The Basel Committee on Banking Supervision's ("BCBS") newly-proposed methodology for calculating risk-weighted assets for credit, market and operational risks will increase banks' overall capital requirements but the committee has said this is not its aim.
The new methodology for calculating risk-weighted assets was an attempt by the committee to address the inconsistency in banks' risk-weighted assets when they use their own internal models to calculate their credit risk regulatory capital requirements.
According to Simon Topping, head of regulatory practice at KPMG China, BCBS' new methodology for calculating the risk-weighted assets for credit, market and operational risks will lead to a 20 to 30 percent increase in risk-weighted assets. This will in turn increase the capital requirements by the same percentage.
BCBS' Statements Contradict its New Proposals
Following its proposals on the new methodology, the Basel Committee issued statements, stating its intent was not to increase banks' overall capital requirements. Topping said these statements were inconsistent with the outcome produced by the new methodology for calculating risk-weighted assets, but he also pointed out that regulators' intent was not to require banks to hold more capital; they wanted banks to be more risk-based.
"The methodology they are preparing to bring in for risk-weighted assets is more risk-sensitive but, as currently calibrated would lead to an increase in capital requirements. As they are saying they are not looking to increase overall capital requirements, my guess is that they will retain the basic pattern they have been proposing but will recalibrate it downwards so that the overall effect is more neutral," he said.
A consultant in Singapore who asked not to be named said in addressing the inconsistency, the Basel Committee was trying to make the model risk-sensitive and yet still sensitive to the actual risk profile.
"The calculation of risk-weighted assets is the final discussion that is being debated at the BCBS level. There are also concerns about whether the change in the calculation for risk-weighted assets will result in different risks being distributed across products in a bank. For instance, will it end up with retail banking being more risky than wholesale banking?" he said.
Banks Lobbying for Internal Models to be Used
Banks are now in a dilemma as they await further clarification from the Basel Committee about the inconsistency. They have also been lobbying, in the hope that they can continue to use their internal models for calculating credit risk.
"Capital and risk sensitivity would both be affected if regulators [put] restraints on the use of internal models," Topping said.
Recalibrating the Methodology for Calculating RWAs
Topping said the committee could either stick to its previous proposal or recommend that regulators implement the new proposal, in which case it would have to recalibrate the methodology for calculating risk-weighted assets so that it will not lead to a 20 to 30 percent increase in capital requirements.
"BCBS overall aim is not to increase the amount of capital in the banking system. My guess is that it will be a combination of two things: BCBS will recalibrate the methodology for calculating risk-weighted assets and reduce the effect of the capital floors when banks use their internal risk-based models," he said.
Market and Operational Risks
The final framework for market risk has been agreed, however, and BCBS has recommended its implementation in 2019. The new market risk framework will introduce a revised internal model approach with a number of new features.
They include replacing value at risk calculations with an expected shortfall measure of risk to capture tail risks more effectively: calculating internal model and standardised approach capital charges at desk level with more stringent requirements on profit and loss modelling and on model validation, and putting a constraint on capital-reducing effects of hedging and portfolio diversification.
Banks have given up arguing for the use of internal models for calculating regulatory capital requirements for operational risk, which is no longer allowed under Basel Committee recommendations. The committee will introduce a single standardised measurement approach.