Basel Risk Weight Functions and Forward-Looking Expected Credit Losses

It is evident that the definition of expected credit losses (ECL) diverges between International Financial Reporting Standard 9 (IFRS 9) (the accounting model recently adopted by European banks) and the probability of default/loss given default methodology used in the Basel internal ratings-based approach to capital adequacy estimation. The ongoing discussion on the incorporation of lifetime ECL into the Basel framework – through the adoption of lifetime expected losses with the greatest possible consensus – will eventually lead to modifications, but for the time being it is not optimal. We establish that the combination of lifetime ECL and the Basel Capital Adequacy Framework, which relies on a one-year horizon, results in capital overestimation. Alongside this finding, and in order to alleviate the problem, we propose two alterations to the risk weight functions that constitute the core of the Basel advanced methodologies.