29 June 2016
The view is presented in the EMF-ECBC’s recent response to the Basel Committee on Banking Supervision’s proposal on Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches.
The BCBS’s proposal could unduly curb the ability of a bank to gauge its risk and could result in a net negative result for the economy, the EMF-ECBC warns. More specifically, the EMF-ECBC’s response highlights the following key issues in the BCBC’s proposal:
The EMF-ECBC is of the opinion that the currently ongoing revisions to the capital framework (credit risk, market risk and operational risk) should suffice to achieve the Basel Committee’s objectives of reducing excessive variability in risk-weighted assets, and that there should be no need for output floors. Floors are hard to reconcile with a risk-based approach. They might impede risksensitivity and even introduce perverse incentives leading to severe misallocation of resources.
Advanced Internal Ratings Based Approach
The EMF-ECBC also believes that a fine-tuning of IRB models can deliver significantly better results than removing the IRB approaches for certain exposures or limiting the use of the Advanced Internal Ratings Based Approach (A-IRB).
The EMF-ECBC believes that A-IRB input floors will not properly address unintended risk weight variation. Nevertheless, they could serve to address potential underestimation of risks, if the input floors are calibrated based on the data availability and the performance of the internal models. Input floors could be activated only in case underestimation of risk is proven. The alignment of definitions and supervisory practices should be prioritised with respect to the introduction of parameter floors.
Additionally, the concept of specialised lending should not include homogenous and common residential or commercial real estate exposures where abundant and reliable data is available, even if they share some of the features with specialised lending. A material increase in the level of capital required for buy-to-let assets will imply to investors that they are more risky than residential owner-occupied mortgage lending. Industry-wide historical arrears rates data in a number of markets show this not to be the reality.
In commenting on the Basel Committee’s proposal, Luca Bertalot, EMF-ECBC Secretary General, stated:
“IRB approaches are vital and effective tools for the determination of banks’ credit risk. Particular caution should be exercised in moving towards output floors and in limiting the use of the approaches for certain types of exposures. This could unduly raise capital requirements for a substantial number of financial institutions, giving rise to proportionality problems and perverse incentives and resulting in damage to the real economy.”