Current developments in the Basel Capital Framework

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On Monday 21 November, ACFS in conjunction with Deloitte Melbourne hosted a Twilight Seminar at the Deloitte Melbourne office, featuring Brad Carr, Deputy Director in Regulatory Affairs at the Institute of International Finance (IIF) in Washington DC. Mr. Carr presented on the topic ‘Current Developments in the Basel Capital Framework’, drawing on insights from research conducted by the IIF.

Based on the size of their risk-weighted assets (RWAs), banks are required to maintain a minimum amount of capital. In 1988, the Basel Committee on Banking Supervision (BCBS), through the enforcement of Basel I, set a standardized approach in place for determining the size of these RWAs, by attributing fixed risk weights to certain asset classes. Since a lack of risk-sensitivity due to a failure to discriminate between risk characteristics within an asset class was the limitation of this approach, 2004 saw the publication of Basel II, where banks were instructed to determine risk weights via the use of internal models consisting of requirements set by supervisory authorities. This publication also included a ‘transitional floor’, ensuring banks maintained a minimum capital requirement.

More recently in late 2015, the BCBS proposed a new capital floor based on a revised standardized approach for credit risk. The Group of Governors and Heads of Supervision (GHOS) earlier this year declared that working through this latest ‘Basel package’, they would be committed to not having a significant increase in capital. Resultantly, this has prompted a closer inspection by the BCBS into the components of this package in terms of credit and operation risk.

More specifically, Mr. Carr’s own research concurs with the BCBS that a quarter of the RWA variance across international banks goes beyond the differences in underlying risk profiles (as evidenced by the significant variety in the Average LGDs for these banks).

“The evidence doesn’t bear this notion that Internal [ratings-based] models have been used to drive down capital requirements, but I do nevertheless accept the argument that the level of variance from one bank to the next has been too great, and that in terms of asserting or restoring credibility of RWAs as a measure, we do as an industry need to improve those models”.

Mr. Carr informed the seminar’s attendees that the BCBS’ resultant revised Standardized approach would include the changes of BBB corporates receiving a risk-weight of 75% instead of 100%, grade-A banks receiving 30% instead of 50% and several other adjustments. Despite this, he seemed adamant of an emerging consensus amongst banks and corporates favouring the Foundation IRB approach, rather than the Standardized approach for credit risk, as well as an agreement that more granular slotting criteria are required to assess the credit risk of types of specialised lending, and the recognition of the importance of including Input Floors on PGs and LGDs.

Despite this favouring of the Foundation IRB Approach for banks and corporates, it was emphasised that if these assets were to move to the revised Standardized approach (or be subject to a binding floor based on that Standardized Approach), any unrated exposure would inevitably converge back towards the same risk-weightings of 100% that were present in Basel I. As well as a causing a greater reliance on external credit ratings, Mr. Carr highlighted the fact that such an approach, he believed, strengthened the case for this ‘Basel package’ to be referred to as ‘Basel IV’, in the highly contentious debate regarding whether or not it should be recognised by this name, or more simply as a revised version of Basel III. He noted a comment made by Andrea Enria, Chair of the European Banking Authority (EBA), who likened the decision to how this most recent package should be named as a “two-part Litmus test”, based specifically on the questions of whether or not the BCBS’ revisions had led to a major loss in risk sensitivity or a significant increase in capital. Mr. Carr argued that making this Standardized approach prominent would indeed result in a major loss in risk sensitivity, and therefore would overhaul its framework significantly enough to justify it being referred to as ‘Basel IV’. “We are essentially unlearning the lessons [of developments in Basel II and III]… and going back to [a framework] where a strong corporate and weak corporate are considered the same”.

Although he was unable to disclose an exact figure due to confidentiality amongst the 53 banks that contributed data, Mr. Carr could reveal that his organisation’s analysis suggested that the estimated increases in capital due to the revised market and operational risk frameworks appeared to be way beyond the 10% typically classified as ‘significant’. Furthermore, whilst the frameworks of market risk and operational risk have already undergone their own revision, it is clear that whether or not the latest package results in a significant increase in capital will be largely shaped by the changes made to the credit risk framework, due to the fact that the world’s Global Systemically Important Banks (GSIBs) have a much larger portion of credit risk, than of operational or market risk.

With regards to these credit risk changes, Mr. Carr outlined three significant components involved. These are revisions in the Standardized approach, asset classes being moved from IRB to a Standardized approach and revisions in the IRB. After the combined effects of these components, the addition of a 60% capital floor, as proposed by the BCBS’ Consultation paper in March 2016, results in a very minute additional increment to Credit RWA. Since March however, the combined effect of these components has been advertently moderated and the addition of the same floor results in a larger increment, so that the same endpoint can be reached.

Mr. Carr explained that this was a significant reason for why he believed that the capital floor was the most critical part of future discussions amongst BCBS members, and as a result, he felt that the committee’s upcoming November 28-29 meeting would result in sufficient recommendations on all aspects of the capital framework except for the Capital Floor, which he believed would “remain contentious through to January 9 [2017]”. He noted that a greater emphasis on the Standardized approach, which would increase the reliance on credit ratings agencies, could well prove to be biased against emerging markets and Australia, where relatively few corporates possess external ratings, contrasting significantly with “the US and Europe, where it is quite common for not only corporates, but indeed even SMEs, to have external ratings”.