Basel IV E-Book

Martin Neisen

• Herausgeber: Wiley-VCH Verlag GmbH & Co. KGaA
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 777

Veröffentlichungsjahr: 2018

Beschreibung

In December 2017 the Basel committee finalised its work on the reform of the Basel III framework. Together with requirements already published in 2015 and 2016, the Basel committee changes all approaches for the calculation of RWA and the corresponding Pillar III disclosure rules. 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. The banking industry will face major challenges in implementing these new rules.
The second edition of the "Basel IV" handbook is updated with all publications up to March 2018 and also extensively enhanced with additional details, examples and case studies. 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. This book covers all new approaches for the calculation of RWA:
- the standardised approach (CR-SA) and the IRB approach for credit risk,
- the new standardised approach for counterparty credit risk (SA-CCR),
- both the standardised approach and internal models approach from the "fundamental review of the trading book" (SBA and IMA)
- the basic approach (BA-CVA) and standardised approach (SA-CVA) for the CVA risk,
- all new approaches (SEC-IRBA, SEC-ERBA, SEC-SA, IAA) for securitisations (incl. STS),
- the approaches for the calculation of RWA for equity positions in investment funds (LTA, MBA, FBA)
- the new standardised approach for operational risk (SA-OpRisk)
Because of the strong relation to the Pillar I requirements, the second edition covers the topics of interest rate risk in the banking book (IRRBB), large exposures and TLAC again. Additionally, the book contains a detailed description of the Pillar III disclosure requirements.
With the aid of a high-profile team of experts from countries all over the globe, the complexity of the topic is reduced, and important support is offered.

Leseprobe

2nd edition

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© 2018 Wiley-VCH Verlag & Co. KGaA, Boschstr. 12, 69469 Weinheim, Germany

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Library of Congress Card No.:

applied forA catalogue record for this book is available from the British Library.

Bibliographic information published by the Deutsche Nationalbibliothek

The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available on the Internet at <http://dnb.d-nb.de> abrufbar.

Layout: pp030 – Produktionsbüro Heike Praetor, Berlin, GermanyCover design: Christian Kalkert Buchkunst & Illustration, Birken-HonigsessenCover photo: © Esin Deniz – stock.adobe.com

