Oct 4 - Proposals from a committee of EU experts on capital requirements for trading assets and real-estate lending could help address the under-estimation of potential losses in these areas, Fitch Ratings says.
The group's report on banking sector reform found that capital requirements for trading book risks suffer from model risk and measurement errors, among them tail and systemic risks. The group, which was led by Bank of Finland governor Erkki Liikanen, argued in favour of an extra, non-risk based, capital buffer requirement for all trading-book assets.
Our research indicates that higher capital requirements are warranted for the trading book as current Value at Risk models do not account for extreme market volatility. The proposal by the Basel Committee that expected shortfall replace VaR will address this issue to some extent. But VaR is needed to calculate expected shortfall, so differences in VaR methodology, model variable assumptions, and dissimilar historical data sets present significant challenges for meaningful comparisons of reported numbers. As a result of these limitations and discrepancies, Fitch uses a conservative internal approach to measuring VaR - particularly stressed VaR.
The addition of more buffer capital would have to be done with caution as it would come on top of several other new requirements, including the counter-cyclical capital buffer, the capital conservation buffer and, for some banks the Systemically Important Financial Institutions, or SIFI, capital buffer. Excessive or misaligned capital charges could reduce financial institution participation - and therefore liquidity - in important financial markets and distort capital and resource allocation in economically inefficient ways. It could also discourage institutions from participating in certain profitable activities that provide income stream diversification; and render regulatory risk estimates and models irrelevant for internal risk management purposes.
On real estate lending, the Liikanen group argues that current levels of risk-weighted assets based on banks' internal models and historical loss data tend to be low compared to the losses incurred in past real-estate crises. The group suggests that the capital adequacy framework include sufficient safeguards against substantial property market stress via - for example - robust floors on the RWAs calculated using internal models.
We agree that current RWAs are highly variable across institutions and can be inadequate for real-estate lending. Several inconsistencies in internal, model-based, capital estimates - particularly in retail real estate - have emerged and we have been considering measures to account for these, including the introduction of a loss given default floor specifically for mortgage exposures.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at
All opinions expressed are those of Fitch Ratings.
(New York Ratings Team)