Kathleen A. Scott

My January 2015 and 2016 columns dealt with proposed changes to the international standards by which banks are required to calculate their risk-based capital. “Basel Committee Proposes Changes to Standardized Approach Capital Rules,” NYLJ, Jan. 14, 2015; “Revised Proposed Changes to Capital Requirements,” NYLJ, Jan. 13, 2016. Those changes have now been finalized and my column this month highlights some of the major revisions.

Background

Generally, there are two recommended methods by which banks can calculate their risk-based capital issued by the Basel Committee of the Bank for International Settlements, which proposes international bank capital standards. The first is the Standardized Approach, under which specific tables and formulas are used to calculate a bank’s risk-based capital; the current calculations are derived from the original 1988 recommended risk-based capital requirements (commonly called Basel I). The second method, which was part of major revisions starting earlier in this century, commonly called Basel II and III, is the Internal Ratings-Based (IRB) Approach and allows a bank, with regulatory approval, to use its own internal risk management systems to calculate the risk weight of its assets and its risk-based capital.

Generally, only the largest most complex banks use the IRB Approach, ones which presumably would carry the most complex risky assets. Most banks use the Standardized Approach. There was no general requirement that the IRB Approach to calculating a bank’s risk-based capital correlate with the Standardized Approach.

In late 2014, the Basel Committee expressed concern about what it perceived as excess variability in how assets were risk-weighted by those using the IRB Approach which resulted, at times, in a lower risk weight for an asset than if the asset had been risk-weighted using the Standardized Approach. The Basel Committee proposed revisions to the methods by which assets were risk-weighted. Initial and revised proposals were issued for public review, comments were analyzed, the Basel Committee assessed the impact of the revisions of the banking system and macro economy, and protracted negotiations took place among central bankers and banking regulators. Final agreement was reached in December 2017 and the final revisions were published. Basel Committee on Banking Supervision, “Basel III: Finalising post-crisis reforms,” December 2017.

In issuing the final revisions, the Basel Committee noted:

A key objective of the revisions incorporated into the framework is to reduce excessive variability of risk-weighted assets (RWA). At the peak of the global financial crisis, a wide range of stakeholders lost faith in banks’ reported risk-weighted capital ratios. The Committee’s own empirical analyses also highlighted a worrying degree of variability in banks’ calculation of RWA.

The revisions now need to be adopted by individual jurisdictions. These are considered to be the minimum standards; jurisdictions are free to impose stricter requirements, as the United States itself has been known to do in the past. The effective date for the revisions is January 2022, although some requirements are being phased in over a longer period of time, ending in January 2027.

Total Risk-Based Capital Floor

One of the most important changes made in the final document was adding a minimum capital floor in calculating a bank’s total risk-based assets.

Under international standards, banks currently are subject to the following minimum risk-based capital requirements:

  • Tier 1 Common Equity: minimum 4.5 percent of risk-weighted assets at all times
  • Tier 1 Capital: minimum 6 percent of risk-weighted assets at all times
  • Total Capital (Tier 1 + Tier 2): 8 percent of risk-weighted assets at all time
  • Common Equity Tier 1 capital conservation buffer: 2.5 percent of risk-weighted assets at all times

There also are additional requirements for global systemically important banks, and possible discretionary supervisory imposition of a counter-cyclical capital buffer.

Under the revised standards, banks using the IRB Approach will no longer be able to use 100 percent of their internal model calculations of total risk-weighted assets. Instead, in order to determine whether it is in compliance with the risk-based capital standards, a bank must use the greater of: (1) its assets utilizing its approved regulator-approved models (which could include a mix of IRB and standardized approaches, depending upon the asset mix) and (2) 72.5 percent of those total risk-weighted assets using solely the Standardized Approach. There will be a phase-in period for full implementation of the 72.5 percent floor, starting in January 2022 at 50 percent up to the full 72.5 percent in January 2027.

The Basel Committee will be developing new disclosure templates to encompass reporting ratios that both exclude the floor in the calculation of risk-weighted assets and ratios that do include the floor. Banks also will be required to disclose more detailed information on their calculations under the IRB and standardized approaches.

