Capital Adequacy: Is Your Company Prepared For Basel II Implementation?

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1 Capital Adequacy: Is Your Company Prepared For Basel II Implementation? By Stephen McCrory The final draft of the Basel II Accord on banking, titled International Convergence of Capital Measurement and Capital Standards, has been introduced, but for those preparing for its implementation, its interpretation remains a moving target. Predominantly a banking accord, Basel II has far-reaching effects on all industries, including leasing, according to preliminary interpretation. Working with the Equipment Leasing and Finance Foundation (the Foundation), White Clarke North America (WCNA) prepared a white paper to provide an overview of the Basel II Accord and how it is subject to national regulatory review. In addition, the paper identified key issues facing the U.S. leasing industry with regard to implementation and potential effects. The white paper also gave details of a recent Basel II Readiness Survey undertaken by the Foundation. The new Basel Accord attempts to strengthen the soundness of the international banking system while ensuring that the regulations are not a source of inequality among internationally active banks. Basel II has enhanced the original Basel Accord's approach to a bank's capital adequacy by moving from the previous one-size-fits-all method to a three-pronged approach to capital allocation focusing on minimum capital requirements, supervisory review process, and market risk. Within the capital requirement approach are three levels of sophistication with respect to the evaluation of credit risk. The original timetable for the accord's implementation was January 1, 2007, after a parallel period through The parallel period was subsequently changed from January 1, 2006, to December 31, 2007, with a go-live implementation date of January 1, However, in the United States, it is highly likely federal regulators will intervene with respect to the timing of Basel II's implementation. U.S. regulators have already commissioned a number of studies into the potential effects of Basel II on the banking industry, including the hypothesis that Basel II will lead to increased bank consolidation. There is concern within the financial services industry that the positive impact on capital allocation, Basel II compliant financial institutions are expected to enjoy may result in these institutions looking at non-basel II compliant financial institutions as potential acquisitions. The potential is more evident for those institutions implementing the most advanced credit and operational risk approaches under the new accord. These approaches would free up the most capital and make these institutions potential acquisitors of less advanced competitors, especially those banking portfolios with high retail content. To address these concerns, the Basel Committee on Banking Supervision has incorporated transitional arrangements for those institutions adopting the advanced internal ratings-based (A-IRB) approach to credit risk and the advanced measurement approach (AMA) for operational risk. (The Basel committee was established in It is comprised of members from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. Countries are represented by their central bank or, where this is not the central bank, by the authority with formal responsibility for the prudential supervision of banking business.) This arrangement will establish a capital floor following implementation to limit the amount of The complete version of this study may be found in the Foundation library at

2 Basel II's approach to maturity calculations imposes short-term maturity dates on long-term leases for capital allocation purposes, the impact being additional capital charges due to the long-term debt structure. capital relief that institutions may enjoy over this transition period. The floor will gradually reduce to 80% of current Basel I risk weights by the end of The committee may seek to take measures to keep floors in place beyond 2008 if necessary. The regulators are very serious about preventing unintended consequences (such as a host of mergers and acquisitions) as a result of Basel II. KEY ISSUES FACING THE LEASING INDUSTRY The key challenges facing the leasing industry appear to be as follow. Type of Legislation Only paragraphs 523 and 524 of the accord specifically address leasing. These paragraphs deal with the requirements for the recognition of leasing with and without residual value exposure. Accordingly, the industry is faced with application by association. Pricing Some pricing issues for the leasing industry include: How to price large-ticket leasing deals when only limited loss data is available. How to price small- to large-ticket deals where the lessee's return charges have gone into arrears but the finance receivable is up to date. The accord states that if one part of a connected account is in arrears, all connected accounts should be placed in arrears. For example, if charges with respect to a returned asset are not paid, the balance of any amount owing by the lessee on any other lease should also be placed in arrears. IT Integration Basel II presents several information technology issues including: Data. What data needs to be collected? How is information collected and presented, especially loss data? How much time must the data cover (such as, historically how many years)? Parent consolidation: Aggregation of receivables and losses across the financial institution. Segmentation: Segmentation of receivables extended across the financial institution. Warehousing: How to store data for ease of retrieval across multiple systems. Systems: Whether to convert, acquire, or enhance. Maturity Basel II's approach to maturity calculations imposes short-term maturity dates on long-term leases for capital allocation purposes, the impact being additional capital charges due to the longterm debt structure. The actual maturity dates of long-term leases are not used. Instead an arbitrary time period set out under the accord is used in the calculation that establishes the capital charge. Residual Value-Based Products The treatment of residual value under Basel II is a concern to leasing companies. Leasing industry experts have developed three interpretations with respect to the allocation of capital on residual values under Basel II. All three will result in a capital charge although both interpretations B and C would most likely produce a lower capital charge than under interpretation A). The three interpretations are described below. There is still an opportunity to present these alternatives to the regulators in an effort to obtain their agreement to the suggested capital allocation calculation for residual value-based structures. The industry is organizing a lobbying effort through the collective efforts of the Equipment Leasing Association. 2 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G W I N T E R V O L. 2 3 / N O. 1

