BASEL III – SCRA IMPLEMENTATION FAQ - By FITCH Solution

BASEL III – SCRA IMPLEMENTATION FAQ ANSWERS TO YOUR QUESTIONS ON THE NEW BASEL III REFORMS ADVISING THE SCRA APPROACH OCTOBER 2021 fitchsolutions.com/basel-iii-scra

Banks have until January 2023 to The scale of the data management implement the new standardised effort will depend on the size credit risk assessment (SCRA) and geographic spread of a approach introduced under bank’s unrated portfolio, but will Basel III updates. This new likely entail significant time and methodology for assigning risk resources, which is why Fitch weightings to unrated bank Solutions developed an SCRA data exposures will undoubtedly offering to meet this need. increase the data management burden for many banks. To help banks understand the challenge, Paul Whitmore, Global In addition to gathering minimum Head of Counterparty Risk capital requirements and capital Solutions at Fitch Solutions, and buffer requirements from any Monsur Hussain1, Head of Financial jurisdictions in which a bank Institutions Research at Fitch has unrated exposures, banks Ratings, answer some frequently will need to comb individual asked questions about this new counterparty banks’ annual approach. reports to obtain relevant information. Contributors 1 Monsur Hussain’s contribution to the document covers technical and regulatory aspects only. PAUL WHITMORE Global Head of Counterparty Risk Solutions Fitch Solutions MONSUR HUSSAIN Head of Financial Institutions Research Fitch Ratings fitchsolutions.com/basel-iii-scra

WHAT IS THE NEW SCRA APPROACH? If such minimum regulatory requirements and buffers are not publicly disclosed or otherwise made available The SCRA approach is a more granular way of assigning by the counterparty bank, and a bank assesses that the risk weightings to unrated counterparty banks exposures. counterparty bank does not meet the definition of Grade The SCRA applies to unrated bank exposures for banks A, then the counterparty bank must be assessed as incorporated in jurisdictions that allow the use of external Grade B or lower. To be classified into Grade B, a bank ratings for regulatory purposes. Banks incorporated in must meet or exceed the published minimum regulatory jurisdictions where credit ratings cannot be used for requirements. prudential purposes, for example, in the US, may apply the SCRA to all their bank exposures. Grade C refers to higher credit risk exposures to banks, where the counterparty bank has material default risks Using published minimum regulatory requirements and and limited margins of safety. For these counterparties, their due diligence, banks use the SCRA approach to adverse business, financial, or economic conditions are determine the required risk weight for their unrated very likely to lead or have led to an inability to meet their counterparty bank exposures by grading them into one of financial commitments. A bank must classify the exposure three categories – Grades A, B, or C – and assigning the as Grade C, if any of the following triggers are breached: corresponding ‘base’ supervisory risk-weights. • The counterparty bank does not meet the criteria To be classified into Grade A, a bank must meet or for being classified as Grade B with respect to its exceed the published minimum regulatory requirements published minimum regulatory requirements, i.e. if and buffers established by its national supervisor as minimum regulatory requirements are not publicly implemented in the jurisdiction where it is incorporated disclosed or otherwise made available by the (some exceptions apply). counterparty bank, In addition, the counterparty bank must have adequate or capacity to meet their financial commitments (including repayments of principal and interest) promptly. This • Where audited financial statements are required, must remain for the projected life of the assets or the external auditor has issued an adverse audit exposures, irrespective of the economic cycles and opinion or has expressed substantial doubt about business conditions. the counterparty bank’s ability to continue as a going concern in its financial statements or audited reports A preferential Grade A risk-weighting can be used, within the previous 12 months. provided that the counterparty bank has a Common Equity Tier 1 ratio that meets or exceeds 14%, and a Tier 1 leverage ratio that meets or exceeds 5%. Using the new SCRA approach allows banks to accurately assess the required risk weight for their unrated bank exposures, and can help reduce the capital charge applied which frees up capital for use elsewhere. 2

