The New Basel Capital Accord: Potential Effects on lending rates in New Zealand

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The New Basel Capital Accord Potential Effects
on lending rates in New Zealand

• Slides prepared by Kurt Hess, University of
  Waikato Management SchoolHamilton, New Zealand

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Basel I
 
Basel on the Rhine RiverRetrieved from
http//www.basel.ch 21 September 2004
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Basel II
 
BIS Building in Basel, Aeschenplatz 1Retrieved
from http//www.basel.ch 21 September 2004
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Basel III
 
Basel FasnachtRetrieved from http//www.fasnacht.
ch 21 September 2004
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Basel II Impact on Lending Rates

• Motivation / Literature
• System of Risk Weighting underBasel I vs. Basel
  II Capital Accord
• Loan Pricing by Banks
• Traditional method
• Pricing in a Modigliani Miller world
• Conclusions

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Motivation

• Uncertainty as to what will be the impact of new
  regulatory framework which has lead to
  speculation among media commentators.
• Some of the comments and conclusions relating to
  revised risk weightings under Basel II did not
  seem convincing.

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Motivation

• Example one

As a generality, lending to mid corporates
represents a higher level of risk than lending to
their FTSE counterparts. This means mid
corporates will tend to attract the higher risk
weightings, making them the first to suffer from
any financing restrictions placed on their
provider by Basel II. Wilcox in Accountancy, 1
May 2003
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Motivation

• Example two

Proposed changes to the Basel Capital Accord
(called Basel II) indicate that banks will have a
greater incentive to lend to the residential
housing market. Brian Gaynor in NZ Herald
article titled Aggressive banks drive housing
boom,27 September 2003
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Literature / Studies

• Numerous studies and articles related to Basel II
  and it potential impact.
• Most important, quantitative impact study (QIS)
  with the participation of more than 350 banks in
  43 countries (May 2003) explores impact on
  capital requirements under the new regime.

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Literature / Studies
QIS Contributions to Change in Standardised
Approach
Relieve for retail
New operational risk category
Basel Committee, May 2003, Quantitative Impact
Study 3 Overview of Global Results, page 5
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Literature / Studies

• Research on possible systemic impacts like the
  suspected procyclicity of the new regulation, for
  example
• Borio, Fufine, Lowe (2001)
• Allen Saunders (2002)
• Special issues of academic journals related to
  Basel II
• Journal of Financial Intermediation, May 2002
• Journal of Banking and Finance, April 2004

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Research Question

• How will the revised risk weights affect lending
  to the various industry sectors? Will there be an
  impact on relative lending rates?

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Basel II Impact on Lending Rates

• Motivation / Literature
• System of Risk Weighting underBasel I vs. Basel
  II Capital Accord
• Loan Pricing by Banks
• Traditional method
• Pricing in a Modigliani Miller world
• Conclusions

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Basel I Risk Weightings
Current Weighting under Basel I
Example Calculation of Risk Weighted Assets ANZ
Bank (NZ Operations) year per 30/9/2003
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Basel I Problems / Effects

• Insufficient granularity and risk sensitivity
• Asymmetry between risk profile, economic capital
  and regulatory capital
• Arbitrage of regulatory capital
• Asset securitisation

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Basel II Pillars

• Pillar 1
• Minimum capital requirements
• Pillar 2
• A supervisory review process
• Pillar 3
• Market discipline (risk disclosure)

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Basel II Pillars
Pages in New Basel Capital Accord (issued June
2004)
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Basel II Risk Weighting Options

• Credit Risk
• Standardised Approach
• Internal Ratings-Based Approach (IRB)
• IRB Foundation- banks estimate PD only
• IRB Advanced- banks estimate PD, LGD, EAD,
  Effective Maturity
• Operational Risk - two options

