They have been called “the most far-reaching reforms to
international banking standards for more than a decade”. Now, a
survey by Leasing Life and a UK consulting firm, Invigors,
reveals how Basel II is forcing banks to identify the fundamental
benefits of asset finance, thereby increasing its importance within
their business portfolios.

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The survey creates an up-to-date perspective on how Basel II
changes are impacting lessors across Europe. While many leasing
organisations are unregulated, the strength of bank-owned lessors
in every national market makes Basel II a key driver of changes in
European asset finance over the coming years. 

The survey is truly European, with the 24 respondents reporting
to lead regulators across a range of countries, including the UK,
Italy, Ireland, Sweden, Belgium, Austria and Luxembourg (only one
third reported to the FSA as the lead regulator). While one-third
of respondents operated in one country only, 6 respondents operated
in 20 or more markets. Main areas of functional responsibility were
general management, risk and sales, while other areas such as
operations and strategy development were also represented.

Implementation well underway

One-third of respondents indicated that Basel II practices were
already fully embedded in their business unit. All respondents
believed this would be the case within three years, with market
impacts fully realised soon thereafter (there appears to be a one
to two year lag).

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Approximately half the respondents are already implementing the
highest standard to measure credit risk, Advanced IRB. Looking to
the future, 80 per cent of respondents indicated that they would be
moving to Advanced IRB. 

Continued sophistication in credit risk analysis and
underwriting is likely to drive a shift towards lower
capitalisation of mainstream asset finance portfolios, giving bank
lessors the option of higher ROE for existing business streams or a
lowering of margins to increase new business volumes and market
share. 

Based on the survey results, most companies already adopting
Advanced IRB are major players operating across multiple national
markets. They are no doubt able to use their greater scale to
cost-justify the development of more advanced risk management
approaches. In due course, this may drive competitive advantage and
consolidation for the largest asset finance providers.

Only one UK organisation indicated it had implemented – and
planned to stay with – the less sophisticated Standardised Approach
for credit risk. At first glance this suggests a difficult
competitive future for the company in question. In reality, this
will depend on the company’s business mix, as higher risk
portfolios may require lower capital using the Standardised
Approach.

Operational risk

A similarly progressive picture was evident for operational risk
approaches. Approximately half of all respondents stated their
organisation was already in the process of implementing the
Advanced Management Approach with the majority stating this was
their company’s preferred future approach. As such, this area of
risk management may be notably more developed than current market
perceptions. 

In 2002 the UK’s Financial Services Authority stated that
“approaches have been designed to give incentives to firms to adopt
advanced risk management techniques” – fundamentally by the
reduction in minimum capital requirement for those firms. Survey
results suggest this is being realised.

In that context, the amounts spent at the business unit level on
Basel II do not seem inappropriate. Of those able to answer the
question, over half of respondents indicated that over £1m (€1.4m)
had been spent by their business unit on Basel II. Clearly this
favours larger firms. As far back as 2002, the FSA recognised there
would be cost-benefit limits for smaller firms developing Advanced
approaches.

Pricing and training lag behind

Not surprisingly, the risk-related elements of Basel II
implementation are most advanced. Some 70 per cent of respondents
felt changes to underwriting procedures were now “well developed”.
For risk models this number was 60 per cent. 

Interestingly, these risk management developments have not fully
migrated into pricing models, with almost a quarter of respondents
indicating that pricing changes were “not developed at all”. This
suggests price-related competitive opportunities for those able to
most rapidly implement Basel II pricing changes. It also raises the
question of whether the Basel II concepts are fully embedded into
the management of the business in the ways required before they can
be used to calculate regulatory capital.

There appears to be systems development lag, which is likely to
be closed as new risk processes and pricing become more
established.

Some 60 per cent of respondents indicated that their business
strategy relating to Basel II was well developed.  In terms of
changing the strategy of their business as a result of Basel II,
approximately half had changed underwriting and pricing, while 20
per cent had changed target markets.

