Slide 1: Mr. Christian Marlier After Basel II: How Will Banks Assess SMEs?
Slide 2: 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 2
Slide 3: 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
Slide 4: 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 4
Slide 5: 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 5
Slide 6: Why a New Accord? “The fundamental objective of the Committee’s 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
Slide 7: 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 7
Slide 8: 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
Slide 9: 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 9
Slide 10: Impact of Basel II on Loan Price Cost Factor Cost of Funds Cost of Capital Cost of Risk Cost of Overheads Profit Margin Affected by Basel II? No Yes Yes Possibly No 10
Slide 11: 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% 11
Slide 12: 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 12
Slide 13: 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 13
Slide 14: 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, it s present in all organisations including yours 14
Slide 15: 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 15
Slide 16: 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 16
Slide 17: Credit Risk " Basel II places emphasis on improving the management and measurement of credit risk " The measurement of credit risk implies assessing the borrower s creditworthiness. " A loan should, therefore, be priced to reflect how much risk it involves. 17
Slide 18: Credit Risk Components Expected Loss (EL) = Probability of Default (PD) x Severity of Loss (LGD) x x Exposure at Default Standardised = External Rating x Regulatory Imposed Regulatory Imposed IRB Foundation = Proprietary Rating x Regulatory Imposed x Regulatory Imposed IRB Advanced = Proprietary Rating x Proprietary Severity x Proprietary Exposure 18
Slide 19: 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 19
Slide 20: The 3 Approaches Standardised Approach Foundation IRB (Internal Ratings Approach Based) 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 20
Slide 21: Standardised Approach " Similar to current Basel I method • " " " " 21 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
Slide 22: 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 22
Slide 23: 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 23
Slide 24: Treatment of SMEs Two broad categories: " Retail " Corporate Apply under Standardised Approach and under Internal Ratings Based Approach Subject to quantitative and qualitative factors. 24
Slide 25: 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. 25
Slide 26: 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. 26
Slide 27: 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 Basel II *11.3% - 14.4% €0.90 to €1.16 X IRB Approach X 8% = €100 (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 4.45% €100 X 100.3% X 8% = €0.36 €8.02 27
Slide 28: 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) 28
Slide 29: 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 29
Slide 30: 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. 30
Slide 31: Basel II Impact on SMEs " Risk Sensitive Credit Access and Pricing: Lower Rating -> Higher Risk -> Higher Price Higher rating -> Lower Risk -> Lower Price 31
Slide 32: 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? 32
Slide 33: 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. 33