Credit risk capital models hanging by a thread in the US

Industry insiders expect Fed to drop IRB and IMM when adopting Basel III, but market risk models may survive

Risk modellers at the largest US banks may soon have more time on their hands. US prudential regulators are said to be preparing to jettison advanced approaches for modelling credit and counterparty credit risk when they adopt the final elements of the Basel III bank capital framework.

Six sources with knowledge of US Federal Reserve discussions say they expect the internal ratings-based (IRB) approach for credit risk, and internal models method (IMM) for counterparty credit risk will be axed.

“What we’ve been hearing from the regulators or from others who are involved in the process, is that US regulators are planning on removing the advanced approaches and models,” says a head of capital management at a large US bank.

Three of the six sources believe the internal models approach (IMA) for market risk will survive when the regulatory agencies adopt Basel’s Fundamental Review of the Trading Book. The remaining three say they have not heard indications on this aspect either way.

Francisco Covas, head of research at bank lobby group the Bank Policy Institute, says it is probable that US regulators will follow the full Basel approach to FRTB, including continuing to allow the use of internal models.

“Banks are doing preparatory work that’s consistent with this narrative,” says Covas.

Under Basel rules, banks are allowed to use their own models to calculate risk-weighted assets subject to supervisory approval, alongside the regulator-set standardised models. Any decision to dump internal modelling could create a split in the way that big US banks measure risk capital compared to their European peers.

Debbie Toennies, global head of regulatory affairs for JP Morgan’s corporate and investment bank, said at an industry conference on May 12 that the Federal Reserve had already drafted the new rules but was waiting for the appointment of a new vice-chair of supervision before releasing them.

US president Joe Biden nominated Michael Barr in April to fill the vacant Fed vice-chair role, after an earlier candidate Sarah Bloom Raskin withdrew from the running due to a Congressional deadlock over her nomination. Senators will vote on whether to confirm Barr’s appointment in the coming weeks.

In theory, the new vice-chair could still request major revisions to the staff proposal. However, since Biden’s election in November 2020, Fed officials have indicated that the future of internal models to calculate capital requirements was in doubt. Sources say that, as the appointment of a Democrat vice-chair for supervision became imminent over the past few months, the signals from officials during meetings with the industry have become firmer.

As a result, many in the industry believe that the path away from internal models for credit risk is now set, and the main decisions still to be taken by the new vice-chair will revolve around how to calibrate the overall regime.

The Fed declined to comment for this article.

Take the floor

Scepticism among US regulators over the accuracy of internal models was supposed to have been accommodated by the Basel Committee on Banking Supervision in the final design of Basel III. Specifically, advanced approaches were removed altogether for operational risk and credit valuation adjustment (CVA), but retained for market, credit and counterparty credit risks.

In addition, the Basel rules introduced an output floor that requires banks using the advanced approaches to maintain capital equivalent to at least 72.5% of what their requirements would be if they used the standardised approaches. This floor is intended to act as a backstop to prevent banks holding inadequate capital by calibrating their models too aggressively, and mimics the aims of the existing Collins floor in the US.

However, it now appears that even the Basel floor may not be sufficient to save IRB and IMM in the US. A senior regulatory expert at a second large US bank says the Fed intends to simplify the risk capital framework and prioritise its stress-testing regime for large banks, known as the Comprehensive Capital Analysis and Review. As of last year, CCAR required banks to hold a capital add-on in the form of a stress capital buffer.

“CCAR stress-testing has become the new models-based framework here in the US, which is why regulators don’t think the advanced methodology is necessary any more,” says the regulatory expert.

By contrast, Fed officials have previously referred to the approval process for internal models under FRTB, and banks are already factoring the time needed for IMA model approvals into their expectations for the Basel III implementation schedule.

The greater regulatory willingness to preserve IMA for market risk may be down to its stringent backtesting regime, which obliges banks to move individual trading desks on to the standardised approaches if their internal models fail reliability tests.

“As long as backtesting continues to demonstrate that internal models are robust, banks should be allowed to use internal models for FRTB,” says Covas.

The Fed’s more favourable view of IMA may also reflect the fact that the vast majority of US financial markets activity is carried out by the largest banks that are all currently on advanced approaches. Conversely, the credit risk framework is important both to the largest banks and to smaller lenders that only use standardised approaches.

As a result, the use of internal models in FRTB is less likely to have level playing field implications between the top tier and the rest. And a large market risk capital increase for the biggest banks could have a disproportionate impact on financial market liquidity.

“The largest banks are the largest players in the capital markets in the US. The capital markets… are providing somewhere between two-thirds and three-quarters of all capital formation and lending in the economy,” says Carter McDowell, associate general counsel at the Securities Industry and Financial Markets Association. “So, to the extent that you raise the capital associated with those activities, it is only logical that you will get less of that activity and likely higher transaction costs.”

Competitive disadvantage?

The European Union has already published the first draft of its legislation to implement Basel III, and this retains IRB and IMM. Since internal model outputs tend to be lower than the standardised approaches for many asset classes, US banks could end up with significantly higher risk-weighted assets and capital requirements for the same products.

This would affect the pricing of their products to ensure a return on capital, potentially making it difficult to compete in European – or even in domestic – credit and swaps markets.

US lobbyists have already expressed concern about the competitive implications of an EU exemption that allows its banks not to hold capital against CVA risk on trades with corporate clients. Obliging US banks that compete globally to use only standardised approaches for credit and counterparty credit risk will exacerbate those fears.

“You not only increase the capital requirements on a large bank in the US, you also massively decouple from the international rules – where our competitors in Europe would enjoy a 72.5% floor, here you have introduced a more punitive standardised metric,” says the head of capital management at the first US bank.

Some sources are less alarmed. They predict that US regulators will make changes to other parts of the overall framework to offset any capital increase triggered by dropping IMM and IRB.

Jeremy Barnum, chief financial officer of JP Morgan, told analysts on the bank’s earnings call for the fourth quarter of 2021: “If you look at central case estimates of [Basel III], you will conclude that there’s inflation of risk-weighted assets. But… this all takes place in the context of the global regulatory community, or at least in the US, saying that the system has enough capital, it doesn’t need more capital.”

However, there is no consensus among market participants as to how the overall capital increase will be curtailed, and many think this is the area where decisions made by the new Fed vice-chair for supervision will play the most significant role.

McDowell also points out that Fed chair Jerome Powell and vice-chair Lael Brainard have specifically referred to the system as a whole having enough capital, rather than individual banks. This is an important distinction, because smaller banks that already use standardised approaches are unlikely to see a capital increase from the implementation of Basel III.

“When [Fed governors] talk about the capital neutrality, they are very quick to point out that means capital neutrality across the system, not for every individual bank in the system,” says McDowell. “If you raise the capital on the big banks, and you lower it on the small banks, it may be system-wide neutral, but it’s going to have a different impact on the economy.”

Editing by Alex Krohn