Risk and Capital PDF

Risk and Capital: the Essential Nexus
SEPTEMBER 2015
1. Synopsis
The financial crisis of 2008 evidenced the need to undertake significant reforms to the Basel framework. The
Basel III capital reforms have helped to materially increase banks’ required capital levels across all businesses
and product-lines, with added impacts for areas specifically identified in the crisis, such as derivatives and
exposures to other financial institutions. These reforms have served to make the financial system safer, whilst
simultaneously preserving risk-sensitivity in the capital framework.
After the completion of the Basel III reforms, subsequent proposals have emerged and a more fundamental
reconsideration of the Basel framework is being undertaken. RWA variability and the reliability of banks’
internal models have been at the center of this, and while refinements and revisions to the framework should
be considered, it is concerning that the value of risk-sensitivity has been discounted in this debate.
Whilst some regulators and commentators have advocated more simplified and standardized approaches for
calculating banks’ RWA, this would come at a significant detriment in not only the accuracy of determining the
risks that banks carry (against which capital should be assessed), but also in the incentives generated within
institutions.
However, if further initiatives (including new capital floors based on the Standardized Approach, and the
possibility of a higher Leverage Ratio) are wrongly devised and calibrated, this could dramatically alter the
relationship between risk and capital in a way that would appear to be unintended, penalizing low-risk assets
whilst favoring the high-risk exposures.
Capital measures are of critical importance not only at the ‘top-of-house’ for measuring the risk of insolvency,
but for the series of ‘downstream’ uses within the organization, including:
 strategic planning
 pricing
 portfolio construction and management (eg. adverse selection)
 performance management and remuneration
It is essential to consider how capital measures impact these dimensions, in how banks originate and manage
exposures and most critically in behavioral incentives and the promotion of a risk-aware culture. Where banks
have great technical capacity to measure risk, it is fundamentally important that this be embedded and aligned
with core metrics inherent in banks’ decision-making.
It is recognized that banks’ internal models are imperfect; they must continue to be enhanced and rigorously
scrutinized, and the IIF continues to pursue proposals for the harmonization of selected modeling assumptions
and parameters. But internal models should not be disregarded, as they remain the best option for estimating
the true underlying risks across banks’ portfolios.
The need for backstop measures is acknowledged, but great care is needed in how these are calibrated, to
ensure that banks’ key strategic drivers and performance measures are not compromised in their sensitivity to
the underlying risk. If calibrated at moderate levels, measures such as the Leverage Ratio and capital floor can
constrain outliers with divergent modeling assumptions or concentrated portfolios, without over-riding the risk-
based approach for all. It is important that regulators and industry invest the time to thoroughly explore these
issues, and get the final design and calibration right.
Risk-sensitivity in the banking system is an essential economic good. Its preservation is so critical to banking
that the industry and supervisors should collectively take up the challenge to improve models and restore the
credibility of the IRB framework.
iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.
RISK AND CAPITAL: THE ESSENTIAL NEXUS page 2
2. Introduction
The BCBS has announced a strategic review of the Basel capital framework, including potentially significant
decisions on the future role of internal models in the framework. This review is concurrent to the consideration
of a suite of other proposals, including:
 revisions to the Standardized Approach for Credit Risk1
 reviews of the Standardized Approaches for Operational Risk and Market Risk (Fundamental Review of the
Trading Book)
 the proposed introduction of a new ‘capital floor’, based on those revised Standardized Approaches
 a review of the proposed calibration of the Basel III Leverage Ratio
A number of objectives and considerations have been outlined as supporting the need for this review. They
include the variability of RWAs resulting from banks’ internal models; potential excessive complexity and
opaqueness of models; and, more broadly, the overall reliability of banks’ internal models. These are all valid
concerns that ought to be carefully considered and addressed.
