The Basel Committee on Banking Supervision released proposed revisions on Dec. 23 to the standardized approach to credit risk, outlining new standards for exposures secured by residential real estate.
The committee updated the standards to “ensure that a simple methodology remains available for a wide range of jurisdictions and non-internationally active banks where the cost of compliance with more complex standards may not be warranted.”
Currently, the standardized approach applies a 35% risk weight to all exposures secured by mortgage on residential property, regardless of whether the property is owner-occupied, provided that there is a substantial margin of additional security over the amount of the loan based on strict valuation rules.
However, the committee believes that this approach lacks risk sensitivity: a 35% risk weight may be too high for some exposures and too low for others. Also, it noted that there is a lack of comparability across jurisdictions as to how great a margin of additional security is required to achieve the 35% risk weight.
As a result, the proposal introduced a table of risk weights ranging from 25% to 100% based on the loan-to-value ratio, since the LTV ratio, to them, is the most appropriate risk driver in this exposure category.
In addition, the committee outlined the following concerns with the proposed risk drivers.
- Differences in real estate markets, as well as different underwriting practices and regulations across jurisdictions make it difficult to define thresholds for the proposed risk drivers that are meaningful in all countries.
- The proposal uses risk drivers prudently measured at origination. This is mainly to dampen the effect of cyclicality in housing values (in the case of LTV ratios) and to reduce regulatory burden (in the case of DSC ratios). The downside is that both risk drivers can become less meaningful over time, especially in the case of DSC ratios, which can change dramatically after the loan has been granted.
- The DSC ratio is defined using net income (i.e. after taxes) in order to focus on freely disposable income. That said, the Committee recognizes that differences in tax regimes and social benefits in different jurisdictions make the concept of ‘available income’ difficult to define and there are concerns that the proposed definition might not be reflective of the borrower’s ability to repay a loan.
Comments on the proposals can be uploaded here by March 27, 2015.