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Basel Committee finalizes output floor, credit risk and operational risk

Basel Committee finalizes

After long deliberation and a delay of a year, the Basel Committee has finalized its standards for the output floor and for revised approaches to the capital treatment of credit and operational risk.

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Basel Committee finalizes output floor, credit risk and operational risk

After long deliberation and a delay of a year, the Basel Committee has finalized its standards for the output floor and for revised approaches to the capital treatment of credit and operational risk.

These revised standards will have a major impact on banks’ systems and data management, and on the capital ratios of many banks.

In addition, higher levels of risk weighted assets will drive other regulatory requirements based on this measure, including the new requirements on larger banks to hold additional loss absorbing capacity in the form of unsecured debt.

This will be cushioned in part by the lengthy phasing-in period for the revised standards, with the full impact not taking effect until January 2027. 

Summary of revised standards

(i) Output floor

The main news in the Basel Committee announcement is that it has set an output floor of 72.5 percent. A bank using internal models to calculate its risk weighted exposures for credit and/or market risk will not be able to reduce its overall risk weighted exposures (for credit, market and operational risk) below 72.5 percent of the risk weighted exposures that would have applied using the standardised approach to each risk. The output floor applies only at the aggregate level, not risk by risk or exposure by exposure.

The revised standards clarify the treatments of the floor so that it applies at the level of Pillar 1 risk weighted exposures.  Any capital buffers and Pillar 2 requirements will be added on to the floored value.

There is a long transitional period before the output floor applies in full.  The output floor will be applied only from 1 January 2027, when the floor will be set at 50 percent.  The floor will then increase by 5 percentage points each year until 1 January 2026 (by when it will be 70 percent), and from 1 January onwards the floor will be 72.5 percent.

(ii) Credit risk

The revised standards for credit risk cover both the Standardised and the Internal Ratings Based (IRB) Approaches.

The revised Standardised Approach largely follows the proposals set out in the Basel Committee’s December 2015 consultation paper, including the continued use of external ratings (where available and permitted by national supervisors) for exposures to banks and corporates, and the use of loan to value ratios to determine risk weights for retail and commercial real estate exposures.

In general, however, the final standards apply lower risk weights to higher quality credit exposures than had been proposed in the consultation paper, and they allow a loan-splitting approach to residential and commercial real estate, at the discretion of the national supervisor. 

The revisions to the use of IRB approaches to credit risk follow some of the constraints proposed in the Basel Committee’s March 2016 consultation paper, although again the final version is more lenient than the proposals in the consultation paper. The final standards:

  • Remove the IRB option for exposures to equities;
  • Remove the advanced IRB option for exposures to banks and other financial institutions, and to large and medium-sized corporates (with revenues above €500 million);
  • Impose probability of default, loss given default and exposure at default floors for the remaining corporate (foundation) and retail (advanced) IRB approaches; and
  • Remove the internal model option from the framework for credit valuation adjustment.

All of these revisions to credit risk will apply from 1 January 2022. 

The treatment of exposures to sovereigns, central banks and public sector entities is not covered by the revised standards. The Basel Committee has however issued a discussion paper on the capital treatment of sovereign exposures as part of its broader review of sovereign-related risks.

(iii) Credit valuation adjustment (CVA)

The revised standards for CVA risk introduce a new basic approach (BA-CVA), which is similar to the current standardised method, and a new standardised approach (SA-CVA), which is an adaptation of the new standardised approach for market risk. While there will be no internal model option such as the current advanced method, the Basel Committee foresees that use of the new SA-CVA will be subject to supervisory approval. The main enhancements of the new approaches are the incorporation of exposure risks in addition to credit spread risks, and broadened criteria on the eligibility of hedges.

(iv) Operational risk

The Basel Committee is introducing a single non-model based method (the standardised approach) for the calculation of operational risk capital,  as proposed in its March 2016 consultation paper.  It has also simplified this standardised approach from the version proposed in its consultation paper.

The standardised approach will be calculated from two components – a business indicator measure of a bank’s income, and a measure of a bank’s historical operational losses (although national supervisors have the discretion not to apply the second component). 

The standardised approach to operational risk will apply from 1 January 2022. 

(v) Leverage ratio

The Basel Committee has finalised the exposure measure for the leverage ratio, and will apply a leverage ratio buffer to global systemically important banks (G-SIBs). This G-SIB leverage ratio buffer will be set at half of a G-SIB’s capital ratio buffer – so a G-SIB with a 2 percentage points capital buffer will have a 1 percentage point leverage ratio buffer, taking its minimum leverage ratio to 4 percent.

(vi) Market risk framework

The Basel Committee has set a revised implementation date for the market risk framework (which was finalised in January 2016), of 1 January 2022.

Annex: Basel Committee revised standards on the output floor, credit risk and operational risk

For more detail on the  Basel Committee revised standards on the output floor, credit risk and operational risk, please read the attached PDF or click here

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