The IIF, through its RWA Task Force, has worked extensively on the issue of RWA variance and on developing
specific recommendations on RWA modeling harmonization2. Similarly, in September 2014, the IRTF produced
a report on Risk-sensitivity: the importance of internal models, which analyzed how capital measures are used
within a bank, beyond demonstrating capital adequacy at institution-level3. These reports have each been
shared with the regulatory community as a constructive input to the current work on RWA variance.
While the IIF is supportive of the work of the BCBS aimed at improving and reinforcing the regulatory capital
framework, concerns exist that some of the proposed revisions could have significant negative and unintended
implications for both banks and their financing of the economy.
Amidst this debate, this paper’s principal purpose is to describe how internal models and capital measures are
used within a bank, in particular their downstream applications beyond demonstrating capital adequacy at an
institution-level. This paper describes the criticality of risk-sensitivity, and conveys some of the dangers that can
be expected from flatter and simpler approaches – both new hazards and the re-introduction of some old ones.
Indeed, as the BCBS’s review activities seek to balance the objectives of simplicity, comparability and risk-
sensitivity, it is important to consider what the erosion of risk-sensitivity might look like in practical application –
in banks’ strategic planning, in how they price deals, in portfolio construction (adverse selection) and in how
bank staff are assessed and remunerated. This links also to the industry’s and regulators’ shared agenda of
promoting a more risk-aware culture.
The IIF reiterates our agreement with the Basel III capital reforms, which have helped make the system safer
without compromising risk-sensitivity. However, through this report, the IIF outlines its significant concern about
the likely severe negative implications of an unbalanced reduction of the risk sensitivity of regulatory capital.
The IIF therefore recommends additional careful consideration of the different alternative policy solutions.
1
The IIF understands that the proposed revisions to the Standardized Approach for Credit Risk (as detailed in the December 2014 Consultative Document) are
under review; nevertheless, the December 2014 proposals have been applied for the purpose of the analysis contained in this document.
2
IIF, IIF Risk Weighted Assets Task Force Final Report, November 2014; this includes detailed analysis of bank modeling practices for each of the Probability of
Default, Loss Given Default, Exposure at Default and the Definition of Default, as well concurrent analysis on Market Risk and Bench-marking and Disclosure,
and recommendations of the specific parameters and assumptions that could be harmonized in banks’ modeling.
3
IIF, Risk-sensitivity: the important role of internal models, September 2014.
3. The Nature and Effect of Changes in Capital Requirements
The Basel III capital reforms have been effective in improving the safety and stability of the system, with
banks holding more and better quality capital against assets across the credit spectrum, and against activities
specifically identified post-crisis. However, the additional reforms currently being considered could markedly
change the relative sensitivity of capital to different assets across the credit spectrum, raising capital
requirements for stronger assets and lowering them for riskier borrowers.
There is an important distinction between (i) the initiatives introduced since the crisis (as part of Basel III) to
increase banks’ required capital levels, and (ii) the initiatives now being considered in the debate on proposed
floors, Leverage Ratio calibration and future use of internal models.
A noteworthy part of Basel III has been the increased capital requirements for trading activities, such as the
CVA Capital Charge and the incentives for the central clearing of trades. Similarly, the Asset Value Correlation
(AVC) multiplier for banks’ exposures to other financial institutions deters inter-connectedness within the
financial sector. These initiatives have affected specific areas of business, in a way that is understood to have
been largely intended in the wake of the crisis.
The other central component of the Basel III capital reforms has been the increased capital levels and buffers,
together with improved quality of capital. Whilst a full impact assessment would also require this to be overlaid
with the Basel III liquidity reforms and Leverage Ratio definitions, the increase in capital ratio requirements has
been broadly neutral in its dispersion across business lines and customer segments, in that the proportional
