Revised standardised approach for credit risk in practice

Purpose - Focusing on delivering practical implications, the purpose of this paper is to show optimal ways of calculating risk weights for public sector entities (PSEs) under the standardised approach in credit risk. Focusing on the changing regulatory background, this paper aims to explain the proposed revisions to the standardised approach for credit risk. Where necessary, upon the review of the forthcoming standards, this paper attempts to indicate room for improvement for policymakers and flag areas of potential ambiguity for practitioners. Design/methodology/approach - This paper discusses and analyses the revised standards for the standardised approach in credit risk with respect to the treatment of PSEs. This paper, analysing the current regulatory proposals, tests the hypothesis stating that the affected banks may experience higher or lower capital charges for credit risk depending on the following factors: Choosing the optimal risk weight calculation methodology; and choosing the optimal composition of the credit risk portfolio. Findings - The paper advises on using sovereign ratings as a base of risk weight calculations and categorising eligible entities as sovereign exposures. Individual entity ratings are not readily available and the majority of PSEs remain unrated by the external agencies. The simplistic approach of using sovereign ratings results in a lower risk weighted capital than the approach of using individual entity ratings. The sovereign rating approach decreases the value of the original exposure by 77 per cent. Reliance on sovereign ratings outperforms the optimal solution proposed in this paper. Categorisation of eligible entities as sovereign exposures significantly decreases the risk exposure capital in the standardised approach. There are, however, specific criteria highlighted in this paper that must be met by a PSE to be categorised as a sovereign exposure. Originality/value - In addition to testing various scenarios of calculating risk weights, this paper highlights regulatory areas that require further improvements and immediate attention from the policymakers and practitioners. At this point, the paper reports that the proposed changes to the risk weight buckets for PSE exposures may be erroneous and resulting from the typos in the second consultative paper.