15 years: Debt capital markets
In this video, Sukhy discusses the evolution of risk weights through the publication of Basel II and III and then spends some time considering the future of risk weights under Basel IV.
In this video, Sukhy discusses the evolution of risk weights through the publication of Basel II and III and then spends some time considering the future of risk weights under Basel IV.
The capital adequacy rules in Basel I were limited. It considered credit risk, but didn’t consider the duration, counterparty not the market risk. Over time the rules have been developed, firstly through an amendment to the Basel I framework in 1996, then with the implementation of Basel II, III and IV.
Key learning objectives:
Outline how risk-weights were calculated under Basel II
Outline how risk-weights are calculated under Basel III
Understand how right-weight calculations are being modified through Basel IV
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Basel II was published in 2004 and amended the framework to consider each type of asset’s risk profile and specific characteristics more effectively by incorporating not just credit risk, but market and operational risk as well.
Under Basel II, banks could implement the risk-weighted through two approaches:
Under Basel I, a Commercial Loan was assigned a risk weighting of 100%, under Basel II it would be weighted according to the credit rating assigned to the loan to better reflect the underlying risk.
Risk weightings for commercial loans were driven by the following credit rating bands:
Claims on Sovereigns and central banks were also risk-weighted by credit rating, but at lower rates to reflect the lower level of associated risk.
Assets secured by residential property and commercial real estate were assigned a risk weight of 35% and 100% respectively.
Basel III was implemented in 2010 following the global financial crisis and the limitations of the Basel II framework the crisis highlighted. It was the mispricings and inadequate credit ratings that led to insufficient capital being held against risky mortgages which ultimately ended up bringing down Lehman Brothers.
The BCBS responded with various reforms relating to the management of liquidity risk, as well as higher minimum capital and leverage requirements.
Key developments in relation to risk-weights in the Basel III framework included:
The BCBS has continued to refine the risk-weighting rules included in Basel III and in 2017 announced new proposals known as Basel IV. These new proposals set out to further enhance the risk sensitivity for the calculation of market, credit and counterparty risk.
One of the key elements which Basel IV set out to address was the inconsistencies still present between the standardised and internal models. This led to a refined output floor of 72.5%, meaning banks that calculate capital requirements based on internal models, cannot be less than 27.5% below the equivalent calculated under the standardised approach.
The other area which underwent a fundamental revision was the credit risk component for almost all exposures using the standardised approach:
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