The EBA’s push for simplification of banking regulations: less (complexity) is more (capital requirements)?

These fallback approaches may also provide on-site inspection teams and JSTs with more streamlined methods for imposing limitations ⁶ on A-IRB models. By establishing ready-made regulatory backstops, supervisors can more easily mandate conservative, "functioning" alternatives if specific components of an IRB model are deemed unsatisfactory. 

In addition to fallback approaches that exchange simplicity for conservativeness there are several changes and opportunities in the EBA paper that could reduce undue (overly conservative by way of e.g. double counting) capital requirements. The request for comments is an opportunity for banks to assess where regulatory complexity has led to overly conservative distortions of their RWA calculations, for example through exploding levels of Margin of Conservatism. 

In the end, the new regulatory framework that would be introduced by such simplifications would be hybrid approach in a continuum between risk-sensitive modelling (the EBA’s traditional point of view) ⁷ and conservative, simple rules of thumbs for capital requirements.

The proposed changes are of different categories:

• Changes that are pure simplifications/harmonizations that should not have an RWA impact

• Changes that offer banks the possibility to exchange a simplification for conservativeness

• Changes that have potentially a larger RWA impact

The impact on each portfolio will be different depending on both the composition of the portfolio and the way in which the rating system is set up. 

Whether potentially significant simplifications occur will depend on the comments and suggestions that are provided by the banks and submitted before the 10^th of May to EBA. Finalyse can help analyze the potential impact of the proposed changes to your specific situation with a workshop on the topic.

Since the introduction of the risk weight floor every bank with a real estate portfolio is exposed to standardized real estate calculations. Banks should assess the degree to which derogations relevant to the national market could help them or are currently hindering them. This is an opportunity to clarify your reporting requirements or remove unduly conservative requirements that are not appropriate to the market.

The EBA is consulting on how to implement the new rule excluding the consideration of implied government support in external credit ratings. If there is a good chance the institution will be supported by the government in case of a default, the debt is roughly as good as the government’s debt. A significant number of PSE’s and other institutions that are highly rated owe that to the implicit government support.

The impact of CRR article 138(g) is therefore significant for portfolios heavily exposed to large institutions that enjoy implied government support. The transitional arrangement allows the banks to use these credit rating until 31 December 2029. A potential disaster scenario turns every (previously A-AAA rated) institution with implied government support with a RW of about 20% into unrated exposures, for which the risk weight will be between 40% and 150%. 

Fitch is the first Credit Rating Agent (CRA) to introduce an “ex-government support” (XGS) product compliant with article 138(g). To see an example of the XGS rating in action we take Qatar National Bank, when the implied government support is taken into consideration Fitch rates its long term debt A+, however its XGS rating is only BBBXGS+ ⁸, a drop of one credit quality step which results in a risk weight adjustment from 30% to 50%.

Both these scenarios could give a shock to the capital requirements of banks that go beyond what CRR 138(g) bargained for. A case can be made that institutions rated AXGS (A rated without implied government support) are more robust than similar institutions with an A rating (possibly taking into account government support), furthermore clarification should be requested on the treatment of institutions for which no XGS rating is available. 

EBA is considering consolidating the various guidelines, RTS and Q&As for credit risk, and potentially integrating environmental and social (E&S) risk into the credit risk framework. Since the publication of the first version of the CRR, numerous regulatory products have been published by the EBA related to the IRB models’ requirements, both a level 2 (RTS/ITS) ^{8 9 10} and level 3 (guidelines) ^{11 12 13 14 15 16 17} Although these regulatory texts help to clarify and specify regulatory expectations, their sheer number makes it difficult to find one's way through them. 

Therefore, the EBA proposes to aggregate those items together by regulatory level or legal nature: the guidelines would be aggregated together and the RTS would be aggregated together into a separate item. Such bundling is meant to increase the readability of the credit risk regulation. While we agree that it will make the regulatory texts easier to navigate, we are also of the opinion that such bundling might make the readability of supervisory conclusions harder more opaque: past and on-going findings and recommendations/obligations will still refer to the old, disaggregated texts.

Secondly, the EBA proposes to integrate E&S risks in a more systematical manner into the credit risk parameters’ differentiation and quantification steps. While no details are given about such greater integration, we are of the opinion that it could be through the following propositions:

• Prescribing mandatory E&S risk factors to be included in the list of risk drivers to be tested for risk differentiation

• E&S overlay: on top of the PD grades, an ESG rating scale is mandatory, and the combination of the two ratings would up-notch or de-notch an exposure’s PD grade

• An E&S risk-dedicated MoC (to cover for ESG data deficiencies ¹⁸ for example)

• Incorporating specific E&S scenarios and risks in the valuation of collateral and guarantees ¹⁹

• The integration of a climate-related downturn scenario for the LGD and CCF parameters

• An E&S stress testing framework

 We are of the opinion that, while such E&S risk integrations are interesting in themselves, they would add to the complexity of the regulatory framework instead of simplifying it.

In this discussion paper, the EBA proposes to add a requirement to have continuous rating scale discretized for the purpose of model validation (particularly for heterogeneity and homogeneity validation purposes). There are multiple possibilities for such discretization methods (equal-width binning, equal size binning, top-down binning procedures such as Multi Interval Discretization ²⁶ or bottom-up binning such as Monotone Adjacent Pooling Algorithm ²⁷). However, we tend to think that the chosen method would be simple enough to ensure its replicability and comparability across multiple banks and portfolios. The ECB, in its 2019 guide on reporting for validation results of internal models ²⁸, states that the AUC should be calculated by mapping PD to a relevant master scale for continuous scale PD models, without specifying such master scale. However, it also specifies that for continuous LGD models, the gAUC should be calculated by mapping the LGD to an equal-width binning discretized scale. This is a possible avenue for future EBA recommendations regarding the discretization of continuous scale PD models.

A “one size fits all” method could introduce biases in model validation in our opinion, as the statistical tests might be inconclusive due to the sub-optimal nature of the discretization method instead of the poor performance of the direct estimate model. 

EBA proposes to require banks to use a single definition of facility in their IRB rating system. CRR 3 introduced a new definition of what a facility is, allowing for the possibility of aggregating multiple contracts into a unique facility if it aligns the modelling with the business practices. Prior to this clarification, there was no clear definition of what a facility was, either in the CRR or by the EBA. 

There is no obligation of consistency of the facility definition between parameters, meaning that the facility definition retained can be different for PD (for retail exposures, it is possible to define the default at facility level) and CCF. It is therefore possible for a bank to choose the facility level optimizing its capital requirements, such as having a single contract facility for the PD to limit the contagion and hence lower the realized default rate, and a multiple contracts facility to have different contracts balance cancelling each other and hence lowering the realized CCFs by circumventing the realized CCF floor to 0. 

To illustrate this point, let’s suppose a retail customer have two revolving products, a credit card (limit of €5,000 and balance amount of €3,000) and an overdraft (limit of €2,000 and balance amount of €1,500). Just before defaulting, the client maxed out its overdraft (drawing €500) and used it to pay toward its credit card balance.

By keeping the two contracts as separated facilities, the average CCF for this obligor is 50%, while by taking the two contracts as a single facility, the CCF drops to 0%, lowering the RWA.

In the discussion paper, the EBA is considering closing this arbitrage opportunity by forcing banks to adopt a single facility definition across all their parameters (at least for the same portfolio). It is, however, acknowledging that that such additional guidance would force some banks to redevelop their models as they would have to change their current facility definition. Banks with models based on different facility definitions should seek to avoid sudden redevelopment burdens. We suggest proposing flexible transitionary measures to ensure a manageable migration to the updated framework.