Back in September 2013 KPMG predicted that ‘Basel 4’ was emerging from the mist. Our predictions about leverage, challenges to internal models, and ever more severe stress tests have largely come true. Now we have further significant proposed changes to capital standards.
The initial focus of Basel 3 was primarily on the numerator of the capital adequacy ratio – the quality (increasing emphasis on CET1 capital and harmonisation of deductions from capital) and quantity (multiple buffers) of a bank’s capital. Changes to the denominator were confined to specific areas such as the risk weights on securitisations and on counterparty credit risk in bilateral trades.
Over the last few years the Basel Committee has been working more comprehensively on the denominator of the capital ratio – a bank’s risk-weighted credit, market and operational risk exposures. The intention is clear: to introduce a revised set of standardised approaches, and to use these to constrain the extent to which banks can reduce their capital requirements through the use of internal models.
A key element of this work is a consultation document issued by the Basel Committee on revisions to the standardised approach to credit risk. The consultation period runs until 27 March 2015.
The main objectives are to make the standardised approach to credit risk more risk sensitive, more closely aligned (in terms of definitions and scope) to the internal ratings-based approach, and less reliant on external credit ratings.
The main proposals are to introduce a ‘risk drivers’ approach to some types of credit risk, with these risk drivers determining the standardised risk weights.
These proposals on credit risk relate closely to four other Basel Committee initiatives:
These proposals are relevant to all banks.
Banks will no doubt have views on the appropriateness of the proposed risk drivers. For example, arrears rates may be a better indicator of risk for residential mortgage lending, while liquidity ratios may be important for exposures to banks. Equally, however, it may be difficult to accommodate differences across countries here while also preserving consistency and simplicity.
Banks using the standardised approach for credit risk will need to change their systems – or indeed to build new systems - to ensure that they are collecting the necessary data on their borrowers and other counterparties, and can calculate the new risk weights using the proposed risk drivers.
Banks using internal model-based approaches will also have to calculate – and publish – what their capital requirements would be under the revised standardised approaches. This is likely to place significant demands on their systems and data management capabilities.
Supervisors will presumably want to check that banks are collecting and applying the right data, which may be an issue in terms of the valuation of residential and commercial real estate, and the calculation of corporate leverage ratios. Deficiencies here could lead to the imposition of ‘Pillar 2’ capital requirements. There is a straight link to BCBS 239 here.
Banks using the standardised approach for credit risk may face higher or lower capital requirements as a result of the proposals depending on the risk profile of the exposures, and the proposed revised credit risk mitigation in place. This may sound obvious, but it is likely to drive lending behaviour, which will have real macroeconomic consequences.
Overall, however, the proposed new risk weights look higher on average than under the current standardised approach – in particular the proposed range of risk weights for corporates of 60 - 300% is considerably higher than the current range of 20 – 150%; while for exposures to other banks the range begins at 30% rather than the current 20%. The Basel Committee’s quantitative impact study should clarify the extent to which the new risk weights lead to higher capital requirements – but banks should be undertaking their own analysis to assess the potential impact of these proposals.
Banks using internal model-based approaches may be constrained by the proposal for a capital floor based on the new standardised approaches, especially where – as seems likely with credit risk – the new standardised risk weights impose a higher starting point. However, the impact of this cannot be determined because the Basel Committee has not yet offered any proposed calibration of the floor.
The move to risk drivers and wider ranges of risk weightings will accentuate the capital requirement ‘cost’ of exposures to borrowers judged under the proposals to be at the riskier end of the spectrum. Depending on the extent to which this matches banks’ current internal risk assessments, this could increase the cost – and reduce the availability – of bank finance for certain types of borrower.
In particular, the use of the proposed risk drivers will increase the capital cost of lending more than €1 million to SMEs (taking them out of the other retail asset class), lending to high LTV residential and commercial real estate, and lending to banks with low capital ratios and poor asset quality.