Basel Capital Allocation Example: Capital Attraction of Long-Dated Structured Leases

THE PROBLEM: A large bank-owned leasing company faced a dramatic increase in Basel-derived Capital Allocations that could savage the economics of its portfolio.

THE ANALYSIS:  Analysis showed that the source of the dramatic increase in Capital stemmed from a "penalty for long-datedness."  Big-ticket (aircraft, railcar) tax-advantaged leases were often written with nominal terms of 20 years or more, saddling them with what Basel calls Credit Migration Risk multipliers, based upon the empirically documented notion that initially highly-rated Credits will likely deteriorate in quality over a long period of time.

THE SOLUTION:  Because we concurred  that Migration Risk was substantial for long-dated leases, we turned attention to another lever of the Basel  model, Loss-Given-Default (LGD).  It was here that our simulations were able to demonstrate that LGD was substantially lower for the lease portfolio than had previously been assumed.  This saved the Leasing Company an estimated $100 Million in annual capital charges.

Kirk Monteverde was an invited speaker to the special Equipment Leasing Association conference on Basel II regulations where he outlined much of the statistics and financial theory underpinning capital allocation for leases.  His practitioner-oriented presentation helped to focus industry participants on the effects of Credit Migration Risk in increasing lease capital allocations at a time when most lessors were much more worried about a proposal to assign Basel Market Risk (related to the variability in collateral values) on top of Credit Risk for leases.  A technical working paper that served as background for that presentation can be assessed HERE.