The New SA Approach for Retail (I)

The real estate exposure asset class consists of:

In this article we will cover the risk weighted assets calculation for the regulatory real estate sub-class.?

To be considered “regulatory real estate”, a loan must meet the following requirements:

1. Finished property
2. Legal enforceability
3. Claims over the property
4. Ability of the borrower to repay
5. Prudent value of property
6. Required documentation

Regulatory real estate can be either:

• A “regulatory residential real estate” (regulatory RRE): secured by a property that is ready to be occupied for housing purposes (i.e. residential property).
• A “regulatory commercial real estate” (regulatory CRE): secured by a property other than regulatory residential real estate exposure.

The calculation of the risk weight of the regulatory RRE and CRE exposures are also dependent on two other important concepts:

1. Material dependency on cash flows generated by the property

This material dependency is observed when the servicing the loan materially depend on the cash flows generated by the property securing the loan instead of the capacity of the borrower to service the debt from other sources. Typical cases include cash flows generated by lease or rental payments.?

2. Loan to Value (LTV)

The LTV is simply given by:

The LTV must be prudently calculated in accordance with the following requirements:

1. Amount of the loan: includes the outstanding loan amount and any undrawn committed amount of the mortgage loan.?
2. Value of the property: the valuation must be appraised independently using prudently conservative valuation criteria.?

LTV bucket and risk weight to be applied to the exposure amount must be determined before the application of the appropriate credit risk mitigation technique.

Risk weights for regulatory RRE exposures?

For regulatory residential real estate exposures, the risk weight to be assigned to the total exposure amount will be determined based on the exposure’s LTV ratio and if it is materially dependent on cash flows generated by the property:

For example, if there is no dependency on the cash flows generated by the property, the property value is 100 and the loan is 70, then total RWA would be 21 as the LTV is 70% and therefore a 30% risk weight is applied to the “whole” loan value.

As an alternative to the whole loan approach for regulatory residential real estate exposures that are not materially dependent on cash flows generated by the property is the “loan splitting” approach, on which the risk weight of 20% is applied to the part of the exposure up to 55% of the property value and the risk weight of 75% (individuals) or 85% (SME’s) is applied to the residual exposure.?

For example, for a property value of 100 and a loan of 70, a total RWA of 22.25 would be calculated based on this “loan splitting approach”:

Where a bank holds the junior lien and there are senior liens not held by the bank, to determine the part of the bank’s exposure that is eligible for the 20% risk weight, the amount of 55% of the property value should be reduced by the amount of the senior liens not held by the bank.

Taking the example above and considering a senior lien of 10, we get a total RWA of 27.75:

Where liens not held by the bank rank pari passu with the bank’s lien, the calculation of the secured amount eligible for the 20% risk weight should be calculated as follow:

In the example above, if the value of liens not held by the bank that rank pari passu is 10 and if there are no senior liens, then the total RWA would be 26.031:

Risk weights for regulatory CRE exposures

For regulatory commercial real estate exposures, the risk weight to be assigned to the total exposure amount will be determined based on the exposure’s LTV and if it is materially dependent on cash flows generated by the property according to the “whole loan” approach:

Like what we saw above for the RRE, there is also “loan splitting” to the whole loan approach for regulatory commercial real estate exposures that are not materially dependent on cash flows generated by the property.?

Source: https://www.bis.org/basel_framework