increase in capital has been equivalent across all assets. The sensitivity of the capital framework to underlying
borrowers’ risk (and to the rank ordering of different risks within banks’ balance sheets) has been largely
preserved.
Taken together, these specific impacts for derivatives and the AVC multiplier, as well as higher capital ratios
have delivered the following effect across the risk spectrum, as we have moved from Basel II to Basel III, with a
minimum Leverage Ratio set at 3%:
Basel II (IRB) Basel III (IRB) Leverage Ratio at 3%
16%
14%
12%
10%
8%
6%
4%
2%
0%
These reforms are acknowledged as having helped make the system safer and more stable, and their impact
was an intended consequence of regulation. There is more capital held consistently across the system, with the
Leverage Ratio only constraining portfolios with very high concentration of low-risk assets.
However, a suite of new proposals (new capital floors based on the Standardized Approach, and the possibility
of a higher Leverage Ratio) stands to have concentrated impacts on specific asset types, business units and
components of the credit spectrum that would appear to be unintended. These initiatives could fundamentally
re-orient banks’ capital allocation strategies and business mixes, by perversely penalizing low-risk lending whilst
favoring the high-risk end of the borrower spectrum.
If the prevalent measure of capital was to be either (i) a capital floor calibrated to 80% of the Standardized
Approach, or (ii) a higher Leverage Ratio (eg. 5%), this would materially erode the sensitivity of capital to the
underlying borrower risk, as per the following:
Basel III (IRB) Standardized-based Floor Leverage Ratio at 6%
16%
14%
12%
10%
8%
6%
4%
2%
0%
As well as the loss of sensitivity across the credit spectrum, the further proportional increase for strong credits
under the Standardized-based floor is immense.
As shown above, the proposed new Standardized Approach exhibits a small degree of sensitivity across the
credit spectrum. This reflects that this Approach relies on only two risk drivers in each asset class (eg. Revenue
and Leverage for Corporate and SME borrowers; Loan-to-Valuation ratio and Debt-Servicing Ratio for mortgag-
ors), as well as its series of steps/thresholds. These factors limit the Standardized Approach, such that it cannot
match the accuracy and depth of internal model estimates, generating the probable outcomes of materially
over-stating risk on strong credits, whilst simultaneously under-stating it on weaker ones.
4. Intersecting Measures: the Binding Constraint for Outliers or for All
The IIF continues to support the inclusion of backstop measures to help constrain outliers and guard against
model risk. However, great care is needed in the calibration of such measures to ensure that they are indeed
such backstops, and that they don’t over-ride the risk-based approach for the majority of credits, for the
majority of banks.
Where multiple sets of capital measures intersect, banks face a scenario of constrained optimization, under
which an efficient and rational bank will optimize to the scarcest resource. Banks’ strategies, operations and
behaviors (how they price deals, and assess and reward staff) will be shaped by which capital measure is the
prevalent one – the binding constraint.
The Leverage Ratio has been consistently described by the Basel Committee as a “supplementary” or
“backstop” measure as part of the Basel III framework4. The IIF supports its inclusion in the capital framework
on this basis, noting that if it is calibrated at a moderate level, it will serve as an effective back-stop without
impeding the role of risk-sensitivity as a behavioral driver.
The Bank of England identified the concept of the “critical risk-weight”, where the Leverage Ratio and RWA
regimes intersect5. On the assumption of 9.5% Tier 1 capital, this means that:
 a 6% Leverage Ratio requirement would prevail as the binding constraint for any bank with an average
risk-weight below 63.2%
 a 3% Leverage Ratio requirement would only become the chief constraining measure for banks that have
low average risk-weights, below 31.6%6.
Using a highly simplified basis (banks’ reported RWA and Total Assets), a plot of 39 banks (the 30 G-SIBs plus
the D-SIBs of Australia and Canada) shows the majority of banks clustered around a simple-average of 43.5%
(orange)7:
Capital
Bank's RWA / Total Assets 3% Leverage Ratio 6% Leverage Ratio
Required
10.00%
9.00% Critical risk-weight
under a 6%
8.00% Leverage Ratio
7.00%
6.00%
Critical risk-weight
5.00% under a 3%
4.00% Leverage Ratio
3.00%
2.00%
1.00%
0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Average risk-weighting
4
Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010 and June
2011.
5
Bank of England, The Financial Policy Committee’s Review of the Leverage Ratio: A Consultation Paper, July 2014.
6
In this scenario, ‘Capital Required’ has been assumed to be a 9.5% Tier 1 Ratio, being the sum of (i) the Basel III minimum level of 6.0%, (ii) the Capital Conser-
vation Buffer of 2.0%, and (iii) the G-SIB Level 1 requirement of an additional 1.0%.
7
The average RWA to Total Assets for the 39 banks is 43.5% on a simple average basis, or 46.4% if weighted by Total Assets.
On this basis, a moderate Leverage Ratio of 3% will constrain only the outliers (whether that outlier status might
represent the effect of modeling choices or a heightened concentration of low-risk assets). In contrast, a 6%
Leverage Ratio serves to over-ride the risk-weight framework for 34 of the 39 banks - ceasing to be a
‘backstop’, and instead assuming the role of the primary measure: the binding constraint.
Whilst a capital floor based on the Standardized Approach is a slightly different proposition to the Leverage
Ratio, the same principle and trajectory apply. With a reliance on sets of only two risk drivers and a smaller,
more concentrated range of available risk-weight outcomes, the Standardized Approach can often over-state
the risk of stronger credits, but under-state it on weaker credits.
Simultaneously, the BCBS’s Regulatory Consistency Assessment Programme (RCAP) identified that as much as
three-quarters of RWA variance for credit risk reflects “underlying differences in the risk composition of banks’
assets”, with only one-quarter is then attributed to variations in bank and supervisor practices8. That RCAP
analysis also identified that, when normalizing for portfolio differences, 69% of IRB-accredited banks calculated
risk-weights that were within 10% of a central mean, with the remaining outliers falling within a 20% range.
Using this RCAP analysis, if we assume a variation of +/- 20% for modeling outcomes across the credit spectrum
(as per the trajectory explored in Section 3), a capital floor calibrated to 80% of the proposed Standardized
Approach will still exceed the upper end of this range for most of the better credits, as per the following:
IRB Upper band IRB Mean IRB Lower band Standardized-based Floor
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
The effect of a floor at this high calibration is to over-ride the risk-based approach, for almost all banks, for all
but the weakest of credits.
Whilst it is understandable (and welcome) to apply a backstop measure for outlier banks and model risk, this
scenario has the capital floor calibrated at a level where it affects much more than just the outliers, materially
raising capital requirements for strong assets (but not weak ones) for the whole industry.
8
Basel Committee on Banking Supervision, Regulatory Capital Assessment Programme (RCAP) – Analysis of risk-weighted assets for credit risk in the banking
book, July 2013.
Concurrently, the IIF accepts that the level of RWA variance is too high, and that some convergence is
necessary to ensure the ongoing credibility of the risk-based framework. Like the RCAP review, the IIF RWA
Task Force (IRTF) has undertaken extensive analysis of banks’ modeling practices for credit risk and market risk,
identifying specific sources of variance in three broad categories:
 national factors (including legal, regulatory and accounting)
 legitimate differences between banks, in their risk management policies (eg. collections practices),
histories and portfolios
 modeling assumptions and parameters that could be harmonized
The IRTF analysis reinforces the view that particular modeling assumptions should be harmonized to narrow the
scope of RWA variance to just those legitimate and national-based factors, and that a moderately-calibrated
floor could support this process through constraining outliers only, whereas a higher floor would over-ride the
risk-based view for the majority of banks. The industry and regulators collectively need to take the necessary
time to further explore these issues.
5. Beyond Adequacy: Capital Metrics Inside Banks
It is critical that risk-based capital continues to be a key driver in banks’ internal metrics. Where the nexus
between risk and capital has been broken, history has shown that modeled risk measures lose their clout, with
practical barriers to their embedding in core business metrics.
One of the key metrics of bank performance (arguably the key metric) is the return they generate on capital, or
Return on Equity (ROE). Banks apply such a measure in their pricing models and their profitability and
performance engines, as per the following function9:
(Net Profit After Tax [function of Revenue, Operational