Print ISBN: 978-3-527-50962-1ePub ISBN: 978-3-527-82140-2

Table of Contents

Cover

Title Page

Copyright

Foreword

Preface

1 Revision of the Standardised Approach for Credit Risk

1.1 Introduction

1.2 General aspects

1.3 Use of external ratings

1.4 Credit risk mitigation techniques

1.5 Conclusions

Recommended Literature

Notes

2 The Future of the IRB Approach

2.1 Introduction of the fundamentals of the IRB Approach (Basel II)

2.2 Basel Committee's initiatives to improve the IRB Approach

2.3 EBA regulatory reform and the revised supervisory assessment methodology

2.4 Definition of Default

2.5 Risk estimates

2.6 ECB's targeted review of internal models (TRIM)

Recommended Literature

Notes

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

3.1 Counterparty credit risk

3.2 Side note: Calculating EAD with the current exposure method

3.3 Measurement of counterparty credit risk according to SA-CCR

3.4 Use of simplified approaches

3.5 Expected impact on the banking industry

Recommended Literature

Notes

4 The new securitisation framework

4.1 Introduction

4.2 The securitisation framework under Basel II

4.3 Revisions to the securitisation framework under Basel IV

4.4 General Conclusions

Recommended Literature

Notes

5 Capital Requirements for Bank's Equity Investments in Funds

5.1 Overview

5.2 Trading book vs banking book boundary

5.3 Own funds requirements for funds in the banking book

5.4 Summary and conclusion

Recommended Literature

Notes

6 Fundamental Review of the Trading Book: A New Age for Market Risks

6.1 Introduction

6.2 Revised trading book boundary

6.3 The revised standardised approach for market risks

6.4 Internal Models Approach for market risk (IMA-TB)

6.5 Business implications and impact in the financial markets

6.6 Optimisation considerations

6.7 Conclusions

Recommended Literature

Notes

7 CVA Risk Capital Charge Framework

7.1 Credit Valuation Adjustment

7.2 FRTB-CVA framework

7.3 Basic CVA framework

7.4 Additional aspects and expected effects

Recommended literature

Notes

8 Operational Risk

8.1 Introduction

8.2 Current methods pursuant to Basel II

8.3 Overview: From Basel II to Basel IV

8.4 Standardised Approach for operational risk (BCBS 424)

8.5 Future impact

8.6 Conclusion

Recommended Literature

Notes

9 Capital Floors

9.1 Introduction

9.2 Reasons for the new capital floor

9.3 Basel IV Capital Floor

9.4 Interactions and interdependencies to other Basel IV rules

9.5 Conclusions

Recommended Literature

Notes

10 New Basel Framework for Large Exposures

10.1 Background

10.2 Scope

10.3 Large exposure limits

10.4 Eligible capital

10.5 Counterparties and connected counterparties

10.6 Definition of exposure

10.7 Assessment base

10.8 Recognition of credit risk mitigation

10.9 Exemptions

10.10 Look-through of funds and securitisations

10.11 Regulatory reporting

10.12 Implementation of the updated framework in the CRR II

10.13 Summary

Recommended Literature

Notes

11 Disclosure

11.1 Introduction

11.2 Disclosure guidelines

11.3 Risk management, key prudential metrics and risk-weighted assets (RWA)

11.4 Linkages between financial statements and regulatory exposures

11.5 Composition of capital and TLAC

11.6 Macroprudential supervisory measures

11.7 Leverage Ratio

11.8 Disclosures related to liquidity

11.9 Credit risk

11.10 Counterparty credit risk

11.11 Securitisation

11.12 Market risk

11.13 Interest rate risk in the banking book

11.14 Remuneration

11.15 Benchmarking

11.16 Operational risk

11.17 Credit valuation adjustments

11.18 Asset encumbrance

11.19 European implementation

11.20 Conclusions and expected effects

Recommended Literature

Notes

12 Interest Rate Risk in the Banking Book (IRRBB)

12.1 Introduction

12.2 Principles for treatment within the framework of Pillar 2

12.3 The Standardised Framework

12.4 Conclusion and outlook

Recommended literature

Notes

13 TLAC and MREL – The Extension of the Regulatory Capital Definition and the Scope of Supervision

13.1 Background

13.2 TLAC

13.3 MREL

13.4 Outlook and summary

Recommended Literature

Notes

14 Strategic Implications

14.1 Introduction

14.2 The capital squeeze

14.3 How to cope with Basel IV – Strategic implications

14.4 Conclusion

Notes

End User License Agreement

List of Tables

Chapter 2

Table 2.1: RW for specialised lending (except HVCRE) exposures per category and maturity

Table 2.2: RW for HVCRE exposures per category and maturity

Table 2.3: Minimum LGD for secured parts of exposures

Table 2.4: RW for SL exposures for the calculation of EL

Table 2.5: Summary of BCBS amendments

Table 2.6: Average risk weights – EBA stress test data 2016

Table 2.7: Median risk weights – EBA Transparency Exercise, June 2017

Table 2.8: BCBS 424 risk parameter floors

Table 2.9: Proposed changes to parameter estimation practices

Table 2.10: Comparison of F-IRB LGDs under Basel II and Basel IV

Table 2.11: Key topics discussed in the EBA/RTS/2016/03

Chapter 3

Table 3.1: Volatility rates CEM (without credit derivatives)

Table 3.2: Volatility rates CEM for credit derivatives

Table 3.3: Hedging-set concept according to SA-CCR

Table 3.4: Supervisory Delta factors under SA-CCR

Table 3.5: Parameters prescribed by the supervisory authority under SA-CCR

Table 3.6: SA-CCR Hedging sets of the asset class Commodity

Table 3.7: Volatility rates revised OEM

Chapter 4

Table 4.1: Tranching of the transaction of the AAA bank

Table 4.2: Parameters for the calculation of the supervisory parameter (p)

Table 4.3: Supervisory parameter p of the tranches

Table 4.4: Tranche maturities

Table 4.5: SEC-IRBA risk weights of tranches

Table 4.6: SEC-ERBA risk weights for long-term ratings

Table 4.7: Determination of risk weights under the SEC-ERBA

Table 4.8: SEC-ERBA risk weights of tranches

Table 4.9: SEC-SA risk weights of tranches

Table 4.10: Risk weights of SA securitisation positions

Table 4.11: Risk weights of IRB Approach securitisation positions

Table 4.12: SEC-ERBA risk weights pursuant to long-term ratings

Chapter 5

Table 5.1: Calculation of the average risk (Germany)

