Demystifying Revised Credit Risk Standardized Approach

Credit Risk is one of the major traditional risk that is actively managed by Banks across geographies .With Changing times the Credit Risk Regulations too have undergone tremendous changes .Regulations such as Basel I bought in some standardization in which credit risk was measured and reported, as times progressed and the framework matured regulations such as Basel II and Basel III saw a more risk sensitive approach towards measuring credit Risk. Post the Financial Crisis, Global regulators started issuing many regulations to contain and control various risk types. As the regulatory agenda has nearly firmed we see a focused rigor from regulatory bodies  to ensure standardization and comparability across numbers that are reported by Banks for various risk types ,in line with the thought process we are a seeing many new regulations and also enhancements to existing frameworks which are trying to attempt this .In 2015 ,Bank for international settlement (BIS)  came up with a revised standardized approach for credit risk as a successor to existing Basel III Credit Risk framework .Since then through various consultations this standard has undergone numerous changes and is finally zeroing in on an  implementation date of Jan 2022.

If we were to get in to basics of credit Risk, It emanates when bank accepts deposits from its depositors and lends the same to its customers who can be sovereigns, corporates or retail customers. This activity creates an exposure for the Banks which can result in a potential loss if the borrower is unable to repay the debt in full or in part.

The image below provides a summarized view of how the Basel Risk Framework has evolved till date

Figure 1 – REVISED STANDARDISED APPROACH

The revised Standardized approach for credit risk was introduced with the following main objectives

• Reduced Dependency on external ratings agencies – External Rating agency plays a critical role in determining credit risk of the counterparty. Mechanical reliance on external ratings without any due diligence will lead to non- prudent risk management. By introducing the due diligence process bank has reduced dependency on External rating agencies
• Increased comparability across banks and jurisdictions:Though there are several implementation options at regulator’s discretion, the new standards will considerably aid in comparability between Banks and Jurisdictions.
• More focus on risk sensitivity& granularity – The revisions introduce newer asset classes and additional credit risk assessment within the framework, which will help in arriving at more prudent estimates of RWA and regulatory capital
• Dynamic Risk Weights –The Risk Weights as prescribed in current standardized approach are in line with the current economic conditions.

This approach sees introduction of two approaches namely

• External Credit Risk Assessment Approach (ECRA) – ECRA is applicable for rated exposures of banks in jurisdiction that allow use of External Ratings for regulatory purposes. Banks adopting this approach will also have to set up a Due Diligence framework to assess the rating applicability

• Standardized Credit Risk Assessment Approach (SCRA) – SCRA is applicable for countries where external ratings are not permitted, banks would classify exposures into three buckets (A, B and C) based on assessment of borrowers’ ability to pay and derive RWA accordingly 

Figure 2 – REVISED STANDARDISED APPROACH – CREDIT RISK

In terms of implementation, the Revised approach will have an impact on the below dimensions

• Capital requirements- likely to increase for banks of varying sizes due to additional due diligence requirements and conservatism. 

• Data and Reporting– The revised guide line will require Additional data elements to be sourced and newer Data interfaces to be established along with adequate Quality Controls for computational as well as reporting needs. Due Diligence requirements will also require vast amount of Data for Banks which are following the ECRA approach. 

• Computations – Rules for RWA computation would depend on the approach followed in each country rather than directly external rating. The below table provides a summary of impact of

 Challenges in implementing Revised Standards:The revised standards will also bring in below challenges for the Banks –

• Complexity and granularity of regulation requirement will increase extensive implementation effort
• Revised approach involves extensive data requirement such as data on residential and commercial real estate collateral etc.,
• Banks and financial institutions applying the ECRA approach have to introduce new due-diligence framework for assessing the counterparty credit worthiness independent of using external rating agency data.
• Need to re-align the business model and strategies as the revised approach will potentially result in an increase in RWA and capital requirements

The Revised standards will also have Cross Program impacts especially with initiatives around Default Management and Pillar III disclosures. Also many Banks have already started initiatives to focus on the revised standards so that they are better prepared to comply with the Jan 22 deadline and are also using Traditional Technologies as well as newer Digital technologies (like AI,ML & RPA etc.)   to overcome the implementation challenges.

About the Author:

Venkatesh A S

Venkatesh A S is a Chartered Accountant by profession. In his current position as a Domain Consultant with Risk Management and Compliance Practice of Banking, Financial services & Insurance (BFSI), a business unit of Tata Consultancy services. He has Rich and Extensive experience of  18+ years in consulting, implementation and solution design in regulatory compliance projects like Basel A-IRB, SACR, CVA, IFRS 9 etc., and has worked extensively with several banks and financial institution across Geographies.

Ajay Katara

Ajay Katara is a Domain Consultant with the Risk Management practice of the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). He currently heads the Solution and Strategy for Enterprise Risk and Compliance Regulations. He has extensive experience of more than 14 years in Consulting & Solution design space cutting across CCAR Consulting, AML, Basel II implementation and credit risk, and has worked with several financial enterprises across geographies. He has significantly contributed to the conceptualization of strategic offerings in the risk management space and has been instrumental in successfully driving various consulting engagements. He has also authored many editorials, details of which can be found in his linked in profile (https://www.linkedin.com/in/ajaykatara/)