The Basel Committee on Banking Supervision
Dear Sir/Madam
A NEW CAPITAL ADEQUACY FRAMEWORK -
Proposals by the Basel Committee on Banking Supervision
Thank you for the opportunity to comment on your proposals for a new capital adequacy framework.
Our comments relate primarily to the proposals for capital to cover credit risk and we are commenting only in general terms on the proposals for capital to cover other risks. The proposals of the Basel Committee are important for borrowers because they may affect loan margins and loan documentation. We are concerned that the existing proposals could have negative implications for both of these for certain borrowers. However, we note that the weighting given to the various risks that capital is to be set against is very uncertain and until this is determined we are unable to judge whether the proposals for capital to be set against credit risk will have a significant impact on loan margins and documentation or not. Our comments below assume that there will be some impact.
In summary our views are:
Our more detailed comments are as follows:
The issue contained in the Basel proposals of most direct interest to treasurers is the weighting given to corporate loans on bank balance sheets. Not surprisingly, treasurers of companies with single-A ratings have expressed their concern at being categorised with those of much lower credit standing.
Firstly, it is illogical that the proposed risk weighting for single-A banks is lower than that for single-A corporates. Clearly any intrinsic difference in the creditworthiness of corporates relative to banks arising from, for example, regulation would be recognised in the credit rating. The risk weightings for identical credit risks should be the same whether the borrower is a corporate, a bank or, indeed, sovereign.
Secondly, the proposed weightings for corporate loans bear no relation to the average cumulative default rates experienced in the bond market as measured by Moody's and Standard and Poors. The big step-up in default risk occurs at the investment grade cut-off, i.e. between the BBB and BB categories. Over a 5 year period the default experience of the single-A rating category is around 0.5% and of the BBB category 1.67% compared with over 11% for the BB category. Single-B risks have a 28% default experience. To put single-A and BBB risks in the same bucket as BB and single-B risks seems bizarre. Relative to this range of default rates, the additional credit risk of a single A credit compared with an AA credit, at around 0.14%, is very small. The cut-off between AA and single A credits seems arbitrary and illogical. The figures quoted are from Moody's Special Comment on default rates by rating category and we can send this to you in hard copy if required.
Further, despite the Committee's objective of minimising the opportunity for regulatory arbitrage, there will almost certainly be negative consequences following implementation of the proposed weighting of low-rated versus unrated loans. Under current proposals unrated loans will be given 100% risk weighting but those rated under B- will carry a 150% rating. Banks will prefer to lend to weak, unrated credits rather than weak, rated credits. This could discourage weak credits from getting rated and could have a negative impact on the development of a rated high-yield bond market in Europe.
It is notable that no account is taken of loan maturity. We understand that the reason for this is that the proposed risk buckets are so broad-brush that making adjustments for the term of loans would be meaningless. However, credit risk is a function of the documentation not just the credit standing of the borrower and loan agreements vary considerably from country to country and lender to lender. There are significant factors other than maturity, such as financial covenants and credit enhancement. External ratings from some agencies, such as Moody's, are ratings of the bond instrument not the issuer, and many bond issuers have a range of ratings depending on the structure of the transaction. It is not clear how these ratings would map across to a bank loan if, indeed, this is the intention. Will lenders be able to use existing bond ratings to categorise their loans?
A major documentation issue for borrowers is the proposed five-fold increase in capital required for a single A relative to an AA loan. We believe that this would encourage lenders to ask for event risk covenants containing an interest rate ratchet increasing the loan margin if the borrower's rating dropped from AA to A. Interest rate ratchets in syndicated loans can have negative tax implications for UK borrowers and will be strongly resisted by them.
If the proposals are implemented, borrowers expect to come under pressure from lenders to obtain an external rating. This is not only costly in cash terms but, particularly for those previously unrated, extremely onerous and expensive in terms of management time.
