Basel III RWA Optimization—Going Beyond Compliance

In the post-financial crisis environment, the global banking industry faces a number of difficult challenges.

These range from pressures caused by the erosion of earnings, to rising operating costs, to an increasingly complex infrastructure, to proliferating regulatory requirements.

These requirements have been implemented in part as a response to the financial crisis, to increase the stability of the financial markets and to prevent further negative impact on the economy. One major focus—represented by Basel III—is on strengthening global capital and liquidity rules.

Key components of the Basel III framework include:

• A stricter definition of capital.

• Increased capital requirements for counterparty credit risk arising from derivatives.

• Repurchase agreements (repos) and securities financing activities.

• The introduction of higher capital ratios, a non-risk-based leverage ratio and a new global liquidity standard.

These new requirements, and the associated higher capital and liquidity costs, put further pressure on the profitability of banks.

Banks may review and adjust their business model and funding strategy to fulfill the new rules on the one hand, and go beyond compliance and restore profitability to protect shareholder value on the other. Basel III, therefore, can be much more than a regulatory matter; it can be a business issue with a regulatory trigger.

The capital squeeze resulting from Basel III is also making the optimization of risk-weighted assets (RWA) a key topic of discussion around the new framework. RWA optimization is not a new topic as many banks have conducted corresponding projects in the past and have implemented different measures.

With Basel III, however, RWA optimization can become more important, as an increase of the capital base which is vital for the survival and growth of banks is limited. Furthermore, with Basel III and the higher capital requirements for certain instruments, topics and methods, new concerns and levers can become the focus of attention.

Accenture has identified the following as key determinants influencing the risk-weighted assets (RWA) of banks:

• Business model—the business model is one of the key factors of banks’ RWA, which can affect the portfolio and balance sheet structure.

• Risk management—the approaches used to calculate the capital requirements for credit, market and operational risk and the models used for estimating the risk parameters, policies and monitoring or recovery procedures often have a significant impact on RWA.

• Data quality and IT infrastructure—RWA is often influenced by the IT infrastructure, data availability and data quality. The correct mapping of transactions to the asset classes or the quality of PD and LGD estimations often depend on the availability and quality of data.

• Supervisory practices—different supervisory practices such as the criteria for cycle adjustments (e.g., point-in-time vs. through-the-cycle models), the definition of a downturn, or the validation and approval process of IRB models might also affect the RWA.

• Accounting standards—can have a material impact on RWA and may also explain some of the RWA differences between banks in different regions.

The new Basel III requirements present major challenges to banks around the world involving their capital and liquidity requirements, as well as their risk management. One of the key issues arising from the new capital framework is the optimization of RWA. Although RWA optimization is not a new topic, it may be gaining in importance due to the increased capital requirements, the stricter definition of capital, as well as the higher capital ratios within Basel III.

There are a number of levers that can be used to reduce the impact on RWA. It is important to note that Basel III RWA optimization may mean more than just fulfilling regulatory requirements; it can also help to restore profitability.

The implementation of Basel III and RWA optimization measures can also lead to changes in the business model and funding strategy of banks. A comprehensive, target-oriented implementation and monitoring program, as well as active, predictive RWA and balance sheet management can be essential to generating potential improvements in RWA and profitability.

As we have seen, Basel III RWA optimization is concerned with more than just regulation. We believe that banks should consider going beyond compliance in an effort to restore profitability and protect shareholder value while establishing the new capital and liquidity framework. Targeted implementations of optimization measures as well as active balance sheet management are key elements to offset at least part of the Basel III impact.

Active balance sheet management can benefit from consideration of assets and liabilities as well as a geographical optimization of the balance sheet within the group. While many banks have already addressed their balance sheets, for instance by reducing the trading portfolio, there is often still room for further optimization through such measures as growing retail deposits or reducing short term funding.

Pricing can offer additional opportunities for improving profitability, as current pricing often does not fully reflect regulatory costs. It is also suggested that detailed actions be analyzed and implemented within the scope of Basel III RWA optimization projects.