Answers to frequently asked questions on the new Basel iii reforms advising the SCRA approach
Starting from January 2023, banks will have to implement the new standardised credit risk assessment (SCRA) approach introduced under Basel III updates. This new methodology for assigning risk weightings to unrated bank exposures will undoubtedly increase the data management burden for many banks.
In addition to gathering minimum capital requirements and capital buffer requirements from any jurisdictions in which a bank has unrated exposures, banks will need to comb individual counterparty banks’ annual reports to obtain relevant information.
The scale of the data management effort will depend on the size and geographic spread of a bank’s unrated portfolio, but will likely entail significant time and resources, which is why Fitch Solutions developed an SCRA data offering to meet this need.
To help banks understand the challenge, Paul Whitmore, Global Head of Counterparty Risk Solutions at Fitch Solutions, and Monsur Hussain1, Head of Financial Institutions Research at Fitch Ratings, answer some frequently asked questions about this new approach.
Frequently Asked Questions:
- What is the new SCRA approach?
- What kinds of banks will be affected by the new SCRA approach?
- Why shouldn’t banks continue to use their internal rating models?
- What is the aim of the output floor that will be phased in under the final Basel iii rules?
- How will this affect the risk weighting for my portfolio of unrated banks?
- How will the composition of a bank’s portfolio affect its implementation process in terms of timing, effort, and required resources?
- What challenge do banks face with the new SCRA approach?
- What benefits will a bank experience from using the new SCRA approach?
- How much time do banks need for the implementation?
- What are the advantages of starting implementation early?
- Why address the data requirements for the SCRA approach now?
- What data will banks need to implement the SCRA approach?
- How can banks incorporate the required data into their systems and models?
- How do banks find the required data?
- What should potential users look for in an SCRA data solution?
- What stage should banks now be at to ensure they are fully prepared for implementation?
WHAT IS THE NEW SCRA APPROACH?
Using the new SCRA approach allows banks to accurately assess the required risk weight for their unrated bank exposures, and can help reduce the capital charge applied which frees up capital for use elsewhere.
The SCRA approach is a more granular way of assigning risk weightings to unrated counterparty banks exposures. The SCRA applies to unrated bank exposures for banks incorporated in jurisdictions that allow the use of external ratings for regulatory purposes. Banks incorporated in jurisdictions where credit ratings cannot be used for prudential purposes, for example, in the US, may apply the SCRA to all their bank exposures.
Using published minimum regulatory requirements and their due diligence, banks use the SCRA approach to determine the required risk weight for their unrated counterparty bank exposures by grading them into one of three categories – Grades A, B, or C – and assigning the corresponding ‘base’ supervisory risk-weights.
To be classified into Grade A, a bank must meet or exceed the published minimum regulatory requirements and buffers established by its national supervisor as implemented in the jurisdiction where it is incorporated (some exceptions apply).
In addition, the counterparty bank must have adequate capacity to meet their financial commitments (including repayments of principal and interest) promptly. This must remain for the projected life of the assets or exposures, irrespective of the economic cycles and business conditions.
A preferential Grade A risk-weighting can be used, provided that the counterparty bank has a Common Equity Tier 1 ratio that meets or exceeds 14%, and a Tier 1 leverage ratio that meets or exceeds 5%.
If such minimum regulatory requirements and buffers are not publicly disclosed or otherwise made available by the counterparty bank, and a bank assesses that the counterparty bank does not meet the definition of Grade A, then the counterparty bank must be assessed as Grade B or lower. To be classified into Grade B, a bank must meet or exceed the published minimum regulatory requirements.
Grade C refers to higher credit risk exposures to banks, where the counterparty bank has material default risks and limited margins of safety. For these counterparties, adverse business, financial, or economic conditions are very likely to lead or have led to an inability to meet their financial commitments. A bank must classify the exposure as Grade C, if any of the following triggers are breached:
- The counterparty bank does not meet the criteria for being classified as Grade B with respect to its published minimum regulatory requirements, i.e. if minimum regulatory requirements are not publicly disclosed or otherwise made available by the counterparty bank, or
- Where audited financial statements are required, the external auditor has issued an adverse audit opinion or has expressed substantial doubt about the counterparty bank’s ability to continue as a going concern in its financial statements or audited reports within the previous 12 months
WHAT KINDS OF BANKS WILL BE AFFECTED BY THE NEW SCRA APPROACH?
All internationally active banks located in jurisdictions that adhere to Basel rules will need to implement the SCRA approach, specifically for their exposures to unrated banks.
Also, banks incorporated in countries, such as the US, that do not allow the use of external ratings for regulatory purposes might need SCRA data to calculate their unrated and foreign bank exposures.
However, it will depend on the shape of the final rules in their jurisdictions and on their level of activity in other international jurisdictions.
