Risk and CRE Backed Loans
Capital retention
As a requirement of Basel III, this represents a safety net to accommodate the worst case scenario of default.
Risk should be based on both impact and probability. In a stress test, the impact is set to a maximum and the probability to a certainty. In a dire situation, these two approaches could coincide. Under normal conditions, with this risk analysis, the risk to a loan is identified, evaluated and accommodated entirely by the borrower.
Given that at present various different approaches are trying to address the same underlying risks, it is hardly surprising that loan terms in difficult situations are generally so unappealing.
Lack of a coherent risk analysis can lead to overestimation of risk and harsh loan terms in bad times, and to underestimation of risk and reckless loan terms in good times.
The calculated support fund shifts the risk from the bank to the borrower, thereby reducing the requirement for retained capital.
Risk and Regulation in Business Loans
There are generally two main areas of risk attached to a loan. One comes from the uncertainty in LIBOR, which determines the interest cost of the loan to the bank. The other is the risk from the collateral that underpins the loan.
Loans are more secure if based on a full risk analysis of both collateral and LIBOR.
Current Approach to Business Loan Risk
ICR and LTV covenants
Such covenants usually apply a very generous safety margin between what the collateral offers, and what the loan actually requires in terms of value and support. The primary impact of this safety margin is to reduce the effectiveness of the collateral, thereby increasing the risk of default. A proper Crucial risk evaluation renders this largely unnecessary.
Swaps
This process effectively calculates the average LIBOR over the term of the Swap, augmented according to the increased risk attached to it. The cover is often extended well beyond the term of the loan. In the event of loan transfer or disposal, truncation of the associated Swap is often regarded as a problem, especially if crystallised under conditions where the Swap rate is very different from the current rate.
However, it is possible to separate LIBOR risk from the collateral risk, and to decouple them. This would allow the Swap to be transferred to different collateral, even to a different borrower, without truncation and with simple readjustment to changes in collateral risk attached to a new situation.
Slotting
This places collateral into one of around five bands of risk on a cautious and pessimistic basis. This process of 'slotting' is crude and rendered unnecessary if risk has been properly assessed.
Who could use this facility?
Banks or other lenders who need to evaluate the risk attached to underwriting loans based on the CRE collateral offered, and concomitant loan structure required.
Banks who want simple, automated self regulation at branch or regional level, for calculating loan values on property collateral within a predetermined and acceptable level of risk.
Borrowers who wish to examine the risk to their residual cash flow and the possibility of default, as they explore the gearing potential of their investments.
Borrowers who wish to assess the funds they should keep in reserve to cover the risk attached to the size of loan they would like to borrow, depending on their risk tolerance or that of their underwriter.
