Risk-weighted assets (RWAs) are a measure of the credit risk of a bank's assets. They are used to determine the minimum amount of capital that a bank must hold to be considered adequately capitalised.
The cost of capital is a key determinant of the pricing of products and services in the financial market. This means that changes in the cost of capital can have significant impact on all market participants, both directly and indirectly.
This increase in the cost of capital will have the following consequences for banks.
- Lending money to businesses and consumers will become more expensive
- Profitability will be reduced
- Vulnerability to financial shocks will increase
To mitigate the impact of the new regulations, banks need to optimize their balance sheets and adjust their asset allocation accordingly. They also need to carefully manage their risk appetite and ensure that they have adequate capital buffers in place.
A recent example of a bank near to default was Credit Suisse in 2021. This was another wake-up call for the financial industry and it highlighted the importance of understanding the consequences of the new regulations. All banks need to do the necessary analyses to ensure that they are well-positioned to withstand negative impact of new regulations.
Risk Weighted Assets implementation and risks
RWAs are calculated by multiplying the value of each asset by a risk weight that reflects the perceived risk of the asset. Basel IV sets out the risk weights that must be used and will be implemented in the EU by Capital Requirement Regulation CRR3 in January 2025.
CRR3 is intended to faithfully implement the Basel IV requirements, while also taking into account the specific features of the EU's banking sector. This means that CRR3 will ensure that banks use accurate and robust internal models to calculate their capital requirements. This will help to ensure that banks have sufficient capital to cover their risks, and that risk-based capital ratios across banks are comparable.
The proposal aims to strengthen the resilience of the banking sector without significantly increasing capital requirements. The European Commission notes that the proposal limits the overall impact on capital requirements to what is necessary to maintain the competitiveness of the EU banking sector. The package also aims to reduce compliance costs, particularly for smaller banks, without loosening prudential standards.
Clients will be affected indirectly by changes in the cost base of banks and need to do their own homework in order to optimize their product and market allocations.
What are the main types of risk considered in the calculation of RWAs?
- Credit risk
- Market risk
- Operational risk
- Counterparty credit risk (CVA risk)
The calculation of RWAs depends also on whether a bank uses the standardized approach (SA) or the Internal Ratings-Based approach (IRB). The SA is mainly used by smaller banks, and the RWAs are predetermined by the supervisor. The IRB is determined by the bank with the approval of the supervisor.
The key differences between the SA and the IRB:
Standardized Approach
- Uses a set of predefined risk weights that are based on the borrower's credit rating.
- Does not require banks to develop their own internal risk models and is simpler to implement and less costly than the IRB
Internal Ratings Based Approach
- Allows banks to develop their own internal risk models to estimate the probability of default, loss given default, and exposure at default
- Is more complex to implement and more costly than the SA
- Can potentially result in more accurate RWAs than the SA
What are the main differences regarding the risks in Basel IV?
For Credit risk, the main difference will be the output floor. This will have a significant impact on banks using the IRB approach. We will address this subject in more detail. For mortgages, specialized lending, off-balance-sheet items and other asset classes, there are changes in the RWA.
The Fundamental Review of the Trading Book (FRTB) and, thus, market risk, has already been incorporated into European Law. However, the existing CRR methods continue to be used with regard to the capital requirements. Selected institutions are currently only subject to a reporting requirement for the new FRTB. In 2025 the revised FRTB will be incorporated in the CRR.
The most significant change is the introduction of the revised trading book boundary into the CRR3. This will affect the internal processes of banks and the need for reallocations. Smaller banks (in particular) may be confronted with the challenge of having to maintain a trading book in the future.
All existing operational risk capital requirements are replaced with a risk-sensitive SA approach to be applied by all banks. It follows BCBS 424[1] but without the multiplier for internal losses (MIV). There is an expanded definition of operational risk and requirements and how to disclose the annual losses.
Credit Value Adjustments (CVA) is a financial metric used to account for the potential risk of default by a counterparty in derivatives or securities financing transactions (SFT). It’s the value adjustment of a derivative transaction and SFT under consideration of counterparty credit risk. Under Basel IV there will be a revised framework with 3 categories namely;
- Standardised approach (SA-CVA)
- Basic approach (BA-CVA)
- Simplified approach
The new CVA risk capital approaches other than the simplified will have more links to the market risk factors and hedging measure. As a result, the CVA charge will be more risk sensitive. Clients need to consider these changes and allocate resources to review their existing and future business. Examples to think about regarding the risks of RWA calculation and the indirect impact on them are:
- The output floor will result in the repricing of asset classes and change the risk-return profile. For example, mortgages will require a higher return.
- The CVA charge for OTC Derivatives and SFT transactions will impact the pricing and therefore the return profile. The cost of Swaps for hedging interest rate risk depends on clearing, bilateral, collateral for instance.
What is the impact of the output floor?
The output floor is a new requirement in Basel IV that limits the amount by which banks can use their internal models to calculate their RWAs. The output floor is designed to ensure that banks have sufficient capital to cover their risks, even if their internal models underestimate those risks.
The output floor has been introduced in response to concerns that banks could use their internal models to game the system and reduce their capital requirements. The output floor is set at 72.5% of the RWAs calculated using the standardised approach. This means that banks can only use their internal models to reduce their RWAs up to 27.5%. This percentage will be phased in from 50% to 72.5% over 5 years. The output floor is calculated on a consolidated basis so the impact will be somewhat diminished.
The above impacts banks who are using the IRB approach as they will also need to calculate the SA approach. This will have a burden on banks by managing two datasets and having new processes, documentation, governance, compliance and risk/regulatory management in place.
For certain assets/products, the cost of capital will be higher which will result in different asset allocations and indirectly higher prices for clients.
Conclusion
Basel IV is a new set of regulations that will change and have an impact on how banks calculate their RWAs. One of the key changes is the introduction of the output floor, which limits the amount by which banks can use their internal models to calculate their RWAs. But on the other type of risks, banks must change their process and calculations to adapt to the new environment. This will be a challenge in the coming 1.5 years.
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