Basel Committee revamps approach to credit risk models

The Basel Committee on Banking Supervision has published consultation documents on changes to its standardised approaches to modelling credit risk, and proposals for a "capital floor" that seek to limit banks' internal risk assessments.

The standardised approaches to modelling credit risk are targeted at smaller banks that may be less sophisticated and less likely to benefit from the complexities of the internal ratings-based (IRB) approach employed by the largest global banks.

However, the current standard approach to risk modelling has a number of drawbacks, the committee said, perhaps most importantly its reliance on external ratings, the shortcomings of which were thrown into stark relief during the financial crisis.

"The hard-wiring of external credit assessments into standards, laws and regulations may often lead to mechanistic reliance on ratings by market participants, resulting in insufficient due diligence and poor risk management," the Basel Committee said.

But the committee did acknowledge the ratings played an "important" role in financial markets, and could potentially be used as a limited part of the modelling process.

In the place of external ratings, the Basel Committee proposes the use of certain "risk drivers" – for example, in the case of exposures to banks, these would be the bank's capital adequacy and asset quality.

The adjustments to the standardised approaches also aim to improve granularity and risk sensitivity, update calibrations, improve clarity and simplicity, and make the standards more comparable with the IRB approach.

Capital floors

Banks are already subject to transitional capital floors based on the Basel I framework, but the Basel Committee has proposed replacing this with a floor based on the standardised approaches to risk modelling.

The aim is to prevent banks with more sophisticated risk models from holding significantly less capital than those using a standardised approach.

The Basel Committee hopes to reduce model risk and measurement error, while encouraging consistent application of the capital requirements and making sure capital does not fall too far.

The floors would be calibrated as a percentage of the standardised approaches to modelling different forms of risk – credit, market, counterparty and operational risk. The forms of risk could either be aggregated or calculated separately, and the committee asks for comments on each approach.

The Basel Committee intends to set the calibration of the floor separately to the current consultation, which is focused on methodology.

Both consultations are open until March 27.