitisation ) while retaining relatively high-risk credits on balance sheet. Therefore, the risk profiles of these banks increased while the required amount of regulatory capital did not. This undermined the effectiveness of regulatory capital rules (see also Ong 1999, pp.21-33). Finally, in the last few years, various banks have been developing new systems to differentiate between the riskiness of various parts of the portfolio to improve pricing and the allocation of economic capital. “In light of those new tools, it is quite clear that the current Accord provides internationally active banks […] with less meaningful measures of the risks they face and of the capital they should hold against them” (McDonough 2003, p.1). In other words, the new systems highlighted the discrepancy between required regulatory capital and the bank’s economic capital. In response to these drawbacks, the Committee has been working on a more flexible and forward-looking capital accord, which better reflects the actual economic risks and encourages banks to make ongoing improvements in their risk assessments capabilities (see also Jackson 2001, pp.55-63).
1.1 The Third Consultative Document
In April 2003, the Committee released its third iteration of the “New Basel Capital Accord”, also called “Basel II” (see also Basel Committee 2003a). This third proposal modifies and expands two earlier proposals, also referred to as consultative documents, for a new accord. These proposals were issued by the Committee in June 1999 (see also Basel Committee 1999) and in January 2001 (see also Basel Committee 2001b). Banks, industry groups and all interested parties can now comment on the third consultative document until July 2003. Provided these comments do not lead to large adjustments, Basel II will be implemented at the beginning of 2007.
In Basel II, banks are subject to a capital adequacy framework compromising minimum capital requirements, supervisory review, and market discipline. Hence the Basel II comprises three mutually reinforcing pillars with a view to better safeguarding the stability of the national and international banking system (see also for overview Deutsche Bundesbank 2001a, pp.15-44; Deutsche Bundesbank 2002a, pp.41-61). In contrast, Basel I has only one pillar – minimum capital requirements. The Committee believes that a risk-adequate capital buffer, though very important, cannot on its own guarantee the solvency of a bank and the stability of the banking system. An essential factor ultimately is the bank's risk/return profile determined by its managers coupled with its ability to control and sustain the risks entered into. The Committee therefore seeks to ensure that banks' own (internal) risk management systems are improved further and that they are reviewed by the appropriate supervisory agencies (see also Deutsche Bundesbank, Basel II, n.d.).
1.1.1 Pillar 3 – Disclosure
In Pillar 3 (see also Basel Committee 2003a, pp.154-168 and 2001c; Boos/Schulte-Mattler 2001a, pp.795-799; Katz 2001), Basel II sets out core and supplementary disclosures that all banks should meet and where the national supervisors should take action to address non-compliance. The difference between core and supplementary is that banks have more leeway not to make the supplementary disclosures if they are not relevant to their actual activities or if they relate to non-material areas. Through this enhanced transparency, banks are also subject to the disciplining forces of the markets as a complement to the regulatory requirements. The required disclosures will cover:
- Application of the new accord to entities within a banking group, i.e. consolidation;
- Risk exposure and assessment – a bank’s profile in credit risk (e.g. the maturity distribution of exposures and amount of past due loans etc.), market risk (e.g. the value at risk for different trading portfolios and the characteristics of any internal models used), operational risk (e.g. losses due to inadequate systems) and interest rate risk (e.g. the increase or decrease of economic value which would be caused by an unexpected interest rate shock);
- Capital structure – the constituent parts of a bank’s regulatory capital, i.e. the amount of Tier1 and Tier 2 capital; and
- Capital adequacy – for example, the amount of capital required for credit risk, market risk and operational risk, and the required capital as a percentage of a bank’s total capital.
1.1.2 Pillar 2 – Supervisory Review Process
Pillar 2 (see also Basel Committee 2003a, pp.138-153 and 2003b, pp.10-11; Boos/Schulte-Mattler 2001b, pp.646-648; Katz 2001) is intended to ensure that a bank’s capital position is consistent with its overall risk profile and that the bank has sound internal processes in place to assess capital adequacy relative to risk, as well as to permit early intervention by supervisors if banks are not appropriately addressing capital requirements. The supervisory review is based on four interlocking principles:
1. Banks should have a process for assessing their overall capital in relation to their risk profile and a strategy for maintaining their capital levels.
2. Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate action if they are not satisfied with the results of this process.
3. Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
4. Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.
1.1.3 Pillar 1 – Minimum Capital Requirements
Pillar 1 (see also Basel Committee 2003a, pp.6-137; 2003b, pp.3-9; Hofmann 2002, pp.10-14; Katz 2001) is based on the fundamental elements of Basel I: A definition of banks’ regulatory capital, which in essence remains unchanged, and a required minimum ratio of regulatory capital to risk weighted assets of 8%. However, the denominator of the capital ratio has been extended by capital charges for operational risk. The denominator therefore consists of three parts: the sum of the bank’s risk weighted assets plus 12.5 times the sum of capital requirements for market and operational risk:
Formula 1: The total regulatory Capital Ratio in Basel II
illustration not visible in this excerpt
How the bank’s regulatory capital is actually calculated becomes clearer when the above stated formula is transformed so that:
Formula 2: Formula for the Calculation of the total Regulatory Capital (RC) Requirement in Basel II
illustration not visible in this excerpt
Regarding the new charge for the bank’s operational risk, the third consultative document states that “Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk” (Basel Committee 2003a, p.120). There are three approaches for the measurement of operational risk reaching from a simple basic indicator approach to an advanced measurement approach (AMA). The capital charge for operational risk is expected to vary between 9% and 12% of total capital requirements for market risk and credit risk, depending on the chosen approach for operational risk measurement.
The charge for credit risk, which is directly influenced by the credit quality of the bank’s borrowers, is the most important and most influencing element in the total regulatory capital charge. As in Basel I, credit risk is expressed by the risk weight of the underlying asset. The regulatory charge for the risk weighted asset is also still 8%. However, in contrast to the old accord, Basel II is more risk sensitive because it demands different amounts of regulatory capital for different levels of credit risk (see also Taistra 2003). The borrower’s credit quality determines the risk weight and therefore capital requirements for the underlying asset. In other words, even exposures in the same asset class (e.g. corporate credits) will require different amounts of regulatory capital depending on their individual credit risk. This approach, which is clearly different from Basel I, implies that banks will have to determine a risk weight for every single exposure. The risk weights in Basel II will be derived with the help of the borrower’s rating, which can be carried out by the bank or by an external rating agency.
1.2 Central Problem
Since 1999, the discussion in the consultation period has mostly been directed to the calibration of risk weights for credit risk. A lot of the Committee’s work has therefore been focused on refining the credit risk charges in response to critical comments from interested parties. Critical comments were especially given by the German delegation, which even threatened to veto Basel II in the first half of 2002. It was criticised that capital requirements for credit risk in Basel II could impose unduly high and therefore expensive capital levies on banks’ lending to the “Mittelstand”, which is currently shaken up by insolvencies. The term “Mittelstand” stands for German small and medium-sized companies with an annual turnover of less than €50 million. Although the “Mittelstand” is currently in a difficult economic situation, these firms are still the backbone of Germany’s economy generating innovations, macroeconomic growth and jobs (see also Deutsche Bundesbank, Basel II, n.d.). Connected with undesired increases of banks’ regulatory capital for corporate credits are two great fears: (1) that banks will generally reduce credit volumes in the lending business and cause “credit crunches”, and (2) that credit rents for companies in the “Mittelstand” will increase considerably to cover the bank’s cost of additional regulatory capital. The German delegation therefore demanded that, in drawing up Basel II, due account had to be taken of the special features and needs of the “Mittelstand” compared to large enterprises to ensure as far as possible that small and medium-sized firms are not put at a disadvantage regarding capital charges for credit risk. In July 2002, the issue was resolved when the Committee agreed to reduce capital requirement levels for credit risk of small and medium-sized enterprises (see also Anon., Mittelstand 2002, p. 21). The corresponding adjustments to the new accord have led to the third consultative document released in April 2003.
