The BCBS 2017 Basel III reforms complement the initial phase of the Basel III reforms announced in 2010. The 2017 reforms seek to restore credibility in the calculation of risk weighted assets (RWAs) and improve the comparability of banks’ capital ratios among financial institutions.
Why are the 2017 reforms necessary?
- Credibility of the framework: A range of studies found an unacceptably wide variation in RWAs across banks that cannot be explained solely by differences in the riskiness of banks’ portfolios. The unwarranted variation makes it difficult to compare capital ratios across banks and undermines confidence in capital ratios. The reforms will address this to help restore the credibility of the risk-based capital framework.
- Internal models: The reforms introduce constraints on the estimates banks make when they use their internal models for regulatory capital purposes, and, in some cases, remove the use of internal models.
- While the first phase of Basel III focused largely on the capital side of the capital ratio calculation (the numerator), the 2017 reforms concentrate on the calculation of RWAs (the denominator).
Standardized Approach For Credit Risk
- Enhanced risk sensitivity while keeping the Standardized Approach for credit risk sufficiently simple.
- Provide for a more detailed risk weighting approach instead of a flat risk weight, particularly for residential and commercial real estate.
- Reduce reliance on external credit ratings.
- Require banks to conduct sufficient due diligence when using external ratings.
- Have a sufficiently detailed non-ratings-based approach for jurisdictions that cannot or do not wish to rely on external credit ratings.
IRB Approach For Credit Risk
In December 2017, Basel introduced the final standards on the IRB approach. These are widespread and affect all aspects of the Internal Rating Based approaches, including certain limitations on scope and restrictions across modelled risk parameters. Generally, The final rules represent a significant improvement on the existing regulatory rules.
Basel estimates that the impact of the changes will increase the minimum Tier 1 Capital requirement by 3.4% for G-SIBs, 2% for internationally active banks and 6.7% for other banks.
The impact will vary across banks. Banks using Advanced IRB approach are on average significantly more affected by the revisions than those using Foundation IRB approach.
The key changes are as follows:
- The removal of the AIRB approach for exposures to banks and other securities firms and financial institutions. These exposures should either be reported under STD or FIRB approach.
- The removal of the AIRB approach for exposures to Corporates and mid-sized corporates defined as corporates belonging to a group with total consolidated annual revenue greater than EUR500m. These corporates exposures should either be reported under STD or FIRB approach depending on supervisory permissions.
- Removal of options for Banks to report Equity exposures under IRB approach. That is, all equity exposures should now be reported under STD approach only.
- Specialized Lending exposures shall continue to be reported under IRB approach and STD approach.
- In the FIRB approach, the CCFs for off-balance sheet items have been aligned to the STD approach.