Change in Use of IRB

Among the other major changes, there now will be exclusions and restrictions on the ability to use an “Advanced” IRB Approach in calculating the risk weight of certain assets. As a result, under the final revisions, those banks currently authorized to use the IRB Approach will no longer be able to use an “Advanced” IRB approach with respect to certain asset classes. Under the Advanced IRB Approach, a bank can estimate the metrics of the probability of default, exposures at default and loss-given default, when internal models might not be sufficient for prudent modeling. Under the final revisions, a bank will no longer be able to use that Advanced IRB Approach for exposures (such as loans) to large and mid-sized corporates, banks and other financial institutions. In those cases, the bank will be able to use only an IRB Approach which eliminates estimation of these metrics (the so-called “Foundation” IRB Approach), or the Standardized Approach, in calculating the risk weights of these assets.

In addition, the IRB Approach is banned entirely for exposure to equities, and only the Standardized Approach will be permissible. However, banks will be able to use the IRB Approach (advanced or foundation) with respect to “specialized lending” (which includes project and commodities finance) as a way to calculate risk weights for these assets. In addition, those banks engaging in such lending may use the Standardized Approach or the “supervisory slotting criteria approach” under which banks are required to map their internal risk grades to five supervisory categories.

Standardized Approach Revisions

The Basel Committee also made several revisions to the formulas used to calculate the risk weight of assets under the Standardized Approach for credit risk.

As noted in the report issuing the final revisions, the intent of the changes to the Standardized Approach is to require “sufficient due diligence” with respect to the risk-weighting of assets and to improve the “granularity and risk sensitivity” in calculating the risk weight of an asset. These revisions also provide an alternative to reliance on externally-based credit ratings in determining the risk weight of particular assets. The United States is an example of a jurisdiction that banned the use of such external credit ratings.

Examples of changes include:

  • Residential mortgage risk weights will depend on the loan-to-value ratio of a mortgage, and not just be assigned a flat risk weight applicable to all residential mortgages
  • With respect to retail exposures, there now will be distinctions between revolving credit facilities that are drawn down on an as-needed basis, and a credit facility that is used to facilitate transactions (rather than just be a source of credit)
  • Separate categories were added for determining the risk weight of covered bonds, project finance, object finance and commodities finance
  • More detailed risk weight treatment has been provided for exposures to banks, corporates and subordinated debt and equity

Leverage Ratio Revisions

In addition to calculating assets in accordance with the riskiness of an asset, banks also are required to comply with leverage ratio requirements, which measure the ratio of Tier 1 Capital to all assets, without regard to risk.

Under the final revisions, global systemically important banks (G-SIBs) will need to maintain a leverage ratio buffer, the design of which is similar to the risk-weighted capital conservation buffer noted above. However, banks will have the ability to exempt from this requirement central bank reserves during “exceptional macroeconomic circumstances.”

Conclusion

Now the job is for each jurisdiction to adopt the revised standards. U.S. bank regulators issued a press release commending the conclusion of the process, noting the revisions “are intended to improve risk sensitivity, reduce regulatory capital variability, and level the playing field among internationally active banks.” The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, “U.S. banking agencies support conclusion of reforms to international capital standards,” Dec. 7, 2017. However, the regulators did not indicate wholesale acceptance of all the changes, noting only that the “agencies will consider how to appropriately apply these revisions to the Basel III reform package in the United States.” As noted in other of my columns, the United States has in the past gone beyond the minimum international standards, a position criticized by the Trump Administration in its ongoing deregulation initiative.

One can think of the Basel Committee’s risk-based capital standards as the engine of a car that needs continual care, maintenance and the occasional upgrade. As I have noted in previous columns, capital is the engine that allows a banking organization to be able to exist. While the Basel Committee does have other things to do than continue to tinker with these basic risk-weighted capital standards, one can assume this will not be the last time that we will see more upgrades that countries will need to consider implementing for their banks.

Kathleen A. Scott is a senior counsel in the New York office of Norton Rose Fulbright.