Table 5.2: Calculation of the average risk weight including FBA for target funds

Chapter 6

Table 6.1: Detailed risk classes

Table 6.2: Liquidity categories and associated risk factors

Table 6.3: Thresholds for backtesting overshootings (VaR breaches)

Table 6.4: Results of the Interim Impact Analysis

Table 6.5: Comparison of liquidity horizons

Table 6.6: Increase of capital requirements under the standardised approach compared to the IMA-TB

Chapter 7

Table 7.1: Weighting rates depending on the credit rating

Table 7.2: Risk weights BA-CVA

Chapter 10

Table 10.1: Examples of economic dependencies according to BCBS 283

Table 10.2: Claims on central counterparties

Chapter 11

Table 11.1: Overview of risk management, key prudential metrics and RWA

Table 11.2: Disclosure of the linkage between accounting and regulatory law

Table 11.3: Disclosure of composition of capital and TLAC

Table 11.4: Disclosure of macroprudential supervisory measures

Table 11.5: Disclosure of the leverage ratio

Table 11.6: Disclosure requirements related to liquidity

Table 11.7: Disclosure requirements related to credit risks

Table 11.8: Disclosure of counterparty credit risks

Table 11.9: Disclosures related to securitisation

Table 11.10: Disclosure related to market risk

Table 11.11: Disclosures related to IRRBB

Table 11.12: Disclosures related to remuneration

Table 11.13: Disclosure of benchmarking

Table 11.14: Disclosure of operational risk

Table 11.15: Disclosure of credit valuation adjustments

Table 11.16: Disclosure of asset encumbrance

Chapter 13

Table 13.1: TLAC instruments

Table 13.2: Requirements for own funds instruments

Table 13.3: Excluded instruments acc. to Art. 72a CRR II

Table 13.4: Reasons for exceptional exclusions

Table 13.5: Eligible instrument acc. to Art. 72b CRR II

List of Illustrations

Chapter 1

Figure 1.1: Approaches for credit risk quantification

Figure 1.2: Elements to determine risk-weighted assets under the standardised approach

Figure 1.3: Risk weights for sovereign and central bank exposures

Figure 1.4: Risk weights for public sector entities

Figure 1.5: Risk weights for multilateral development banks (MDB)

Figure 1.6: Risk weights for banks based on applicable external ratings (ECRA)

Figure 1.7: shows the SCRA risk weights for banks.

Figure 1.8: Risk weights for corporates based on external ratings

Figure 1.9: Determination of preferential risk weights for SMEs

Figure 1.10: Risk weights for specialised lending

Figure 1.11: Subordinated debt instruments, equity and other capital instruments

Figure 1.12: LTV vs Loan Splitting approach

Figure 1.13: LTV approach for residential real estate

Figure 1.14: Loan splitting approach for residential real estate

Figure 1.15: Risk weights of LTV vs loan splitting approach for residential real estate

Figure 1.16: LTV approach for residential real estate where repayment materially depends on cash flows generated by the property

Figure 1.17: LTV approach for commercial real estate

Figure 1.18: Loan splitting approach for commercial real estate

Figure 1.19: LTV vs loan splitting approach for commercial real estate exposures to individuals

Figure 1.20: LTV vs loan splitting approach for commercial real estate exposures to unrated corporates

Figure 1.21: Commercial real estate where repayment materially depends on cash flows generated by the property

Figure 1.22: Overview of risk weights for real estate exposures

Figure 1.23: Selected credit conversion factors (CCF)

Figure 1.24: Process if multiple external ratings by several ECAIs are available

Figure 1.25: Issue-specific vs issuer rating

Figure 1.26: Supervisory haircuts using external ratings

Figure 1.27: Supervisory haircuts without use of external ratings

Figure 1.28: Calculation of the haircut based on holding period and revaluation

Figure 1.29: Calculation of the haircut based on holding period and revaluation

Chapter 2

Figure 2.1: The answer to the loss of confidence in the IRB Approach by both regulators and supervisors

Figure 2.2: EL vs UL on a portfolio basis

Figure 2.4: Change from a 10% hypothetical capital ratio when individual banks' risk weights are adjusted to the median in the sample

Figure 2.5: Basel IV Risk Weights for a hypothetical portfolio of large corporates