WHY SHOULDN’T BANKS CONTINUE TO USE THEIR INTERNAL RATING MODELS?
The final Basel III ‘endgame’ standards taking effect from January 2023 restrict the use of internal models in favour of revised standardised approaches, in a bid to restore credibility in the calculation of banks’ risk-weighted assets (RWA) and capital ratios. Specifically, modelled RWA will be permanently floored at a fixed percentage of those calculated with the standardised approach under the output floor restriction.
Otherwise, banks with permission to use internal models will still calculate the Probability of Default or Loss Given Default, and exposures to business lines such as retail lending, mortgages, and project finance. Models will still be used to calculate holistic capital requirements for Pillar 2 risks and expected credit losses.
But in light of the output floor measure, even banks with permission to use internal models will still need to compute RWA under the standardised approach. Therefore, the new SCRA approach may benefit banks by potentially limiting the impact of capital charges for their unrated portfolios.
WHAT IS THE AIM OF THE OUTPUT FLOOR THAT WILL BE PHASED IN UNDER THE FINAL BASEL III RULES?
It will create a more level playing field between banks that use sophisticated internal models and those using the standardised approach. Historically, larger banks typically used internal model estimates, and these could generate very low-risk weightings, reducing their minimum capital requirements.
Smaller banks that do not have the resources to create complex internal models will be less disadvantaged. The output floor will also help reduce the excessive variability of RWA calculated under banks’ current models.
Under the new regulations, modelled capital charges will have to be at least 72.5% of aggregate RWA calculated using the standardised approach. This could cause very low modelled risk weight estimates to increase sharply unless standardised risk weights are optimised – for example, by using the SCRA approach.
HOW WILL THIS AFFECT THE RISK WEIGHTING FOR MY PORTFOLIO OF UNRATED BANKS?
It depends on the make-up of individual banks’ portfolios and where those counterparty banks that they have exposure to are registered. Initial analysis shows that the risk weights attached to those unrated banks could be considerably reduced. From a sample of over 4,600 unrated banks, risk weights could be reduced by the SCRA approach for 98% of those banks, to either a 30% risk weight or a 40% risk weight. 2
HOW WILL THE COMPOSITION OF A BANK’S PORTFOLIO AFFECT ITS IMPLEMENTATION PROCESS IN TERMS OF TIMING, EFFORT, AND REQUIRED RESOURCES?
At this stage we expect a lot of banks to be analysing their portfolios to examine any gains or losses with regard to the final reforms. Most banks will still keep designating rating agencies to calculate their risk weights under the External Credit Risk Assessment Approach (ECRA).
However, many scenarios are being tested and banks will be looking at using one or more agencies, together with the SCRA approach. Using the SCRA approach alone for a sample set of rated banks (1671), 72% of those banks could achieve the same or better risk weight than just using the three big rating agencies.3
For those banks that are unrated, banks are likely to be trying to gather the information they need to lower the risk weights on those exposures from 150% to potentially 30% or 40%. This could have a significant impact on the capital charges the banks would incur. Reducing capital charges was a key driver for our clients in requesting the creation of our SCRA data set.
WHAT CHALLENGE DO BANKS FACE WITH THE NEW SCRA APPROACH?
Using the new SCRA approach requires banks to collect minimum capital requirements and capital buffer requirements from all jurisdictions in which the bank has unrated exposures. They must also obtain relevant information from counterparty banks’ annual reports.
Collecting and maintaining these minimum requirements detailed in many different formats and languages from regulators and banks in over 130 countries will be time-consuming and resource-heavy, especially for banks with a large number of unrated counterparties in their portfolios.
In addition, banks may encounter issues in using the SCRA approach to process and calculate RWA. For example, there can be different capital buffer requirements in each jurisdiction, with some requirements being additive and others the higher of two amounts. These may also change to reflect evolving developments among jurisdictions or bank counterparties themselves.
Banks will face the choice of resourcing this internally or going to a third-party supplier such as Fitch Solutions for an evergreen data solution.
WHAT BENEFITS WILL A BANK EXPERIENCE FROM USING THE NEW SCRA APPROACH?
Fixed risk weightings are currently applied to unrated banks under the standardised approach, requiring more capital than typical investment grade credit ratings. Under the Basel III regulatory framework, provided the SCRA approach can be used, risk weights may fall, reducing banks’ capital requirements.
This is because the SCRA approach is more granular than the current unrated standardised approach. Instead of a single fixed risk weight that sees all unrated banks treated the same by regulators, the SCRA approach has three different buckets for unrated banks. It could therefore result in a reduction in risk weights from 100% under the current Basel framework, to 30% in some instances.
From a sample of over 4,600 unrated banks, risk weights could be reduced by the SCRA approach for 98% of those banks, to either a 30% risk weight or a 40% risk weight*.
