Standardised approach for credit risk: almost back to where we started

Standardised approach for credit risk

Latest credit risk proposals differ significantly from the initial set of proposals published by the Basel Committee in December 2014.

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The Basel Committee on Banking Supervision has issued a second consultative document (for comments by 11 March 2016) on Revisions to the Standardised Approach for credit risk.

This paper is important. It takes us back towards the Basel 2 use of external credit ratings. And the impact on the level and price of lending to the real economy remains uncertain.

The latest proposals differ significantly from the initial set of proposals published by the Basel Committee in December 2014 (Towards Basel 4: a risk driver approach to credit risk).

The 2014 proposals had removed all references to external credit ratings and assigned risk weights based on a limited number of alternative risk drivers (including revenue and leverage for risk weighting exposures to corporates).

Major concerns that the complete removal of references to ratings was unnecessary and undesirable have been raised. The Basel Committee is now proposing to reintroduce the use of ratings for exposures to banks and corporates, albeit less mechanistically than currently, and with alternative approaches for unrated exposures and for jurisdictions that do not allow the use of external ratings for regulatory purposes.

The proposed risk weighting of retail and commercial real estate loans has also been modified, with the loan-to-value ratio as the main risk driver. The use of a debt service coverage ratio as a risk driver for residential real estate exposures (as proposed in December 2014) has been dropped. Instead, the Basel Committee now proposes requiring the assessment of a borrower's ability to pay as a key underwriting criterion, with higher risk weights on real estate exposures where repayment is materially dependent on the cash flows generated by the property securing the exposure.

The Committee will conduct a comprehensive quantitative impact study in 2016. All calibrations in the consultative document are preliminary, and will be subject to review based on evidence from the impact study.

As in December 2014, the credit risk standardised approach treatment for sovereigns, central banks and public sector entities is not within the scope of these proposals. The Committee is considering these exposures as part of a broader review of sovereign-related risks.

Related proposals

These proposals on credit risk relate closely to other Basel Committee initiatives, some of which we expect to be finalised soon, including revised standardised approaches to market risk and operational risk, and a capital floor based on the revised standardised approaches, to replace the ‘Basel 1’ capital floor.

Implications for banks

Systems and data – all banks 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 approaches. Where relevant, this includes the use of due diligence to check on the accuracy of external credit ratings; and an assessment of whether borrowers are materially dependent on the cash flows generated by a property securing an exposure.

Supervisors will presumably want to check that banks are collecting and applying the right data, for example in calculating loan to value ratios for retail and commercial real estate. Deficiencies here could lead to the imposition of ‘Pillar 2’ capital requirements. There is a straight link here to the Basel Committee Principles on Risk Data Aggregation and Reporting.

Capital requirements – 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 their exposures. For example, buy-to-let and similar exposures to property where repayment relies on income from the property will carry higher capital requirements than currently. This in turn is likely to drive lending behaviour, which will have real macroeconomic consequences. While the revised proposals appear likely to generate lower risk weights than the initial December 2014 proposals; and this is welcomed, there is only upward pressure compared to the current position.

Investment banks – the latest proposals carry forward the December 2014 proposal that a bank cannot use an internal model method for credit risk mitigation (mostly for counterparty credit risk) while remaining on the standardised approach for credit risk. This would force such banks either to gain approval to use an internal ratings-based approach to their bank, corporate and sovereign exposures, or to switch to the more penal standardised approach to counterparty credit risk.

Further insights

For a more detailed analysis please download the “In the details” PDF for additional information on what the consultation paper means with regard to exposures for banks, corporates, and real estate.

Regulatory Challenges

KPMG’s Financial Services Regulatory Centers of Excellence can provide insights into the implications of the raft of regulatory change.

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