Last year we discussed the changes to the standardised approach (SA) for calculating risk-weighted assets (RWAs) for credit risk and its implementation challenges. All banks, including banks using the Internal Ratings Based (IRB) Approach will have to calculate the SA either as their main capital calculation or, in the case of ‘IRB banks’, in order to apply the output floor. The rules are now final in the EU with a go live date of 1 January 2025 with full implementation by end-2032 following a phase-in period. Several regulatory interpretation questions have emerged as banks are implementing these changes, some of them driven by larger banks who are focusing on the standardized approach more than they have in the past. Despite the changes to the SA for calculating RWAs, banks still need to keep robust, independent credit risk management at the core of assessing their exposures and risk-weighted asset calculations.
Regulatory Ambiguity in Implementing the SA for Credit Risk
As noted in last year’s article, the SA (as implemented in the EU) for calculating credit risk RWAs allows for the use of external credit assessments from a nominated External Credit Assessment Institution (ECAI) across exposures. Fitch Ratings is a registered ECAI in the EU and its ratings can be used across exposure classes. Analysis by Fitch Solutions has shown that including Fitch Ratings improves RWAs across all exposure types, including corporates. That is because the rule permits banks to use the second lowest rating when there are three or more ECAI ratings being used. For more details, refer to the FIRM Yearbook 024, page 169 – 171.
The EU has acknowledged that widespread availability of corporate ratings still needs to be established which is one reason for the long transition period. As banks are adopting the rules, many are faced with corporates that are not externally rated by an ECAI, resulting in higher capital charges, even with the investment grade transitional treatment of 65% RWA. As a result, banks are increasingly utilizing methods such as synthetic risk transfers (SRTs) or seeking private ratings issued by an ECAI on exposures to optimize their regulatory capital. Private rating use is an area that is somewhat ambiguous in terms of whether they can be used for regulatory capital purposes. We expect this trend to continue, particularly as banks get closer to full implementation.
Institution exposures also allow credit ratings from nominated ECAIs, but they require banks to use ECAI ratings that exclude implicit government support for their institution exposures. Fitch Ratings introduced XGS ratings over a year ago, which allows banks and other similarly rated end-users to quickly identify which ratings benefit from government support and what the rating excluding government support is. These XGS ratings are also available on select non-bank financial institutions, where relevant. Under the Basel rules, banks are also required to classify their unrated institution exposures into Grades A, B, or C under the Standardised Credit Risk Assessment Approach (SCRA), with the possibility of lower weights within the Grade A category if additional CET1 and leverage requirements are met. Fitch Solutions provides data for credit institutions to help banks to comply with the SCRA requirements to classify their unrated bank exposures.
Under SCRA as implemented in the EU, Article 119 (5) of the CRR allows the inclusion of financial institutions “authorized and supervised by the competent authorities and subject to prudential requirements comparable to those applied to institutions in terms of robustness shall be treated as exposures to institutions.” This would appear to include investment firms that are governed by the Investment Firms Regulation (IFR) in the EU (Class 1 investment firms are already included in the institutions definition). This nuance points to even broader data collection requirements that go beyond banks. As a reminder, based on the table below banks would benefit from the broader definition to include investment firms, as well as other financial institutions if they have minimum own funds requirements that are deemed equivalent.
However, it does appear that based on the IFR rules it would be difficult to achieve a so-called Grade A* classification for an investment firm as they are not held to a leverage ratio, unless the EBA permits banks to exclude that requirement for class 2 and 3 investment firms since the leverage ratio is not a regulatory requirement for those institutions. However, there are several other requirements that include minimum capital, K factor and liquidity requirements that would need to be met to achieve the Grades. Fitch Solutions is currently working on a solution to help banks with the additional data required for investment firms under the SCRA.
Another sometimes overlooked challenge with the SCRA in the EU is the regulatory equivalence requirement. The EU requires that exposures in third country jurisdictions are required to be deemed equivalent to the EU. Banks will need to carefully check their exposures to ensure they are in regulatory equivalent countries. If they are not those exposures will have to be treated as unrated corporate exposures. There are still many countries that do not have EU equivalence which will likely result in higher capital charges when applying the SCRA.
Institutions under the CRR and CRD in the EU are still required to conduct their own comprehensive credit assessments, considering both internal and external data, to better reflect the risk characteristics of their exposures. Therefore, they cannot mechanistically rely on credit assessments provided by an External Credit Assessment Institutions (ECAIs) for rated exposures or third parties for unrated exposures to determine risk weights. For firms that are already using the Internal Ratings Based (IRB) approach this requirement should be relatively easy to meet. However, for exposures where the SA is being used firms will need to ensure they still employ robust credit risk assessments for their exposures. In addition, banks that are using third party data providers for SCRA compliance will not just be able to rely on data to determine the grade classifications. The rules clearly outline the expectation that firms will conduct their own credit assessment overlay to ensure the grades are appropriate. Therefore, credit risk teams will continue to have meaningful work in complying with the final rules.
Fitch Solutions believes that additional information, such as independent credit research provided by Fitch Ratings and CreditSights and geopolitical, macro and industry research provided by BMI provide additional context for making informed credit risk decisions. Research across these businesses provide in-depth information on their coverage. Tools, such as the sovereign and bank scorecard, as well as credit risk indicators, such as Financial Implied Credit Scores, CDS – Implied Credit Scores and News sentiment provide additional analytical tools to validate internal credit risk assessments. The latter also provide a way to monitor these risks.
Conclusion
The European Union’s finalized rules for the standardized approach (SA) to calculating risk-weighted assets (RWAs) for credit risk, effective from 1 January 2025, mark a significant shift in regulatory frameworks. These changes necessitate that all banks, including those utilizing the Internal Ratings Based (IRB) approach, apply the SA and an output floor throughout the phase-in period, concluding by end-2032. This transition has prompted various regulatory interpretation challenges.
As detailed in last year’s analysis, the SA uses external credit assessments from nominated External Credit Assessment Institutions (ECAIs), such as Fitch Ratings, to calculate credit risk RWAs. Fitch Solutions analysis shows that using Fitch Ratings, a registered ECAI in the EU, has demonstrated RWAs improvements across exposure types when its ratings are nominated in regulatory capital calculations. Additionally, banks must classify unrated institution exposures under the Standardized Credit Risk Assessment Approach (SCRA), involving grading exposures. Fitch Solutions is addressing these challenges by developing data solutions to facilitate compliance with evolving regulatory standards.
For additional information on how Fitch Solutions can help you meet your Basel III implementation needs, as well as Fitch Ratings’ unparalleled regulatory research: https://www.fitchsolutions.com/credit/basel-iii-scra-data
For additional information on credit risk indicators, tools and comprehensive financial data:https://www.fitchsolutions.com/credit/fundamental-data-analytics
To learn more about the Fitch Solutions businesses, including CreditSights, BMI, Sustainable Fitch and Fitch Learning:https://www.fitchsolutions.com/
