Banks’ scope on credit risk narrows significantly as Basel tightens rules

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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 has proposed 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 standardised 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 standardised approach.
The Basel group, whose members include the US 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.

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.”

Credit Crunch
In a separate proposal in December on the standardised 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 US 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.
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 criticised the setting of a new floor, arguing that it will hurt the industry’s ability to lend further.

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.

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