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Second NEFI Statement on Basle II - Februrary 2003      Activities  As SME Financiers, the NEFI Partners welcome the decision of the Basel Committee to agree on an SME package and the willingness of the Commission Services to follow this approach. We agree very much that these efforts were necessary to ensure that the new proposal delivers an appropriate treatment to credit exposures related to SMEs. We acknowledge the special treatment mentioned in the Working Document and are happy that some of the opinions expressed in their last comments were taken into account in the current documents of the Commission Services and the Basel Committee. The NEFI Partners underline the importance of an adequate financing structure for SMEs for wealth and growth in the EU, and are firmly convinced that the efforts made by NEFI Partners both in regard to loans and equity will help to reach the ultimate goals of the EU. Better access to financing with reasonable terms and conditions has formed a key element in the EU policies to safeguard an improved financial environment for SMEs. Most of the SME loans will be covered by the “retail portfolio”. The S-factor (for size adjustment) contributes to alleviating cliff effects by passing from the retail portfolio to the corporate portfolio. As to maturity adjustments, NEFI Partners agree that loans to corporates situated in the EU with a turnover as well as total assets for the consolidated group of less than € 500 million can be excluded from the explicit maturity adjustment. We also very much appreciate the openness of the Commission Services to a dialogue with industry and SME organizations. NEFI Partners strongly supports the idea of an impact study to prove the intended effects of the New Basel Accord and the EU Directive. The NEFI Partners support the Commission in establishing a well-defined equilibrium with the following features: - a level playing field for all banks in the EU and the Accession Countries, where these banks act in the same relevant market; - the acknowledgement of the European financing culture with long-term loans and a deep and fruitful relation between banks and their SME clients and appropriate approaches for even smaller and less complex banks and other financial institutions like promotional banks; - a flexible approach towards changes in the banking industry and appropriate procedures with the European Parliament and the Council. In this respect, the NEFI Partners welcome the plans expressed in the Working Document to allow risk mitigation for operational risk by insurance contracts even in the standardized approach for operational risk. We also agree to the proposal of the Working Document to allow small institutions with a limited number of sovereigns or institutions as counterparts a permanent partial use for these asset classes even in cases where institutions' exposures to such counterparts are material. In this context, the NEFI Partners wish to present the following remarks to keep in touch with the work in progress: 1) The change from the standardized approach to the Internal Rating-Based approach – and with it an improved risk management – should be worthwhile also for those banks which are strongly specialized in financing small and medium-sized customers. The conditions of use of the IRB approach should take into account the constraints of certain promotional banks, in particular, the practical difficulties for them to annually update the rating of part of the borrowers. As financing concepts vary between EU Member states due to a predominant on-lending concept, and as a result limited access to the borrowers’ data, special provisions might be necessary. Generally speaking, the problem of the applicability of the IRB approach to SMEs remains. Due to the promotional nature of NEFI Partners, problems in obtaining the necessary information even for exposures for SMEs of over € 1 million are known. Nevertheless most of them belong to special programs in which risk is assessed taking into account relevant factors such as collateral or commercial contracts. The approval decision criteria follow a standardized procedure close to the retail procedure. Therefore the NEFI Partners think that banks should have the possibility to include these loans in a specific retail bucket in the absence of information even if the exposure exceeds the € 1 million limit. An operational relief for promotional banks as indicated above should also be discussed. 2) Furthermore we believe that important threshold effects between corporate and retail portfolios exist in the IRB Foundation Approach, which could lead to discriminations between analogous SMEs due to the cumulative influence of two factors: (i) despite the S-factor, the disparity between the corporate weighting and the retail weighting remains very significant for comparable risk parameters and (ii) the product dimension of a retail pool permits the technical effects of credit risk mitigation which are not recognized in the framework of the IRB Foundation Approach. Equipment leasing is a good example of these cumulative effects. In retail equipment leasing portfolios, taking into consideration the property of financed assets, lead to LGDs from 15% to 40% (according to the estimates of the French ASF), depending on the nature of the assets, when the LGD will be 45% for analogous operations in favor of corporate portfolio ranked SMEs. For equipment leasing operations, capital requirements for analogous quality SMEs will thus vary depending on their qualification in corporate or retail portfolios. 3) The Basel Committee has kept the core propositions on the capital requirement of equity exposures unchanged and added some floors. The unintended effects may be that the standardized approach is substantially more attractive than the IRB approach. The new Basel Accord and the European Directive should provide banks with more proper incentives to move from the standardized to the IRB approach and ensure the market for equity financing. The NEFI Partners agree that equity covers more risk than loans, but we would like to take into account the importance of equity financing especially for start-ups. Risk weights of the IRB approach and the amount of the LGD should therefore be reviewed critically. Just like loans to SMEs, small equity exposures should benefit from lower risk weights by assigning them to a retail portfolio. The planned partial carve-out of national legislated promotional programs is beneficial in principle. However, equity capital financing plays a much greater role for US SMEs than for EU SMEs, since in most of the EU Member States long-term financing or guarantees on long-term credits granted by banks predominate. Accordingly, an improvement of the terms of loans and guarantees should be called for in the IRB approach for loans and guarantees. So the NEFI Partners would like to see the wording changed into: “programs by promotional banks”. 