BASEL II - Part 1

The topic of BASELII is widely discussed, both by banks and, to an increasing extent, by lending companies. The following aspects are to be considered within the framework of this issue:

• Key features of Basel II
• Rating criteria

Background

In 1975 the Basel Committee on Banking Supervision was established. The objective of this committee is the development of an international banking supervision law or network in order to improve the quality of banking supervision. Members of the committee are representatives of the central banks and banking supervisory authorities of the G10 countries as well as Luxembourg. The committee usually meets at the Bank for International Settlements (BIZ) in Basel, where the permanent secretariat is also located. In 1988, for the first time, banking supervision regulations under the name Basel I were standardized with the aim of ensuring the stability of the banking sector by limiting the insolvency risk of banks.
The essential instrument of Basel I is the requirement to provide own funds as collateral for the loans granted, equal to 8% of the loan amount – regardless of the individual creditworthiness of the borrower.
Under Basel II, a comprehensive new regulation of banking supervision is meant to come into effect on January 1, 2007.

:: The three pillars of Basel II

Basel II consists of three pillars: the Minimum Capital Requirements #(#MINIMAL CAPITAL REQUIREMENTS), the Qualitative Supervision (SUPERVISORY REVIEW PROCESS), and Market Discipline (MARKET DISCIPLINE). While the second pillar describes the process of review by the supervisory authorities, market discipline is understood to mean the transparency of risk exposure and capital adequacy of credit institutions. At the heart of the discussion and currently particularly relevant for the credit industry is the aforementioned redesign of the capital requirements for credit institutions. The new regulation is attributed immense repercussions on the lending policies of banks.

:: Basel II regulates the own funds required for lending by banks, depending on the individual creditworthiness of the customer.

Due to the new capital requirements, banks are required in the future under Basel II to align their capital ratios to the quality of their loan portfolio in line with the risk. Borrowers are divided into different credit quality classes. A loan to a company with a poor credit rating must therefore be backed by more capital from the bank, which in turn increases the bank’s credit costs. These increased costs are then passed on to the company through poorer credit terms. The capital requirement principle remains unchanged at 8%, but this is significantly influenced by the approaches described below.

:: Three approaches for calculating credit risk

Basel II provides banks with three approaches with increasing risk sensitivity for calculating credit risk and thus for the capital adequacy ratio.

1. The Standard approach It is applied to external ratings or to companies that do not have any rating. An unsecured corporate credit is still classified as 100% of% own funds, as before. What is new is that non-performing loans (claims due for more than 90 days) are subject to a 150% of 8%, i.e., a total of 12% equity capital requirement.

2. The Basic IRB approach (Internal Rating Based) is based on internal bank ratings (ratings). This approach enables a much more accurate and individual risk assessment of loans. However, for non-performing loans, this can in the worst case mean a capital buffer of up to 562.5% of 8% (45% EK buffer).

3. The Advanced IRB approach Refines the bank’s internal rating processes. While in the basic IRB only the probability of default is assessed by the bank, with this approach the bank can also assess the default rate, the amount at the time of default, and the remaining maturity of a loan. The choice of one of the three approaches or a combination thereof is in principle at the bank’s discretion; however, credit institutions must meet certain requirements for choosing the IRB approaches. It is therefore assumed that only the large banks will use the advanced IRB and the smaller institutions will choose the standard approach.

Aspects of the rating process

The process of assessing customer creditworthiness is called rating. With the help of this systematic method, the current and future economic situation of a company or organization is evaluated. In addition to external economic information (industry statistics, market share data, etc.), the basis for a rating is primarily extensive quantitative and qualitative information that the company must provide to the external rating agency or the lending bank for its own use.

:: Internal vs. External Rating

While listed companies in particular are assessed by external rating agencies such as Moody’s or Standard & Poor’s, the assessment of small and medium-sized businesses is usually based on internal ratings. While internal credit assessments are only published with the consent of the company or by the company itself due to bank secrecy, external ratings are generally intended for publication. The decision to use an internal or external rating is usually not entirely voluntary due to the costs of public ratings. For small and medium-sized companies, external ratings are generally not recommended and only beneficial if the cost of the rating is within the expected interest benefits of the loan, although (from a more marketing-oriented perspective) even (communicated to the respective target group (suppliers, customers, employees, cooperation partners, etc.) ratings can strengthen confidence in the own company and thus strengthen the business relationship.

:: Companies are divided into customer segments

As part of the rating process, the bank takes into account the customer segment of the company being evaluated in terms of size (e.g., SMEs, freelancers), industry (e.g., trade, services), region, accounting regulations (e.g., HGB, IAS/IFRS), and financing method (e.g., project financing, export financing). As a benchmark, companies from the same customer segment are used in the assessment. It is therefore in the interest of the borrowing company to be served by a bank that handles similar clients and therefore has a high level of industry knowledge and sufficient experience.

:: In the framework of the rating, both hard facts and soft facts are taken into account.

A rating is a company assessment condensed into one „note&# #147;. It includes both quantitative („hard facts&147;) and qualitative factors („soft facts“). The financial health of a company is assessed based on the balance sheet and the G&V in the form of key indicators such as equity ratio, total capital profitability, cash flow rate etc. The equity ratio is considered the most important „hard fact“ here.

The qualitative factors consist of a variety of criteria that are sometimes difficult to grasp and are intended to be assessed in addition to the company’s market and product, as well as management skills, corporate strategy, personnel turnover, control systems, etc. The future prospects of the company in being able to maintain its position in the market are of primary importance.

Based on this rating, the probability of default of the loan is assessed, thereby determining the necessary own funds of the bank and subsequently influencing the credit terms.

Credit institutions as well as borrowers must already today prepare for the additional requirements of Basel II and take preparatory measures.

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