Basel II’s restrictions on banks are bound to change their relationships with their corporate clients. Jules Stewart looks at what firms should expect once the new Accord is in place.
The countdown has begun to Basel II, not only for the banks that will have to comply with the new capital adequacy framework, but also for their many thousands of corporate clients. Under the new rules the focus for determining capital adequacy will shift squarely to credit risk, taking into account the numerous and often spectacular financial disasters that have rocked the corporate world, from Enron to Parmalat, since the original proposals for Basel I were drawn up in 1988.
“Basel II is already having an impact on corporates,” says Rob Boyd, executive director financial markets advisory at ABN AMRO. “Banks have had to prepare for implementation in 2007. For them to be able to use the internal ratings-based approach, they have to have at least three years of data to support their calculations. So they need data at least from the beginning of 2004.”
Mr Boyd says that a lot of banks have had their systems in place for years and it has become a routine part of how they do business, assess credit and determine appropriate pricing for corporates. “We’ve seen things in the market that indicate banks are changing their behaviour, such as the growth of the credit derivatives market, which gives banks more of an opportunity to adjust their exposure levels by buying protection and actively managing their portfolio of credits,” he says.
Special relationship
Basel II bestows a more prominent role on preferred banking relationships and a greater attachment to credit ratings. Banks will assign a more generous rating to companies they know and trust, and this applies in particular to the more sophisticated banks that will be allowed to use their own internal risk management systems rather than relying on external rating agencies.
This is most relevant in the US, says Robert Motyka, executive director, global banks research, at UBS. “US banks will not be allowed to use the external ratings-based approach. They will take their own credit assessment into account in each case to get a risk weight. As regards Basel II and corporate lending, I would expect any change in relationships between banks and corporates to have more of an effect in Europe and Asia than in the US, as most of corporate America is already rated.”
Cost of lending
Under Basel I, banks are obliged to hold 8% of capital against all loans to corporate borrowers, regardless of the client’s credit rating. That is, all corporate loans are currently 100% risk-weighted. With Basel II, the capital that banks have to put aside for loans to corporates will vary according to the level of risk rather than the status of the borrower, on a sliding scale from 30% to 150%.
The amount of capital a bank has to hold against its corporate customers will decrease significantly for better rated credits, therefore as distortions caused by the present rules are removed, borrowers should see their cost of debt relate more closely to their credit ratings. Corporates rated B- or lower by the three major rating agencies will see their capital weighting go up to 150%. Currently, this affects a large number of mid-cap corporates in the UK and Europe. For instance, if a BB-rated company is downgraded, its bank will need to put up 50% more capital and this will raise the cost of lending.
“The whole thrust of Basel II is to make lending more risk sensitive,” says Ian Linnell, head of credit policy Europe at Fitch rating agency. “This will lead to more polarisation between the haves and the have nots. That is, poorly rated companies can expect to see their cost of borrowing go up and this will entail a potential undermining of traditional banking relationships. On the other hand, these relationships are likely to be strengthened for companies with higher ratings.”
Return on credit hurdle
Mr Boyd says that as banks start looking at the Basel II world, they are reassessing their relationships to ensure that they are earning an appropriate return on these relationships. As the capital associated with lending adjusts from the Basel I methodology to that of Basel II, he believes clients will perceive a change in behaviour towards them from their banks.
“Borrowers with weaker credit profiles may now find that the return on their credit alone is not going to meet a bank’s hurdle rate. In this case the bank will normally look at the ancillary revenue on the relationship, to see if on this basis they can get above the hurdle for the amount of capital committed. Banks are becoming more aware of which client relationships are getting them over that hurdle or, in other words, which clients they can add the most value to in exchange for a good return. When this can’t be achieved, we’ve seen banks reducing the amount of capital they are willing to commit to some clients in order to bring them in line with their target return. We expect that this trend will continue,” says Mr Boyd.
Basel as bond boost?
Another offshoot of Basel II could be a boost for the corporate bond market, particularly in Europe where corporate issuance has lagged the US. The higher a corporate is rated, the lower the credit charge against its paper – hence the lower the cost of issuance. The proposed increase in the risk weighting for low-grade debt could therefore lead to more bond issuance as companies in this category may pay a higher premium on their borrowings in the lending market than they do in the bond market.
Analysts believe that this will promote the growth of the high-yield market. Corporates who fall into this category may get better financing from the bond market than from banks that have to put up 12% of their capital against a loan: 8% times the 150% risk weighting, versus a much more attractive 2.4% capital requirement for loans made to the best rated companies.
“This will be the case for corporates that are able to attract a higher rating,” says Norman Bernard, director of banking consultancy, First Consulting. “But obtaining a better rating is an expensive business, since corporates will have to keep more capital and be less geared. Finance directors will be playing a complicated balancing act to work the most efficient and cheapest mix of their sources of financing.”
Banks will lend on the expectation of certain ancillary business to come their way and after a few years they may feel that they are achieving the appropriate level of business from a corporate client. If not, they are likely to reassess the relationship. As a company begins to nudge the limit of ancillary business it can offer its lender bank, it will need to think about diversifying, because the cost of any additional lending is likely to start converging with the pricing it would face from bond investors who don’t require that extra business revenue.
“It’s important for corporates to identify who they want in their bank group and what they want these banks to be doing,” says Mr Boyd. “They should deliberately allocate their ancillary business, whether it requires capital commitment or not, to get the most from their banking relationships and balance the objectives of best pricing and best execution.”
