EBA publishes reports on comparability of Risk Weighted Assets (RWAs) and pro-cyclicality

In the context of its ongoing work on comparability of RWAs, the European Banking Authority (EBA) published today three reports: (i) an interim report on the consistency of RWAs in SMEs and residential mortgages portfolios; (ii) a report on the comparability of supervisory rules and practices; and (iii) a report on variability of RWAs for market risk portfolios. Furthermore, the EBA also released its report on the pro-cyclicality of banks' capital requirements, which supplements the work on comparability, together with a summary report that compiles all the work on comparability of RWAs for IRB models.

The objective of this work is to address unjustified differences in the denominator of the capital ratios, to understand the sources of such differences and, if need be, to formulate the necessary policy solutions to enhance convergence in supervisory and banks' practices, ultimately improving disclosure too.

The two reports related to IRB models published today and the two previously published interim reviews on the consistency of credit risk RWAs together with the pro-cyclicality report have been compiled in a summary report which has been submitted today to the European Commission, in line with the EBA's mandate in the CRR.

The summary report includes the policy responses that the EBA considers as particularly important for addressing concerns about RWA consistency. In this respect, the EBA will focus its future work on the following aspects:

• Enhancing disclosure and transparency of RWA-related information.
• Supporting competent authorities in properly implementing the single rulebook with the delivery of existing mandates set out in the CRR. These include the important benchmarking work on RWA parameters that supervisors can use to assess model outcomes.
• Developing additional guidance that specifically addresses and facilitates consistency in supervisory and banks' practices, which includes for example uniform default definitions and harmonised treatment of defaulted assets under the IRB approach, clearer guidance on PD and LGD estimations and treatment of low-default assets.

Report on SMEs and residential mortgages

This report outlines the interim results of the third stage of the EBA's work on banking book exposures and focuses on SMEs and residential mortgages portfolios. Forty-three banks provided quantitative and qualitative information on the Internal Ratings-Based (IRB) models used for Residential Mortgages, SME Retail and SME Corporate, along with the historical data used for the development and calibration of the internal approaches.

One key finding was the importance of defaulted assets which account for over half of the variation in risk weights and expected losses. The underlying portfolio mix represents around a third of the variation in the overall Global Charge (GC) and Risk Weights (RW) for non-defaulted assets. The remaining two thirds of the dispersion for non-defaulted assets can be attributed to other drivers such as: differences in underlying credit risk, use of credit risk mitigation, modelling and supervisory practices. The geographical location of the exposures, notably the different economic conditions and other country-specific aspects, also play an important role. Regarding SMEs, the size of the enterprise influences variations in RWAs.

Report on the comparability of supervisory rules and practices

The EBA also issued a report on the impact of supervisory rules and practices on comparability of capital requirements under the IRB approach across the EU. On the basis of data collected from EU supervisors, the EBA noticed divergences in terms of how regulatory frameworks are implemented at national level. Some aspects were identified that may require additional work to ensure better harmonisation of supervisory practices across the EU. These relate to aspects such as supervisory practices, roll-out plans, PD and downturn LGD computation.

Report on pro-cyclicality of the IRB approach

As mandated by the European Commission, the EBA also assessed whether the Capital Requirements Directive (CRD) contributes to pro-cyclicality in the financial system, i.e. whether the capital requirement regulation exacerbates business cycle fluctuations. Capital requirements under the IRB approach are inherently risk sensitive, through the input risk parameters to IRB models, namely the probability of default (PD), the loss given default (LGD) and the exposure at default (EAD). During a downturn, assessments of credit and market risk may increase, and may force banks to hold more capital against those increased risks. As a consequence, banks may shrink their lending behaviour, and may hence contribute to the downturn. The question addressed in this report is, therefore, whether the design of the current capital requirement regulation is a cause of higher business cycle fluctuations. On the basis of currently available data, the EBA found limited evidence for pro-cyclicality of capital requirements, and could not to establish a clear link between capital requirements legislation and pro-cyclicality.

Report on variability of RWAs for market risk portfolios

Besides the RWA work related to credit risk, the EBA has also focused its attention on market risk. This report outlines the conclusions stemming from a market hypothetical portfolio exercise (HPE) which the EBA conducted in 2013 in parallel with a similar exercise performed by the Basel Committee. The report focuses on the level of variability in banks' internal models for market RWAs. This study shows that, for banks applying historical simulation, around 30% of the variability observed for individual portfolios and 50% for the aggregated ones may be driven by modelling options explicitly provided for in the CRR. The EBA has also conducted a Profit and Loss (P&L) analysis, which is complementary to the assessment of variability based solely on model outcomes. This analysis provides, for each individual portfolio, an assessment of the degree of P&L volatility and correlation across banks.