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Basel Proposes Using Risk Drivers Over Credit Ratings

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The Basel Committee on Banking Supervision (BCBS) has released a proposal to reduce the reliance on credit agencies and internal models when calculating risk-weighted assets for regulatory capital, requesting comments by March 27 next year.

“The hard-wiring of external credit assessments into standards, laws and regulations may often lead to mechanistic reliance on ratings by market participants, resulting in insufficient due diligence and poor risk management on the part of lenders and investors,” the BCBS writes in Revisions to the Standardised Approach for credit risk.

Balancing generality with the need to identify local risks

Some of the proposed changes are technical updates meant to correct out-of-date calibrations from the current Standardized Approach or improve comparability between the Standardized Approach and the internal-ratings based approach, but swapping explicit references to external credit ratings with risk drivers is something the BCBS has been aiming to do for years.

Credit Ratings Risk Driver

The problem, aside from the fact that credit ratings are widely used and familiar, is that risk drivers must be specific enough to account for local differences (such as different real estate markets) but general enough to give a reliable global standard.

“These alternative risk drivers have been selected on the basis that they should be simple, intuitive, readily available and capable of explaining risk consistently across jurisdictions,” the BCBS writes, adding that it “recognises that the proposals are still at an early stage of development.”

Credit Ratings Risk Driver

The Basel Committee’s proposed risk drivers

Bank and corporate exposures are currently risk-weighted according to external credit ratings, but under the new system they would each be weighted using a lookup table. Bank exposure weights would range between 30% and 300% depending on the capital adequacy ratio and an asset quality ratio, while corporate exposure would range from 60% to 300% depending on revenue and leverage.

Credit Ratings Risk Driver

Residential real estate, which currently gets a 35% risk weight across the board, would vary from 25% to 100% depending on loan-to-value and debt-service-coverage ratios, improving risk sensitivity (and probably increasing the amount of required regulatory capital). Commercial real estate would either vary from 75% to 120% depending on the loan-to-value ratio or simply be treated as unsecured exposures to the counterparty. Retail loans would still be eligible for a 75% risk weight, but the proposed rules would make the criteria to qualify more stringent.

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