Basel Restores Rating Role in Overhaul of Banks' Credit Risk

Updated on
  • Regulator to impose standardized-approach floor on risk models
  • Rules for measuring mortgage risk eased after Nordic protest

Rating companies are set for a comeback in global rules for how lenders assess credit risk, as the Basel Committee on Banking Supervision reverses course after pushback from the financial industry.

In a draft revision of its standardized approach to measuring credit risk, the regulator reintroduced the use of external ratings in a “non-mechanistic manner” for loans to banks and other companies. The Basel committee is adjusting its rules for gauging banks’ credit, market and operational risks in an attempt to simplify the process and reduce the variation in results across lenders and jurisdictions.

The regulator also eased proposed rules for measuring mortgage risk after a number of countries warned that an initial draft would choke their home finance systems. The ratio of a loan’s size to the value of a property should be the main driver for determining an asset’s risk weighting, the Basel committee said, backing away from an earlier plan to include a borrower’s ability to service debts.

Credit ratings of Moody’s Investors Service, Standard & Poor’s, Fitch Ratings and similar firms came under fire during the financial crisis because of the over-optimistic grades they assigned to securities backed by subprime U.S. real estate loans that imploded as property prices slumped during the credit crunch. Some countries went so far as to forbid the use of external ratings for regulatory purposes.

Reduce Variation

While remaining distrustful of rating firms, global regulators are looking for ways to reduce variations in lenders’ assessments of the riskiness of similar assets. That’s important because the risk assigned to an asset dictates how much capital is required to fund it, which in turn influences the cost of making the loan or holding the security.

To address the variability in the risk-weighted assets across banks using internal models, the regulator “intends to impose a standardized-approach floor on modeled credit risk capital requirements.” The paper also seeks to “align, to the extent possible, the definitions and scope of exposure classes” for the standardized and the internal ratings based approaches.

Basel research, including study the group published in 2013, found variations of as much as 20 percent in the risk weights banks attach to similar assets in the banking book, undermining confidence that the capital ratios lenders report reflect the real risks they are taking on. That has prompted regulators to introduce leverage ratios and other measures to rein in banks’ risk-taking, and to examine ways of using standardized models and imposing capital floors to prevent risk assessments from falling too low.

‘Primary Basis’

For interbank business, ratings would be the “primary basis” for determining risk weights for rated exposures in jurisdictions that allow their use. “To reduce mechanistic reliance on ratings, this approach would be subject to due diligence requirements, which could result in a higher risk weight than that determined by ratings,” the regulator said.

Where external ratings aren’t permitted, as well as for unrated exposures in all jurisdictions, the Basel committee proposed dividing exposures into three parts, with different risk weights assigned to each of the three buckets.

A similar procedure is proposed for corporate exposures. Unrated exposures would carry a 100 percent risk weight. Where ratings aren’t allowed, corporates deemed to be investment grade would attract a 75 percent weight, while other exposures would be weighted at 100 percent. In all jurisdictions, exposures to small and medium companies would be weighted at 85 percent.

Scandinavian Protest

On mortgage rules, the committee said its new proposal recognizes concerns that a “one-size-fits all approach has its limitations” because of differences among countries in underwriting, tax legislation and income.

The regulator decided “not to use a debt service coverage ratio as a risk driver given the challenges of defining and calibrating a global measure that can be consistently applied across jurisdictions.” Instead, the assessment of a borrower’s ability to pay should be required as a “key underwriting criterion,” it said.

The Basel committee proposed to categorize “all exposures related to real estate, including specialized lending exposures, under the same asset class, and apply higher risk weights to real estate exposures where repayment is materially dependent on the cash flows generated by the property securing the exposure.”

Basel’s initial proposal was fought by Sweden, Denmark, the Netherlands and Germany, where residential mortgage risk weights are low. The countries argued that their low weightings reflect decades of low losses.

Under the existing standardized approach, residential property carries a risk weight of 35 percent. That compares with levels as low as 13 percent for Danish banks using internal models. Sweden has set a floor of 25 percent.

The Basel committee plans to complete the revision of its standardized approach to credit risk by the end of 2016. It seeks comments on Thursday’s proposals until March 11.