Basel Committee may look to floors and fixed parameters

Good apples and a rotten apple
BCBS finds notable outliers in RWA study

The Basel Committee on Banking Supervision may become more rigid in the setting of risk parameters and capital floors, after a report showed a lack of appropriate data and differing modelling practices within banks are key factors behind variations in risk-weighted assets (RWAs) for credit risk in the banking book.

The problem is particularly acute for low-default sovereign portfolios, where the Basel Committee found a lack of reliable, long-term data is resulting in banks assigning very different probability of default and loss given default (LGD) figures to the same exposures.

Among the potential policy responses identified by the committee are the setting of supervisory benchmarks – including representative LGD estimates for various types of risk exposure and probability of default benchmarks for particular rating grades – and the creation of floors for certain parameters such as LGD.

Some national regulators have already taken this step. Risk reported last October that the Financial Services Authority had required UK banks using the advanced internal ratings-based (IRB) approach to apply an LGD floor of 45% on sovereign bond exposures. Meanwhile, the Swedish regulator recently opted to set a 15% floor on RWA calculations for residential mortgages – and analysts think this will be more common in the future.

"It feels like the tide is turning – I'm convinced we'll see more of this over the next year," says Nick Anderson, senior bank analyst at Berenberg Bank in London.

It feels like the tide is turning

The risk for the Basel Committee is that individual regulators will go their own way, with a variety of floors and other national discretion items leading to even more disparity in bank RWA numbers. This is already having an effect on RWA numbers – the report found supervisors applying national discretion and deviating from the Basel standards in their national implementation accounted for a reasonable chunk of the differences. For instance, the use of country-specific capital floors and the partial use of the standardised approach accounted for 3% and 5% of overall RWA variability, respectively.

The report was based on a top-down analysis using supervisory data submitted by more than 100 major banks across the globe, plus a bottom-up portfolio benchmarking exercise that involved 32 large international banking groups calculating risk weights for a common group of corporate, banking and sovereign exposures to identify differences in bank IRB practices.

Overall, the hypothetical benchmarking analysis found that risk-weight variation between banks could cause capital ratios to vary by more than 2 percentage points – or 20% – in either direction from a 10% risk-based capital ratio benchmark. The majority of banks surveyed, however, were within 1 percentage point of the benchmark.

The Basel Committee found a number of potential reasons for the differences in the benchmarking exercise, but noted that differences in LGD figures were a significant source of variations, particularly for sovereign and bank portfolios. In particular, it found that many banks are using only a few distinct LGD values across their portfolio – an approach the Basel Committee dubs the modified foundation internal ratings-based approach – with individual banks applying quite different fixed LGD values. Others attempted to compensate for a lack of reliable data by adjusting LGD values according to human judgement – this element of judgement led to greater variation in both directions, the committee found.

Analysts say the exercise gives regulators ammunition to argue certain banks need to revise their assumptions. "The regulators have finally got a weapon – they can turn to the hypothetical study. If it shows that for the same 300-odd corporate names a bank has lower risk weights on 90% of them, then they'll act. Banks can no longer hide behind saying they've got better quality portfolios justifying lower risk weights," says one regulatory capital expert.

Overall, the Basel Committee reported that more than three quarters of the differences observed in banking book RWAs across the full sample of banks can be attributed to underlying differences in the risk composition of their portfolios. However, it suggested a number of changes to improve bank disclosure, including more granular information on internal risk grade distribution. It also suggested it might be more specific in its requirements to eliminate areas that are open to interpretation by banks or national regulators, and reduce the number of national discretion items.

But a reduction in flexibility for advanced approaches, including floors and fixed risk parameters, was also mooted as a way of bringing bank practices into line. A second report, published yesterday, also raised the prospect of new floors on internal model outputs, based on standardised methods.

This is the second report on RWA comparability – the first, published in February, concentrated on trading book RWAs, and found variations of up to 2,500% from the median for some portfolios. The changes have encouraged some regulators to push for a simpler, less risk-sensitive approach to Basel III.

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