It remains to be seen how this compromise works in practice. Whatever the result will be, the first fear mentioned above can already be declared as not founded: According to several sources, Basel II will not cause a reduction in overall credit volumes. Therefore, a credit crunch is not expected either (see also Hofmann 2002, p.34; Paul / Stein / Horsch 2002, pp.578-582). First, there is the Committee’s explicit “goal of neither significantly decreasing nor increasing the aggregate level of regulatory capital in the banking system”(Basel Committee 2002), which makes a dramatic reduction of the banks’ lending business unlikely. Second, the catalogue of eligible credit risk mitigation techniques, which is now also more suitable for small and medium-sized enterprises, has been extended. This will contribute to an adequate availability of credits. Third, if we look at the overall development of the volume of credits to companies and self-employed in Germany during the last 10 years, we do not find an absolute decrease. In the fourth quarter of 2001, the total volume of credits even grew by 2.2% compared to 2000. And in the first quarter of 2002, there has still been an increase of 0.4% despite the economic downturn. However, there are differences regarding the allocation of credit volumes to companies among different bank types: While large private banks have reduced their credit volume to small and medium-sized companies in the first quarter of 2002 for the fourth time, credit volumes at credit unions and savings banks have increased by 0.7% and 3.1% respectively. Credit unions and savings banks have stated that they want to keep and even extent their lending business in the “Mittelstand” (see also Anon., Kredite 2003; Anon., Mittelstandsadresse 2002). This underlines that German small and medium-sized companies will not be confronted with a credit crunch.
Even if the aggregate level of regulatory capital in the banking system will not rise significantly, the second fear remains within “Mittelstand” associations and unions. It is feared that still there will be higher capital requirements for credit risk for the small and medium-sized enterprises than for large companies. Consequently, credits for many German small and medium-sized enterprises could nevertheless be more expensive. To see if this fear is founded, the consequences of the third consultative document for credits to companies in the “Mittelstand” have to be analysed. Furthermore, the possible impact on credit rents has to be derived. In other words, the objective of this final thesis is to give an answer to the question:
“Will Basel II make credits in the “Mittelstand” more expensive?”
1.3 Line of Proceeding
To be able to answer this question, various aspects have to be taken into account. The central idea is that an exposure’s risk weight and, hence, capital requirements for credit risk have an influence on credit conditions. This is because the bank’s cost of regulatory capital is included in the credit rent. If the bank has to hold more regulatory capital for a credit, the additional cost of capital will be added to the borrower’s credit rent. Therefore, it has to be derived if credits to German small and medium-sized enterprises will require more regulatory capital in Basel II compared to Basel I.
The second and central chapter starts with the definition of credit risk and introduces credit ratings as the tool for measuring credit risk. In paragraph 2.1, Basel II’s framework for the calculation of regulatory capital for credit risk with the help of credit ratings will be discussed. Only the parts of the framework which are relevant for corporate credits will be mentioned. The second paragraph (2.2) deals with the characteristics and current situation of German small and medium-sized enterprises. Furthermore, the attitude and preparation status of these companies regarding rating in Basel II are presented. In paragraph 2.3, Basel II’s framework for the calculation of risk weights and capital requirements for credit risk will be applied to calculate average capital requirements for German small and medium-enterprises. With these capital requirements the impact on credit conditions for German small and medium-sized enterprises is derived in paragraph 2.4. In the third chapter, the central question stated in paragraph 1.2 will be answered. Subsequently, developments in bank lending will be discussed and an outlook is given on what German small and medium-sized enterprises can do to deal with Basel II and the developments in the banking sector.
1.4 Credit Risk in Basel II and its Impact on Credits to German small and medium-sized Enterprises
Credit risk is the risk that customers default, that is fail to comply with their obligation to service debt (see also Bessis 1998, p.6). Default triggers a total or partial loss of any amount lent to the counterparty. Credit risk is also the risk of a decline in the credit standing of a counterparty. Such deterioration does not imply default, but means that the probability of default increases. Credit risk is critical since the default of a small number of important customers can generate large losses, which can lead to insolvency. At banks, it is normally monitored and managed by the risk management. Risk has two dimensions: the quantity of risk, or amount that can be lost, plus the quality of the risk, which is the probability of default.
