Your Slice of the (Credit) Pie May Be Smaller in Future

November 10, 2004 by admin

“Basel II” is an equity capital guideline for banks that was defined by the “Basel Committee on Banking Supervision.” This committee consists of the representatives of the issuing banks and the banking supervisory authorities of the G10+ states (Belgium, Germany, France, the United Kingdom, Italy, Japan, Canada, Luxembourg, the Netherlands, Sweden, Switzerland, Spain, and the USA).
The core message of Basel II is that the capital backing required when a loan is approved should be based on the risk actually associated with the loan. Or, put more simply, the higher the credit risk, the more equity capital is required to secure the loan. The Basel II guidelines aim to stabilize the international finance system.
So any statutory provisions that will result from the Basel II guidelines will only directly affect the financial sector. Any impact felt by industrial and service companies will therefore be merely an indirect result of the demands made on the financial sector. The start date for the Basel II guidelines, which require financial institutions to factor in historical data when calculating credit risk, is the end of 2006. As a result, a whole host of institutions have started to behave as though the guidelines are already in force.
Financing by banks is an important source of companies’ liquidity, particularly in German-speaking countries. A 2001 study by EXCO, Grant & Thornton demonstrated that 66 percent of German companies are financed by loans. The EU average, in comparison, is just 46 percent.

Impact on companies

In order to assess the risk on a loan, banks will in future subject potential borrowers to a rating procedure. Put simply, this rating is a kind of reference on a company’s credit-worthiness. A good rating essentially means low interest on the loan, while a bad rating means high interest.
The criteria used to draw up a rating can be divided into two categories. The first category includes what are referred to as the “hard facts”. This group covers all quantitative data, such as equity ratio, return on total capital employed, debt payment period, ratio of outside capital to total capital, percentage return on sales, personnel expenditure ratio, material expenditure ratio, sales growth etc., to name just a few criteria. This category deals primarily with those criteria that can be calculated from the annual statement of accounts (balance sheet, profit and loss account) or from a business management analysis. In terms of the rating, it is important that all these figures are not just submitted as current figures, but also as projected values with a planning horizon of two to three years.
The list of the qualitative criteria, the so-called “soft facts”, has not been defined precisely, and its exact form depends largely on the individual bank. The soft facts mainly refer to the assessment of the individual company and its prospects in terms of development potential and flexibility. Alongside qualitative criteria, such as positioning in the market, customer orientation, or ability to innovate, company-specific success criteria, such as the quality of the management and the employees, may be assessed.

Basel II and IAS/IFRS

When being rated by lenders, companies always need to demonstrate transparency and comparability, the latter being a particularly key concept here, as the risk of default on a particular loan is always compared with the risks of default on any other loans that may also be approved. As each bank’s maximum credit volume is limited, demand for loans always translates into competition for liquid funds. Yet, with the internationalization of the financial markets, SMBs also have the option of cross-border finance. In order to be able to access the international capital market, company accounts must be produced on a basis that can be compared internationally using IAS/IFRS accounting standards. IAS stands for “International Accounting Standards” and IFRS for “International Financial Reporting Standards.” The IAS/IFRS are defined by the IASB (International Accounting Standards Board), which is based in London. One of the main goals of IAS/IFRS-compliant accounting is internationally comparable annual accounts.

Interaction of Basel II and IAS/IFRS

At first glance it would seem that SMBs in Germany are not affected by the obligation to introduce a parallel IAS/IFRS-compliant accounting system. However, this is not strictly true. The guideline for listed companies to publish IAS/IFRS-compliant consolidated annual accounts means that only IAS/IFRS-compliant figures may be included in these statements. This means that all groups and their subsidiary SMBs need to produce IAS/IFRS-compliant accounts alongside annual accounts based on national law for calculating taxation and dividends.
An SMB that is part of a group will compete with other SMBs for liquid funds at least in terms of the use of overdraft facilities. To provide a realistic assessment of the risk of approving loans, lenders will demand comparable figures. This means that a company that up to now has only ever presented HGB-compliant figures (that is, figures in accordance with German commercial law) will in future also have to present figures that conform to IAS/IFRS. This becomes particularly significant in terms of the international capital market, which, in the context of cross-border finance, can be accessed more easily if IAS/IFRS-compliant accounts are used.

Conclusion

Basel II and IAS/IFRS pose significant challenges to a modern accounting system. Basel II creates the requirement to make precise and timely company data available. The introduction of IAS/IFRS impacts above on balance sheet evaluation and makes parallel accounting in accordance with both local law and IAS/IFRS compulsory.
The decision whether an IAS/IFRS annual statement should be presented alongside the local statement has been taken away from capital market-oriented companies by the EU which has decreed that, as of 2005, they must present IAS/IFRS-compliant consolidated accounts. SMBs that do not form part of groups have this decision yet to come. They will need to weigh up the cost of implementation against the opportunities it offers. While IAS/IFRS accounts provide a good basis for accessing the international capital market, the complexity of implementing IAS/IFRS should not be underestimated.

Thomas Jordan

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