The Basel Committee on Banking Supervision’s (Basel) proposal to eliminate the use of internal models for specialized lending couldreduce bank funding as a financing source for aircraft lessors, unrated/lower-rated airlines and other secured borrowers, says Fitch Ratings. That said, the long lead time before implementation, opportunity for market participants to respond to the proposal, and diversity of aircraft financing sources offer multiple avenues to manage the potential impact.

The proposal is part of broad reforms to the risk-weighted asset (RWA) framework, commonly referred to as the “Basel IV” reforms. These proposals would require banks to adopt either a revised standardized approach or supervisory slotting approach for object finance, which includes aircraft/shipping finance and commodities finance. Specialized lending describes forms of financing where the repayment of the bank loan depends on the cash flows generated by specific assets that are financed and pledged or assigned to the lender.

Aircraft lessors, unrated/low-rated airlines and other secured borrowers could be more adversely affected than more highly rated unsecured borrowers under the current revised standardized approach proposals. An airline operator without security on an aircraft would get a lower risk weight (100%) than object financing with a first-lien on the aircraft (120%). The revised standardized approach proposals also do not differentiate among aircraft types, even though Fitch has found young/in-demand aircraft tend to remain more liquid and secondary market pricing is more predictable, even during times of economic distress.

In response, the Aviation Working Group — an organization of aircraft manufacturers, lessors and financial institutions — noted in early 2016 letter that the flat risk weight for aircraft-backed loans is “vastly out of proportion with transactional risk and loss data.” Manufacturers are prepared to continue lobbying behalf of banks, according to Airbus.

Borrowers currently benefit from healthy access to aircraft financing from multiple sources, including the capital markets (unsecured notes, EETCs and ABS), commercial banks, insurance companies, and certain export credit agencies (ECAs). According to Boeing, bank debt represented 28% of $122 billion of commercial aviation financing in 2015 and is expected to represent 27% of $127 billion of financing in 2016. While Basel has yet to provide a final implementation date, Basel IV compliance is expected by the beginning of 2019. U.S. agencies have not yet signalled whether they will adopt the guidelines but have exhibited generally exhibited a highly conservative approach toward bank regulation post-crisis.

Borrowers may use the transition period to further expand relationships with new lending vehicles should banks reduce their aviation lending appetite. Currently, banks do not appear to be materially reducing their specialized lending exposures because of regulatory requirements, but Fitch believes banks may expand their capital markets/syndication capabilities and focus more on rated corporate debt over time.

This shift could be more pronounced for U.S. and European banks relative to Asian banks, which already tend to use the standardized approach for object finance. China and Japan are expected to be the two largest country sources of bank debt for commercial aircraft deliveries in 2016, according to Boeing, representing 29% and 15%, respectively. Asian banks have been active in the aviation industry for many years through lending and aircraft ownership. Aircraft finance is also growing business for Gulf Coast banks.

One trend that may mitigate the impact of Basel’s proposals is the continued ratification of the Cape Town Convention. The treaty has positively affected the aircraft finance industry, with ECAs granting a fee discount to borrowers in countries that have ratified the treaty. Certain ECAs and other non-banks may remain active even if banks reduce their aviation exposures.