At the end of last month the European Commission published a consultation paper proposing new capital adequacy rules for European Union banks and securities houses. The move echoes a similar effort by the Basel Committee on Banking Supervision, which published a working paper to update its 1988 Basel Capital Accord earlier this year (DW, 6/7). However, once implemented the EU rules would cover a much wider range of banks than Basel, which is only targeting large international firms. Moreover, as opposed to the Basel proposals, the EU guidelines will be binding once they are adopted by European legislators. Comments to both the Basel and the Commission draft proposals are due by March 31, 2000.
In the first part of this paper, we address the treatment of credit risk in the Commission proposals and analyze how they compare to suggestions in the Basel discussion paper. In next week's issue we will compare the treatment of credit risk mitigation by both regulators. The document itself is available at http://europa.eu.int/comm/dg15/en/finances/
INTERNAL RATINGS-BASED APPROACH
"The Commission services recognise that pressure on the current framework of allocating capital charges in respect to credit risk has intensified to the extend that a major review of the regime is required."
The Commission backs the Basel suggestion of an approach to credit risk measurement based on internal ratings, but disagrees that this should be available only to sophisticated international banks. "The Commission services are of the view that such an evolutionary approach is best suited to delivering a regime which can be applied to a wider range of institutions ... ." The Commission argues that the majority of financial institutions of all sizes use some sort of internal loan grading system to determine and differentiate the credit quality of exposures, and that the proposal to base capital requirements on internal ratings should thus not be restricted to large institutions. An internal ratings approach is preferable because it incorporates customer information that is typically not available to external rating institutions, extends a risk-based approach to a greater number of counterparties and is consistent with the desire to implement prudent risk management.
However, the Commission recognizes that certain issues, including the lack of homogeneity among ratings systems at different institutions and definitional differences need to be addressed prior to implementing an internal ratings approach. It suggests mapping institutions' credit risk exposures into a series of risk weight "buckets," with banks using their own systems to allocate assets between those buckets. The Commission is asking the industry for suggestions as to how many buckets there should be, where the cut-offs are and how capital charges should be calculated for each bucket.
The Commission also wants to ensure consistency between the standardized approach and an internal ratings-based approach. It accepts that institutions may use internal ratings for some risks and the published risk weighting system for others but says this must be subject to appropriate minimum standards for allocating assets to avoid "cherry picking."
STANDARDIZED RISK WEIGHTING APPROACH
"One of the prime objectives of the capital review is to address deficiencies in the credit risk charges under the present framework. At present, there is almost no scope for differentiating between credit risk within classes of counterparty."
The Commission is addressing the revision of the standard risk weighting approach using external credit assessment institutions (ECAIs), such as external ratings agencies and credit registers, as proposed by Basel. According to the Commission, it is the only feasible way forward in refining the current system, other than internal ratings. Problems it identifies include the limited prevalence of ratings among the corporate and banking community, the appropriateness of ratings to particular classes of counterparties and the treatment in the case of multiple ratings.
Sovereign Risk
Currently exposures to governments enjoy a zero weighting, though exposures to countries not associated with the Organisation for Economic Co-Operation and Development or the International Monetary Fund attract a 100% weighting--except where denominated and funded in the national currency of the borrower, in which case it also gets a zero weighting. The Commission agrees with the indicative sovereign risk weightings set out by Basel, based on ECAI ratings, but proposes other measures of credit risk should be taken into account as well, such as export insurance agency categories. The Commission also suggests that the special treatment of banks' exposures in domestic currency and funded in that currency to their own sovereign could be discontinued.
Regional Governments And Local Authorities
Regional governments and local authorities in IMF- and OECD-affiliated countries currently are weighted 20%, unless the member states fix a zero weighting under certain circumstances. The Commission proposes either a "sovereign plus one notch" approach, or to use the lower rating if there is a difference between the regional government and the sovereign.
Credit Institutions
The Commission is rejecting Basel's proposal to weigh credit institutions one category higher that the rating assigned to the sovereign, taking the sovereign risk weight as a proxy for the credit risk, because it violates Article 6 of the Treaty of Rome and could cause problems for expansion of the European Union (DW, 6/28). Article 6 prohibits EU governments from discriminating against business in other member countries on the basis of their sovereign origin. The Basel suggestion would link the treatment of a credit institution to its nationality.
Though it does not oppose a weighting approach based on ECAIs, the Commission said it could be problematic because of the plethora of small, unrated institutions in Europe. It also suggests a floor for all claims on banks of 20% or a sovereign floor--no claim on a bank could receive a lower risk weight than that of its sovereign. Investment firms should receive the same treatment as credit institutions.
Corporates
At present, corporates attract a 100% risk weighting. The Commission is expressing concern over the low penetration of international rating agencies in Europe, with less than 1,000 corporates rated. It is thus wary of the Basel proposal of granting a 20% risk weighting to highly-rated corporates, and identifies a need to define quantitative and qualitative criteria that could be applied in the EU to assign corporates to a higher or lower risk category. Criteria that might be considered include external and internal ratings, as well as financial ratios or qualitative assessments of credit policies in the context of a supervisory review process.
High-Risk Items
The Commission does not rule out a risk weighting over 100%, such as 150%, for high-risk items, which could include exposures to:
* Low-rated counterparties or assets (B- and below)
* Highly leveraged institutions
* Some equity holdings
* Concentrated credit exposure
* Lack of credit information
* Impaired assets, such as defaulted loans that have not yet
been written off.
OTC Derivatives
A 50% cap applied to the risk weight of counterparties to OTC derivatives transactions should be abolished.
Securitization
The Commission retains the Basel proposal whereby notes rated BB- and higher will be weighted according to their rating, and all other notes will be deducted from capital. First loss credit support may be required to be deducted from capital whether provided by issuer, arranger or third-party institutions. Second loss credit support may be 100% weighted when provided by a third party.
ECAI CRITERIA
The Basel paper listed a number of criteria for ECAIs that should be eligible to play a role in regulatory capital allocation--objectivity, independence, transparency, credibility, international access and resources. The Commission says EU criteria should address two primary requirements: credibility and transparency. Options for the process of accreditation by EU member states include:
* Complete national discretion
* National discretion with mutual recognition
* National discretion with bounded mutual recognition
* Centralized recognition
* Subsidiarity--for national ECAIs, national discretion with
mutual recognition is applied; for international ECAIs, a
form of centralized recognition is applied.
Given the pivotal role that credit rating agencies will play in the new structure, the Commission envisages that EU governments will wish to encourage the development of national credit rating bodies, either by opening domestic credit registers to international access or from a standing start.
This week's Learning Curve was written by Elisabeth Bertalanffy, managing editor of Derivatives Week in London, with the help of Simon Gleeson, an attorney in Allen & Overy's financial services group.
