ID 5558
Armin Krenzer / Björn Schlüter / Gregor Scharf / Karl
Filsinger / Lea-Maria Hohmann / Sylvia Albers
Consequences of basel II for
small and mid-sized enterprises
Studienarbeit
an der Hogeschool Zeeland, 9
Juni 2002 Abgabe
ID 5558
Krenzer, Armin / Schlüter, Björn / Scharf, Gregor / Filsinger, Karl / Hohmann, Lea-Maria /
Albers, Sylvia: Consequences of basel II for small and mid-sized enterprises / Armin Krenzer /
Björn Schlüter / Gregor Scharf / Karl Filsinger/ Lea-Maria Hohmann / Sylvia Albers - Hamburg:
Diplomica GmbH, 2002
Zugl.: Vlissingen, Hochschule, Studienarbeit, 2002
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1
INTRODUCTION
4
1.1
Overview
4
1.2
Definition of the new Basel Capital Accord 4
1.3
Targets
5
1.4
Structure
5
2
BASICS
6
2.1
Small and mid-sized Enterprises (SMEs) 6
2.1.1 Definition
of
SMEs
6
2.1.2 Economic Situation and Importance of SMEs
7
2.2
Rating
7
2.2.1 Credit
ratings
7
2.2.2 External ratings by rating agencies
8
2.2.3 Bank-internal
ratings
9
2.2.4 Function of credit ratings
10
2.2.5 Rating procedure and structure
12
2.2.6 Rating as an opportunity to prepare for Basel II
16
3
BASEL II THE NEW BASEL CAPITAL ACCORD
18
3.1
The Basel Committee of Banking Supervision 18
3.2
The way from Basel I to Basel II 18
3.3
Overview of the new Capital Approach 19
3.3.1 The first Pillar: Minimum Capital Requirements
19
3.3.1.1
In context of granting credits to small and mid-sized companies
23
3.3.1.2
Possibilities of asset securitisation
26
3.3.2 The second Pillar: Supervisory Review Process
27
3.3.3 The third Pillar: Market Discipline
27
4
THE CONSEQUENCES OF BASEL'S RESOLUTIONS
29
4.1 Current financial requirements of the small to medium-sized business sector 29
4.2
Internal vs. external rating of SMEs 31
4.3
Actual preparation status of SMEs 35
4.4
Rating under aspects of Investor Relations 42
4.5
Alternative financing possibilities for SMEs 44
4.5.1 Effects on banks
45
4.5.2 Effects on interest rates for SMEs
46
4.6
Possibilities for SMEs to prepare for Basel II 48
4.6.1 Implementation of a value-based management
50
I
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5
CONCLUSION
55
6
APPENDIX
57
6.1
Index of Abbreviations 57
6.2
Index of Literature 58
II
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1 I
NTRODUCTION
In this chapter, the fundamental meaning of the topic will be explained; difficulties
and targets will be defined. The further approach will be explained briefly as well.
1.1 Overview
At present, rating is the number-one-topic discussed, both within the banking
community and also, even more frequently, at enterprises. The second consultative
package of the Basel Committee for Banking Supervision provides a basic change
in equity capital contribution of banks. It is expected to change the rules of the
credit business with institutional customers considerably. As a result, especially
small and mid-sized enterprises are forced to enhance their credit standing in order
not to struggle with the serious consequences of Basel II, which means they will
have to get a positive rating or they have to pay higher interest rates.
1.2
Definition of the new Basel Capital Accord
The Basel Committee on Banking Supervision has decided to undertake a second
round of consultation on the more detailed capital adequacy framework proposals
that, once finished, will replace the 1988 Accord. The amended accord will be more
extensive and complex contents are planned to be valid from 2006 on in order to
ensure sufficient credit risk sensitivity. This consultative package consists of three
parts, redefining the three columns of the Basel Accord: minimum capital
requirements, supervisory review and market discipline. Each of these will be
described later on in this case study, as well as the targets set by them.
Both, banks and companies, have to adapt to the upcoming innovations. While
credit institutions have entered into the discussion and preparation phase already,
an adequate information basis among most small and mid-sized enterprises could
not been stated yet. An insufficient preparation for the requirements of the new
Basel II Accord could lead, next to disadvantageous interest rates, to further risks,
like i.e. image losses, that may result from a negative or a non-rating.
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1.3 Targets
Target of this case study is to analyse which practices are most successful in
preparing small and mid-sized enterprises efficiently for the strict requirements
resulting from the Basel II Accord. Therefore, we will work out alternative
preparation concepts, considering typical finance and reporting structures of small
and mid-sized enterprises.
Based upon a thorough analysis of the controlling and risk management of small
and mid-sized enterprises in place, individual solutions have to be developed and
implemented, enhancing the actual situation of attaining outside capital under
consideration of various criteria in finance and reporting procedures.
