If adopted and implemented globally, these proposals would have broad ramifications across the banking world, including fundamental shifts in how banks view and price risk in their businesses. The two documents are inextricably entwined.
"The intricate web of measures might look complex (but), they actually sacrifice sophistication in the management and measurement of risk."
Brad Carr, Brad Carr, Senior Policy Adviser, Institute of International Finance
The concept of the Capital Floor would mean that where some banks are currently accredited by their regulators (such as APRA, the Australian Prudential Regulation Authority) to use sophisticated risk models, they would be subject to new ‘floors’ based on the Standardised Approach to capital, hence the links.
Such is the scope of the change implied by the mix of a new capital floor, revisions to the Standardised Approach and the introduction of Basel 3’s Leverage Ratio, that some suggest it represents a shift to “Basel 4” or at least “Basel 3+”.
The issue is while the intricate web of measures might look complex, they actually sacrifice sophistication in the management and measurement of risk, particularly for the larger banks that are of greater systemic importance.
Far from continuing the evolution of risk models, this would unfortunately make banks’ key performance measures and strategic decision-making less sensitive to their underlying risk. Rather than Basel 3+, more akin to ‘Basel 1.5: Back to the Future’.
Standardisation and Simplification
The Basel Committee has been careful to not pre-empt the level of its proposed floor (and has canvassed feedback on the floor’s mechanics) but it is significant it looks to use the Standardised Approach as its reference point.
The Standardised Approach has been the domain of banks with smaller balance sheets or narrower business models. The new floor proposal means it suddenly comes into play as a major (and potentially predominant) factor in the capital requirements for all banks, regardless of size or complexity.
This means we need to look closely at the specifics within that approach. Under the status quo, the Standardised Approach recognises assessments from credit ratings agencies for loans to those sovereign, institutional and corporate entities that are externally rated.
For unrated exposures, there is no variability for individual borrowers’ risk characteristics – all corporate and SME loans are assumed to have the exact same level of risk, as are all mortgages. As such, the current Standardised Approach resembles the Basel 1 conditions that prevailed pre-crisis. There is no real discrimination even though we know the risk characteristics can be radically different.
The Basel Committee’s proposed revisions to the Standardised Approach would make a number of changes, firstly by removing the use of external credit ratings altogether. This move is motivated by the widespread criticism of ratings agencies’ assessments of structured securitisations and some sovereigns during the crisis, notwithstanding the fact their ratings of banks and corporates were mostly vindicated.
Each class of borrower would instead have a series of blunt risk-weights applicable, via a simple matrix.
For instance, for corporates and SMEs, the applicable risk-weighting on each loan would be determined by the combination of their size (expressed in terms of their amount of revenue) and their leverage, as follows: