implementation of basel ii in lease sectorbartlomiej... · basel ii accord in the leasing industry....

Implementation of Basel II in lease sector

18th of October, 2007

1© 2007 KPMG Advisory Sp. z o.o., the Polish member firm of KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted.

KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.

l Lease companies which are part of bank groups must apply to the requirements of Basel II (no other option).

lWhen writing Basel II, the specification of lease companies was not taken into account.

l Selection of approach of adapting requirements for credit, operational and market risks are for mother companies (banks); mother company may make a decision that the selection of approach should be made by lease company.

lOn the next slides we are presenting KPMG version of „Basel II Implementation, Ranking 2003” prepared by Solvay Business School Université Libre de Bruxelles for Leaseurope.

Basel II vs. lease sector

What Romanian lease companies should do?

Basel II Implementation, Ranking 2003



lOur main objective was to write a report on the challenges of the implementation of the Basel II Accord in the leasing industry. The aim of the survey was to find out the questions; difficulties or challenges European leasing companies are facing or will face regarding the implementation of the Basel II Accord. The concerns of the leasing industry constitute the core of the paper. l Information has been gathered through 21 interviews with professionals from small,

medium and large size leasing companies spread over different European countries, as well as with a few national associations. Nevertheless, the number of large leasing companies is predominant in our sample. A larger and more balanced sample could have provided a clearer and more precise view especially on the problems faced by smaller companies.

l The majority of information was gathered trough a questionnaire during the Business Seminar organized by Leaseurope on December 3rd 2003. These interviews identified problems which are mentioned in report.

l The encountered difficulties are grouped in 8 main areas: models, physical collaterals, residual value, retail-corporate distinction, level-playing field, operational risk, pillar II and III, discrepancies with IAS. Then, recommendations of further actions for lease sector are presented

Implementation of Basel II



l Leasing accounts for 15% of the total amount of gross fixed capital formation in Europe and is among the most used external sources of financing by European SMEs. Therefore changes within the leasing environment can have a significant impact on the economy. The New Capital Adequacy Framework outlined by the Basel II Accord introduces a major change in the leasing industry. Although it is essential to set high standards for prudential regulation of capital requirements in order to achieve financial services stability in a global market, it is also crucial to take into account the specificities of the leasing sector in order to preserve that stability. As a result, there is a growing need for assessing whether the leasing sector is prepared for the revolution that Basel II entails in the financial industry.

l Hence, the aim of this research is to outline the questions, difficulties and challenges that are faced or will be faced in the future by European leasing companies regarding the implementation of the Basel II Accord. The concerns of the leasing industry constitute the core of this work.

Basel II and lease sector: implementation aspects (1)



l Information has been gathered through 21 interviews with professionals from small, medium and large size leasing companies spread over different European countries, as well as with a few national associations. Nevertheless, the number of large leasing companies is predominant in our sample. A larger and more balanced sample could have provided a clearer and more precise view especially on the problems faced by smaller companies. The majority of the contacts were gathered through a questionnaire during the Business Seminar organized by Leaseurope on December 3rd 2003.

l The interviews were lead by means of a guideline to ensure that several key topics of the Basel II Accord were dealt with. The guideline is available in appendix.

l These interviews have outlined many common concerns across leasing companies.




l The encountered difficulties are grouped in 8 main areas: models, physical collaterals, residual value, retail-corporate distinction, level-playing field, operational risk, pillar II and III, discrepancies with IAS. Then, suggestions regarding further research and the role of Leaseurope in facilitating the implementation of the New Capital Adequacy Framework for the Leasing industry are made.




AIMFind out what challenges European leasing companies are facing or will face regarding the implementation of the Basel II Accord”

METHODOLOGY

21 interviews

Spread geographically and of different size Identification of issues through interview guideline

“Basel II and the Leasing Industry: Implementation Issues”

Interviews 2

Questionnaire: 43 respondents

“Basel II Implementation in the Leasing Industry: A Snapshot”

Business forum survey

1

Implementation of Basel II



Readiness of the sector ?(1 –Not ready at all; 4 –Totally ready)

“Which of the aspects of the Basel II accord will be the most challenging to implement?”