Business awareness

Of particular note, two-thirds of respondents indicated that
“business awareness and training” was only “slightly developed”.
The result suggests that this area needs to be improved to
efficiently embed Basel II practices, and is supported by
respondent comments. When asked what had been the most difficult
aspect of implementation, Peter De Neef, chief credit and risk
officer of Fortis Lease Group, stated that is was “making the
commercial and credit community understand the importance, the
building blocks and the mechanisms of the practical tools resulting
from the advanced Basel methodology”.

Other respondents made statements that backed-up the requirement
for increased business awareness. One lessor operating across
several European countries commented that the most difficult aspect
was “to find acceptance in all departments, especially in sales,
and get the necessary budgets”.  Another stated it was
“understanding the detail and being able to co-ordinate across a
large organisation”.

A small number of large, international firms stated that their
responses were “well developed” across all functional areas. These
firms are likely to represent thought leaders within the asset
finance community.

In general, respondents indicated that Basel II would drive
operational changes, though almost one-quarter suggested that they
believed Basel II was treated fundamentally as a compliance issue.
In these cases, an inevitable risk is that commercial applications
are not embedded, and high levels of investment will see little
positive return.

Making lessors more attractive
 
Nearly one-third of respondents indicated that their business unit
considered finance leasing more attractive as a result of Basel II.
The position regarding operating leasing was largely
neutral. 

Over half of the bank-owned lessors surveyed indicated that
Basel II has made leasing operations more attractive to their
parent bank. Driven by reduced Loss Given Default (LGD), in
particular for those adopting Advanced IRB, this has started to
have profound effects. De Neef reported a switch in Fortis Bank
from vanilla credit to asset finance, a trend that was also
highlighted by another international lessor. Assuming it is adopted
across the industry, the importance of leasing subsidiaries within
banking groups could grow significantly, reinforcing leasing’s role
as a core bank product line. This dynamic was summed up by Derren
Sanders, HSBC’s
head of equipment finance, who stated: “Leasing will come more to
the forefront and will grow as a proportion of bank books over the
next five years, across the whole spectrum of deals.” 

Among other things this may drive acquisition strategies such as
that adopted by Fortis Lease. As Philippe Delva, CEO of Fortis
Lease, indicated: “We have acquired a lot of leasing
companies.”

For most respondents, acquisition strategy is still under
consideration. With growing consolidation and a limited supply of
attractive targets, they may need to accelerate their thinking.
Indeed, the increased attractiveness of leasing to bank parents may
help to explain high acquisition premiums in the market.

For potential acquirers operating on Advanced IRB, opportunities
may exist to target Standardised bank-owned lessors carrying excess
capital and leverage that excess capital for an immediate
benefit.

Whether through finance or operating leases, a focus on LGD
reinforces the importance of collections, debt management and asset
management processes and policies. Sanders highlighted the
importance of minimising LGD through identifying quickly those
transactions that might default, then actively managing them for
the best outcome.

Ultimately, those lessors with the best collections and asset
management capabilities may generate not just a transactional
profit benefit, but also a capital benefit. Lessors may seek to
quantify more overtly the asset cover within individual
transactions.

Big ticket big impact

While there was common consensus that there would be some impact
across all financing markets, the two markets that were expected to
experience the greatest Basel II impact were big ticket and project
finance.

The common view of respondents was that the major change would
be pricing-related, as risks become better defined and required
capital levels reduce. The largest reduction in capital requirement
is likely to take place with high value transactions. This appears
to be supported by a previous analysis from KPMG which
suggested that for a BBB rated corporate customer, the capital
requirement under Foundation IRB would be 56 per cent lower than
under Basel I (rising to 83 per cent for a AAA rated company). The
differentials are likely to increase further under Advanced
IRB.

Respondents also highlighted the higher capital and therefore
higher pricing associated with sub-prime customers. Recent credit
crisis aside, those looking for wholesale funding to finance a
sub-prime customer portfolio are likely to experience higher cost
of funds.

