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Feeding the slotting machine

Slotting in a nutshell:Regulated banks and other regulated financial institutions such as insurers need to hold capital to guard against the financial and operational risks they face - a risk

Slotting in a nutshell:

Regulated banks and other regulated financial institutions such as insurers need to hold capital to guard against the financial and operational risks they face - a risk weighting system designed to protect the institution (and its shareholders and other stakeholders) from losses. This capital is commonly known as regulatory capital, or capital adequacy.

Real estate loans from banks regulated by the PRA (and formerly the FCA) are subject to a strict "slotting" regime so far as regulatory capital is concerned. This note does not consider the position of insurers, who are regulated by a different regime (which will change in January 2016 under "Solvency II").

Generally speaking, an alternative asset management firm (or debt fund) will not be subject to the capital adequacy regulations of banks or insurers, albeit there may be restrictions in the relevant fund's investment objectives or constitutional documents.

This difference is regulatory capital treatment is a factor in the divergence of the real estate loans market, opening up the market, particularly for the higher risk transactions, to non-bank lenders.

Bank's and Regulatory Capital for real estate loans:

Under EU Regulations invoking the so called Basel II and Basel III international capital framework, (the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CDD)), a typical real estate investment loan to a special purpose entity, secured over income producing real estate, is considered a "specialised lending exposure".

Basel II allows two systems for banks to measure their regulatory capital, the "standardised approach", under which the regulations state the appropriate risk weighting for any given loan and the "internal models based (IRB) approach" that allows a bank to develop its own system to assess risk for regulatory capital purposes.

Whilst an institution can opt to operate the IRB approach instead of the standardised approach towards specialised lending exposures, Art 135(5) CRR states that where the relevant institution cannot estimate the relevant PD (probability of default), or the institution's PD estimates do not meet the requirements [for the IRB approach], the institution shall assign risk weight to these exposures according to the following table:

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% 0%[1]
Equal to or more than 2.5 years 70% 90% 115% 250% 0%


 

[1] On the basis the expected loss calculation would have written off 50% of the outstanding loan amount following default, then no further contingency is necessary

The table based risk weighting approach is known as "supervisory slotting" – as loans are "slotted" into the categories above. The FCA made a strong statement in 2013 by insisting that all institutions regulated by it adopt the slotting regime, notwithstanding the institution may risk weight assets using the IRB approach.

Earlier this year (May 2015)  the European Banking Authority (a body formed in 2010 that has the power to issue guidelines and recommendations in applying EU legislation) launched a consultation on slotting, the consultation period ending in August 2015. The consultation was motivated by the perceived lack of harmony in the EU banking industry in determining the capital requirements for specialised lending exposures. The objective of the consultation therefore was to try and establish (a minimal level of) harmonisation across the EU banking sector. We set out below some of the comments that have been made on slotting and the actual (and predicted) effect of the new proposals put forward by the EBA:

CREFC Europe:

Stated that the imposition of this prescriptive and mechanistic methodology for assigning risk to specialised lending exposures will be too "reductionist and inadequate in the context of commercial real estate".

CREFC also predicted that the impact of such a mechanistic system will be pro-cyclical and given that the most reliable indicator of risk in Income Producing Real Estate is the point in the cycle at which a loan is written, regulatory capital rules should be designed to operate in a counter-cyclical way.

It was also highlighted that this model would lead to competitive distortions as regulatory capital requirements would differ greatly depending on the categorised risk weight assigned to that lending exposure.

British Property Federation:

Commented that given the limited number of risk weight categories under slotting this will lead to a significant mismatch between true economic risk and regulatory capital outcomes.

BPF also highlighted the significant competitive distortions this may cause.

Investment Property Forum:

Commented that the standardised approach is not risk sensitive in the context of an overwhelmingly private and unrated CRE lending market. They comment that the new slotting criteria will create perverse incentives (particularly dangerous in the competitive environment of an overheating market) for lenders to move up the risk curve in pursuit of more profitable returns, without the discipline of capital rules to encourage appropriate pricing.

So what you may think!

One of the joys of the real estate lending in the current market is the diversity of lenders and asset classes of differing interest to such lenders. The different regulatory treatment does not create a level playing field, but for the time being, is one factor driving competitive tensions in the market. For borrower's, it is perhaps very confusing and an important take away point is that different institutions will be interested in different types of assets and deals, the regulatory capital treatment being one of many factors a lending institution will take into account in deciding whether to do a deal and at what price.

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