Revised standardised approach for credit risk in practice. evidence from public sector entities (PSEs)

Author:Lukasz Prorokowski
Position:H.L. Prorokowski Consultancy, Wroclaw, Poland
Pages:87-102
SUMMARY

Purpose Focusing on delivering practical implications, the purpose of this paper is to show optimal ways of calculating risk weights for public sector entities (PSEs) under the standardised approach in credit risk. Focusing on the changing regulatory background, this paper aims to explain the proposed revisions to the standardised approach for credit risk. Where necessary, upon the review of the forthcoming standards, this paper attempts to indicate room for ... (see full summary)

 
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Revised standardised approach
for credit risk in practice
evidence from public sector entities (PSEs)
Lukasz Prorokowski
H.L. Prorokowski Consultancy, Wroclaw, Poland
Abstract
Purpose Focusing on delivering practical implications, the purpose of this paper is to show optimal ways of
calculating risk weights for public sector entities (PSEs) under the standardised approach in credit risk. Focusing
on the changing regulatory background, this paper aims to explain the proposed revisions to the standardised
approach for credit risk. Where necessary, upon the review of the forthcoming standards, this paper attempts to
indicate room for improvement for policymakers and ag areas of potential ambiguity for practitioners.
Design/methodology/approach This paper discusses and analyses the revised standards for the
standardised approachin credit risk with respect to the treatment of PSEs. This paper, analysingthe current
regulatory proposals, tests the hypothesis stating that the affected banks may experience higher or lower
capital charges for credit risk depending on the following factors: Choosing the optimal risk weight
calculationmethodology; and choosing the optimal compositionof the credit risk portfolio.
Findings The paper advises on using sovereign ratings as a base of risk weight calculations and
categorisingeligible entities as sovereignexposures. Individualentity ratings are not readilyavailable and the
majorityof PSEs remain unrated by the externalagencies. The simplisticapproach of using sovereign ratings
results in a lower risk weighted capital than the approach of using individual entity ratings. The sovereign
rating approach decreases the value of the original exposure by 77 per cent. Reliance on sovereign ratings
outperforms the optimal solution proposed in this paper. Categorisation of eligible entities as sovereign
exposures signicantly decreasesthe risk exposure capital in the standardisedapproach. There are, however,
speciccriteria highlighted in thispaper that must be met by a PSE to be categorisedas a sovereign exposure.
Originality/value In addition to testing various scenarios of calculating risk weights, this paper
highlights regulatory areas that require further improvements and immediate attention from the
policymakers and practitioners.At this point, the paper reports that the proposed changes to the risk weight
bucketsfor PSE exposures may be erroneous and resulting from the typosin the second consultative paper.
Keywords Credit risk, Basel Committee, Capital charge, Public sector entity, Risk weights,
Standardised approach
Paper type Research paper
1. Introduction
In December 2015, the Basel Committee on Banking Supervision issued an updated
consultative paper that revises the existing standards for the standardised approach to
credit risk exposures BCBS (2015) and PWC (2015). While the updated proposal is
signicantly different to the initial suggestions (for comparison see: BCBS, 2014) for the
standards published in December 2014, several regulatory areas remain unchanged.
Furthermore, the proposal reintroduces the reliance on external credit ratings along with
updated risk weights KPMG (2016).
JEL classication G21, G28
Credit risk in
practice
87
Received18 October 2016
Revised19 December 2016
12January 2017
Accepted19 January 2017
Journalof Financial Regulation
andCompliance
Vol.26 No. 1, 2018
pp. 87-102
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-10-2016-0093
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
This paper focuses on the most recent revisions, introduced in December 2015 by the
updated consultative paper,to the standardised treatment of public sector entities (PSEs).In
doing so, this paper, analysing the currentregulatory proposals, tests the hypothesis stating
that the affected banks may experience higher or lower capital charges for credit risk
depending on the followingfactors:
choosing the optimal risk weight calculation methodology; and
choosing the optimal composition of the credit risk portfolio.
Banks and other credit institutionsshould understand that the aforementionedfactors affect
Relationship Managers and their preferences for lending to specic obligors as well as
Credit Risk Analysts and their preferences for the regulatory prescribed methodologies for
calculating credit risk weights. Ultimately, the amount of capital charge depends on smart
choices made by industry practitioners.
First, focusing on the changing regulatory background, this paper aims to explain the
proposed revisions to the standardisedapproach for credit risk. The paper limits its scope to
discussing the regulatoryimplications for the standardised treatment of PSEs, as other asset
classes will be discussed and empiricallytested in forthcoming studies. This paper analyses
the proposed regulatory changes to nd out whether the new standards for calculating
specic risk weights for PSEs under the standardised approach for credit risk are clear,
consistent and result in the overall improvement of risk management. Where necessary,
upon the review of the forthcoming standards, this paper attempts to indicate room for
improvement for policymakers and ag areas of potential ambiguity for practitioners. One
should note that the Basel Committeewill conduct a qualitative impact study in the future to
highlight any room for improvementand further amend the proposed regulations. With this
in mind, the paper aims to support the future studyconducted by the Basel Committee with
original ndings.
Second, focusing on delivering practical implications, this paper attempts to show
optimal ways of calculatingrisk weights for PSEs under the standardisedapproach in credit
risk. In the second consultativepaper, the Basel Committee has proposed two methodologies
for calculating credit risk weights with respect to PSEs and agreed that certain PSEs can
received the sametreatment as sovereign exposures:
bank can map PSEsrisk weights to the sovereign rating;
bank can map PSEsrisk weights to the specic rating of an entity; and
bank can treat certain PSEs as sovereign exposures.
Against this backdrop, an optimal solution for the standardised treatment of public sector
entities is sketched in this paper. Thus, industry practitioners can benet from achieving
lower capital charges while maintainingthe appropriate level of conservatism. All in all, the
research questionsattempted in this paper boil down to resolving the followingissues:
RQ1. What needs to be improved in the revised standards for the standardised
approach to PSEs?
RQ2. What is the optimal solutionto calculating risk weights for PSEs?
RQ3. What are the criteria fora PSE to be treated as a sovereign exposure?
The current paper is organised as follows. The next section (Section 2) discusses and
analyses the revised standards for the standardised approach in credit risk with respect to
the treatment of PSEs. This section highlightskey challenges, aws and implications of the
JFRC
26,1
88

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