Risk Drivers as Alternatives to Risk Weights and External Credit Ratings : Regulatory Developments

Certain developments which have prompted recent regulatory concerns – consequently resulting in the Basel Committee's decision to introduce risk based drivers, include amongst others, concerns that the standardized approaches to credit and counterparty risk relied too heavily on external credit ratings, unjustified applications by banks in their use of internal model-based approaches to drive down risk weightings, and that risk weightings generated by internal models are too complex and opaque.In its Consultative Paper, “Revisions to the Standardized Approach for Credit Risk”, the Basel Committee, whilst acknowledging the vital role played by credit ratings and rating agencies in financial markets and that external credit assessments provide valuable information that may assist in the analysis of credit risk exposures, also concedes that overdue, unjustified reliance may be placed by market participants on such ratings – further resulting in poor risk management in their application. Unaccounted-for exposures are also attributed to considerations prompting a need for other options to external ratings.Other identified weaknesses attributed to Internal Ratings Based approaches include calibration related issues, lack of comparability with exposures risk which are weighted under the Internal Ratings Based approach, as well as a lack of clarity and transparency with related standards. Recent focus by the Committee has included the need to ensure an adequate balance is struck between comparability and sensitivity within the Basel Capital framework, as well as addressing concerns that Credit Conversion Factors, introduced as a means of addressing certain off balance sheet exposures, are inappropriate in their application to leverage ratios.This paper is aimed at highlighting and investigating those developments which have occurred over the years and which have triggered a need for revision in the above mentioned regulatory approaches - as well as changes in the financial environment within which such approaches were introduced. Within such background and framework, inapplicable approaches, out-of-date calibration, and applicability of recently introduced approaches will also be incorporated