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Basel IV: The Next Generation of Risk Weighted Assets

ISBN: 978-3-527-50918-8
338 pages
June 2017
Basel IV: The Next Generation of Risk Weighted Assets (3527509186) cover image

Description

In reaction to the financial market crisis that started in 2007, the Basel Committee on Banking Supervision substantially revised its existing framework for regulation, supervision and risk management in the banking sector. This revision was introduced with the so-called Basel III framework in December 2010. It essentially comprises a strengthening of the quality of a banks' own funds, as well as new requirements with regard to the amount of required capital. Furthermore, new ratios were introduced in order to limit the leverage employed by banks as well as new liquidity ratios.

Since 2012 the Basel Committee has increasingly pursued a revision of the calculation methods for risk-weighted assets. In addition, a large number of new requirements have been developed. This package of new standards from the Basel Committee, which is unofficially called "Basel IV", is now the most comprehensive package of modifications in the history of banking supervision. It is only a matter of time until the innovations of the Basel IV package are transferred into binding EU law. The banking industry will face major challenges in implementing these new rules.

In the editor's volume "Basel IV - The Next Generation of Risk Weighted Asset" Martin Neisen and Stefan Röth present the current edition of the Basel reform proposals. The aim is to convince the reader that we are facing a new framework called "Basel IV" and not just a fine adjustment of the existing Basel III regulations. Moreover, the innovations of the Basel IV package are explained in a clear, comprehensible and practical manner. With the aid of a high-profile team of experts, the complexity of the topic is reduced and important support is offered.
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Table of Contents

