Banks and borrowers could start to reclassify investment property lending as corporate loans to side-step the slotting regime’s onerous capital reserve requirements, an authoritative research paper on the controversial regulatory regime suggests.
IPD has this morning published a first-of-its-kind research paper attempting to quantify how effective slotting would have been in reducing UK banks’ risk management if the ‘five-bucket’ regime, to be implemented by the FSA, was in place prior the collapse of property markets and the evaporation of bank property lending more than five years ago.
Among a wide-ranging set of findings in the 69-page report – called The Slotting Approach to IPRE Risk Weighted Capital – IPD warns that a number of “perverse incentives” may lead to a further shift in the already blurred line between corporate loans and investment property real estate (IPRE) loans.
IPD argued that lenders and their borrowers could seek to redefine loans that were once deemed IPRE into corporate loans, a much lower risk-weighted asset (RWA) designation.
“This would rob commercial real estate risk managers and regulators of valuable information needed to pre-empt a future property lending crisis,” wrote Malcolm Frodsham and Kate Gimblett, the IPD report’s co-authors.
Slotting was first outlined in the original BIS Basel II to assign the risk weights applied to loans categorised as ‘specialist lending’ – a category that includes IPRE lending.
In its current form, slotting requires banks to classify the risk of each income-producing commercial real estate loans according to one of five slots ranging: ‘strong’, ‘good’, ‘satisfactory’ and ‘weak’ to ‘default’. Each slot requires the bank to hold a progressively higher amount of capital.
IPD’s findings – based on a ‘simulation experiment’ by constructing hypothetical loans made on actual IPRE assets contained in the IPD Quarterly Databank on the basis of a set of slotting ‘rules’ – reveal some distributing findings about the effectiveness of slotting as it stands, and the potential unintended consequences of its introduction.
Among IPD’s conclusions are:
- The methodological weakness in slotting is that: LTV; unexpired lease term; asset quality; and ICR/DSCR are given apparent equal weighting in the BIS criteria.
- IPD’s analysis show that the LTV at any point in time is dominated by market conditions which can lead to indiscriminate changes in asset values when the market rises or falls rapidly and causes frequent slot migration if a ‘Point in Time’ (PIT) approach to risk weights is required.
- The former FSA draft guidance on lease lengths was not consistent with leasing norms in the UK and IPD demonstrated that lease lengths need not be so restrictive.
- Income and lease security measures are based on idiosyncratic risks which are far more indicative of loan servicing capacity on a ‘Through The Cycle’ (TTC) basis.
- The impact of the DSCR on the maximum LTV “would have been a powerful countercyclical force in the recent cycle, enforcing a sharp fall in the average maximum loan-to-value for loans as yields declined during the run up to the market’s peak”. IPD said the use of combined LTV and ICR guidelines could prevent repetition of some of the worst excesses in lending and moderate cyclical extremes.
- Slotting could significantly exacerbate economic risks by reducing the value of banks’ current stocks of property. The additional capital required if the slotting method is used will force further de-leveraging of banks’ property loan books. The result will be more forced property sales that will further depress the property market, thus creating a vicious cycle of further losses in loans secured by commercial property.
Frodsham and Gimblett wrote: “In its present construction, the slotting method does not provide a useful methodology for improved risk management. Instead it may act to discourage IPRE lending altogether and it is likely to discourage low risk lending in particular.
“Our simulations indicate that slotting as currently construed provides disincentives for underwriting ‘strong’ and ‘good’ IPRE loans due to high capital requirements relative to downturn loss given defaults (LGDs).
“A retreat from the market is a possible consequence for many lenders if the capital required to underwrite loans is not consistent with risk-adjusted prospective returns. Further, the incentives embedded in slotting could skew the remaining bank lending toward future exposure concentrations in the higher risk slots.”
Framework for IPD’s analysis
IPD used actual historic data across the whole of the last downturn. By looking at how real assets performed over that period, IPD drew up projections to assess the forward-looking implications of slotting.
With a complete picture of the last downturn, IPD analysed the subtleties around the allocation of risk-weighted capital – using three simulations to model loan performance.
The framework for IPD’s simulations blended hypothetical loans with a period of actual severe distress in property values, and is based on 3,442 UK IPRE assets initially valued at £56.6bn over the period Q2 2007, the UK market’s peak, to the end of Q4 2011.
IPD’s analysis attempts to determine whether the calibration of risk weights would have been sufficient, insufficient or overly conservative to absorb losses through the last cycle.
Three simulations were run: the first assumed no amortisation, i.e. full bullet interest only loans. The second and third simulations assumed partial amortisation on the hypothetical loans of 0.5% per quarter.
In all three simulations, IPD found that the risk-weighted capital mandated for the ‘strong’ and ‘good’ slots was well in excess of downturn loss given default (LGD) – even at the nadir of the cycle using the restrictive assumption that any loan with an LTV greater than 100% immediately results in the collateral asset’s possession and sale by the lender.
IPD also found that the risk weighted capital mandated for the ‘weak’ slot is in excess of downturn LGD at the cyclical low in both of our part-amortising simulations. Only in the bullet loan simulation does the risk weight appear about right for the ‘weak’ slot.
However, the risk weight for the ‘satisfactory’ slot is too low at the cyclical nadir in all three simulations if an LTV in excess of 100% triggers possession and sale at the bottom of the cycle.
Frodsham and Gimblett wrote: “We do see ample potential for a more a more risk sensitive UK slotting regime that would provide capital cost incentives to lend in a stabilising manner.
“Such a slotting regime would involve the use of more slots, and each slot would have a risk weight that is more finely calibrated to align with the downturn LGD for exposures with that slot’s associated risk profile. Such a regime could operate on a TTC basis and thus avoid pro-cyclicality.”
For a full explanation of the three simulations and IPD’s conclusion, please download the full report here.
IPD hope to provide evidence to underpin the above alternative slotting methodology in a further paper.
In this second paper, IPD will employ further simulations using IPD data in which the sensitivity of defaults for variations in the LTV, ICR, DSCR, Tenant PD and Unexpired Average Lease Length will all be examined to quantify the relative influence of each of these dimensions.
IPD will then use these simulations to provide insights into the weightings that should be attached to each risk factor in order to place each exposure in an appropriate slot.