EBA publishes second interim report on the consistency of risk-weighted assets in the banking book of EU banks

The European Banking Authority (EBA) released today its second interim report on the regulatory consistency of risk-weighted assets (RWAs) for credit risk in the banking book. This report illustrates the outcomes of the next stage in the EBA's review into RWA consistency in sovereigns, institutions and large corporate exposures, generally referred to as low default portfolios (LDP). The aim was to identify and further understand the sources of any material differences in RWA outcomes for portfolios which are specifically challenging for the banks due to limited availability of data. This analysis is closely aligned with the global work of the Basel Committee which recently released the results of their report.

Outcome of the LDP review

Following the first top down analysis which identified the most obvious drivers of differences, this comparative analysis, conducted with a benchmarking portfolio exercise, found relevant differences in:

• The scope of the application of internal models to LDP counterparts (e.g., application of the standardised approach - permanent exemption and roll-out);
• The probabilities of default (PDs) and the loss given defaults (LGDs) parameters for the same exposure to a counterparty;
• The definition of default and the computation of the default rate used for the calibration of the internal models;
• The computation of risk weights and expected losses on defaulted assets.

The study also identified the existence of discrepancies in the ways of computing maturity parameters, the Credit Conversion Factor (CCF) parameters applied for calculating the exposure at default (EAD) and banks' reporting practices.

Moreover, the report noted that banks' choices or supervisory requests to apply minimum PDs, LGDs or add-ons to the risk weights computed with the internal models could create challenges in comparing the outcomes.

Policy options and actions

While some differences in risk weights are foreseen in the Basel II regulatory framework when using internal models, some inconsistencies appear driven by bank and supervisory practices that require further analysis. The EBA will address some of these unwarranted variations through the development of regulatory and implementing technical standards, as mandated by the Capital Requirement Regulation (CRR).

Four areas have been identified where additional efforts and work are needed:

• Supervisory disclosure and banks' transparency on RWA-related information needs to be enhanced. Some RWA-related information will be incorporated in the transparency exercise that the EBA is expected to carry out in the second half of 2013;
• Banks should be more rigorous in the validation and monitoring processes of their internal models. Good practices should be identified, promoted and shared;
• Additional Guidelines and Technical Standards addressing specific LDP issues should be developed, so as to foster convergence in supervisory assessments and banks practices;
• Benchmarks or constraints for some IRB risk parameters could be developed, so as to control and possibly reduce unjustified variations in risk weights and expected losses, as well as to increase awareness among supervisors and banks on the variability of the parameters.

Commenting on this review, Andrea Enria, Chairperson of the EBA, said: "This is an important step in a series of exercises the EBA is conducting with the aim of ensuring consistency in the calculation of RWAs across the EU. Some National Supervisory Authorities are already taking actions based on the outcomes of this work. The EBA will provide appropriate disclosure of RWA-related information and coordinate further work to restore market confidence in risk sensitive measures of capital adequacy."

By the end of 2013, the EBA is expected to finalise a market risk benchmarking exercise on the trading book and to publish a review of risk weights for SMEs and residential mortgages.

Methodology underlying the LDP review

The review of LDP portfolios is based on a Hypothetical Portfolio Exercise (HPE) that the EBA carried out in the second half of 2012. The exercise involved 35 banks from 13 EU countries using the Internal Ratings-Based (IRB) approach.

The HPE was designed to allow a direct comparison of the IRB parameters - probabilities of default ( PDs) and loss given defaults (LGDs) - and the resulting risk weights on a set of common counterparties which would be assuming senior and unsecured exposures (hypothetical exposures). Banks participating in the exercise were also asked to report the real risk weights and expected losses applied to the same set of counterparties (real exposures). This comparative analysis between hypothetical and real portfolio exposures allowed the EBA to examine the impact of the maturity and credit risk mitigation of the exposures.

The HPE was complemented with important qualitative information as well as with bilateral interviews conducted with a selected sample of 12 banks, which allowed the EBA to gain a deeper insight into key practices that have a bearing on the outcome of banks' IRB models. In addition, data were also collected on parameters and risk weights for the overall wholesale exposures (sovereigns, institutions, large corporate and other corporate).