How Bad Is Basel III?

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Sam Chandan
Sam Chandan

Property lenders of all stripes will originate more debt in 2014. Measured by anecdote, survey, and by the numbers themselves, lending volume is on the rise for assets in primary and secondary markets, for core and non-core properties and for both anchored and speculative development. The uneven and deeply bifurcated commercial real estate recovery—as much a reality for debt as for equity—is a narrative on the wane. In its place, more confident lenders are expanding their field of view. Yet for all the regulatory encroachment of the post-crisis era, few have sought or seen breakthroughs in the calculus of their risk-taking.

Trends in underwriting standards are working against life companies and other lenders with a conservative bent, as banks and conduits are ready to quote and close on more liberal terms. Market discipline is eroding as our distance from the crisis increases. Apart from pervasive myopia, the adjustment reflects a brighter outlook for the economy and the labor market, as well as a slow improvement in property fundamentals in cases where supply has remained in check. The trend toward loosened underwriting also captures lenders’ growing capacity and the relatively slower rebound in borrower quality.

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The first quarter’s Survey of Lender Sentiment, published by the Real Estate Lenders Association and Chandan Economics, shows that originators expect increasing volume across the board. Pent-up capacity is projected to converge on a long-overdue improvement in prevailing borrower credit quality.

As mortgage volume picks up, the center of gravity for new activity is shifting. Growth opportunities are moving away from apartments, to other commercial properties and construction loans. Half of all participating lenders anticipate an increase in demand for construction loans by well-qualified borrowers. But their positive view is tempered with reservation. A small minority of banks report making non-recourse construction loans; an even smaller share reports something more than de minimis exposure. If previous cycles offer any guide, construction terms will liberalize soon enough.

As banks and other less conservative lenders move to reengage with borrowers and revisit opportunities to fund development projects, they are not operating in a vacuum. Apart from changes in the real estate market, changes in the regulatory environment are presenting new headwinds. For real estate as much as any sector, the primary legacy of the financial crisis is significant new regulation of the banking system. The Dodd-Frank Act has been law for some time. Its demands on commercial lenders are now coming into force, first for large institutions and then for their smaller counterparts.

Bank regulators in the United States finalized terms of Basel III implementation last year. Basel II, its immediate predecessor, applied only to a subset of banking organizations in the United States. But the risk-based capital requirements defined in Basel III have a broad scope of application. For stabilized property lending, the new rules have not been a great source of alarm for the industry. Risk weights on construction lending and the treatment of mortgage servicing rights are another matter.

All things being equal, Basel III’s more onerous risk weights on construction loans should lower their profitability to banks. Borrowers will see slightly higher interest rates. At least on the margins, capital will rebalance in favor of other asset classes. Riskier properties with maturing pre-crisis loans may bear higher costs, but that is exactly as intended. Any resulting capital shortfalls to weaker assets may be described as an unintended consequence of regulation, but the outcome is very much by design.

A new equity exemption threshold for high volatility commercial real estate may be the most demanding aspect of the strengthened regulatory framework. Considering the overall default and loss profile of the banking system’s legacy construction loans, and the impact of construction loan losses on the viability of many banks during the financial crisis, it is hardly surprising that an entire class faces higher risk weighting.

The industry has every incentive to argue that Basel III’s impact on construction loan availability will prove formidable. But theory and practice may not converge. Whether it will materially impact borrowers’ access to construction financing when it comes into full effect is uncertain. Similarly, the differential impact on smaller banks, including the many community and regional banks that lend heavily for construction, is undetermined.

The problem arises in part from regulation’s blanket treatment of each class of loans. Multifamily is low risk. Commercial is riskier. Construction is riskiest. In failing to provide a framework for the differentiation and efficient pricing of higher and lower quality loans, it discourages the outcome it seeks to promote. In terms of regulation and in bank practice, both evolution and revolution in the methods of credit risk measurement are conspicuously absent in the post-crisis era. Whether the new rules of banking will help or hurt the sector is open for debate. One thing is for sure: until risk measurement is made a priority, real reform will remain elusive.

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at dsc@chandan.com.