Foreword 11

Preface 13

1 Revision of the Standardised Approach for Credit Risk 15

1.1 Introduction 15

1.2 Provisions in detail 19

1.2.1 General aspects 19

1.2.2 Claims on banks 20

1.2.3 Exposures to Corporates 24

1.2.4 Specialised lending 28

1.2.5 Subordinated debt instruments, equity and other capital instruments 29

1.2.6 Retail portfolio 30

1.2.7 Exposures secured by real estate/Real estate exposure class 31

1.2.8 Additional risk weights for risk positions with currency mismatch 36

1.2.9 Off-balance-sheet items 37

1.2.10 Defaulted exposures 39

1.2.11 Claims on multilateral development banks (MDB) 39

1.2.12 Other assets 40

1.2.13 Changes in credit risk mitigation techniques 40

1.2.14 Additional aspects and other possible adjustments 43

1.3 Conclusions 44

Recommended Literature 46

2 The Future of the IRB approach 47

2.1 Basel Committee’s initiatives to improve the IRB approach 47

2.1.1 Introduction 47

2.1.2 Scope of application of internal models 49

2.1.3 Floors as an instrument of RWA variability reduction 54

2.1.4 Parameter estimation practices 57

2.1.5 Conclusion 58

2.2 Definition of Default 59

2.2.1 Past-due criterion in definition of default 59

2.2.2 Indications of unlikelyness to pay 60

2.2.3 Application of default definition for retail exposures 64

2.2.4 Implications of the default definition for financial institutions 65

2.2.5 Criteria for the return to non-defaulted status 66

2.2.6 Materiality threshold 67

2.2.7 Implementation of changes 67

2.3 Risk estimates 68

2.3.1 Treatment of multiple defaults 69

2.3.2 Default rate 70

2.3.3 PD estimation 71

2.3.4 LGD estimation 71

2.3.5 Downturn adjustment of LGD and conversion factor estimates 72

2.3.6 Implementation of changes in risk estimates 72

2.4 Treatment of defaulted assets 73

2.4.1 Implementation of changes in the treatment of defaulted assets 74

Recommended Literature 75

3 The New Standardised Approach for measuring Counterparty Credit Risk Exposures (SA-CCR) 77

3.1 Counterparty credit risk 77

3.1.1 Definition of the counterparty credit risk 77

3.1.2 Measuring counterparty credit risk according to CRR 78

3.1.3 Background and motives for introducing the SA-CCR approach 79

3.2 Side note: The supervisory measurement of counterparty credit risk within the current exposure method 79

3.3 Measurement of counterparty credit risk according to SA-CCR 83

3.3.1 Exposure at Default 83

3.3.2 Current replacement cost 84

3.3.3 Potential future exposure 85

3.3.4 Calculation example: EAD determination under SA-CCR 97

3.4 Expected impact on the banking industry 98

Recommended Literature 99

4 The New Basel Securitisation Framework 101

4.1 Introduction 101

4.2 Current EU securitisation framework 102

4.2.1 Exclusion of securitised exposures from the calculation of the risk-weighted exposure amounts 102

4.2.2 Approaches for the determination of risk-weighted exposure amounts 104

4.2.3 Regulations for external credit ratings 110

4.3 Revisions to the securitisation framework 110

4.3.1 Criticism of the existing rules 110

4.3.2 Revisions to the securitisation framework 112

4.3.3 Risk weights for securitisation positions when complying with STC criteria 125

4.4 General Conclusions 130

Recommended Literature 131

5 Basel IV for funds 133

5.1 Assignment to the trading book or banking book 135

5.2 Own funds requirements for funds in the banking book 137

5.2.1 Funds under the Standardised Approach 138

5.2.2 Funds under the Internal Ratings-Based Approach (IRB) 140

5.2.3 Leverage Adjustment under the LTA and the MBA 141

5.2.4 Credit Valuation Adjustment 142

5.2.5 Treatment of target funds 143

5.3 Conclusion and impact 144

Recommended Literature 146

6 Fundamental Review of the Trading Book: New Framework for Market Risks. 147

6.1 Introduction 147

6.2 Trading book boundary 148

6.2.1 Revised boundary between the trading and banking book 149

6.2.2 Reallocation 151

6.2.3 Internal Risk Transfer 153

6.3 The revised standardised approach for market price risks 154

6.3.1 Linear and non-linear price risks 155

6.3.2 Default risk 166

6.3.3 Residual risk add-on 167

6.4 Internal Model Approach for market risk (IMA-TB) 167

6.4.1 Regulatory background and goals 168

6.4.2 Procedural and organisational challenges 169

6.4.3 Methodical amendment 169

6.4.4 Impact on capital requirements 176

6.5 Conclusions 179

Recommended Literature 182

7 CVA Risk Capital Charge Framework 183

7.1 Credit Valuation Adjustment 183

7.1.1 Definition of the term “Credit Valuation Adjustment” 183

7.1.2 Background of the regulatory CVA 185

7.1.3 Revision of the CVA framework 185

7.1.4 Hierarchy of approaches 187

7.2 FRTB-CVA framework 188

7.2.1 Regulatory requirements for the application of the FRTB-CVA framework 188

7.2.2 Exposure Value for the FRTB-CVA 191

7.2.3 Standardised approach for CVA (SA-CVA) 194

7.2.4 Internal Model Approach for CVA (IMA-CVA) 197

7.3 Basic CVA framework 198

7.3.1 Side note: Calculation of the CVA Risk Capital Charge under the current standardised method in the CRR 198

7.3.2 Regulatory requirements for the application of the basic CVA framework 202

7.3.3 Exposure Value for the basic CVA 202

7.3.4 Determination of regulatory capital requirements based on the basic CVA framework 202

7.4 Additional aspects and expected effects 206

Recommended literature 208

8 Operational risk. 209

8.1 Background information 209

8.2 Methods to determine operational risk pursuant to Basel II 210

8.2.1 Basic Indicator Approach and Standardised Approach 211

8.2.2 Advanced Measurement Approaches 212

8.3 Criticism of the existing approaches 213

8.4 Operational Risk — Revisions to the simpler approaches

(BCBS 291) 214

8.4.1 Requirements for the Revised Standardised Approach 214

8.4.2 The mechanics of the Revised Standardised Approach 214

8.5 Standardised Measurement Approach for operational risk

(BCBS 355) 216

8.5.1 Requirements on the SMA 216