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Risk Weights Basel I vs. II
For categories relevant for NZ registered banks
(1)
Exposure Category Basel I Basel II
Cash, short-term claims on NZ government and RBNZ 0 0
Claims on NZ government with maturities more than one year 10 10
Claims on NZ banks and local authorities 20 20 to 100 depending on credit rating
Basel II Standardized Approach
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Risk Weights Basel I vs. II
For categories relevant for NZ registered banks
(2)
Exposure Category Basel I Basel II
Loans to rated companies (corporates) AA- to AA A- to A BB- to BBB Less than BB- Unrated 100 2050100150100
Loans collateralised with residential real estate 50 35
Retail type lending (e.g. credit cards, small business loans) 100 75
Relieve for retail
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Risk Weights Basel I vs. II
For categories relevant for NZ registered banks
(3)
Exposure Category Basel I Basel II
Past due loans w/o proper provisions 100 150
Residual and low-rated tranches retained in asset securitizations 100 350 and more
Basel II Standardized Approach
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Basel II Impact on Lending Rates

• Motivation / Literature
• System of Risk Weighting underBasel I vs. Basel
  II Capital Accord
• Loan Pricing by Banks
• Traditional method
• Pricing in a Modigliani Miller world
• Conclusions

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Traditional Loan Pricing (1)
Bank Deposit Funding Cost 4.00 Average costs of deposits non-capital funding sources
Risk premium for expected losses 0.50 To compensate for expected credit losses
Credit administration 0.70 To pay for the banks operational expenses
Total pre-capital charge price 5.20

Capital charge 0.64 From next slide 0.64 as a percentage of a 100 loan
Total post-capital charge loan price 5.84 Pre-capital charge price plus capital charge
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Traditional Loan Pricing (2)
Calculation of Capital Charge
Minimum capital adequacy ratio 8 Minimum capital adequacy ratio for tier 1 2 capital
Risk weight 50 for residential mortgages under Basel I
Capital required per 100 of loan 4.00
Cost of capital 20 Assumption on average return demanded by the banks capital investors
Excess over bank funding costs () 16 20 minus 4 (4 deposit funding costs)
Excess over bank funding costs () 0.64 16 of 4.00
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Traditional Loan Pricing

• A decrease in the risk weight as foreseen under
  New Accord would affect loan pricing under this
  traditional scheme

50
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Risk Weight
0.64
0.45
Capital charge
5.84
5.65
Loan Price
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Loan Pricing in MM World

• Fundamentally credit risk of loan does not change
  if funding mix is change
• What changes is the return required by the
  provider of the equity capital.
• Leaving the required return constant under
  traditional scheme is thus flawed.

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Loan Pricing in MM World

• Modigliani Miller (1958) propositions without
  taxes
• Proposition ICapital structure does not
  matter
• Proposition IIRisk to equity holders rises
  with leverage

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Loan Pricing in MM World
Hypothetical Loss Distribution Mortgage Loan
Portfolio
Hypothetical example assumes Poisson distribution
for 200 loans with a probability of default 2.5
(intensity 5) and loss given default of 20.
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Loan Pricing in MM World
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Loan Pricing in MM World
r WACC is constant and given by
where B is the amount of funds obtained from
bank deposits, E the amount of equity
capital. rB required return on the deposits
(gross deposit funding costs) rE required return
on equity capital (cost of equity)
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Loan Pricing in MM World
Cost of equity (rE) then becomes as a function of
leverage l which is defined as the percentage of
the loan funded though deposits
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Loan Pricing in MM World
Basel I weight 50 leverage96 Basel II weight
35 leverage97.2
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Conclusion

• Revised risk weights under Basel II are sometimes
  instinctively being blamed for expected impacts
  on relative credit availability/lending rates to
  various borrower segments.

• This paper argues that
• Regulatory capital under Basel I should never
  have been the basis for allocating economic
  capital to loans and pricing in the first place.

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Conclusion

• This paper argues that
• (If anything) Basel II will drive lenders to
  allocate capital more in line with actual risk of
  the loan as regulatory and economic capital will
  be better aligned under the New Accord.

As a consequence, not revised risk weights but a
correction of erroneous thinking could bring
about some changes to internal loan allocation
and pricing systems.
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Basel Melbourne Transport