Risk weighting under CRD
- Examples
So far, banks have not been allowed to use internal models and estimates to calculate their regulatory capital requirements. However, the new Capital Requirements Directive (CRD) allows the use of such models and estimates.
The banks’ regulatory capital requirements are defined by the requirements under Pillar I and Pillar II of the CRD.
- Pillar I contains general rules for estimating the risks of an average bank and thus sets out the minimum capital requirements.
- Pillar II sets a framework for further capital requirements to meet the specific risks of the individual bank. Under Pillar II, the banks calculate internal capital requirement targets to match their specific types of business and risk.
This article focuses solely on the requirements of Pillar I.
The transition to internal models requires banks to increase the level of sophistication of their risk and capital management. For example, the credit quality of customers and the collateral provided play an important role. But the new models also offer a number of business advantages.
Banks rate the credit quality of their customers. Customers with low ratings increase the credit risk of the banks more than customers with high ratings and thus tie up more capital because of their higher risk weighting. This difference is reflected in the pricing of products offered to individual customers.
The CRD allows banks to include more types of collateral in their calculation of solvency. This new option requires regular valuation and management of the collateral provided.
The examples below illustrate in simple terms some of the advantages of the new rules under Pillar I. The rules under Pillar II may subsequently lead to an adjustment of the capital requirement calculated under Pillar I. The two examples are based on:
1) retail customers with mortgage loans secured on real property
2) corporate customers
1) Retail customers with mortgage loans secured on real propertyAs regards credit risk on retail customers, the risk weighting is a function of the following variables:
PD, LGD og EAD.
The example below illustrates the effect, broken down by rating category, of the Pillar I requirements applied to mortgage loans secured on real property with a loan to value ratio lower than 80%. Under the Basel I requirements, mortgage loans had a risk weighting of 50%, whereas their weighting of the CRD standardised approach is only 35%. The Advanced internal rating-based (A-IRB) approach relies on internal estimates and assumes an LGD of 10% (the regulatory minimum LGD is 10%, and this rate will apply until the end of 2010).
The figure shows that opting for the A-IRB approach may be a significant advantage in terms of reducing capital requirements for mortgage loans secured on real property.
2) Corporate customers
In addition to the three variables mentioned above, remaining term is used to calculate the credit risk on facilities held by corporate customers and other types of facility. The remaining term may vary between one and five years. The capital requirement increases – considerably – the longer the remaining term. The simple reasoning for this correlation is that the PD of the customer is higher if the remaining term is long. The figure below shows the impact of remaining term on the risk weighting of a facility extended to a corporate customer in rating category 4.
The following example is based on a remaining term of one year and shows the risk weighting of loans to corporate customers (CIB) under Pillar I broken down by rating category. Under the Basel I requirements and the standardised approach, the weighting determined by the Danish FSA was used (100% under Basel I and credit quality steps mapped from assessments of recognised credit agencies under the standardised approach). Own LDG data are used under the A-IRB approach.
The figure shows that opting for the A-IRB approach may be a significant advantage in terms of reducing capital requirements also with respect to corporate customers with high credit ratings. The figure also shows that the higher the credit rating, the more profitable the A-IRB approach becomes.
Last updated/revised on August 9, 2007