International Regulators Fail to Agree on Proposed Capital Floor for Internal Risk-Based Model

A recent leaked Basel Committee on Banking Supervision document on the proposed capital floor rules for calculating risk-weighted assets using internal risk-based ("IRB") models shows regulators are caught in a quagmire. 

The document shows the Basel Committee has proposed 55 percent as the capital floor for the IRB approach used by banks to calculate credit risk. The proposed capital floor will take effect in 2021 and will gradually increase by 5 percent until it hits 75 percent in 2023. 

But many European regulators could not agree on the 55 percent proposed capital floor largely because it will have different implications for different countries in continental Europe as well as banks in the United States. 

United States versus Europe

A source who declined to be named said this was a debate between the United States and certain European countries, largely because the former felt that a higher capital floor should be imposed. US regulators have introduced a 90 percent capital floor on their banks which use the IRB approach to calculate credit risk. 

Regulators in France, Italy and Spain, however, prefer to impose a lower capital floor for the IRB approach because they are aware that their banks will have difficulty meeting a high capital floor due to the lack of capital, the source said. 

The issue has become irresolvable as regulators each have their own idea about what the appropriate capital floor should be. The source said the only way to resolve the problem is for European banks to use the IRB model, which will produce lower risk-weighted assets, and that this will in turn make the capital ratio appear acceptable to regulators. 

"It is no longer a question of risk but practicality," he said. 

The source said a higher capital floor makes sense, and a logical floor should start at 75 percent and increase by 5 percent per annum. The Basel Committee's proposed 55 percent capital floor is considered low and may not help to reduce risks in the banking system, he said. European regulators are aware that their banks will not be able to meet the requirements if the floor starts at 75 percent. 

But Keith Pogson, senior partner, financial services at EY in Hong Kong, said it is difficult to say with certainty whether a 55 percent capital floor is too low without first conducting a stress test. 

"Most banks are more confident with the low numbers, not the high numbers. It is just where it bites, on what products," he said.

Difficult Topic, Subtle Discussion

The topic of what would be the appropriate capital floor is a difficult one, and a subtle discussion as well, largely because it is about its impact on a country's economy. 

"In Europe where the biggest factor is predominantly credit risk, using [the] IRB approach will give a very different outcome than the standardised approach, particularly for things like mortgages and securitisations," Pogson said.

Pogson cited Germany and the Scandinavian countries as examples whereby credit risk for assets such as mortgages is generally low. Banks in these countries often take advantage of the results produced by the IRB model to net down their risk-weighted assets. Using the standardised approach, which takes a basic view on credit quality, shows a relatively high credit risk which he said, is disproportionate to the real credit risk.

"If regulators impose a high floor on the standardised approach, it will penalise banks quite heavily. That's why a number of European regulators are quite worried about the floor. My understanding is that a number of European regulators are not happy with this," he said. 

Scandinavian and German banks typically carry a lot of mortgages in their books, but despite that, have low default on mortgages as it is considered socially unacceptable to default on mortgages, according to Pogson. This explains the relatively low risk in the Northern European and German banking systems.

"They just have [a] very different risk history. It is not that the Scandinavian banks or the German banks are in a bad place. The marketplace is very different," he said. 

If the standardised approach is introduced, it is effectively implementing an approach on some products for which it does not deal with well, Pogson said. The standadised approach will penalise mortgages with high loan-to-values, among other things, which will lead to a strange outcome.

Governments are concerned about the regulatory implications of the proposed capital floors. If regulations make it too expensive for banks to offer certain products, this may discourage banks from lending to corporates or individuals for instance, which is not good for the country's economy.

"It will be inappropriately penalising the products and the country because banks will reduce the amount of exposure to the products, and this is bad for the country. It's about macro economy and the credit of the country," Pogson said.

Two Factors to Consider

Pogson said two factors need to be taken into consideration when applying the capital floor: the transition path to the floor and the finite level of the floor. A number of European countries are said to prefer a lower number at the beginning of the transition and at the finite point. 

The capital floor was originally slated to take effect in 2020 and banks are supposed to start from a low threshold in 2018 and gradually increase it over time. Given the tight timeframe, the Basel Committee has pushed back the starting time to 2021 but concerns remain as to the appropriateness of the proposed capital floor.

Asian Banks Less Affected

The Basel Committee's proposed capital floor is less of a concern to Asian regulators because Asian banks rely less heavily on IRB models than their counterparts in Europe and the United States and they tend to be heavily capitalised. Pogson said this is largely because Asian regulators are conservative in their capital requirements.

Jurisdictions: 

Patricia Lee is a South-East Asia editor at Thomson Reuters Regulatory Intelligence in Singapore. She also has responsibility for covering wider G20 regulatory policy initiatives as they affect Asia.