On 1 January 2007, a "revolution disguised as regulation" (as described by one KPMG report) will reshape the prudential environment of major banks worldwide. Under the Basel II Accord on capital adequacy requirements, new rules guiding how much capital banks will need to set aside as a safety margin against their loans, will be introduced.

The Accord was developed by representatives from the central banks and regulatory authorities of 13 developed countries, and while the agreement cannot technically be enforced outside the banking systems of endorsing countries, compliance under Basel II will become a given if a bank is to be competitive within the international market.

Preparing for and subsequently remaining in compliance with the agreement is set to be a challenge both for banks and their lawyers and will also have implications for borrowers and their own legal counsel. 

Under a preceding accord, Basel I, banks and other financial institutions were to maintain capital funds of no less than 8% of their risk-weighted assets. While this rule will still apply under Basel II, the new accord introduces capital adequacy requirements against credit, market and operational risks, representing a considerably more sophisticated - and thus legally challenging - regulatory structure.

Also under Basel II, a new 'supervisory review' process will require regulators to evaluate a bank's assessment of its risks and to determine whether they are reasonable, the aim being to encourage greater interaction between the bank and the regulator.

Finally, the Accord's disclosure provisions require banks to provide more public information, and to demonstrate greater transparency and more responsible corporate governance, with the marketplace acting as an additional 'regulator'.

All of which represents a feast of work for the banks' lawyers.

One obvious strategy for decreasing the amount of capital a bank would have to set aside against its risks would be to decrease the risk itself. An apparently frequent criticism of Basel II, however, is that it assesses risk on a deal by deal basis rather than recognising that, for a bank, a diversified portfolio is considerably less risky than a concentrated portfolio.

"In not taking into account the risk mitigation effects of international diversification, Basel II in its current form runs the risk of materially reducing the incentive for larger internationally active banks to maintain and expand their operations in emerging market economies," Citigroup vice chairman Stanley Fischer told an international banking conference in September 2005. "Given the economic and other benefits of such operations, not just for the host economies and for the international financial system more generally, this must be considered a significant shortcoming."

A further concern of banks in developing countries is that the Accord will weaken their competitive position against the larger international banks. In part, this is because there are two alternative approaches to compliance under Basel II - the "standardised" and the "advanced". The second approach, however, requires more resources and experience and therefore favours the larger players.

"Greater competition from internationally active banks could see banks from the developing world being taken over by foreign banks, at a pace even quicker than has occurred in recent years," suggested a 2001 report by the UK-based Institute of Development Studies. "[D]eveloping and transition country banks would tend to use for a significant period, the standardised approach ... which requires more capital, whilst the large international banks would be able to use the more advanced approach, which requires less capital. If developing and emerging banks attempt to switch to the more sophisticated approach (so as to avoid a higher capital requirement that increases their costs), they will find it extremely complicated and demanding to do so, if not impossible in the medium term."

Preparation for Basel II has not been easy: "While the revised Basel framework is sure to lead to a much more meaningful assessment and management of risk in the long run, the actual implementation is strewn with regulatory burdens," according to a July 2006 report by the United Nations Conference on Trade and Development (UNCTAD). "The massive amount of compliances and the human, technical and intellectual infrastructure which it requires will disqualify many players," the report says.

In addition, not all jurisdictions have moved towards implementation at the same rate. According to a 2004 study by Gilles Thieffry, partner with Geneva-based Pestalozzi Lachenal Patry, while 60% of banks in Europe had at that time moved into implementation phases (build, text and roll-out) of their Basel II programs, Asian and emerging markets lagged behind with only 27% and 12%, respectively.

The UNCTAD report raises specific concerns about the effects of Basel II implementation on non-developed countries. "[The Accord's developers'] concern is the health and shock-resistance of the world financial system," the report says. "Any damage that their new rules may cause developing countries is collateral damage - unfortunate, but not their concern ... There is no doubt that as a result of Basel 2, those developing countries who experience macroeconomic volatility and vulnerability to external shocks will find themselves further on the fringe of the international financial market."

These predictions come at a time when the Asian region is experiencing strong economic growth, high liquidity and a buoyant loans market.

Lawyers will play a key role in the Basel II implementation process, whether acting for bank and institutional lenders or for borrowers. "The involvement of lawyers in delineating the potential liabilities of the various risk-takers in that new framework will be fundamental," argues Thieffry. "Even more so when legal risk will find its direct way to capital through both operational risk and setting LGDs (Loss Given Defaults)."

