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The New Basel Capital Accord: Potential Effects on lending rates in New Zealand. Slides prepared by Kurt Hess, University of Waikato Management School Hamilton, New Zealand. Basel I. Basel on the Rhine River Retrieved from http://www.basel.ch 21 September 2004. Basel II.

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The new basel capital accord potential effects on lending rates in new zealand

The New Basel Capital Accord: Potential Effects on lending rates in New Zealand

Slides prepared by Kurt Hess, University of Waikato Management SchoolHamilton, New Zealand


Basel i
Basel I

Basel on the Rhine RiverRetrieved from http://www.basel.ch 21 September 2004

Kurt Hess, WMS [email protected]


Basel ii
Basel II

BIS Building in Basel, Aeschenplatz 1Retrieved from http://www.basel.ch 21 September 2004

Kurt Hess, WMS [email protected]


Basel iii
Basel III

Basel FasnachtRetrieved from http://www.fasnacht.ch 21 September 2004

Kurt Hess, WMS [email protected]


Basel ii impact on lending rates

Motivation / Literature

System of Risk Weighting underBasel I vs. Basel II Capital Accord

Loan Pricing by Banks

Traditional method

Pricing in a Modigliani & Miller world

Conclusions

Basel II Impact on Lending Rates

Kurt Hess, WMS [email protected]


Motivation

Uncertainty as to what will be the impact of new regulatory framework which has lead to speculation among media commentators.

Some of the comments and conclusions relating to revised risk weightings under Basel II did not seem convincing.

Motivation

Kurt Hess, WMS [email protected]


Motivation1

Example one: framework which has lead to speculation among media commentators.

Motivation

“As a generality, lending to mid corporates represents a higher level of risk than lending to their FTSE counterparts. This means mid corporates will tend to attract the higher risk weightings, making them the first to suffer from any financing restrictions placed on their provider by Basel II.”

Wilcox in “Accountancy”, 1 May 2003

Kurt Hess, WMS [email protected]


Motivation2

Example two: framework which has lead to speculation among media commentators.

Motivation

“Proposed changes to the Basel Capital Accord (called Basel II) indicate that banks will have a greater incentive to lend to the residential housing market.”

Brian Gaynor in NZ Herald article titled Aggressive banks drive housing boom,27 September 2003

Kurt Hess, WMS [email protected]


Literature studies
Literature / Studies framework which has lead to speculation among media commentators.

  • Numerous studies and articles related to Basel II and it potential impact.

  • Most important, quantitative impact study (QIS) with the participation of more than 350 banks in 43 countries (May 2003) explores impact on capital requirements under the new regime.

Kurt Hess, WMS [email protected]


Literature studies1
Literature / Studies framework which has lead to speculation among media commentators.

QIS: Contributions to Change in Standardised Approach

Relieve for retail

New operational risk category

Basel Committee, May 2003, Quantitative Impact Study 3: Overview of Global Results, page 5

Kurt Hess, WMS [email protected]


Literature studies2
Literature / Studies framework which has lead to speculation among media commentators.

  • Research on possible systemic impacts like the suspected procyclicity of the new regulation, for example …

    • Borio, Fufine, & Lowe (2001)

    • Allen & Saunders (2002)

  • Special issues of academic journals related to Basel II

    • Journal of Financial Intermediation, May 2002

    • Journal of Banking and Finance, April 2004

Kurt Hess, WMS [email protected]


Research question

How will the revised risk weights affect lending to the various industry sectors? Will there be an impact on relative lending rates?

Research Question

Kurt Hess, WMS [email protected]


Basel ii impact on lending rates1

Motivation / Literature various industry sectors? Will there be an impact on relative lending rates?

System of Risk Weighting underBasel I vs. Basel II Capital Accord

Loan Pricing by Banks

Traditional method

Pricing in a Modigliani & Miller world

Conclusions

Basel II Impact on Lending Rates

Kurt Hess, WMS [email protected]


Basel i risk weightings
Basel I: Risk Weightings various industry sectors? Will there be an impact on relative lending rates?

Current Weighting under Basel I

Example Calculation of Risk Weighted Assets ANZ Bank (NZ Operations) year per 30/9/2003

Kurt Hess, WMS [email protected]


Basel i problems effects
Basel I: Problems / Effects various industry sectors? Will there be an impact on relative lending rates?

  • Insufficient granularity and risk sensitivity

  • Asymmetry between risk profile, economic capital and regulatory capital

  • Arbitrage of regulatory capital

  • Asset securitisation

Kurt Hess, WMS [email protected]


Basel ii pillars
Basel II Pillars various industry sectors? Will there be an impact on relative lending rates?

  • Pillar 1:

    • Minimum capital requirements

  • Pillar 2:

    • A supervisory review process

  • Pillar 3:

    • Market discipline (risk disclosure)

Kurt Hess, WMS [email protected]


Basel ii pillars1
Basel II Pillars various industry sectors? Will there be an impact on relative lending rates?

Pages in New Basel Capital Accord (issued June 2004)

Kurt Hess, WMS [email protected]


Basel ii risk weighting options
Basel II Risk Weighting Options various industry sectors? Will there be an impact on relative lending rates?

