ISDA PRESS REPORT - DECEMBER 27, 2001 RISK MANAGEMENT * A spanner in the works - Risk TRADING PRACTICE * ISDA and FpML.org to merge - Risk A spanner in the works Risk - December 2001 When the Basel Committee issued its second consultative document proposals (CP2) for a new regulatory capital Accord in January, it prompted fierce opposition from banks, academics and lobbying groups over its treatment of loans to small- to medium-sized enterprises (SMEs). This sector is the backbone and growth engine of many major economies. Now, nearly a year later, the issue has come to a head. The US and Germany - which is fiercely protective of its SME sector, the mittelstand - are engaged in brinkmanship over the capital treatment of loans to SMEs that could cause the entire Basel II capital Accord to unravel. SME lenders' initial concerns included the steepness of Basel's credit risk weighting curve for the internal ratings-based (IRB) approach, its insistence that expected loss provisions should be made in addition to typical unexpected loss provisions, confusion over which SME loans could be included under the retail approach, and the extent to which physical collateral could be used as a risk mitigant. The Committee has moved to address many of these concerns, although some, like the risk weighting curve, remain prickly. But a critical issue, the use of maturity adjustments in the calculation of capital charges for corporate and SME lending, which requires banks to put aside more capital for longer-dated loans, is far from being settled. The German banking industry in particular is worried that overly harsh SME treatment would push up lending costs, thereby stifling capital to a vital source of the country's economic growth. While German banks have several concerns, the country's lack of flexibility on the maturity issue threatens to derail the entire Basel II process, which in turn would throw the European Directive based on Basel II into disarray. While most Basel lobbying has been carried out via traditional banking channels - with national banking associations petitioning their regulators that sit on the Basel Committee and its working groups - the debate in Germany, Europe's largest economy, involves the highest levels of government. German chancellor Gerhard Schr?der and economics minister Werner M?ller said in late October that German funding to the mittelstand must not be impaired by Basel II. "Basel II is not acceptable to Germany in its present form. Everyone must reckon with our opposition to a European Union guideline based on Basel II," said Schr?der, referring specifically to treatment of SMEs. The Basel Committee has since issued a paper, 'Potential modifications to the Committee's proposals', which outlines current thinking within the Committee and indicates that it will make key concessions to SME lenders. The most important aspect of the paper, released November 5, is the Committee's move to lower and flatten the IRB risk weighting capital curve - which is a function of a firm's probability of default. This significantly lowers capital requirements for SME lending. The move is based on evidence that small companies are less likely than large corporates to default during economic downturns. But the paper failed to touch on the maturity debate. "[It] says nothing about maturity, just about the risk weights without any maturity adjustments," says Tobias Winkler, head of international banking issues in the department for banking supervision at the Bundesverband deutscher Banken (Association of German Commercial Banks). "This a right step, but certain additional things have to be done to take account of special circumstances of SME lending [in Germany]," he adds. "The maturity adjustment has to be abolished in the advanced approach," he argues. The German side claims the terms of loans to the mittelstand are significantly longer than those to their SME counterparts in the US or the UK. "We have got very long maturities, this would put German banks at an enormous competitive disadvantage compared with other countries," says Winkler. Evidence to support this argument is hard to come by, especially since the Basel Committee refuses to disclose cross-country comparisons for factors like average loan maturities from its second quantitative impact study (QIS 2). But several officials with access to QIS 2 data say the average maturity of loans made by domestic financial institutions to businesses in Germany is 4.28 years, a figure that falls to 2.95 years for Germany's internationally active banks. Average maturities for business loans in other G-10 countries were said to lie between two and 2.5 years. The CP2 proposals for Basel II contained two maturity approaches in IRB treatment, one called the 'default model', ironically said to be a German proposal, and the other a US 'mark-to-market' approach strongly backed by the British. Under these two approaches, it is assumed that the risk of default on a loan is higher if it is longer-dated, an assertion that has been supported by several studies of historic data. The 'mark-to-market' approach also takes into account the economic deterioration of the position and not just final default. This Anglo model heavily penalises longer-term loans. According to the Zentraler Kreditausschus (ZKA), a central banking association which represents the interests of German commercial banks, savings banks, regional state banks and co-operatives, long-term exposures of seven years could require up to six times as much capital as one year exposures - although one German banking official said a cap had now been placed on maturities at five years, reducing this figure to 400%. "Capital add-ons for long-term loans would therefore seriously affect the international competitiveness of the German banking industry and result in higher interest rates for borrowers that would not be justified by the risk exposure," said the ZKA in a statement during the comment period. But Germany stands virtually alone in its refusal to accept the US-led maturity proposals. "The data analysed by the Committee clearly shows that you have these upward-sloping curves for maturities. What kills a bank is deterioration of value, and it has got to provide for a lot of things on the books, so you can't wait for final default," said a Basel Committee member. "But you can argue about the steepness, and that is a matter for debate." The fact