BANKING ON EXPERIENCE
Closing on Asia's largest ever leverage buy-out earlier this year, Lovells continues to build its banking and finance presence in the region
A global surge in acquisition finance, followed by stronger economic growth, delivered the Asia-Pacific loan market another active year in 2005.

Against that background, Lovells has in the last year continued its strategy of increasing market share of syndicated loan transactions, using these transactions to increase the firm's profile and expand its contacts in order to leverage into more structured deals. Five years ago, explains Hong Kong-based banking and finance partner John Hartley, Lovells did not have a significant presence as a banking firm in Hong Kong, partly because the firm had previously done mainly private deals and was not known for acting for the banks. All that has changed, however, with Lovells now established as a key player in the Asian finance market.

"Essentially, the banks aren't going to give you [high-end work] unless they're comfortable with you, and therefore we took the view that the easiest market to target to raise profile was the general syndications market," Hartley says.

Within the past 18 months, Lovells has acted for major clients across a wide range of significant finance deals. Closing the deal in November 2005, the firm acted as legal counsel to the lenders in relation to a US$1.1bn syndicated five-year loan facility to Sinopec Overseas Oil & Gas Ltd, guaranteed by the PRC state-owned entity China Petrochemical Corporation. Also in 2005, the firm acted as legal counsel to Bank of China, Bank of East Asia, BNP Paribas, China Construction Bank, Citigroup and ICBC as coordinating arrangers on the HK$3.6bn revolving credit and loan term facilities to a wholly-owned subsidiary of, and guaranteed by, Hopewell Highway Infrastructure Ltd. In a deal closed September 2005, Lovells acted for Morgan Stanley in connection with a refinancing to be provided by Bank of China Hong Kong to Good Focus Holdings Ltd and Treasure Spot  Investment Ltd to refinance a securitisation relating to Paliburg Plaza and Kowloon City Plaza.

In addition, within Hong Kong and the PRC, Lovells has capitalised on an increase in cross-border and structured finance work, and enjoys a strong reputation for PRC receivables-backed structures.

Perhaps the firm's most significant banking and finance deal this year, however, has been Lovells' advising the SoftBank Group on its acquisition of Vodafone Japan. Completed in April 2006, the acquisition is the largest ever leverage buy-out in Asia, with Vodafone valued at an approximate enterprise value of JPY 1.8 trillion.

While the Vodafone Group owned 97.68% of Vodafone Japan, the acquisition required a public offer for all shares. Acceptances of the offer allowed SoftBank to acquire 99.5% of Vodafone Japan, with the aim being to clean up the remaining minority interests in the coming months.

Hartley believes the Vodafone deal has boosted Lovells' reputation in the Asian region "quite considerably"."We had a number of significant Japanese lenders, plus we had a number of large international banks coming into the syndicate," he says. "One of the difficult things was that there were a number of competing offers coming in for this asset ... and so one of the critical factors was Vodafone being comfortable that we could raise enough finance to actually buy the asset. To my knowledge it was the first time that anyone has got certain funds from their lenders on a deal in Japan."

Another jurisdiction into which Lovells is extending operations is Korea. While the firm does not have any Korean-speaking lawyers in its Hong Kong office, it is Lovells' experience out of that office that will underpin the push into Korea.

"We've slowly begun to act on Korean deals, and as with our original strategy, we will start small and hopefully we can build up from there," says banking and finance partner Prisca Lo. "I think the only way you can credibly [increase a firm's profile] is by doing deals on the ground. What we've been trying to do is build certain relationships, or alliances, with the local law firms. The challenge for that is you have to find the right law firm to have that alliance with.

"In terms of our knowledge in structuring and our cross-border transactions, we are very experienced," says Lo. "We may not have 20 deals under our belt in the Korean jurisdiction; however, we have seen enough difficult, complicated cross-border deals in a lot of other jurisdictions, and we can bring that experience to our Korean clients if necessary. So far, a lot of deals are structured as domestic deals, but I think I see the beginning of a movement now - [Korean corporations] are looking to branch out of their own country and start doing deals in the international fashion.

"Generally, I would envisage [Lovells experiencing] incremental growth, obviously assessing the market all the time," says Lo. "I don't think we would grow just for the sake of being big; I think we very much need to understand where the market is going, and what the areas of opportunity are going to be."