Credit Conversion Factor: a Worked Example

A balance sheet shows what a bank has lent. It does not show what the bank has promised to lend, or the guarantees it has given on a customer's behalf, and both can become loans at the worst moment. A business that is losing money draws its revolver to pay suppliers. A customer whose contract goes wrong has its performance bond called, and the bank pays the beneficiary and looks to the customer for reimbursement. Capital rules therefore count part of each promise as exposure today.

The factor deals with how much of the promise is likely to be called on. The risk weight deals with how likely the borrower is to fail. They answer different questions and are applied one after the other.

On the standardised approach each item falls into a category with a fixed percentage. The Basel framework's current table runs from 100% for direct credit substitutes, such as a guarantee of a customer's borrowing or a standby letter of credit that backs a financial debt, through 50% for transaction-related items such as performance and bid bonds, 40% for commitments of any maturity, 20% for short-term self-liquidating trade letters of credit, down to 10% for a commitment the bank can cancel at any time without notice. Where the bank has committed to issue an off-balance-sheet item, such as a line for future letters of credit, the lower of the two factors applies.

The markets do not use one table. Australia's APS 112 follows the Basel factors but has no 10% line: an arrangement the bank can cancel is still a commitment at 40% unless it meets every condition in Attachment C, among them that the borrower is a closely monitored corporate, no fees are charged and each drawing is assessed before it is made, in which case it is not a commitment at all. The UK, until 31 December 2026, uses four buckets of 100%, 50%, 20% and 0%, which grade committed lines by original maturity and give a cancellable line nothing; from 1 January 2027 its Basel 3.1 rules move most commitments to 40% whatever their term and cancellable lines to 10%, and keep performance bonds and documentary credits at 20%. New Zealand's Reserve Bank sets its own table for banks on the standardised approach, so the Basel figures should not be read as New Zealand's.

Where their supervisor allows it, banks approved to use advanced internal models estimate their own factors for some facilities, mostly revolving ones, from how much borrowers drew before they defaulted, subject to floors.

A builder of truck bodies, constructed for this page like every figure in it, has a three-year committed revolver of US$12m with US$5m drawn, US$1.5m of performance bonds issued to fleet customers, US$2m of import letters of credit for chassis secured on the shipments, a US$0.8m standby letter of credit backing an equipment loan from a finance company, and a US$1m overdraft, unused, that the bank can cancel at any time without notice. Amounts in US$m.

The UK column uses today's buckets: 50% on a revolver of more than a year, 20% on bonds and on letters of credit secured on the goods, nothing on the cancellable overdraft. The Australian column assumes the overdraft does not meet every Attachment C condition. The totals sit close together, but for different reasons, and the revolver is the largest single source of exposure in every column. On the UK's 2027 rules the same facilities would come to 9.40: the revolver falls to 40%, the overdraft rises to 10% and the bonds stay at 20%.

Apply a 100% risk weight and a 12% capital ratio, both the example's assumptions rather than any bank's figures, and the Basel column needs about US$1.18m of capital, of which about US$0.34m supports the unused part of the revolver. If the builder asks to lift the revolver to US$16m for comfort, without drawing more, the extra US$4m adds US$1.6m of exposure and about US$0.19m of capital.

The factor is an input; exposure at default is the result. Exposure at default adds the converted share of everything undrawn or contingent to the drawn balance, and the factor is the percentage used for that conversion. In the Basel and Australian columns the revolver's factor is 40% and its exposure at default is US$7.8m; on the UK's current buckets the factor is 50% and the exposure US$8.5m.

It is also distinct from utilisation, which is how much of a limit is drawn today. Utilisation describes the customer's current behaviour; the factor is the rule, or the model, for what that behaviour becomes before a default. A revolver used at 10% for years can still be drawn to the limit in the month before a business fails, which is why the factor does not fall because a customer has been careful.

DEFINED IN ONE PARAGRAPH → · RISK-WEIGHTED ASSETS, WORKED → · EXPECTED LOSS, WORKED →

The factor sits behind three things a borrower sees. The first is the utilisation fee and the line or commitment fee: an undrawn committed limit uses capital, so the bank prices it, and a borrower who asks for headroom it will not draw is asking the bank to hold capital for comfort. The second is structure. An uncommitted facility the bank can cancel takes a lower factor in some markets, and the UK's change in 2027 ends the lighter treatment of committed lines of a year or less. The third is the annual review, where a credit officer cancels limits that sit unused or asks for cash cover over a bond line.

The factor also feeds a bank's tests of concentration. The Basel large exposures standard counts off-balance-sheet items through the same factors, with a floor of 10%, so a group whose drawn debt looks modest can still approach a bank's limits once its bonds and undrawn lines are added.

HOW BANKS PRICE BUSINESS LOANS → · BANK GUARANTEE OR LETTER OF CREDIT → · CONNECTED EXPOSURE →