Credit Risk Framework – Standardised Approach
The majority of smaller institutions rely on the Standardised Approach for Credit Risk (SA-CR) to calculate their own funds requirements for credit risk exposures. This approach provides a credible alternative to internal models. However, the current SA-CR lacks sensitivity to risks in several areas, leading to occasional inaccuracies in credit risk measurement and inappropriate calculation of own funds requirements.
Below is an overview of the primary changes from CRR III pertaining to credit risk. This examination aims to provide a nuanced understanding of the evolving landscape of credit risk calculations, enabling informed decision-making and strategic planning.
Off-Balance Exposures
CRR III introduces several changes in calculating the exposure value for off-balance sheet items and commitments:
- New Definitions and CCFs: New definitions for commitments are introduced, along with two new Credit Conversion Factors (CCF) of 40% and 10%, respectively, while removing the 0% CCF. An exemption allows institutions to continue applying a 0% CCF to contractual arrangements for corporates that are not classified as commitments.
- Transitional Period: A transitional period until 2029 permits the use of a 0% CCF for unconditionally cancellable commitments, with a phased-in increase to 10% over three years (2.5% → 5% → 7.5% → 10%). The European Banking Authority (EBA) will assess potential unintended consequences for obligors relying on commitments as a source of funding and provide technical guidance.
The proposed change from 0% to 10% CCF will substantially impact institutions with exposures to unconditionally cancellable commitments, increasing their risk-weighted assets (RWA).
Exposures Secured by Real Estate
The approach to managing the real estate exposure class has been revised to enhance granularity in assessing the inherent risks associated with various types of real estate transactions and loans. While maintaining the distinction between residential and commercial mortgages, the updated framework introduces additional layers of granularity:
- Financing Dependence: Based on income streams generated by the collateralised property.
- Property Phase: Whether the property is under construction or finalised.
- Income-Producing Real Estate (IPRE) Loans: Dependent on cash flows generated by the property.
Loan Splitting Approach
- Residential Mortgages: Split into secured and unsecured parts with adjusted calibration.
- The secured part (up to 55% of the Exposure-to-Value (ETV)) receives a risk weight of 20%.
- The unsecured part receives a risk weight of 75%.
ADC (Land Acquisition, Development, and Construction)
ADC refers to financing for land acquisition, development, and construction of residential or commercial property.
- 100% Risk Weight: If the project meets governance and credit requirements and one of the following:
- Legally binding contract with a substantial cash deposit.
- Debtor payment before dwelling completion.
- 150% Risk Weight: Otherwise.
IPRE (Income-Producing Real Estate)
Refers to investments in real estate generating income.
- 150% Risk Weight: If none of these criteria:
- Property must be completed, agricultural, or forest land.
- Residential under construction with approval, primary residence, max four units.
- First lien on property.
- Property value not dependent on obligor’s credit.
- Documented repayment ability and property valuation.
- Meets valuation and economic criteria.
- Table 1 Risk Weight: If any of the criteria above are met but none of the criteria below are met:
- Primary residence.
- Secured by income-producing residential unit (max four properties).
- Associations or cooperatives for primary residence.
- Public housing or not-for-profits serving social purposes.
- Table 2 Risk weight: If one criterion from each of the sections above is met.
Table 1:
| ETV | ≤ 50% | 50% < ETV ≤ 60% | 60% < ETV ≤ 80% | 80% < ETV ≤ 90% | 90% < ETV ≤ 100% | > 100% |
| Risk Weight | 30% | 35% | 45% | 60% | 75% | 105% |
Table 2:
| Counterparty | Residential | Unsecured | Commercial |
| ETV | ETV ≤ 55% | ETV > 55% | ETV ≤ 55% |
| Risk Weight | 20% | 75% | 65% |
Additional Framework
- Property Value Monitoring: To stabilise own funds requirements for mortgages and minimise cyclical effects on property valuation, property values must be monitored allowing for upward adjustments up to the average value over the last eight years for commercial property and six years for residential property.
Equity & Subordinated Debt Exposures
- Subordinated Debt: The revised treatment for exposures to subordinated debt is a risk weight of 150%.
- Equity Exposures: The revised risk weights account for the higher loss risk associated with equity compared to debt exposures:
- A 250% risk weight for equity phase in to 2030.
- A 400% risk weight for riskier speculative investments phase in to 2030.
- Equity exposures from legislative programs aimed at promoting specific economic sectors may receive a 100% risk weight, subject to a threshold of 10% of the institution’s own funds and supervisory approval.
- Equity exposures to central banks receive a risk weight of 0%.
- A 100% risk weight for equity exposures to financial sector entities within the same scope of prudential consolidation.
- A 100% risk weight for equity exposures within the same institutional protection scheme, subject to supervisory approval.
Exposures to Institutions
- Breaking Linkage to Sovereigns: Non-rated institutions can no longer assign a risk weight based on their sovereign’s rating. A new method determines the appropriate risk weight for unrated institutions based on qualitative and quantitative criteria, such as capital- and leverage ratio.
- Rated Institutions: Risk weights are assigned based on the available credit quality step, with a notable change from 20% to 30% for Step 2.
Rated Institutions:
| Credit Quality Step | 1 | 2 | 3 | 4 | 5 | 6 |
| Risk Weight | 20% | 30% | 50% | 100% | 100% | 150% |
Rated Institutions with a Maturity Less than Three Months:
| Credit Quality Step | 1 | 2 | 3 | 4 | 5 | 6 |
| Risk Weight | 20% | 20% | 20% | 50% | 50% | 150% |
Unrated institutions:
| Credit risk assessment | Grade A | Grade B | Grade C |
| Risk weight for short-term exposures | 20% | 50% | 150% |
| Risk weight | 40% | 75% | 150% |
Lower risk weights apply for exposures with a residual maturity of less than three months or exposures from the movement of goods across national borders with a maturity of less than six months.
Exposures to Corporates and Retail
- Corporate Exposures: Unrated corporations should be assigned a risk weight of 100%. The risk weight for credit quality step 3 has decreased from 100% to 75%.
Rated Corporates:
| Credit Quality Step | 1 | 2 | 3 | 4 | 5 | 6 |
| Risk Weight | 20% | 50% | 75% | 100% | 150% | 150% |
- Retail Exposures: A new sub-category, “transactors,” with a 45% risk weight, applies to exposures with characteristics similar to credit cards where the balance to be repaid at the next scheduled repayment date is determined as the drawn amount and is repaid in full at each scheduled repayment date for the previous 12 months. Exposures to natural persons not meeting all other conditions for retail exposures are assigned a 100% risk weight and classified as “Other retail”.
Summary
The forthcoming changes outlined in CRR III will have substantial implications for financial institutions. Some of the key changes include:
- Adjustments in CCF for off-balance exposures.
- Revisions in risk weights for real estate and equity.
- Enhanced sensitivity and accuracy in credit risk calculations.
Institutions must prepare for these regulatory impacts, recalibrate their credit risk calculations, and ensure compliance with evolving standards. The magnitude of these changes underscores the need for proactive adaptation and strategic planning among financial institutions to navigate the evolving landscape. Additionally, the new updates require robust data management to ensure accuracy, consistency, and reliability in all regulatory and risk management processes.
We at Advisense are here to help with the implementation of CRR III and provide systems that can assist with data management, calculations for regulatory reporting, and risk management, ensuring that your institution remains compliant and strategically positioned. Feel free to reach out if your institution is in need of support.
