The standardised approach is one of the methods that banks can use to determine their risks and thus their minimum capital requirements. It is a simple model, prescribed by the supervisory authorities. In addition to the standardised approach, there are other approaches available, based on internal ratings: the foundation internal ratings-based approach (F-IRBA) and the advanced internal ratings-based approach (A-IRBA).

The standardised approach is the method most frequently applied. It is usually used by small and medium-sized credit institutions, but is also used by big banks that supplement their internal modelling in part with the risk weights of the standardised approach (partial use).

The new standardised approach is also intended in future to serve as a yardstick for internal model approaches for credit risk. For in the future there will be lower limits for the minimum capital that must be held, known as “floors”, which will be linked to the standardised approaches. They come into effect whenever the internal models come up with lower capital requirements. The floors paper was also open for consultation until 27 March.

In addition to the standardised approach for credit risk, the BCBS is also currently revising the standardised approaches for market risk and operational risk.

Frank Pierschel, Head of the Banking Supervision Section of the department for International Policy/Affairs at BaFin and co-chair of the Task Force on Standardised Approaches (TFSA) at the BCBS, sets out the background of the new standardised approach and explains what is in store for the banks.

Mr Pierschel, why does the BCBS want to revise the standardised approach for calculating credit risk?

The standardised approach is the method most frequently used by credit institutions to calculate their capital requirements. In the immediate aftermath of the financial crisis, the standardised approach for credit risk was not much in focus. But now the time is ripe to address the issue. It is essential to remedy the shortcomings of the standardised approach and to adapt it to the BCBS’s new direction. Capital requirements are to be made simpler, more comparable and more risk-sensitive. Furthermore, the aim is to create an approach than can be applied to all banks. It is to apply world-wide – not just in the 27 countries that are members of the BCBS. And finally, the new standardised approach would as far as possible reduce external ratings. To this end, the TFSA will in due course develop additional procedures for risk classification.

Will the banks therefore have to get used to the idea of completely new rules?

Yes and no. The fundamental concept of the standardised approach – namely weighting by risk classes – will remain. But there will have to be changes within these classes. They are both sensible and necessary – for example, where external ratings are currently used, but also in matters relating to the risks attached to certain claims and banks’ incentive structures. Both must be taken into account in a better fashion. The new approach will also involve revised credit risk mitigation techniques. The draft that was open for consultation is based on a risk-driver matrix approach. The TFSA took great care to select the drivers that best reflect default rates. The new standardised approach should also exclude the use of internal modelling. Furthermore, wherever possible its definitions are to be harmonised with those of the framework for the IRB approaches.

Will the new standardised approach be more expensive for the banks?

The TFSA is not mandated to increase capital requirements. Nevertheless, the new standardised approach will contain elements that may perhaps entail additional capital requirements. One example: There is to be a risk weight add-on for lending to retail clients that is denominated in a different currency to their income. This plays only a minor role in Germany, but in Austria and Hungary, for instance, a lot of banks have extended loans in Swiss francs. This risk came to light after the Swiss franc peg against the euro was abandoned. It has not yet been decided how high the add-on should be. The risk weights that are used in the consultation document are only a first indication. As soon as the QIS has been completed, the TFSA will begin to re-calibrate the risk weights.

When will that be?

I expect the first results of the QIS to become available in June. Like the consultation document, the QIS has deliberately been left open-ended. We are examining various risk drivers to identify the most suitable – or whether there are actually any that are even better. It is therefore very important for the industry to involve itself as closely as possible in the study.

What happens then? When will the banks have to apply the new standardised approach?

We expect to have incorporated all contributions to the consultation and the results of the QIS into the draft by autumn. The TFSA currently plans to submit the new approach to the BCBS in December 2015. Whether this compromise will then be ready for all members to adopt it remains to be seen. After that, it will take a good two years more before the new standardised approach can actually be applied – for governments will also need time to implement it legally.

Why the scepticism? Are there particular pitfalls that you are having to grapple with in the revision of the standardised approach?

Our job is not an easy one insofar as the Task Force does not consist just of the members of the BCBS. The World Bank and many non-BCBS countries such as Poland, Thailand, Chile, the United Arab Emirates and Jersey – representing offshore centres – also sit around the table. All told, 33 countries and five multilateral organisations are represented in the TFSA. On the one hand it makes sense to bring the broadest possible experience into the standardised approach, but on the other hand it means that we have a very great mix of interests represented in the TFSA. Everyone can live happily with 90 per cent of the document – unfortunately, the remaining 10 per cent causing the problems does not overlap and is spread across the whole approach.

What issues are the subject of particular dispute?

We must find a compromise for the new standardised approach that settles how external ratings can be replaced by a supervisory approach. It is here that the greatest problems are occurring. Many countries do not want to do away with external ratings; others, on the other hand, are actually having to do so because national legislation so requires. The best example is the Dodd-Frank Act in the US. And yet more others are not convinced by the proposed risk indicators or believe that the Basel III terminology – such as the risk indicator for core capital CET 1 – cannot work for counterparties from countries that use Basel I or II.

A further problem is the thresholds used to differentiate between retail and corporate customers. Since Basel II, aggregate borrowing of 1 million euros has applied. Retail customers are given a risk weight of 75 per cent, while a risk weight of 100 per cent has to be applied to unrated companies. With a higher entry threshold small businesses with borrowings of a little more than 1 million euros could also benefit from the more favourable risk weight for retail customers. Some more highly developed markets, including most EU member states, would therefore like to have a higher threshold; on the other hand, various less developed financial markets, such as Indonesia or the Philippines for example, want a lower threshold. The treatment of the risks attaching to commercial real estate lending is a contentious issue as well, since the existing approach reflects only the corporate risk represented by the real estate company, the developer or the letting company, without taking any account of the value of the real estate as collateral in the risk analysis.

An open-ended consultation document, a lot of differences. Are you confident of reaching agreement?

Yes. Irrespective of how long the project takes, at the end of the day there will have to be international agreement. A lot of countries have amended their legislation in response to the financial crisis, so that the foundations on which the standardised approach is based have also changed – see external ratings, for example. A further factor is that the standardised approaches are having to be amended to take account of the BCBS’s new philosophy of making supervisory requirements simpler and more comparable but sufficiently risk-sensitive. But all that will be achievable only if all sides are prepared to compromise. We are maintaining a constant dialogue with all parties, including the financial industry. We are on the right track.