0Pillar 3, including the new market discipline procedures

5Pillar 2, including the new supervisory review procedure

22Pillar 1, including risk modeling for operational risk

23Pillar 1, including risk modeling for credit risk

7%

63%

27%

2%0%

10%

20%30%40%50%

60%70%80%

90%100%

1 2 3 4

Business Forum Research (1)



Which approach will your company be using to assess credit risk?

Has enough attention been paid tothe implementation issues related tothe pillars 2 and 3 ? (1- Not enough; 4- Enough) 24%

62%

14%

0%0%

10%

20%30%

40%50%

60%70%

80%90%

100%

1 2 3 4

70%

23%

7%

IRB Advanced Approach

Standardized Approach

IRB Foundation Approach




If you were to choose one of the IRB approaches how challenging will the task of calculating

internally generated inputs (PD, LGD, EAD) be?

(1 –Straightforward; 4 –Very challenging)

3%12%

41% 44%

0%

10%20%

30%40%

50%

60%70%

80%90%

100%

1 2 3 4




Lack of response from the authorities

Undefined discretionary power of national regulatorsHurdle

Problems

Potential

solution

Current

situation

Complex and Unclear RulesLack of clear examples in the CP3Leasing specificities not acknowledged

Need for dialogue with– Regulatory authorities– European Commission– Industry & Associations

Advance on “moving bases”

Challenges connected with implementation (1)



Uncertainty of–The validation of the LGD model–The required complexity of the LGD model

Data availability and reliability (Real Estate, Acquisitions)

Data pooling

Disclosure to the competition

External data use

Only for validation of the model?

Problem

Hurdle

Potential Solution

Current situation

Hurdle

Potential Solution




Arbitrary Period

Problem

Potential

Solution

Technical or Economic Defaults

End of DefaultProblem

Potential Solution

Need for dialogue with regulators




Annual Revision & Inspection of the assets–Scope of application ?

–Number of assets

–Mobility of assets

–Cost implied

–Irrelevance: low deterioration rate

Problems

Potential

SolutionsInspection of a sampleCombine signing of contract with inspectionDialogue with authorities




Level-playing FieldScope of discretionary power

Supervisory authority for subsidiaries: host or home country?

Reduce discretionary powerSupervisory cooperation Coordinating supervisory authority

Problems

PotentialSolutions




Retail–Corporate DistinctionRegular small amount contracts &Naturally corporate clientsNeed for dialogue with regulators

Need for dialogue with regulators

Residual ValueNeed for further academic researchE.g. residual value for equipments

Problems

Potential

solution




l Assist with interpretation of texts and provide examples

l Enhance exchange of information

lOrganize discussion forums at industry level

l Represent sector’s preoccupations at EU level

l Identify best practices

l Lead further academic studies

Implications for Leaseurope



l 175 respondents

l Description of Ranking 2003

– Total value of leased assets

– Value of new contracts (production)

– Parent (59%) & subsidiary (41%)

l Evolution with 2002

− Sectorial split:l Automotive (automobile & trucks)

l Equipment

l Real Estate

Ranking 2003



l Figure confirmation by companies

l Comparison of the sum of leased assets by country with national associations’ figures

l Comparison with 2002 figures

l Average duration

l Further investigation of individual problems

Verification Process



New Contracts as a Percentage of Leased Assets

54%

44%

27%

0%10%20%

30%40%50%60%70%

80%90%

100%

Automotive Equipment Real Estate

Results Analysis (1)



31% 32%

37%

Real EstateAutomotiveEquipment

Parts of Sectors in Total Value of Leased Assets 2003




Part of Sectors in Total Value of New Contracts 2003

41%

39%

20%

AutomotiveEquipmentReal Estate




lMost of the time, the interviewed leasing companies will be adopting the IRB Advanced approach to credit risk management. The few respondents using the IRB Foundation approach intend to switch to the IRB Advanced approach at a later stage. For leasing companies belonging to a larger banking group, the choice of approach has been made at the level of the mother company. If the latter adopts an IRB approach, the same approach has to be adopted across the entirety of the group.

l Leasing companies are confronted with several difficulties when having to build their PD and LGD models.

l First, given that an agreement concerning the final provisions of the Capital Adequacy Directive has not yet been reached at the European level, much uncertainty is added to the preparation process.

