A far smaller share of banks’ credit risk capital and exposures is set to be calculated using their own internal models under the fully loaded Basel III rules, as the new framework disqualifies some exposure classes from the advanced internal ratings-based (A-IRB) approach, data from the Basel Committee on Banking Supervision shows.
Across 107 banks sampled globally, the A-IRB approach captured an average of 62% of exposure at default (EAD) and 47% of risk-weighted assets (RWAs) at end-2021 – weighted for the number of banks in each region. By 2028, the proportions are projected to drop to 46% and 32% respectively.
Banks in the Americas showed the most dramatic trajectories, with coverage forecast to fall from 83% to 59% in EAD terms and from 67% to 40% for RWAs.
On the other hand, the reach of the foundation IRB (F-IRB) approach – a halfway house between A-IRB and the standardised approach, which only allows banks to assess probabilities of default – was projected to increase its reach across the sample from 18% to 22% of EAD and from 30% to 32% of RWAs.
Americas dealers again proved the most sensitive to the shift in rules, with F-IRB going from being virtually unused to covering 24% of EAD and determining 25% of RWAs by 2028.
Across Europe, the Americas and the rest of the world alike, the standardised approach’s reach was forecast to only grow one percentage point, to a weighted average of 27% of EAD. This is however set to have an outsized impact on capital charges, with a weighted average of 31% of RWAs underpinned by the wholly regulator-set approach, versus 26% at end-2021.
What is it?
Basel Committee rules allow credit risk capital to be calculated using standardised and IRB approaches.
Under the standardised approach, credit exposures are assessed using standard industry-wide risk weightings. In some instances, banks can use one of two IRB approaches. The F-IRB allows banks to provide their own estimates of the probabilities of default of their credit exposures, but uses regulator-set schema for other risk components, such as loss given default measures, to generate the ultimate RWA amount. The A-IRB approach uses banks’ own data, internal models and conversion factors.
Under the finalised Basel III package, banks can no longer use the A-IRB approach for exposures to financial institutions or corporates with consolidated annual revenues of more than €500 million ($485 million).
The Basel III monitoring report, issued semi-annually by the BCBS, assesses the effects of new regulatory standards on large banks. Capital, liquidity and leverage ratio metrics are taken by data submitted by national supervisors on a representative sample of institutions in each country. BCBS countries must implement the final batch of reforms by 2023 and fully adopt them by the start of 2028, though the UK, EU, Japan and Switzerland have all postponed implementation by one or more years.
The credit risk analysis covers 42 banks in Europe, 19 in the Americas and 46 in the rest of the world. The region-specific proportions contained in the monitoring report refer to aggregates across banks, whereas the all-region proportions were calculated by Risk Quantum as averages across the three regions, weighted by the number of banks in each.
Why it matters
Ever since the final Basel III rules were finalised in December 2017, banks knew their internal models were headed for an evolutionary bottleneck. “The use of the SA and the F-IRB … approach will increase substantially in the coming years as more restrictive requirements and supervisory standards are implemented for the use of internal models and business strategies are updated,” ABN Amro wrote in 2020.
In the European Union, part of the reforms’ impact around credit risk was brought forward by the European Central Bank’s targeted review of internal models. In the UK, the PRA has applied its own straitjacket to IRB approaches. No comparable all-sweeping, bank-by-bank review has been conducted in the US or Canada – possibly explaining Basel III’s outsized hit to A-IRB’s reach in the Americas.
Though more restrictive in terms of banks’ control over models, F-IRB’s rise may not necessarily come at lenders’ expense. In the monitoring report, the Basel Committee noted that revised F-IRB rules “in many cases” result in a decrease of capital requirements – a finding that aligns with some banks’ experience.
Preference for one approach over the other will also be driven by output floors. If the RWA savings generated by IRB models end up being for naught because of the floors, banks may opt to cut back on the investment and save on costs.
Explore our data
Readers of Risk Quantum now have access to some of the datasets that sit behind our stories – not just the segment of data that is the focus for the story, but the full time series, for the full population of covered firms. Readers can choose the institutions they want to look at, the metrics they are interested in, and download the data in CSV format to run their own comparisons and build their own charts. Risk and capital managers told us it would be helpful for internal reporting and benchmarking, but we figured many of our readers might get something out of it.
Currently, the available data covers more than 70 banks and over 100 risk and capital metrics, but we’ll be adding more throughout the year. The Risk Quantum database can be found here. The full list of data points currently available can be found here.
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