ROE = costs, EL (or provisions), Funding & Liquidity costs, Tax])
Capital
This metric is directly sensitive to the measure of capital used, and capital’s underlying drivers. For instance, a
bank using the Advanced IRB approach would use capital that is sensitive to PD, LGD, EAD and Tenor/
Maturity.
Whilst banks should always seek to manage risk in a sophisticated way, pricing, incentives and strategy will be
intrinsically linked to regulatory capital. Pricing, performance metrics and strategic decision-making will follow
whichever measure of capital is prevalent for the organization.
If banks were to be prevented from using their internal models for the purposes of regulatory reporting and
demonstrating capital adequacy, they could retain some of the technical capabilities to be able to measure and
calculate a theoretical price for risk – the issue is in the practical application, under which those technical
capabilities would likely be overwhelmed by the reality of a flat capital measure as the binding constraint on the
firm’s business.
Where some banks have historically attempted to redistribute a flat regulatory capital measure internally along
on a more risk-aligned basis, this has invariably necessitated the use of unsustainable cross-subsidization or
unstable scaling factors that ultimately erode credibility.
Cross-subsidization
Cross-subsidization as a concept is generally discouraged (by banks, economists and regulators alike), and
would not be necessary under a risk-sensitive capital framework. But some banks using the Basel II
Standardized Approach have adopted it to internally redistribute the allocation of regulatory capital in order
that their low-risk operations can be more competitive.
In cases where this has been initially successful, it has had the short-term consequence of enabling the lower-
risk portion to grow faster than the rest of the portfolio – but over the medium-term, this growth mismatch (as
low-risk assets paying lower spreads have outgrown the high-yield segment) has eroded the capacity of the
high-risk portfolio to support other transactions, and reduced the bank’s ROE.
9
Individual bank practices vary in how this is applied. Some banks will set a specific Return on Capital ‘hurdle’, which the calculated Return value for any pro-
spective transaction must surpass. Other approaches include Economic Value Added (EVA), and some banks apply a P&L calculation in which capital is reflect-
ed by a ‘Capital Cost’.
Common to each of these approaches, there is always a direct sensitivity to whatever underlying form of ‘capital’ is being applied, whether that’s Regulatory
Capital, Economic Capital or some other calculation.
Furthermore, cross-subsidization can only be attempted by banks that are diversified across multiple business
lines (eg. wholesale, corporate and retail segments), inclusive of different portfolios where risk that is both
under- and over-stated by Standardized regulatory capital. Banks that are in purely or primarily one segment
(eg. largely an investment bank, or a mortgage bank) could only achieve this by either (i) making an acquisition
(where allowable under structural reform and ring-fencing regulations), or (ii) expanding into a new business line
and under-cutting pricing to achieve the desired growth and a risk profile that they may be unfamiliar with.
As such, the cross-subsidization model can apply only in limited circumstances, and cannot be sustained for the
long-term, before the regulatory capital measure again asserts itself as the binding constraint in credit and
pricing decisions.
Scaling Factors
Some banks have sought to approximate a risk-based internal capital allocation method by firstly taking their
total (bank-wide) amount of regulatory capital, and then using their internally modeled economic capital as the
basis for allocating that regulatory capital out to their business units.
In practice, this means a scaling factor is required (ie. to ‘scale up’ the economic capital for each deal and each
business unit by a factor of the bank-wide relativity of regulatory capital to economic capital), and that required
scaling adjustment is inherently unstable, being subject to constant revision to keep the two measures in
alignment, and minimize any unallocated capital.
This instability erodes credibility at the business unit level, and suppresses the intended capital management
signals to drive pricing decisions and encourage risk-aware behaviors at origination. For instance, a business
unit which manages its business to reduce its consumption of capital may find that decisions by other business
units (eg. increasing exposure to activities with higher regulatory capital requirements) drive an increase in the
scaling factor, thereby negating their own actions.
The adoption of the Basel II Advanced IRB approach had enabled many banks to overcome such tensions, as
economic capital and regulatory capital measures became broadly aligned in their design and risk-sensitivity
(although banks using the Standardized Approach have not had the same benefit).
Moving to a non-risk-sensitive measure (whether that is a standardized approach or the leverage ratio) as the
dominant measure of capital would un-do much of the progress that has been made.
Stress Testing
Supervisory stress testing is welcomed as an additional overlay, unveiling potential vulnerabilities in portfolios
and risks and complementing the insights generated by banks’ own models – but it is dangerous to rely on it as
the sole risk-sensitive measure in the capital framework.
Where an external stress test is conducted on the basis of an undisclosed model, with no transparent
benchmarks available, it cannot form the basis of banks’ internal pricing decisions, performance targets and
remuneration structures. These functions will invariably be aligned to a more visible measure that is
constraining the business, with the potential that risk is viewed in isolation, and not fully embedded in such
fundamental operational activities.
Having internal models inherently tied into the core determinants of bank capital and core performance
reporting measures is a vital tool for the Risk team’s efforts in promoting a risk-aware culture within the
institution. Concurrently, using internal risk estimates in the bank’s day-to-day business also helps to ensure
that any weaknesses in models are identified and promptly corrected, creating a feedback loop to help drive
continuous improvement of models.
6. Driving Behavior: Capital for Effective Management and Culture
If capital is not risk-based, this creates a heightened risk of adverse selection in banks’ portfolios, and
dangerous mis-incentives in pricing and performance management. Capital requirements have a key role to