Models (1)



lMoreover, the degree of discretionary power handed over to national regulators is not clearly defined.

l Despite these problems, companies have to start building their models and advance on moving bases. Ambiguity as to the required level of complexity for the models as well as whether these will be approved by the national regulators has to be managed. In some countries, this issue has been addressed through a constant and constructive dialogue with the regulatory authority.

l Second, data collection and processing is another major challenge related to model building. According to Article 146 of the CP3 working document, companies willing to adopt an IRB approach between December 31, 2006 and December 31, 2009 have to have at least two years of available data on December 31, 2006. Both availability and reliability of data are main difficulties that arise in a vast majority of companies.

Models (2)



lOften data on defaults is contained in physical archives. These have to be transposed into an electronic format, which is extremely time consuming and costly, and involves risks of human errors. No particular solution exists as to the problem of data reliability. Time and resources are to be allocated to it in order to build the models on an appropriate base.

l In some companies or for some types of contracts sufficient data for the validation of the models was not available at all. This problem is particularly acute in the real estate segment of the leasing industry. Real estate leasing appears to bear very little risk, since many leasing companies were confronted with statistically insufficient numbers of defaults to validate their models. The long life period of such assets represents an additional difficulty.

Models (3)



l A potential solution to this problem is creating pools of data among industry members. However, sometimes difficulties as to convincing some companies to give in their data may prove to be troublesome. Moreover, it is not yet clear that all regulators will approve this method. Indeed, the question of whether external data can be used to build the models themselves, or can be used only for their back-testing remains open. If accepted, appropriate data could be potentially transmitted to the national regulators which would subsequently provide the required model parameters.

l In some instances, leasing companies need to develop a new IT system for data processing. It was considered as necessary to introduce a common platform for a given group and it had to be started as early as possible in order to be ready by the end of 2006 despite the fact that the regulatory framework had not been finalized.

Models (4)



l Third, a number of problems relate to the definition of default. The latter is defined with regard to a particular obligor when either or both of these events have occurred:

– The institution considers the obligor is unlikely to pay the entirety of his credit obligations;

– The obligor is past due 90 days on any material credit obligation to the institution.

l The number of days limit varies across countries. Nevertheless, the central problem resides in the fact that a default on one contract triggers default on all contracts of an obligor. Sometimes, the delay in payment is simply due to the lessee experiencing technical problems. Thus, it is a technical rather than an economic default.

Models (5)



l Lessees having a large number of small contracts with the same lessor are very sensitive to this issue. While ultimately these defaults involve little losses for leasing companies, they have a significant consequence on capital requirements. Leasing companies would prefer to operate a distinction between “economic” and “technical” defaults.

lMoreover, if a client is defined as defaulted by Basel II, but still continues to meet his subsequent obligations, doubts remain as to the duration after which he would no longer be considered as being in default.

Models (6)



l Fourth, some difficulties arise from the annual revision of the rating (PD). It is specified in Annex D-5 that rating for individual corporate exposures should be revised annually (Annex D-5 § 2.2 - 27). Retail exposure should be assigned to a pool. The rating of each identified risk pool is to be revised at least on an annual basis (Annex D-5 § 2.2 - 29). Several players mentioned the laborious process of gathering information related to their small clients. Again data pooling at company or at regulatory level could be a solution to cope with the demanding regulation. However, for leasing companies which are part of a larger group, ratings could be provided by the Parent company for common clients.

Models (7)



lWhereas financial institutions will assess internally the impact of collaterals on capital requirements under the IRB A approach – under the Standardized approach, eligible physical collaterals are limited to real estate and under the IRB F approach, the capital relief granted is constrained by regulatory floor to LGD adjustment (a maximum decrease in LGD from 45% to 40%). The current legislation does not correctly reflect the fact that the lessor has the legal title of ownership of the leased asset during the entire lease term.

l Respondents implementing the Standardized Approach were asked if they considered that the non-recognition of physical collateral affected them significantly. This seemed to be indeed the case even though a majority did not appear to be very knowledgeable about this issue. This stresses once again the lack of information and preparedness of the small independent leasing enterprises, which are obviously the most concerned regarding this matter.

