Read the Opinion from the ECB

  • Source: ecb.europa.eu

Treliant Takeaway:

Treliant’s Capital Markets consulting services offers end to end program and implementation support covering the entire spectrum of Basel IV capital standards including the credit risk, market risk, and operational risk. Treliant’s global, multi-disciplinary team of risk & regulatory SMEs, legal and technology experts, and regulatory advisors can assist institutions to conduct the regulatory gap analysis, design and implement the target operating model, and help obtain regulatory / supervisory approvals on the use of internal models.

Highlights:

General Observations:

ECB emphasizes the importance of finalizing the EU implementation of the Basel III reforms in a timely, full, and faithful manner. ECB also considers it important to fully implement the Basel III standards and is strongly attached to the faithful implementation of Basel III reforms and considers this important for financial stability, as well as for the EU’s international credibility.

Output floor related views from ECB

ECB emphasizes that output floor is an important element of the Basel III reforms. It reduces unwarranted variability of risk-weighted assets across institutions, thereby reinforcing the level playing field and strengthening the prudential framework.

  1. ECB notes that there are transitional arrangements leading to lower risk weights than those envisaged in the Basel standards in some specific areas, namely
    1. residential real estate exposures with low historical losses,
    2. exposures to unrated corporates, and
    3. the calibration of counterparty credit risk related to derivative exposures.
      The ECB considers that these deviations from the Basel III standards are not justified from a prudential and financial stability perspective and may leave pockets of risks unaddressed.
  2. The transitional treatment of residential real estate (RRE) exposures in particular poses several concerns resulting in further fragmentation inside the EU banking market, insofar as institutions may be subject to different capital requirements for similar risks, depending on Member State implementation. Given these concerns, the ECB considers that there should be no such preferential treatment of RRE. If retained, this mechanism should be of a strictly temporary and limited nature.
  3. ECB is also concerned about the transitional provisions pertaining to unrated corporates. Under the Basel standards, lending to such corporates comes with a higher risk weight, which reflects the higher uncertainty about their actual riskiness. Lowering the risk weight based on a bank’s own risk estimates weakens the purpose of the output floor, which is to protect against the underestimation of risks by institutions’ own models, as institutions could rely on their own probability of default (PD) estimates for attributing a lower risk weight to corporates. The Commission proposes to make the application of a 65% risk weight conditional on an estimated one-year probability of default that could be as high as 0.5%. The ECB considers that this is too broad, as it could cover corporates with elevated risk profile. Given the risks involved, the ECB therefore considers that no such exception for unrated corporates should be made.
  4. SA-CCR output floor – ECB cautions against any change to the treatment of counterparty credit risk related to derivative exposures in the context of the output floor, be it temporary or permanent. The ECB is concerned that any change in the calibration of the standardized approach for measuring counterparty credit risk exposures (SA-CCR) would leave some prudential risks uncovered and would underestimate the exposure amount for counterparty credit risk

SA Approach to Credit Risk related views from ECB

While ECB welcomes the new standardized approach for credit risk, it also notes these proposals contain several new deviations from Basel III standards, especially as regards

  1. specialized lending exposures,
  2. equity exposures,
  3. retail exposures and
  4. the methodology for collateral valuation for exposures secured by immovable property

ECB considers that these deviations may altogether reduce the consistency and safety of the new standardized approach and leave certain risks uncovered. This could in turn leave banks without sufficient available capital in case risks materialize in these market segments.

Operational Risk observations from ECB

ECB welcomes the Commission’s decision to implement the new standardized approach for operational risk in accordance with the Basel III framework, which aims to increase the comparability and simplicity of the calculation of own funds requirements. However, ECB favors an implementation where the internal loss multiplier is determined by historical losses incurred by the institution and gradually introduced. ECB also notes that supervisors are required to take into account the quality of risk management and loss history while defining the risk profile and capital requirements under the ‘Supervisory Examination and Review Process’ (SREP).

Market Risk observations from ECB

ECB calls for a faithful implementation of these internationally agreed standards by 2025. This would be important to provide clarity to institutions and ensure the soundness of the EU Single Rulebook, whilst avoiding negative implications for institutions’ internal implementation plans and the application and approval process for internal models.

ECB welcomes the clarity provided by the Commission proposal on the minimum frequency applicable under the look-through approach when collective investment undertakings are included in internal models. At the same time, the ECB is concerned that such a treatment might lead to some risks not being included in the internal model, and therefore suggests to add a separate requirement to identify, measure and monitor the relevant risks in case no daily look-through approach is used.

CVA (Credit Valuation Adjustment) Risk observations from ECB

ECB wants a disclosure requirement to be implemented with regards to the open hedges for CVA of EU-exempted counterparties.

IRB Approach observations from ECB

ECB welcomes the proposed changes to the IRB approach for credit risk, in accordance with the final Basel III package, as they are deemed necessary to maintain risk sensitivity whilst significantly reducing the scope for unwarranted risk-weighted exposure amount (RWEA) variability.

The ECB supports the proposal to disallow:

  1. the use of the advanced IRB (A-IRB) approach for exposures to large corporates, exposures to credit institutions and investment firms and to financial institutions treated as corporates and
  2. the use of IRB for equity exposures.

Likewise, the ECB supports the:

  1. implementation of the input floors on risk parameters, which will ensure a minimum level of conservatism in model parameters, while reducing undue RWEA variability.
  2. additional clarifications and enhancements related to the estimation of PD, loss given default (LGD), and credit conversion factors (CCF).

 

Author

Kishore Ramakrishnan

Kishore Ramakrishnan is Delivery Partner and Regulatory Change Practice Lead (Europe) at Treliant. He has over 20 years of global industry and consulting experience across the banking, capital markets, asset, and wealth management businesses. Kishore is a trusted advisor and respected thought leader in the risk, regulation, and compliance domains…