What is the Simplified Approach to Credit Risk

The Simplified Approach is a basic method of calculating regulatory capital for credit risk. It is aimed at firms with only incidental credit risk exposures and for whom the costs of adopting the Standardised Approach would more than outweigh the benefits of increased risk sensitivity that such an approach would bring.

How does it differ from the Standardised Approach to Credit Risk?

The fundamental difference between the two approaches for calculating regulatory capital is that unlike the Standardised Approach, firms adopting the Simplified Approach will not be required to risk weight each exposure on an individual basis but will instead apply a generic risk weight assigned to each particular exposure class.

Firms using the Simplified Approach will not be required to nominate an eligible ECAI or include a credit assessment in their regulatory capital calculations. Firms on the Simplified Approach will instead adopt the 'fall back' risk weightings set out in the CRD under Annex VI for each exposure class.

What are the Risk Weightings for the Different Exposure Classes?

The following risk-weightings will be applied to all exposures in the following asset classes:

 
Exposure Class Risk Weighting
Sovereigns 100%
Regional/Local Governments 50% Like Institutions
PSEs 100%
Institutions 50%, (20% for short-term exposures);
Corporates (Providing issuing institution has 100% RW) 100%
Covered Bonds 50%
CIUs 100%

 

In addition to the table above there are certain asset classes that do not have their risk weighting determined by reference to the ratings from an eligible ECAI. The risk weighting applicable to these exposures will determined in the same manner by firms adopting the Simplified Approach as those adopting the full Standardised Approach.

Will firms be able to put different exposures on the Standardised and Simplifed Approach

Firms must decide to adopt either the Simplified Approach or the Standardised Approach for their risk weighting and cannot use a mixture of both. They will not be permitted to nominate an ECAI and the Standardised Approach for some of their exposures and use the 'fall back position' of the Simplified Approach for others.

Which firms will be eligible to use the Simplified Approach for credit risk?

As the Simplified Approach is a less risk sensitive version of the Standardised Approach, it is intended to apply only to small, limited licence and limited activity investment firms on whom it would be inappropriate to apply the full Standardised Approach.

We envisage that firms undertaking the Simplified Approach will have incidental credit risk exposure only and therefore the loss of risk sensitivity in the approach will be outweighed by the benefits of having cheaper operating costs.

Firms intending to use the Simplified Approach should inform of the FSA of their intention to do so.

What approach to Credit Risk Mitigation should firms on the Simplified Approach adopt?

Firms on the Simplified Approach will not be able to use Financial Collateral Comprehensive Method for their Credit Risk Mitigation (CRM). They will instead only be allowed to adopt the simple approach to CRM, which involves firms substituting the risk-weight of the original exposure for the risk weight of the risk-mitigant. For funded protection, this means adopting the risk-weight of (eligible) collateral provided. For unfunded protection, this involves adopting the risk-weight of the protection provider (e.g. guarantor).

Moreover, firms on the Simplified Approach will only be able to adopt the Simple Approach to CRM subject to one modification. In order to prevent inconsistencies firms on the Simplified Approach will only be able to adopt the "simplified" credit risk weighting of the collateral/protection provider rather than the more beneficial risk weighting which may be afforded under the full Standardised method.

Therefore if a firm on the Simplified Approach has an exposure to a corporate (100%) which is guaranteed by a AAA bank, the firm will be able to adopt the risk weighting of the bank rather than the corporate: however under the Simplified Approach that risk weight will be the 50% applied to all firms under the Simplified Approach rather than the 20% applicable to a AAA bank.