8.5.2 Functionality of the SMA 216

8.5.3 Comparison among the BIA, Revised SA (BCBS 291) and SMA

(BCBS 355) based on an example calculation 223

8.6 Summary and conclusions 226

Recommended Literature 229

9 Capital Floors 231

9.1 Introduction 231

9.2 Alternatives to design a capital floor 233

9.2.1 Option 1: Risk category-based approach 233

9.2.2 Option 2: Aggregate RWA-based approach 234

9.2.3 Option 3: Floor at exposure class level 235

9.2.4 Treatment of credit risk adjustments 235

9.2.5 Choice of the standardised approach 236

9.2.6 Disclosure 236

9.2.7 Level of floor factor and current discussion 237

9.3 Conclusions 237

Recommended Literature 238

10 New Basel Framework for Large Exposures 239

10.1 Background 239

10.2 Scope 240

10.3 Large exposure limits 240

10.4 Eligible capital 241

10.5 Counterparties and connected counterparties 242

10.6 Definition of exposure 245

10.7 Assessment base 246

10.7.1 On and off-balance sheet items in the banking book 246

10.7.2 Counterparty risk 246

10.7.3 Trading book items 247

10.8 Recognition of credit risk mitigation 247

10.9 Exemptions 249

10.10 Look-through of funds and securitisations 250

10.11 Regulatory reporting 254

10.12 Summary 255

Recommended Literature 258

11 Disclosure 259

11.1 Introduction 259

11.2 Disclosure guidelines 259

11.3 Risk management and risk-weighted assets (RWA) 261

11.4 Linkages between financial statements and regulatory exposures 263

11.5 Credit risk 264

11.5.1 General information on credit risk 265

11.5.2 Credit risk mitigation 267

11.5.3 Credit risk under the standardised approach 268

11.5.4 Credit risk under the IRB approach 268

11.6 Counterparty credit risk 270

11.7 Securitisation 274

11.8 Market risk 275

11.9 Enhancements to the revised Pillar 3 framework and further revisions and additions arising from ongoing reforms to the regulatory policy framework 278

11.9.1 New content 279

11.9.2 BCBS 356: Overview on disclosure by different categories 282

11.9.3 Applicability of existing and prospective BCBS disclosure requirements (second phase of the Pillar 3 review) 282

11.10 Disclosures related to liquidity indicators 283

11.10.1 Disclosure requirements for the Liquidity Coverage Ratio (LCR) 284

11.10.2 The Net Stable Funding Ratio — NSFR (BCBS 324) 285

11.10.3 Additional quantitative and qualitative disclosure requirements 287

11.10.4 Summary and challenges 287

11.11 Conclusions and expected effects 288

Recommended Literature 289

12 Interest Rate Risk in the Banking Book (IRRBB) 291

12.1 Regulatory treatment of interest rate risk in the banking book 291

12.2 The Standardised Framework 292

12.2.1 Introduction 292

12.2.2 Assigning positions to time buckets 293

12.2.3 Interest Rate Shock Scenario Design 295

12.2.4 Estimating the impact on EVE 296

12.2.5 Calculation of minimum capital requirements 296

12.3 Principles for treatment within the framework of Pillar 2 297

12.4 Conclusion and expected impact 297

Recommended literature 299

13 Corporate Governance. 301

13.1 Initial situation 301

13.2 Principles on corporate governance for banks 303

13.2.1 Principle 1: Board’s overall responsibilities 303

13.2.2 Principle 2: Board qualifications and composition 306

13.2.3 Principle 3: Board’s own structure and practices 307

13.2.4 Principle 4: Senior Management 308

13.2.5 Principle 5: Governance of group structures 309

13.2.6 Principle 6: Risk management function 309

13.2.7 Principle 7: Risk identification, monitoring and controlling 310

13.2.8 Principle 8: Risk communication 311

13.2.9 Principle 9: Compliance 311

13.2.10 Principle 10: Internal audit 312

13.2.11 Principle 11: Compensation 312

13.2.12 Principle 12: Disclosure and transparency 313

13.2.13 Principle 13: The role of supervisors 314

13.3 Conclusions 314

Recommended Literature 316

14 TLAC and MREL — Two initiatives, one goal 317

14.1 Background 317

14.2 The regulations in detail 319

14.2.1 MREL as a new “capital” parameter 319

14.2.2 Scope of application — individual vs. consolidated perspective 319

14.2.3 Responsibility of the “gone-concern” supervisor 320

14.2.4 Eligible Liabilities 321

14.2.5 Deductible items 325

14.2.6 Calibration of the MREL requirement 327

14.2.7 TLAC calibration 331

14.3 Operational impact 332

14.3.1 Preparation 333

14.3.2 Ongoing reporting 333

14.3.3 Management and Pricing 334

14.3.4 Disclosure 334

14.4 Recent developments — TLAC/MREL in the CRR II /CRD V consultation package 335

Recommended Literature 337

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Author Information

Martin Neisen is a partner at PwC in Frankfurt and head of the global Basel IV initiative of PwC. He is also leads the division Regulatory Management of Germany, Austria, Belgium, the Netherlands and Turkey. With extensive experience and technical expertise in the German and European banking industry, Mr. Neisen has more than 14 years of project and audit experience with banks and financial services providers. In particular, he advises institutions in issues relating to the entire spectrum of banking supervision and risk management.
Mr. Neisen is involved in PwC's international project teams and is well known as the expert in the implementation of regulatory requirements, which also affect regulatory, risk management and accounting.

Stefan Röth has been working for PwC since 2008. As a Senior Manager in the Regulatory Management division, he advises banks and financial services providers on all aspects of banking supervision. Mr. Röth operated as a project manager on several CRD IV / CRR preliminary studies and implementation projects. He has accompanied various banks in the implementation of the EBA / ECB Stresestest from 2014 until 2016. Currently, he focuses on the impacts of "Basel IV" on the banking world.He has already given numerous lectures at specialist conferences and published several articles on this topic.
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