The supervisory slotting approach fixes the risk weight by grade. Here is the capital it implies, the margin that capital costs, and what a downgrade does to both.
Under the supervisory slotting approach, a bank multiplies the loan by a risk weight set by the loan's grade, 70, 90, 115 or 250 per cent, then by its capital ratio. On a 50,000,000 income-producing real estate loan graded Satisfactory, at an illustrative 10.5 per cent capital ratio, that is 6,037,500 of capital, which needs about 145 basis points of margin just to earn a 12 per cent return on it. A downgrade to Weak more than doubles both.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Banks that use internal models for corporate loans often cannot estimate reliable default probabilities for income-producing real estate, because the repayment depends on one property rather than a diversified business. For those exposures, the Basel framework, carried into EU and UK rules, gives them supervisory slotting: the bank grades each loan into one of five categories on the strength of the cash flow, the asset, the sponsor and the security package, and the regulator fixes the risk weight for each category. The lower weights for Strong and Good loans with less than 2.5 years to run are a national discretion in the Basel text and are written into the EU rules.
| Category | Risk weight, 2.5 years or more to maturity | Risk weight, under 2.5 years | Regulatory expected loss |
|---|---|---|---|
| Strong | 70% | 50% | 0.4% |
| Good | 90% | 70% | 0.8% |
| Satisfactory | 115% | 115% | 2.8% |
| Weak | 250% | 250% | 8.0% |
| Default | 0% | 0% | 50% |
A defaulted loan carries no risk weight because its whole cost sits in the expected loss: 50 per cent of the exposure, which has to be covered by provisions or deducted from capital. The expected loss figures shown are those for loans with 2.5 years or more to run; where the short-maturity weights apply, the EU table cuts Strong to 0 and Good to 0.4 per cent. High-volatility CRE, such as land acquisition and construction lending, sits on a separate, higher Basel table: 95, 120, 140 and 250 per cent.
| Input | Value |
|---|---|
| Loan, remaining term 5 years | 50,000,000 |
| Capital the bank holds per unit of risk-weighted assets | 10.5% |
| Target return on equity, after tax | 12% |
| Tax rate | 25% |
| Marginal cost of funding the rest of the loan | 4.0% |
The 10.5 per cent stands for the bank's whole requirement, minimum plus buffers plus its own management margin, not the 8 per cent headline minimum. Every bank's number is different, and the answer scales with it.
Risk-weighted assets = loan × risk weight
Capital = risk-weighted assets × capital ratio
Capital margin = risk weight × capital ratio × (cost of equity / (1 − tax) − funding rate)
Excel, with loan in B1, risk weight in B2, capital ratio in B3, cost of equity in B4, tax in B5 and funding in B6: =B2*B3*(B4/(1-B5)-B6) for the margin, =B1*B2*B3 for the capital.
For the Satisfactory loan: 50,000,000 × 115 per cent = 57,500,000 of risk-weighted assets. At 10.5 per cent the bank holds 6,037,500 of equity against it. That equity costs 12 per cent after tax, or 16 per cent before it, and it replaces funding that would have cost 4.0 per cent, so the extra cost is 12 per cent of the capital: 724,500 a year. Spread over the loan, that is 145 basis points of margin before operating costs and before any allowance for credit loss.
| Category | Risk-weighted assets | Capital | Capital per 100 lent | Capital margin, bp | Margin if under 2.5 years, bp |
|---|---|---|---|---|---|
| Strong | 35,000,000 | 3,675,000 | 7.35 | 88 | 63 |
| Good | 45,000,000 | 4,725,000 | 9.45 | 113 | 88 |
| Satisfactory | 57,500,000 | 6,037,500 | 12.07 | 145 | 145 |
| Weak | 125,000,000 | 13,125,000 | 26.25 | 315 | 315 |
The gap between Strong and Weak is 227 basis points of margin, on capital alone. That is why a bank's credit grade, not just its view of the property, sets the price it can offer: the same loan graded Strong rather than Satisfactory frees 57 basis points.
The downgrade is where it bites. Move the Satisfactory loan to Weak during its life, after a tenant loss or a covenant breach, and the capital rises from 6,037,500 to 13,125,000, an extra 7,087,500, or 2.17 times as much. The regulatory expected loss jumps from 1,400,000 to 4,000,000 at the same time. The margin was fixed at origination; the capital was not.
| Cost of equity | Strong | Good | Satisfactory | Weak |
|---|---|---|---|---|
| 10% | 69 | 88 | 113 | 245 |
| 12% | 88 | 113 | 145 | 315 |
| 15% | 118 | 151 | 193 | 420 |
A bank with a 15 per cent cost of equity needs 193 basis points on a Satisfactory loan just to pay for the capital. Debt funds and insurers are not subject to slotting and work under different capital rules, often lighter for this kind of loan, which is commonly cited as one reason non-bank lenders have taken share in commercial real estate lending.
Capital on a slotted real estate loan is loan × risk weight × capital ratio, and its cost in margin is that share times the cost of equity, grossed up for tax, less the funding it replaces. On 50,000,000 graded Satisfactory: 6,037,500 of capital and 145 basis points. Borrowers who understand which grade they are in understand the price they are quoted. How a lender values the property behind the grade is the subject of Real Estate Finance, and its four workbooks, including the sizing and binding-test sheets, are in the free files for the book. For the covenant side of the same loan, see which loan covenant breaches first.
For income-producing real estate that is not high-volatility CRE, the supervisory slotting categories carry 70 per cent (Strong), 90 per cent (Good), 115 per cent (Satisfactory) and 250 per cent (Weak) with 2.5 years or more to maturity. Where the short-maturity discretion applies, as in the EU, Strong and Good fall to 50 and 70 per cent under 2.5 years. A defaulted loan carries 0 per cent but a 50 per cent expected loss.
Risk weight times capital ratio times the gap between the pre-tax cost of equity and the funding rate it replaces. At 115 per cent, 10.5 per cent, a 12 per cent cost of equity (16 per cent pre-tax at 25 per cent tax) and 4.0 per cent funding, that is 145 basis points, before operating costs and credit losses.
The risk weight jumps from 115 to 250 per cent. On a 50,000,000 loan at a 10.5 per cent capital ratio, capital rises from 6,037,500 to 13,125,000, an extra 7,087,500, and the regulatory expected loss from 1,400,000 to 4,000,000. The margin agreed at origination does not move, so the loan's return on capital falls by more than half.
This article is one calculation from Real Estate Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1614 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.