Borrowers would certainly be reluctant to pay for loan ratings unless they could be assured of at least an AA rating. This will put tremendous pressure on the relationship between companies and the rating agencies.
It is unclear whether capital, under these proposals, is required to cover default or loss. The average recovery rate on single A and single B bonds is quite different, generally estimated at around 50% and 30% respectively. Banks can presumably provide similar statistics for loans. The difference in credit risk as measured by loss experience between these two rating categories would be even more marked than the difference in default risk, thus further undermining the rationale for putting them into the same risk bucket.
We understand that there has been considerable progress since the original report on the development of an internal ratings system. We welcome this. Our main concern would be that, if internal systems are to be mapped to the external one as originally proposed, the AA/A "cliff-face" will become entrenched. We would much prefer that the existing arrangements were maintained until such time as a system more closely mapped to actual default experience could be put into place.
Our proposal for the Basel Committee to consider is the development of a global measuring yardstick for credit risk based on the probability of loan default. At present there are a number of rating agencies each of which uses different criteria to assess credit risk within different risk buckets. A more rational approach, which would form a common yardstick for all rating agencies and internal rating systems developed by lenders, would be to start with defining risk buckets by the probability of default in any one year for the financial instrument being credit assessed. Once the default probability range for each risk bucket has been determined (perhaps by a doubling or trebling of the risk probability from one bucket to the next) a suitable scale could be developed to identify each bucket.
Early adoption of such a framework would enable the default experience of lenders to be assigned to each risk bucket. This would give a natural feedback to ensure that the assigned credit risk ratings to specific loans are, over time, justified by the historical default experience.
Some of this work has already been done by the rating agencies, but it is not uncommon for banks themselves to fail to keep adequate default and loss statistics properly correlated with the risk assessment process. A mandatory requirement under the Basel proposals to establish default experience statistics, within a standardised risk bucket measurement system, would create a framework for credit risk appraisal which became a global standard allowing comparison of data between different lenders and their counterparties.
It is our opinion that the absence of such a common performance definition and measurement system will seriously retard the efforts of the Basel Committee to identify the appropriate levels of risk capital for specified counterparties.
The lack of a reasonably consistent approach could result in a new form of regulatory arbitrage whereby certain credits would attract different capital charges depending on the lender. Weaker credits could find it too expensive to move their business to another bank, while some lenders might find it impossible to retain the business of stronger credits.
We think that the need for capital should be made explicit. Capital is needed to cover specific risks, eg counterparty default, operational risk, interest rate risk, systemic risk (although we understand this is a controversial area) and a final element across all banks 'just to be safe'. It is important that this safety net is added at the end of the risk evaluation process, not in the calculation of each element, to avoid unnecessary, and hidden, conservatism. Where the risk elements can be measured, or estimated, the capital allocated should be proportional to the risk, including a margin to allow for the expected volatility in that risk. For an investment grade borrower the capital set aside for the bank's operational and interest rate risks is likely to be much higher than that for the counterparty credit risk. For well managed risk-averse banks, their operational and interest rate risk capital could be small in comparison with their systemic risk.
Although we may be a long way from being able to identify all of the risk categories for which capital needs to be set aside, the approach outlined here gives a conceptual and stable framework for the development of a much better regulatory control of capital allocation which could fit within the Basel proposals. The framework suggested would give banks a financial incentive to identify and measure their significant risks accurately, and focus on doing so when the result of better measurement could lead to a lower capital allocation.
We appreciate that the task of re-designing the Basel Accord is a very difficult one. Our purpose in making these comments is to represent the views of borrowers who could be affected significantly and possibly arbitrarily by the Basel Committee's proposals. We hope that our response will serve to keep the interests of the borrowing community in the Committee's mind during the next stage of this project. If you have any questions please contact our Technical Officer, Caroline Bradley on 020 7213 0738 or via cbradley@treasurers.co.uk1.
Yours faithfully
Philip Gillett
Chairman of the Technical Committee