Credit Risk Management
Commercial Loan Market
Commercial loans are debt arrangements agreed upon by the lender (business) and borrower (financial institution) to cover operational costs or fund business projects. During economic downturn, financial institutions are cautious of their lending and consequently import strict regulations that force borrowers to pay a higher interest rate. The agreement between the lender and borrower in the market is documented in a “credit agreement.” In credit risk management, the most important components of the agreement describe the covenants, the security requirements, priority of payments and events of default.
Segmentation of Commercial Loan Market
Financial institutions use credit rating to qualify borrowers based on the lending conditions set. Hence, the commercial loan market is segmented to investment grade borrowers and non-investment grade borrowers. The purpose of the segmentation is to enable financial institution differentiate the loans they give to the two segments. Investment grade borrowers are individuals and businesses in the loan market that have a credit rating of BBB- or higher by Standards and Poor’s or Baa on Moody’ ratings (Caprio, 2013). Non-investment grade borrowers comprises on businesses that qualify for leverage loans and have a ratting of BB+ or lower.
Difference between Investment Grade Borrowers and Non-Investment Grade Borrowers
Composition
The investment borrowers segment comprises of well-established companies that are not making losses. However, the non-investment grade (leverage) borrower comprises of leveraged or non-performing companies (Bouteille & Coogan-Pushner, 2012). Other companies acquired by private equity firms as a form of buy-out can be leverage borrowers.
Lending Terms and Conditions
For investment grade borrowers, all the loans are parri passu implying that the lenders are treated equally without seniority. Contrastingly, non-investment borrowers are issued with loans that have different priorities. This condition is created so that in case of liquidation, some lenders can recover their money before others (Bouteille & Coogan-Pushner, 2012).
Loan Securities
Loans that are issued to investment borrowers are mostly unsecured. This is because the borrowers are well-established companies or commercial banks, which are allowed to take unsecured loans to maintain a relationship with lender. The borrower’s assets must secure all the loans in the case of non-investment borrowers (Bouteille & Coogan-Pushner, 2012). Large investment banks structure the loans to leveraged borrowers and they are distributed to investors in form of structured financial vehicles such as hedge funds.
Loan Yield and Funding structures
Investment borrowers are unfunded revolvers meaning that they take huge loans but do not necessarily need the cash at all times (Bouteille & Coogan-Pushner, 2012). However, non-investment borrowers are funded and their loans are high-yield because the borrowers need to high interest in return.
Terms and conditions of loans to Investment and Non-Investment Grade Borrowers
Non-investment grade borrowers present high risk to the lenders because they have very low credit rating score. As such, the lenders impose very strict rules to try to mitigate the risk in case of liquidation. The loan terms comprise of extensive covenants and debt structures, which provides seniority of bank debts with different maturities. Such loans are mostly underwritten where a pool of lenders come together to form a vehicle to offer the funding. Institutional investors commonly provide leveraged loans since they are more sensitive than bank they tend impose strict rules. These borrowers are required to secure their loans using some of their assets as collateral. In most cases, loans issued to leverage borrowers have a high interest so that the principal can be recovered within a short period. Additionally, non-investment borrowers need to repay their loans in a shorter period compared to investment borrowers. Considering that institutions rated as non-investment borrower are likely to be liquidated, the lenders need to protect their interest through prioritizing creditors. In summary, lenders impose very strict terms and conditions when issuing loans to borrowers in the non-investment market segment.
In the case of investment grade borrowers, lenders are lenient on the terms and conditions imposed because they want to maintain a good relationship. The banks maintain the relationship because it could lead to auxiliary services such as foreign exchange and advisory. The loan terms are standardized and the lenders rely on the covenant in the agreement and not the collateral. Since these borrowers borrow for long-term projects, they do not need to be funded for their operations. Their high credit scores provide them with an advantage because they can take unsecure loans from financial institutions that do not have high interest rates. In most cases, the lenders only earn a margin less than 1.5% on LIBOR. Additionally, the loans are not prioritized and lenders are treated equally.
Differences between Basel I, Basel II and Basel III
Basel capital regulatory framework is a risk management tool uses to assess bank’s capital adequacy. The international Basel Committee on Bank Supervision (BCBS) first introduced Basel I in 1988, which provided regulatory guidelines to the banking sector. Basel I provided specific measures that could be undertaken to reduce credit risk. In 2004, the BCBS came up with Basel II, which provided a series of rules in relation with the 1988 economic downturn. EU adopted Basel II in 2008 and the financial made the committee to realize the implications of bank credit risk to an economy. In 2010, adjustment to Basel II were made and Basel III was adopted (Capgemini, 2014).
