The financial supervision demands imposed on banks have significantly increased since the financial crisis broke out. With the introduction of Basel III, both the quantity and quality of capital requirements were increased, a leverage ratio was introduced, and quantitative requirements were imposed on the level of liquid assets and long-term funding to be maintained. One of the last steps to be taken in the completion of the post-crisis supervisory framework is the review of the determination of risk-weighted assets, which constitute the basis for the risk-weighted capital requirements of banks.
Determination of risk weightings for capital requirements
Banks are allowed to use internal models to determine their required capital, providing these models comply with the requirements set by the supervisory authorities. A big advantage of the internally modelled approach is that capital requirements rise in tandem with the institution's risk profile (risk sensitivity). This also stimulates banks to improve their quantitative risk management. The current implementation of this approach also has its weaknesses, however. Banks are for instance given considerable room for bank-specific interpretation, and transparency about the relationship between risks and model outcomes is limited.
The alternative for determining capital requirements is the standardised approach: a simpler but less risk-sensitive method of determining risk weightings.
Review of the standardised approach and the internally modelled approach
The Basel Committee is currently reviewing the standardised approach. The purpose of the review is to enhance the risk-sensitivity of the standardised approach and to reduce the use of external ratings. See http://www.bis.org/bcbs/publ/d307.htm
The Basel Committee is also working on proposals intended to respond to the lack of confidence in the use of internal models by banks. Important elements here are the ongoing harmonisation of internal models and the increased transparency on the model outcomes. We also refer you to the answers of the Minister of Finance to Parliamentary questions on this subject. [in Dutch]
In addition to proposing immediate improvements to the internal model-based approach, the Committee has made a proposal to enhance the comparability of the capital requirements of banks using internal models. In early April, the Committee completed a consultation round in which the financial sector was asked to respond to proposals to subject risk-weighted assets based on internal models, to a minimum level ( floor). The proposed floor is expressed as a percentage of risk-weighted assets that would apply under the standardised approach. See http://www.bis.org/bcbs/publ/d306.htm
Impact of the proposals
The impact of the various Basel proposals is as yet unclear as the proposals are still to be finalised. What is clear, however, is that the proposed risk weightings under the reviewed standardised approach combined with the proposed floor could significantly increase the capital requirements for Dutch banks.
For Dutch banks, the impact may be considerable as the internally modelled approach generally leads to lower risk weightings than the standardised approach. The difference is particularly significant for Dutch mortgage portfolios as the risk weightings based on internal models are relatively low, due to the low credit losses on Dutch mortgage portfolios, while risk weighting based on the standardised approach will be relatively high as this approach to a large extent depends on the loan-to-value ratio of mortgages. This is because the loan-to-value ratio, i.e. the value of the mortgage loan as a percentage of the value of the underlying collateral, is relatively high among Dutch mortgages.
The increasing importance of loan-to-value ratios could also push up capital requirements for Dutch banks using the standardised approach for risk weightings of mortgage portfolios.
It is important to formulate capital requirements that are consistent with the level of risk in the portfolios to which they apply. In the Basel Committee on Banking Supervision, De Nederlandsche Bank is pressing for an approach that does justice to the risk profiles of Dutch mortgage portfolios. That said, by its very name, no international standardised approach will fully take into account all regional differences in risk profiles.
Next stages in the process
The Basel Committee is not expected to take any decisions on the review of the standardised approach and the proposed floor before the end of 2015. The Basel agreements will serve as a basis for the European Commission to prepare the relevant legislation. Processes of this kind usually take several years. Until there is more clarity on the final outcome of the capital requirements review, banks would do well to factor in an increase in capital requirements in their strategies and business operations.