One area that is causing me concern in this "Covid-19 market" is the amount of money that banks have loaned towards business. In particular I am thinking about those businesses not large enough to be listed on any market, yet still large, right down to SMEs (excluding traditional 'really small business' that is likely to be funded by a mortgage taken out over the proprietors home, out of sight of 'business lending' rules).
These businesses do not have externally verified credit ratings. Yet they are still a significant part of the business loan book for any bank.
I think such investments are classified under the 'Basel 3' Standardised Credit Risk Assessment Approach (SCRA). Under SCRA, there are three risk weighted loan grades: 'Grade A', 'Grade B' and 'Grade C'.
The standardised credit risk table and associated risk weighting for each of the three grades of loans is as follows:
|
Grade A |
Grade B |
Grade C |
Risk Weightings |
40% |
75% |
150% |
Risk Weightings (Short Term) |
20% |
50% |
150% |
Risk Weightings (50/50 ST LT) |
30% |
62% |
150% |
'Grade A' loans are not dependent on business cycles and economic conditions going 'just right'. 'Grade B' loans can be seriously affected by business cycles. While Grade C have 'material default risks'.
One way to interpret the 59% Risk weighting over all business loans is to think of the majority of these loan being 'Grade B' with a small percentage 'Grade A'. However, if more of each loan were directed towards 'stock for sale', then the average risk grade would be skewed more towards 'Grade B', with even a few loans classified in 'Grade C' under a 'business as usual' situation.
I am now going to produce a 'plausible' current scenario to work with. Using the format
a(RW Grade A) + b(RW Grade B) + c(RW Grade C) = 0.59
we need to solve for 'a', 'b' and 'c'. There is no unique answer to this equation. So I am going to make a couple of educated guesses and say that:
1/ In normal times business loans are precarious and 'something like' 10% are 'Grade C'.
2/ 'Around' two thirds (66%) of businesses are tied to business cycles and are 'Grade B'.
Given these two assumptions we can now calculate what proportion of business loans are 'Grade A".
a(0.3) + (0.66)(0.62) + (0.10)(1.5) = 0.59
=> a=0.1
The relative proportion of each loan grade A:B:C is therefore: 0.1:0.66:0.1
That is the same relative proportion as: 12:76:12 OR
12% 'Grade A', 76% 'Grade B' and 12% 'Grade C'. (12% + 76% + 12% = 100%)
I am happy with that scenario, as it is not too far from my initial guesses and it sounds plausible. We now have a 'base scenario' to work from!
(0.1)(0.3) + (0.66)(0.62) + (0.10)(1.5) = 0.59
Now
we can imagine a severe recession where half of all 'Grade A' loans become 'Grade B' and half of 'Grade B' loans become 'Grade C'.
0.05(0.3) + (0.05+0.33)(0.62) + (0.33+0.1)(1.5) = 0.90
0.9 is the new 'stressed' Averaged Risk Weighted factor. Now we can calculate a new 'risk weighted loan balance figure' from the existing 'exposed assets at default' figure.
The sum of the business related loan assets 'exposed at default' on the last balance date (30-09-2019) was $87,935m. So our new 'Risk Weighted Adjusted' figure is:
0.9 x $87,935m = $79,142m
This is an increase of: $79,142m - $51,560m = $27,852m
WBC requires a minimum of 8% of the incremental 'book value' of business loans on the books.
So the amount of new capital WBC needs to cover off these business loans under my 'stressed business' scenario is:
0.08 x $27,852m = $2.2billion.
SNOOPY