The quality of credit risk is often appraised through credit ratings. Measuring the quality of credit risk leads, ultimately, to quantifying the default probability of borrowers, plus the likelihood of any recovery under the event of default. The loss depends on a guarantee, either from third parties or from any posted collateral, of recovery after bankruptcy and liquidation of assets. Standard & Poor's, one of the most famous rating agencies, defines a credit rating (from now on referred to as “rating”) as an opinion on the general creditworthiness of an obligor, or with respect to a particular debt security or other financial obligation. The main function of a rating is to create transparency and comparability for investors and creditors with regard to the credit risk connected with a particular company or a financial asset. Ratings help to take decisions in portfolio management and are the foundation of adequate pricing of an investment, as for example a bond or a credit. Capital markets value the credit standing of firms through higher interest rates on the debt issues of these firms, or a decline in the value of their shares.
There are two important types of ratings: the issue rating and the issuer rating (see also Standard & Poor’s 2001). An issue rating is a current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program (including ratings on medium term note programs and commercial paper programs). It takes into consideration the creditworthiness of guarantors, insurers, or other forms of credit enhancement on the obligation and takes into account the currency in which the obligation is denominated.
An issuer or counterparty rating is a current opinion of the company’s overall financial capacity (its creditworthiness) to pay all its financial obligations. This opinion focuses on the obligor’s capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation. It does not take into account the nature of the obligation and its provisions, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. In addition, it does not take into account the creditworthiness of the guarantors, insurers, or other forms of credit enhancement on the obligation. The issuer rating is the type of rating Basel II uses for the calculation of capital requirements. For the rest of this thesis the term “rating” will always stand for an issuer credit rating. Such a rating usually includes the analysis of quantitative and qualitative factors as for example (see also Hofmann 2002, p.169):
- Quantitative factors: capital structure, debt structure, liquidity-/earnings-situation, financial ratios, balance-sheet policies, business sector figures
- Qualitative factors: Management, business policies, customer relationship, financial / investment / turnover plans, market situation, competition, accounting / controlling / risk / financial management, product development
Ratings are carried out by rating agencies, such as Standard & Poor’s, Moody’s and Fitch IBCA as well as by banks. Ratings from rating agencies are called external ratings while ratings from banks are defined as internal ratings. Rating agencies are commissioned and paid by companies to carry out a rating. Usually, the external ratings are also made publicly available; this is decided by the rated company. The publication of a rating serves as an indication of the company’s credit quality to the market and is, for example, used by a company in the following events:
- Credit negotiations with banks
- Bond issue
- Issue of shares
The costs of an external rating vary significantly and lie between €5,000 and €60,000 (see also Krämer-Eis 2001, p.24). Other factors which influence the rating costs are, for example, the type of agency, the quality of the rating and the size of the company.
In contrast to rating agencies, the bank carries out ratings of its borrowers on its own initiative. Many banks use their own rating systems whose results are usually not communicated to the rated borrower or the public. The internal rating systems are built in line with the characteristics of the specific bank, because banks want a monitoring system tailored to their risk strategy, size and complexity as well as to specific market and borrower structures (see also Krämer-Eis 2001, p.27). The bank’s rating system often serves as a tool for credit policy. For instance, some minimum rating might be required to make a loan, or to delegate authority to credit officers. They can be allowed or not allowed to enter transactions based on the borrower’s rating (see also Bessis 1998, p.88). The bank also uses its internal ratings for:
- Loan Pricing Analysis
- Portfolio Monitoring
- Risk Management/Portfolio Management
- Management Reporting
- Securitisation of Credits
- Setting of own Loan Loss Reserves
- Calculation of Regulatory Capital Requirements
The internal rating is the bank’s front-line defence against default risk. It is the bank’s primary indicator of risk for individual credit exposures. Although credit risk ratings are becoming increasingly important in the credit risk management process of large banks, Treacy and Carey (1998) noted in their paper that “…banks’ rating systems differ significantly from those of the [rating] agencies (and from each other) in architecture and operating design as well as in the uses to which ratings are put. One reason for these differences is that banks’ ratings are assigned by bank personnel and are usually not revealed to outsiders…” rendering the risk-rating systems of banks rather opaque and non-comparable.