play in encouraging behaviors and in promoting a strong risk-conscious culture.
To encourage the desired behaviors at the point of origination, and to ensure that banks have a capital
consciousness at the grass-roots level that is linked to the overall bank strategy, an alignment must be
maintained between ‘top-of-house’ capital adequacy and the capital measures used throughout the
organization.
This is critical to getting institutional buy-in, and also formed the basis of the Basel Committee’s Use Test, for
which banks must explicitly demonstrate that the “IRB components” of PD, EAD and LGD used in regulatory
capital are also employed for internal purposes, notably (i) strategy and planning processes, (ii) credit exposure
measurement and management (including pricing and remuneration), and (iii) reporting10.
Strategic Planning
Most major banks are diversified across multiple business lines and customer segments, such that each bank
itself represents a collection of business units that each compete for capital and investment.
Banks’ strategies and investment decisions could be likened to an ‘internal capital market’, with businesses
competing for the available investment, and with projected Internal Rate of Return (IRR) calculations scrutinized
accordingly. This is fundamental to where capital is invested within a bank – in decisions about potential
acquisitions or divestments, in the development of new business lines and new products, in risk mitigation, and
in allocating capacity in which segments to lend to.
In this environment, in order for risk-consciousness to be truly reflected in strategic planning, and to influence
the decisions on which business units and segments to invest in, risk cannot be left in a vacuum. This links with
the need for all banks have a sustainable business model – that they can not only withstand a crisis and remain
solvent, but also be viable beyond such a shock or crisis.
If fully embedded within the business drivers, capital can be a powerful tool for the promotion of a risk-
conscious culture as part of the budgetary process.
Pricing
In pricing transactions, banks aim to adequately compensate for risk and generate a return on the shareholder’s
capital. The desirable pricing structure is one where the prevailing measure of capital accurately reflects the
transaction’s risk, so that the return generated is commensurate with risk that is being taken. If the level of
required capital assigned to an asset is not risk-based, then this concept is eroded, and some significant
distortions and false mis-incentives are instead created.
10
Basel Committee Newsletter No. 9, the IRB Use Test: Background and Implementation, September 2006.
In the following illustrative scenario for a 5-year $10 million Corporate Loan, the IRB approach to capital will
encourage banks to lend to stronger-rated clients, as the ROE will reflect a risk-based denominator (capital) as
well as risk-based spread income. Conversely, flat or less-sensitive approaches will instead incentivize lending
to high-yield borrowers, where banks can generate higher earnings whilst holding the same capital as if they
lent to the safer counterparties.
Example: $10 million, 5-year Corporate Loan Investment Grade Non-Investment Grade
Indicative equivalent rating A+ BBB BB B+
EAD $10,000,000 $10,000,000 $10,000,000 $10,000,000
Risk Variables PD 0.05% 0.25% 1% 4%
LGD 50% 50% 50% 50%
Market Spreads (over funding costs) 100bp 200bp 350bp 550bp
Risk-weight 100.0% 100.0% 100.0% 100.0%
Leverage Ratio RWA $10,000,000 $10,000,000 $10,000,000 $10,000,000
ROE 3.4% 6.6% 10.5% 12.2%
Proposed Risk-weight 60.0% 70.0% 90.0% 90.0%
Standardized RWA $6,000,000 $7,000,000 $9,000,000 $9,000,000
Approach ROE 5.7% 9.4% 11.7% 13.6%
Risk-weight at commencement 40.4% 89.0% 148.9% 203.9%
RWA at commencement $4,044,890 $8,898,512 $14,885,700 $20,389,692
Advanced IRB
Ave. risk-weight over loan life 24.5% 60.9% 112.8% 169.4%
Approach
Ave. RWA (loan life) $2,448,100 $6,094,566 $11,281,093 $16,943,514
ROE 13.9% 10.8% 9.3% 7.2%
The Expected Loss (EL) or provisions component of the ROE formula will reflect risk – but this will be the only
risk-sensitive component if capital requirements are flat. But under IRB, the incentives swing markedly in favor
of lending to the stronger borrower.
The use of risk-based pricing is particularly crucial to activities such as trade finance, which are typically low-risk
with very short-dated tenors and (depending on the specific instrument type) strongly-rated counterparties
and/or tangible collateral. Correctly reflecting the low risk on this asset class is not only desirable for the sake of
accuracy in and of itself, but it also has an economic benefit in helping to direct credit towards an area of
productive investment that is central to economic recovery in developed economies, and growth in emerging
markets.
This is an important example of how appropriate risk-sensitive capital requirements create incentives for the
efficient management of finance in society, whereas simple capital approaches are sub-optimal for financing
growth and for overall stability.
Portfolio Implications
The potential distortions of capital lacking risk-sensitivity can also affect the shape of banks’ portfolios, creating
the risk of adverse selection. A flat (or Standardized) measure of capital across the credit spectrum generates
false incentives, encouraging banks to progressively shift their portfolios towards the higher-risk, high-yield
segments. There emerges the risk that the regulated sector over-prices credit for well-rated counterparties and
under-prices it for the more marginal counterparties – driving the stronger borrowers to seek their funding
elsewhere, and weakening the overall average credit quality of the regulated system.
This is compounded by the Basel III liquidity requirements mandating that banks must hold portfolios of High
Quality Liquid Assets (HQLA) sufficient to withstand their potential cash outflows in a shock scenario. This
directly requires banks to hold a material portfolio of low-risk assets, in particular sovereign bonds and (in some
jurisdictions) super-senior RMBS.
With material holdings of such low-yielding assets (with low risk-weights, but each counting at 100% of their
face value for the purpose of the Leverage Ratio) mandated within each bank’s portfolio, optimizing ROE and
profitability under a flat or simple capital measure requires pursuing high-yield assets to counter-balance this.
Banks’ portfolios become somewhat ‘barbelled’ in this scenario, concentrated at either end of the credit
spectrum, and reducing the valuable diversity in banks’ portfolios.
Assets required for Regulated banks deterred from Banks optimize ROE by
HQLA (LCR) lending at economic pricing lending to these segments
Incentives and Remuneration

