Banking & finance - Lending is a risky business.

(From Financial Director)

Byline: Jules Stewart, freelance journalist.

The third consultative paper on capital adequacy will replace the 1988 Basel Accord, the first global attempt to set minimum levels of capital that banks need to hold against their core base. The focus for determining capital adequacy will now shift to credit risk, taking into account the numerous and often spectacular financial disasters that have taken place since the original proposals were drawn up. Under the final draft agreement, credit ratings come to the fore, as this is the yardstick by which banks will determine the level of risk involved in granting loans and accepting bonds issued by corporate customers.

Under the current rules, for every GBP100 of loans granted to a corporate borrower, a bank must hold GBP8 of capital, regardless of the customer's rating. That is, all corporate loans are currently 100% risk-weighted.

"The trend set by Basel II is that the capital which banks have to put aside for loans to corporates will vary according to riskiness rather than the status of the borrower," says John Tattersall, a partner at PricewaterhouseCoopers and chairman of its UK financial services regulatory group. "Companies that are a good risk and highly rated will have lower capital requirements and a lot will depend on relationships. This sort of company will find it easier to borrow from its banks. Conversely, any adverse development or downgrade will increase the cost of borrowing. As distortions caused by the present rules are removed, borrowers should see their cost of debt relate more closely to their credit ratings."

This obviously puts a more prominent role on preferred banking relationships and a greater attachment to credit ratings. Banks will assign a more generous rating on companies they know and trust, and this applies, in particular, to the more sophisticated banks that will be allowed to use their own internal risk management systems rather than relying on external ratings agencies.

While all corporate borrowers are now rated 100%, going forward, this will vary according to the level of risk, moving from 30% to 150%. The amount of capital a bank has to hold against will decrease significantly for better rated corporates.