Modifications to the capital treatment for expected and unexpected credit losses

January 2004

As announced in the 15 January 2004 press release from the Basel Committee, this technical paper has been issued.

In its 11 October 2003 press release, the Basel Committee on Banking Supervision (the Committee) announced its intention to move to a UL-only risk weighting construct. The Committee requested comments on this revision, and received 52 comment letters. Respondents generally welcomed the Committee’s solution and agreed that it will align regulatory capital more closely with the concepts underpinning banks’ economic capital modelling processes. Many commenters, however, requested the Committee to provide more detailed information on the new framework.

Responding to such requests, the Committee, at its meeting on 14 and 15 January 2004,decided on a number of questions arising from the move to the UL-only construct. The purpose of this paper is to provide information on the concrete modifications that have been decided. In summary, for the IRB approach, expected losses will be removed from the risk weight functions. However, banks will be required to compare their actual provisions with expected losses. Any shortfall should be deducted equally from Tier 1 and Tier 2 capital and any excess will be eligible for inclusion in Tier 2 capital subject to a cap. The current treatment of general provisions will be withdrawn from the IRB approach. The Committee is not intending to make any changes to the standardised risk weights. Where banks are partly on the standardised approach and partly on the IRB approach, an element of general provisions may be retained in Tier 2 capital.

Issues relating to securitisations are discussed in a separate working paper. It should also be noted that a number of components remain subject to change depending on the Committee’s decision on calibration or other reviews.