WHAT KINDS OF BANKS WILL BE WHY SHOULDN’T BANKS CONTINUE TO AFFECTED BY THE NEW SCRA APPROACH? USE THEIR INTERNAL RATING MODELS? All internationally active banks located in jurisdictions that The final Basel III ‘endgame’ standards taking effect from adhere to Basel rules will need to implement the SCRA January 2023 restrict the use of internal models in favour approach, specifically for their exposures to unrated banks. of revised standardised approaches, in a bid to restore credibility in the calculation of banks’ risk-weighted assets Also, banks incorporated in countries, such as the (RWA) and capital ratios. Specifically, modelled RWA will US, that do not allow the use of external ratings for be permanently floored at a fixed percentage of those regulatory purposes might need SCRA data to calculate calculated with the standardised approach under the their unrated and foreign bank exposures. However, output floor restriction. it will depend on the shape of the final rules in their jurisdictions and on their level of activity in other Otherwise, banks with permission to use internal models international jurisdictions. will still calculate the Probability of Default or Loss Given Default, and exposures to business lines such as retail lending, mortgages, and project finance. Models will still be used to calculate holistic capital requirements for Pillar 2 risks and expected credit losses. But in light of the output floor measure, even banks with permission to use internal models will still need to compute RWA under the standardised approach. Therefore, the new SCRA approach may benefit banks by potentially limiting the impact of capital charges for their unrated portfolios. From a sample of over 4,600 unrated banks, risk weights could be reduced by the SCRA approach for 98% of those banks, to either a 30% risk weight or a 40% risk weight*. * These results were found by checking a sample of banks with reported regulatory CET 1 Capital, Tier 1, Total Capital and Leverage Ratios (within the last year) against their region’s reported regulatory minimum requirements and buffers. The financial ratios used are sourced by Fitch Group. fitchsolutions.com/basel-iii-scra

WHAT IS THE AIM OF THE OUTPUT FLOOR THAT WILL BE PHASED IN UNDER THE FINAL BASEL III RULES? It will create a more level playing field between banks that use sophisticated internal models and those using the standardised approach. Historically, larger banks typically used internal model estimates, and these could generate very low-risk weightings, reducing their minimum capital requirements. Smaller banks that do not have the resources to create complex internal models will be less disadvantaged. The output floor will also help reduce the excessive variability of RWA calculated under banks’ current models. Under the new regulations, modelled capital charges will have to be at least 72.5% of aggregate RWA calculated using the standardised approach. This could cause very low modelled risk weight estimates to increase sharply unless standardised risk weights are optimised – for example, by using the SCRA approach. HOW WILL THIS AFFECT THE RISK WEIGHTING FOR MY PORTFOLIO OF UNRATED BANKS? It depends on the make-up of individual banks’ portfolios and where those counterparty banks that they have exposure to are registered. Initial analysis shows that the risk weights attached to those unrated banks could be considerably reduced. From a sample of over 4,600 unrated banks, risk weights could be reduced by the SCRA approach for 98% of those banks, to either a 30% risk weight or a 40% risk weight. 3

HOW WILL THE COMPOSITION OF WHAT CHALLENGE DO BANKS FACE A BANK’S PORTFOLIO AFFECT ITS WITH THE NEW SCRA APPROACH? IMPLEMENTATION PROCESS IN TERMS OF TIMING, EFFORT, AND REQUIRED Using the new SCRA approach requires banks to collect RESOURCES? minimum capital requirements and capital buffer requirements from all jurisdictions in which the bank At this stage we expect a lot of banks to be has unrated exposures. They must also obtain relevant analysing their portfolios to examine any gains information from counterparty banks’ annual reports. or losses with regard to the final reforms. Most banks will still keep designating rating agencies Collecting and maintaining these minimum to calculate their risk weights under the External requirements detailed in many different formats Credit Risk Assessment Approach (ECRA). and languages from regulators and banks in over However, many scenarios are being tested 130 countries will be time-consuming and resource- and banks will be looking at using one or more heavy, especially for banks with a large number of agencies, together with the SCRA approach. Using unrated counterparties in their portfolios. the SCRA approach alone for a sample set of rated banks (1671), 72% of those banks could achieve In addition, banks may encounter issues in using the same or better risk weight than just using the the SCRA approach to process and calculate RWA. three big rating agencies.* For example, there can be different capital buffer For those banks that are unrated, banks are likely requirements in each jurisdiction, with some to be trying to gather the information they need requirements being additive and others the higher to lower the risk weights on those exposures from of two amounts. These may also change to reflect 150% to potentially 30% or 40%. This could have a evolving developments among jurisdictions or bank significant impact on the capital charges the banks counterparties themselves. would incur. Reducing capital charges was a key driver for our clients in requesting the creation of Banks will face the choice of resourcing this internally our SCRA data set. or going to a third party supplier such as Fitch Solutions for an evergreen data solution. *Banks do not have the option to use only the SCRA approach; this example is for illustrative purposes only. WHAT BENEFITS WILL A BANK EXPERIENCE FROM USING THE fitchsolutions.com/basel-iii-scra NEW SCRA APPROACH? Fixed risk weightings are currently applied to unrated banks under the standardised approach, requiring more capital than typical investment- grade credit ratings. Under the Basel III regulatory framework, provided the SCRA approach can be used, risk weights may fall, reducing banks’ capital requirements. This is because the SCRA approach is more granular than the current unrated standardised approach. Instead of a single fixed risk weight that sees all unrated banks treated the same by regulators, the SCRA approach has three different buckets for unrated banks. It could therefore result in a reduction in risk weights from 100% under the current Basel framework, to 30% in some instances.