  • Credit Risk

    • Standardised Approach

    • Internal Ratings-Based Approach (IRB)

      • IRB Foundation- banks estimate PD only

      • IRB Advanced- banks estimate PD, LGD, EAD, Effective Maturity

  • Operational Risk - two options

Kurt Hess, WMS [email protected]


Risk weights basel i vs ii
Risk Weights: Basel I vs. II various industry sectors? Will there be an impact on relative lending rates?

For categories relevant for NZ registered banks (1)

* Basel II Standardized Approach

Kurt Hess, WMS [email protected]


Risk weights basel i vs ii1
Risk Weights: Basel I vs. II various industry sectors? Will there be an impact on relative lending rates?

For categories relevant for NZ registered banks (2)

Relieve for retail

Kurt Hess, WMS [email protected]


Risk weights basel i vs ii2
Risk Weights: Basel I vs. II various industry sectors? Will there be an impact on relative lending rates?

For categories relevant for NZ registered banks (3)

* Basel II Standardized Approach

Kurt Hess, WMS [email protected]


Basel ii impact on lending rates2

Motivation / Literature various industry sectors? Will there be an impact on relative lending rates?

System of Risk Weighting underBasel I vs. Basel II Capital Accord

Loan Pricing by Banks

Traditional method

Pricing in a Modigliani & Miller world

Conclusions

Basel II Impact on Lending Rates

Kurt Hess, WMS [email protected]


Traditional loan pricing 1
Traditional Loan Pricing (1) various industry sectors? Will there be an impact on relative lending rates?

Kurt Hess, WMS [email protected]


Traditional loan pricing 2
Traditional Loan Pricing (2) various industry sectors? Will there be an impact on relative lending rates?

Calculation of Capital Charge

Kurt Hess, WMS [email protected]


Traditional loan pricing
Traditional Loan Pricing various industry sectors? Will there be an impact on relative lending rates?

  • A decrease in the risk weight as foreseen under New Accord would affect loan pricing under this traditional scheme:

50%

35%

Risk Weight

0.64%

0.45%

Capital charge

5.84%

5.65%

Loan Price

Kurt Hess, WMS [email protected]


Loan pricing in m m world
Loan Pricing in M&M World various industry sectors? Will there be an impact on relative lending rates?

  • Fundamentally credit risk of loan does not change if funding mix is change

  • What changes is the return required by the provider of the equity capital.

  • Leaving the required return constant under traditional scheme is thus flawed.

Kurt Hess, WMS [email protected]


Loan pricing in m m world1
Loan Pricing in M&M World various industry sectors? Will there be an impact on relative lending rates?

Modigliani & Miller (1958) propositions without taxes:

  • Proposition I:“Capital structure does not matter”

  • Proposition II:“Risk to equity holders rises with leverage”

Kurt Hess, WMS [email protected]


Loan pricing in m m world2
Loan Pricing in M&M World various industry sectors? Will there be an impact on relative lending rates?

Hypothetical Loss Distribution Mortgage Loan Portfolio

Hypothetical example assumes Poisson distribution for 200 loans with a probability of default 2.5% (intensity = 5) and loss given default of 20%.

Kurt Hess, WMS [email protected]


Loan pricing in m m world3
Loan Pricing in M&M World various industry sectors? Will there be an impact on relative lending rates?

Kurt Hess, WMS [email protected]


Loan pricing in m m world4
Loan Pricing in M&M World various industry sectors? Will there be an impact on relative lending rates?

r WACC is constant and given by

where B is the $ amount of funds obtained from bank deposits, E the $ amount of equity capital.

rBrequired return on the deposits (gross deposit funding costs)

rE required return on equity capital (cost of equity)

Kurt Hess, WMS [email protected]


Loan pricing in m m world5
Loan Pricing in M&M World various industry sectors? Will there be an impact on relative lending rates?

Cost of equity (rE) then becomes as a function of leverage l which is defined as the percentage of the loan funded though deposits:

Kurt Hess, WMS [email protected]


Loan pricing in m m world6
Loan Pricing in M&M World various industry sectors? Will there be an impact on relative lending rates?

Basel I weight 50%: leverage=96%

Basel II weight 35%: leverage=97.2%

Kurt Hess, WMS [email protected]


Conclusion

Revised risk weights under Basel II are sometimes instinctively being blamed for expected impacts on relative credit availability/lending rates to various borrower segments.

Conclusion

This paper argues that …

  • Regulatory capital under Basel I should never have been the basis for allocating economic capital to loans and pricing in the first place.

Kurt Hess, WMS [email protected]


Conclusion1
Conclusion instinctively being blamed for expected impacts on relative credit availability/lending rates to various borrower segments.

This paper argues that …

  • (If anything) Basel II will drive lenders to allocate capital more in line with actual risk of the loan as regulatory and economic capital will be better aligned under the New Accord.

As a consequence, not revised risk weights but a correction of erroneous thinking could bring about some changes to internal loan allocation and pricing systems.

Kurt Hess, WMS [email protected]


Basel melbourne transport
Basel & Melbourne Transport instinctively being blamed for expected impacts on relative credit availability/lending rates to various borrower segments.

Kurt Hess, WMS [email protected]


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