HOW MUCH TIME DO BANKS NEED FOR THE IMPLEMENTATION?
This will depend on each jurisdiction and its chosen legislative path to implementing the final Basel III standards. It will take some time to ensure that these requirements are embedded into the necessary data infrastructure and that relevant resources are trained and ready, and to test the process sufficiently.
All of our clients who are using our SCRA data are already some way into this process. To ensure effective governance, some banks have already begun using the SCRA approach alongside their current approach, ahead of their country’s implementation deadline.
WHAT ARE THE ADVANTAGES OF STARTING IMPLEMENTATION EARLY?
By starting early, banks can ensure that they meet both the regulatory requirements and the spirit of the regulations, in particular when considering governance and oversight within each jurisdiction.
It is time-consuming to collect and standardise the required data for the SCRA approach, so getting ahead will reduce any last-minute rush to meet the deadline. Banks not in a position to gather the data internally will need to have selected a third-party provider, and both executed and tested the integration of this data in their systems well in advance of this date.
WHY ADDRESS THE DATA REQUIREMENTS FOR THE SCRA APPROACH NOW?
Implementing the approach is a small part of a much larger undertaking and delivers an immediate measurable ROI, which frees more bank resources to address the full implementation of Basel III.
As mentioned previously, the risk weighting reductions can be significant, and being able to get a handle on those projections ahead of time is commercially advantageous.
WHAT DATA WILL BANKS NEED TO IMPLEMENT THE SCRA APPROACH?
Banks will need to obtain regulatory minimum capital requirements and buffers data, as implemented in the jurisdiction of the counterparty bank, available from regulators and bank websites.
HOW CAN BANKS INCORPORATE THE REQUIRED DATA INTO THEIR SYSTEMS AND MODELS?
To bring the data into internal systems, the bank can use channels such as API, data feeds, or even via an Excel Add-In, and easily incorporate it into existing datasets. Fitch Solutions SCRA data will work alongside fundamental financial data from any provider, making it very simple to implement.
HOW DO BANKS FIND THE REQUIRED DATA?
The required data can be collected in-house, or obtained through an external provider. The data is in many different formats and languages, from regulators and banks in a large number of countries and jurisdictions, and will require continuous monitoring and updating as the requirements change.
Some banks will prefer to use an SCRA data solution from a third-party vendor, to avoid the challenges of gathering and standardising the data. Several of our clients had already tried and failed to gather this data themselves when they approached us to create the SCRA data product. It’s not as simple as getting a junior analyst to cut and paste information from websites. Even large banks with sufficient resources find gathering the data onerous.
WHAT SHOULD POTENTIAL USERS LOOK FOR IN AN SCRA DATA SOLUTION?
For those that seek an external solution, finding a provider with a strong track record in collecting and maintaining high volumes of comprehensive, standardised data should be a top priority. With the information being hard to find and difficult to interpret, prior experience is a benefit.
It is important to check the credentials of the team behind the numbers. Sourcing this data effectively requires professionally qualified analysts and data specialists equipped with the expertise and language skills needed to analyse bank and supervisory documents from jurisdictions worldwide.
WHAT STAGE SHOULD BANKS NOW BE AT TO ENSURE THEY ARE FULLY PREPARED FOR IMPLEMENTATION?
Many banks took advantage of the extra 12 months delay to final Basel III implementation the Basel Committee on Banking Supervision granted in March 2020 because of the Covid-19 pandemic. Most are only assessing the implications of the reforms now that draft rules have been published by some of the regulators.
Banks are likely to be currently performing quantitative impact studies to understand how the reforms will affect their capital calculations. They will be looking at all permutations of their internal ratings-based models, credit ratings for the external credit risk assessment approach, and their current datasets to help them adhere to the SCRA guidelines. We’re currently helping a significant number of clients in this process and are happy to have a conversation with any bank looking for expert support in this area.
It is worth remembering that the larger the bank – or the broader its geographical reach – the larger the task. For banks of any size, however, preparing for this change should be a priority.
Avoid needless increases to your capital charges
Fitch Solutions SCRA Data solution allows you to easily implement the new SCRA approach and accurately assess the required risk weight for your unrated bank exposures, without having to gather, standardise, and maintain the supporting data.
Uniquely designed to complement and enhance your credit risk analysis workflow, Basel III – SCRA Data is available via API, Data Feed, or Excel Add-In, and can be used alongside other data sets.
2These results were found by checking a sample of banks with reported regulatory CET 1 Capital, Tier 1, Total Capital and Leverage Ratios (within the last year) against their region’s reported regulatory minimum requirements and buffers. The financial ratios used are sourced by Fitch Group.
3Banks do not have the option to use only the SCRA approach; this example is for illustrative purposes only.