UK: The New "Slotting" Regulations: What Are They And Why Should I Care?

Summary and implications

The UK banking sector is facing a number of challenges as a result of increased regulation and supervisory control which may adversely impact commercial real estate lending. The objective is to improve capital ratios and supervision and avoid future bank failure and systemic risk in the wider economy.

As part of the increased regulation, the Financial Conduct Authority (FCA), formerly known as the Financial Services Authority, has introduced new guidelines in relation to slotting which seek to standardise risk assessment models across the banking sector. The greater the risk, the greater the capital provision and potentially this will further reduce debt in the market.

This article considers:

  • a background to lending in the commercial property sector;
  • the new requirements in relation to slotting; and
  • the impact that the new slotting requirements could have on borrowers.

Background

The UK banking sector has been a key provider of debt to the commercial property sector. Bank exposure to property assets has increased substantially, driven by the sector's attractive marginal profitability and low equity capital requirements. Research by De Montfort University estimated the size of the UK property loan book to be £224bn at mid-2012, a significant increase on the £50bn book of 1999.

However, lending practices have recently come under renewed focus from regulators as they seek to maintain stability in the financial system. The introduction of the Basel reforms sought to reduce the probability and severity of future fiscal crises, including requirements to strengthen the quality and quantity of capital held by banks. The Basel Accords are the regulatory standards on capital that banks must set aside. The latest Basel Accord, Basel III, is in the process of being implemented with a deadline of 2018.

Alongside Basel III, the FCA has placed greater scrutiny on the internal models used by banks when calculating their risk-weighted capital in lending to "specialised" income producing assets, and this includes commercial property. Losses on commercial real estate have at times been volatile, and therefore difficult to model, which increased concern that banks were not setting aside enough regulatory capital to cover these risks.

What is slotting?

All current and future performing property loans are to be assigned to one of four categories ("strong", "good", "satisfactory" and "weak"), with risk weights attached to each ranging from 50 per cent to 250 per cent. These weights then determine how much capital is to be held against potential losses on each loan. The final category is a loan in "default" (category 5). This refers to where there has been an "event of default" under the loan agreement and the bank has decided to accelerate the loan. Once a loan is in category 5, a bank is required to make no allocation to risk-weighted assets because the FCA suggests that the expected loss calculation would have written 50 per cent off the outstanding amount on any loan in default, so no further contingency is necessary.

Risk weights used to determine how much capital should be held against each loan

Remaining maturity

Category 1 (Strong)

Category 2 (Good)

Category 3 (Satisfactory)

Category 4 (Weak)

Category 5 (Default)

Less than 2.5 years

50%

70%

115%

250%

Write off 50% of the outstanding loan amount

Equal to or more than 25 years

70%

90%

115%

250%

Write off 50% of the outstanding loan amount

How will this impact on me?

The effect of higher regulation and greater reserve requirements will be increased costs for both the banks and borrowers. Indeed, the FCA initially estimated that slotting could lead to £1bn to £3bn of additional equity capital requirements.

A report by property analysts Investment Property Databank last year warned that slotting could also have a "significant" impact on the wider economy as it would force banks to rid themselves of unsustainable property loans. The forced property sales that would result would "further depress" the property market, creating a "vicious cycle of further losses in loans secured by commercial property".

The British Property Federation (BPF) has also criticised the move from internal risk-based models to enforced harmonisation and consistency brought about by "slotting". Commenting on the reforms, the BPF stated that they see these as being "almost certain to result in new systemic risk build-up, because risks cannot safely be assessed in an entirely objective way without perfect knowledge". The BPF's view is that "regulators should focus on encouraging better collection and management of real estate lending data to support better internal risk-based models, and not on requiring all banks (which will inevitably have different experience, expertise, customer relationships and business models) to assess risks – which may look "similar", but almost certainly aren't exactly what they seem to be – in the same way".

Some property companies warn that the move, which could sharply increase their cost of borrowing, will exacerbate the already wide gap in values between buildings in London and those elsewhere in the UK and hinder the chances of economic recovery. The largest lenders to the sector are also concerned that the tougher regulation will constrain their ability to finance new development.

Calculation of default interest

In addition to the new slotting requirements making real estate lending more expensive to borrowers, lenders are also looking to pass on to the borrower any increase in slotting costs during the life of the loan. This is being done by introducing a margin ratchet in the loan documentation where there is an event of default under the loan (but the bank has not decided to accelerate and therefore the loan does not fall into category 5) and thereby increasing the interest payments which the borrower is obliged to make. The rationale for this being, that where there is an event of default (and the bank have not accelerated the loan) this could change the loan from being in categories 1 to 3 and move it into category 4, thereby requiring banks to attribute a greater amount of capital against the loan than envisaged at the outset.

This provision goes further than the standard Loan Market Association documentation, which only provides for default interest on unpaid sums. Furthermore there is no direct correlation between the additional amount of capital the banks are required to attribute to the loan and the increase in margin passed on to the borrower if default interest is applied.

Borrowers should be careful when negotiating new loan documents or amending existing deals and if in doubt should speak with an advisor.

Conclusion

The new slotting requirements will make banks review their lending exposure to commercial property. Given the difficulty of finding the additional equity required and the lower returns on capital, slotting may further restrict banks' ability to lend. But this is to be balanced against other developments such as the funding for lending scheme and other efforts by the government to encourage banks to stay open for business. One should also not forget new entrants to the real estate loan market, such as insurance companies and senior debt funds, to whom the slotting requirements will not apply.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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