Minimum capital requirements for credit risk

In banking, the minimum capital requirements for credit risks are an essential part of the Capital Adequacy Regulation (CRR) that has been in force in all EU member states since January 2014 as part of Basel III .

General

The credit risk is one of the most significant risks in banks . In order to limit it, the legislature has enacted regulations that are intended to bring these risks into an appropriate relationship to the equity capital of the credit institutions. When the Banking Act (KWG) came into force in Germany in January 1962 , it contained - even today - a generally formulated general clause on the equity capital ( § 10 KWG) of credit institutions. As operational concretization of this KWG provision in April 1962 developed the principles I , II and III, and in August 1974 Principle Ia , which in January 1980 to precious metal positions and in October 1990 to market risks and interest rate risks was expanded Off-balance sheet. They were valid until January 2007, when the Solvency Ordinance took over the allocation of credit risk. This was replaced in January 2014 by the Capital Adequacy Ordinance, which deals in more detail with the limitation of risky financial instruments .

The total exposure amount of all risk positions to be covered by equity capital is still limited to 12.5 times the equity capital according to Art. 92 (1) CRR:

{\ displaystyle {\ text {Capital adequacy}} = {\ text {Risk position}} \ cdot {\ text {Risk weight}} \ cdot 8 \, \%}

Although the previous quota is retained, the core capital ratio is higher than before because the minimum equity requirements have been increased by Art. 25 ff. CRR.

Rating process

The capital adequacy regulation (CRR) applicable in all EU member states initially provides for a rating requirement for all risk positions. Art. 144 No. 1a CRR requires a meaningful assessment of each debtor , whereby a rating system must take into account the risk characteristics of the debtor and the transaction (Art. 170 No. 1 CRR) and, in the case of credit approvals, each debtor must be assigned a rating (Art. 172 No. 1a CRR). The rating code resulting from the rating forms the basis of the risk weighting of each risk position. The worse the rating code (and thus the credit risk), the higher the risk weighting of a financial instrument and vice versa. A higher risk weighting, in turn, requires a stronger backing of the corresponding credit risk with equity. In order not to burden the equity too much, credit institutions are ultimately forced by the risk weighting not to enter into any risky and therefore badly rated banking transactions .

KSA and IRB - two alternative approaches to determining the capital requirements for credit risks

The CRR has two approaches, namely the credit risk standardized approach (CRR, Part 3 Title II Chapter 2 CRR) and the internal ratings-based approach (IRBA, Part 3 Title II Chapter 3 CRR). Both differ in particular in whether the institutions make internal assessments (e.g. for the probability of default (PD) and the loss of default rate (LGD)).

A predominant part of the German credit institutions use the KSA (especially almost all savings banks and Volks- / Raiffeisenbanken).

Credit Risk Standard Approach (CRSA)

The Credit Risk Standard Approach ( CRR ) applies to all CRR credit institutions that have not applied to the banking supervisory authority for an IRB approach in accordance with Art. 143 CRR . With the KSA, the risk parameters of the probability of default (PD) and the loss of default rate ( LGD) are specified by the banking supervisory authority. According to Art. 113 (1) CRR, the rating is to be adopted by recognized external rating agencies and determines the third risk parameter, the default credit amount (EaD). The assignment of the rating codes of the rating agencies to the KSA creditworthiness levels is carried out in accordance with Art. 122 Para. 1 CRR (for companies ).

Risk weight	0%	20%	50%	100%	100%	150%	100% (unrated)
Credit rating according to CRR	1	2	3	4th	5	6th	7th
Rating code Standard & Poor’s	AAA to AA-	A + to A-	BBB + to BBB-	BB + to BB-	B + to B-	CCC + and below	unjudged
Moody's rating code	Aaa to Aa3	A1 to A3	Baa1 to Baa3	Ba1 to Ba3	B1 to B3	Caa1 and below	unjudged

With the KSA, all three risk parameters come from external bodies and therefore cannot be influenced as data parameters from the perspective of the KSA institutes .

