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Basel Committee finalises output floor, credit risk and operational risk

Basel Committee finalises standards

After long deliberation and delay, the Basel Committee has finalised its standards for the output floor, credit risk and operatonal risk.

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The revised standards

After long deliberation and a delay of a year, the Basel Committee has finalised its standards (PDF 1.50 MB) or 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.

What are the implications for banks?

  1. Capital requirements
  2. Business model
  3. Systems and data
  4. Incentives for good risk management
  5. National implementation

Capital requirements

KPMG professionals estimate that if the revised standards were implemented in full for the 128 European banks in the KPMG Peer Bank tool:

  • On average, the common equity tier 1 (CET1) capital ratios of these major European banks would fall by around 90 basis points. However, the range is wide: 10 percent of 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 internal ratings based (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 additional impact of the output floor reduces the CET1 capital ratio of 12 banks by at least 50 basis points.
  • 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), reflecting mainly the balance of their asset portfolios and the extent to which they have used IRB models to drive down capital requirements.
  • In terms of peer groups, banks with more focussed business models are most affected by the revised standards, with average reductions in CET1 capital ratios of 2.8 percentage points for asset managers and custodians, and 1.6 percentage points for sector-specific (mostly real estate) lenders. The average reduction for universal banks and for European G-SIBs is around 0.7 percentage points.

Banks using internal model approaches for credit risk will need to (a) apply the constraints on the use of the IRB approach for credit risk; (b) calculate the output floor as 72.5 percent of the total of the revised standardised approach (SA) calculations for all credit and market risk exposures and the new standardised approach for operational risk; and (c) apply the output floor if the use of internal model approaches for credit and market risk would otherwise drive overall risk weighted exposures below the output floor.

The largest impacts on these banks will be where:

  • The IRB constraints force banks to apply higher risk weights to high quality exposures where no IRB approach can be used (equities); where the advanced IRB approach can no longer be used (exposures to banks and to large corporates); or where tougher parameter constraints apply under IRB approaches (in particular on mortgage lending and credit card lending);
  • The standardised approach for operational risk generates a much higher capital charge for banks that previously used a more advanced approach, or that have high recent misconduct costs;
  • The output floor constrains the extent to which banks can drive down their capital requirements through the use of internal models for credit and market risk; and
  • Measured counterparty credit risk increases for banks that have to switch from using an internal model method for credit risk mitigation to the more penal standardised approach to counterparty credit risk for the purpose of applying the output floor.

Banks using the Standardised Approach (SA) for credit risk will need to move to the revised SA for credit risk. This will drive higher capital requirements for some types of lending, including buy-to-let and similar exposures to property where repayment relies on income from the property. However, for some banks the lower risk weights on high quality credit exposures under the revised SA may result in reduced capital requirements.

The impact on banks will be cushioned by the long transitional period, in particular for the output floor, although - as with earlier elements of Basel 3 - they may face pressure from supervisors, rating agencies and market analysts to meet the `fully loaded' revised standards ahead of schedule.

Banks may also gain some offset to higher Pillar 1 capital requirements through national supervisors agreeing to reduce Pillar 2 requirements or other capital buffers - on the basis that these add-ons in part reflected the risks posed by the use of internal models. In addition, banks that can demonstrate good internal modelling and strong systems and controls for operational risk could potentially gain a partial Pillar 2 offset to higher Pillar 1 requirements.

Equally, however, the impact of the revised standards will add to the reductions (on average of around 0.5 percentage points) in CET1 capital ratios driven by the introduction of IFRS 9, and many European banks could be vulnerable to prospective changes in the capital treatment of sovereign exposures.

Business model

All banks will face shifts in the relative attractiveness of different types of exposures as a result of changes in risk weightings and the impact of the output floor. Some specific areas of business may become significantly less attractive, with an impact on the cost and availability of these specific products and services. This will have an adverse impact on some borrowers and other bank counterparties, and in turn on the wider economy.

Some banks will face higher capital requirements that cannot be met without either issuing or retaining additional capital or reducing risk weighted assets - just as European banks in aggregate followed both these paths in order to meet the tougher capital requirements imposed under Basel 3 and corresponding EU legislation from 2010 onwards. The higher cost of funding for these banks will be accentuated by the introduction of higher minimum requirements for loss absorbing capacity over much the same time period. This will be reflected in a higher price and reduced availability of bank products and services, again with implications for the wider economy.

Systems and data

All banks will need to change their systems - or to build new systems - to ensure that they are able to collect, analyse and report the necessary data on borrowers and other counterparties in order to calculate the new risk weights under the revised approaches to credit and operational risk and to apply the output floor. Where relevant, this includes the use of due diligence to check on the accuracy of external credit ratings; an assessment of whether borrowers are materially dependent on the cash flows generated by a property securing an exposure; and the calculation of internal loss experience.

For operational risks, banks not currently using the advanced measurement approach (AMA) will have to put the necessary systems and processes in place to collect, analyse and report the data required to calculate business indicators and internal loss experience; while even banks currently adopting AMA may have to revise their systems and processes to deliver the required calculations.

Banks will also need to ensure that they are reporting the correct data and calculations to their supervisors and in their Pillar 3 disclosures. The difficulties faced by many banks in meeting all of the Basel Committee Principles on Risk Data Aggregation and Reporting suggests that the systems and data requirements of the revised standards will require considerable investment and senior management attention.

Incentives for good risk management

The combination of parameter constraints on the remaining permitted IRB approaches and the output floor reduces the incentives for banks to use IRB approaches for credit and market risk. This could have an adverse unintended consequence on the quality of risk management in some banks.

Similarly, banks may become less inclined to model operational risks. Although the introduction of an internal loss component in the standardised approach to operational risk will provide some regulatory incentive for firms to reduce their operational risk losses, this element of risk-sensitivity is limited to past losses, and does not include other key elements of the currently available advanced measurement approach (AMA), including the use of external data, forward-looking scenario analysis information, and business environment and internal control factors data.

National implementation

It remains unclear whether - as with earlier elements of Basel 3 such as the revised framework for market risk and the Net Stable Funding Ratio - there will be some diversity in the timing and the substance of the national implementation of the revised standards, and in the use of some newly introduced scope for supervisors to apply national discretion. Such fragmentation of requirements could pose some difficulties for international banking groups.

Summary of revised standards

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.

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.

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.

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.

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.

The revised exposure definition and the G-SIB leverage ratio buffers will both apply from 1 January 2022.

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 (PDF 853 KB).

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