Download Workshop 1 The regulatory treatment of “risk

24-25 SEPTEMBER
TIANJIN
2014
International Conference of Banking Supervisors
Venue: The Renaissance Tianjin Lakeview Hotel, Tianjin, China
The post-Basel III agenda
September 2014
Workshop 1
The regulatory treatment of “risk-free” exposures
Chair: Bryan Stirewalt (Dubai Financial Services Authority)
The financial crisis has highlighted a number of issues with exposures perceived as “risk free” under the
regulatory capital regime. In the first phase of the crisis, many banks suffered significant losses from
assets held in their trading books which were perceived as risk-free by banks’ market risk models. Low
price volatility under benign market conditions as well as a number of modelling assumptions which
turned out to be inappropriate contributed to this effect. The Committee addressed many of these issues
in the Revisions to the Basel II market risk framework in 2009 and 2010. However, the significant rise in
sovereign risk since 2009 raised questions regarding the regulatory treatment of “risk-free” assets in the
banking book as well.
1.
Introduction
Under the Basel capital framework, sovereigns include central banks, certain public sector entities
identified as sovereigns, certain multilateral development banks as well as the Bank for International
Settlements, the International Monetary Fund, the European Central Bank, the European Community, the
European Stability Mechanism and the European Financial Stability Facility. 1
For some banks, exposures to sovereigns represent a significant share of their overall exposure.
Analysis of end-June 2012 data from the Committee’s Capital Monitoring database, which is covering
banks applying the internal ratings-based approaches to credit risk, showed that on average 14% of the
banking book exposure-at-default of these banks can be attributed to the regulatory sovereign
portfolio. However, there is significant variation across the banks in the sample, ranging from a zero
share to a share as high as 48% (see Table 1). Exposures held in banks’ trading books are not included in
these numbers.
1
See paragraphs 53 to 59 of the Basel II framework.
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Share of sovereign exposures in overall credit exposure (EAD)1
In per cent
Table 1
Mean
Median
Minimum
25th percentile
75th percentile
Maximum
14
5
0
0
15
48
1
Exposures are post credit risk mitigation and after applying credit conversion factors where applicable. For some banks sovereign
exposures may exclude those exposures which are subject to partial use of the standardised approach.
Source: Capital Monitoring exercise of the Basel Committee, end-June 2012 data. Published in: Basel Committee on Banking Supervision,
Regulatory Consistency Assessment Programme (RCAP) – Analysis of risk-weighted assets for credit risk in the banking book, July 2013,
pp 50.
Graph 1 shows the development of the share of sovereign exposures relative to total banking
book exposures for the smaller sample of 30 Group 1 banks2 in nine Basel Committee member countries
for which these data are available over the full period from the end of December 2008 to the end of June
2012. The average share of sovereign exposures for this sample of banks increases from 11.4% at the
end of December 2008 to 19.1% at the end of June 2012. However, there is substantial variability across
banks and countries.
Share of sovereign exposures in total banking book exposures1
Consistent sample of 30 Group 1 banks
Graph 1
In per cent
1
Exposures are post credit risk mitigation and after applying credit conversion factors where applicable. For some banks sovereign
exposures may exclude those exposures which are subject to partial use of the standardised approach.
Source: Capital Monitoring exercise of the Basel Committee, published in Philip Turner, “Benign neglect of the long-term interest rate”, BIS
Working Papers No 403, p 44.
2
Group 1 banks are those that have Tier 1 capital in excess of €3 billion and are internationally active. All other banks are
considered Group 2 banks.
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2.
Treatment of sovereign risk in the Basel capital framework
It is sometimes asserted that the Basel capital framework prescribes a zero risk weight for bank
exposures to sovereigns. However, Basel II and Basel III call for minimum capital requirements
commensurate with the underlying credit risk, in line with the objective of ensuring risk sensitivity.
2.1
Sovereign exposures in the banking book
In most jurisdictions, the treatment of sovereign exposures in the banking book follows the Basel II
framework, which Basel III has not changed.3 Jurisdictions typically allow banks to choose from the
standardised approach to credit risk, which relies on external credit ratings; and the internal ratingsbased (IRB) approach, which relies on banks’ own risk assessments.
2.1.1
IRB approach
Across all regulatory portfolios the most relevant standard for internationally active banks is the IRB
approach. This approach has been designed bearing in mind the world’s largest banks, including global
systemically important banks. The IRB approach requires banks to assess the credit risk of individual
borrowers, including sovereigns, using a granular rating scale, accounting for all relevant differences in
risk with a bespoke risk weight per exposure. Risk weights are primarily determined by banks’ own
estimates of probability of default (PD) and loss-given-default (LGD) for a given exposure. While the IRB
framework prescribes a 0.03% floor for banks’ PD estimates for most borrowers, this floor does not apply
to sovereigns, and there is generally no floor for banks’ LGD estimates. However, the IRB framework
includes detailed qualitative minimum requirements, in particular a requirement for “meaningful
differentiation” of risk, and risk parameters are subject to validation.