Figure 2.6: Effect of IRB implementation for a single portfolio with the highest IRB potential

Figure 2.7: Basel IV RWA expressed as a percentage of Basel II RWA at various collateralisation levels under the F-IRB Approach

Figure 2.8: Decomposition of the Basel IV impact for FIRB portfolios

Figure 2.9: Decomposition of the Basel IV impact for AIRB portfolios

Figure 2.10: EBA regulatory review since mid-2016

Figure 2.11: Simulation of new default definition impact on RWA

Figure 2.12: Estimation of expected future recoveries

Figure 2.13: Overview of LGD parameters based on EBA requirements

Figure 2.14: Overview of TRIM

Chapter 3

Figure 3.1: Methods to determine the EAD according to CRR

Figure 3.2: Objectives of SA-CCR

Figure 3.3: Calculation example EAD pursuant to CEM

Figure 3.4: Determination of the PFE component according to SA-CCR

Figure 3.5: Determination of the EAD according to SA-CCR

Figure 3.6: Thresholds for simplified approaches

Chapter 4

Figure 4.1: Basic concept of a traditional securitisation

Figure 4.2: Systematic of current approaches

Figure 4.3: Basel documents on revisions to the securitisation framework and STC criteria

Figure 4.4: The revised hierarchy and new approaches for the calculation of risk weights

Figure 4.5: Tranching of the transaction of the AAA bank

Figure 4.6: Risk weights of the SA portfolios of the AAA bank

Figure 4.7: Risk weights of the IRB portfolios of the AAA bank

Figure 4.8: Risk weights on all tranches of the AAA bank's sample securitisation under the assumption of STC-compliance and non-compliance

Chapter 5

Figure 5.1: Treatment of equity investments in funds

Figure 5.2: Three-step approach under the standardised approach

Figure 5.3: Four-step approach under the IRBA

Chapter 6

Figure 6.1: The fundamental review of the trading book – an overview

Figure 6.2: Decision tree for banking and trading book allocation

Figure 6.3: Qualitative requirements on trading book positions

Figure 6.4: Requirements for the trading desk

Figure 6.5: Overview of the internal risk transfer (IRT)

Figure 6.6: Internal risk transfer in detail

Figure 6.7: New thresholds under CRR II

Figure 6.8: Overview of the sensitivities-based approach

Figure 6.9: Risk factors and risk classes under the SBA

Figure 6.10: Example calculation of delta sensitivity

Figure 6.11: Calculation approach for linear risks

Figure 6.12: Schematic overview of calculation approach for linear risks

Figure 6.13: Overview of the distinction between credit spread risks

Figure 6.14: Example calculation: Delta risk charge for FX

Figure 6.15: Schematic overview of calculation approach for non-linear risks

Figure 6.16: Overview of the default risk charge calculation

Figure 6.17: Overview of the reduced sensitivities-based method

Figure 6.18: Comparison of risk weights between SbM and R-SbM

Figure 6.19: VaR: Incoherent risk metric since it is not sub-additive

Figure 6.20: IMA-TB changes

Figure 6.21: Mean score example

Figure 6.22: Examples for possible NMRF and the corresponding basis risk factors

Figure 6.23: Two possible choices of basis risk factor for the same NMRF

Figure 6.24: Capital requirement aggregation

Figure 6.25: 99% VaR and 97.5% ES for two hypothetical portfolios

Figure 6.26: Selective IMA capital requirements

Chapter 7

Figure 7.1: Unilateral and bilateral CVA

Figure 7.2: Goals of the revision of the CVA framework

Figure 7.3: The revised CVA framework (BCBS 424)

Figure 7.4: Application requirements for the FRTB-CVA framework

Figure 7.5: Calculation steps under the SA-CVA

Figure 7.6: Differences between the SBA and the SA-CVA

Figure 7.7: Example calculation – current CVA Risk Capital Charge (1/2)

Figure 7.8: Example calculation – current CVA Risk Capital Charge (2/2)

Figure 7.9: Example calculation B-CVA (1/2)

Figure 7.10: Calculation example B-CVA (2/2)

Chapter 8

Figure 8.1: Delimitation of operational risk

Figure 8.2: Comparison of previous approaches

Figure 8.3: AMA requirements at a glance

Figure 8.4: Requirements on the revised SA

Figure 8.5: Composition of the Business Indicator

Figure 8.6: The BIC under the SA

Figure 8.7: Evolution of the Internal Loss Multiplier

Figure 8.8: Fictional P&L statement of the Model Bank

Figure 8.9: Capital requirements pursuant to Basel II (BIA)

