Friday, July 17, 2009

C-EBS Releases Counter-Cyclical Capital Buffer Position Paper

Posted on PrefBlog:

The Committee of European Banking Supervisors has released a position paper on counter-cyclical capital buffers, favouring discretionary supervision (Pillar 2) over Capital Rules (Pillar 1):

While the mechanisms identified might be alternatively employed in Pillar 1, its use under the Pillar 2 umbrella is still considered the most sensible option at this stage. Pillar 2 allows for flexibility in testing new prudential tools; moreover, an application in Pillar 1 would require further work and refinements.

With regard to this last point a meeting with rating agencies was organized. They stated very clearly that transparency on capital adequacy is a key issue and it is a precondition for market acceptance of time-varying capital buffers. Rating agencies seem to prefer Pillar 1 solutions, considered more transparent [and] less prone to national discretions; however, they seem also aware that Pillar 2 would allow quicker responses and may be used for testing tools to be subsequently improved and, possibly, implemented under Pillar 1.

Essentially, the position paper aims at a different methodology for calculating Expected Losses (EL) - see Expected Losses and the Assets to Capital Multiple. EL is calculated by the formula

EL = PD * EAD * LGD

where PD = Probability of Default
EAD = Exposure at Default
LGD = Loss Given Default (a percentage)

What C-EBS is aiming at is:

the use of mechanisms that rescale probabilities of default (PDs) estimated by banks, in order to incorporate recessionary conditions.

Currently:

The input to the IRB formula is the annual PD expected to be incurred in that grade (computed as the long-run average of one-year default rates).

As for the LGD, banks are requested to use LGD estimates that are as much as possible estimated for an economic downturn (where these are more conservative than the long-run average).

One problem I see with the approach is there does not appear to be an allowance for the term of the exposure. Would a bank dealing exclusively in mortgages with a 5-year term be expected to use the same recessionary PD as a bank with a portfolio of exclusively 30-year mortgages?

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