Background
In the late 1980’s a uniform framework for the levels of capital banks must hold was introduced by the Bank for International Settlements based in Basel, Basel l.
By the late 1990’s it was considered that a more sophisticated regime was required,
Basel ll. With a introduction timetable from the beginning of 2007.

Basel ll: An overview
Consists of three pillars.

Pillar 1
Credit Risk: Basel 1 had a single approach to calculating capital for credit risk. Basel ll offers a choice of three subject to approval by the FSA.

1/ The standardised approach: Group exposures classified into a series of categories.
2/ Foundation Internal Rating Based ( IRB): Lenders will be able to develop their own models to calculate capital requirements.
3/ Advanced IRB: Lenders with a more sophisticated approach can estimate the Loss Given Default (LGD), Exposure at Default (EAD) and the Probability of Default (PD).

Operation risk.
The risk of loss resulting from inadequate or failed internal processes. As with credit risk there are three models for calculating operating risk. Basic Indicator, Standardised Approach and Advanced Measurement Approaches (AMA)

Pillar 2
Identification of risks not included in Pillar 1.

Pillar 3
Requires lenders to disclose details of their risk management systems

Effect on Asset Finance Market:
Change within the market are likely to be driven by four major factors:

1/ Companies using the more sophisticated credit and operational risk management approaches permitted by Basel II (most likely to be the largest banks) will be able to source funds and write business at a significantly lower rate than others. Business will therefore migrate to the largest banks.

2/ The heavy capital requirements associated with high-risk business will make this particularly unattractive to IRB banks. IRB banks will therefore move towards the lowest risk business, which they will attract with the lower rates they can offer.

3/ Banks will adjust their portfolios of businesses to get rid of those that do not fit with the desired corporate risk profiles.

4/ The new focus on operational risk will punish AMA banks with poor financial controls. We can expect to see an increase in control and a corresponding reduction in entrepreneurialism in larger banks.

The effect of these factors specifically on the asset finance market can be subdivided as below.

Large-Bank-Owned Lessors:
Asset finance companies belonging to IRB banks are likely to benefit most from Basel II. Lessors using the most sophisticated approaches are likely to have significantly lower costs of funds than other competitors, and should therefore either be super-competitive or super-profitable or both. This is particularly the case with Advanced IRB lessors, who will be able to use leased assets as collateral.

Also, given the very low regulatory capital requirement associated with high quality business, there will also be strong pressure to write prime business at the expense of sub-prime business.

Taking both of these, IRB lessors can expect to face strong pressures from shareholders to realise these potential benefits. They can expect:

• Pressure to generate much stronger returns on equity
• Pressure to write more profitable business
• Pressure to vastly expand the size of their books using the same amount of capital, or
• Massively-intensified competition as IRB lessors fight for the same small pool of high quality business.

Only the most efficient lessors with the most finely-tuned systems will meet shareholder expectations in this hyper-competitive market.

More than this, the magnified damage that will be caused by operational risk losses under the AMA approach will intensify control demands. The potential fraud exposures caused by legacy non-integrated systems, off-system workarounds and loose financial control risk raising lessors’ cost of funds by an unacceptable amount for an unacceptably long period of time. Only with strong systems controls and constant vigilance will the cost of operational risk be driven down.

Medium-Sized-Bank-Owned Lessors:
Asset finance companies belonging to medium-sized banks (assume will find it difficult to move to Advanced IRB) will find it increasingly hard to compete on rate for commodity business, which will migrate to the largest banks. Problems with risk weightings on residual values will get in the way of using operating leasing as a differentiating factor.

Medium-sized lessors will have to “go niche” to survive.

To do this, they will have to compete with existing niche specialists. And to win, they will have to offer the high levels of specialised customer service that customers demand if they are not to source finance through their own (mainly big, IRB) banks.

Medium-sized lessors with old, inflexible, legacy systems will find it very hard to survive in this new market. But by investing in new systems now, they can position themselves to “blow away” existing niche incumbents where these have not adjusted to the new reality.

Niche Lessors:
Niche lessors will lose some business to the majors as the difference in rates offered increases. However, with their knowledge of the specialised needs of their clients’ needs, they should be able to mount a robust defence of their markets.

However, they need to keep a sharp eye on other finance companies seeking to enter their markets – it will become a matter of urgency for medium sized players to do so if they are to survive.

Bank-Based Operating Lessors:
Operating lessors face many of the same pressures as other finance companies, but have some protection from the bundling of other services with their product, which will help to camouflage rate differences.

On the other hand, they face the 100% risk weighting for operating leases under the IRB approaches. This may be particularly punishing for bank-based operating lessors with long-life assets and high residual values.

This is likely to put a lot of pressure on these lessors to achieve substantial cost-reduction if they are to achieve reasonable returns on equity. These can only be achieved through extensive automation.

Captives, Independents and Non-Bank Finance Companies:
For much of the world, Basel II only applies to internationally active banks. Within the EU, it is likely [2] to apply to the majority of credit institutions and investment firms that hold client funds (there are likely to be some specialist waivers).

Many existing lenders will therefore be outside the scope of Basel II. Other non-Basel II lenders may enter the market, either as spin-outs from banks or as new entrants. Prime among these may be captives able to use the strong credit rating of their parent to secure lower cost funding than is now possible.

As well as these, banks with primarily non-prime business may opt to use the Standardised Approach to credit risk assessment rather than IRB-based approaches: While this will damage their ability to compete for high quality business with majors, it will make them more competitive for sub-prime business.

As the largest, IRB-based banks focus on high quality business and withdraw from sub-prime lending, this will create plenty of opportunity for companies that can compete effectively in this new market space.

References:
Tracey Welch www.netsolcq.com
http://www.hm-treasury.gov.uk