The Basel Committee is currently conducting work on a revision of the standard approaches to risk (credit, market and operational) and prepares for the arrival of Basel IV. In this context, the Panel is considering an evolution of the floor of regulatory capital based on these standard approaches in replacement of the transitional floor existing under Basel II
The transitional capital floor, an outdated system
Under Basel II the banks using an approach based on internal models (IRB) for the credit risk and/or an approach advanced measurement (AMA) operational risk were subject to a floor of capital. The objective of this floor was to maintain regulatory capital at a level higher than 80% of the equivalent under Basel I. This system, implemented during the passage of Basel I to Basel II, becomes obsolete for the following reasons:
The legacy of Basel I: banks implemented Basel II/III without having implemented Basel I have no systems to calculate the floor of capital.
Changes in the structure of capital: regulations Basel 2.5 and Basel III brought additional charges of capital which in some cases may not be captured in the floor (i.e. Credit Valuation Adjustment).
A new floor of capital in discussion
Beyond the need for evolution, the Basel Committee wished to strengthen the comparability of the banks capital requirements. On December 22, 2014 consultation was intended to define a non-transitory capital floor that would replace the current floor.
This new floor based on standard approaches must meet the following objectives:
Ensure that the modelled capital requirements do not fall below a prudent level, including by preventing excessive optimism in modelling of Bank practices.
Reduce regulatory capital variations between banks by improving the comparability of risk and limiting the variation between models of calculation of risk-weighted assets.
The level of aggregation of risks for the calculation of floor discussion
The Basel Committee provides two methods for calculation of the floor:
(1) a floor for each category of risk
A floor would be applied to each type of major risk (credit risk, market risk and operational risk) and correspond to a percentage of their respective standard approach.This method has the advantage of not allowing compensation between the variouscategories of risk and to be more judicious when banks use internal models on a limited number of categories of risk.
2) a unique floor on the associate RWA
With this method, the floor would be a percentage of assets weighted by risk (RWA)in standard approach. This would allow a communication and an interpretation easier as in the method 1 but would require a higher calibration to get the same impacton the capital. :
The objective of the Basel Committee is developing measures to constrain the risk of model at the level of the exposure categories, for example for low default portfolios. That is why the approach by risk category is more accurate than the aggregate method, despite its greater operational complexity.
A complex process of reprocessing of provisions related to credit risk
The regulatory treatment of provisions for losses on loans is different depending on the approach chosen for the risk of credit (IRB or standard approach). These differences in treatment are material in the calculation of the floor of capital and their adjustment induces a greater complexity in the calculation.
The Basel Committee proposes two process of reprocessing of provisions:
Adjust the capital by converting the result obtained by the IRB method capital obtained by standardized method.
Adjust the calculation of the RWA by converting the provisions concerned “equivalent RWA” and adding / subtracting at the RWA used for calculation of the floor of capital.
The capital floor, a complementary regulations in the leverage Ratio
We can legitimately question the role of the floor of capital compared with the Ratio of leverage at the sight of their similarities. Reminder, the leverage Ratio means own funds on the exposure report.
The floor of capital and leverage Ratio are both complementary requirements for bearing the inherent limitations of the regulations and thus reinforce confidence in thebanking system. The following table describes the role that these two ratios take in this context.
Regulators see in the redesign of the floor of capital increased harmonization of theprudential system; but the key issue will be the value taken by the floor of capital after calibration of standard approaches and in particular that concerning the credit risk. This could help to reduce the real gain from banks to apply a management of their risks in advanced method of the fact of a lesser reduction of their regulatory capital. Beyond the methodological considerations, the introduction of the floor of capitalbased on standard methods will certainly add to the stack of regulations that obligebanks to review their business model.