Physical Collaterals (1)



l Besides, when assessing whether the IRB-A companies would go for the Standardized Approach if the risk mitigating property of physical collateral were to be acknowledged under the latter approach, very few responded positively. Since smaller leasing companies are the party which is most concerned with the physical collateral recognition under the Standardized approach, they should increasingly try to garner influence at the commission level, potentially through Leaseurope.

l As mentioned above, under the IRB Foundation approach, lease contracts are assigned a PD according to the internal borrower grade and a LGD of 45%. LGD can be adjusted to recognize the mitigating effect of “other physical collateral” to reach a floor of 40%.




l For “other physical collateral” to be recognized as eligible a number of minimum requirements have to be met. One of them states that in the case of inventories and equipment, the periodic revaluation process must include physical inspection of the collateral (cf. Annex E-2, §2.1.6. sixth bullet point). Given the large number of contracts that leasing companies have, often in thousands, physical inspection would represent an excessive burden. Many industry professionals point to the impossibility of proceeding to such inspections. This problem is exacerbated by the mobility of some assets.

l Besides the tremendous costs implied, some interviewees point to the irrelevance of such a provision. Non-recovery of an asset is extremely rare, even for automotive leased assets. Some argue that the non-recuperation of assets should be taken into account in operational risk, while for others it would have already been reflected in the LGD figures through the lower resale price of the asset.




l Currently, there appears to be confusion among professionals as to whether physical inspection is required under both the IRB Advanced and the IRB Foundation approaches or is only applicable in the latter approach. Although the text is a bit confusing, this provision appears under the title “Minimum requirement for the recognition of other physical collateral under the IRB Foundation Approach.” One of the solutions to this problem resides again in the dialogue with the regulatory authority.

l Some leasing companies suggest that inspection should be done only on a sample of contracts. Others suggest proceeding to the inspection of some contracts only based on the relationship with the clients. A third solution is that salesmen proceed to an inspection of assets when they go to the clients’ for the signature of a new contract. Nevertheless, salesmen are not experts in this field.




l The residual value risk for leases will be risk weighted at 100% as a result of the company’s exposure to potential loss due to the fair value of the equipment declining below its residual estimate at lease inspection (Annex E-2; §2.1.7 (b), 2nd bullet point, p.17). The Commission Services’ feedback on responses received to the CP3 corroborates this provision. According to the Commission the 100% weighting represents a proportionate treatment. Thus it would not be prudentially justified to require capital to be held in relation to this risk only from the date of expiry of the lease contract.

l For a vast majority of interviewees, accounting for residual value risk could lead to an overstatement of risks, especially if the residual value of the leased asset is included in the exposure at default of the customer. On the one hand, if the lessee defaults during the contract, the LGD assigned to the transaction already reflects the loss due to the depreciation of the asset.

Residual Value (1)



lOn the other hand, if the lessee performs according to his obligations residual value risk would arise only at the end of the contract. Thus, it is only when the asset ceases to be included in the exposure to the lessee, that it can be risk-weighted for the residual value risk. Moreover, the risk arising at the end of the contract is often mitigated by the repurchasing agreements that leasing companies have with the suppliers of the leased asset. Even when repurchasing agreements are not concluded, the residual value is sometimes estimated by expert analyses thus considerably reducing this risk. Finally, uncertainty as to whether the residual value provision is applicable only to financial leases or both to financial and operating leases persists among industry professionals.

Residual Value (2)



l There was much support to further debate the residual value issue. Leaseurope could therefore lead further discussion with the European Commission regarding the weighting ratio attributed to residual value. Furthermore, some of the interviewees suggested that a discussion forum with the Commission Services should be set up in order to have a structured and constructive dialogue on this topic.

