Basel regulators make U-turn on banks’ use of credit rating agencies

• Basel has second thoughts on excluding external credit ratings
• Basel to end use of models for assessing operational risk
• Review of trading book rules to be completed by year’s end
• Outcome of strategic review of capital rules due around year-end

LONDON (Reuters): Global banking regulators have decided to allow lenders to keep using credit rating agencies to help them determine how much capital they need to hold to cover the risks of borrowers getting into trouble, a top central banker said last week.

Stefan Ingves, head of the Swedish central bank and chairman of the Basel Committee on Banking Supervision, said few banks were happy with proposals made in March to revise a ‘standardized’ approach for calculating credit risk. This refers to actual losses or fall in credit quality at the individuals, companies and other banks it deals with.

Revised proposals would be published by the end of the year, Ingves said.

“This is likely to include re-introducing a role for external credit ratings into the credit risk capital framework,” Ingves told a meeting in Lima of the Institute of International Finance, according to the text of his speech which was made available in advance.

The Basel Committee of banking regulators from nearly 30 countries proposed in March revising how lenders assess what capital provisions they must make to guard against credit risks, which for many banks account for most of their risk-weighted assets.

In particular regulators wanted to simplify how the capital buffers are calculated after seeing wide variations in the methods used, and proposed reducing a reliance on external credit ratings of borrowers issued by agencies like Moody’s, Standard & Poor’s and Fitch. This followed policymakers’ concerns following the 2007-09 financial crisis that banks had become too reliant on agencies, some of whose ratings on securities such as collateralised debt obligations (CDOs) were too lenient, leaving lending such as in the sub-prime U.S. home loans market to balloon. Since then U.S. financial industry reforms under the Dodd-Frank Act have gone as far as barring all references to external ratings agencies, leaving regulators scratching their heads as to how exactly banks should assess their inter-bank risks.While many banks use Basel’s standardised approach to assessing risks big bank use more bespoke in-house models which can mean having to hold less capital.

Operational risk

Ingves said the Basel Committee will also consult on revised proposals that banks should only use a standardised approach rather than in-house modeling to calculate their operational risk capital requirements.

Operatonal risk is defined by the Basel Committee as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” Work on revising bank trading book rules, which began well before the financial crisis, will also be completed by year end, he added. The aim is to require banks to hold more capital to cover trading in less liquid securities such as longer dated bonds. 

Meanwhile banks complain privately that regulators are piling on changes to the Basel III industry reforms that have resulted from the financial crisis and that there is a Basel IV in the making which leaves them unsure of the business model they should operate. Ingves said Basel’s policy response to the financial crisis, when taxpayers had to rescue undercapitalised banks, was largely complete and the overall architecture clear.

But he also said the committee would publish the outcome of its strategic review of its capital framework rules around the end of the year which could call for further reforms. “This will provide further clarity on how the committee intends to address the issue of excessive variability in risk-weighted assets,” Ingves said.