Basel’s IRB attack ‘a capital game-changer’

Sid Verma
Published on:

BCBS wants greater comparability; new risk weights worry bankers.

The Basel Committee on Banking Supervision’s (BCBS) clampdown on the internal ratings-based approach to credit risk will have a profound knock-on impact on the regulatory framework for lenders and will hike capital requirements across the board by stealth, say bankers, as they struggle to fathom an array of new supervisory initiatives. 

Gerrit Zalm 160x186
Gerrit Zalm,
ABN Amro

The fear is that the clampdown on the IRB and risk-weight changes to the standardized approach together represent wholesale changes to the bank-capital framework, given the interconnected nature of rulemakings, including on the leverage ratio, total loss-absorbing capacity standards, sovereign/operational risk, securitization, interest-rate risk in the banking book, and the Fundamental Review of the Trading Book. 

The BCBS argues that proposed constraints on models’ usage will boost comparability of capital adequacy ratios and transparency. But bankers fear the lack of a risk-sensitive standardized approach (SA) will exacerbate systemic risk and savage the profitability of corporate portfolios for European lenders, in particular, where the IRB approach has been in vogue over the past two decades. 

The BCBS could endanger downstream lending through systemic changes to the capital framework in a quixotic quest to standardize risk management, says one credit-risk portfolio manager in New York. "There are probably some institutions that do try to game risk ratios aggressively. But it’s a value judgment about what’s more important: getting the few bad apples or impeding business for the vast majority of firms."

He concludes: "No one is thinking through the systematic impact of this shift in the IRB regime, and Basel has been pretty clear that they want to wrap this up as soon as possible."

A wide-ranging consultation the BCBS published in March took industry participants by surprise. It proposes to heavily curtail the use of internal models for calculating bank capital requirements, including ending its use for hard-to-model portfolios, such as specialized financing vehicles and equities, as well as low-default portfolios. 

The latter includes banks and large corporates with assets of more than €50 billion. This means all lenders would be forced to use the standardized approach for these asset types. 

In December, Basel updated standardized framework proposals, retaining the focus on credit ratings and assigning higher risk-weights for real-estate exposures, among other things. Some of these changes are controversial. High-quality but unrated corporates would incur a flat 100% risk-weighting, increasing the cost of credit to medium-sized businesses in particular, while buy-to-let mortgages are also set to become more capital-intensive for lenders. 

Meanwhile, banks would have to apply a 50% risk weighting for unhedged FX exposures, increasing market-entry costs for companies seeking foreign currency funding and borrowers in dollarized economies such as Latin America. 

Basel also proposes floors for loss-given-default assumptions used in the advanced IRB approach, while giving regulators more power in providing LGD ratios for corporates with revenues of more than €200 million. 

The final design of its proposals will be informed by a quantitative impact study, with a consultation that runs until June 24. The BCBS, which has weathered bankers’ complaints over the past two years that regulatory uncertainty has bedevilled capital planning, has called the industry’s bluff and is expected to finalize rules by end of the calendar year. 


Announcing the proposal to restrict the IRB approach, Swedish central bank governor and BCBS chairman Stefan Ingves said: "Addressing the issue of excessive variability in risk-weighted assets is fundamental to restoring market confidence in risk-based capital ratios. 

"The measures announced today largely retain the use of internal models for the determination of credit risk-weighted assets, but with important safeguards that will promote sound levels of capital and comparability across banks." 

Basel proposes to abolish internal models for credit valuation adjustments on derivative positions and impose a floor on internal models – calculated as a percentage of the SA – for counterparty risk on derivatives. 

The BCBS claims the proposals are not designed to hike systemic capital requirements. A similar claim was made during the fundamental review of the trading book, but lenders estimate there has subsequently been a 40% increase in trading-book risk weights. 

Wiebe Draijer, chairman of Rabobank, dubs the proposed SA/IRB changes a declaration of the onset of Basel IV and says: "It would limit the amount of credit to the economy at a point in time when that’s pretty needed. That’s the macroeconomic impact of that regulation."