The new partial use philosophy of the Basel Committee and the EBA could be the first step into a revival of the IRB approach. Both, institutions that want to use the IRB approach and banks using the IRB approach will profit from much more flexibility and cost reduction.
The finalisation of Basel III, also called „Basel IV“ by the banking industry, together with the amendments to the new Capital Requirements Regulation (CRR II), is probably the most comprehensive revision of the rules and regulations for calculating risk-weighted assets (RWA) since the introduction of Basel II. Discussions to date on the effects of the changes have focused on the requirements related to the new capital floor, the credit risk standardardised approach (CRSA), the revised capital requirements for credit valuation adjustments (CVA) and the requirements for calculating RWA in the internal ratings-based approach (IRBA). However, an important innovation described only briefly in the final Basel paper of December 2017 (Basel III: Finalising post-crisis reforms, BCBS 424) has received little attention so far: the so-called „partial use philosophy„. The new requirements for partial use of the IRBA will lead to significant changes in the nature and level of RWA of institutions – the impact of the new partial use requirements on individual institutions may even be greater than that of any other innovation.
Overview of current partial use requirements
One of the most important requirements for IRBA institutions is the obligation to apply the IRBA not only at the level of individual positions, portfolios or asset classes but also at the level of the bank as a whole (Consolidated Basel Framework CRE 30.47 – CRE 30.49). The background to this is the aim of banking supervision to avoid „cherrypicking“, in other words, situations where IRBA is applied only to those positions for which risk-weighted assets as determined using IRBA are lower than using the Credit Risk Standard Approach (CRSA). In order to make it easier for institutions to switch to the more individual and risk-sensitive IRBA, the CRSA may still be used to calculate RWA for certain portfolios or positions in exceptional cases. This so-called Partial Use (PU) can take the form of:
- Permanent Partial Use (PPU), where CRSA is permanently applied for certain immaterial exposures or run-off portfolios, or
- Temporary Partial Use (TPU), which is used in a transitional period during the IRBA implementation phase.
This provision of the Basel framework has also been transposed into European law and is regulated in Article 148 of the CRR for the TPU and in Article 150 CRR for the PPU. The CRR rules leave considerable discretion to the national authorities as to how the PU must be applied in detail by the institutions.
Although the above two articles of the CRR give the European Banking Authority (EBA) a mandate to develop a Regulatory Technical Standards (RTS) for the Europe-wide standardisation of PU requirements, these standards have not yet been issued. As a result, national interpretations continue to be deciding, and sometimes there are large differences between interpretations in different countries.
In Germany, the national interpretation was based on the Solvency Regulation (SolvV). Sections 7 to 17 of the SolvV describe in great detail which positions may be permanently excluded under the PPU. The TPU pursuant to SolvV requires banks to achieve a degree of coverage of at least 50% (entry threshold) of RWA and Exposure at Default (EAD) when applying IRBA for the first time. After two and a half years the coverage must be 80 % (reference time) and after five years it must be 92 % (exit threshold). These are very conservative values by European and international standards. This can be seen, for example, from the interpretation of the PU by the European Central Bank (ECB) during the Targeted Review of Internal Models (TRIM): here the ECB only requires a coverage ratio of 80% per exposure class for banks that have been using the IRBA for many years. (please click to enlarge)
Figure 1: Temporary partial use according to SolvV
Partial use as an obstacle to switching to IRBA?
The PU requirements described above, especially when interpreted as strictly as in Germany, have in the past prevented many institutions from switching from the CRSA to the IRBA. These are, for example, special institutions such as Covered bond banks (Pfandbriefbanken) and building societies, regional banks, but of course also large and medium-sized cooperative banks and savings banks. The reason for not switching to the IRBA is in particular that, although these institutions already have very good internal rating and scoring procedures for their core portfolios, which already meet the CRR requirements or can be improved very quickly, for the remaining portfolios the institutions only have rating procedures which, for various reasons, do not meet the CRR requirements and would be very costly to improve. Since this means that the very high requirements for the degree of coverage of the SolvV cannot be met, many of the above-mentioned institutions have not taken the path to the IRBA, although there is a will to do so. Germany is just one example. Other EU countries have similarly stringent requirements on the PU, with the same impact on the institutions‘ ability to switch from the CRSA to the IRBA.
