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Mr. Christian Marlier
After Basel II:
How Will Banks Assess SMEs?
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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
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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?
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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
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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
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“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?
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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
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“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
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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
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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
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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
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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
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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.
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