Following the adoption of the final Basel III rules, the real estate exposure class will be reclassified to provide greater granularity in terms of the inherent risk associated with various forms of real estate transactions and loans.
The new risk-weighting treatment keeps the distinction between residential and commercial mortgages. Still, it adds more granularity depending on the type of exposure (whether the guaranteed property generates income streams) and the stage of the property (construction phase vs completed property).
What is new is the provision of special treatment for income-generating real estate mortgage loans (IPRE), loans whose repayment is heavily reliant on the cash flows generated by the property that backs them up. According to evidence gathered by the Basel Committee, such loans are inherently riskier than mortgage loans, whose repayment is dependent mainly on the borrower's underlying ability to repay the loan. However, there is no special treatment for such higher-risk exposures under the existing SACR, even though the reliance on cash flows supplied by the property guaranteeing the loan is a substantial risk element. Because of the lack of specific treatment, there may not be enough money to cover unexpected losses on this sort of real estate risk.
As a result, new definitions are updated, replaced, or inserted in CRR3 to clarify the meaning of the various forms of real estate exposures secured by mortgages, including IPRE mortgages, by clearly separating exposures secured by mortgages on residential and commercial real estate (residential and commercial).
In terms of secured mortgage exposures on residential real estate, CRR3 is in line with Basel III rules. While the loan split technique, which divides mortgage exposures into a secured and unsecured portion and applies the appropriate risk weight to each of these two portions, will be preserved, its calibration will be changed in accordance to Basel III criteria. The risk-weighted exposure of up to 55 per cent of the property value is 20 per cent. Furthermore, for residential mortgages, when the property is not suitable for a loan split, CRR 3 provides a more risk-sensitive exposure-to-value (ETV) ratio-based endorsement treatment (e.g. because it is not yet completed).
Commercial real estate risks are treated similarly to residential real estate exposures. For properties with a value of up to 55 per cent, the tried-and-true loan-split method is preserved and adjusted to Basel III criteria, with the secured half of the exposure carrying a 60 per cent risk weight. Additionally, if loan-splitting is not an option, CRR 3 offers a risk-sensitive alternative strategy based on the ETV ratio for commercial mortgages.
While maintaining the "hard test," which allows institutions to apply the same preferred risk weights to income-generating and other real estate exposures secured by property located in markets with annual loss rates that do not exceed certain thresholds, a specific and more detailed risk weight treatment for commercial IPRE exposures is also introduced.