Why the Basel II Accord Is Worrisome

In 1988, the Group of Ten (G-10), an international consortium of senior officials from central banks and regulatory agencies, agreed to a voluntary framework for sound banking practices. Called the Basel Capital Accord, the regulations were a stabilizing force in the international banking system for more than a decade because they fostered financial cooperation between participating countries.

Member countries and virtually all other nations with active international banks embraced the framework for the balance of the 1990s. Seven years after the standard was implemented, the Basel Committee on Banking Supervision proposed new regulations to replace the 1988 Accord. Members of G-10 maintained that the financial marketplace had changed dramatically in the past decade, making Basel I capital ratios — a minimum of 8% of capital to risk-weighted assets — an inaccurate measure of a bank's financial condition in the 21st century.

A Threat to Real Estate Lending

As proposed, the new Basel II Accord guidelines pose serious threats to both real estate lending by commercial banks and the viability of the entire industry. Experts say proposed higher capital charges — or those interest and amortization costs a bank charges borrowers during the life of a loan — could force some banks to curtail lending for commercial properties.

Simply stated, higher capital charges could reduce available capital for commercial real estate. Basel II will encompass three pillars:

  • establish minimum capital requirements (or the rules a bank uses to calculate its capital ratios) to cover losses;

  • create a standardized review process for participating banks' loan policies and reserve capital;

  • impose public disclosure requirements.

The proposals will seek to establish more sophisticated guidelines that require banks to measure risk and set aside sufficient capital to cover losses. It also recognizes that minimum capital requirements alone cannot ensure the safety and soundness of the banking system — they must be supplemented with supervisory review and market disciplines.

Comments from the banking industry on Basel II guidelines have been plentiful, as the revised regulations are expected to reshape the entire financial services industry by creating new classes of competitors based on their risk-measurement and value-measurement technologies.

The U.S. real estate community has voiced opposition to the new guidelines of Basel II, particularly the high capital charges. The charges for some types of commercial lending could escalate to the point that they would lead to a loss of credit opportunities and have a negative impact on lending and investment.

Of particular concern: Basel II identifies some commercial real estate financing as more volatile when compared with lending for other business purposes. Specifically, capital levels would be increased for banks with significant concentrations in so-called High Volatility Commercial Real Estate (HVCRE), or properties where acquisition, development and construction loans did not contain “substantial equity” or were not “sufficiently pre-leased.”

Supporters of higher reserves maintain that loan defaults for commercial properties often take place at the same time when a market undergoes a downturn, thereby requiring higher capital standards.

CCIM Institute, along with the National Association of Realtors (NAR), has serious concerns about this portion of the accord. Since the accord would require commercial banks to hold disproportionately high levels of capital against commercial real estate loans, banks could be forced to reallocate capital to non-commercial real estate loans.

To provide a level playing field in the commercial real estate loan industry, the authors of Basel II need to refine definitions of “substantial equity” and “sufficiently pre-leased” with input from the industry.

Call to Action

There's still time for the industry to rally forces in Washington to achieve needed revisions. Implementation of Basel II is scheduled to take effect in member countries by the end of 2006. However, a number of countries already have initiated the rule-making process to incorporate the changes in the Basel II Accord.

In August 2003, U.S. federal bank regulators issued a paper that clarified most of the provisions contained in the latest Basel II draft. The House Subcommittee on Financial Institutions and Consumer Credit reported out H.R. 2043, the United States Financial Policy Committee For Fair Capital Standards Act.

The act establishes a committee comprised of the representatives from the four U.S. bank regulating agencies to agree on revisions to the Basel II Accord and report to Congress before the accord can be implemented in the United States.

Commercial real estate — and the vitality of the national economy — could be adversely affected by Basel II regulations as prescribed. Therefore, the entire community should lobby Congress to support H.R. 2043 and reach a workable consensus.

Chere LaRose-Senne is the legislative liaison of the CCIM Institute.

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