Basel III Reforms: What This Means and Why Borrowers Should Care

Out of the ashes of the 2007-2008 financial crisis, the international banking community devised a new regulatory framework introduced in 2009 that was adopted by many countries, including Canada. Although originally scheduled to be implemented by 2015, Basel IlI and specifically how it affects bank capitalization and credit rating will now come into full effect in Q1 of 2023, replacing it's predecessor, Basel II. We want to note that these new regulations apply specifically to financial institutions that are regulated by the Office of the Superintendent of Financial Institutions (OSFI), however a select few institutions we've surveyed (primarily in the class of trust companies and credit unions) are voluntarily electing to follow their industry peers as well.

On page 4 of this memo we have provided the links to the OSFI chapter 4 and chapter 5 guidelines for the implementation, but let's be honest... unless you're heavily into the world of finance, accounting, and banking regulations, the 250+ pages full of text, charts and formulas make for a very dry read. As it relates to the world of commercial mortgages, we've endeavored to simplify this as much as (reasonably) possible to help our clients understand how these regulatory changes affect the financing landscape and ultimately the pricing of their loans.

OSFI has provided two options as to how you can follow the guidelines: 1) a Standardized Approach (available for institutions under $5B of capital) and 2) an Internal ratings-Based Approach. We'll start with the standardized approach which is less complicated.

Standardized Approach

The standardized approach consists of classifying assets into categories, then applying the risk weighting provided by the guidelines. There was also the introduction of a new category: loans secured by land acquisitions, developments and construction (referred to as "ADC" loans by OSFI). ADC loans will now be risk weighted at 150%, compared to the previous weighting of 100% in Basel Il. What this means (albeit admittedly an oversimplification) is that lenders are now required to hold 50% more capital in reserve for these loans. Another change is the risk weighting for mezzanine loans, which will be held at 300% and with the added restriction that lenders now cannot be in the same capital stack for an ADC loan in both senior and mezzanine tranches.

There are several exceptions to the requirements for residential ADC loans (both condo and rental) which will allow the risk weighting to remain at 100%. They are:

• If the loan is underwritten with prudent standards (we agree..fairly vague)
• For construction: presales of at least 50% of total contracts OR equity equivalent to at least 25% of the as-complete value contributed by the borrower
• For land acquisition: LTV does not exceed 60%

For income producing commercial real estate (including if a property is forward sold) the risk weighting is provided by the table below dependent on the loan to value (LTV).

Internal Ratings Based Approach

We'd like to clarify that the Internal Ratings Based Approach (IRB) will likely be the approach used by most Canadian institutions. All institutions above $5B of capital are expected to use this approach and institutions under this threshold also have the voluntary option.

Simply put, the IRB approach requires each institution to prepare their own internal credit modelling approach for approval by OSFI, sample back testing the validity of their methods as well as adherence to other qualitative and quantitative requirements. They must also be used in the lender's regular operations and not just for calculation and compliance with Basel. As the calculations for the weighting look like the following formula... we won't go in depth on them.

The IRB approach also treats a subsection of commercial real estate financing with increased risk defining it as "high volatility commercial real estate or HVCRE." From a Canadian market perspective, this is classified as an ADC loan whereby there is:

• uncertainty around a future sale of the property, or
• cash flows whose source of repayment is substantially uncertain
• or if the Borrower does not have substantial equity at risk (25% or greater equity)

In other words: spec construction/land financing and high leverage financing for commercial properties will be priced higher than before with risk weighting factors beginning at a minimum of 100% with the ability to be as high as 625%.

Without going into in depth analysis (that would likely require a specialized degree), the institution's credit modelling on these HVCRE assets will need to risk weight based on rating grades (Strong, Good, Satisfactory, Weak) that are dependent on conditions such as:

Financial Strength

• Market Conditions (Supply/demand of the project type and location)
• Financial ratios (Debt service coverage and LTV)
• Stress analysis (test rates based on ability to service a or repay in a downturn economic condition)

Cash Flow Predictability

• For complete and stabilized properties, lease terms and deemed tenant creditworthiness
• For complete but not stabilized properties, realistic leasing activity projections and % target leasing achieved
• For construction phase, pre-leasing or presales with weighting on the strength of buyers or tenant credit worthiness

Asset Characteristics

• Desirability of location
• Design and property condition
• Is the property under construction or complete?

Strength of Sponsor/Developer

• Financial capacity and covenant inclusive of "skin in the game"
• Reputation and track record with similar properties
• Relationships with relevant real estate third parties such as leasing agents, construction managers etc.

Security Package

• Assignment of rents/GSA etc.
• Quality of the insurance coverage

A few interesting notes and special
guidelines around Basel III:

For the purposes of assessing the LTV of an ADC exposure, institutions may count the following as equity:

• Land lift included in the "appraised as completed" value of the property
• Note that land lift should not be reflected in LTV calculations for land acquisition loans
• Deposits from future purchasers and/or cash equity from the builder injected into the construction project prior to senior loan disbursement and that insulate the lender from loss should the borrower default Senior lenders may also treat debt subordinated to the senior exposure, that would insulate the lender from loss in the amount of the subordinated tranche in the case of borrower default, as equity for purposes of.

Summary

Although there isn't an exact formula to quantify how the implementation of Basel IlI will affect loan pricing across the market, one thing is for certain- commercial real estate financing will become more expensive due to increased risk weighting and therefore increased capital reserve requirements. Anecdotally, Oakbank was recently retained to source a construction loan for a top tier client and a a Tier I lender provided us the following bid:

• Rate of Prime + 1.35% until March 1, 2023, increasing to Prime + 1.85% thereafter

This structure came at the recommendation of the Lender's treasury who was accounting for the forthcoming implementation of Basel IlI.

Hopefully you have found this simplified summary helpful. Our team is ready to help Borrowers and Lenders alike navigate through this framework in the new year.

Links

OSFI: Chapter 4, Capital Adequacy Requirements- Standardized Approach
OSFI: Chapter 5, Internal Ratings Based Approach
OSFI: Basel IlI Implementation - Frequently Asked Questions