Residual Value (3)



l The CP3 distinguishes between retail and corporate exposures. The treatment of these two categories differs in complexity, for instance, as far as the rating attribution and revision processes, as well as data maintenance are concerned. This distinction is perceived as somewhat artificial by many professionals of the leasing sector. In some cases, leasing companies are not even certain as to whether a given contract is to be considered as retail or corporate exposure. Moreover, regulatory authorities’ responses on this issue are seldom seen as satisfactory.

l Additionally, leasing companies have often developed a standardized and automatic procedure to deal with the small-ticket items. However, according to Basel II, some of the latter are to be considered as corporate exposures if the lessee has a corporate-nature status. This is the case for large companies, banks, public authorities. This implies a more complex approach on behalf of the leasing companies even for regular contracts below €30,000. Leasing companies fear that their productivity and cost-effectiveness may be affected. Some of them have addressed this issue to the national regulator.

Retail - Corporate Distinction



l The Basel II proposal and the CP3 grant a number of discretionary powers to the local supervisory authorities. In general, interviewees agree country-specific elements should be recognized even if some of them are critical of the number of national options and discretions. The Commission’s recent feed-back report underlines the importance of keeping these discretions to minimum. Nevertheless, these discretionary powers are not clearly comprehended by leasing companies.

l Local supervisory authorities engage in a dialogue with their local leasing companies to develop solutions to the potential problems. It appears necessary that the rules remain coherent with the spirit of Basel II; the supervisory authorities should remain intermediaries. Concern has been expressed about the potential for divergences in implementation, interpretation and application of the Basel II framework.

The Level-playing field (1)



l Leasing companies, particularly larger groups, have a working relationship with their local supervisory authority. Through the dialogue with these authorities, the leasing companies generally receive answers to Basel II related problems. However, solutions or orientations given by an authority are not necessarily comparable to the solutions proposed by the authority of a second country. For example, at the Belgian level, a working group has been established to find solutions for the lack of data in the real-estate sector. By a pooling of data, companies will be able to build an adequate model. In France, however, the pooling of data would only be used to validate a model but not to build one.




lMany companies remain in doubt as to which authority they should report to and whether they have to comply to local rules or with their home rules.

l The Commission is conscious of this difficulty and encourages an enhancing of the supervisory cooperation.

l Competition related problems could arise between direct competitors subject to different regulatory authorities. It could happen that subsidiaries of a European group are subject to the authority of the mother company’s regulator, while its direct competitors in the local country are subject to the local authorities. If the two regulators have a different interpretation of the provisions of the Capital Adequacy Directive, then the above two companies will not be competing on equal bases. Currently, most leasing companies are not aware of the solutions given by foreign authorities and how these solutions differ from those proposed by their local regulators or how they might apply in their own country.




l Basel II requires from bank groups to hold additional capital against operational risk. The prudential framework for operational risk will consist of three elements. Firstly, risk management standards which are there to provide a first line of defense against operational risk, in particular with respect to low-frequency high-impact events. Secondly, a capital buffer against adverse operational risk events. Every institution will be subject to a minimum capital requirement for operational risk. In comparison with the requirements for credit risk and other requirements, requirements for operational risk are perceived as requirements with lower priority. Only the most advanced companies will adapt to AMA requirements (advanced method of operational risk measurement).

Operational Risk (1)



lMost of lease companies is well aware of the necessity to manage operational risk. However, even when aware of it, SMEs hardly ever take care of operational risk management as things stands. As a matter of fact, if the company is a subsidiary, the operational risk management is often transferred to parent companies, generally banks. But smaller companies lacking those deep pockets experience huge difficulties even with operational risk assessment and management. All this led us to the conclusion that the only players that started to deal with the operational risk challenge are the biggest companies, but that even in this case, the issue is seen as being secondary.

