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ention Basel II to many FDs and you’re likely to get a reaction along the lines of: “Oh, yes. I know about that, but it’s just a banking thing. It won’t really affect my business.” This, unfortunately, is wishful thinking on their part. The revised framework issued last June by the Committee on Banking Supervision at the Bank for International Settlements in Basel will affect all but the very largest corporate borrowers – and it could have an even bigger impact on those that aren’t adequately prepared for its new rules. To understand Basel II you need to go back to Basel I, the first concerted attempt by the global banking industry to apply a consistent set of risk assessments to commercial lending. It required banks to categorise their lending according
The Basel II accord will affect many more industries than banking when it takes effect in 2007. Mike Brooks explains its rules – and how to ensure that your business won’t suffer from the way lenders will implement them.
to the perceived probability of default by the borrower. The level of capital adequacy that banks were required to carry to satisfy national solvency requirements were determined largely by the allocation of tranches of lending to each category. But these categories were not borrower-specific and most banks made their allocations on very broad principles. Both large and small companies could, therefore, find themselves allocated to the same risk categories. Given the fixed costs of lending, this meant that banks were more willing to lend large amounts to large borrowers than small amounts to small borrowers in the same category. The principal innovation of Basel II is that the banks must base their allocations on individual assessments. This allows
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SAMPLE PROPOSAL TO A BANK Assumption: a seven-year loan with a two-year grace period and a five-year repayment period at an interest rate of ten per cent.
Current business plan – “base case” Revenues Costs Operating cash flow Current debt service Free cash flow Current business plan – “low case” Revenues Costs Operating cash flow Current debt service Free cash flow Project expenditure and borrowing Capex Incremental revenues Incremental costs Net project cash flow Financing Additional debt service Incremental free cash flow Business plan with project Revised free cash flows – base case Revised free cash flows – low case Operating cash flow to debt service ratio Base case Low case
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
1,000 600 400 100 300
1,050 625 425 100 325
1,100 650 450 100 350
1,160 690 470 100 370
1,220 720 500 100 400
1,280 750 530 100 430
1,350 800 550 100 450
1,000 600 400 100 300
1,000 640 360 100 260
1,050 680 370 100 270
1,100 710 390 100 290
1,100 750 350 100 250
1,150 800 350 100 250
1,150 850 300 100 200
250
250 300 40 260
350 50 300
350 50 300
400 50 350
400 50 350
– 250 250
– 250 250
0
0
155 105
155 145
155 145
155 195
155 195
300 300
325 260
455 375
515 435
545 395
625 445
645 395
4.00 4.00
4.25 3.60
2.78 2.47
3.02 2.71
3.14 2.55
3.45 2.75
3.53 2.55
From the above, it can be shown that the extra borrowings can easily be serviced by the operating cash flow, even under the low case. But, if the bank requires a ratio of, say 2.75:1 or more, the model can be adjusted to identify the amount and term of a loan that will satisfy this requirement. A further project low case could be added to provide extra confidence regarding the downside risk.
corporate borrowers who can show that their individual circumstances warrant a more favourable probability-of-default assessment to reduce their borrowing costs. Basel II goes even further than corporate lending. Its requirements represent a change of priority in the global financial services industry. The old rules of thumb are now seen as inadequate to manage the range of risks that lenders face and Basel II represents a more focused approach. It’s likely that the new emphasis will be felt in areas such as insurance and fund management and in transaction banking issues such as the new UK money-laundering laws. It will be felt whether or not Basel II becomes legally binding – the European Commission has already published a draft directive on this issue, which it plans to make effective by 2007. The objective of Basel II is to harmonise banks’ risk assessment processes and make them controllable by the relevant national supervisory bodies. It requires banks to subject all loans worth more than €1m (£690,000) to a defined rating
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process and allocate them to different risk categories. They must make separate assessments of each borrower and each loan, which must be documented and reassessed periodically. This does not mean that sums of less than €1m will escape the system. Once a bank has implemented Basel II, it’s likely to use the same method for assessing all material loans. Basel II does not specify an assessment system. It allows banks to choose between two broad approaches: a standardised measure supported by external assessments or their own rating method. A bank that wants to use its own system – known as the internal rating-based approach (IRB) – needs the approval of its national regulator. Each loan, therefore, will be assigned a risk weighting and the overall capital requirement of each bank will be based on the aggregate of its weighted assets. Basel II prohibits the allocation of risk weightings based on factors other than objective assessment and it severely limits the discretion of individual bankers to categorise certain borrowers more favourably
