OREANDA-NEWS. The Basel Committee on Banking Supervision's second set of proposals to update the standardised approach to credit risk, published in December 2015, represents a change of approach that will improve risk sensitivity. But the regime proposes to retain flexibility for national regulatory implementation and bank risk weighting. This means that comparing capital ratios across banks and countries will continue to be elusive, says Fitch Ratings.

If the proposals are implemented, there will be two separate risk weighting approaches. One will use external credit ratings and the other will rely on standardised assessments. Capital adequacy ratios will vary, depending on which methodology is used, and this will make it difficult to preserve consistency and simplify comparison of output ratios.

The use of credit ratings for assessing bank and corporate credit exposures, scrapped under Basel's original proposals, has been reinstated. We think this is an improvement because credit ratings serve as important credit risk benchmarks and have been effective in assessing relative credit risk. They can also be effective in fostering consistency. The external credit rating based approach (ECRA) maps credit ratings to a number of risk weight buckets and is currently used by the majority of the Basel Committee's 27 national members.

Some countries however, notably the US, prohibit the use of credit ratings for regulatory purposes. Basel proposes that banks in these countries use a new standardised credit risk assessment (SCRA) approach. Under the SCRA, bank and corporate exposures will be split into categories and risk weighted according to the specific characteristics of the counterparty.

Risk weights calculated for bank exposures using either the ECRA or SCRA could vary because banks have to undertake mandatory due diligence when using credit ratings. This could lead to a bank assigning a risk weighting at least one bucket higher (but not lower) than the "base" risk weight. The SCRA proposal also imposes a higher risk weight floor for bank exposures and applies larger haircuts to highly rated non-sovereign bonds than the ECRA. If implemented, this means US banks will see risk weights more than double on exposures to their US peers and will need to post or receive higher collateral on repurchase transactions over corporate securities, for example.

Basel is also proposing an overhaul of capital allocation to real estate lending, with more granular risk weights. Capital requirements for property development loans, buy-to-let (BTL) mortgages and more speculative real estate finance will be hiked to reflect greater risk. All mortgages will be capitalised at original loan to values (LTV) to inhibit cyclical changes to risk weights. But during times of rising property prices, lenders might encourage borrowers to refinance their loans, to reduce their own capital requirements. If the proposals are adopted, we think some banks, notably those heavily involved in high LTV BTL lending, will have adjust their business models.

The proposals discourage banks from lending in foreign currency and holding equity investments by increasing risk weightings. By requiring banks to recognise capital charges on unconditionally cancellable commitments, such as credit card and personal overdraft facilities, the most affected banks may reduce credit card limits or pass higher costs of capital to consumers.