Finance
Andrew Petersen reports on the impact of
Basel II standard on Europe’s fast-evolving commercial
mortgage-backed securitisation market
A new
What is Basel II?
dawn
European commercial mortgagebacked securitisation (CMBS) has been
enjoying a period of tremendous growth.
Issuance volume for 2007 year-to-date
is running at approximately E28bn
(£19bn), having had a 47% increase in
volume in the first quarter of 2007.
These figures, coming off the back of
2006’s total issuance of just under E63bn
(£42.4bn) and the total tally for 2005
of E47bn (£31.6bn), have led to predictions that there is still room for growth
in the European CMBS market and that
the total issuance for 2007 may hit the
E100bn (£67.3bn) mark. The buoyancy
in the market has been attributed to a
variety of factors, including:
l an increased number of pan-
European deals;
l a number of new conduits being
established (currently around 20 conduit
financings are active in the market);
l a growth of German deals providing
access to the German multi-family
rental market;
l a favourable commercial real estate
environment; and
l the fact that European CMBS’ share
of the total lending market is currently
approximately 11%, whereas in the US,
the more seasoned CMBS market has a
40% share of total mortgage financings.
As a result of these growth factors,
CMBS is a market where the advent of
Basel II and its potential to affect growth
has generated a great deal of discussion.
Basel II is the second of the Basel
Accords, which are recommendations on
banking laws and regulations issued by
the Basel Committee on Banking Supervision. Basel II’s aims include:
l ensuring that capital allocation is
more risk-sensitive, without changing
the required overall level of regulatory
capital;
l separating operational risk from
credit risk and quantifying both;
l reducing the scope for regulatory
arbitrage by attempting to align economic and regulatory capital more
closely.
Through its aims, Basel II is designed
to be both wider in scope and more risksensitive than its predecessor, the Basel
Capital Accord covering credit risk that
was issued in 1988 (Basel I).
Basel I established a minimum ratio
of required Tier One capital-to-risk
weighted assets. The risk-weights for
assets were assigned only for credit
risk, based on categorisation of types
of assets and obligors. Although a
good starting point, Basel I has been
criticised as simplistic in its approach
towards credit risk and failing to keep
pace with advances in the banking
markets. For example, Basel I does not
distinguish the risk characteristics
between, say, a three-year loan and a 10year loan, as it assumes the regulatory
capital cost of loans remains constant
over the life of each loan.
Basel II’s intentions of maintaining
the overall level of regulatory capital
in the system, by focusing on improvements in the measurement of risk and
setting out credit risk measurement
methods, are considerably more elaborate than those in Basel I.
Through the introduction of three pillars, banks are incentivised to enhance
their control processes and capital is
allocated on a risk-adjudicated basis,
resulting in banks offering better credit
loans and cheaper rates than under
Basel I. This may result in some sectors shrinking as some banks with less
advanced risk assessment models find
themselves priced out of the market,
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22 Legal Week 12 July 2007
LW_1207_p22-23 Basel_FVMG.indd 22
www.legalweek.com
9/7/07 17:11:08
Finance
The regulatory framework is changing
under Basel II. As a result banks will look for
alternative means to maximise revenues
reducing the number of active participants and, consequently, liquidity. So
what of Basel II’s implementation?
Basel II’s global implementation
Basel I rules will no longer be available, and UK and EU banks must adopt
Basel II. By contrast, in the US, regulators are requiring the IRB approach for
the largest banks, and the standardised
approach will not be required.
Expertise
The world is currently in limbo as
regards the implementation of Basel II.
Regulators in most jurisdictions around What effect on CMBS
the world have indicated an intention to will Basel II have?
implement Basel II (95 national regula- The regulatory framework is changing
tors, at last count, indicating they were under Basel II. As a result banks will
to implement Basel II, in some form or look for alternative means to maximise
another, by 2015), but with widely var- revenues while avoiding the need to hold
ying timelines and methodologies.
unrated and sub-investment-grade loan
Prior to 1 January, 2008, European assets. It has already been seen that as
Union (EU) banks and other financial a result of Basel II (and undoubtedly
institutions may apply Basel I-based greater competition from bank lenders),
rules or adopt either of the Basel II stand- there is now no longer a pricing differenardised or foundation internal ratings- tial between capital markets and banks.
TL_3VBinsurance_dis
24/11/06
pm Page
based
(IRB) approaches. From
1 January, 2:54
Further
effects1 that are possible in a
2008, within the UK and Europe, the post-Basel II world arise when one con-
www.legalweek.com
LW_1207_p22-23 Basel_FVMG.indd 23
In Numbers:
E28Bn
issuance volume
for commercial
mortgage-backed
securitisation so
far in 2007
Banking
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siders the relative change in the required
capital to assets ratio pre- and postBasel II implementation and the relative difference in capital required under
Basel II to hold commercial real estate
(CRE) assets either on the balance sheet
or in a CMBS structure.
Because banks which use the IRB
approach and perform portfolio analysis may hold significantly less capital
against most CRE exposures (but particularly low-risk exposures), than required
under Basel I or under the Basel II standardised approach, less capital may be
required if CRE assets are placed into a
CMBS rather than held on balance sheet.
As a result, Basel II will have a major
impact on the securitisation of CRE
assets, which may in turn:
l based on fairly strong capital incentives, encourage banks with identical
CRE loan portfolios to securitise the
loans, further stimulating CMBS;
l encourage banks which use an IRB
approach to increase lower-risk CRE
lending and offload higher-risk real
estate assets;
l encourage banks to sell-off noninvestment-grade tranches to market
participants not subject to Basel II (such
as hedge funds and investment groups);
l encourage banks using the Basel
II standardised approach to invest in
lower-rated CMBS positions, potentially
leading to erosion in the credit quality of
their holdings of structured notes;
l result in separate mezzanine or B-note
lending, attracting lower capital requirements than BB-rated CMBS tranches.
As a result of this regulatory capital
incentive, banks may target the rated
portion of the CMBS market, causing
CRE loan origination to purely facilitate
full CMBS funding without any equity
or below investment grade tranches;
l increase the volume of separate
mezzanine lending or B-note lending
which occupies the band in property
lending 70%-85% loan to value. What
is not entirely clear is what the risk
weighting or IRB capital charge would
be for this type of lending;
l result in a separation in the mezzanine area of CRE lending from conventional bank lending suitable for CMBS.
This could further tighten spreads for
non-rated B-note lending relative to BBrated CMBS tranches; and
l encourage banks originating CRE
loans, particularly banks using the
Basel II standardised approach, to
minimise the size of the first loss piece
retained and to sell-off a senior-ranking
double-B rated tranche.
It is clear that the CMBS market still
has much to offer. There are conflicting
opinions as to whether the market is
maturing or is still in high-growth
mode.
Whichever cycle the CMBS market
is in, history has shown that due to its
innovative nature and ability to adapt
and to position itself as a strong and
robust asset class, CMBS will emerge
from any period of reflection the market
may be about to embark on in a strong
position, spurred on by the effects highlighted above. n
Andrew Petersen is a partner at Kirkpatrick &
Lockhart Preston Gates Ellis’ London office.
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12 July 2007 Legal
Week 23
9/7/07 17:11:11