Assessments of performance, both at a business unit level and at the level of the individual banker, will consider
a series of dimensions, such as revenue or profit, market share and growth, customer satisfaction, minimization
of costs and losses, alignment with group-level strategic objectives and corporate values – plus capital and
ROE.
It is tremendously powerful to have bankers accountable and responsive to earning a return relative to the
amount of the firm’s capital that they are putting at risk.
The Basel Committee has similarly highlighted the importance of ensuring that compensation structures must
reflect all types of risk, and that employees must see an adverse impact on their own pay as they take more risk
on behalf of the firm. The Basel Committee’s Compensation Principles put it succinctly that:
“Two employees who generate the same short-run profit but take different amounts of risk on behalf of
their firm should not be treated the same by the compensation system;” and “Compensation outcomes
must be symmetric with risk outcomes.”11
11
Basel Committee on Banking Supervision, Compensation Principles and Standards Methodology, January 2010.
7. The Way Forward: Enhancing the Framework
Where internal models need important improvements, the criticality of risk-sensitivity makes it contingent on
the industry and regulators together to ensure that they are enhanced, such that the IRB approach is improved,
not abandoned.
It is acknowledged that banks’ internal models are imperfect – but, steeped in years (sometimes decades) of
historical data and a breadth of risk drivers, they remain the most accurate source for estimating the true risk on
banks’ portfolios.
It is nevertheless essential to ensure that banks’ models continue to improve. The considerable supervisory
rigor and review must be retained and expanded, and modeling practices should converge where appropriate.
Most importantly, internal models should not be disregarded, nor should they be pushed to an irrelevant role
purely in the background, overshadowed and overwhelmed by other constraints. The internal modeling
approach needs to be enhanced, continuously scrutinized, and preserved as a central component of the capital
framework, where it not only provides a risk-informed view of solvency risk, but can influence the desired
behaviors throughout the banking system.
To this end, it is a significant first step that the 43 banks participating in the IIF RWA Task Force have endorsed
78 recommendations on specific credit risk modeling parameters and assumptions that could be harmonized –
initiatives that would converge RWA calculations and reduce unnecessary variance.12 Taken together with
increased transparency and benchmarking, this would serve to remove any outliers and narrow the gaps, while
keeping models at the centerpiece, helping continue the risk management discipline’s endeavors of continuous
improvement.
Risk-sensitivity in the banking system is an essential economic good. The criticality of its preservation demands
that the industry and supervisors each invest the time to thoroughly explore theses issues, in collectively taking
up the challenge to improve models and restore the credibility of the IRB framework.
Just as importantly, they would also ensure that risk-sensitivity is preserved and enhanced, and further
embedded as the basis for which banks price credit and make strategic decisions, and individual bankers are
remunerated – all of which is a substantial social and economic good. The IIF stands ready to contribute to that
endeavor on behalf of the global financial industry.
12
IIF, IIF Risk Weighted Assets Task Force Final Report.
Appendix: Calculation Assumptions
The estimated IRB risk-weights represented in charts and tables are approximate and indicative only, and do
not represent the levels generated by any individual bank’s models. Within the calculation of these risk-weights,
an unsecured corporate LGD had been assumed at 50%.
Standardized Approach calculations are based on the 2014 Consultative Document for the proposed revised
approach. Capital Floors have been assumed at 80% of that Standardized Approach.
Required capital levels have been assumed at 6.0% of Tier 1 under Basel II (representing a minimum of 4.0 plus
buffers that were expected to be observed in some jurisdictions) and 9.5% under Basel III, consisting of the
minimum Tier 1 Capital of 6.0%, plus the Capital Conservation buffer of 2.5%, plus the G-SIB Level 1
requirement of 1.0%.
For the counterparties described in scenarios:

