Basel’s IRB attack ‘a capital game-changer’

The Basel Committee on Banking Supervision’s (BCBS) clampdown on the internal ratings-based approach to credit risk will have a profound knock-on impact on the regulatory framework for lenders and will hike capital requirements across the board by stealth, say bankers, as they struggle to fathom an array of new supervisory initiatives. 

Gerrit Zalm, ABN Amro

The fear is that the clampdown on the IRB and risk-weight changes to the standardized approach together represent wholesale changes to the bank-capital framework, given the interconnected nature of rulemakings, including on the leverage ratio, total loss-absorbing capacity standards, sovereign/operational risk, securitization, interest-rate risk in the banking book, and the Fundamental Review of the Trading Book. 

The BCBS argues that proposed constraints on models’ usage will boost comparability of capital adequacy ratios and transparency. But bankers fear the lack of a risk-sensitive standardized approach (SA) will exacerbate systemic risk and savage the profitability of corporate portfolios for European lenders, in particular, where the IRB approach has been in vogue over the past two decades. 

The BCBS could endanger downstream lending through systemic changes to the capital framework in a quixotic quest to standardize risk management, says one credit-risk portfolio manager in New York. “There are probably some institutions that do try to game risk ratios aggressively. But it’s a value judgment about what’s more important: getting the few bad apples or impeding business for the vast majority of firms.”

He concludes: “No one is thinking through the systematic impact of this shift in the IRB regime, and Basel has been pretty clear that they want to wrap this up as soon as possible.”

A wide-ranging consultation the BCBS published in March took industry participants by surprise. It proposes to heavily curtail the use of internal models for calculating bank capital requirements, including ending its use for hard-to-model portfolios, such as specialized financing vehicles and equities, as well as low-default portfolios. 

The latter includes banks and large corporates with assets of more than €50 billion. This means all lenders would be forced to use the standardized approach for these asset types. 

In December, Basel updated standardized framework proposals, retaining the focus on credit ratings and assigning higher risk-weights for real-estate exposures, among other things. Some of these changes are controversial. High-quality but unrated corporates would incur a flat 100% risk-weighting, increasing the cost of credit to medium-sized businesses in particular, while buy-to-let mortgages are also set to become more capital-intensive for lenders. 

Meanwhile, banks would have to apply a 50% risk weighting for unhedged FX exposures, increasing market-entry costs for companies seeking foreign currency funding and borrowers in dollarized economies such as Latin America. 

Basel also proposes floors for loss-given-default assumptions used in the advanced IRB approach, while giving regulators more power in providing LGD ratios for corporates with revenues of more than €200 million. 

The final design of its proposals will be informed by a quantitative impact study, with a consultation that runs until June 24. The BCBS, which has weathered bankers’ complaints over the past two years that regulatory uncertainty has bedevilled capital planning, has called the industry’s bluff and is expected to finalize rules by end of the calendar year. 

Announcing the proposal to restrict the IRB approach, Swedish central bank governor and BCBS chairman Stefan Ingves said: “Addressing the issue of excessive variability in risk-weighted assets is fundamental to restoring market confidence in risk-based capital ratios. 

"The measures announced today largely retain the use of internal models for the determination of credit risk-weighted assets, but with important safeguards that will promote sound levels of capital and comparability across banks.” 

Basel proposes to abolish internal models for credit valuation adjustments on derivative positions and impose a floor on internal models – calculated as a percentage of the SA – for counterparty risk on derivatives. 

The BCBS claims the proposals are not designed to hike systemic capital requirements. A similar claim was made during the fundamental review of the trading book, but lenders estimate there has subsequently been a 40% increase in trading-book risk weights. 

Wiebe Draijer, chairman of Rabobank, dubs the proposed SA/IRB changes a declaration of the onset of Basel IV and says: “It would limit the amount of credit to the economy at a point in time when that’s pretty needed. That’s the macroeconomic impact of that regulation.”

Gerrit Zalm, chairman of ABN Amro, adds: “We hope that our representatives in Basel can convince the others that these kinds of portfolios should have a local judgment in terms of risk weighting, if there’s enough local history and if the law of large numbers applies. 

"Our national regulator agrees with us that we have modelled our risk weighting conservatively. The battle in Basel itself is not over, and after that we will have the battle in Brussels, because it has to be put into European regulation too.”

He explains further: “Let me first say what I think is fair: if there’s an international company, there are three banks giving the same type of loan, a syndicated loan, you should have the same risk weights in these three banks, because it’s the same loan, the same company. 

"What is not so sensible is that you make one term sheet for all mortgages worldwide, because legal systems differ, tax systems differ, the culture differs and a 100% loan to value in the US or a 100% loan to value in the Netherlands is completely different in terms of risk.”

Proposals to increase probability of default assumptions for retail mortgages to 5 basis points from 3bp could increase risk weights on these portfolios by 50%, other things being equal, according to Fitch. 

In addition, the BCBS proposes to introduce a permanent risk-weighted asset-capital floor on the revised standardize approach in the range of 60% to 90%, which will limit the capital relief generated by IRB models. 

Banking systems most exposed to the imposition of the capital floor risk include Japan (low risk-weighting for corporate exposures under IRB models), Switzerland and Singapore (low total retail RWA density) and Scandinavia (low corporate and retail IRB RWA density), according to Citi. 

Swedbank, Lloyds and Sabadell, in particular, could be forced to increase capital allocated for mortgage loans, and SHB (Svenska Handelsbanken), SEB and BNP Paribas for corporate exposure, according to Citi. 

Zalm at ABN Amro says blunt risk weights for mortgages would be a regressive risk-management step, and the proposals would punish banks that managed their portfolios well during the crisis. “We have about a million mortgages with a lot of history. So, we think that the present risk weighting is sufficient. 

"If you look at, say, the loss rates we have on our mortgage portfolio, over the past 10 years the average loss rate was 6bp. And in the height of the housing crisis when the economy went down, the house prices went down, the maximum was in a year 25bp. Of course if you would make that analysis for Spain or the US you would have completely different impairment rates for higher risk weights.” 

Mayra Rodriguez Valladares, an independent New York-based regulatory consultant, supports Basel’s latest intrusive push to micro-manage banks’ liability management, citing the fact that low bank equity prices, in part, reflect a loss of investor confidence in apparently opaque capital management. 

“While I love the ethos of the Basel III, risk sensitivity has become out of control because of the variability and opaqueness in models,” she says.

She adds: “The challenge still remains that banks get to use too many opaque models which involve hundreds of personnel such as modellers, risk managers, validators, compliance officers and auditors. Since all of them have different motives and skills, there is a lot of scope for errors. 

"Also, big banks continue to struggle with having complete, accurate data sets to measure their risks reliably and consistently. Hence, there is a lot of scope for subjectivity. Worst of all, banks are not required to be granular in their disclosures, so the market does not have the information to discipline.”

Samuel Theodore, financial ratings analyst at Scope Ratings, says the new rules are a watershed in the BCBS’s bid to banish the demons of Basel II and make good on its mantra to balance risk-weight sensitivity, simplicity and comparability of capital ratios. 

“I don’t expect a wholesale chunky boost in capital requirements overall,” he says. “Also we should bear in mind that the Basel risk proposed changes will be implemented very gradually, so there will be plenty of time for banks to adjust and recalibrate portfolios.”