It is therefore not much known about banks’ rating systems. However all rating systems, from banks as well as from rating agencies, have one objective in common, which is to construct an ordinal, relative ranking of the ability to service debt. As for school grades, the distance between the different ratings is not metric. A rating does not imply one certain analytical method, but the language definition to be able to compare and communicate credit risks. The best known rating scales are those of rating agencies. They mostly use alphabetical-numerical rating scales (see table 1). Although these external rating symbols were chosen randomly by John Moody, they have become a commonly understood language in the financial sector worldwide. Each agency uses a system of letter grades that locate an issuer on a spectrum of credit quality from the very highest (triple-A) to the very lowest (D). The ‘D’ rating category is used when payments on an obligation are not made on the date due. The ‘D’ rating also will be used upon the filing of a bankruptcy petition or the taking of a similar action if payments on an obligation are jeopardized (see also S&P Corporation 1997). The lower the grade, the greater the risk that interest and principal payments will not be made. An issuer rated Baa3 or BBB- and above is considered to be of investment-grade quality, while issuers rated Ba1 or BB+ and below are viewed as being of speculative or non-investment quality.
Table1: External Rating Symbols
illustration not visible in this excerpt
1.5 Regulatory Capital for Credit Risk in Basel II
The capital requirement for credit risk (from now on referred to as “capital requirement”) for a particular credit depends on the borrower’s rating. With the help of this rating, the risk weight for the underlying asset is calculated by using the corresponding risk weight formula. The Committee demands that the ratio between the bank’s liable capital and its risk weighted assets should be at least 8%. The formula for the minimum capital requirement for a risky asset expressed in percent can be calculated as follows:
Formula 3: Minimum Capital Requirement for a risky Asset in %
Capital Requirement for a risky Asset % = Abbildung in dieser Leseprobe nicht enthalten
As mentioned in the introduction, one of the guiding principles of the new accord is that the size of the required capital buffer for credit risk is made contingent on the borrower’s rating instead of being constant per asset class as in Basel I. A portfolio is characterized by a relatively small number of risk categories and each risk or “rating” category will be associated with a specific risk weight. The size of the risk weights can be based on either an external rating or a bank-internal rating of the borrower. For the actual calculation of risk weights to which the borrower’s rating is an essential input, Basel II proposes two approaches in Pillar 1:
1. A standardised approach using external ratings
2. An internal-ratings-based approach (IRB approach) using internal ratings
Banks have to decide which approach they want to apply. However, the Committee has created an incentive for banks to choose the IRB approach because risk weights and, hence, capital requirements are generally lower than in the standardised approach. As in Basel I, the first step, regardless of the chosen approach, is a categorisation of the bank’s banking book portfolio into five sub-portfolios from which each contains a specific asset type:
1. Corporate exposures
2. Bank exposures
3. Sovereign exposures
4. Retail exposures
What is of particular importance is the fact that corporate credits will either belong to the sub-portfolio with corporate exposures or to the retail sub-portfolio for regulatory purposes. In the retail portfolio, capital requirements are lower than in the portfolio with corporate exposures because the Committee assumes a natural risk diversification due to the large pool and small sizes of exposures in the retail segment. In line with the objective of this thesis, only the derivation of risk weights for corporate credits in the retail and in the corporate segment will be discussed for the different approaches.
1.5.1 Standardised Approach
The standardised approach (for details see Basel Committee 2003a, pp. 6-38; Boos/Schulte Mattler 2001e) makes an exemption in so far that it does not require a rating for corporate credits that belong to the retail segment. Corporate credits in the retail segment have a uniform risk-weight of 75% which will reduce the capital requirement from the current 8% (due to the uniform 100% risk weight for corporate credits in Basel I) to 6% (which is 75% of 8%). However, if retail credits are past due for more than 90 days, net of specific provisions, they can not be included in the retail portfolio and receive a risk weight of 150%. This is also true for past due credits in the corporate segment. Corporate credits in the bank’s retail portfolio must comply with the following four criteria (see also Basel Committee 2003a, p.11):
1. Orientation criterion – The credit is to a small business.
2. Product criterion – The exposure takes the form of small business facilities and commitments.
3. Granularity criterion – The supervisor must be satisfied that the retail portfolio is sufficiently diversified in order to reduce the risks in the portfolio.
4. Low value of individual exposures. The maximum aggregated retail exposure to one counterpart cannot exceed an absolute threshold of €1 million.