HOW MUCH TIME DO BANKS NEED FOR THE IMPLEMENTATION? This will depend on each jurisdiction and its chosen legislative path to implementing the final Basel III standards. It will take some time to ensure that these requirements are embedded into the necessary data infrastructure and that relevant resources are trained and ready, and to test the process sufficiently. All of our clients who are using our SCRA data are already some way into this process. To ensure effective governance, some banks have already begun using the SCRA approach alongside their current approach, ahead of the Basel Committee’s January 2023 implementation deadline. WHAT ARE THE ADVANTAGES OF STARTING IMPLEMENTATION EARLY? By starting early, banks can ensure that they meet both the regulatory requirements and the spirit of the regulations, in particular when considering governance and oversight within each jurisdiction. It is time-consuming to collect and standardise the required data for the SCRA approach, so getting ahead will reduce any last-minute rush to meet the January 2023 deadline. Banks not in a position to gather the data internally will need to have selected a third party provider, and both executed and tested the integration of this data in their systems well in advance of this date. WHY ADDRESS THE DATA REQUIREMENTS FOR THE SCRA APPROACH NOW? Implementing the approach is a small part of a much larger undertaking and delivers an immediate measurable ROI, which frees more bank resources to address the full implementation of Basel III. As mentioned previously, the risk weighting reductions can be significant, and being able to get a handle on those projections ahead of time is commercially advantageous. 4

WHAT DATA WILL BANKS NEED TO WHAT SHOULD POTENTIAL USERS LOOK IMPLEMENT THE SCRA APPROACH? FOR IN AN SCRA DATA SOLUTION? Banks will need to obtain regulatory minimum capital For those that seek an external solution, finding a provider requirements and buffers data, as implemented in the with a strong track record in collecting and maintaining jurisdiction of the counterparty bank, available from high volumes of comprehensive, standardised data should regulators and bank websites. be a top priority. With the information being hard to find and difficult to interpret, prior experience is a benefit. HOW CAN BANKS INCORPORATE THE REQUIRED DATA INTO THEIR SYSTEMS It is important to check the credentials of the team AND MODELS? behind the numbers. Sourcing this data effectively requires professionally qualified analysts and data To bring the data into internal systems, the bank specialists equipped with the expertise and language can use channels such as API, data feeds, or even skills needed to analyse bank and supervisory documents via an Excel Add-In, and easily incorporate it into from jurisdictions worldwide. existing datasets. Fitch Solutions SCRA data will work alongside fundamental financial data from any WHAT STAGE SHOULD BANKS NOW provider, making it very simple to implement. BE AT TO ENSURE THEY ARE FULLY PREPARED FOR THE JANUARY 2023 HOW DO BANKS FIND THE REQUIRED IMPLEMENTATION? DATA? Many banks took advantage of the extra 12 months delay The required data can be collected in-house, or to final Basel III implementation the Basel Committee obtained through an external provider. The data is in on Banking Supervision granted in March 2020 because many different formats and languages, from regulators of the Covid-19 pandemic. Most are only assessing the and banks in over 130 countries and jurisdictions, and implications of the reforms now that draft rules are starting will require continuous monitoring and updating as to be published by regulators. the requirements change. Banks are likely to be currently performing quantitative Some banks will prefer to use an SCRA data solution impact studies to understand how the reforms will from a third-party vendor, to avoid the challenges affect their capital calculations. They will be looking at of gathering and standardising the data. Several of all permutations of their internal ratings-based models, our clients had already tried and failed to gather this credit ratings for the external credit risk assessment data themselves when they approached us to create approach, and their current datasets to help them the SCRA data product. It’s not as simple as getting adhere to the SCRA guidelines. We’re currently helping a a junior analyst to cut and paste information from significant number of clients in this process and are happy websites. Even large banks with sufficient resources to have a conversation with any bank looking for expert find gathering the data onerous. support in this area. It is worth remembering that the larger the bank – or the broader its geographical reach – the larger the task. For banks of any size, however, preparing for this change should be a priority. fitchsolutions.com/basel-iii-scra

FITCH SOLUTIONS BASEL III – SCRA DATA AVOID NEEDLESS INCREASES TO YOUR CAPITAL CHARGES Our SCRA Data solution allows you to easily implement the new SCRA approach and accurately assess the required risk weight for your unrated bank exposures, without having to gather, standardise, and maintain the supporting data. Uniquely designed to complement and enhance your credit risk analysis workflow, Basel III – SCRA Data is available via API, Data Feed, or Excel Add-In, and can be used alongside other data sets. LEARN MORE Visit fitchsolutions.com/basel-iii-scra or email us at [email protected] to request additional information or speak to a dedicated advisor. Our specialists can also show you how to save time and reduce errors with Fitch Connect, a modern, flexible, multi-channel delivery platform. 5

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