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How will the credit crisis impact on asset finance?

We have all heard recently about the USA’s sub-prime lending problems and that this is having a knock-on effect around the world, so how will it affect the availability of funding for European asset finance operations?

The general consensus amongst serious economists seems to be that this is a correction which was bound to happen following the progressive relaxation of credit criteria over recent years, which had resulted in margins and amounts lent not properly reflecting risk. Consequently we can expect to see more restrictive lending criteria and a widening of margins for risk. Coupled with this, we must remember that banks need to lend in some way to make any profit on funds deposited with them.  Which takes us back to the old cliché that there will always be someone to lend to a good quality credit.

At the top end of the asset finance market are companies within large bank groups. They are primarily if not exclusively funded by their parent bank, so their credit standing is wholly dependent on the parent. Similarly, the credit standing of captives will be at least strongly influenced by their parent’s status. Which takes us on to the independents, with nothing to fall back on in support, and it is these who will need to consider their position most carefully.

For subsidiaries of bank and strong prime groups, the issue will focus more on the extent to which they are prepared to take on customer exposures, than whether they can borrow to finance these. Because of the underlying credit driven culture in typical bank groups, we should expect to see a lower risk appetite. However, this may manifest itself in a variety of ways, rather than just reduced levels of lending. In particular this could involve a move to more secure forms of lending eg leasing or HP rather than unsecured loans, shorter finance periods, or a greater proportion of “up-front” payment/ rentals. Similarly other asset finance companies will be reassessing their own lending criteria, which is likely to result in a reduced borrowing requirement.

Taking the crystal ball out, the likely funding position for independents is:

• various short term crises when liquidity in the markets dries up as an immediate response to further shocks.  Asset finance companies need to plan ahead to ensure they have appropriate headroom in facilities to accommodate their own lending commitments;
• borrowing margins will increase. In particular spreads for different credit risks will widen. The normal market reaction in this situation is an overreaction, with a subsequent settling back towards, but still well away from, the previous position;
• apart from the short term blips, funding should remain readily available for asset finance companies who can demonstrate that they remain solid credit risks.

The last of these begs the question of which asset finance companies are still considered by lenders to be solid credit risks. This will come down to issues such as the nature and quality of the company’s own customers, the level of reserves to absorb potential bad debts and the quality of management. But, as Northern Rock has seen, it is the perception of each of these by the lender that matters, however irrational that view may be, not the company’s view.

If you'd like to discuss the implications of the credit crisis with George you can contact him at george.tonks@invigors.com or call +44 (0) 845 003 1000

Basel II Operational Risk

As managers within bank groups will already be well aware, we continue to move along the timetable towards the adoption of Basel II. Parallel running of capital calculations under the new rules is due next year (although, as noted elsewhere, there may be some slippage due to delays within the EU parliamentary process). Commentaries so far have concentrated on the credit risk aspects of the new rules, which is appropriate as all companies within bank groups will need to upgrade their systems and customer data to ensure compliance with these.

Alongside the changes in capital requirements for credit risk, Basel II introduces additional capital requirements for operational risk, which is defined as the risk of loss from inadequate or failed internal processes, people or systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. Previously there has been no explicit capital requirement for operational risk, although the regulators have argued that its existence has been reflected in the overall capital requirements to date.

As with credit risk, there are different levels of operational risk measurement that can be adopted, with different capital requirements as a consequence and with different development/ cost requirements. Under the simplest “basic indicator” approach, the capital required is 15% of the bank’s average gross income for the latest three years. The slightly more sophisticated “standardised” approach also uses standard percentages of average gross income, but divides the bank’s business into eight business lines, with different percentages (of between 12% and 18%) used for each. By contrast, the “advanced management” approach allows a bank to calculate its capital requirement using its own operational loss data. The requirement for a bank using AMA is for its capital in respect of operational risk to be at least sufficient to cover operational losses over a one year horizon at a confidence level of 99.9%.

As with the advanced approaches for credit risk, the use of AMA requires approval from the regulator (the FSA for UK banks), who will require compliance with stringent standards and data history. Whilst many larger banks have been collecting relevant data for some time, others will not have this level of detail and so will have to use the lower level approaches and hence the standard percentages of gross income at least initially.

The Basel Committee has said that it expects the capital for operational risk to form about 12% of the overall capital requirements for the banking community. A simplistic reconciliation of this relationship could be as follows:

• Capital for credit risks is c10% of RWA, so c6.6% of gross assets
• Gross income is c6% of gross assets.
• Capital for operational risk at c15% of gross income is c0.9% of gross assets.
• Total capital for the banking book is c7.5% of gross assets of which 0.9% relates to operational risk, which is c12% of the total.

Clearly the relationship will vary for individual banks, depending on factors such as average risk weightings, capital ratios, interest rates, margins, fee income and business sector/ mix. Growth will also play a part as the standard calculations use historical averages, so there will be a lag for fast growing companies. For banks with high levels of fee income the operational risk element of capital will be relatively high.

There is general concern at present about the requirements in respect of operating leasing. The gross income definition appears to point back to the rental income reflected in the profit and loss account, whereas for loans and finance leases the equivalent starting point is interest income. Where this happens, instead of applying the standard percentage to an income figure of around 6% of the asset, it would be applied to a much larger figure, possibly 30% or even more of the asset balance. Indeed with a mature operating leasing book, with significant amounts of maintenance or other service income included within rental income, the amount of capital required for operational risk could even exceed the amount required for credit risk.

This issue is being addressed as part of the response to the FSA’s Basel II implementation plans circulated in January. However, if it is not resolved satisfactorily it will give a major cost disadvantage to operating leases against other bank products.