1.4 Structure
After explaining the history of the Basel Capital Accord and its rearrangement at
first, we will show in a second step which requirements will be set by banks in
future for granting credits to small and mid-sized enterprises. Further on, we will
analyse, how good companies are prepared at the moment for the criteria set and
where there is a need for action. Based on the outcome, we will recommend
practices, how to prepare small and mid-sized enterprises best for rating.
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2 B
ASICS
2.1
Small and mid-sized Enterprises (SMEs)
2.1.1 Definition of SMEs
The commission of 03.04.1996 recommended the following general definition for
SMEs:
1
The mid-sized enterprises are characterized as followed:
- less than 250 employees and
- annually sales of less than 40 Mio EURO
or
- balance score less than 27 Mio Euro and
- fulfil the following criteria of independence
The small-sized enterprises are characterized as followed:
- less than 50 employees and
- annually sales of less than 7 Mio EURO
or
- balance score less than 5 Mio Euro and
- fulfil the following criteria of independence
Enterprises are called independent if they are not owned
2
by one or more
enterprise(s) that do not fulfil the definition of SMEs. This threshold can only be
passed in two in two cases:
- The enterprise is owned by public venture capital companies or institutional
shareholders. The owners do not practise any controls, neither alone nor
together;
1
,,Amtsblatt" of European Community no. L 107/4 as of 30.04.1996 / order (EC) no. 1103/97 as
of 17.06.1997
2
25% or more of capital or shares
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- The enterprise cannot determine who are the shareholders and states that
they are not owned by a company of more than 25%.
2.1.2 Economic Situation and Importance of SMEs
In Germany exists a "special culture of Enterprises"
3
. The most bigger part of all
medium sized enterprises is organized as partnership or single-owned companies.
Subsequent to the definitions of IfM Bonn in 1999 there are existing about 3,2
millions medium sized enterprises with 20 millions employees in Germany.
4
More
than 3 millions SMEs achieved nearly 60 percent of the gross added value, effect
nearly 50 percent of the gross investments and provide nearly 70 percent of all
employment- and 80 percent of all trainee-opportunities. These figures show that
the economy and society in Germany is dependant upon these enterprises.
2.2 Rating
2.2.1 Credit
ratings
Under the terms of Basel II, the credit risk of banks has to be determined on the
basis of debitor credit ratings. There are two different rating concepts which allow
the appraisal of a bank`s capital requirement for credit risks:
the standard approach, based on external ratings by rating agencies,
the internal rating based approach IRB, based on bank ratings.
Opting for the IRB Approach while fulfilling the minimum requirements, banks are
able to determine the risk weights of their debitors by themselves. The risk weights
depend on the probability of default (PD) within the different rating classes. For
each debitor, the medium annual probability of default of its rating class serves as
the basis for the definition of its risk weight. Thus far, a great amount of various
types of bank-internal ratings have been employed in order to evaluate debitor
3
Schoser, F. (2000): [Mittelstand], P. 2.
4
IfM Bonn (2000 ): [Definition], P. 1 f.
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creditworthiness, however, none of these procedures had official character. Under
the new Basel regulations, these bank-internal procedures will be finally approved
for risk assessment. Therefore, many small and mid-sized enterprises do have
ratings as a result of business ties with banks, yet, due to a lack of detailed
information, these ratings cannot provide possible steering effects to the
companies.
Thus far, external ratings have been an exception in Germany, mainly due to high
costs. External rating agencies usually have to be mandated and paid by private
companies. Contrary to that, banks carry out the ratings taking into account a credit
relationship whilst paying for the entire expenditure.
The national supervision institutions are responsible for making decisions as to
whether an external rating agency or a bank fulfils the given requirements such as
objectivity, independence, international access and transparency, exposure,
sufficient resources and reliability. The objectivity of external rating agencies is
intrinsically dependent upon the ,,view" of the market which tends to judge their
services almost exclusively by the quality of their analysis.
2.2.2 External ratings by rating agencies
External rating agencies conduct their creditworthiness assessment independently
of any market interests. In contrast to a bank rating, it is not used to sell financial
products afterwards.
International rating agencies are:
-
Standard & Poor's (founded in 1860)
-
Moody's (founded in 1913)
-
Fitch (founded in 1913).
These agencies offer capital market-focused ratings of enterprises and issues e.g.
corporate bonds. A company rating by Standard & Poor's amounts to about 50,000
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euro, the annual rerating costs around 30,000 euro
5
, whereas Moody's charges
approximately 60,000 euro for the first rating and roughly 30,000 euro for
reratings.
6
Finally, Fitch demands about 35,000 euro, reratings go for 35,000 euro.