Basel I
This framework provided a way to assess a bank’s risk management from the perspective of capital adequacy. The guidelines provided are not risk sensitive compare to Basel II and Basel III. Basel I set the bank’s minimum capital requirements and focuses on risk weighting of assets rather than the bank’s future portfolio. Different classes of assets are assigned predetermined risk weights such as cash (0%), mortgage backed securities (20%), uninsured residential mortgage loans (50%), and corporate debt (100%). Banks were needed to report off-balance sheet items such as unused commitments (Capgemini, 2014). The Tier calculations are simple and are calculated as
The tier 1 capital ratio = tier 1 capital / Total RWA
The total capital ratio = (tier 1 + tier 2 capital) / Total RWA
Leverage ratio = total capital/average total asset
Basel II
This was an improvement to Basel I guidelines and in this case it was risk sensitive while calculating the Bank’s capital. Small banks had the option to adopt more risk sensitive approach based on Basel I. Basel II introduced a 3-pillar approach to risk management (Capgemini, 2014). Pillar I provides that capital should be maintained based on credit, operational and market risk. Pillar II, which is the supervisory review is aimed at giving a response on the capital requirements to the banks. Additionally, it provides a framework on how to deal with other business risks such as systematic and liquidity risks. Pillar III focuses on market discipline by providing a set of guidelines on disclosure requirement that would allow investors to access the credit adequacy of any institution. As such, Basel II improved supervisory oversight to ensure banks reports on credit risk and capital management practices (Capgemini, 2014).
Basel III
This voluntary bank capital adequacy regulatory framework also focuses on market liquidity risk and stress testing. The comprehensive reforms adopted in Basel III focus on improving the banking sector to enable it to survival during economic shocks. It also aims to strengthen bank’s disclosures and transparency. Basel III focuses on minimizing systematic risk through countercyclical buffer that allow banks to accumulate capital in reserves during good times and utilize them during bad times. The risks addresses by Basel III are portfolio related and relevant to the macroeconomic environment. Further, the introduction of leverage ratios such as liquidity coverage ratio (LCR) aims to improve banking financial systems by reducing liquidity risks. Basel III enhances risk coverage by allowing provisions for counterparty risks and wrong way risks. Data governance and data requirements have also become stricter than in Basel I and Basel II (Capgemini, 2014).
Implementation of Basel III and Small and Medium Sized Enterprises (SMEs)
The aim of the proposed provisions in Basel III is to protect the global financial system from a crisis similar to that of 2008 (UEAPME, 2010). However, the guidelines in Basel III are unclear on the tradeoff between economic growth and financial stability. The policy makers still do not understand the impact that Basel III would have to lending SMEs and the inequality treatment it would create. Although lending to SMEs did not cause the 2008 financial crisis the economic downturn has affected theses businesses’ operations. The new capital and regulatory requirement framework highlighted in Basel III might greatly affect SMEs and the analysis on the impact aims to highlight areas that need to be changed (UEAPME, 2010).
The lack of quantitative SMEs data and a proper definition of the term might make it difficult to assess the impact Basel III would have on lending to SME (Datta, 2010) V. Even so, it is possible to highlight from the bank’s perspective the impact on financing SMEs. SME lending can be categorized as credit pricing and credit rationing. Under normal economic conditions, lenders who consider pricing as a lending factor are likely to provide more loans to SMEs. However, the recent provision in Basel III might force lenders to improve their risk models and reporting systems. Information would be available to SMEs implying that banks would not impose high interest rates and borrowers can use credit rating to access huge funds (Canales & Nanda, 2010). This implies that loans to SMEs would be price-based and not rationing based. Basel III changes provide that lenders need to demand for additional security and reduce unsecured lending to business (Ambler, 2011). SMEs with assets would be able to offer collateral but SMEs with no wealth will not be able to access credit forcing lenders to be rational-based.
In summary, lenders are likely to shift their assets from trading making funds available to borrowers including SMEs. However, lenders consider SMEs as riskier borrowers and improving their capital adequacy would require them to ration the lending towards them (Ambler, 2011). The lenders could in turn requests for deposits, which could create competition in the marketing allowing for ease access of loans to SMEs. Bank would likely have standardized loans for SMEs based on capital adequacy but this could lead to lack of information asymmetry causing rationing. Such changes in lenders behavior could affect the funding of SMEs both positively and negatively.
Bibliography
Ambler, T., 2011. How Basel III Threatens Small Businesses, Adam Smith Institute Briefing Paper (London: Adam Smith Institute) [Online] (Updated 14 Aug. 2016). Available at: <http://docplayer.net/4339959-How-basel-iii-threatens-small-businesses.html> [Accessed 14 Aug. 2016]
Bouteille, S. & Coogan-Pushner, D., 2012. The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures. New Jersey: John Wiley and Sons.
Canales, R., & Nanda, R., 2010. The Dark Side of Decentralized Banks: Market Power and Credit rationing in SME Lending. Harvard Business School Entrepreneurial Management, Working Paper no. 08-101, pp.1-32.
Capgemini, 2014. The ABCs of Basel I, II, and III: Key Aspects and Difference. [Online] (Updated 14 Aug. 2016). Available at: <https://www.capgemini.com/resource-file-access/resource/pdf/the_abcs_of_basel_i_ii_iii.pdf > [Accessed 14 Aug. 2016]
Caprio, G., 2013. Handbook of Key Global Financial Markets, Institutions, and Infrastructure, London: Academic Press.
Datta, D., 2010. Small Business Finance: Implication of Delay in Formal Sector. International Journal of Economics and Finance, 2 (4), 130–9.
UEAPME, 2010. New Capital requirements for Banks (Basel III). [Online] (Updated 27 October 2010). Available at: <http://www.ueapme.com/IMG/pdf/101027_Basel_III_assessment.pdf> [Accessed 14 Aug. 2016]
