It is no secret1 to the Basel Committee that the Basel II regulatory framework did muster quite a bad reputation as an efficient means to strengthen the resilience of banks, in particular during and after the 2008 financial crisis.
Indeed, the initial framework was somewhat flawed; with the benefit of hindsight, ‘obvious’ issues were overseen. Risk weights did not always adequately capture the risks inherent to their corresponding assets and certain institutions proceeded to amass these assets in a form of regulatory arbitrage, losing among others the benefits of a proper diversification of risks. When the tail risks on the assets eventually realised, many an institution found themselves exposed, particularly to these assets.
Basel III, and its latest iteration, “Basel III: Finalising post-crisis reforms”, aims at getting rid of perverse incentives that the former way of calculating RWA created, whilst still making sure that institutions hold an adequate capital level against their credit and counterparty risks.
In this section we will turn our attention to Credit Risk in particular. It has been long expected that Credit Risk would be massively impacted by Basel 3.5, presented with the stated objective of tackling all the perceived issues of the previous versions and ensuring a level playing field as much as possible; indeed, the current regulation totally overhauls the way risk weighted assets (RWA) are calculated.
1. The most obvious cases of awareness are for instance the Basel Committee on Banking Supervision identifying “mechanic reliance on external ratings” and “insufficient risk sensitivity” as two major weaknesses of the Securitisation Framework in their December 2014 ‘Revisions to the securitisation framework’, or the October 2013 Discussion Paper on ‘The regulatory framework: balancing risk sensitivity, simplicity and comparability’.