Mr.

Christian Marlier

After Basel II:

How Will Banks Assess SMEs?

Purpose of this Session

Explain Potential Impact on SMEs
Possible Higher Loan Costs More information required

Show Potential Benefits for SMEs

Possible Lower Loan Costs Greater Transparency

Prelude to Afternoon session on SME Access to Finance

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What Is Basel II?

A New Standard for the Measurement of Risks in Banks, and for the Allocation of Capital to cover those risks.
Published by the Basel Committee of G10 Central Banks

What Does Basel Committee Do?

Acts as Think-Tank for banking regulators Issues guidance on best practice for banks Standards accepted worldwide Generally incorporated in national banking regulations

Why Does Basel II Matter to SMEs?

Changes How Banks Measure Risks
Greater Sensitivity to Customer Risk

Changes How Banks Allocate Capital for Unexpected Losses Changes Information Published by Banks Changes Customer Information Needed by Banks
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Why a New Accord?

The fundamental objective of the Committees work has been to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks. The Committee believes that the revised framework will promote the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits
Basel Committee on Banking Supervision, June 2004

Comparison of Basel Accords

1988: Basel I
Focus on Single Measure (Capital) One Size Fits All Broad Brush

2004: Basel II
Three Pillars Menu of Approaches Greater Risk Sensitivity

SMEs are Important to Banks

If we are to promote growth by strengthening the banking sector, the Basel Committee must act in a manner that benefits banks and their ultimate customers as well. We must recognise that fair and reasonable access to credit matters, not just because credit helps small businesses to grow, but more importantly because small businesses help the economy to grow.
Mr Jaime Caruana, Governor of the Bank of Spain Chairman of the Basel Committee on Banking Supervision Brussels, July 2003

Banks are Important to SMEs

2002 Survey of 7,750 European SMEs Most SMEs depend on Banks for external finance In previous 3 years, 76% of SME loan requests were granted Collateral requirements problematic Cost (Interest and Fees) higher for SMEs
Source: EU Website

Impact of Basel II on Loan Price

Cost Factor
Cost of Funds

Affected by Basel II?

No

Cost of Capital Cost of Risk Cost of Overheads

Profit Margin

Yes Yes Possibly

No

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Changed Capital Requirement

Basel I
Minimum Regulatory = Capital

Capital

8%

(Credit & Market) Risk adjusted assets

Basel II
Minimum Regulatory = Capital Capital Credit + Operational + Market risk risk risk

8%

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Basel II the Three Pillars

Capital Adequacy
PILLAR 1 PILLAR 2 PILLAR 3

Minimum Capital Requirement

Rules To Calculate Required Capital

Supervisory Review Process

Increased Supervisory Power

Market Discipline Requirements

Increased Disclosure Requirements

New Regulatory Structure Based on Three Pillars

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The Risk Categories in Basel II

Credit risk the risk that a borrower or counterparty might not honour its contractual obligations Very relevant to SME Market risk the risk of adverse price movements such as exchange rates, the value of securities, and interest rates Less relevant to SME Operational risk the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events NEW
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Operational Risk
Capital requirement for Operational Risk (OR) introduced Banks OR models not as developed as for Credit Risk Operational Risk (OR) will add to banks regulatory capital requirements Increased cost for OR might offset any capital savings on Credit Risk Operational risk is not restricted to banks, its present in all organisations including yours
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Credit Risk Key Points

The main area of banks exposure to SMEs Credit risk is main source of problems at banks Effective management of credit risk is critical for all banks

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Components of Credit Risk

Size of Expected Loss Expected Loss

EL =

1. What is the probability of a counterparty going into default?

Probability of Default

PD X

2. How much will that customer owe the bank in the case of default? (Expected Exposure)

Loan Equivalency (Exposure at Default)

EaD X

3. How much of that exposure is the bank going to lose?

Severity (Loss Given Default)

LGD

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Credit Risk
Basel II places emphasis on improving the management and measurement of credit risk The measurement of credit risk implies assessing the borrowers creditworthiness. A loan should, therefore, be priced to reflect how much risk it involves.

