After long deliberation and a delay of a year, the Basel Committee has finalised its standards (PDF 1.50 MB)for the output floor and for revised approaches to the capital treatment of credit and operational risk.
The Basel Committee has set an output floor under which 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 overall risk weighted exposures that would have applied using the standardised approach to each risk.
On credit risk, the revised Standardised Approach largely follows the proposals set out in the Basel Committee's December 2015 consultation paper (albeit with lower risk weights than had been proposed on higher quality credit exposures), 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.
The revisions to the use of internal ratings based (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 earlier proposals. 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; impose probability of default, loss given default and exposure at default floors for the remaining corporate and retail IRB approaches; and remove the internal model option from the framework for credit valuation adjustment.
On operational risk, the Basel Committee is introducing a single non-model based standardised approach for the calculation of operational risk capital, as proposed in its March 2016 consultation paper. This will be calculated using 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).
These revised standards will have a major impact on banks' systems and data management, and on the capital ratios of many banks.
KPMG professionals estimate that if the revised standards were implemented in full for the 128 major European banks, the common equity tier 1 (CET1) capital ratios of these banks would fall by around 90 basis points. However, the range is wide: 10 percent of these banks would suffer a CET1 capital ratio reduction of at least 4 percentage points.
More than half of this impact would be driven by the constraints on the use of IRB models to measure credit risk - for most banks the output floor has only a minor impact once these IRB model constraints are imposed.
The largest impacts (CET1 capital ratio reductions of 2.5-3 percentage points on average) would fall primarily on banks in Sweden and Denmark, followed by banks in the Netherlands and Norway (a reduction of around 1.5 percentage points).
These impacts 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.
Further details of the new standards can be found in our client alert.