BasleMr. Christian Marlier, How Will Banks Assess SMEs

7/29/2019 BasleMr. Christian Marlier, How Will Banks Assess SMEs

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Mr. Christian Marlier

After Basel II:

How Will Banks Assess SMEs?



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



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 G10Central Banks

What Is Basel II?



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



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



“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

Why a New Accord?



7

Comparison of Basel Accords

Greater Risk

Sensitivity

Broad Brush

Menu of

Approaches

One Size Fits All

Three PillarsFocus on Single

Measure (Capital)

2004: Basel II1988: Basel I



“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

SMEs are Important to Banks



9

Banks are Important to SMEs

2002 Survey of 7,750 European SMEs

• Most SMEs depend on Banks for externalfinance

• In previous 3 years, 76% of SME loanrequests were granted

• Collateral requirements problematic

• Cost (Interest and Fees) higher for SMEsSource: EU Website



10

Impact of Basel II on Loan Price

Cost Factor Affected by Basel II?

Cost of Funds NoCost of Capital Yes

Cost of Risk

Cost of Overheads

Yes

PossiblyProfit Margin No



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Changed Capital Requirement

Minimum Regulatory

Capital

Capital

(Credit & Market) Risk adjusted assets

= 8%

Minimum RegulatoryCapital

Capital

Credit

risk

Operational

risk

Market

risk

=+ +

8%

Basel II

Basel I



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PILLAR 1 PILLAR 3 PILLAR 2

Increased

Supervisory

Power

Increased

Disclosure

Requirements

Minimum

Capital

Requirement

Market

Discipline

Requirements

Supervisory

Review

Process

Rules

To Calculate

Required Capital

New Regulatory Structure Based on Three Pillars

CapitalAdequacy

Basel II – the 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 frominadequate 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 CreditRisk

• Operational Risk (OR) will add to banks’regulatory capital requirements

• Increased cost for OR might offset any capitalsavings on Credit Risk

• Operational risk is not restricted to banks, it’s 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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1. What is the probability of a

counterparty going into default?

2. How much will that customer

owe the bank in the case of

default? (Expected Exposure)

3. How much of that exposure

is the bank going to lose?

“Probability of Default”

“Loan Equivalency”

(Exposure at Default)

“Severity”

(Loss Given Default)

PD

LGD

EaD

=

=

=

X

X

Size of Expected Loss “Expected Loss“ EL=

=

Components of Credit Risk



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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 borrower’s creditworthiness.

• A loan should, therefore, be priced to reflect how

much risk it involves.



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Expected Loss

(EL) =

Probability of

Default(PD)

Severity of Loss

(LGD)

Exposure at

Defaultxx

Standardised = External x Regulatory x Regulatory

Rating Imposed Imposed

IRB = Proprietary x Regulatory x Regulatory

Foundation Rating Imposed Imposed

IRB = Proprietary x Proprietary x Proprietary

Advanced Rating Severity Exposure

Credit Risk Components



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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

Advanced IRB

Approach

- One size fits all - No capital incentives

for better Credit Risk

- Risk based

- Incentive to manage risks

Simple

Low level of detail

Sophisticated

High level of detail

High sensitivity to riskLittle sensitivity to risk

Foundation IRB

Approach

Management

(Internal Ratings

Based)(Internal Ratings

Based)



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Standardised Approach

• Similar to current Basel I method

• 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



22

Foundation Internal Ratings Based

ApproachComponents provided by banks:

- internal ratings (probability of default -

requires sophisticated database)

Components provided by Basel Accord

- loss given default ; exposure at default;maturity



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



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Treatment of SMEs

Two broad categories:

• Retail

• Corporate

Apply under Standardised Approach and under

Internal Ratings Based ApproachSubject 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 includesSmall 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 reducecorporate 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 Retail20% €1.60

50% €4.00

100% €8.00

Basel II

StandardisedApproach

€100 X

150%

X 8% =

€12.00

€100 X 75% X 8% = €6.00

€5m €50m

*11.3% - 14.4% €0.90 to €1.16 4.45% €0.36

X €100 X 8% =

X

Basel II

IRB Approach

(PD 0.03% to 20%;LGD 45%)

188% to 238%

X 8% =

€15.07 to €19.06

€100 X

100.3% €8.02

From Basel II Annex 3*Shows Firm – size adjustment effect

for Sales of €5m and €50m



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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 Informationfrom customers



30

Likely Response of European

Banks

• Banks’ responses to Basel II will vary

- No clear agreement on Pricing implicationsof 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.

BasleMr. Christian Marlier, How Will Banks Assess SMEs

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