Basel II credit risk charge to be lower with modifications, says survey

Banks using a more complex risk measurement approach under the Basel II bank Accord, once potential modifications are put in place, would have lower credit risk capital charges than under the current Basel I Accord. This is the view of global banking regulators following the release of the Basel Committee on Banking Supervision's QIS 2.5 study.

A key aim of the proposed risk-based Basel II capital adequacy Accord is to ensure there is an incentive for banks to use the so-called foundation internal ratings based (IRB) approach to calculating credit risk capital charges.

The results of QIS 2.5, a limited quantitative impact study conducted in November last year, showed that on average, across the 38 banks sampled, credit risk capital charges would decline by 8% with the modifications compared with Basel I, the Basel Committee said today. The decline would apply to the core portfolios, namely corporate, sovereign, interbank and retail.

This compares with an increase of 14% indicated in an earlier and more comprehensive survey, QIS 2. But QIS 2.5 still showed that Basel II, which will determine from late 2006 how much capital major banks must set aside against market and operational risks as well as credit risks, would result in a small overall 2% increase in capital charges compared with Basel I, assuming an op risk capital charge of 10% of current minimum regulatory capital. QIS 2 had indicated an overall increase in charges of 24%.

The Basel Committee said the comprehensive QIS 3 – the key third Basel II quantitative impact study that the regulators hope to issue on October 1 – will analyse the effects of the new proposals on all portfolios. QIS 3 will encompass results on all three credit risk approaches proposed under Basel II, including the simple standardised approach as well as the foundation and advanced IRB approaches.

The modifications considered were: adjusted risk-weight functions for various portfolios under the IRB approach; a revised treatment of specific provisions under the IRB approach where these could be used to offset the expected loss portion of capital requirements of loans falling into the defaulted loan category; a revised treatment of general provisions, where these provisions could be offset against expected loss changes; possible elimination of the granularity adjustment under the IRB approach; the removal of the so-called w-factor when treating credit risk mitigation techniques; and greater recognition of collateral.

Basel II aims to encourage major banks to measure and allot protective capital according to the risks they actually face. Banks using sophisticated internal models to measure their risks should enjoy lower capital charges than banks using cruder methods.

Basel II will apply to large international banks of the Group of 10 leading economies, but it is designed for banks of all sizes and from all geographies. Basel I, the less complex, ‘one-size-fits-all’ capital adequacy Accord that dates from 1988, has been adopted in over 100 countries.