Figure 8.10: Calculation of the BIC pursuant to BCBS 424

Figure 8.11: Total capital requirements (BCBS 424) in millions

Figure 8.12: Minimum standards for the use of loss data

Chapter 9

Figure 9.1: Risk weight variations under IRBA

Figure 9.2: Floor and leverage ratio

Figure 9.3: Evolution of Capital Floor Requirements

Figure 9.4: Changes to Capital Requirements between Basel II and IV

Figure 9.5: Example 1: RWA according to Basel I

Figure 9.6: Example 2: RWA according to Basel II

Figure 9.7: Example 3: Overview of results

Figure 9.8: Example 4: Overview of results incl. Basel IV

Figure 9.9: Example 5: Overview of Capital ratios incl. Basel IV

Figure 9.10: Scenario 1: High SA versus Low IM ('m $)

Figure 9.11: Scenario 2: Low SA versus Low IM ('m $)

Figure 9.12: Overview of Basel IV

Figure 9.13: Overview of Basel IV

Figure 9.14: Overview of Basel IV

Figure 9.15: Overview of Basel IV

Figure 9.16: Overview of Basel IV

Figure 9.17: Optimisation of the standardised approaches

Figure 9.18: Example 2, Case 1: Overview of RWA, capital costs and capital floor

Figure 9.19: Example 2, Case 1: Hypothetical RWA and capital costs

Figure 9.20: Example 2, Case 1: Total and marginal capital costs

Figure 9.21: Example 2, Case 2: Hypothetical RWA and capital costs

Figure 9.22: Example 2, Case 2: Total RWA and capital costs

Figure 9.23: Example 2, Case 3: Overview of RWA, capital costs and capital floor

Figure 9.24: Example 2, Case 3: Hypothetical RWA and capital costs

Figure 9.25: Example 2, Case 3: Total and marginal capital costs

Figure 9.26: Removal of the IRB option and new capital floors

Chapter 10

Figure 10.1: Large exposure upper limits according to BCBS 283

Figure 10.2: Development of eligible capital

Figure 10.3: Example: Economic dependencies

Figure 10.4: Substitution effect in the weighting of financial collaterals (credit risk mitigation)

Figure 10.5: Overview of currently applicable reductions in capital requirements

Figure 10.6: Look-through methods

Figure 10.7: Look-through: determination of exposure values (ex. 1)

Figure 10.8: Look-through: determination of exposure values (ex. 2)

Figure 10.9: Potential tightening of large exposure provisions for interbank claims (outline)

Chapter 11

Figure 11.1: Pillar 3 disclosure requirements in three phases

Figure 11.2: Pillar 3 phases of revision

Figure 11.3: Reporting frequency and formats of Phase I

Figure 11.4: Phase I and Phase II reporting frequency and format of disclosure

Figure 11.5: Phase III reporting frequency and format of disclosure

Figure 11.6: Guiding principles for disclosures

Figure 11.7: KM1 template

Figure 11.8: KM2 template BCBS 435

Figure 11.9: Prudent valuation adjustments template – PVA

Figure 11.10: Composition of regulatory capital template – CC1 extract CET 1 component

Figure 11.11: Geographical distribution of credit exposures used in the countercyclical capital buffer template – CCyB1

Figure 11.12: Leverage ratio common disclosure template – LR2

Figure 11.13: Overview of disclosures related to liquidity indicators

Figure 11.14: LCR common disclosure template

Figure 11.15: NSFR common disclosure template

Figure 11.16: CR1 Template BCBS 309

Figure 11.17: CR1 Template BCBS 435

Figure 11.18: CCR2 template

Figure 11.19: CCR5 template

Figure 11.20: CCR7 template

Figure 11.21: Disclosure related to internal market risk models

Figure 11.22: MR1 Template (Phase II)

Figure 11.23: Market risk IMA per risk type

Figure 11.24: RWA flow (Phase I)

Figure 11.25: RWA flow (Phase II)

Figure 11.26: Clean P&L backtesting results

Figure 11.27: Proposed benchmarking template illustrative example – BEN1

Figure 11.28: Proposed operational risk historical losses template – OR1

Figure 11.29: Proposed full basic approach for CVA risk (BA-CVA) template – CVA 2

