Exposure Classification for Risk Weightings

Background
We have recently seen an increasing number of clients approach 4most for support with exposure classification for Risk Weighted Asset (RWA) purposes. This has been primarily driven by two main factors, outside the obvious need to consider Basel III changes:

• The reassessment of existing classifications following some highly publicised events across the industry
• Organisations looking to optimise returns through new opportunities and product offerings.

Case study
A UK tier 1 banking client approached 4most to deliver a high-level opinion paper used to inform a business case – presented to their executive management – to progress a new proposition in the mortgage market.
The approach taken was to consider four different scenarios with regards to the exposure classification, specifically:

• Standardised Approach with current rules
• IRB Approach with current rules
• Standardised Approach with future rules
• IRB Approach with future rules.

The main focus was the immediate impact under current Standardised rules. In theory, the Standardised Approach to credit risk capital rules is meant to be simple to interpret and apply, it has been how many banks have approached – and continue to manage – this aspect of their capital reporting. It’s simple, easy and controlled.

There is a significant difference from the 35% Standardised risk weight associated with exposures secured by mortgages on immovable property (residential), compared to other classifications (for example, retail exposures typically attract a 75% Standardised risk weight) and is the most restrictive of the exposure classes that allow mortgaged property to be considered. Banks who lend to a customer who may be a natural person (i.e. an individual) or a company, need to know if the property can be classed as residential.

A key consideration are properties that are Houses in Multiple Occupation (HMO ), possibly licenced as such and/or classed for planning differently to standard family residential use. By nature, they may have multiple tenancy agreements and may not be valued in line with Article 229 of the Capital Requirements Regulation (CRR) rules. These interpretations formed a key point of our opinion paper alongside other considerations regarding the continued evidence of low industry losses and guidelines on classification hierarchies.

Longer term thinking required future applicable regulation to be considered; clearly the level of certainty varied for different scenarios.

Whilst current Internal Ratings-Based (IRB) rules are defined, their interpretation is ambiguous. This is particularly the case regarding the definition of retail lending when considering portfolios with material levels of individual underwriting such as Buy-to-Let lending as prescribed by the Prudential Regulation Authority (PRA) in SS 13/16. Our approach was to consider the differences between current IRB portfolios and aspects of the proposal that would likely result in more individual management, such as taking into account concentration risks and varying property types.

Future regulation requires consideration of the EU/UK interpretation of the Basel Committee on Banking Supervision (BCBS) reforms, based on previous adoptions. Although there are clear differences to the application of Standardised risk weights, guidance has been applied by the EU to current regulations, which could be assumed to be repeated for future adoption. An example of this is the exclusion of exposures secured on residential property for the Retail SME exposure thresholds (CRR Article 147 5(a)(ii)).

Industry Overview
The list of banks regulated by the PRA suggests there have been approximately 30 newly incorporated UK banks in the last 10 years – some being reincarnations of earlier lenders – and added to this are a number of newly authorised deposit taking branches. Many of these new lenders are highly focused on niche markets and specialised product offerings where lending can lie at the boundaries between regulatory rules. These products are often the most complicated to appropriately class due to instances where they partially meet rules across classes, this requires a level of judgement to determine where to class each exposure. For larger organisations, these ‘borderline’ classings are often less material against the entire balance or internal regulatory resource is sufficient to dedicate time to produce a compliant solution.

However, the maturity and robustness of classification approaches varies across the industry and is not necessarily correlated to the size of lender or the time operating as an IRB lender. As experienced over the last 10 years, capital rules continue to change out of necessity. Greater focus has been applied to existing implementations than it was previously, potentially at inception or on a frequent basis since.

Newer banks may find it more difficult to identify where an issue may arise in the first place as they typically would not have the corporate memory or networks that can augment what can be understood from official published views.

For established banks, whilst many have specialist regulatory functions, there are likely to be decisions and hardcoded logic in systems that are not fully documented and understood, leading to potential misclassifications. This can be further compounded as ambition and competition drives continued expansion from incumbents towards finer niches of lending – particularly where there are a better value propositions available.

Many variations in product and borrower characteristics as discussed above can result in complexity in classing exposures, particularly when you add collateral type and use according to the rules for residential property lending. In addition to the different types of property lending, the governing laws and rules can also change, leading to shifts in market composition, sometimes presenting opportunity and at other times new risks. For example, the reduced relief in taxation on Buy-to-Let and second homes, increases to stamp duty, and the introduction of Help-to-Buy government sponsored initiatives to improve home ownership and changes to planning rules. With each moving part there is a need to review the commercial and lending policy position but also to review the classification of exposures and treatment under Standardised rules. Industry body responses by the Council for Mortgage Lenders* in response to changes in the most recent international capital rules highlight some of the areas where further clarity has been requested.

To address these concerns, we have seen some of the organisations currently applying for IRB place significant investment into the development of easy-to-understand and interpret exposure classification policies. Tools include decision trees that look to create a well-defined and presented ruleset from the regulation available, ensuring consistent decisions are made across the organisation over time and provide a clear audit trail for future reference, internally or for regulators.

Few banks, if any, can sit on their current approach to Standardised capital reporting when it comes to property lending – this may be a result of incoming rule changes, or a change in composition of the intended portfolio. A best-case scenario is that it confirms that what is in place is robust and gives the Executive Committee and Board comfort that exposures and associated risk weights are being reported correctly. This is likely to be a relatively small cost for addressing such a materially important concern.

*CML, now part of United Kingdom Finance Ltd

For more information or to see how we can help your business, get in touch with Phil at phillip.dransfield@4-most.co.uk