Exposure classes

The following exposure classes are listed in Art. 112 CRR :

Exposure class / risk position	Risk weight (s) in percent	CRR article	Possibly. short explanation
Central governments or central banks	0, 20, 50, 100, 150	Art. 114	Risk positions vis-à-vis the ECB as well as central governments and central banks of the member states that are denominated in the national currency of the central government and the central bank and are refinanced in this currency are assigned a risk weight of 0%.
Regional or local authorities	0, 20, 50, 100, 150	Art. 115	The risk weight is based on the debtor's rating .
Public bodies	20, 50, 100, 150	Art. 116	The risk weight is based on the debtor's rating .
Multilateral Development Banks		Art. 117
International organizations		Art. 118
Institutes	20, 50, 100, 150	Art. 119, 120, 121	The risk weight for credit institutions is based on the debtor's rating .
Companies	20, 50, 100, 150	Art. 122	The risk weight is based on the debtor's rating .
Bulk business	75	Art. 123	Regulatory retail portfolio of standardized private customer business (e.g. consumer loans , other claims against a natural person or a small or medium-sized company, etc.)
Risk positions secured by real estate	35, 50, 100	Art. 124, 125, 126	If privileged through residential or commercial properties 35% or 65%, otherwise 100%. In principle, receivables secured by real estate can also be assigned to the retail business receivables class if they are not privileged (provided the requirements are met). The competent authorities in the individual states can set the risk weight between 35% and 150% (residential privilege) or 50 and 150% (commercial privilege) in accordance with Art. 114 para. 2 set.
Defaulted risk positions	100, 150	Art. 127	Here, non-performing loans with payment default ( English default recorded).
Risk positions associated with particularly high risks	150	Art. 128
Covered bonds	10, 20, 50, 100	Art. 129	Here, mortgage bonds and other covered bonds ( English covered bonds ) is detected.
Securitization positions	1,250	Art. 130	Here are securitizations as asset-backed securities or collateralized debt obligations acquired.
Institutes and companies with short-term credit ratings	20, 50, 100, 150	Art. 131
Shares in collective investment organizations (UCI)	20, 50, 100, 150	Art. 132
Investment positions	100, 250, 1250	Art. 133
Other items	0, 20, 100	Art. 134

Risk position

The risk position of each individual exposure class results from the book value less loan collateral and value adjustments:

Buchwert einer Risikoposition
− anrechenbare Kreditsicherheiten
− Wertberichtigungen
= Risikoposition

This risk position is multiplied by the risk weight resulting from the rating:

{\ displaystyle total claim amount = risk position \ cdot risk weight}

The total of all exposure classes, their product represents the total exposure amount, which must not exceed 8% of the total capital ratio.

Others

The term is not taken into account in the capital adequacy requirement in the CRSA. The credit collateral in the CRSA is limited to financial collateral (Art. 207 CRR). In order to further reduce the credit risk, banks can also conclude netting agreements.

Internal Assessment Based Approach (IRBA)

For the two methods based on banks' internal assessments ( English Internal Rating Based Approach , IRBA ) gradually eliminating the regulatory requirements for risk parameters. Both procedures have in common that no ratings have to be adopted by rating agencies, but rather the credit institutions are allowed to create and apply ratings based on their own, regulatory-approved rating procedures and methods. The default volume (EaD) therefore results from the self-created ratings. The prerequisite is an approval by the banking supervisory authority in accordance with Art. 143 ff. CRR. In the IRBA, additional credit collateral beyond the financial collateral is recognized to relieve equity capital. With the IRBA, too, netting agreements reduce the risk position and credit derivatives (as protection buyer ) or guarantees reduce the value at risk ( default risk ) and, in the advanced approach, can reduce the loss of default rate (LGD). In addition, other financial instruments such as securitization positions and other assets are permitted as exposure classes.

Basic IRBA

In the Foundation IRB Approach ( English foundation approach ) only the acquisition of applicable ratings of the rating agencies, so that internal ratings are to create and lead to the bank's own estimate of the probability of default. The other risk parameters - in particular the loss of default rate (LGD) - will continue to be specified by the banking supervisory authority. In addition to the uniform conversion factor of 45% for senior claims and 75% for subordinated claims in the LGD, the remaining term in the IRB basic approach is uniformly set at 2.5 years (Art. 162 (1) CRR). In addition to financial collateral, marketable physical collateral can also be recognized. In retail business, all collateral can be included in the internal estimate of the default loss rate.

Advanced IRBA

With the advanced IRBA ( English Advanced Approach ) these requirements are also omitted, so that the credit institutions also have to calculate and estimate the default loss rate, default volume and remaining term based on their own data history and / or external data sources. This determination is made using the IRB formulas . These are based on a model that compares the standardized return on a credit institution's assets with a default threshold. If the standard normally distributed return is below the critical value , there is a bad debt loss . The default probability for a bank is therefore ${\ displaystyle Y}$ ${\ displaystyle D}$ ${\ displaystyle P}$

{\ displaystyle P = P (Y <D)}

If a bank's return is at least at the critical value or even above, its probability of default is reduced. If the weight of the systematic risk factor ( market risk ) and the weight of the company-specific risk factor - and if these weights are the same for all companies - then the standardized return can be represented as follows: ${\ displaystyle w_ {1}}$ ${\ displaystyle M}$ ${\ displaystyle w_ {2}}$ ${\ displaystyle e_ {i}}$ ${\ displaystyle Y_ {i}}$

{\ displaystyle Y_ {i} = w_ {1} \ cdot M + w_ {2} \ cdot e_ {i}}

The standardized return is therefore the sum of the weighted market risk and the weighted credit risk of a bank.

