Banks’ Internal Rating Models – Time for a Change? The System of Floors as Proposed by the Basel Committee

Author (Corporate)
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Series Details November 2016
Publication Date November 2016
ISBN 978-92-846-0196-7
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Please note: Each In-Depth Analysis is assigned a DOI (digital object identifier), which is a safe and long term way of ensuring a hyperlink to the full text of this report. However, when ESO creates this record, on occasion the DOI still has not been activated by the EU Bookshop. If you find the source url hyperlink does not work please use the alternative location hyperlink listed as a related url.A series of three separate externally produced Briefings provided in advance of the public hearing of the Chair of the Single Supervisory Mechanism in the European Parliament Economic and Monetary Affairs Committee (ECON) on 9 November 2016.

1. Source url: The authors provide an assessment of the BCBS proposal on restricting the IRB approach and introducing RWA floors. If well enforced, risk-sensitive capital regulation results in a more efficient credit allocation compared to the SA. Thus, IRB should be maintained. Further, the use of IRB output floors potentially results in unintended negative side effects. Input floors are likely a valuable tool to achieve RWA comparability. Finally, the proposed measures have a potential detrimental impact for European banks as compared to others. [External authors: Rainer Haselmann and Mark Wahrenburg, Goethe University Frankfurt and SAFE]

2. Related url: This briefing paper reviews evidence showing that the adoption of an International Ratings Based (IRB) approach to estimating risk weights by banks has been associated with reductions in average reported risk weights. Several economic studies find that the lower reported risk weights using the IRB methodology to some extent reflect downward risk manipulation by banks. In a system of floors, the purpose of an aggregate output floor should be to prevent wholesale bank-level downward risk weight manipulation, giving rise to effective bank undercapitalization and a heightened probability of bank failure. Input floors can play a useful role alongside an aggregate output floor, if they are targeted to address the problem of potential mismeasurement of risk. [External author: Harry Huizinga]

3. Related url: In this note, the authors discuss the proposal for a reform of internal rating models outlined by the Basel Committee. They first present internal rating models (which currently generate roughly 50% of supervisory capital in the European Union) and the reasons why they have been increasingly criticised. They then review the key proposals circulated by the Basel Committee: the removal of internal models for 'low-default portfolios' (where defaults are too infrequent to allow adequate calibration); additional constraints on internal models’ estimates ('input floors'); an 'output floor' tying the capital requirements generated by internal ratings to those that would emerge from the standardised approach. We than explain why, in our opinion, floors represent a technically flawed answer, and suggest a number of supervisory actions that may be pursued, instead, to restore internal models’ credibility, without causing an excessive burden for banking authorities. Such actions, which have already been explored by the EU in the last few years, should be embraced wholeheartedly by supervisors, to ensure that increased transparency on implementation and validation practices may restore market confidence in internal models. [External author: Andrea Resti, Bocconi University]

Source Link Link to Main Source http://dx.publications.europa.eu/10.2861/457377
Related Links
European Parliament: Directorate-General for Internal Policies of the Union: Publications available via the EU Bookshop http://bookshop.europa.eu/en/directorate-general-for-internal-policies-of-the-union-cbf.cKABstF7wAAAEjwYYY4e5K/
European Parliament: European Parliamentary Research Service: In-Depth Analysis, November 2016: Banks' Internal Rating Models - Time for a Change? The "System of Floors" as Proposed by the Basel Committee http://www.europarl.europa.eu/RegData/etudes/IDAN/2016/587365/IPOL_IDA(2016)587365_EN.pdf
European Parliament: European Parliamentary Research Service: In-Depth Analysis, November 2016: Banks' Internal Rating Models - Time for a Change? The 'System of Floors' as Proposed by the Basel Committee http://www.europarl.europa.eu/RegData/etudes/IDAN/2016/587366/IPOL_IDA(2016)587366_EN.pdf
European Parliament: European Parliamentary Research Service: Publications: Tag: Economic and Monetary Issues http://www.europarl.europa.eu/thinktank/en/search.html?policyAreas=ECOMON

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