03 December 2013

Fitch: Loss estimates overlooked driver of Basel risk weights

Basel III's more conservative risk-based ratios will in effect "turbo-charge" the risk weights already in effect under Basel II, says Fitch Ratings. Banks will consequently face even stronger incentives to use Basel's "advanced" internal ratings-based approach.

Under Basel's "advanced" internal ratings-based (IRB) approach, loan capital charges are driven by banks' internal ratings and estimates of probabilities of default (PD) and loss given default (LGD). 

Regulators and market participants have focused on the rigour and consistency of banks' risk weightings in recent years. One example is the European Central Bank's plan to conduct "asset quality reviews" of Member States' banks that "will lead to adjustments in the risk-weights, where justified." How banks internally derive borrower ratings and PD estimates - and their concomitant impact on risk weightings - has received considerable attention. By comparison, banks' estimates of LGD have largely "flown under the radar", despite their potentially significant influence on regulatory capital.

The use of internal LGD estimates might soften the potential negative impact of Basel III on lending to SMEs. Those that can borrow on a secured basis could benefit because collateralised lending reduces the lender's LGD and so the risk weights applied to these borrowers. Basel III's explicit allowance of the use of internal LGD estimates has given banks greater incentives to manage and mitigate potential loss severity in order to benefit from reduced risk weightings. This might strengthen banks' efforts to apply prudent lending standards, enhance risk management, and monitor collateral and covenant compliance in corporate loan portfolios. However, it is challenging to compile statistically robust LGD data. An LGD observation requires that borrowers actually default, which is a relatively rare event for many asset classes.

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