Evolution of Risk Weightings

How were risk-weights determined under Basel II?

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:

• Standardised approach: Follows the rules laid out in the framework and is based on external credit ratings which translate to a fixed risk weight
• Internal Model approach: Based on internal loss models and has to be signed off by the regulator

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: 

• AAA to AA-: 20% risk-weighting
• A+ to A-: 50% risk-weighting
• BBB+ to BB-: 100% risk-weighting
• <BB-: 150% risk-weighting
• Unrated instruments: 100% risk-weighting

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.

How are risk-weights determined under Basel III?

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:

• Residential mortgage risk weights would depend on the loan-to-value ratio of the mortgage, rather than the 35% flat rate in Basel II.
• Banks were required to conduct their own due diligence, rather than rely solely on the external credit rating. This led to the introduction of a revised output floor under Basel III, which limited the benefits that banks were able to gain from using internal models.
• Introduced a capital charge for potential mark-to-market losses of derivative instruments which were aligned with any deterioration in creditworthiness of the counterparty (CVA risk). 

How are risk-weightings being refined under Basel IV?

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:

• Corporate exposures are now determined between general and specialised lending
• Exposure to residential real estate is further refined and split based on income-producing or general real estate
• Subordinated debt and equity exposure are now assigned risk-weights of 150% and 250% respectively