7
Furthermore, there are several German rating agencies that offer rating services
particularly for small and mid-sized enterprises. They are the Creditreform Rating
AG, the Euro Ratings AG, the GDUR Mittelstandsrating AG, the Global Rating
GmbH, the Hermes Rating GmbH, the RS Rating Service AG and the URA
Unternehmensratingagentur AG. Companies pay between 4,000 and 40,000 euro
for a first rating
8
. However, ratings of these agencies do not enjoy parity with
international top agency ratings as far as their reputation is concerned. Yet,
German agency ratings are generally preferred by business partners in a supply
relationship whose main interests revolve around ,,certified" stability and reliability.
2.2.3 Bank-internal
ratings
A bank-internal rating, namely the creditworthiness assessment is carried out by
credit institutions. The objective is to determine a company`s probability of default
(PD), as required by the Basel II rules. Therefore each debitor has to be classified
into a risk class before a credit is granted. The bank-internal rating serves as a
basis for the definition of credit terms as well as for the bank`s risk and portfolio
controlling. It is also used for credit approval, risk management and evaluation of
the bank`s own resources. Internal ratings further permit a special handling of
project business such as real estate financings.
Bank ratings have to meet minimum requirements as set forth in Basel II. Thus, the
structure of a bank rating system must include at least 6 rating classes. An
updating of ratings must be done at least once each year. Further, an independent
inspection of rating classifications has to be conducted. All relevant characteristics
of a debitor must be taken into account for a bank rating, which covers quantitative
and qualitative factors. Banks shall implement methods of ensuring the correctness
of the rating process as well as the probability of default (PD) estimation. A
5
http://www.hvb-rating-advisory.de/565.htm
6
http://www.hvb-rating-advisory.de/559.htm
7
http://www.hvb-rating-advisory.de/571.htm
8
http://www.hvb-rating-advisory.de/onwDtRatAgency.htm
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comparison of actual and estimated loss rates for each risk class has to be done at
least yearly. The publishing regulations of Basel II have to be fulfilled.
Intensive arrangements for the introduction of the new bank ratings were put in
place by credit institutes. Internal working processes were modified to suit the new
credit rating; in light of its implementation, special IT projects had to be carried out.
Additionally, the historic data must be made available. In order to make credit risks
more transparent, banks need to increase the expenditure for creditworthiness
checks; further, they need to invest in advanced risk systems. The competitive
situation of smaller banks might worsen thereby, as they probably find it very
difficult to invest financial resources and key individual skills in developing the
aforementioned systems contrary to their large competitors.
2.2.4 Function of credit ratings
When approximately 100 years ago the principle of credit rating was developed, the
success of ratings could not be foreseen. Meantime it is established as a generally
accepted measuring instrument and founded its own line of business.
With a rating one makes a statement about the probability of insolvency and the
financial sustainability of an enterprise is determined. The analysis report, compiled
by the rating agency, represents a documentation of the essential quantitative as
well as qualitative aspects of the credit assessment and summarizes these in a
rating conclusion. The rating scale extends from AAA for top businesses up to D for
default for insolvent enterprises, which may find it very hard to survive, thus easy-
to-understand categories are employed to explain the results of a rating.
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fig.1: rating classes
9
Rating classifications are generally intended for a very broad audience. The bank
rating, however, serves only as a basis for the bank`s risk assessment and does
not have any further effects, whereas the external rating addresses far more
parties, e.g.:
-
bond and credit creditor
-
management
-
supervisory board
-
partners and shareholders
-
customers and suppliers
-
employees.
Ratings provide larger security for banks, with regard to the granting of credits and
they are basis for controlling credit risks. Even small and mid-sized enterprises can
take advantages from an objective external rating of the company. For stock
9
http://www.westpactrust.co.nz/olcontent/olcontent.nsf/AttachmentsByTitle/GDS_PDF/$FILE/DEC01wtgdp.
pdf
Standard Moody's
Fitch
& Poor's
The following grades display investment grade
characteristics:
Ability to repay principal and interest is extremely strong.
AAA
Aaa
AAA
This is the highest investment category.
Very strong ability to repay principal and interest
AA
Aa
AA
Strong ability to repay principal and interest although
A
A
A
somewhat susceptible to adverse chances in economic,
business or financial conditions
Adequate ability to repay principal and interest.
BBB
Baa
BBB
More vulnerable to adverse changes.
The following grades have predominantly
speculative characteristics:
Significant uncertainties exist which could affect the
BB
Ba
BB
payment of principal and interest on a timely basis.
Greater vulnerability and therefore greater
B
B
B
likelihood of default.
Likelihood of default now considered high. Timely
CCC
Caa
CCC
repayment of principal and interest is dependent
on favourable financial conditions.
Highest risk of default.
CC to C
Ca to C
CC
Obligations currently in default.
D
-
C