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Capital floors have been used by regulators for a long time to ensure that risk-based capital requirements do not fall too far. For instance, the final draft of the Basel II accords in 2006 contained a floor that prevented the capital requirements from falling below 80% of the previous Basel I requirement.
However, the concept became much more high-profile with the advent of Basel III. The Basel Committee advocated using the standardised approaches to calculating risk-weighted assets (RWAs) as a floor for the outputs from internal modelled approaches. The initial suggestion was that internal model RWAs should not fall below 60% to 90% of standardised outputs. The aim was to reduce the variation of internal model outputs between banks and to mitigate model risk and measurement error.
After more than 18 months of negotiations, the Basel Committee agreed in December 2017 to set a floor of 72.5%. This was a compromise between US regulators who had argued for a higher level, and European regulators who wanted a lower level. The US already imposes its own floor, based on the Collins Amendment to the Dodd-Frank Act, which limits overall RWAs to 100% of the standardised outputs, but excludes operational risk and credit valuation adjustments from the calculation.
By contrast, European banks make more use of internal models, and critics of the floor say it makes Basel III less risk sensitive compared with Basel II, potentially encouraging banks to load up on riskier assets in order to boost their return on equity.
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