Capital requirements for banks

The Basel Committee’s new rules on capital adequacy is likely to impact the private equity industry in more than one way. Comment from SJ Berwin.

Last year, the Basel Committee – an international organisation of central banks and bank regulators – published new proposals to regulate capital requirements for the world's banks. These proposals, which the Committee expects to be adopted in 2006, are aimed at rationalising the existing rules (which date from 1988). The intention is to align a bank's capital requirements more closely with the actual risks it takes, and to improve their risk management.

 

While this might appear to have nothing to do with private equity, some (including the European Private Equity and Venture Capital Association) believe that the impact on the industry could be significant.

 

That impact comes in two distinct ways: first, the rules would increase the capital which a bank must hold to compensate for the risk it takes in lending to smaller companies, which might make it harder for SMEs to raise debt finance. Second, the capital requirement for a bank which engages in private equity activities – either by investing in an independent fund or through a subsidiary private equity division – will also rise. That could reduce the willingness of banks to keep a private equity operation, or to invest in external funds.

 

A welcome announcement at the end of last year confirmed that the Basel Committee was sympathetic to concerns which had been expressed on the first issue, and in July the Committee confirmed that it would seek lower capital requirements for SME loans than for general corporate lending. The Committee accepts that the risk management procedures are different when banks are lending to smaller companies, and that the capital requirement ought to reflect this.

 

However, a paper by EVCA has highlighted the second concern, and so far there is no clear indication that this will be addressed by the Committee as it revises its proposals. EVCA points out that 20 to 30 per cent of the amount invested in European venture capital and private equity comes from banks, and anticipates that a change to the way that their exposure to the asset class is measured for capital purposes could affect their appetite for continued investment.

 

Although the proposals are not yet final, it seems that the way in which private equity and venture capital are classified will lead to a significant increase in the level of capital required to cover the exposure. So, if the proposals were adopted in their present form – and EVCA's assumption as to the effect they might have on banks' behaviour is correct – the impact on the industry would indeed be significant.

SJ Berwin is a European law firm with a particular focus on private equity. The above comment is taken from the firm's weekly e-bulletin, Private Equity Comment, which provides commentary on legal and tax developments which affect the European private equity community. For comment or to subscribe to these bulletins, please email sjbnetworks@sjberwin.com.