At the request of the G20 heads of state and government, the Basel Committee on Banking Supervision (BCBS) has been working for some time on finalising the post-crisis reform agenda, in particular on the revision of the global capital requirements for banks, known as "Basel III". The central focus of the revision work was on model approaches, which had generated outcomes that were too widely divergent from one another. A number of studies had identified excessive variability in risk-weighted assets and therefore in the regulatory capital derived from models.¹

However, the variability is not always unintentional. Sometimes the divergences are caused by the business models or by the fact that countries have exercised options permitted at national level. All of this was fed into discussions about the internal ratings-based approach (IRBA). In BaFin's opinion, a healthy scepticism about models is entirely appropriate. Banks have used internal models too frequently for the purpose of optimising their regulatory capital requirements, as shown by the divergences – substantial in some cases – from the applicable standardised approaches. But the deliberate use of internal models to calculate lower capital requirements is only one reason for the noticeable differences from the standardised approaches. The Basel Committee also established that the standardised approaches for credit risk, market risk, counterparty default risk and its pricing (credit valuation adjustment) and operational risk were no longer correctly calibrated to reflect the relevant risks, and adjusted them.

Output floor

Other elements of the finalisation of Basel III were the discontinuation of the advanced measurement approach for operational risk (AMA), a surcharge on the leverage for ratio global systemically important banks (G-SIBs) and, last but not least, the possible introduction of an output floor in addition to the leverage ratio.

The reason for the output floor is that the Basel Committee wants to ensure that the use of internal models does not result in regulatory capital falling below a specified percentage of the applicable standardised approach. In particular, the output floor is intended to address the issue of gaming risk, i.e. the deliberate use of modelling to lower the regulatory capital requirements. By contrast, the leverage ratio is meant to cover errors in the model.

The negotiations have proven to be difficult. While some states would prefer to dispense with modelling and apply only the standardised approaches to determine regulatory capital requirements, BaFin takes the view that internal modelling makes an important contribution to the analysis, assessment and management of risk. Many risks would remain unidentified without the use of internal models. It is important to retain these benefits.

Reducing excessive variability

In the negotiations, BaFin represented, and continues to represent, the opinion that excessive variability must be reduced, but without losing the advantages of modelling for the purposes of assessing risk. The output floor should therefore only affect outliers and not the bulk of the German banking industry.

Differing national interests have also become evident during the discussions. The differences are partly due to the fact that some risks are measured differently in different countries. For example, it is impossible to compare the default risk on a real estate loan between different countries, since the member states of the BCBS have completely different systems of insolvency law. Default on a credit derivative, however, would have almost identical legal ramifications. This has made, and continues to make, the negotiations particularly difficult, since no country wants to see its markets, major institutions or systemically important banking products restricted by international regulation.

The Basel Committee has resolved to make changes to the IRBA and to the standardised approach for credit risk. It is going ahead with scrapping the AMA and has developed a new standardised approach for operational risk. The leverage ratio for global systemically important institutions will also be introduced, depending on their existing, already known G-SIB capital buffers. These points have been cleared up. The structure and level of the output floor remain unresolved at the present time. In connection with real estate loans in particular, discussions are continuing on specific national circumstances for which there are expected to be either transitional provisions or national options. There is also no agreement at present on the level of the output floor. BaFin's position is that the output floor should be binding on institutions which use models to optimise the regulatory capital requirements. It should not penalise internal modelling to the point that institutions consider it to be no longer worthwhile, but should impose a small number of restrictions on them in the form of higher capital requirements. At the time of going to press, no decisions had been made about the final unresolved issues. The BCBS requires implementation of the whole package to be completed by 2025 – with a few special provisions as in the case of real estate financing.

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