Basel attacks on credit ratings misfire

By:
Sid Verma
Published on:

The Basel Committee on Banking Supervision’s (BCBS) proposals to reduce lenders' reliance on external credit ratings and boost the risk sensitivity of exposures through new metrics could trigger a slew of unintended consequences, according to a Fitch report.

In recent years, regulators have fought tooth and nail to reduce financial markets’ dependence on global credit rating agencies (CRAs). 

Citing attempts to address conflict-of-interest, risk-management and pro-cyclical fears, regulators have encouraged the growth of alternative rating agencies, investigated the culture and practices of the big three, and, in the US, removed references to CRAs outright in the Dodd-Frank Act.

Basel Committee Tower-large
BCBS headquarters in Basel
The contentious issue of risk-modelling banks’ sovereign debt portfolios by reference to ratings is now subject to a formal investigation at the Basel level. After all, the eurozone sovereign debt crisis underscored the flaws of the current system whereby banks, in theory, are free to attach zero risk capital to debt issued by their homes states in internal risk models, subject to supervisory discretion.

However, perhaps the most damaging attack to the credit-rating business came in December with the publication of a Basel consultative document aimed at limiting lenders’ freedom to measure risk by reference to credit ratings

In a bid to further micro-manage financial institutions’ asset-liability mismatches, the Basel paper advocates risk-weighting exposures for corporates by a given borrower’s revenue and leverage, rather than ratings. For banks, it suggests common tangible equity ratios and the non-performing assets ratio.

As Euromoney reported in March, these proposals are political dynamite since such measurements fail to discriminate between supervisory, covenant, insurance and accounting standards. It is also likely to constrain the profitability of certain loan portfolios. For example, the risk-weighting attached to corporates would jump from 30%-150% to 60%-300%. 

Meanwhile, the proposed risk weights for mortgages is in the 25% to 100% range, compared with a flat 35% currently, based on the loan-to-value (LTV) ratio and a borrower’s indebtedness.

Given Europe’s dependence on bank lending to finance corporate borrowing, and the relative depth of local capital markets in the US, the proposals, at first blush, threaten to hike the cost of bank capital as the eurozone stages a recovery.

At the end of last month, Fitch released an instructive report calculating the likely impact of the BCBS's proposals on Fitch-rated corporates. While it has a clear self-interest in advocating for the continued use of external credit-rating agencies, Fitch’s calculations are surprising.

From the report:

The proposed use of balance sheet leverage is surprising given the more common use of cash-flow leverage metrics (e.g. debt/EBITDA) in corporate credit assessments, and leads to some surprising results. The new proposals would assign a number of highly-rated issuers to the highest risk buckets, and conversely, would have treated the majority (60%) of defaulted issuers in the Fitch portfolio as low risk (risk weighted below 100%). This indicates that the proposed metrics would fail to discriminate adequately between different credits.

Decrease in Rated Corporate Risk-Weights: Analysis of the Fitch-rated portfolio of global corporates indicates the proposals lead to a decline in average risk weights to 84% from 102% as compared to ratings based risk weights, with lower-rated corporates and cyclical sectors such as property and real-estate benefitting most. Risk weights for higher-rated corporates increased. However, the overall decrease would likely be offset by the proposed increased requirements for off balance sheet exposures. The overall impact will depend on the size and make-up of a bank's portfolio, and the portion of corporate lending to rated entities.

Exposures to Banks

Missing Important Factors, Lack of Comparability: The BCBS proposes to determine risk weights for banks’ exposures to other banks based on the common equity Tier 1 (CET1) risk- based ratio and non-provisioned impaired exposures. In contrast, the current Basel framework provides two options, both ratings-based; the first based on the sovereign rating, and the other (more risk sensitive) based on banks’ issuer ratings. Fitch agrees that asset quality and capital ratios are important considerations in bank credit assessment. But these metrics on their own provide an incomplete basis for credit differentiation, as they omit important factors such as the bank’s operating environment (especially important for emerging-market banks), company profile, governance, liquidity and profitability. The proposed metrics also suffer from lack of comparability and consistency across jurisdictions (as reflected e.g. in the BCBS’s efforts to address consistency of risk-weighted assets, which underpin the CET1 ratio).

Some of these conclusions are pretty damning. Not only are some of the metrics questionable, such as the blunt balance-sheet-leverage metric, their usage could punish low-risk corporates and reward high-risk organizations, such as property and real-estate.

The irony is that Basel has already acknowledged blue-chip corporates offer relative stability for financial institutions, by including the highest-rated corporate bonds, with strong free cash-flow positions, in the liquidity coverage ratio (LCR). Punishing, albeit unintentionally, such institutions through new risk metrics undermines the rationale for the expansion of assets eligible for inclusion in the LCR.

What’s more, the net impact could provide billions of dollars of capital relief for banks’ corporate exposures just as lobbyists deplore the proposals, fearing new onerous risk-weights could curb lenders’ balance-sheet expansion. After all, Fitch calculates the proposals lead to a decline in average risk weights to 84% from 102% as compared with ratings-based risk weights. 

Nevertheless, the Basel proposals certainly have some merit. Most research corroborates the view that debt-service-to-income and, to a lesser extent, LTV ratios are effective at predicting mortgage defaults, while the standardized approach at present lacks such granularity. (Nevertheless, both metrics play a substantial role at loan origination.)

Commercial real-estate risk-weights currently fail to discriminate between senior and subordinate debt, a potential source of systemic risk. In addition, unrated corporates, in relative terms, should benefit from Basel’s proposals, given their onerous risk-weights in the current standardized model – a boost for emerging market (EM) banks with large SME books, in particular.

Further reading

Financial regulation:
special focus

However, by highlighting the unintended consequences of the new metrics, the Fitch report adds to the market expectation that Basel’s move to apply new risk weights could take years and change beyond recognition once implemented. Since Basel is also proposing a floor on the capital relief provided by internal models relative to the standardized approach, these proposals will apply to all lenders, including those that deploy an internal-ratings-based (IRB) approach to quantify capital for credit risk.

In that sense, Basel’s motivation to beef up the granularity of the standardized approach to make it more like the IRB approach seems squarely aimed at the larger banks given the new-found role of the standardized approach in calculating capital floors.

Once new metrics to risk-weight exposures are agreed upon, Basel would then need to work out whether such a floor would apply across a given bank or to individual categories, including credit, market, operational, counterparty and securitization risks.

The very complexity of the new standardized approach might also trigger lobbying efforts from smaller EU-headquartered banks for a degree of regulatory forbearance. After all, US regulators’ tend to shelter smaller lenders from the specific burdens of Basel, in contrast to the EU's history of imposing the Basel agenda on all lenders in full.

As a result, a multi-year lobbying effort between regulators and lenders is surely on the cards.

The longer the uncertainty, the higher the stakes. As Euromoney has reported, it's unclear to what extent banks can continually invest in the IRB approach, given the costs involved and the lack of clarity of the capital relief it provides until the floor, influenced by the revised standardized approach, is calculated. 

If that becomes the case – and EM lenders never migrate to the IRB model en mass – Basel would be blamed for intensifying systemic risks if the standardized approach performs badly during the next banking crisis. 

Basel risk weights
Source: Fitch