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than such an assessment would allow. This does not mean, of course, that subjective judgments have no place in these assessments, or that certain customers will no longer receive favourable treatment. But it does mean that such customers’ borrowings must be allocated to the categories that they deserve and that the banks will have to take any extra capital requirements as a result of this on the chin. Although most banks are expected to use their own IRBs, some, particularly the smaller ones, will need to resort to external assessment, at least at the outset. The external credit assessment institutions (ECAIs) they use for this must be approved by national regulators. Potential borrowers will not be able to rely on a credit rating that they themselves have initiated. Banks won’t be allowed to cherry-pick ratings from different ECAIs, either. IRBs will be largely opaque for many borrowers, but we can shed some light into this black box by examining some of the principles that Basel II will require banks to incorporate into their rating processes: ■ A bank must have specific rating definitions, processes and criteria for assigning risk exposures to grades within a rating system. The rating definitions and criteria must be both plausible and intuitive, resulting in a meaningful differentiation of risk. ■ To ensure that banks are consistently taking available information into account, they must use all relevant and material information in assigning ratings. ■ Information must be current. ■ The less information a bank has, the more conservative it must be in its assignments of risk exposures to borrower and facility grades or pools. An external rating can be the main factor determining an internal rating assignment, but the bank must consider other relevant information. In determining which information is relevant, banks are expected to look at the following factors for each borrower: ■ Its historical and projected ability to generate cash to repay its debts as well as to support other cash requirements – eg, capital expenditure and working capital. ■ Its capital structure and the likelihood that unforeseen circumstances could adversely affect its solvency. ■ Its quality of earnings with particular regard to its reliance on non-recurring sources of income. ■ The degree of operating leverage and the effect that varying levels of activity could have on profitability and cash flow. ■ The level of financial flexibility it has from its access to other sources of finance. ■ The quality of its management team. ■ Its position in its industry or market segment. ■ The risk characteristics of its main countries of operation. Before outlining how a borrower may best deal with this, it’s important to realise that many banks won’t necessarily be explicit about the information they request. They may ask for certain items in an apparently piecemeal and unstructured way. This may be because they believe that they have some of the information they need already, or that they can obtain it from other sources. The danger to the borrower of this approach is
obvious: it will not be in control of the process by which its lenders form their view of the probability of default and, therefore, the risk category to which it will be assigned. Some banks may prefer this opacity, because it gives customers no scope for challenging the terms of any loan facility offered to them. But borrowers cannot afford to submit passively to the process of risk assessment. Armed with their knowledge of the ratings criteria, they can put together the whole package of information required by the banks, whether it’s solicited or not. There’s little doubt that most competent finance departments will be able to collate the required information fairly easily. Deciding how to present it may be harder. How do you do it without appearing either unreasonably optimistic or providing all the material that a conservative banker might need in order to justify refusing your application? It’s particularly important to acknowledge the risk factors. If borrowers don’t do this willingly, there’s a danger that the assessment will be made by people who don’t know their business and who’ll probably err on the side of caution if in doubt. Your presentation must, therefore, include a low case that sets out the consequences of a plausible, if unlikely, occurrence – for example, the loss of a major customer. By all means explain how you would deal with such a problem. And make sure that the timescale of the business plan covers not only the period of the facility but also the normal business cycle of the activity for which you are seeking finance. While you’re putting your presentation together, it’s worth bearing in mind that bankers are human. (Some bank customers might dispute this, but let’s assume that it’s true for the sake of argument.) They may be conservative by nature, but their ambitions are similar to those of anyone else in business. They realise that they will benefit their careers by making good lending decisions. While they would rather refuse a good proposal than unknowingly accept a major risk, if the information you give them doesn’t support a decision to lend, they won’t often take the personal risk of putting it in front of their credit committee. This means that presentation as well as content is crucial – it’s likely that more applications for commercial loans are turned down for poor presentation than for poor content. Bankers’ time is limited and they won’t often be prepared to plough their way through a turgid and over-detailed data package. By understanding the workings of the loan assessment process under Basel II and providing a balanced answer to the issues that their banks must take into account, informed borrowers will be able to ensure that their bankers view their applications possessing specific knowledge of their business. In this way, they should increase their chances of securing the finance they need – at a price they can afford and on terms that are beneficial to both borrower and lender. F M
It’s likely that more applications for commercial loans are turned down for poor presentation than for poor content
Mike Brooks FCMA is a business writer and consultant. FIN A NCIA L May 2005 M A N A GEM EN T
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