December 22, 2014 SFIG Alert - Basel Committee Consults on Capital Floors, Standardized Approach
Today, the Basel Committee on Banking Supervision (“the Committee”) released two consultative documents (see below). Comments on both are due on March 27, 2015. As noted in an earlier SFIG Alert, the Committee released its Revisions to the Basel Securitization Framework on December 11, 2014.

I. Capital floors: the design of a framework based on standardized approaches
The Capital Floors Consultative Document outlines the Committee's proposals to design a capital floor based on standardized, non-internal modeled approaches. The proposed floor would replace the existing transitional capital floor based on the Basel I framework. The floor will be based on revised standardized approaches for credit, market and operational risk, which are currently under consultation.

The floor is meant to mitigate model risk and measurement error stemming from internally-modeled approaches. It would enhance the comparability of capital outcomes across banks, and also ensure that the level of capital across the banking system does not fall below a certain level.

As noted in the Committee's November 2014 report to the G20 Leaders, the Committee is taking steps to reduce variation in capital ratios between banks. The proposed capital floor is part of a range of policy and supervisory measures that aim to enhance the reliability and comparability of risk-weighted capital ratios. The Committee will consider the calibration of the floor alongside its work on finalizing the revised standardized approaches.

II. Revisions to the standardized approach for credit risk

This proposal seeks to strengthen the existing regulatory capital standard in several ways, including:
• reduced reliance on external credit ratings;
• enhanced granularity and risk sensitivity;
• updated risk weight calibrations, which for purposes of this consultation are indicative risk weights and will be further informed by the results of a quantitative impact study;
• more comparability with the internal ratings-based (“IRB”) approach with respect to the definition and treatment of similar exposures; and
• better clarity on the application of the standards.

The Committee is considering replacing references to external ratings, as used in the current standardized approach, with a limited number of risk drivers. These alternative risk drivers vary based on the particular type of exposure and have been selected on the basis that they are simple, intuitive, readily available and capable of explaining risk across jurisdictions.

Given the challenges associated with identifying risk drivers that can be applied globally but which also reflect the local nature of some exposures – such as retail credit and mortgages – the Committee recognizes that the proposals are still at an early stage of development. Thus, the Committee seeks respondents' comments and analysis with a view to enhancing the proposals set out in this consultative document.

The key aspects of the proposals are:

• Bank exposures would no longer be risk-weighted by reference to the bank's external credit rating or that of its sovereign of incorporation, but would instead be based on two risk drivers: the bank's capital adequacy and its asset quality.
• Corporate exposures would no longer be risk-weighted by reference to the borrowing firm's external credit rating, but would instead be based on the firm's revenue and leverage. Further, risk sensitivity and comparability with the IRB approach would be increased by introducing a specific treatment for specialized lending.
• Retail category would be enhanced by tightening the criteria to qualify for a preferential risk weight, and by introducing an alternative treatment for exposures that do not meet the criteria.
• Residential real estate would no longer receive a 35 percent risk weight. Instead, risk weights would be based on two commonly used loan underwriting ratios: the amount of the loan relative to the value of the real estate securing the loan (i.e., the loan-to-value ratio) and the borrower's indebtedness (i.e., a debt-service coverage ratio).
• Commercial real estate: two options are currently under consideration: 1) treating the exposures as unsecured with national discretion for a preferential risk weight under certain conditions; or 2) determining the risk weight based on the loan-to-value ratio.
• Credit risk mitigation: the framework would be amended by reducing the number of approaches, recalibrating supervisory haircuts and updating the corporate guarantor eligibility criteria.
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