3 POTENTIAL INTERPRETATIONS OF RESIDUAL VALUE A. 100% Capital Allocation Interpretation All residual value-based products would have 100% capital allocation applied to their structures. This is felt to be onerous given the risk mitigating effect of the collateral. The financial industry was looking for some relief from the original accord but it appears none is contemplated. B. Fair Market Value Interpretation Residual value risk in a lease transaction is defined in paragraph 524 (Basel II) as the bank's exposure to potential loss due to fair value of the equipment declining below its residual estimate at lease inception (residual value). Fair value refers to the weighted average cash flows associated with the equipment "price risk" value at the end of the lease. Under this interpretation, residual value would only be risk-rated at 100% if the residual value (booked at inception of the lease) is greater than fair value of the asset. If this were the case, the transaction would be exposed to residual value risk and the two components (receivable and residual) would need to be segregated. C. Proprietary Investment Interpretation This interpretation uses the rules created by Basel II to determine risk capital requirements for investments held by banks. Under this scenario, the residual portion of an asset is being treated as an investment by the bank. This interpretation would require extensive analysis based on external data of the volatility of asset values. Because of the nature of these assets, the model measures risk capital as the difference between booked residual value and distressed value. So what is Basel II's impact on the U.S. leasing industry? Many leasing companies are saying Basel II does not affect them, that they are not a bank, or that they are not part of a major top 10 bank. Although these comments may be accurate for the parties involved, here are some other considerations: Some banks with leasing companies will be affected by Basel II. The survey conducted by the Foundation, combined with WCNA's own research, indicates far more U.S. financial institutions are adopting Basel II capacity. The rating agencies (such as Moody's and Standard & Poor s) are looking more favorably at Basel II as a rating-based indicator than previously thought. Financial institutions looking to implement best practices will need to employ Basel II practices, to ultimately improve risk management. Major financial institutions will look to switch capital requirements by product suite across the portfolio freeing up tactical capital on demand. What is surprising and contrary to initial expectations of the survey's results is the number of financial institutions appearing to be progressing toward Basel II compliance. U.S. regulators are expecting the 10 largest U.S. financial institutions to become Basel II compliant along with a number of non-u.s. parent finance institutions (European Banks such as HSBC Holdings PLC). However, based on the Foundation's survey results and White Clarke North America's own research, we believe the number of U.S. financial institutions adopting Basel II is materially higher. Bank-owned leasing companies will find themselves caught in Basel II's regulatory net. Independents will be touched through lending arrangements and changing product mixes. Transparency will be increasingly evident, as many institutions will move to higher standards for business. Risk should be better identified and evaluated, and priced appropriately. Operational risk will be acknowledged and priced into future transactions. In effect, the playing field should be leveled for those competing within the Basel II U.S. regulators are expecting the 10 largest U.S. financial institutions to become Basel II compliant. However, we believe the number of U.S. financial institutions adopting Basel II is materially higher. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G W I N T E R V O L. 2 3 / N O. 1 3

4 Recently, an error was discovered in a federal guidance notice used to calculate capital levels for certain products. The error could have resulted in a significant underestimation of required capital. framework, resulting in an enhanced approach to risk and risk-mitigation techniques. White Clarke and the Equipment Leasing and Finance Foundation recently conducted an industry survey on Basel readiness. Here are some key findings: 1. Leasing companies exhibit varying levels of understanding and preparedness with respect to the implementation of Basel II. This lack of readiness is a cause for concern. Recently, an error was discovered in a federal guidance notice used to calculate capital levels for certain products. The error could have resulted in a significant underestimation of required capital. Ironically, the error was found by a bank that was thoroughly reviewing the calculations and not by the regulators. This only serves to underscore the complexity of the accord and the need for careful attention to detail. 2. Very large and internationally active banks are becoming compliant. Remaining institutions will operate under Basel I regulations. This may encourage future merger and acquisition activities. 3. There are definite challenges with respect to implementation of approaches to credit risk evaluation; the introduction of a capital charge for operational risk; alignment of IT systems and procedures for Basel compliance; and production, capture, and retention of required data on a consistent and ongoing basis across all business lines. 4. The interpretation of residual value capital allocation under Basel II remains unclear. The equipment leasing industry must put forth a unified interpretation to the regulators. 5. Reconfiguration of the industry will affect the leasing industry in many ways including product mix, pricing, and financing alternatives. 6. Many leasing companies are looking for the best method of preparing for implementation. 7. There is an immediate need to start data and systems evaluation and begin accumulation of necessary data. 8. Model building, testing, and working with regulators must begin immediately to ensure the process is consistent with the accord's parameters. 9. To align operations to Basel II standards, transition planning and execution must occur over the next several years. Organize a team, work with outside resources, gap current systems, and align as closely as possible with Basel rules. 10. Each company should analyze and evaluate its position against competitors, vis-à-vis Basel compliance to project any potential direct and indirect impacts on its business. 11. Identify and move toward products receiving favorable Basel treatment. Basel II will change the way many banks do business and what product lines they choose to offer. It may also cause merger and acquisition activity as Basel II compliant banks seek out existing Basel I compliant banks with strong retail portfolios. Implementation of the accord will take several years. However, lessors that align their business practices with Basel II standards now will be best positioned to identify new areas of growth as well as niches created as banks shift capital to support other product lines. There is strong opportunity for growth in leasing fueled by these regulatory changes. The challenge will be to understand the Basel II Accord's implications on business lines and how to fill voids created by financial institutions as they comply with Basel II requirements. Acknowledgment This article was developed in partnership with the Equipment Leasing and Finance Foundation and its Basel II Advisory Group. For more information on the Basel II Accord visit 4 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G W I N T E R V O L. 2 3 / N O. 1

5 Stephen A. McCrory Stephen A. McCrory is a consultant with White Clarke North America in Toronto, Ontario, Canada, with particular emphasis on Basel II and other bankrelated issues. Mr. McCrory has spent several years as a consultant in the structured finance and securitization industries in Canada. Prior to opening his consulting practice in 1991, he was engaged in the asset-based lending, factoring, and banking businesses and was formerly a vice president of Bank of New York Canada. Consulting clients have included major banks in Canada, Industry Canada, and several companies in the leasing and systems industries. Mr. McCrory holds a bachelor of commerce degree from Concordia University in Montreal, Quebec. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G W I N T E R V O L. 2 3 / N O. 1 5