Measuring and managing risk: implications of Basel II for commercial real estate lenders.(Commercial Real Estate)

All banks and their commercial real estate lenders may be affected directly or indirectly by Basel II, considered landmark in its scope. The goal of this article is to help clarify the nature of these changes and their implications for commercial real estate lenders.

In 1988, the Basel Committee, representing the preeminent nations in international finance, introduced a capital measurement system usually referred to as the Basel Capital Accord. The Basel Accord recommended a universal minimum capital requirement of 8% for loans--regardless of the potential risk associated with a specific borrower or the respective industry.

Although this attempt to create a uniform capital measurement system was paved with good intentions, in reality, the "one size fits all" standard was recognized as imperfect in the boom and bust economy of the 1990s. "Under the original Accord," says Paul Widuch, senior vice president for Portfolio Management at LaSalle Bank, ABN AMRO's middle market bank in the U.S., "a loan to Enron would have required the same capital as a loan to a well-capitalized company." Under Basel II, in contrast, the Committee [in its own words] "... seeks to provide equivalent treatment for equivalent types of risk." While seemingly simple in concept, the Basel II recommendations, slated for full implementation by 2006, have ignited a firestorm of controversy. In recent congressional testimony, for example, John D. Hawke Jr., U.S. Comptroller of the Currency, described the 700-page Basel II bank capital rulebook as "virtually impenetrable."

There is no single set of Basel II implications for commercial real estate lenders, but rather various considerations based on whether a bank: 1) is an internationally active bank that must become Basel II compliant; 2) is a regional bank that could "opt in" for Basel II credit risk management guidelines, if it so chose; or 3) is a community bank not obliged nor likely to adopt Basel II requirements.

Credit Risk--From Precision to Accuracy

For internationally active banks in the U.S. that must sock Basel II compliance (generally defined as the 10 largest banks in the U.S.), four considerations are used in the calculation of credit risk: PD (probability of default), LGD (loss given default), EAD (exposure at default), and maturity. "With Basel II," explains Widuch, "specific capital will be held related to a specific asset, as we lenders measure it. You're going to be at a competitive advantage or disadvantage based on how well you measure and manage risk."

PD is the likelihood, expressed as a percentage, that a loan will default. This is a familiar concept in the industry and a number of off-the-shelf statistical models exist to measure probability of default, LGD models are less well developed, and--most significantly--relevant data on losses is often lacking. A number of industry consortiums may be developed to pool data on LGDs. Some large commercial loans, of course, are shared among several banks to …