that Germany's other key allies in the wider SME debate - namely Japan, Italy and Spain - are in favour of maturity adjustments, has prompted a number of non-German regulators, albeit veiled behind the protection of anonymity, to play down the importance of the maturity impasse to Basel II's implementation. But such views fail to take into account the depth of feeling that German banks, banking associations, the Bundesbank, parliament and the general public have in protecting funding to the mittlestand. This unusual level of pressure has left the German negotiators with very little room for manoeuvre. Gerhard Hofmann, director of banking supervision at the Deutsche Bundesbank, was one of the few regulators prepared to speak publicly on the issue. He said his hands were all but tied on the maturity debate, and confirmed that the German side would be prepared to scupper Basel II's timetable should a deal fail to be reached. "If this does not come to an end, then the European effort will be postponed too. I have difficulties imagining that we would introduce Basel II in Europe and not have a level playing field on a G-10 basis." While Hofmann said the matter was "very serious", he remained confident that all sides could reach a solution. Compromise Risk was told by one European banking representative who claims to be closely involved in the talks that a current compromise suggestion is to halve the US mark-to-market maturity adjustments. This would mean the 600% figure mentioned in the ZKA paper for a 'AAA'-rated, seven-year loan would be reduced to 200%. But a US representative distanced himself from this being a US proposal. "I would not describe the negotiating position that way," he said. Asked if the US team would agree such a concession, he added, "I couldn't say that we would, but it would depend on the whole package. Fifty per cent on the mark-to-market adjustment seems an obvious point to try and compromise on, but I'm not sure the US side would agree to that." Hofmann was also cautious, saying "I would rather hesitate to comment on that, but yes, it is a direction we are heading. This is a critical point and I hesitate to comment in public because we are in the midst of this rather difficult negotiating process and I really don't want to jeopardise anything. It will be quite tough." While almost every country that supports maturity adjustments believes a 50% mark-down would be an acceptable compromise, Germany may still hold out. Another German bank executive says it may find a 50% mark-down unsatisfactory. Another area of potential compromise is to allow banks with loan maturities of less than three years to gain a downward capital allocation adjustment, while banks with loans of more than three years would be capped at the three-year level - as factored into the current proposed standardised credit approach. But German bankers appear set to resist even this level of compromise, claiming that German internationally active banks (with average maturities of 2.95 years) would be on an unfair playing field with other internationally active banks, which have average maturities closer to the two years. But German banking officials could not come up with hard data to support the claims. While maturity is the largest single SME-related issue for the Basel Committee to resolve, there are a number of other matters that also need clearing up, and, once again, the Germans are digging in their heels. For example, the IRB credit risk-weighting curve proposed by the Committee on November 5 fails to completely assuage concern about higher SME lending charges. While Basel's current approach would mean that banks would have to set aside significantly less capital against SMEs, which typically fall in the 1% to 3% probability of default range, compared with CP2 proposals, charges are still higher than under the present rules. For example, a bank lending to an SME with a 2% probability of default would now have to set aside 10.3% of the capital, compared with 15.4% under the January proposals. Collateral mitigation could reduce this to 9.3%, and receivables mitigation might further reduce the amount to 8.3%. But Hofmann believes this risk-weighting curve does not go far enough. "When you look at the curve, the typical probability of default range for an SME, which is around 2%, still triggers a capital charge of above 10% - 2 percentage points above the current treatment," he says. This will translate into the pricing of these loans. "How big will the interest rate effect be on SMEs? According to our calculations it is still significant," Hofmann says. As a result, the Bank of Italy and the Deutsche Bundesbank drafted a confidential joint paper, released October 19, which was submitted to the Committee's working group on overall capital. The paper proposes that a function based on the relationship between asset correlation and size should be added to the IRB risk-weight curve methodology based on the relationship between asset correlation and probability of default. The paper, 'Calibration of benchmark risk weights in the IRB approach to regulatory capital requirements', contends that joint treatment of probability of default and a firm-size effects on asset correlation could produce a risk weighting function that addresses both procyclicality issues produced by the new framework and concerns related to the treatment of lending to SMEs. The Committee is now investigating the matter as part of an additional quantitative impact study, QIS 2.5. But many banks, including German financial institutions, are strongly opposed to the introduction of additional parameters, such as number of employees, assets and turnover functions into the risk-weighting curve. They see a size function as an unnecessary complication. "Segmentation on the grounds of turnover is unsatisfactory to us. Retail businesses and wholesale businesses may have similar turnover, but the characteristics and the way you would manage them in risk terms would be quite different," says Colin Jennings, senior manager, non-retail related risk at Lloyds TSB, the UK's third largest bank. "If that was imposed on us we would have to change our systems considerably to do what we think would achieve no real benefit," adds Simon Baker, Lloyds TSB's head of risk policy, overseeing about ?6 billion in commercial portfolios (above ?2 million in turnover) and an equal amount in small business