The first phase of the Accord will take effect in 2007, and the second phase will be implemented in 2008.

The Accord regulates the amount of capital that banks will have to set aside for their loans. In addition, it prescribes that this capital must be a better reflection of the actual credit risks represented by the companies to which the banks lend. Banks can select from three methods of determining the risks and the associated capital requirements; the banks with the most sophisticated risk management will be rewarded with a lower capital requirement relative to their existing capital bases. This is one of the reasons why credit will not necessarily become more expensive. There is also no question of credit crunch; banks' loan portfolios have in fact grown as a proportion of their total assets.

As from 1 January 2007, banks will be required to have historical credit information on their lending customers; this information is needed to evaluate their customers' creditworthiness. Three quarters of companies are currently reported to have insufficient information about the banks' new credit risk criteria.

An increase in the transparency of company accounting and of the information exchanged with banks is intended to result in greater objectivity with regard to the granting of new credit lines. The more favourable the company's risk profile, the better the credit risk rating and the more favourable the bank's terms and conditions will be.

Creditworthiness a management priority

The banks' credit risk assessment will be repeated during the term of the financing; this seems to be paving the way for a greater role for companies' accountants. Systematic analysis of a company's creditworthiness is a useful part of medium-term planning.

A company's creditworthiness must be a management priority. Efficient debtor management, good payment history, and up-to-date financial reporting will help to boost credit ratings.

Banks use both quantitative and qualitative criteria to assess credit risk. The quantitative factors are gearing, liquidity, profitability, debt repayment capacity, and security. The qualitative factors are the quality and the expertise of the management, the market environment, and the legal form of the business. They use many different information sources, ranging from balance sheets and profit and loss accounts, to business plans and tax returns, but also meetings with the management.

A company that does not score well in a bank's credit risk assessment may face difficulties in the future. Under Basel II, the bank would then be forced to make its loans more expensive, to restrict outstanding credit lines, or to refuse to grant further loans.

In order to improve their credit risk assessment or rating, companies have the option of making greater use of off-balance sheet finance, such as leasing or factoring. Another option is to raise private equity.

Undercapitalisation is a mortgage on the future

Under Basel II the basic lending criteria will certainly continue to be the competence of the management, the company's ability to repay the loan, and adequate equity.

Companies demonstrate their ability to repay debt using credible business plans and historical cash flows. Under Basel II, the cash flows that companies are able to demonstrate will become more important.

Companies must also demonstrate their inherent profitability and the managers of many SMEs and medium-sized corporates will certainly have to address this issue. Benefits in kind and the segregation of corporate and personal assets must be properly organised. In this way, the business can organise its activities at the level of a management company, thereby increasing the transparency of the operating company.

Basel II will also have a major impact on equity, as the penalties for undercapitalisation will increase. Undercapitalisation is generally tax-driven and under a /historically high tax burden in many countries, overcapitalisation has become synonymous with an expensive price tag. Too many companies have excessively high gearing. In Europe, for instance, bank loans account for 22% of financing, compared with 12% in the UK, and 4% in the US.

Undercapitalisation constitutes a mortgage on the future; this situation needs to change. Profit retention and capital injections have become fiscally more attractive in recent years and personal equity needs to be used more extensively to finance businesses.

The new lending relationship: six recommendations

What precautions can a company take in order to avoid a poor credit risk assessment? The European Commission has put forward six recommendations, which are the basic rules governing lending relationships in the new Basel II environment.

The collection of information and credit rating systems vary from bank to bank. One recommendation is that companies should obtain information at the outset on the type of documentation that the bank issues, on its approach to credit assessment, on the information that it will require, and on whether it will disclose the results of its credit assessment.

The company must develop the discipline to present complete, unambiguous information to the bank within the agreed time period.

Each bank has different credit terms. The factors that affect these terms are, in descending order of importance: the credit risk assessment, security (in the form of cash, property, securities, receivables, stocks, etc.), the term of the loan, special clauses (maximum gearing, minimum liquidity, debt to equity ratio, etc.), the relationship with the customer, the volume of loans (borrowers can generally secure better terms by raising a number of loans from the same bank).

An active credit rating system requires companies' managements to be vigilant; they need to monitor the quantitative and qualitative factors that change their companies' risk profiles.

A company's position will be monitored from a distance throughout the term of a credit by the bank. Disappointing figures, the expiry of supplier credit, a negative cash flow, or fluctuating accounting ratios can result in a breach in its loan terms and all represent alarm signals. In particular, companies should make their banks aware of the real financial situation in the market environment.

Finally, the company can use other types of finance, including innovative products.

Measures to reduce borrowing requirements

In summary, Basel II tightens up requirements on the demand side for loans and it is worth giving serious consideration to measures to limit borrowing requirements and to alternative credit products, which can have a considerable impact on a company's balance sheet.

Companies can reduce their borrowing requirements by using leasing, factoring, and/or efficiency gains. All three are reflected on the asset side of the balance sheet. Leasing affects capital employed, factoring affects debtors, and efficiency gains affect the assets that can be converted into cash within one year. Efficiency gains lie primarily in lower stocks and/or real productivity gains.

Use of alternative forms of finance is growing. These include private equity, mezzanine structures, and even financial incentives, such as government subsidies. These are shown as liabilities on the balance sheet. Private equity affects the company's capital base, mezzanine finance affects borrowings and the capital base, and subsidies affect borrowings.

Mezzanine finance is funding using hybrid debt and equity, and is expected to become increasingly widely used. By 2007, all European banks will be offering this type of finance.

Conclusion

The result of the Basel II Capital Accord will be that all banks will have a more sophisticated approach to credit risk assessment. Companies will therefore need to put their financial housekeeping in order and their managements will need to optimise their credit risk profiles. Companies that regularly submit clear and well-substantiated reports and figures to their lenders will have good negotiating positions.

The medium-sized corporate segment will not be disadvantaged by the new Accord and will continue to be very important to the banks. As well as using traditional forms of debt, medium-sized and larger corporates can take advantage of a range of new credit products for specific purposes, such as leasing, factoring and private equity, which do not adversely affect their credit profile.