Andrew Petersen reports on the impact of Basel II standard on Europe's fast-evolving commercial mortgage-backed securitisation market
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:
- an increased number of pan- European deals;
- a number of new conduits being established (currently around 20 conduit financings are active in the market);
- a growth of German deals providing access to the German multi-family rental market;
- a favourable commercial real estate environment; and
- 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.
What is Basel II?
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:
- ensuring that capital allocation is more risk-sensitive, without changing the required overall level of regulatory capital;
- separating operational risk from credit risk and quantifying both;
- 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 10- year 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, reducing the number of active participants and, consequently, liquidity. So what of Basel II's implementation?
Basel II's global implementation
The world is currently in limbo as regards the implementation of Basel II. Regulators in most jurisdictions around the world have indicated an intention to implement Basel II (95 national regulators, at last count, indicating they were to implement Basel II, in some form or another, by 2015), but with widely varying timelines and methodologies.
Prior to 1 January, 2008, European Union (EU) banks and other financial institutions may apply Basel I-based rules or adopt either of the Basel II standardised or foundation internal ratingsbased (IRB) approaches. From 1 January, 2008, within the UK and Europe, the 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.
What effect on CMBS will Basel II have?
The regulatory framework is changing under Basel II. As a result banks will look for alternative means to maximise revenues while avoiding the need to hold unrated and sub-investment-grade loan assets. It has already been seen that as a result of Basel II (and undoubtedly greater competition from bank lenders), there is now no longer a pricing differential between capital markets and banks.
Further effects that are possible in a post-Basel II world arise when one considers the relative change in the required capital to assets ratio pre- and post- Basel 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:
- based on fairly strong capital incentives, encourage banks with identical CRE loan portfolios to securitise the loans, further stimulating CMBS;
- encourage banks which use an IRB approach to increase lower-risk CRE lending and offload higher-risk real estate assets;
- encourage banks to sell-off noninvestment- grade tranches to market participants not subject to Basel II (such as hedge funds and investment groups);
- 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;
- 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;
- 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;
- 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
- 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.
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