Effects of Basel II on commercial real estate lending.

Basel II is important to any business whose profitability is linked to cost of funds provided by banks.

This new government regulation will come into effect in both Europe (January 2007) and the United States (2008). It primarily concerns the amount of capital that banks must hold in their reserves.

Under Basel I, banks were required to hold capital equal to 8% of the balance of all assets.

Under Basel II, the capital percentage will be evaluated on a case-by-case basis and for low risk assets it will be greatly reduced.

In the US, only the largest banks will need to adopt Basel II, and the vast majority will be under a modified version of Basel I called Basel IA. The net effect will be a fall in lending rates for all commercial real estate loans and a redistribution of assets, with the Basel IA banks are taking the lower quality assets.

The Structure of Basel H for Commercial Real Estate Banks under Basel IA will most likely continue to require capital equal to at least 8% of the outstanding loan for commercial real estate (CRE).

Basel II bases the amount of capital on the banks' in-house risk models. The two main risk factors that are considered in the calculation of capital are the probability of default (PD) and the loss given default (LGD).

The Basel equation allows capital to vary approximately as the square root of PD and linearly with LGD. For example, a four-fold reduction in PD is needed to halve the capital requirements, whereas only a two-fold reduction of LGD is needed for the same halving effect.

The graph below shows the Basel IA and Basel II capital for a range of assets with different credit grades (here the capital for Basel II assumes 3 year maturity and 25% LGD). The graph shows that for assets below BB-, capital costs are cheaper for banks operating under Basel IA, however, for low risk assets, the capital under Basel II is significantly less than 8%.

Assuming a 10% cost of capital, this translates into a drop in the funding cost, of up to 60 basis points.

The cost of capital can be lowered further if an asset can be classified as a trading asset, and therefore treated under Basel's Market Risk approach, which avoids counting the risk of default events. This will greatly increase the push to create vanilla loans that can be bundled into CMBS.

One of the consequences of this new arrangement will be when lending to high quality assets, banks under Basel II will be able to make more profit, or drop their rates, while maintaining the same profitability. This will crowd the Basel IA banks into the lower quality assets. If bank management are not aware of this trend, they will unexpectedly find that the quality of the portfolio has deteriorated. The best safeguard against this is strong internal risk measurement.

For the Basel II banks, the challenge will be to maintain their competitive advantage and avoid being dragged into a low-margin business. They can do this if they are able to structure the sophisticated non-vanilla deals to have low risk and good margins. This means having risk measurement tools that separate them out from the pack and allow them to create specialized assets where the effects of innovative deal structures are reflected in lower PDs and LGDs.

This sophisticated use of models for deal structuring continues the trend whereby CRE lenders are becoming more like options traders, using both their gut and their own proprietary models to reflect their market view.

In the long term, the market will rearrange itself to have vanilla CMBS assets, assets with sophisticated structures that allow them to be classified as low risk, and high risk assets with high margins held by the Basel IA banks. However, the path to that point is filled with both risk and opportunity.

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BY CHRIS MARRISON, FOUNDER & CEO, RISK INTEGRATED