Fitch: Basel Proposals on Credit Risk Well-Intended but Flawed

Fitch Ratings says in a new report that the Basel Committee on Banking Supervision (BCBS) should assess the predictive power of its proposals to reduce reliance on ratings before committing to any changes. This will help avoid degradation in the quality of its risk-based bank capital framework which could undermine confidence and result in unintended consequences.

The proposals represent a dramatic change from a relatively simple risk-weight regime based in part on external credit ratings to a more complex - and harder to implement - system based on metrics identified by the BCBS. As they stand, the committee's proposals appear to have unproven predictive power and give some surprising results when tested on Fitch-rated corporates and banks. The changes are likely to have greatest effect in markets which are highly dependent on bank-lending by changing the relative capital cost of different types of lending. 

Capital charges on Fitch-rated corporate exposures would fall by around 20% with cyclical sectors and property/real estate being the main beneficiaries; both would see large reduction in risk-weights. Conversely, the proposals would see increases for highly-rated corporates (with some 'A' rated corporates even being assigned the highest 300% risk-weight).

More importantly, the proposals appear to perform particularly badly for corporates that subsequently defaulted. The committee's proposed approach would have treated the majority (60%) of defaulted issuers in the Fitch portfolio as low risk (risk-weighted below 100%) prior to default. This indicates that the metrics would fail to discriminate adequately between corporate credits.

The committee's proposed treatment of inter-bank exposures relies on backward-looking metrics and omits risk-factors including operating environment (particularly important for emerging markets), company profile, governance, liquidity and profitability. The proposals would see steep declines in capital charges for inter-bank lending to some emerging market banks (up to 80% in some cases).

On a more positive note, capital charges for high-LTV residential mortgage-lending would rise, and the overall approach to both residential and commercial mortgages would seem more risk-sensitive, but harder to implement; especially the proposed inclusion of affordability criteria for residential mortgages where the necessary data may not be available.

Fitch regards the wide-spread practice of exempting banks' sovereign exposures from capital charges as a major weakness in the current risk-based framework. Over time, capitalising sovereign exposures could impose greater market discipline on sovereign finances and narrow the gap between the capital cost of lending to corporates and that of sovereigns. It is disappointing therefore that they were excluded from the Basel Committee's review and are instead being progressed on a separate and apparently longer timeframe.

Implementation will likely be difficult and costly, as banks will find it hard to source, maintain and protect all of the specific information needed to calculate risk weights. Corporate financial information, especially for SMEs, could face timeliness, accessibility and comparability hurdles.