FSA scaremongering or a whole slot of trouble?

Posted: 27/09/2012

In what may be described as an attempt to prevent careless property–backed lending, the Financial Services Authority (FSA) has threatened to impose ‘slotting’ rules on banks in the UK, to instruct them as to how they should assess the risk of their portfolios of property–backed loans. Penningtons banking and finance partner Malcolm Pearson examines these proposals in Estates Gazette:

In 2007, the FSA outlined five criteria of slotting, under the Basel II banking regime, and attached various risk weightings to each. Stemming from the remains of the UK's economy post credit crunch, the plans to introduce the slotting rules form part of a global effort to prevent banks from understating the risks involved in lending.
 
In essence, the FSA's basic reasoning seems morally sound. Nevertheless, imposing such an unsophisticated strategy on the complex, multifaceted banking system, and expecting it to succeed having only just risen from the ashes of the financial crisis, seems recklessly optimistic.
 
Crude and prescriptive

Slotting involves assigning new and existing loans to proposed categories; consisting of just five slots under the FSA criteria, the risk weighting is as set out in the table below:

Owing to the 9% equity ratio arising from the Basel III global banking code, a bank that lends £100bn is required to have at least £9bn of its own. The remaining £91bn belongs to depositors at the bank, including private customers, pension funds and corporate treasurers. These figures dictate the percentages for the FSA's suggested slots in the table, meaning even the best–performing loan of less than 2.5 years would require the bank to allocate £4.50 for every £100 of loan (9% x 50%) and £6.30 (9% x 70%) for a loan of 2.5 years or more.
 
It is arguably a crude system; the prescriptive nature of compartmentalising commercial properties in this way has sounded alarm bells for many as the new regime will apply to both existing and new lending. David Melhuish, director of the Scottish Property Federation, said: "Slotting is exactly what was needed when the market was overheating in 2005–06. The phrase 'locking the stable door after the horse has bolted' springs to mind."
 
The FSA's chairman, Lord Turner, has argued that poor loan choices in the area of commercial property have been central to the most recent financial crises. The Bank of England also reported that a total value of £50bn is in forbearance, which makes up one–third of the commercial property loans made by the UK's six largest banks. Ultimately, this means that the banks are losing money on these property loans; thus the FSA's slotting proposals, which, it has been estimated, will require UK banks to raise £40bn in new capital to cover their prospective losses on property loans that would be newly classified as ‘weak’ or ‘default’.
 
The FSA currently has a statutory duty to regulate banks. Considering the uncertain and volatile situation in Europe in particular and around the world in general, the FSA chose to adopt a relatively quick and straightforward approach to identify bad loans, even if that method, in some cases, will disadvantage shareholders and customers. In trying to alleviate any risks, the FSA has overlooked the potential domino effect and the consequences for the economy as a whole.
 
The introduction of slotting will probably compel banks to put aside more capital to cover the heightened risk suggested by the method of assessing risk. This in turn could potentially act as the catalyst for a collapse in the property market, due to the increased costs of borrowing. The FSA's June 2012 deadline seems to have been overlooked, and the implementation of the new slotting regime will take place in phases. The FSA is working with banks to introduce the change.

One size fits all?

Defined as ‘a narrow opening’ or ‘an assigned place’, slots are a fitting description for the FSA–designated pigeon holes. The danger of such a simplistic process arises due to the FSA's approach of dealing with properties as separate entities, as opposed to investors as individuals.

An example of this would be an investor with a portfolio of 10 properties, where nine properties are sound assets and the remaining one is classified as in ‘default’. The slotting rules would require that the bank sets aside capital to cover potential losses for the latter, ignoring the fact that the overall bank lending may well be more than adequately covered by the portfolio of 10 properties. As a result, the investor will also lose out because setting aside more capital will inevitably increase the cost of borrowing either on lending margins, fees, or both.

Accordingly, if the bank's risk assessment was based on the investor (with 10 properties) alone, the value of the nine properties would be more than enough to cover any potential losses from the 10th, rendering the demand to set capital aside unjustifiable. Although the FSA proposes that these well–intended guidelines provide more clarity and consistency across the banking system in the UK, it would appear highly likely that bankers will be forced to classify under a ‘one–size–fits–all’ policy. It seems almost inevitable that it will become a case of trying to fit very square pegs into very round holes, with serious consequences for many.

Over time, such an approach will result in banks adopting different pricing models based on the assumed risk. Those considered ‘strong’ or ‘good’ would be offered a competitive rate, whereas those falling into the categories below this would suffer the consequence of substantially higher costs of borrowing, creating more defaults and resulting in a vicious downward spiral. Of course, this is, generally speaking, what banks do anyway, but if they are required to assess risk according to the slotting rules, then the market could be distorted because the bank's ability to use its expertise in assessing overall risk will be fettered.

One has to ask the question, notwithstanding the unfortunate experiences of 2005–06, who is best placed to assess risk? An experienced property lender (accountable to his bank) or a crude system designed by, in effect, a civil servant?

Quality control

The FSA's suggestions for rigorous scrutiny of risk assessments can only be regarded as a positive development borne from hindsight of the economic downturn in 2007. However, this attempt to protect the banks' capital seems far too simplistic for the wide spectrum of commercial properties in the UK.

With banks still suffering from the wave of profligate lending that led to the crashing property market, property groups are unsurprisingly still battling to tread water. Liz Peace, representing investors and developers as chief executive of the British Property Federation, has said that increasing the weighting of properties would be likely to ‘put the brakes on deal making in the sector and slow down the deleveraging process’. The banks should be permitted to provide loans to customers in order to strengthen the process of developing the economy, but reckless lending, as feared by the FSA, will only lead to a repeated financial crisis.

A possible way forward would be to strike a balance between, on the one hand, basic stratification and quality control; and on the other hand, meeting the needs of investors, while maintaining quality control.

The FSA's prioritisation of quality control across banks is arguably an optimistic attempt at a quick–fix solution, but the rules of the slotting regime seem far too simplistic for the complexities involved in commercial property lending. Not all banks are reckless and not all investors are high–risk, despite the impending possibility of having a property classified as such. Is the FSA simply taking precautionary action in introducing the slotting rules, or assuming the role of a judge and sentencing both the banks and their investors to the same fate? You can be the judge of that.

(This article was written with the kind assistance of Alexandra Ioannou of Royal Holloway College, University of London.)

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