Basel II - the revised framework and its effect on loan finance from a borrowers perspective

Abstract: This thesis is about the risk management of banks and how changes in regulatory capital charges can affect a borrower in the Swedish capital market. The thesis takes the perspective of a borrower but also explains how banks are affected by changes in regulatory capital requirements. The main focus is on changes in a borrower's situation and each of the parts in this presentation is intended to include various aspects of these changes. Basel II, or the International Convergence of Capital Measurement and Capital Standards: A Revised Framework was released in June 2004. It is meant to be fully implemented at the end of 2006. The effects of the new capital accord will be substantial and some of its effects on capital markets are probably appearing much earlier than the implementation date. The subject of this thesis is therefore highly relevant today even if the actual implementation is a few years away. Basel II is the new framework regulating how banks should calculate their capital in relation to their exposures. A banks capital is a safety cushion in the event of a counterparty defaulting on its commitment to pay interest or principal upon maturity. Basel II provides banks with a more accurate instrument for the measurement of risk than the first capital accord, Basel I, did. The first capital accord was issued in 1988 as a response to the increase in credit risk at the time. Basel I contained much less detail than Basel II, a fact that helped the first framework's international adoption and implementation process. For a borrower with good credit rating the first framework could be disadvantageous since corporate lending in Basel I is connected with the same regulatory risk weight regardless of the financial status of the borrower. This is not a reflection of the real risk involved and Basel II seeks to rectify such inaccuracies and adds the much-needed details that Basel I lacked. Besides adding the needed details for risk calculation the revised framework provides guidance for the supervision of banks through a new supervisory review process resting upon four key principles. The revised framework also promotes financial stability through increased market transparency and disclosure. Basel II will provide banks with an opportunity to use new models for the calculation of risk. The essence of risk management lies within the estimation of the risk of a counterparty failing on its obligations. If the risks were known and could be exactly calculated then banks would know precisely what amount of capital to keep as a buffer. It is, however, impossible to know the exact risk involved in a certain situation since there could be many factors behind a default. Each borrower is specific and the circumstances are never the same in two situations. The risks can derive from market fluctuations, or other reasons not easily foreseeable. What is also important to have in mind is that keeping capital as a buffer in case of a counterparty defaulting is expensive for banks, which will want as much return as possible on their funds through lending or investment activities. The best way to deal with this problem of risk uncertainty is to use all parameters possible and try to calculate the risk related to a certain exposure as accurately as possible. Basel II is intended to provide the banks with an instrument to perform these calculations. The new risk models will divide the banks along a spectrum with the banks allowed to use the most complex and sophisticated models at one end and the banks only allowed to use a standard model similar to the one in Basel I at the other. The standard model in Basel II is similar to the model in Basel I but with some significant changes. It is therefore easier to estimate the effects of the standard model compared to the more advanced ones. The new advanced risk models are not intended to jeopardize the financial system and soundness will be ensured through the national financial supervisory authorities which are given a much more defined role in the banking markets with Basel II. The Swedish Financial Supervisory Authority is both attaining the role as approver of the banks seeking to use the more advanced internal ratings based approaches in Basel II together with the role as provider of some of the risk estimates used for the calculation of risks in Basel II. This role could affect the impartiality of the FI since it will be working much closer to the banks and since it possesses the power to increase capital charges of a bank if its judgement of the bank's risks related to its capital does not give a satisfactory image of the banks ability to control a crisis. Basel II also imposes new capital requirements on banks regarding operational risk, which is the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events. This new requirement could affect a borrower in a number of ways since banks in the end will want to pass on the costs related to the operational risk capital charge to the borrowers even if the capital charge is not related to the borrowers but with the banks and their activities. Some borrowers will see lower capital charges connected with their borrowing with Basel II and others will face higher credit prices since their capital charges will go up. When capital charges for certain lending goes up banks will want to make sure through their loan agreements that they are reimbursed by the borrowers. I have therefore examined one of the standard loan agreements, used frequently in international syndicated lending to investment grade rated companies, and the possible Basel II related changes to the increased cost clauses in that agreement. The final draft of a loan agreement is much related to the negotiations between the borrower and the bank and negotiation will be a key element determining which party that will bear the Basel II related costs. The final changes to the agreement examined here will most likely be drafted to protect the banks against the increased costs that Basel II could bring about for certain categories of lending. One trend that is likely to repeat itself is the trend first seen after Basel I was implemented. When banks became able to predict the costs related to regulatory capital it became market practice to exclude Basel I related costs from the increased cost clauses. The exclusion of Basel I related costs from the increased cost clause meant that the banks did not have the right to be reimbursed if the costs for the loan increased due to an increase in regulatory capital. When banks are able to predict the practical impact of Basel II, these costs will probably be excluded from the increased cost clauses since the price of the loan is set with Basel II related costs taken into consideration. The general conclusion to be drawn is that borrowers with high credit ratings and strong financial positions will probably be the winners after the implementation of the revised framework. Large banks will probably invest in the complex risk models and measurement systems and will most likely see lower capital charges on highly rated credits and thus benefit from an allocation of capital towards such credits. It is however difficult to assess the outcome of the advanced risk models since every bank could adopt its specific model with specific results for each individual borrower. Although the risk models are more advanced they are not intended to have a negative effect on the overall financial soundness. The intentions are that the total amount of regulatory capital is to be sustained after Basel II implementation. There will, however, be some winners among the banks gaining from lower capital charges than with Basel I. For borrowers the fundamental difference between Basel I and the new framework in Basel II is that borrowing costs will to a much greater extent depend on a specific borrower's financial status. Lending to a poorly rated company, which in fact is a riskier counterparty for a bank, will be connected with higher capital charges than lending to a highly rated borrower. This means that the real counterparty risk will be taken into consideration in a better way than was possible under Basel I.