Corporate credits which do not comply with these criteria automatically belong to the corporate segment of the bank. Here, risk sensitivity is introduced with the recognition of external ratings from eligible rating agencies (i.e. recognised by national supervisors in accordance with specified criteria) (see Basel Committee 2003a, pp.14-17). In contrast to the retail segment, credits will be slotted into several ratings bands depending on the external rating of the underlying borrower. A rating band reaches for example from an “AAA” to an “AA-“ rating, which is also shown in table 2. To each rating band is a certain risk weight assigned with which the bank can calculate its risk weighted assets and, hence, regulatory capital (see also Jackson 2002, p.104). Note that compared to Basel I with only one risk weight for corporate loans (100%), there are now several possible risk weights depending on the borrower’s rating.
Table 2: Risk Weights for Corporate Credits in the Corporate Segment and in the Retail Segment in the Standardised Approach
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The standard risk weight for unrated credits will still be 100%. However, the supervisory authorities are allowed to increase this risk weight where they judge that a higher risk weight is warranted by the overall default experience in their jurisdiction. No credit to an unrated corporate may be given a risk weight preferential to that assigned to its sovereign of incorporation. As part of the supervisory review process (Pillar 2), supervisors may also consider whether the credit quality of corporate claims held by individual banks should warrant a standard risk weight higher than 100%.
1.5.2 IRB Approach
In the IRB approach (for details see Basel Committee 2003a, pp. 38-99; Boos/Schulte Mattler 2001e), banks may rely on their own ratings and internal estimates of risk components when determining the risk weight for a given exposure. The underlying idea of the IRB approach is to make further use of the information collected and processed in the bank’s internal borrower rating system. Since banks have developed their own systems to evaluate risks, these evaluations ought to be a reasonable basis for a risk-contingent determination of risk weights (see also Carling et al. 2002, p.3). The bank calculates up to four risk parameters in the IRB approach:
1. The probability that the borrower will default (PD, Probability of Default).
2. The exposure amount at the time default occurs (EAD, Exposure at Default).
3. The percentage of exposure that would be lost in the event of default (LGD, Loss Given Default).
4. The maturity (M) of the credit.
The probability of default represents the borrower’s rating. If a bank has had its systems for assessing the default probability of borrowers recognised by its supervisor and has had such a system in place for at least three years, it will be able to use its own ratings to slot corporate credits into internal rating categories. Each rating category in an asset class is characterised by an estimate of its average probability of default, calculated by the bank. The bank will be able to choose as many rating categories as it wishes. By means of a complex risk weight formula, the Committee provides a mapping from the estimated probability of default to a relative risk weight for the particular borrower. Important input parameters for the formula are the risk parameters mentioned above. The multiplication of the relative risk weight, the exposure at default (usually taken as the face value of the credit), and the 8% absolute capital requirement give the capital charge for credit risk of a particular credit (see also Carling et al. 2002, p.3).
In the retail segment, capital requirements are generally lower than in the corporate segment. This is because the Committee assumes that credit risk in the retail portfolio is lower due to the (required) small size and large number of exposures. Banks using the IRB approach have to divide assets in their retail portfolio into three sub-classes: (1) residential mortgage loans, (2) revolving exposures and (3) all other retail exposures (also called “base line retail”). Each sub-class has its own risk weight function for which the bank estimates the probability of default, the loss given default and the exposure at default. The maturity of the particular asset is not needed for the risk weight calculation. Corporate credits belong to the third sub-class (“base line retail”). Compared to the standardised approach, the requirements for qualification for the retail segment are higher in the IRB approach, especially with regard to the treatment of exposures (see also Basel Committee 2003a, pp.41-42):
- Nature of borrower or low value of individual exposures: Loans extended to small businesses and managed as retail exposures are eligible for retail treatment provided the total exposure of the banking group to an individual small business is less than €1 million. Small business loans extended through or guaranteed by an individual are subject to the same exposure threshold.
- Large number of exposures: The exposure must be one of a large pool of loans, which are managed by the bank on a pooled basis. National Supervisors may choose to set a minimum number of exposures within a pool for exposures in that pool to be treated as retail. Small business exposures below €1 million may be treated as retail exposures if the bank treats such exposures in its internal risk management systems consistently over time and in the same manner as other retail assets. This requires that such an exposure has to be originated in a similar manner to other retail exposures. Furthermore, it must not be managed individually in a way comparable to corporate exposures, but rather as part of a portfolio segment or pool of loans with similar risk characteristics for purposes of risk quantification. However this does not preclude retail exposures from being treated individually at some stages of the risk management process. The fact that an exposure is rated individually does not by itself deny the eligibility as a retail exposure.
