Credit Risk
Credit risk standardised approach (CRSA)
For a typical bank, credit risk is, by far, the most significant type of risk. Each bank needs to implement the standardised approach for credit risk (CRSA). For standardised approach banks, the quantified RWAs are used directly, without further modifications, to calculate the capital ratio. For banks that use the IRB approach, the CRSA acts as a backstop in the output floor calculation. CRR III introduces substantial modifications to numerous aspects of the CRSA, notably in terms of exposure classes and assigned risk weights. Nonetheless, the fundamental methodology of allocating risk weights based on external ratings remains unchanged.
Assignment of exposures and determination of risk weights
Under the CRSA, the exposure value for balance sheet positions is defined as the accounting value, adjusted for provisions and other deductions. Off-balance sheet positions are assigned a credit conversion factor (CCF) that ranges between 10% and 100%. The exposure value for derivative products is determined based on the standardised approach for counterparty credit risk (SA-CCR). The exposure value can be reduced using netting techniques, which permit the offsetting of opposing exposures. The exposure value is then multiplied by the relevant risk weight to derive the risk-weighted assets (RWA).
For some exposure classes banks may use external ratings in order to determine a risk weight which may range between 0% (only for sovereigns and certain multilateral development banks) up to 150% in case of poor external ratings. If external ratings are to be used, a separate due diligence has to be performed.
If external ratings are not available, a standardised credit risk approach (SCRA) or a fixed risk weight must be applied. Based on these two approaches, a risk weight ranging from 30% to 150% is derived.
The chart below provides an overview of the various exposure classes and their corresponding risk weights, contingent on the availability of external ratings.
Deep dive on immovable property financing
Immovable property collateral represents one of the most important forms of collateral in commercial banking. While technically a risk mitigation instrument, transactions secured with immovable property have to be assigned to a separate exposure class under the CRSA. The secured part may receive either a risk weight according to the exposure-to-value (ETV) ratio using the whole-loan approach or the loan splitting approach.
Qualification as exposure collateralised with mortgages on real estate property requires multiple qualitative criteria. Among others, the financing institution must be able to legally enforce the collateral and hold a prudent valuation available. Provided that those criteria are met, the mortgaged backed exposures can be categorised either as “regular financing”, “income-producing real estate” (IPRE) or “land acquisition, development or construction financing” (ADC). For each type different risk weights may apply depending on the property being residential or commercial.
Internal ratings based approach
Since 2012, the Basel Committee has been actively working on revising the internal ratings-based (IRB) approach. Their objective is to achieve an optimal balance between simplicity, comparability, and risk sensitivity in banking regulations. This initiative stems from the recognition that the current IRB framework has become excessively complex, leading to a range of negative outcomes.
In a parallel effort, the European Union is committed to reducing unwarranted variability in regulatory capital requirements. This effort is focused on ensuring that any differences in requirements are justified by the distinct risk profiles of financial institutions. With the implementation of CRR III, the EU Commission is working to bring its regulations in line with the revised standards set by the Basel Committee. This alignment involves significant alterations to the use of IRB approaches.
IRB exposure classes and scope
Numerous modifications have been made to the structure of IRB exposure classes, with the goal of enhancing comparability with the standardised approach for credit risk (CRSA). A key development is the introduction of a distinct exposure class for regional governments, local authorities, and public sector entities, termed 'Regional governments and local authorities and public sector entities' (RGLA-PSE). This class is further segmented into RGLA and PSE sub-classes. In addition, the exposure classes for corporates and retail portfolios have been subdivided into additional sub-classes, aiming to provide a more nuanced and detailed framework for risk evaluation.
CRR III has introduced limitations on the use of internal models, mainly due to the potential unreliability of risk parameter estimates when default data is insufficient. These changes particularly affect exposures to corporates, financial institutions, specialised lending, and equity risk positions. The latter have been excluded from the IRB approach.
Furthermore, the Advanced-IRB will no longer be allowed for banks and other financial institutions, including insurance companies as well as corporations belonging to groups with a consolidated annual turnover exceeding € 500 million or generating this independently.
New Permanent Partial Use
A key aspect of CRR III is the flexibility it offers banks to select specific exposure classes for implementing the Internal Ratings-Based (IRB) approach. This flexibility could greatly enhance the IRB's appeal, particularly for banks currently using the CRSA that had not previously considered the IRB. Nevertheless, to appreciate why this simplified access is attractive, understanding the typical IRB rollout process is essential.
Under the Basel II IRB framework, banks must extend the IRB to all exposure classes and across the entire banking group, typically achieving a minimum of 85% of their total credit portfolio's risk-weighted assets (RWA) using internal models within three to five years, as mandated by supervisory authorities, with exceptions like Permanent Partial Use (PPU) for unfeasible sub-portfolios. Implementing the IRB demands extensive model development, significant investments in IT and internal processes, and varies in benefits and cost-effectiveness across different exposure classes. This comprehensive transition, often with higher ratios in some EU countries (e.g., Germany), requires a detailed rollout plan from banks to achieve compliance.
CRR III allows institutions to introduce the IRB for individual exposure classes without the obligation to extend it across all classes to maintain group-level coverage. Under CRR III, the requirement is to ensure that all positions of the transitioning exposure class(es) are moved to the IRB. Therefore, a bank using the Standardised Approach under CRR can selectively transition exposure classes to the IRB, prioritising those with the most favourable combination of high RWA savings and low implementation costs, while permanently keeping other classes under the Standardised Approach. Although an output floor limits the potential RWA savings, in practice, this could lead to some banks achieving optimal RWA savings by transferring only a select few exposure classes to the IRB.
New Input Floors and Risk Parameters
CRR III introduces additional minimum floors for key risk parameters: Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD). These floors are designed to mitigate the effects of modeling inaccuracies or overly lenient modeling practices on risk-weighted assets (RWAs) and are applied on a per-exposure basis. In practice, banks calculate PD, LGD, and EAD as they normally would, but for RWA calculations, they must use whichever is higher: their internal estimates or the established regulatory minimums. In addition, CRR III introduces additional changes to the LGD calculation. Moreover, specific haircuts, or reductions, are applied to the collateral before determining the LGD, depending on the type of collateral.
