Basel II and Residual Value Risk

The new capital charges proposed by The Basel Committee on Banking Supervision (BCBS or “Basel Committee”) of the Bank for International Settlements (BIS) in the framework of the Basel II Accord Rules (the “Basel II Rules”) are risk weighted and provide substantial relief for better rated credits. However, the Basel II Rules maintain a 100% weighting on operating lease residual values, which is highly penalizing for the leasing industry. This paper discusses the capital charge relief that can be provided to a bank subject to the EU’s Capital Requirements Directive by a residual value insurance policy provided by an insurer rated AA.

Figure 1 shows the capital charge methodology for a lease of a £100,000 item placed by a bank leasing company on a tenyear lease using an implicit 7.5% rate with a 40% residual value to an A-rated lessee. In the lease with the unguaranteed residual (“Base Lease”), the residual value is provisioned for each year as follows: 1/t * 100% * exposure value, where “t” is the number of years of the lease contract term remaining, and the capital charge is 8% of the provisioned residual. In the lease with a guaranteed residual, the residual is treated as the final rental payment, and the base capital charge rate of 8% is reduced by the guarantor’s credit weighting (using an assumed 15% weighting). The NPV of the capital charge savings is 28% and can be used to give the lessor an improved return on capital employed. The balance of this paper is designed to work through the statutory scheme and show how it works, as well as to demonstrate that a “safe” residual is treated exactly the same way that a high-risk is treated.

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