Regulators urged to recognise importance of internal models

Recent proposals regarding the application of the revised Basel 3 standards in the UK and the US favour the standardised approach and include strict restrictions on the use of internal models for calculating regulatory capital. A new paper from PGGM outlines the firm’s concerns that such standardised risk weights oversimplify the diversity in the real world and could disincentivise banks to maintain adequate risk measurement tools.

“Under [the Basel 3] proposals, banks are incentivised - or even required - to use the same standardised view of risk. When everyone measures risk the same way, they will all mitigate the same risks, but will also all ignore the same risks. This greatly increases the probability that one such risk materialising will affect a large cross-section of banks in the financial system – the definition of systemic risk,” the PGGM paper explains.

In terms of credit risk sharing (CRS) transactions, PGGM notes that by sharing the credit risk of banks’ core lending activities, investors also share in the quality of their risk measurement and management. “The better banks measure and manage their credit risk, the more comfort we have and the better we can price a transaction. Conversely, when banks become strongly disincentivised to maintain adequate risk measurement tools - such as internal rating models - investors will have to become more conservative in their assessment, if they get sufficient comfort to invest at all,” the paper states.

The advanced internal ratings-based approach (IRBA) to credit risk allows banks to develop their own sophisticated internal models to determine the inputs for capital charges on their credit exposures. Under the advanced IRBA, banks can model the probability of default (PD), loss given default (LGD) and exposure-at-default (EAD) levels, which are essential for understanding the risk of a credit portfolio.

Under the current Basel 3 Endgame proposals in the US, however, none of these metrics would be modelled as they would be replaced by fixed risk weights. In the UK, only PD would still be estimated using internal models, while LGD and EAD would be prescribed.

“As a long-term investor, we see this as a potential negative impact on credit risk modelling practices, as well as on the availability of risk metrics and historical data to investors in exposures on banks’ balance sheets,” PGGM states.

As an investor in CRS, PGGM shares in the credit risk of over 15 banks, active across the globe. “Through due diligence at various banks over the last 18 years, we have learned that a variety of well-performing PD and LGD models is in use. Banks are uniquely capable of modelling the individual components of credit risk. Combined with extensive experience to lending in particular markets and industries, this leads to a wealth of current and historic performance data, which makes it possible to model and test appropriate PD and LGD assumptions,” the firm argues.

Part of PGGM’s due diligence process involves checking the track record of these models. If the firm is not comfortable with the model performance pertaining to a given transaction, it does not invest in it.

“That said, we are generally impressed by the strength and sophistication of banks’ credit risk modelling, and the robust governance set up to make sure these models remain in the best possible shape. Overall, banks have shown that their own PD and LGD models are highly effective for estimating expected losses,” PGGM confirms.

Developing and maintaining sophisticated internal models requires a significant investment by the banks. Through these models, banks have a comprehensive and detailed view of their portfolios and risk drivers, which filters through into efficiency of capital allocation. Efficient capital allocation, in turn, benefits economic growth, as firms that are well-managed, with sound financial performance and robust capital structures will be prioritised in attracting the capital required to grow.

Overall, PGGM argues that restrictions on using internal models for credit risk capital requirements do not contribute to the goals of the Basel standards. “We strongly support the use of internal models, because this approach incentivises banks to model, monitor and manage the risk factors constituting the expected loss profile of exposures on their balance sheets in a holistic and comprehensive way. By permitting banks to apply modelled PD, LGD and EAD metrics, as foreseen under the advanced IRBA, banks are incentivised to develop and maintain robust models for these metrics,” the paper concludes.

Corinne Smith