Greater comparability in capital requirements across EU banks is likely to take time, Fitch Ratings says. Meanwhile, doubts surrounding internal ratings-based (IRB) models are likely to continue to undermine trust in regulatory capital ratios.
The European Banking Authority’s (EBA) consultation on the future of the IRB approach, which closed last month, included proposals for detailed changes to IRB models. Fostering supervisory convergence lies within the EBA’s remit, but to address some of the consistency and comparability issues, legislative changes, particularly to the EU’s Capital Requirements Regulation, will be required. This is likely to take considerable time.
Greater consistency in the way capital ratios are calculated is especially important because almost all the world’s 30 global systemically important banks use IRB models, as do most of the EU’s systemically important banks. Market participants mistrust capital ratios generated using IRB models to calculate risk-weighted assets (RWA) in part because model input variation and definition inconsistencies make meaningful comparison of ratios across banks and countries very difficult.
The Basel Committee on Banking Supervision’s Regulatory Consistency Assessment Programme (RCAP) initiative is making slow progress in reducing RWA variability and there is limited transparency on which banks’ ratios might be overstated. For example, in April 2015, the Committee announced it had agreed to remove just six of around 30 national discretions from Basel II’s capital framework.
The Committee’s reluctance or inability to name the banks whose capital ratios are overstated undermines confidence in the IRB models generally. The Committee’s EU Assessment of Basel III regulations report, published last December under the RCAP, highlighted that the exclusion of sovereigns and other public-sector exposures from the IRB framework, plus liberal risk weights for SME exposures, as permitted in the EU, positively affected the capital ratios of five EU banks. It did not name any banks. We understand that disclosure may be difficult because banks often participate in initiatives voluntarily and the Committee has no legal means to force disclosure.
Unwillingness to name names is not new. In July 2013 the Committee reported on a hypothetical portfolio benchmarking exercise across 32 major international banking groups and found material differences in IRB-calculated RWAs. The names of the outlier banks were not made public. This was also the case in the EBA’s reports, which analysed the consistency of RWA across banks, published in December 2013. A benchmarking exercise of SME and residential mortgages highlighted substantial variations. Naming the banks would be useful for market participants as it could shed some light on the banks’ estimated default probabilities and loss expectations, allowing analysts to adjust reported capital ratios if required.
The Committee’s November 2014 G20 presentation outlined five policy proposals to reduce excessive variability in the IRB approach. We think the most significant initiative is the proposal to introduce some fixed loss given default (LGD) parameters. LGDs, which measure the losses a bank would incur if a borrower defaulted, taking into account mitigating factors such as collateral, are a key input into the IRB models.
The EBA’s discussions on the IRB approach appear to be gaining momentum but its proposed timeline for defining technical standards is set at end-2016. Harmonisation of the definitions of default, LGD, conversion factors, probability of default estimates and the treatment of defaulted assets is essential as a first step towards achieving capital ratio comparability. We think delays to the EBA’s proposed timetable are likely.
