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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 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

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  1. 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

  2. Basel I Basel on the Rhine RiverRetrieved from http://www.basel.ch 21 September 2004 Kurt Hess, WMS kurthess@waikato.ac.nz

  3. Basel II BIS Building in Basel, Aeschenplatz 1Retrieved from http://www.basel.ch 21 September 2004 Kurt Hess, WMS kurthess@waikato.ac.nz

  4. Basel III Basel FasnachtRetrieved from http://www.fasnacht.ch 21 September 2004 Kurt Hess, WMS kurthess@waikato.ac.nz

  5. 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 kurthess@waikato.ac.nz

  6. 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 kurthess@waikato.ac.nz

  7. Example one: 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 kurthess@waikato.ac.nz

  8. Example two: 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 kurthess@waikato.ac.nz

  9. Literature / Studies • 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 kurthess@waikato.ac.nz

  10. Literature / Studies 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 kurthess@waikato.ac.nz

  11. Literature / Studies • 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 kurthess@waikato.ac.nz

  12. 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 kurthess@waikato.ac.nz

  13. 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 kurthess@waikato.ac.nz

  14. Basel I: Risk Weightings Current Weighting under Basel I Example Calculation of Risk Weighted Assets ANZ Bank (NZ Operations) year per 30/9/2003 Kurt Hess, WMS kurthess@waikato.ac.nz

  15. Basel I: Problems / Effects • Insufficient granularity and risk sensitivity • Asymmetry between risk profile, economic capital and regulatory capital • Arbitrage of regulatory capital • Asset securitisation Kurt Hess, WMS kurthess@waikato.ac.nz

  16. Basel II Pillars • Pillar 1: • Minimum capital requirements • Pillar 2: • A supervisory review process • Pillar 3: • Market discipline (risk disclosure) Kurt Hess, WMS kurthess@waikato.ac.nz

  17. Basel II Pillars Pages in New Basel Capital Accord (issued June 2004) Kurt Hess, WMS kurthess@waikato.ac.nz

  18. Basel II Risk Weighting Options • 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 kurthess@waikato.ac.nz

  19. Risk Weights: Basel I vs. II For categories relevant for NZ registered banks (1) * Basel II Standardized Approach Kurt Hess, WMS kurthess@waikato.ac.nz

  20. Risk Weights: Basel I vs. II For categories relevant for NZ registered banks (2) Relieve for retail Kurt Hess, WMS kurthess@waikato.ac.nz

  21. Risk Weights: Basel I vs. II For categories relevant for NZ registered banks (3) * Basel II Standardized Approach Kurt Hess, WMS kurthess@waikato.ac.nz

  22. 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 kurthess@waikato.ac.nz

  23. Traditional Loan Pricing (1) Kurt Hess, WMS kurthess@waikato.ac.nz

  24. Traditional Loan Pricing (2) Calculation of Capital Charge Kurt Hess, WMS kurthess@waikato.ac.nz

  25. Traditional Loan Pricing • 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 kurthess@waikato.ac.nz

  26. Loan Pricing in M&M World • 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 kurthess@waikato.ac.nz

  27. Loan Pricing in M&M World 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 kurthess@waikato.ac.nz

  28. Loan Pricing in M&M World 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 kurthess@waikato.ac.nz

  29. Loan Pricing in M&M World Kurt Hess, WMS kurthess@waikato.ac.nz

  30. Loan Pricing in M&M World 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 kurthess@waikato.ac.nz

  31. Loan Pricing in M&M World 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 kurthess@waikato.ac.nz

  32. Loan Pricing in M&M World Basel I weight 50%: leverage=96% Basel II weight 35%: leverage=97.2% Kurt Hess, WMS kurthess@waikato.ac.nz

  33. 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 kurthess@waikato.ac.nz

  34. Conclusion 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 kurthess@waikato.ac.nz

  35. Basel & Melbourne Transport Kurt Hess, WMS kurthess@waikato.ac.nz

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