For illustrative purposes, Table 5 in the Annex sets out PDs and their associated risk weights for
banks using the IRB approach assuming a maturity of 2.5 years and an LGD of 45%, which is the LGD of
senior unsecured exposures under the foundation IRB approach. Table 2 shows that the weighted
average PD of non-defaulted sovereign exposures for a sample of 67 banks subject to the IRB approach
to credit risk was 0.1% at the end of June 2012. The EAD-weighted average LGD was 30.0%.
3
Basel I’s treatment of sovereign risk was based on the distinction between OECD and non-OECD members. Under Basel I,
banks assigned a 0% risk weight to exposures to OECD member countries; exposures to non-OECD countries were assigned a
100% risk weight. The Basel I framework remains the minimum standard in some jurisdictions.
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PDs and LGDs of IRB banks’ sovereign exposures
In per cent
Table 2
Number of
portfolios
Mean
5th
percentile
25th
percentile
75th
percentile
95th
percentile
EAD-weighted PDs (including
defaulted exposures)
65
0.3
0.0
0.0
0.5
3.4
EAD-weighted PDs (excluding
defaulted exposures)
67
0.1
0.0
0.0
0.1
0.6
EAD-weighted LGDs
65
30.0
5.3
14.3
45.0
45.1
Source: Capital Monitoring exercise of the Basel Committee, end-June 2012 data. Published in: Basel Committee on Banking Supervision,
Regulatory Consistency Assessment Programme (RCAP) – Analysis of risk-weighted assets for credit risk in the banking book, July 2013,
p 53.
The resulting mean risk weights are 2.2% for banks subject to the foundation IRB approach and
3.1% for banks subject to the advanced IRB approach (Table 3). Again, there is significant dispersion
across banks, ranging from (almost) zero to 21.6% for foundation IRB banks and 46.3% for advanced IRB
banks.
Risk weight distribution for the sovereign asset class
In per cent
Table 3
Number of
banks
Mean
Median
Minimum
25th
percentile
75th
percentile
Maximum
FIRB banks
22
2.2
4.2
0.0
2.9
8.3
21.6
AIRB banks
44
3.1
4.1
0.2
1.8
7.6
46.3
Source: Basel Committee on Banking Supervision, Regulatory Consistency Assessment Programme (RCAP) – Analysis of risk-weighted
assets for credit risk in the banking book, July 2013, p 23.
2.1.2
Standardised approach
The standardised approach assigns risk weights based on external credit ratings. As shown in Table 4, it
assigns a positive risk weight to all but the highest-quality exposures (AAA to AA). However, national
supervisors are allowed to exercise discretion and set a lower risk weight provided that the exposures are
denominated and funded in the currency of the corresponding state. 4
Risk weights for claims on sovereigns under the standardised approach
Credit assessment
Risk weight
Table 4
AAA to AA-
A+ to A-
BBB+ to BBB-
BB+ to B-
Below B-
Unrated
0%
20%
50%
100%
150%
100%
Source: Basel II framework, paragraph 53.
4
See paragraph 54 of the Basel II framework. Where this discretion is exercised, and in order to ensure a level playing field,
bank supervisory authorities in other jurisdictions may also permit their own banks to apply the same risk weights to the
given sovereign under the same conditions, ie as long as those exposures are denominated and funded in the corresponding
currency.
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2.1.3
Partial use of the standardised approach
The Basel II framework is based on the premise that banks which adopt the IRB approach use it across
the entire banking group and across all asset classes. It recognises, however, that it may not be
practicable for banks to implement the IRB approach across all asset classes and business units at the
same time. Therefore, it allows national supervisors to permit their banks to phase in the approach
across the banking group. Furthermore, it allows them to keep some exposures in the standardised
approach indefinitely if they are in non-significant business units or in asset classes that are immaterial in
terms of size and perceived risk. As a result, the Basel II framework expects banks adopting the IRB
approach to move all material exposures to the IRB framework over time.
2.2
Sovereign exposures in the trading book
With the introduction of an incremental risk charge on the trading book, Basel 2.5 also improved risk
differentiation through the capture of default risk (including sovereigns) in the trading book for banks
which use their internal market risk models for such exposures. Banks which apply the standardised
measurement method to specific market risk are subject to capital charges which are derived from the
risk weights in the banking book described in Table 4.
