After two years of intensive discussion and negotiation, the Basel Committee on Banking Supervision (BCBS) finalized the Basel III framework in December. The related document was published on 7 December 2017 and stretches over 160 pages (translations in French and Spanish are forthcoming).
The major stumbling block for the governors and heads of supervision was the controversial “output floor”, a limit for the calculation of risk-weighted assets (RWAs). The introduction of floors means that the RWAs calculated using internal models cannot fall below a given percentage of the RWAs calculated using the standardised approach. On this point, there was a clash of different ‘risk cultures’, roughly speaking, between a European and an Atlantic approach. The compromize that was reached was a calibration of the output floor to 72.5 %.
Nevertheless, it would be reductive to blame the delay of the entry into force of the entire framework only on the output floor: like many stakeholders and analysts are accustomed to say, Basel III underwent a shift after the initial phase, which concentrated on capital requirements (own funds). The regulator wanted to ensure consistency and credibility in the calculation of RWAs, with the aim of tackling the wide variation in risk-measurement methodology. That is why, in the finance community and among regulation experts, is common to speak of Basel IV. In the same way, it might be near-sighted to see the consequence of the output floor merely in an expected increase in capital requirements.
The implementation of the final package of measures of Basel III will have not only quantitative effects on capital, but it will require an individual approach, one which considers all aspects linked to the implementation of the standards in a holistic manner. Each individual bank will need to carry out an impact analysis of the new standards, which will be, by and large, dependent on its business model, on the use of internal models, on the market situation and, finally, on the profitability targets of the institute. The day of first application in 2022 might be nearer than imagined: an early assessment and a regular follow-up of the exercise would greatly contribute to a bank’s readiness.
Now let us take a closer look at the most important point of the paper from the BCBS. First, the introduction of the output floor, as calculated according to the formula
RWA = MAX [RWAIM; RWASA x 72.5%],
means that the RWA will be the greater of that calculated using an internal model and the revised standardized model multiplied by 72.5%. This last percentage will apply from 1 January 2027. During the five-year transitional period, the following values will be used:
Furthermore, the following caveats have to be considered:
On 1 January 2022, the revised leverage ratio standard together with the buffer for global systemically important banks (G-SIBs) will go into effect.
December 2017 was also a significant milestone for the finalisation of four pending topics regarding the standardized approach for credit risk (CR-SA), the internal-ratings-based (IRB) approach, credit value adjustment (CVA) and operational risk.
In the CR-SA, within the standardized credit risk assessment approach (SCRA) for financial institutions exposures an intermediate “A+” grade, with a risk-weight (RW) of 30%, is added. The RWs have been lowered for specialized finance, pre-operational finance project and the operational cluster, and criteria introduction for qualifying for an 80% RW. In residential and commercial real estate, it is permitted to split the credit into a “property” part (up to 55% of the property value with a RW of 20% or 60% respectively) and a “counterparty” component – the remaining loan value - to be evaluated according to the creditworthiness of the client (for retail 75% RW). Other measures from the supervisor regarding retail exposures and commitments aim to soften the impact of the CR-SA on IRB banks. All in all, the BCBS attempts to graduate the previously suggested approach and to alleviate the impact of the introduction of a floor. However, only an individual impact analysis will be able to give a first assessment of the application of the finalized rules for the single case.
As far as the IRB is concerned, the BCBS maintains the applicability of the method except for the equity exposure class. However, for exposures to financial institutions and large corporates only the foundation-IRB will be allowed. Exposures to specialized lending, retail and SMEs may still be treated under the advanced-IRB. The scaling factor of 1,06% is removed. However, conservative measures are introduced by raising the input floors with respect to probability of default (PD) and loss given default (LGD).
In terms of CVA, the FRTB internal-model-based approach is no longer valid (as already suggest in BCBS 362). The standardized approach, basically following the FRTB methodology, must be approved by the supervisor. The standardised approach is based on the sensitivity of the credit spread of the counterparty. Historical calibration is not allowed. Accounting values for Exposure at Default (EAD) are permitted. For the alternative CVA Basic Approach (BA-CVA), the major differences are the lower risk rates and EAD per sector. Here the supervisor reacted to the criticism of the stakeholders and introduced a discount factor reducing conservatism. The fall-back scenario for the institution not calculating CVA foresees the adoption of twice, and not ten times, the counterparty credit risk capital requirement, as in the previous consultation paper (CP).
For operational risk, there is a change in naming convention: the supervisor speaks simply of “standardised” approach (the word “measurement” is obsolete). The components are still the interest/lease/dividend (ILDC), the service (SC) and the financial component (FC). In terms of calculation, the formula is strongly simplified. Further, the business indicators are allocated to three buckets instead of the four of the previous CP and a marginal coefficient and an internal loss multiplier (only for bucket 2 and 3) are to be considered.
These were the most important finalized topics in Basel: the date of the entry into force is fixed at 1 January 2022. The EU supervisory authorities are expected to adopt the new rules and the national competent supervisors to have finalised the implementation by this deadline. It will be extremely important for institutions to meet this deadline gradually: this will not only prevent any unpredictable effects of a sudden introduction, but also help the management to take all the necessary measures in terms of strategy and refinement of profitability targets in advance. The only possible way will be to start an impact analysis and to repeat this exercise regularly until the implementation deadline.