New constraints threaten the future of internal model approaches

At the same time as regulators as a whole express their support for the harmonisation, transparency and comparability of banking models at the European level, a new consultative document published by the Basel Committee on 24 March 2016 partly calls into question the use of internal model approaches when evaluating credit risk.

The release of the consultation comes as a shock, particularly as the Basel Committee’s consultation on a revised approach for measuring counterparty credit risk exposures (SA-CCR) ended only 3 weeks ago, and the uncertainty on the design of capital floors remains.

Following the announcement of the withdrawal of internal modelling for operational risk regulatory capital from the Basel Framework, the Basel Committee has now proposed changes to the use of internal model approaches when evaluating credit adjustment risk (IMA-CVA).

This change is surprising inasmuch as the approach was proposed in a consultation as recently as July 2015. The Basel Committee noted that CVA risk will be significantly reduced by greater use of central clearing and margining for non-centrally cleared transactions and concluded that the additional complexity of the IMA-CVA is therefore not warranted.

Yet the CVA VaR (value at risk) requirements under the Basel III regime have already generated significant costs of implementation, which now become superfluous, and at the same time the capital charge is set to rise significantly.

In addition, the consultation outlines proposals to prohibit the use of internal models for certain asset classes and the introduction of exposure level floors in certain circumstances.

The prohibition applies to portfolios involving banks and other financial institutions, large corporates and equities whose credit risk exposures are deemed not capable of being modelled sufficiently reliably or consistently for use in determining regulatory capital requirements. Exposure level floors will apply to probability of default (PD) and loss given default (LGD) for portfolios remaining eligible for use of IRB (Internal Rating Based) approaches; PD for portfolios remaining eligible for use of foundation IRB (F-IRB) approaches; and on the Credit Conversion Factor (CCF) used to determine exposure at default (EAD) for off-balance sheet items. The new floors are not without consequence as they produce RWA (risk-weighted asset) amounts sometimes greater than those calculated by use of the standard approaches.

The Basel Committee proposes to retain the internal model method for counterparty credit risk (IMM-CCR) subject to a floor based on a percentage of the applicable standardised approach (namely the standardised approach to counterparty credit risk (SA-CCR) for OTC (over-the-counter) derivatives and the new standardised approach for securities financing transactions). This is good news for the major French banking groups which currently apply IMM to more than 95% of their market transactions (source: 2015 reference documents.

However, the associated parameter estimation practices will also be subject to scrutiny. The Basel Committee pinpoints unwarranted variability in RWA in the context of the estimation of model parameters under the IRB approaches. In order to create a more harmonious approach, the Committee has proposed changes to the calculation of probability of default (PD); loss given default (LGD), credit conversation factor (CCF), and credit risk mitigation (CRM).

When assessing proposals, it is worth recalling that both France’s ACPR (Autorité de contrôle prudentiel et de résolution, responsible for supervising the banking and insurance sectors in France) and EBA (European Banking Authority) had already, last year, stressed the existence of significant disparities in RWA calculations using IRB approaches.

• In particular, the ACPR, in its March 2015 report on corporate portfolios, observed disparities in LGD for otherwise equivalent corporate portfolios arising from differences in the integration and modelling of applicable guarantees; the estimation of losses; and the margin of prudence to take account of estimation errors (cf. article 178 1.f) of regulation n°575/2013 dated 26 June 2013).

The EBA’s report of July 2015 also revealed strong disparities in PD/LGD estimates for corporate portfolios (under both the A-IRB and F-IRB approaches) and in LGD estimates for bank portfolios.

If portfolios involving banks, other financial institutions and large corporates are particularly targeted, the reason is no doubt also that historically they constitute portfolios subject to low rates of default, thereby rendering the estimation of losses all the more difficult. This factor was also stressed by the Basel Committee in the findings of a survey published in July 2013.

Details for the proposed capital floor proposals are of course not yet finalised, but the current consultation proposes an aggregate floor level of between 60 and 90% of RWAs calculated in accordance with the new standardised approach, which appears exorbitant.

The current CWA-based floor is much less severe because it includes fewer items in the denominator (excluding IRC (Incremental Risk Capital) and CRM (Comprehensive Risk Measure) for market risk, as well as CCP (Central Counterparty) risk and settlement risk for the CVA and operational risk). Also because the reinforcement of equity since the introduction of Basel III provides generous coverage of the current CWA-based equity requirement set at 8%*80%*CWA.

• All the proposals will be the subject of a QIS (Quantitative Impact Study) in the course of 2016, but it is already clear that whatever happens, the range of reforms applicable to credit risk has become considerable. Independently of the partial reconsideration of the very concept of internal model approaches, the current consultation raises essential questions on their relevancy and their degree of sensitivity to risk.

The trend towards ever more standardised models implies striking out the specific risk profile features associated with each individual institution and questioning the associated business model. In turn, this suggests the partial or complete abandonment of certain excessively capital-intensive financing arrangements (use of a cost/equity saving ratio).

Post written by Audrey Cauchet, Prudential Regulatory Affairs, Mazars France.