Impact and Relevance

The minimum capital requirements are intended to limit the credit risk at banks through quantitative and qualitative requirements. In doing so, they have a considerable influence on the banks' lending policy, which is becoming more restrictive overall and leaves less room for maneuver for unsecured loans , places greater demands on loan collateral and can lead to a deterioration in loan conditions , especially for large-volume and long-term loans. The CRR quotas tend to lead to a higher burden of own funds, so that the cost-income ratio falls and a higher credit margin is necessary for constant profitability . This is likely to affect medium-sized and small credit institutions ( savings banks , cooperative banks and private banks ) in particular , which only use the KSA standard approach because of their size .

If the increased capital requirements were to be fully transferred to the lending business with medium-sized corporate customers , this would result in banks being classified as very risky lending business. To avoid this, the CRR introduced a correction factor so that these loans are only considered with a risk weight of 0.7619%. As a result, the equity capital requirement of 8%, as in Basel II , is achieved again and a credit crunch caused by supervisory law is avoided in the case of SME loans .

Current development

On 22 December 2014, the Basel Committee published on Banking Supervision (BCBS), the first consultation paper on the review of the credit risk standardized approach ( English Revisions to the Standardized Approach for credit risk ). The second consultation paper followed on December 10, 2015 and was available for consultation until March 11, 2016. With the revision of the KSA, the committee is pursuing the goal of eliminating a number of weaknesses in the current approach. The BCBS has identified the one-sided dependence on external ratings by rating agencies as the main weaknesses of the previous KSA regulations . In particular, the associated related to external ratings negative impact on the stability of the financial sector, for example, of a spike which risk weights ( English cliff effects ) or herding behavior ( English herd behavior yield) of financial institutions should be avoided in the future. It should be noted that for a large part of the claims on non-banks (especially small and medium-sized companies ) there is no external rating. The BCBS wants to counter this problem by linking the risk weights for bank claims and corporate claims to specific risk drivers. These include in bank claims the hard core capital ratio ( English capital adequacy ratio , CET1) and the ratio of non-performing loans ( English net non-performing assets ratio , net NPA ratio), for corporate receivables revenue and the debt ratio . In addition, the risk weights are to be increased significantly to 300%.

Individual evidence

↑ Capital requirements for credit risk. Retrieved on July 22, 2018 (German).
↑ Overview of the German IRB approach institutes. BaFin, accessed on July 22, 2018 .
↑ Thorsten Gendrisch, Walter Gruber / Ronny Hahn (eds.): Solvency Handbook. 2014, p. 121.
↑ Christian Cech, The IRB Formula - To calculate the minimum capital required for credit risk , March 2004, p. 7 ff.
↑ Christian Cech, The IRB formula - To calculate the minimum capital required for credit risk , March 2004, p. 4 f.
↑ Gerhard Dengl, Basel III: Effects on the Financing of German Companies , 2015, p. 3.
↑ ECB of April 16, 2014, Regulation (EU) No. 468/2014, p. 106.
↑ Gerhard Hofmann, Basel III, Risk Management and New Banking Supervision , 2015, o. P.

[1] Capital requirements for credit risk. Retrieved on July 22, 2018 (German).

[2] Overview of the German IRB approach institutes. BaFin, accessed on July 22, 2018 .

[3] Thorsten Gendrisch, Walter Gruber / Ronny Hahn (eds.): Solvency Handbook. 2014, p. 121.

[4] Christian Cech, The IRB Formula - To calculate the minimum capital required for credit risk , March 2004, p. 7 ff.

[5] Christian Cech, The IRB formula - To calculate the minimum capital required for credit risk , March 2004, p. 4 f.

[6] Gerhard Dengl, Basel III: Effects on the Financing of German Companies , 2015, p. 3.

[7] ECB of April 16, 2014, Regulation (EU) No. 468/2014, p. 106.

[8] Gerhard Hofmann, Basel III, Risk Management and New Banking Supervision , 2015, o. P.