2.3
Leverage ratio
In addition, the leverage ratio introduced in the Basel III framework acts as a backstop to the risk-based
capital requirements. Sovereign exposures are fully included in the leverage ratio exposure measure,
whether they are held in the banking or in the trading book. The capital measure for the purposes of the
leverage ratio is currently defined as Tier 1 capital, and the minimum leverage ratio is 3%. This compares
approximately to a 35% risk weight at a risk-based Tier 1 target capital ratio5 of 8.5%.
2.4
Large exposure regime
Paragraph 61 of the Committee’s Supervisory framework for measuring and controlling large exposures
exempts banks’ exposures to sovereigns and their central banks from the large exposure limit. This
exemption also applies to public sector entities treated as sovereigns according to the risk-based capital
requirement. Any portion of an exposure guaranteed by, or secured by financial instruments issued by,
sovereigns would be similarly excluded from the scope of this framework to the extent that the eligibility
criteria for recognition of the credit risk mitigation are met. However, a bank must report exposures
subject to the sovereign exemption if these exposures meet the criteria for definition as a large
exposure.
5
Ie a 6.0% Tier 1 minimum capital requirement plus 2.5% capital conservation buffer.
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2.5
Liquidity requirements
Under the Basel III liquidity standards, high-quality liquid assets are categorised into Level 1 and Level 2
assets. Highly rated sovereigns receiving a zero risk weight under the standardised approach to credit
risk form an important part of Level 1 liquid assets. For the banks included in the Committee’s most
recent Basel III monitoring report, these highly rated sovereign exposures represent approximately half
of their overall holdings of eligible liquid assets.6 However, highly rated corporate and covered bonds
also qualify as liquid assets (Level 2), albeit subject to some limits, including a 40% limit for Level 2
assets.
3.
Examples for national implementations of the Basel II framework to
sovereign exposures
There are significant differences in the application of the Basel rules across jurisdictions.7 As a
consequence of these differences, applied sovereign risk weights can vary considerably for large
internationally active banks.
3.1
United States
In the United States, internationally active banks are required to implement the IRB approach; partial use
of the standardised approach is not permitted. While IRB banks will also be subject to a floor based on
the standardised approach, the relevant risk weights can reach zero similar to the Basel II standardised
approach.
3.2
European Union
The European Union’s CRDs have introduced a generalised zero risk weight also for “exposures to
Member States’ central government […] denominated and funded in the domestic currency of that
central government”. Instead of confining the zero risk weight to the standardised approach, EU rules
permit a generalised zero risk weight to the sovereign debt of EU member states through the so-called
“IRB permanent partial use”, even if a bank otherwise applies the IRB approaches to credit risk.
According to the 2011 European stress test report only 36 out of the 90 participating banks applied their
own internal model to sovereign risk, a lower fraction than for other regulatory portfolios.8
6
Basel Committee on Banking Supervision, Basel III monitoring report September 2014, p 26.
7
Basel Committee on Banking Supervision, Progress report on implementation of the Basel regulatory framework, October 2013.
8
See Hervé Hannoun, Sovereign risk in bank regulation and supervision: Where do we stand?, speech at a Financial Stability
Institute High-Level Meeting, 26 October 2011.
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Q1. How have the Basel standards for treatment of “risk-free” assets been implemented in participants’
jurisdictions?
Q2. Do you have different regulatory treatment for “risk free” assets of your own country, versus
regulatory treatment of “risk free” assets of another country?
Q3. Do you use any additional methods to assess or limit the risk from banks’ exposures to sovereigns?
Q4. Have the Basel Committee’s Liquidity Coverage Ratio, Leverage Capital Ratio and/or Large Exposure
Regime affected the demand for, or trading patterns for, “risk free” assets in your country?
Q5. What steps could the Committee take to improve the treatment of “risk-free” assets?
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Annex
Illustrative IRB risk weights for sovereigns
Probabilities of default and IRB risk weights
In per cent
Table 5
PD
Risk weight
Capital charge
0.01
7.53
0.60
0.02
11.32
0.91
0.03
14.44
1.16
0.05
19.65
1.57
0.10
29.65
2.37
0.25
49.47
3.96
0.40
62.72
5.02
0.50
69.61
5.57
0.75
82.78
6.62
1.00
92.32
7.39
1.30
100.95
8.08
1.50
105.59
8.45
2.00
114.86
9.19
2.50
122.16
9.77
3.00
128.44
10.28
4.00
139.58
11.17
5.00
149.86
11.99
6.00
159.61
12.77
10.00
193.09
15.45
15.00
221.54
17.72
20.00
238.23
19.06
Source: Basel Committee on Banking Supervision.
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