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Credit Risk Components

Expected Loss (EL)

Probability of Default (PD)

Severity of Loss (LGD)

Exposure at Default

Standardised = External Rating

x Regulatory
Imposed

Regulatory Imposed

IRB Foundation

Proprietary x Rating

Regulatory Imposed

Regulatory Imposed

IRB Advanced

Proprietary x Rating

Proprietary Severity

Proprietary Exposure

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Credit Risk Approaches

For each portfolio, the banks must choose One approach from a set of Three:
Standardised Approach Foundation Internal Ratings Based Approach Advanced Internal Ratings Based Approach

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The 3 Approaches
Standardised Approach
Foundation IRB (Internal Ratings Based) Approach Advanced IRB (Internal Ratings Based) Approach

- One size fits all - No capital incentives for better Credit Risk Management

Risk based Incentive to manage risks

Simple Low level of detail Little sensitivity to risk

Sophisticated High level of detail High sensitivity to risk

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Standardised Approach
Similar to current Basel I method

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New risk weights (0%; 20%; 50%; 100%, 150%) used for assessing capital required. Uses External Ratings (where available) Unrated (most SMEs) weighted at 100% 35% weight for claims secured by Residential Mortgage 100% weight for claims secured by Commercial Mortgage

Foundation Internal Ratings Based Approach

Components provided by banks: - internal ratings (probability of default requires sophisticated database)
Components provided by Basel Accord - loss given default ; exposure at default; maturity

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Advanced Internal Ratings Based Approach

- Same principles as for Foundation Approach, but all items are provided by the bank, based on internally developed models - Capital charge - subject to a floor at 90 % in 2008 and 80 % in 2009

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Treatment of SMEs
Two broad categories: Retail Corporate
Apply under Standardised Approach and under Internal Ratings Based Approach Subject to quantitative and qualitative factors.

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Retail Criteria under Standardised Approach

(To achieve 75% capital weighting)
Exposure to person or small business Must be defined as a Product (list includes Small Business Facilities) Part of a Diversified Portfolio Maximum counterpart exposure 1m Portfolios must be managed on a pool basis.
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Corporate SME
IRB Treatment
Where Sales total is less than 50m A Firm-size adjustment to reduce corporate risk weight Sliding Scale 0% reduction at 50m sales, down to 20% at 5m.

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Examples of Capital Charges

Capital Required For 100 Unsecured Loan
Basel I
100 X 100% X 8% = 8.00

Corporate
Basel II
Standardised Approach 20% 50% 100 X 100% 150%
5m 50m
X

Retail
100 X 75% X 8% = 6.00

1.60 4.00 8% = 8.00 12.00

*11.3% - 14.4% 0.90 to 1.16 X IRB Approach 100 X 8% = (PD 0.03% to 20%; X LGD 45%) 188% to 238% 15.07 to 19.06 *Shows Firm size adjustment effect From Basel II Annex 3 for Sales of 5m and 50m

Basel II

4.45% 100 X 100.3% X 8% =

0.36

8.02

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Credit Risk Mitigation

Basel II allows banks to accept a wider range of collateral than under Basel I Subject to legal certainty test Eligible Financial Collateral Eligible IRB Collateral
Receivables and Real Estate (conditions apply)

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Timetable
Basel I for Credit Risk available until end-2007 Basel II simple and intermediate approaches optional from end-2006 Mandatory implementation end-2007 BUT IRB Banks are building databases Now Some banks seeking more detailed Information from customers

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Likely Response of European Banks

Banks responses to Basel II will vary - No clear agreement on Pricing implications of Basel II - Most major European banks expect to reduce capital needed for Credit Risk. - Large banks expect faster cost recovery.
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Basel II Impact on SMEs

Risk Sensitive Credit Access and Pricing:
Lower Rating -> Higher Risk -> Higher Price Higher rating -> Lower Risk -> Lower Price

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Issues For SMEs

What Basel Approach is your Bank using (Standardised, Foundation IRB or Advanced IRB)? Does your bank treat you as Retail or Corporate? What additional information does your bank want from you? How does your bank weight the risks in your business?
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What SMEs Can Do

To optimise your rating from your bank: Keep bank accounts within agreed limits Submit required financial reports promptly No surprises warn bank before any material changes Supply information requested but discuss any difficulty in complying Keep talking to your bank!

The Toolkit will help you to achieve this.

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