Time for the standardised approaches to shine

It’s a question that has exercised banks for almost two decades: should they use internal risk models or regulator-set standardised approaches to size their credit risk capital requirements?

Models offer a more risk-sensitive means of weighing capital, and a more granular understanding of the credit exposures within lenders’ loan books – making for a more efficient allocation of capital. So say proponents of internal approaches.

Critics counter that letting banks run wild with their own models invites disaster, as firms will be incentivised to lowball their exposures to minimise capital charges. Investigations by European watchdogs suggest there’s some truth to this. Standardised approaches, the argument runs, guard against this abuse.

In practice, the debate is not so black and white. Most of Europe’s biggest banks use the internal ratings-based (IRB) approach for some of their credit portfolios, and the standardised approach for the rest. A mix-and-match method, as it were.

The 11 largest European banks had 70% of their credit assets capitalised using the IRB approach as of end-2019. Some even expanded the scope of their credit models over the first quarter of this year, such as Italian giant UniCredit.

Still, that leaves 30% under the standardised approaches: a substantial share of overall exposures. Several factors could be behind this.

One, a bank needs regulatory permission to apply the IRB approach to specific portfolios. While they wait for this, they need to capitalise these exposures using the standardised approach. Two, a bank may run the numbers and find that the expense of building a model outweighs the capital benefits it could generate.

But sometimes, it appears that banks favour the standardised approach on its own merits. Take Credit Suisse. At end-2018, the bank had 91% of its portfolio under the IRB approach – the most of the large European lenders. Fast-forward to March 2020, and this proportion had dropped to 81%. Why?

In some cases, it looks like the regulator-set, cookie-cutter approach can produce similar – if not greater – [capital] savings

It turns out that in the first half of last year, the Swiss bank moved a pile of its sovereign exposures out of the IRB approach. At end-2018, 86% of its sovereign portfolio was under the IRB approach. Six months later, this had fallen to just 22%.

Credit Suisse said the switch followed regulatory guidance, but didn’t go into specifics. UBS, its Swiss rival, did not undergo a similar shift.

A clue to Credit Suisse’s motivation can be found in the dramatic 37% drop in the portfolio’s minimum capital requirement – when sovereign exposures themselves fell just 2% over the same period. The bank’s Pillar 3 report shows the vast majority of its sovereign exposures under the standardised approaches merited a 0% risk weight, meaning they attracted no capital charges.

Often, banks want to shift exposures the other way – on to the IRB approach – in order to lower required capital. But in some cases, it looks like the regulator-set, cookie-cutter approach can produce similar – if not greater – savings.

More banks may expand the scope of the standardised approach over their portfolios like Credit Suisse in the coming years. Some may choose to do so because models are under increased regulatory scrutiny, and those that don’t pass muster imperil their host banks with capital add-ons.

Others, however, may do so for reasons of capital optimisation. Incoming Basel III rules floor required capital as calculated using internal models at 72.5% of the amount generated by the revised standardised approaches. This means those banks with much of their loan portfolio under the IRB approaches could see their required capital rise precipitously, as it’s likely their modelled capital today is far lower than this floor amount. It therefore would make sense for these firms to shift some exposures on to the standardised approach now to avoid this fate – or at least parcel the pain out over a lengthy timeframe.

The ideal outcome for banks, of course, would be for each exposure to be assigned to the approach that produces the lowest capital requirement. But faced with the standardised floor, it may be that banks are more selective with their IRB models, choosing to deploy these only for exposures that would be tagged with especially onerous charges under the standardised approach.

It’s a balancing act that will play out a hundred different ways at a hundred different banks over the years leading into, and immediately following, the implementation of Basel III in 2023.