Corporate credits which do not comply with these criteria belong to the corporate segment. Here, banks have the choice between two variants of risk weight calculation:
1. The IRB foundation approach, where the bank sets the probability of default through its internal rating but the Committee lays down the loss given default and the exposure at default to be used, or
2. The IRB advanced approach, where the bank uses its own estimates for all three parameters.
In the IRB foundation approach (from now on referred to as “the foundation approach”), the Committee sets a loss given default of 45% for senior claims on corporates which are not secured by recognised collateral. Subordinated claims on corporates without specifically recognised collateral will be assigned a loss given default of 75% (see also Basel Committee 2003a, p.52). Regarding maturity, national supervisors can choose between two approaches. One is an implicit approach which requires a general 2.5 year maturity to be applied to all credits regardless of their probability of default. The other approach uses an explicit maturity adjustment function to which the underlying probability of default is an input parameter. In the IRB advanced approach (from now on referred to as “the advanced approach”), supervisors can also choose between these two maturity functions but only for firms with an annual turnover of not more than €500 million. For exposures to firms with an annual turnover larger than €500 million, the explicit maturity function is compulsory and therefore not subject to national discretion (see also Jackson 2002, p.105). The explicit maturity is capped at five years. German supervisors have already announced that in Germany the implicit maturity adjustment (uniform maturity of 2.5 years) will be used in both, the foundation and advanced approach, where this is subject to national discretion (cited Taistra 2003, p.14).
In the corporate segment, regardless of the chosen approach, the Committee added a special regulation for small and medium-sized companies, which is subject to national discretion. In this regulation, small and medium-sized companies which do not qualify for the retail segment can still benefit from a reduction in regulatory capital compared to large companies. For regulatory purposes, the Committee defines small and medium-sized enterprises as companies with less than €50 million annual turnover, which corresponds to the “Mittelstand” definition in Germany. Risk weights and therefore capital requirements for credits of at least €1 million granted to small and medium-sized enterprises can be reduced with the help of a so-called “size-factor”. However, companies with an annual turnover of less than €5 million will be treated as if they were equivalent to €5 million for the purposes of the size factor adjustment, i.e. the maximum reduction is reached at a turnover of €5 million. The maximum reduction contributed by the “size-factor” can be 20%. On average a reduction of 10% in capital is expected for exposures qualifying for the size-factor adjustment. To sum up, the size factor is an extension of the risk weight formula for the corporate segment and leads to an additional differentiation of capital requirements depending on the company size of the borrower. The following section presents the risk weight formulas for the retail and the corporate segment.
 Spain was invited to join the Basel Committee on 1 February 2001.
 OECD = Organization for Economic Cooperation and Development.
 Regulatory capital is a reserve that cannot be used for the bank’s profit generating business. As the bank has to earn an adequate return on capital and capital is a scarce factor, the costs for capital are usually included in the credit rent.
 Securitisation transforms traditionally non-traded bank assets into marketable securities.
 Economic capital is the capital buffer determined by the bank itself next to the required regulatory capital cushion determined by the national supervisor.
 This is only possible if the bank adopts the Internal Ratings Based Approach under Basel II.
 Founder of the rating agency Moody’s.
 In the banking book portfolio are mostly assets from the banks lending business. Next to the banking portfolio there is also a trading book portfolio which contains assets such as derivatives.
 “A default is considered to have occurred with regard to a particular obligor when either or both of the two following events has taken place: (1) The bank considers that the obligor is unlikely to pay its credit obligations to the banking group in full, without recourse by the bank to actions such as realising security (if held); (2) the obligor is past due more than 90 days on any material credit obligation to the banking group. Overdrafts will be considered as being past due once the customer has breached an advised limit or been advised of a limit smaller than current outstandings” (Basel Committee 2003a, p.80).
 The loss given default can be reduced with the help of applied credit risk mitigation techniques to the exposure (see also Basel Committee 2003a, pp.52-56).
 There should be at least seven rating categories.