Financial Modelling to manage regulations’ negative impact on the Real Estate industry.

With the development of two main regulatory frameworks, Basel III and Solvency II, there are worries about the potential effect on the Real Estate industry.

Financial Modelling Article
After the global financial crisis revealed the deficiencies of the financial regulatory system, a global program of Basel III and European Union framework of Solvency were both launched with goals to improve the stability of the financial system through reforms. It is clear that the requirements will have a fundamental impact on business models, but there are fears that the frameworks could have unintentional outcomes for cost of capital, funding patterns, interconnectedness, and risk migration.

Significantly, Basel III has been designed to strengthen the capital requirements for banks to prevent them from collapse by improving risk management processes. The overall theme of the framework is that banks are required to reserve more capital for commercial real estate lending. This new requirement will make banks review their lending exposure to commercial property. Given the difficulty of finding the additional equity required and the lower returns on capital, reserving capital may restrict banks’ ability to lend. As UK banking sector has been a key provider of debt to the commercial property sector, it can have a severe impact leading to some tightening in credit provision and an increase the cost of borrowing for property companies.

Similarly, Solvency II is designed to add protection to the financial system in the event of another crisis. It “shock tests” different asset classes to determine the necessary capital requirements for insurance companies, which increase together with the perceived risk. Insurers must set aside the required amount of capital to ensure that it can cover liabilities to policyholders if its value falls. Although in general, real estate is allocated a 25% capital requirement, there is high uncertainty level on how different types of property investment will be treated (e.g., REITS, unlisted real estate funds). Solvency’s uncertainty is causing the insurers to delay the deployment of capital, and as they are major investors in real estate, both directly and indirectly, it can have a huge effect on the industry.

For both regulatory frameworks it is clear that financial modelling and the accessibility of robust data will be essential for stress tests, recording of collateral, and accounting for capital requirements, amongst others. The knowledge in building fully flexible models, identifying sources of risk, optimising leases and presenting easily interpretable models to clients is essential when dealing with difficulties presented by new regulations. Even though some market participants have been overlooking the ability of adequate modelling reporting, it will be impossible to ignore it in the future.

author: Sandra Bekeryte

References

  • Laas, D., Siegel, C. F., 2015. Basel III versus Solvency II: An Analysis of Regulatory Consistency under the New Capital Standards. Available at SSRN: http://ssrn.com/abstract=2248049
  • Chan, S. P., 2014. Interest bill on UK’s £1.27 trillion debt to hit £1bn a week. Available at Telegraph: http://www.telegraph.co.uk/finance/economics/10849333/Interest-bill-on-UKs-1.27-trillion-debt-to-hit-1bn-a-week.html
  • Taliance, n.d., Interview – Leigh Wormald, Mazars – Preparing for Change: the New Regulations Due to Impact the Industry. Available at Taliance: http://www.taliance.com/preparing-change-the-new-regulations-due-impact-industry
  • Milliman, F., 2011. A Real Estate View of Solvency II. Available at Solvency II Wire: http://www.solvencyiiwire.com/a-real-estate-view-of-solvency-ii/3446
December 7th, 2015|