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# Linking different sectoral risk weight policies to capital buffer and leverage ratio policies

Prepared by Jan Hannes Lang and Marek Rusnák

In recent years different macroprudential sectoral risk weight policies have been used in EU countries to address systemic risk in residential real estate markets. For example, sectoral risk weight floors for domestic internal ratings-based (IRB) mortgage loans were adopted in Estonia, Finland and Sweden, while sectoral risk weight add-ons and multipliers were implemented in Belgium.[1] The use of different sectoral risk weight policy designs raises the question of how they link to policies that would change sectoral capital or leverage ratio requirements.[2]

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

A sectoral risk weight floor is similar to imposing a common sectoral leverage ratio requirement for all banks, in addition to the risk-based capital requirement. For the example above, we consider a sectoral risk weight floor of 15%. As both banks had initial sectoral risk weights of less than 15%, the floor will be binding for the calculation of minimum capital requirements. The risk weight floor will thus give rise to an implicit minimum sectoral leverage ratio of 1.5% for both banks. Therefore, the sectoral risk weight floor acts like a minimum sectoral leverage ratio imposed on both banks, along with the sectoral risk-based capital requirement. Such a policy would be warranted if systemic risk could result in minimum unexpected losses for all sectoral exposures.

A sectoral risk weight add-on is similar to a common increase in the sectoral leverage ratio for all banks. We go on to consider that a sectoral risk weight add-on of 5 percentage points is imposed, which raises average risk weights to 15% and 17.5% for banks 1 and 2 in the example. The implicit minimum sectoral leverage ratios will now be 1.5% and 1.75%, respectively, which represents an increase of 0.5 percentage points for both banks (Chart A, panel b) and. Hence, the common risk weight add-on acts like a common increase in the implicit sectoral leverage ratio for both banks. Such a policy would be warranted if systemic risk could increase unexpected losses for all sectoral exposures by the same amount.

A sectoral risk weight multiplier is similar to a common increase in a sectoral risk-based capital requirement for all banks, akin to a sectoral systemic risk buffer (SyRB). Finally, we consider the application of a 1.33 risk weight multiplier. As the capital requirement remains unchanged at 10% but risk weights (and risk-weighted assets) increase by 33%, both banks in the example will face a 33% increase in required CET1 capital. In an alternative policy scenario where risk weights (and risk-weighted assets) remain at their initial levels, it is intuitive that the capital requirement of both banks would need to increase by 33% to achieve the same increase in required CET1 capital as the risk weight policy. Given the initial capital requirement of 10%, this could be considered analogous to imposing a common increase in a 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) riskiness of the exposure, then a risk weight multiplier would be appropriate.

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

1. See European Systemic Risk Board (2019), “Use of national flexibility measures under Article 458 of the CRR”, A Review of Macroprudential Policy in the EU in 2018, April.

2. The term “sectoral leverage ratio” is used to refer to the ratio of required CET1 capital that a bank needs to hold relative to total sectoral exposures. While such a sectoral leverage ratio is currently not part of the EU capital requirements framework, linking risk weight floors and add-ons to conceptually similar leverage ratio policies helps to better understand their impact on banks.

3. This similarity in the capital impact will hold as long as initial capital requirements are similar across banks. The close link between risk weights ($RW$), minimum required CET1 capital ($CET1-$), capital requirements ($R$) and the implicit leverage ratio ($LR$) is shown in the equation: $R=CET1-RW∙A→LR=R∙RW=CET1-A$.

4. For example, the Netherlands introduced an Article 458 measure in the form of an LTV-dependent risk weight floor for domestic mortgage loan portfolios, which entered into force on 1 January 2022.