IPD completes first UK slotting simulation report

IPD, the property performance analysis and risk measurement specialist, has carried out the first fact-based study into the effects of slotting, a practice designed to ensure banks have enough funds set aside to cover losses on property lending.

IPD set about creating an independent study to model how loans would perform in the future to see what the effects of slotting would be.

The regulation change would affect all lending that relies on the performance of income-producing commercial property. There is an estimated GBP212.3bn of outstanding loans in this area, according to the latest De Montfort University survey.

IPD used figures from its property databank to simulate what would happen to risk-weighted capital if the slotting regulatory structure was in force and a slump identical to 2007-2009 occurred.

The study used evidence on the performance of 3,442 UK commercial property assets initially valued at GBP56.6bn at the peak of the market.

Slotting requires banks to classify the risk of each income producing commercial real estate loan according to one of five slots ranging from Strong, Good, Satisfactory and Weak to Default. Each slot requires the bank to hold a progressively higher amount of capital.

The original Financial Services Authority (FSA) consultation guidance was published in 2011, outlining the attributes required for each slot and sparking widespread debate. Although the FSA’s suggested slotting framework parameters were subsequently removed, slotting is still set to be introduced.

IPD used actual historic data across the whole of the last downturn. By looking at how real assets performed over that period, IPD was able to draw up workable projections to assess the forward-looking implications of slotting. With a complete picture of the last downturn, IPD could effectively look at all the subtleties around the allocation of risk-weighted capital – using three simulations to model loan performance.

The intention was to see whether the amounts of capital required of the banks to be set aside were too low or too high, relative to potential losses.

Slotting could significantly exacerbate economic risks by reducing the value of banks’ current stocks of property. The additional capital required if the slotting method is used will force further de-leveraging of banks’ property loan books. The result will be more forced property sales that will further depress the property market, thus creating a vicious cycle of further losses in loans secured by commercial property.

The limited number of slots in the structure of slotting and the absence of risk weighting for each risk factor discourages detailed risk analysis, which would take account of the observed risk characteristics of commercial real estate. Such detailed risk analysis is necessary to encourage safer lending in the future.

There will be far more capital held on low risk exposures than necessary. This could discourage low-risk bank lending in particular as the amount of excess capital attached to it is disproportionate to the risk compared with the capital required for the satisfactory slot. This raises cost of finance for borrowers seeking low risk loans, and means fewer transactions are likely to happen, ultimately leading to reduced construction activity, with inevitable consequences for the wider economy.

Slotting could push dependence on finance to foreign lenders and unregulated lenders in the ‘shadow banking’ sector.

Phil Tily, managing director of IPD in the UK and Ireland, said:

“The problem with banks’ risk models was the lack of sound market data going into them. Our intention here was to create an evidence-based study that allowed us to demonstrate the true effects of slotting using actual property data.

“Tracking underlying property data on the security of income as well as values is vital to being able to gauge the real underlying risks of lending against income producing commercial property and IPD will continue to make data available for further research.

“Based on our findings, slotting could cause serious harm if the impact on the property market and its relationship to the wider economy are not fully understood.

“We see potential for a more a more risk sensitive UK regulatory regime that would provide capital cost incentives to lend in an economically efficient and stabilising manner. We hope to do further research using the IPD Databank to inform the debate.”

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