Last week, the Basel Committee on Banking Supervision (Basel) proposed floors and other constraints on the use of internal models for calculating credit risk capital. The proposal aims to reduce complexity and variation in the calculation of regulatory capital among banking institutions, thus improving comparability. To that end, the proposal generally discourages (and in some instances prohibits) the use of internal ratings-based (IRB) approaches in calculating risk weighted assets (RWA) related to credit risk. The proposal’s objective is consistent with Basel’s other recent issuances, i.e., the re-proposed standardized approach for credit risk (issued last December),1 revised final capital requirements for market risk (issued in January),2 and the proposed standardized measurement approach for operational risk (issued in March).3
- US implementation of the Basel proposal is unlikely. US banking institutions are already subject to risk-based capital floors under the Dodd-Frank Act’s Collins Amendment4 that are more stringent than the proposal’s restrictions on the use of internal models. Although the US could, in theory, impose similar restrictions on the use of internal models to align with this proposal, such harmonization would have no bearing on required capital for US banking organizations that are already constrained by the standardized approach.
- Basel’s risk-based capital floors advantage non-US banks. In December 2014, Basel proposed two alternative forms of capital floors: one floor on aggregate risk-based capital (i.e., held against credit risk, market risk, operational risk, and counterparty credit risk), or separate floors applicable to each of the four risk categories. The current proposal, for the first time, identifies a possible range for the first option (60% to 90% of RWA), while stating that Basel continues to consider both options. If this range is adopted, even at its higher end it falls short of the 100% of RWA capital floor that US banking institutions are currently subject to. Therefore, once finalized, Basel capital floors will narrow the gap between US and non-US banking entities, but not entirely close it.
- The Basel proposal prohibits the use of IRB approaches for certain loan portfolios. Under the proposal, banks would no longer be able to measure exposure to other financial institutions and large corporations (i.e., those with over EUR 50 billion in total assets) using IRB approaches. This phase-out of IRB approaches is likely to have a significant impact on non-US global systemically important banks (G-SIBs) that are the main lenders to large corporations, but will have little impact on US firms that are subject to the Collins Amendment.
- The proposal further limits banks’ use of IRB approaches by introducing floors for model inputs. Even where banks are still allowed to use IRB approaches (e.g., with respect to exposures to smaller corporations), the proposal limits their flexibility by introducing floors for underlying parameters, including probability of default (PD) and loss-given-default (LGD).5 These floors are likely to lead to an increase in credit risk capital for institutions with a more conservative risk appetite, as these institutions generally lend to more creditworthy clients and structure loans to minimize potential losses. These institutions may yet receive more bad news as the proposal suggests that some floors may be revised upward as a result of Basel’s upcoming quantitative impact study.
- Refinements to “Downturn LGD” will further increase regulatory capital under IRB approaches. Currently banks are required to calculate a single LGD amount (which is the main driver of credit risk RWA calculations), based on average historic losses that take into consideration the effects of a market downturn. The proposal adds more specificity by requiring that Downturn LGD be calculated separately as an add-on component to LGD (rather than being taken into consideration as part of the LGD calculation) based on the most severe losses during the historical look-back period. The proposal further contemplates the addition of a floor for this add-on component which we believe is likely and would further increase regulatory capital.
4 The Collins Amendment requires that “generally applicable” risk-based capital requirements serve as a floor for banking institutions’ regulatory capital. In their implementation of the Basel III capital rules, US regulators specified that capital requirements calculated under the standardized approach (SA) would serve as the Amendment’s mandated floor. This constraint only affects advanced approaches banking institutions (i.e., generally those with over $250bn in assets), as these are the only firms that calculate their capital requirements under a methodology other than SA (i.e., using internal models). For purposes of their minimum regulatory capital ratios, these institutions must calculate RWA (i.e., the ratio’s denominator) as the sum of credit risk RWA (using the standardized approach) plus market risk RWA (applying internal models to the banking book). Operational risk is not directly built into these RWA calculations, but is instead considered to be a component of the capital ratio’s numerator (i.e., 4.5% Common Equity Tier 1, 6% Tier 1 Capital, and 8% total regulatory capital).
5 PD and LGD are two of the three main components of exposure calculations (the other being exposure-at-default).
The preceding post is based on a memorandum prepared by PwC on April 1, 2016 and available here.