 Trade Finance, AA scenario describes an LC with a AA counterparty bank with CET1 9.5-12% and
NPA<1%, from a Basel-compliant jurisdiction
 Trade Finance, BBB+ scenario describes an LC with a BBB+ counterparty bank with CET1 7-9.5%
and NPA 1-3%, from a Basel-compliant jurisdiction
 'Corporates' are all assumed to have revenue >€1b
 'SMEs' are all assumed to have revenue <€5m
 Well-rated Corporate assumed to be approx. A+ rated, with Leverage 1-3x
 Well-rated Corporate assumed to be approx. BBB+ rated, with Leverage 3-5x
 Sub-investment Grade Corporate assumed to be approx. BB- rated, with Leverage >5x
The data on banks’ Total Assets and RWA is from each bank’s 2014 Annual Report.
Within the Return on Equity calculations, the following assumptions have been made:
 Target capital ratio equivalent to 10% of RWA
 Cost: Income Ratio (or ‘Efficiency Ratio’) of 50%
 Tax rate of 30%
 A weighted-averaging approach to the RWA calculation over the full tenor of the loan facility.
 Yield assumptions are based on selected bond yields and index data for bonds and CDS
published by FT.com, Reuters and Bloomberg

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Risk and Capital: the Essential Nexus

3. The Nature and Effect of Changes in Capital Requirements

Basel II (IRB) Basel III (IRB) Leverage Ratio at 3%

Basel III (IRB) Standardized-based Floor Leverage Ratio at 6%

4. Intersecting Measures: the Binding Constraint for Outliers or for All

5. Beyond Adequacy: Capital Metrics Inside Banks

(Net Profit After Tax [function of Revenue, Operational

6. Driving Behavior: Capital for Effective Management and Culture

Incentives and Remuneration

7. The Way Forward: Enhancing the Framework

Appendix: Calculation Assumptions

For the counterparties described in scenarios:

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