The CRR3 Output Floor: A Strange Backstop for Credit Risk Measurement
Article Marco Folpmers, Partner Risk Advisory Deloitte
Basel 3.1 has a so-called output floor that places strict limits on the amount of benefits a bank can gain from using internal models to meet supervisory capital requirements. However, this counterintuitive backstop itself suffers from inconsistencies.
The latest update to the capital requirements regulation under Basel 3.1 reinforces the notion that EU supervisors strongly favor a standardized approach (SA) to credit risk measurement over an advanced internal ratings-based (A-IRB) approach. This is particularly true with respect to one of the most controversial elements of Basel 3.1: the output floor, which is scheduled to go into effect on January 1, 2025.
The output floor incentivizes the adoption of the SA by banks, partly by restricting the advantages they can gain from applying the A-IRB approach. Consistency in the calculation of risk-weighted assets is the line of reason most cited by prudential authorities (especially the European Banking Authority) when explaining the output floor changes that have been implemented and the reason SA is favored over A-IRB. Today, supervisors argue, there is too much variability in RWA computations.