From the institutions’ point of view, a strict interpretation of the PU requirements is, of course, disadvantageous, as they cannot benefit from the potentially lower RWA in the IRBA. There are also many reasons from the banking supervision point of view why the use of IRBA is advantageous. For example, the use of the IRBA leads to better lending standards, better pricing of credit risks, more appropriate risk provisioning and better credit risk management. A strict interpretation of the PU rules can, therefore, hamper the further development of credit risk management procedures at some institutions.
The new partial use philosophy of the Basel Committee
With the publication of BCBS 424, the existing PU requirements will be fundamentally revised by the Basel Committee. According to the new partial use regulation, also known as the „PU philosophy“, institutions may in the future choose whether to apply the IRBA or the CRSA for each asset class. There are no longer any requirements for an overall coverage ratio at the level of the entire institution. (please click to enlarge)
Figure 2: Overview of asset classes according to BCBS 424
The new partial use philosophy applies not only to the situation when a bank wants to switch from the CRSA to the IRBA, but also when an institution already uses Foundation IRBA and wants to switch to the Advanced IRBA.
At first glance, this change does not seem so significant, but it does mean that it will be much easier for institutions to switch from the CRSA to the IRBA in the future. For the above-mentioned institutions, which were excluded from the IRBA due to the strict PU requirements, one of the main obstacles to a change has now been removed. The rating procedures for portfolios for which the institutions already meet most of the IRBA requirements can now be transferred to the IRBA with relatively little effort, while the remaining portfolios remain on the CRSA.
In order to avoid the aforementioned problem of cherrypicking, the BCBS makes it clear that national supervisors must carry out a very intensive IRBA approval process. In contrast to the previous procedure, the purpose of this approval process is not only to check whether all the requirements of the IRBA for the relevant portfolios have been met but also to intensively check whether an IRBA can be implemented at a reasonable cost for the portfolios remaining on the CRSA.(please click to enlarge)
Figure 3: Example of temporary partial use according to BCBS 424
The redesign of the PU scheme brings the BCBS a step closer to its objective of strengthening confidence in the use of internal models for RWA calculation purposes. The development of rating models becomes all the more complex, less representative and thus less accurate the less internal default data is available for modelling. Taking into account the new PU requirements, institutions will tend to transfer core portfolios in which they have been able to develop good rating procedures as described above and have collected default data to the IRBA. Smaller, less strategically important portfolios with less default data will remain on the CRSA. The Basel Committee is thus consistently following the motto: „Do not model without reliable data“. The new regulations will ensure that only positions for which high-quality rating and scoring procedures can be developed will be dealt with in the IRBA.
It is not only the changed PU philosophy that will motivate institutes to switch back to IRBA more frequently in the future. Since the introduction of Basel II, the modelling techniques and processes have steadily improved. The development of CRR / Basel II-compliant rating and scoring procedures is also far less complex than 15 years ago. In addition, there are also considerably more interpretation aids on the part of the supervisory authorities, which, like the institutions, have learned a great deal in recent years about rating and parameter modelling. These new interpretation tools include the EBA’s IRB Repair initiative including guidelines on the estimation of risk parameters, guidelines on the application of the new default definition and guidelines on credit risk mitigation techniques. (please click to enlarge)
Figure 4: Overview of additional supervisory guidelines and interpretation aids (IRB repair or IRB 2.0)
In addition, the introduction of IFRS 9 has also given the institutions experience in modelling credit risks (even if the risk parameters under CRR and IFRS 9 differ significantly).
Against the backdrop of the new CRSA, which will bring significant RWA changes for European institutions as part of the implementation of Basel IV, the new PU philosophy will become an important response instrument for CRSA institutions. Individual impact analyses at CRSA institutions have already shown that the RWA increases due to the changes in the new CRSA can be (over)compensated by switching individual asset classes to the IRBA.