portfolios, plus retail loans to its 16 million retail customers base. Further effects Bankers are also opposed to another key aspect of Basel II that affects SME lending. The Committee believes banks should put aside capital for expected losses in addition to the current practice of making capital charges against unexpected losses - credit risk. From a theoretical view of capital, such requirements should be fulfilled by future margin income and not by regulatory capital allocations. The Germans favour this 'pure' approach. "Expected losses are covered by future margin income. We don't need any double counting by using regulatory capital to cover expected losses," says a German banker. Although Basel has made some concessions in this area, saying it would scrap expected loss provisions for retail loans - excluding mortgages - and allow deductions from special and general loan loss reserves against expected losses, the Committee's 'inelegant solution' has again run into German opposition. "The German Ministry of Finance restricts the amount of loan-loss reserves due to fears that banks would attempt to reduce their income figures to avoid tax payments," says one German banker. "We fear that this could lead to a severe international competitive disadvantage for German banks because of tax regulations, so we are very much against covering expected losses with regulatory capital." A potential solution is to include expected losses under Pillar II of Basel II, leaving it up to the discretion of national supervisors to ensure expected losses are fully covered, while ensuring a level playing field among nations. But some claim the Committee is unconvinced that expected losses are fully accounted for by national regulators in specific product areas or nations like Japan, and have pushed for specific Pillar I treatment to alleviate their concerns. "The current envisioned compromise is that this will not be done across the board. While it is not an elegant solution, it addresses the most important substantive concerns the industry has raised about the inclusion of expected loss," says a Basel Committee member. The strong German opposition to so many SME-related treatments will make a speedy resolution difficult, with much said to be hinging on sideline discussions between the German and American contingents ahead of the Capital Task Force and Basel Committee meetings, scheduled for December 6 and 7 in New York, and the December 12 and 13 in Basel, respectively. With the timing tight in terms of enshrining a European Directive in European Union and European national legislation, the industry needs a major breakthrough based on sound banking supervision practices, rather than an appeasement in response to political sabre-rattling, which risks weighing down the entire Basel II process. ISDA and FpML.org to merge Risk - December 2001 By Rob Dwyer The International Swaps and Derivatives Association plans to integrate FpML.org the not-for-profit company set up to develop Financial products Markup Language (FpML) - into its organisational structure by the end of the year. The merger of the two organisations is aimed at facilitating the development of FpML by allowing FpML.orgs members to concentrate on technical issues. Mart Meinel, co-chair of FpML's standards committee and head of fixed-income IT at UBS Warburg, says becoming part of ISDA will remove the burden of administration from the technical team. We will be able to use ISDA resources which will speed up the implementation of version 2.0 and the development of version 3.0,' he says. 'The standards committee ended up doing a lot of the administration work to run the FpML symposiums, and we hope to leverage off ISDA conferences (for future symposiums)." FpML based on the flexible extensible markup language' (XML), is designed to create an industry standard for electronic trading. FpML 1.0, launched in July 2000, covers interest rate swaps and forward rate agreements. FpML is presently working on version 2.0, which will include swaptions, caps, floors, collars and straddles, as well as several other instruments, as well as those covered in 1.0. Implementation is slated for the end of December. The committee is also planning to publish a draft of 3.0, which will extend FpML coverage to foreign exchange and equity derivatives, by the end of this year. Meinel says FpML's integration with ISDA was part of the standards committee's strategy from the organisation's inception. 'Since we have been working on ISDA documentation then converting that into XML, our work has a natural fit with ISDA," says Meinel, Operating from inside ISDA will help the development of FpML be better aligned with the documentation of new products as it comes along." Strain Robert Pickel, ISDA's chief executive officer, says the merger will allow members of FpML to focus on technical development. But will it prove a strain on often-stretched ISDA resources? We envision adding some extra staff, and we project that we will be able to find the extra funding needed through due-based revenues' says Pickel. "As a volunteer organization, it was an issue for FpML members to find time aside from their day jobs. And yet they have still managed to establish FpML as a brand that is the basis for OTC derivatives transactions in the future," he adds. FpML users welcomed the announcement. Mark Brickell, chief executive officer of online swaps trading platform Blackbird, and chairman of lSDA between 1988 and 1992, says: "We actively encouraged ISDA to take on this project. Creating FpML is as important as the ISDA Master Swap Agreement, because it will strengthen the framework for the swap negotiation." Brickell says Blackbird was the first company to offer FpML confirmations to its customers, and he believes ISDA will accelerate the adoption of 2.0 and expand FpML further to cover more kinds of transactions more quickly. Observers say the success of the project depends on recruiting. An official at an FpML-affiliated company says: "ISDA hasn't had this level of technology project before, so the key will he whether it hires someone with the requisite level of technological expertise." ISDA officials say details about FpML recruitment have yet to be finalised. **End of ISDA Press Report for December 27, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT.
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ISDA PRESS REPORT - DECEMBER 27, 2001