The latest update to the capital requirements regulation under Basel 3.1 reinforces the notion that EU supervisors strongly favor a standardized approach (SA) to credit risk measurement over an advanced internal ratings-based (A-IRB) approach. This is particularly true with respect to one of the most controversial elements of Basel 3.1: the output floor, which is scheduled to go into effect on January 1, 2025.
Marco Folpmers
The output floor incentivizes the adoption of the SA by banks, partly by restricting the advantages they can gain from applying the A-IRB approach. Consistency in the calculation of risk-weighted assets is the line of reason most cited by prudential authorities (especially the European Banking Authority) when explaining the output floor changes that have been implemented and the reason SA is favored over A-IRB. Today, supervisors argue, there is too much variability in RWA computations.
Banks, supervisors further contend, have in the past used diverse internal models to comply with a wide range of regulatory capital requirement measures for the same hypothetical portfolio. More problematic, however, may be the inconsistencies in Basel’s near-final rules for capital requirements regulation (CRR3), specifically with respect to the formulas for calculating the output floor during a five-year transition period. Let’s now discuss the mechanics of this backstop and why it is such a rough and counterintuitive measure.
The output floor is the “lock on the door” – or the backstop for the A-IRB approach. It puts a limit on the amount of capital benefit a bank can obtain from its use of internal models relative to the SA.
The BCBS describes this restriction as follows: “Banks’ calculations of risk-weighted assets generated by internal models cannot, in aggregate, fall below 72.5% of the RWAs computed by the standardized approaches. This limits the benefit a bank can gain from using internal models to 27.5%.” It needs to be applied, moreover, not merely at the group level but at all levels of consolidation.
Consequently, when determining the final total risk exposure amount (
Essentially, this means that the
Specifically, the output floor will gradually increase from 50% in January 2025 to 70% in January 2029; it will not reach its final value of 72.5% until January 1, 2030.
During the transition period, the formula for calculating the output floor will be modified as follows:
Under this formula, the output floor will be limited to 25% of the unfloored
In the figure, we have added the 45° line in light green, as well as its multiple (1.25) in gray. Moving along the x-axis (from the right to the left), we can see that there are three different regimes – or possible areas for the unfloored 𝑇𝑅𝐸𝐴 as a percentage of the capital requirement as computed under the standardized approach:
The outcomes of all three scenarios are baffling. Firstly, both the 72.5% output floor and the transition path toward it (captured in variable
Indeed, for
The near-final text of CRR3 contains baffling specifications of the output floor. This leads us to ask the following unresolved questions: (1) How was the 72.5% value of the floor calibrated, if it was indeed statistically calibrated rather than politically motivated? (2) Why should banks stop fully relying on the IRB capital requirement below this exact percentage? and (3) Why is confidence in the IRB capital requirement restored as soon as the gap between floored and unfloored
Supervisors and legislators claim to want to reduce variability in banks’ RWA calculation – but have yet to clarify the logic behind the output floor. Banks that are forced to comply with the Basel 3.1 rules for capital requirements are at least owed a detailed explanation about why the output floor modifications, and the preference toward standardized approach over internal models, make sense.
Dr. Marco Folpmers (FRM) is a partner for Financial Risk Management at Deloitte the Netherlands.