Anecdotally, over the last couple of years astute big ticket
customers have sought a Basel II related pricing benefit. As a
result, the net impact may be a lowering of margins for the best
clients rather than increased profitability, with only those
bank-owned lessors operating at advanced Basel process standard
able to compete. 

What seems unlikely is that Basel II will suddenly grow the big
ticket leasing market by a material amount, in the UK at least.
Based on FLA monthly statistics, the last two years have seen a
reduction in big ticket leasing in the UK, following the
introduction of long funding leases and changes in income
recognition practices as a result of IFRS implementation.

Project finance may be alien to many asset finance providers,
but increased demand for managed service funding may have an
impact.

Survival of the biggest – and quickest

Nearly 80 per cent of respondents agreed or strongly agreed that
Basel II can bring a big competitive advantage for some leasing
companies.

When asked who would be the winners and losers under Basel II,
one respondent responsible for Basel II implementation across a
number of countries summed up the views of many, when he stated:
“Winners will be the great banks, who are able to spend for
implementation enough money and start early.”

De Neef supported that view while highlighting the importance of
residual value based products, citing winners as: “Bank owned
leasing companies having more capacity to invest in the Advanced
IRB approach provided that: (1) They have a decent asset quality in
their portfolio; (2) They are going the extra mile in investing in
asset knowledge to develop residual value based products which will
enable them to sell value instead of throwing money on the street
for a couple of basis points less compared to the competitor.”

Building on that theme, another respondent highlighted the
opportunity for major banks with the sophistication and data to
progress to advanced risk assessment modeling. Indeed, there seems
the potential for a virtuous circle for sophisticated risk managers
to improve pricing to increase scale, with that increased scale
then justifying continued investment in risk management. 

While lower (or higher) pricing has been identified by many as a
product of Basel II implementation, market realities remain
unclear, with uncertainties over the extent to which increased
transactional profitability will be realised, or prices forced down
by equally able competitors. 

Other potential winners pinpointed were niche financiers not
subject to Basel II, looking for higher risk credits and/or
operating leases (since more sophisticated Basel II risk rating
structures increased the minimum capital requirement for banks
operating in this area). In those markets, banks may seek to divest
portfolios or businesses with increased capital requirements.

The same respondent suggested losers were likely to include
small bank players without the systems to take full advantage of
the changes and manufacturer finance companies who raise funds via
their parents.

As such, Basel II may offer an opportunity for bank-owned vendor
finance providers, well positioned to helping manufacturing
organisations migrate their captive operations into a “virtual
captive” run through a bank partner.

Being a winner and loser is complicated by timing uncertainties.
Lucian Vinatoriu, regional manager of Raiffeisen Leasing IFN,
stated: “It is obvious the companies with a good strategy in
portfolio risk management would record a competitive benefit over
the others. Moreover, more risk data available allows a better
capital allocation and an improved risk management. However, the
main issue consists in meeting implementation deadlines: some
organisations still expect regulatory term delays and more specific
guidelines to appear in some regions/countries. The impact on the
market could be significant but it will take some time until all
potential advantages of Basel II will appear.”

When asked if Basel II would affect the competitive positioning
of their business unit, approximately half the respondents stated
that it would, under 20 per cent said that it would not, with the
remainder uncertain. When asked what changes were likely, the
result depended on company status, size and ability to adopt Basel
II practices. A UK non-bank lessor highlighted high cost of funds,
greater focus on niche operating lease products and a reduction in
portfolio credit quality. That said, he indicated that it was
“still early days with no clear strategy visible by any of the
majors”.

A large bank lessor identified that “finer granularity of the
risk profile will allow us to price accordingly”. Perhaps the
clearest statement of intent came from Philippe Delva: “The
economic capital needed to run our business will be far less than
the equity we needed under Basel 1. This enthuses all our
stakeholders and customers, by having better returns and better
prices.”  

The author is a partner in the consulting and services firm
Invigors LLP peter.hunt@invigors.com