Operational Risk (2)



l Pillar II establishes supervisory review processes and Pillar III deals with market discipline. Both pillars are far from being considered as priorities by the leasing sector. In some countries companies argue that regulation is already at the edge with the Basel II requirements and that little or no changes would therefore need to be introduced. Most large leasing companies do not perceive any potential difficulties with the implementation of Pillars II and III. Maybe more information will need to be disclosed but this will not increase their costs considerably. Moreover, parent companies seem to be viewed as fully responsible for this issue. For smaller companies, other issues need to be addressed first. Consequently, little attention is paid to these two pillars of the Basel II Accord. The issue is more compelling in countries, where supervisory and disclosure standards are not yet satisfactory.

Pillars II and III of the Basel II Accord



l Along with the implementation of the Basel II Accord, some leasing companies face the challenge of adopting the International Accounting Standards (IAS). Therefore, difficulties may arise because of discrepancies between the IAS standards and the Basel II requirements. In practice, all publicly traded companies have to comply with IAS.

l However, this problem is not considered as a major one in the latter companies. Interviewees suggest that both Basel II provisions and IAS are complementary if operational and financial lease are dealt with separately. If this is not the case, then some discrepancies may exist. Again parent companies are often the planners and decision makers in this regard. However, the leasing sector, in his great majority, appears not to be aware yet of potential problems with regard to IAS and Basel II interactions.

Discrepancies between the implementation of the IAS accounting standards and the Basel II requirements



l In conclusion, most difficulties experienced by leasing companies with relation to the implementation the Basel II Accord, are concentrated around Pillar I and in particular Credit Risk.

l As far as model building is concerned, the following four main challenges arise: – Uncertainty related to the fact that final provisions have not yet been agreed

upon at the European level and to the degree of discretionary power of national regulators;

– Data collection and processing;

– Definition of default and in particular the distinction between technical and economic default as well as the period necessary for a defaulted lessee to be considered as “cured” if he continues to pay;

– Annual revision of the PD.

Conclusions (1)



l Physical inspection of inventories and equipment is a minimum requirement that cannot be possibly met by leasing companies.

l The excessive nature of the 100% weighting of residual value is stressed by the existence of repurchasing agreements and expert analyses.

l The retail-corporate exposure split is perceived as an artificial one among most industry professionals.

l If too many discrepancies exist between national regulations as to capital requirements, a genuinely level playing field may not exist.

l Leasing companies appear to be less concerned about issues related to Operational Risk, Pillars II and III, and IAS.

Conclusions (2)



l Suggestions and needs of surveyed banks are tasks to perform for Leaseurope.

l The most demanded action is certainly the representation of leasing companies’preoccupations and needs at the European commission level. Among these needs are the ones expressed in previous paragraphs, especially the residual value weighting and physical inspections issues. Nevertheless, numerous other actions were directly or indirectly suggested:

– Assist with a common interpretation of the Basel II text and provide examples;

– Enhance exchange of information about the progress of the relations between regulatory authorities, associations and companies in other countries;

– Inform as to what happens on the regulatory and political level;

– Represent sector’s preoccupations and needs at the European Commission level;

Implications for Leaseurope (1)



– Give the opportunity to set contacts within the leasing sector;

– Act as a benchmark on international basis;

– Contribute to the data pooling movement;

– Evaluate the probability for the sector that the leased assets are not recovered by companies;

– Lead further studies as to the residual value risk related to equipment leases;

– Identify best practices.




l Therefore, discussion and business forums should continue to enhance awareness and knowledge of the New Capital Adequacy Framework among the leasing sector. Exchange of information will then be facilitated through the making of new contacts. Training could also be provided to small or medium size companies that do not dispose of adequate competences. Best practices can then be disseminated to less resourceful companies.

l Bargaining power at the European Commission should be enhanced. Therefore, the law of high numbers should be stressed. Efforts made directly by Leaseurope are already very intensive. Indirect efforts could be enhanced by stimulating companies to lobby directly towards the European commission with the support of Leaseurope. Nevertheless, the question remains open as to what extent the high number of letters arriving at the Commission level will contribute to represent the importance of taking into account the specificities of the leasing sector.




Contact

Bartłomiej Ś[email protected]

KPMG Advisory Spolka Komandytowa Sp. z o. o.ul. Chłodna 5100-867 WarszawaTel: +48 (22) 528 11 00Fax: +48 (22) 528 10 09www.kpmg.pl

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