Banks' Leeway on Credit Risk Narrows as Basel Tightens Rules

  • Regulator aims to finish post-crisis risk reforms this year
  • Banks deny seeking to game capital requirements with models

Banks’ latitude in assessing their biggest source of risk is set to be curtailed as global regulators try to prevent the financial industry from gaming capital requirements.

The Basel Committee on Banking Supervision proposed on Thursday to remove the option for lenders to use their own models to determine how much capital they need to fund exposures to financial firms, equities and large corporations, forcing them to use a standardized method set by the regulator. The plan also envisions a floor to limit how far risk assessments using the models still allowed for assets such as mortgages and small-business loans can diverge from those obtained with the standardized approach.

The Basel group, whose members include the U.S. Federal Reserve and the European Central Bank, is adjusting its rules for gauging banks’ credit, market and operational risks to simplify the process and reduce the variation in results. A 2013 Basel study 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 take on.

‘Important Safeguards’

“Addressing the issue of excessive variability in risk-weighted assets is fundamental to restoring market confidence in risk-based capital ratios,” Basel Committee Chairman Stefan Ingves said in a statement. While the proposal continues to allow the use of internal models in some cases, it introduces “important safeguards that will promote sound levels of capital and comparability across banks,” he said.

The Basel Committee has soft-pedaled the impact of its post-crisis agenda in response to industry warnings that the new rules could hinder their ability to lend. In January, the regulator said that as it wrapped up work on credit risk and other issues, it would “focus on not significantly increasing overall capital requirements” for banks, a claim it repeated on Thursday. The planned capital floor will be set after an impact assessment.

The credit-risk plan amounts to a retreat for the Basel Committee, which first allowed the use of internal models for trading-book assets in 1996, extending this to the banking book in 2004. Proponents of models say they deter banks from over-investing in high-yield assets and provide an incentive for lenders to analyze risk more thoroughly. The Basel Committee sees capital floors and the risk-blind leverage ratio as reinforcements for the risk-weighted capital framework.

‘No Evidence’

Critics argue that because the amount of regulatory capital banks must have is a function of risk-weighted assets, they have both an incentive to shrink assets and, through internal models, the means to do so. 

The industry rejects this assertion. A study earlier this year funded by the Association for Financial Markets in Europe, an industry group, looked for links between potential reasons for the gaming of models and the observed variation in modeling changes for risk-weighted assets.

“We have found no evidence for such links,” said Europe Economics, the London-based consultancy that conducted the study. “This analysis does not disprove the thought that a bank might engage in such activities, but the finding is wholly inconsistent with the hypothesis that this is common practice.”

In its credit-risk proposal, the Basel Committee concludes that banks lack adequate data to estimate the potential for a default by other lenders, financial firms and large corporations, and should instead rely on the standardized approach.

Credit Crunch

In a separate proposal in December on the standardized approach for measuring credit risk, the regulator reintroduced the use of external ratings in a “non-mechanistic manner” for loans to banks and other companies.

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.

In Thursday’s consultation paper, the Basel Committee said it’s currently determining how to set a floor for how much capital banks must have where they continue to rely on internal models. These will continue to be used to assess the riskiness of mortgages, card lending and of loans to corporations with assets of less than 50 billion euros ($56 billion). The regulator is considering setting an aggregate floor at between 60 percent and 90 percent of the level of risk determined by regulators in the standardized approach.

Capital Floor

The capital floor framework now in development would replace the current, transitional floor based on an earlier Basel standard. The regulator said on Thursday that it’s “still considering the design and calibration” of the credit-risk floor.

Lobbying groups including the European Banking Federation criticized the setting of a new floor, arguing that it will hurt the industry’s ability to lend. The Institute of International Finance, a group that includes Goldman Sachs Group Inc., Deutsche Bank AG and HSBC Holdings Plc, said last year that a floor of 80 percent or a higher leverage ratio “would materially erode the sensitivity of capital” to the riskiness of underlying borrowers.

Thursday’s proposal doesn’t consider the treatment of sovereign exposures, which are “subject to an ongoing separate review, which is being conducted in a careful, gradual and holistic manner,” the Basel Committee said.

The consultation period ends on June 24.

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