Whether it makes economic sense for a bank to switch selected asset classes from the CRSA to the IRBA ultimately depends on the individual case and, of course, on many parameters which we cannot go into further here.
No way back or back to the future?
The new PU philosophy should be welcomed. Institutions have the possibility to benefit from their previous investments in rating systems, which in the past were only used for internal purposes, and now could be used for regulatory purposes and RWA estimation. Supervisors can expect an improvement in risk management and better credit decisions from the implementation of IRBA at individual institutions. It is always ensured that only those rating procedures are permitted in which very good modelling has been carried out on the basis of individual default and loss histories of the institutions. In its report on the implementation of Basel IV (finalisation of Basel III) published at the beginning of August, the EBA, therefore, took up and expressly addressed the topic of the changing PU philosophy (EBA Policy advice on the Basel III reforms: Credit Risk Standardised Approach and IRB Approach (EBA-Op-2019-09a)).
However, the new PU philosophy may lead to a competitive disadvantage for institutions already using the IRBA: these institutions have often invested heavily in the rollout of the existing IRBA for all asset classes, regardless of potential RWA savings. On the other hand, institutions seeking to switch to the IRBA in the future can achieve a balance between the effort required to implement the IRBA and RWA savings. This comes along with the intensive scrutiny from supervisors of potential uses of regulatory arbitrage or questions from the supervisors about potential cherrypicking.
A change from the IRBA to the CRSA seemed unlikely or even impossible on the basis of the experience of recent years. The EBA takes up this fact of unequal treatment in its above-mentioned report and makes a very important statement. The EBA expressly points out that, according to the CRR, even today it is possible to switch to less advanced approaches in extraordinary circumstances with the approval of the competent authority. In the view of the EBA, the implementation of Basel IV with the far-reaching changes to the RWA calculation in the CRSA, the IRBA and the introduction of the new capital floor is such an extraordinary circumstance. This means that institutions that already use the IRBA today will in future be able to exclude individual asset classes from the IRBA’s scope of application, with the approval of the competent authority. The return to the CRSA and the possibility of „dismantling the IRBA“ will enable institutions to optimise costs for the further development and maintenance of the IRBA procedures. This is in the interest of both the institutions and the supervisor. This is the first time that the EBA has provided an indication of when and under which conditions it may be possible to switch from the IRBA to the CRSA. Against the background of the very strict interpretation to date, this recommendation is a small revolution. (please click to enlarge)
The EBA also recommends that the entire new PU philosophy (new requirements for switching to the IRBA and for switching from the IRBA) should be incorporated into CRR III and, in addition, that a mandate to the EBA to develop detailed requirements for the PU should be included as well.
Importance of the new Partial Use Philosophy
The new partial use philosophy will breathe new life into the IRBA together with the new additional EBA guidelines, improved modelling standards, enhanced IT systems and experience from IFRS 9 implementation. Many European institutions that previously used the CRSA to determine RWA for credit risk have begun to conduct analyses of the economics of switching to the IRBA since the beginning of 2019. Institutions that are particularly affected by a potential RWA increase from the new CRSA rules within the framework of Basel IV see the IRBA as a good opportunity to compensate for the RWA increase, and at the same time to add a further purpose to the investments in rating procedures that have already been made over many years. The supervisory authorities will welcome this approach in principle but will prevent the institutions from cherrypicking by means of intensive approval tests. Since it can be assumed that asset classes with large and long default histories are more likely to be transferred to the IRBA, this will increase confidence in IRBA rating procedures.
If the existing IRBA institutions are actually given the opportunity to exclude individual asset classes from the application of the IRBA as part of the Basel IV implementation and thus save costs, this is also a step in the right direction, namely to strengthen confidence in internal models. This is because it is to be expected that rating procedures that cover non-core portfolios will be removed from the scope of application due to insufficient default histories. These portfolios often have only minor differences between the RWA in the CRSA and the IRBA, as the supervisory authority requires RWA add-ons or Margin of Conservatism on top of estimated parameters to account for model risks.
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 In the Foundation IRBA, institutions estimate only the probability of default (PD) internally. LGD and CCF are prescribed by supervisors and can be reduced through credit risk mitigation techniques.