2.1 Standardised approach for credit risk
The standardised approach for credit risk (SA-CR) is a methodology used for calculating the minimum capital requirements for credit risk in a bank’s banking book, with the minimum capital requirements being determined based on prudential requirements. The revised SA-CR introduced more granular risk weights as a way of making the standard more risk-sensitive overall. Furthermore, the calibration was adjusted to the losses experienced during the financial crisis years, and efforts were made to achieve greater consistency with internal model approaches. One reason why this is important is that banks that use the internal ratings-based (IRB) approach to calculate their minimum capital requirements for credit risk in the banking book will also be required, going forward, to use the SA-CR to determine the RWA output floor (see the section entitled “Output floor: lower limit for capital requirements”). Another reason for updating the SA-CR is to reduce the reliance on external ratings, or to ensure that banks perform due diligence upfront to ensure the appropriateness of those ratings.
The manner in which capital requirements for interbank exposures are determined will change in terms of the importance and use of external ratings. Two techniques will be available for calculating these capital requirements: the External Credit Risk Assessment (ECRA) approach and the Standardised Credit Risk Assessment (SCRA) approach. As part of the implementation of the finalised Basel III standards, EU legislators agreed to continue to permit the use of external ratings provided these do not incorporate assumptions of government support. This measure aims to mitigate the nexus between banks and sovereigns and send the appropriate signal to market participants. 7 8 The SCRA is intended for exposures without an external rating. Under this approach, the lending bank, with due regard for the prudential capital metrics and having performed due diligence, is required to assign the obligor bank to one of three risk weight buckets (grades), which indicates the appropriate risk weight to be applied. The risk weights used here range from 40 % (grade A) to 150 % (grade C). A risk weight of 30 % is also possible, subject to certain conditions (i.e. the leverage ratio meets or exceeds 5 % and the CET1 ratio meets or exceeds 14 %).
The option of using external ratings has been retained in the corporate exposure class as well. Risk weights will be made more risk-sensitive. 9 As hitherto, a flat 100 % risk weight will be assigned in the absence of an external rating. Specialised lending exposures are subdivided into three subcategories: object finance, project finance, and commodity finance. If certain conditions are met, unrated project finance exposures and, on a transitional basis, unrated object finance exposures as well, can be given privileged treatment. 10 EU legislators likewise decided to leave the supporting factor for small and medium-sized enterprises (the “SME SF”), which already exists in the EU, unchanged. 11 The new 85 % risk weight envisaged in the Basel standards for SMEs that cannot be assigned to the retail exposure class was not (additionally) implemented.
Subordinated debt and equity exposures will be grouped in separate exposure classes. The risk weights have been increased to take into account the greater risk of loss compared with senior loan exposures. In future, risk weights can be as high as 400 % for certain exposures (speculative equity exposures, for example). CRR III grandfathers what it calls strategic equity holdings – that is to say, equity investments that a bank has already been holding for at least six years and over which it can exercise a certain degree of control and influence continue to be exempt from the adjustment of risk weights. Furthermore, exemptions (still) apply to equity exposures to institutions covered by the same institutional protection scheme. 12 In general, subordinated debt exposures will receive a risk weight of 150 %.
In the retail exposure class, 13 a distinction will be made in future between normal exposures used to finance a retail customer and revolving exposures that result from payment transactions (such as credit card payments). The latter are assigned a more favourable risk weight of 45 % (instead of 75 %) if the banks can demonstrate regular repayments and thus a lower risk of loss.
Far-reaching changes will be made concerning real estate exposures. Overall, this exposure class will be rendered more granular, thus making the capital requirement more risk-sensitive. In the first step, a distinction is made between exposures secured by a residential property and those where a commercial property is used as collateral. In the second step, banks are required to assess whether the mortgage loan can be repaid out of the borrower’s income (“classic” real estate exposure) or whether repayment is materially dependent on cash flows generated by the property (for example, rental income). CRR III continues to permit the use of the loan-splitting approach to calculate the capital requirement for “classic” real estate exposures. In this approach, the exposure is divided into a secured portion (loan-to-value ratio (LTV) of up to 55 %) and an unsecured portion (LTV above 55 %). The secured portion is assigned a flat risk weight of 20 % (secured by a residential property) or 60 % (secured by a commercial property), while the unsecured portion is assigned the obligor’s risk weight (for example, 75 % for a retail obligor in a residential property exposure). The weighted average of the two portions is then the risk weight of the entire exposure. In future, exposures where repayment depends materially on the cash flows generated by the property will be subject to higher capital requirements because experience has shown that these have a higher risk of loss given default (LGD). CRR III introduces a new procedure for determining the risk weights for these exposures (the “whole loan” approach). This provides for individual ranges to which the total claim is assigned depending on the loan-to-value ratio. The higher the LTV, the higher the risk weights and thus the higher the capital requirements. Real estate exposures of this kind may, however, be subject to the same rules as “classic” real estate exposures if the national loss rates from real estate lending overall do not exceed certain ceilings, based on what is known as the hard test. The national competent authority (in Germany, the Federal Financial Supervisory Authority (BaFin)) conducts hard tests annually to assess whether this condition has been met. In addition, CRR III introduces a third category of mortgage loans. This category contains loans to companies and special-purpose vehicles (SPVs) financing land acquisition, development and construction (ADC) exposures. ADC exposures are normally risk-weighted at 150 %, regardless of the obligor’s creditworthiness. If certain conditions are met, ADC exposures to residential properties may be risk-weighted at 100 %. 14
Moreover, CRR III amends the definition of “value” for immovable property collateral and eliminates the distinction between market value and mortgage lending value. Banks have to ensure that the value of a property is not based on possible future price increases, but is sustainable in the long term. This measure is intended to help ensure that the value of the collateral contains no speculative elements. EU legislators did, however, decide that, subject to certain conditions, increases in the value of immovable property would be permitted during the life of a loan, as long as these do not exceed the average value measured over the previous years. 15
Another new measure is the introduction of a risk weight multiplier for unhedged foreign currency exposures. These are exposures denominated in a currency which is different from the currency of the obligor’s source of income. This risk weight multiplier is applicable to exposures to natural persons assigned to the retail and residential real estate exposure classes. The idea behind it is to cover the risk of default that could arise if the currency in which the loan is denominated appreciates significantly.
Off-balance-sheet items will also be affected by changes to the SA-CR. These changes will affect unconditionally cancellable commitments (UCCs), for example. In future, 10 % of the committed but undrawn amount of such commitments will be recognised as an exposure and have to be backed by capital. Exempting these exposures from the capital requirement has proven unwarranted in practice. Unlike the Basel standard, however, CRR III allows this arrangement to be phased in up until the end of 2032.
The supervisory haircuts applied when counting financial collateral have also been updated to reflect newer market data and will have to be applied in future by all SA-CR banks that use the financial collateral comprehensive method. Institutions are no longer permitted to use their own haircut estimates as part of the financial collateral comprehensive method.