A revised look at credit risk mitigation for 2015 from the Basel Committee

We welcome the new year with one of the thorniest issues in financial regulation: how banks calculate their internal risk. Before the end of 2014, the Basel Committee for Banking Supervision (BCBS) slipped in a Consultative Document, “Revisions to the Standardised Approach for credit risk“. The Committee has made some important proposed changes and also takes aim at direct comparability with the internal ratings based approach.

The BCBS has considered the question of whether ratings agencies should have a role in risk models. The Committee says no, its time for ratings agencies to move on. According to the document, “Bank exposures would no longer be risk-weighted by reference to the external credit rating of the bank or of its sovereign of incorporation, but they would instead be based on a look-up table where risk weights range from 30% to 300% on the basis of two risk drivers: a capital adequacy ratio and an asset quality ratio.” That’s pretty straight-forward and meets the Committee’s objectives of getting risk measurements to be as transparent as possible. It would also ease the burden for transacting with counterparties that lack a rating, sometimes because they have no debt to even rate.

Taking out ratings as a component of risk models makes sense but we aren’t yet convinced that the new BCBS approach eliminates gaming. The Committee proposes that the new risk exposure measurement be (self-reported) Common Equity Tier 1 Capital divided by risk-weighted assets. The idea is to get a figure of capital adequacy. The problem is that there’s a lot of potential for playing with the numbers in this calculation.

If the Committee really wants transparency, they have some work to do to ensure that RWA figures are clean and consistent across organizations. In this consultation paper, the Committee proposes a number of changes to the credit risk mitigation framework. An important change to current practices would be disallowing financial institutions to use their own risk calculations, including:

  • Own estimates of haircuts. The Committee has proposed a revised mandatory haircut schedule including look-throughs for UCITS and mutual fund holdings.
  • Value-at-risk models approach for certain secured financial transactions (SFTs). We aren’t big VaR fans – its probably best that other approaches be given consideration or preference.
  • Internal Model Method for SFTs and collateralised OTC derivatives transactions. The Committee is considering eliminating an exception to the simple and comprehensive approaches that has given a 0% risk weight and 0% haircut to repo and OTC derivative transactions with core market participants.

“As a consequence, when calculating capital requirements using the comprehensive approach, only supervisory haircuts will be available. For calculating exposure amounts for SFTs and OTC derivatives, the standardised approach for counterparty credit risk (SA-CCR) must be used.” This would really serve to lock down several aspects of RWA and reduce differentiation. We note that the Fed recently published a study, “Banks’ Incentives and the Quality of Internal Risk Models“, looking at how banks use RWA calculations to influence their loan portfolio valuations.

The next step in this consultative document is a Quantitative Impact Study on the potential effects of these changes.

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