Combine different sector risk weighting policies with capital buffer and leverage ratio policies

Prepared by Jan Hannes Lang and Marek Rusnák

In recent years, different sectoral macroprudential risk-weighting policies have been used in EU countries to address systemic risk in residential real estate markets. For example, sector risk weight floors for domestic mortgages based on internal ratings (IRBs) have been adopted in Estonia, Finland and Sweden, while sector risk weight add-ons and multipliers have been set. implemented in Belgium.[1] The use of different sector risk weighting policies raises the question of their relationship to policies that would alter sector capital or leverage ratio requirements.[2]

Sector risk weight floors, add-ons and multipliers can be shown to be similar to different sector policies for capital requirements and leverage ratio. This conceptual similarity between the different policy instruments occurs because they lead to similar changes in the minimum capital required for a given bank.[3] To illustrate this, we consider two banks that have an initial sector capital requirement of 10%, and no sector leverage ratio requirement. The two banks differ only in their average sector risk weight, which is 10% for bank 1 and 12.5% ​​for bank 2. The minimum capital requirement and the average risk weight implicitly set together a minimum sector leverage ratio (CET1 capital required / sector exposure) of 1% for bank 1 and 1.25% for bank 2. We then consider three different risk weighting policies: a risk weighting floor of 15%, a risk weight add-on of 5 percentage points and a risk weight multiplier of 33%.

A sector weight floor amounts to imposing a common sector leverage ratio requirement for all banks, in addition to the risk-based capital requirement. For the example above, we assume a sector risk weight floor of 15%. As both banks initially had sector risk weights below 15%, the floor will be binding for the calculation of minimum capital requirements. The risk weight floor will thus result in an implied minimum sector leverage ratio of 1.5% for both banks. Therefore, the sector risk weight floor acts as a minimum sector leverage ratio imposed on both banks, alongside the risk-based sector capital requirement. Such a policy would be justified if systemic risk could lead to a minimum of unexpected losses for all sector exposures.

A sector risk weight add-on is similar to a common sector leverage ratio increase for all banks. We then assume that a sector risk weight add-on of 5 percentage points is imposed, bringing the average risk weights to 15% and 17.5% for Banks 1 and 2 in the example. Implied minimum sector leverage ratios will now be 1.5% and 1.75%, respectively, representing an increase of 0.5 percentage points for both banks (Chart A, Panel B) and. Therefore, the common risk weight add-on acts as a common increase in the implied sector leverage ratio for both banks. Such a policy would be justified if systemic risk could increase unexpected losses by the same amount for all sector exposures.

Table A

Sector risk weight floors, add-ons and multipliers are similar to different sector leverage ratio and capital requirement policies

Source: ECB calculations.
Notes: The chart shows the changes in a risk-based sector capital requirement (panel a) and a sector leverage ratio requirement (panel b) that would result in the same increase in required CET1 capital as a given risk weighting policy. The term “sector leverage ratio” is used to refer to the ratio between the required CET1 capital and the total sector exposure. The results of three different risk weighting policies that apply at the portfolio level are shown: (i) a 15% floor, (ii) a 5pp add-on and (iii) a 1.33 multiplier. The exercises are performed for two hypothetical banks. Both banks are assumed to have an initial capital requirement of 10%. They differ only in their average initial sector risk weight, which is assumed to be 10% for bank 1 and 12.5% ​​for bank 2.

A sector risk weight multiplier is similar to a common increase in a sector risk-based capital requirement for all banks, similar to a sector systemic risk buffer (SyRB). Finally, we consider applying a risk weight multiplier of 1.33. As the capital requirement remains unchanged at 10% but the risk weights (and risk-weighted assets) increase by 33%, the two banks in the example will face a 33% increase in CET1 capital. required. In an alternative policy scenario where risk weights (and risk-weighted assets) remain at their initial levels, it is intuitive that both banks’ capital requirement would need to increase by 33% to achieve the same capital increase. CET1 required as political risk weight. Given the initial capital requirement of 10%, this could be seen as analogous to imposing a common increase in the risk-based capital requirement of 3.3 percentage points for both banks (Chart A, panel a). If systemic risk could increase unexpected losses in proportion to the underlying (microprudential) risk of the exposure, then a risk weight multiplier would be appropriate.

The flexibility of risk-weighting policies provides a rich set of policy tools that are useful in making macroprudential policy effective and targeted at different types of underlying systemic risks. Therefore, even though the sectoral SyRB is now available as part of the Capital Requirements Directive (CRD) V legislative package, the flexibility offered by the sectoral risk weighting policies under Article 458 of the Capital Requirements Regulation (CRR), which allows a targeted approach to the underlying systemic risks, is still likely to be useful to macroprudential authorities in certain situations.[4]