4) The widened recognition of risk mitigation techniques in the framework of standardized and foundation IRB approaches notably improves the risk evaluation. But this recognition focuses essentially on techniques (collateral on transferable securities, credit derivatives) which are marginally utilized in loans to SMEs. However, these loans benefit from collateral techniques which vary from one country to another in accordance with their legal traditions. This is even more relevant in the case of property and equipment leasing, as the lender is also the owner of the assets he has financed. The financing of SMEs could be strongly penalized if this collateral was not recognized by the Supervisory Body. In the framework of the IRB Foundation Approach, a widened recognition could alleviate the threshold effects between corporate and retail portfolios. In many Member States of the EU, general economic interest policies in favour of SMEs include guarantees granted by financial institutions, such as those of some NEFI Partners. It is very important that the Basel proposals on Credit Risk Mitigation Techniques do not unduly penalize these operations. The Basel Committee gives a definition of eligible guarantee which does not take into account national specificity linked to legal traditions. It is desirable that the Directive give the national supervisors the possibility to integrate in the Risk Credit Mitigation specific guarantee modalities when they deem their soundness equivalent to well-recognized guarantees. The fact that the capital requirement of a guaranteed credit depends on the probability of simultaneous default by both the debtor and the guarantor is not disputed. This probability depends on the credit quality of the debtor and the guarantor as well as the existing correlation between the debtor’s default and the guarantor’s default. But this reality is not taken into account in the propositions of the Basel Committee related to the processing of credit collateral in the framework of the standardized approach and the IRB Foundation Approach. Therefore, for these approaches, the NEFI Partners ask the Supervisory Body for the recognition of the effect of the joint default probability in the calculation of risk weights. Consequently, the guarantee effect should be independent of the nature of the guarantor (i.e. not limited to sovereign entities, PSE and banks), and no exclusion based on the guarantor’s rating or the relative value of default probabilities (or ratings) of the debtor and the guarantor can be considered justified. In particular, it seems very important that the institutions guaranteeing credits to SMEs, independently of their status, whether they be subject to banking supervision or not, be recognized by the Supervisory Board, notably the Reciprocal Guarantee Companies, as these companies provide typical collateral to SMEs. This demand seems all the more justified as the correlation between the event of default of an SME and the event of default of an institution intervening usually in the framework of a mission of general economic interest can reasonably be deemed very low. Since it can be assumed that numerous small or medium-sized banks will first choose the standardized approach in view of the long delays of implementation and the high investment costs of the IRB approach, the comprehensive recognition of customary banking collateral should be ensured already under this approach. 5) In order to preserve an efficient securitisation market, the Basel Committee and the European Commission should make sure that the total regulatory capital of all banks involved in the transaction does not exceed the capital requirement that would be effective without the securitisation. Any additional systemic capital charge will discriminate securitisation against other banking products. An increased capital requirement as a result of a securitisation is not justified from a strict methodological viewpoint because the transaction does not lead to additional risks within the banking sector. Furthermore, capital requirements for synthetic securitisations not only remain too high but discriminate synthetic securitisations against traditional securitisations. Synthetic securitisation has become an essential element in banks' risk management tool-kits, in particular in Europe. Despite the benefits of synthetic securitisations compared with traditional cash transactions (such that they are easier and less expensive to execute and value greater efficiency as they allow to transfer exactly the risks a bank wants to transfer), the proposed rules apply additional capital charges on senior positions in synthetic securitisations (due to the substitution approach). With regard to the effective transfer of risk that in practice is broadly the same as in a cash transaction this charge is disproportionate. Applying the suggested approach will result in inefficiency of synthetic transactions and so will disturb the markets. The nascent European Market will be most affected by these effects. 6) The default definition of past due more than 90 days may produce problems in the calculation and follow-up of the LGD in the case of small businesses. According to collected data about 2/3 of them survive in spite of fulfilling this default criterion. Therefore, this definition should be reconsidered or left to a national discretion. 7) The NEFI Partners would like the credit risk coverage techniques used in financing operations (guarantee funds, and notably guarantee funds managed in the framework of public programs of general economic interest, ex ante provisions) to be recognized at a prudential level through their incorporation in regulatory capital, in order not to penalize financial institutions utilizing them. Moreover, we would like to underline that such appropriately implemented techniques constitute the best means for smoothening a pro-cyclical character of which SMEs are the first victims in case of a credit crunch. Brussels, 30th January 2003 printversion