Basel update: Where do we stand?

By Massimiliano Coluccia | 23 April 2018

At the end of last year the Basel Committee on Banking Supervision (BCBS) announced the final rules that completed the Basel 3 reforms. Basel 4 - as the latest incarnation has since become known as - was presented at the time by Mario Draghi as “the end of the game”.

A key objective of the revisions is to reduce the excessive variability of risk-weighted assets (RWAs) among banks and across jurisdictions by applying the principles of simplicity, comparability and risk sensitivity already outlined in 2013.

The main points of the revision are:

  • Amendment to the standardized approach (SA) for credit risk, enhancing its robustness and risk sensitivity
  • Constraints on the use of the internal ratings-based (IRB) approach for credit risk
  • Revision of the output floor that limits the amount of capital benefit a bank can obtain from the use of its internal models: banks’ calculations of RWAs generated by internal models cannot, in aggregate, fall below 72.5% of the risk-weighted assets computed with the standardized approach
  • Setting a new standardized approach for credit valuation adjustment (CVA) risk and operational risk, replacing the four current methods (basic, standardized, alternative standardized and advanced);
  • Adding a leverage ratio surcharge for the largest banks (G-SIBs): the leverage ratio buffer for each G-SIB will be set at 50% of its risk-based capital buffer.

The agreement also includes implementation dates and long phase-in arrangements: most of the changes will be operational from 2022, while the output floor will be applied gradually and come fully into force only in 2027.

The standard method for credit risk

The revision aims at increasing risk sensitivity by introducing more granularity in the rating of loans and by changing how the exposures guaranteed by real estates (residential and commercial) are treated. In particular, the risk weight applied to mortgage will be dependent on the loan-to-value ratio (LTV) and on the loan repayment clauses.

The impact study of the Basel Committee shows that for smaller banks which presumably mainly use the standard approach for credit risk, there would be a reduction in the average risk weight. This effect results from the greater granularity of credit rating classes for non-financial corporations and from the new calculation method for residential mortgages.

In particular, the greatest benefit would be for the risk weight applied to exposures to SMEs classified in the corporate portfolio, since it will be reduced to 85% from the current 100%. This revision could benefit the European banking sector (and the Italian one in particular), since it operates in an economy in which small and medium-sized enterprises are predominant. At present, in Europe the risk weight on loans to SMEs is adjusted to take into account an "SME supporting factor", ie a discount factor that was introduced when the Basel 3 standard was implemented in the EU to offset the increase in capital requirements imposed by the new rules. The revision of the CRR and the CRD4 (the so-called CRD5), currently under discussion, might result into the introduction of a further discount factor (15%) to be applied to the weights of exposures towards SMEs of over €1.5m. Therefore, applying Basel 4 leaves open whether a supporting factor will still have to be applied to a risk weight that will be already lighter for SMEs.

If the changes to the framework discussed so far seem favorable, the same does not apply to the treatment of off-balance sheet items. In fact, the conversion factors (ie the parameters that convert these exposures into "credit equivalents") for commitments that are revocable at any time without notice will have a weight of 10% (it was 0 in Basel 2).

Internal model-based approach to credit risk

The revision of the internal models is deeper than that of the standardized approach. This difference is due to what emerged from the analyses on the comparability of RWAs that have been carried out by the BCBS on banks worldwide and by the EBA on European banks alone. These studies found that IRB models result in excessive variability of risk-weighted assets and, in particular, in a limited reliability of parameters’ estimates (PD and LGD). What emerged is that an important component of the risk-weighted assets’ variability is due to “unintended” effects: not a result of the portfolio’s characteristics but something coming from other sources, such as the monitoring practice for the validation of the internal models. These results made it clear that it was necessary to introduce new constraints on the parameters estimated by the banks that use internal models (input floor) and also on the RWA decrease arising from the introduction of internal models (output floor).

Basel 4 also introduced the ban on the use of advanced models (AIRB) in the estimation of the risk-weighted assets of the so called “low default portfolios” (credits to banks, financial institutions, large corporates and firms with more than 500 million euros revenues). Because of their intrinsic nature – the low number of defaults makes it difficult to estimate the LGD accurately – a wide dispersion of the risk parameters has been observed. This ban is the most penalizing amendment introduced in Basel 4. These portfolios will hence be evaluated according to the standard method or to the basic internal method (Foundation Internal Rating Base, FIRB), that keeps a fixed value of the LGD while the PD is estimated.

The Basel Committee also reviewed minimum PD and LGD levels, increasing them with respect to Basel 2 (eg the current PD floor of 0.03% has been raised to 0.05%).

To partially balance the impact of the new restrictions, however, adjustments to other risk parameters are envisaged. Among them: the reduction of the LGD for exposures to companies (from 45% to 40%) in the FIRB approach and, more importantly, the removal of the scaling factor (equal to 1.06). It had been introduced in Basel II and applied to credit risk weighted assets under IRB approaches, with the aim to limit the reduction in capital requirements obtained with the Internal Ratings Approach. All other things equal, its elimination will lead to a capital benefit of 6 percentage points compared to the current situation.

Basel 4’s European introduction

Basel 4 standard definition process has lasted for 10 years and has already been partially transposed into community law with Regulation n.575/2013 (CRR) and Directive n.36/2013. Therefore, the transposition of Basel 4 will require an amendment to the CRR and thus will undergo a legislative process, probably starting in the second part of 2019. Indeed, EU institutions are currently engaged in the amendment of the CRR/CRR4 to include the technical standards issued in 2014-2016 (including leverage ratio, liquidity requirements, TLAC, the review of market risk calculation) and that are now subject to a legislative proposal of the EU Commission, submitted on 23 November 2016.

In order to understand the impact of Basel 4 on European banks we cannot ignore two aspects:

  • First, the revision of the accord is bound to a political mandate: on G20 indication, changes do not have to cause an increase in capital requirements. The intent  was reaffirmed in the last two annual relations on the Banking Union of the EU Parliament, which also recommended such reforms should not undermine banks’ ability to finance the real economy (SMEs in particular).
  • Second, the actual scope of Basel 4 for European banks will depend on the outcome of the current review of regulation and supervisory practices of internal models, the so-called Targeted Review of Internal Models (TRIM). The EBA and the ECB have already started a process to limit the excessive variability of capital requirements in internal models, which will inevitably anticipate the impact of Basel 4, at least in part.

Together with the publication of the new Basel standards, the EBA announced the results of an impact study on a sample of 88 European banks. Overall, the CET1 ratio (as of December 2015) would decrease by 60 basis points with a €17.5bn capital shortfall, almost entirely relative to larger groups, which make a more extensive use of internal models. The impact of the reform is positive, instead, on the capital of smaller banks (+20 basis points), which are likely to benefit from the increased risk sensitivity of the new standard approach for credit risk.

Some banks communicated the impact of Basel 4 presenting their industrial plans or 2017 results to the market, along with the impact of new EBA guidelines on internal credit models. The erosion of the CET1 ratio is mainly due to the revision of the requirements for the calculation of credit and operational risk, where the major restrictions on the use of internal models are imposed.

The reform of the banking regulation cannot be considered closed with the finalization of Basel 3 rules. Indeed, together with the implementation in the various national jurisdictions, the competent authorities will have to produce technical standards to detail the implementation practices. Furthermore, the integration of the new standard into the existing regulatory framework in Europe will require the revision of some provisions of the CRR as well as taking into account the specific features of the European banking system.

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