Figure 11.30: Proposed asset encumbrance template – ENC

Figure 11.31: Phase I in European level– EBA GL 2016/11 disclosure requirements

Figure 11.32: Phase II in European level– CRR II consideration of proportionality

Figure 11.33: Challenging data requirements regarding the implementation of Phase I

Chapter 12

Figure 12.1: BCBS 368 vs EBA Guidelines 2015

Figure 12.2: Time buckets

Figure 12.3: Treatment of non-maturity deposits

Figure 12.4: Calculation of minimum capital requirements

Chapter 13

Figure 13.1: Bail-in ranking

Figure 13.2: Overview TLAC and MREL

Figure 13.3: TLAC requirements within a group

Figure 13.4: Principles on internal TLAC

Figure 13.5: Treatment of TLAC holdings

Figure 13.6: Overview on TLAC disclosure

Figure 13.7: Supervisory and resolution authorities in the EU

Figure 13.8: Overview CRR, CRD, BRRD

Figure 13.9: MREL calibration

Figure 13.10: Eligible liabilities

Figure 13.11: Overview MREL reporting

Figure 13.12: Example for a data field assessment for ad-hoc reporting purposes

Chapter 14

Figure 14.1: Aggregated RWA impact in €tn

Figure 14.2: Estimated increases in credit risk RWA

Figure 14.3: Estimated increases in credit risk RWA in different European countries

Figure 14.4: Compound effect on required capital

Figure 14.5: Increase in required capital in €tn

Figure 14.6: Strategic implication dimensions

Figure 14.7: Levers to align capital with RWA

Figure 14.8: Illustrative impact on the risk-return profile

Figure 14.9: Income and costs across bank business models

Figure 14.10: Mortgage loan example of Basel IV product structure

Guide

Cover

Table of Contents

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E1

Foreword

Unimpressed by John M. Keynes' motto “I would rather be roughly right than precisely wrong”, the Basel Committee on Banking Supervision is putting in motion the most comprehensive reform package in its entire supervisory history under the term “Basel IV”. The banking and financial market is a highly interconnected and dynamic system in which the strong connections make it almost impossible to assess the risks of the system under certain conditions. Moreover, supervision keeps pace with the financial sector's increasing complexity by penning more and progressively detailed rules for determining the minimum capital requirement for a bank's risk positions.

Currently, every European bank must observe approximately 40,000 legally binding requirements of the European Union. In the field of banking supervision, four thousand and one different rules have been set down on 34,019 pages. With a reading speed of 50 words per minute and one hour reading time per working day, you would need around 32 years to read all the pages! And because the rules are constantly changing, they can never be fully read and understood. Today it is almost impossible to find any banking supervisor or bank practitioner who is able to explain exactly the supervisory rules and their consequences. The scope and complexity of the rules are just too great.

Behind this book is a highly qualified, expert team committed to a necessary reduction of regulatory complexity by providing this important companion volume to the reams of legislation. Broad knowledge is an especially crucial characteristic for dealing with complex systems. The authors come from pertinent sectors and have many years of consulting experience. The team of authors is led by Martin Neisen and Stefan Röth, two publishers whose experience and reputation are a guarantee of quality.

This book presents the innovations of the Basel IV package in a concise, understandable and practice-oriented way. It is committed to an optimised view by focusing on all relevant aspects. It is an outstanding work which, thanks to its clear structure and intellectual rigour, allows the reader to “see the wood for the trees”.

I strongly recommended this volume to all scientific readers concerned with the development of banking supervision and risk management, as well as for practitioners interested in these issues. I hope this book will be openly received and widely distributed, and that the reader will find much of interest within these pages.

Professor Dr Hermann Schulte-Mattler – Dortmund, February 2016

Preface

Two years have passed since the publication of our book's first edition. These two years have seen an unprecedented dynamic in the area of banking regulation. Nearly all of the topics covered in the first edition are ripe for an update.

On the one hand, the Basel Committee on Banking Supervision published its final standards on those topics after the date of the editorial deadline of the first edition. Of note among these topics are the approaches for credit risk, CR SA and IRB, but also the methods for calculating capital requirements for operational risk and Credit Valuation Adjustments (CVA). And, of course, the capital floors responsible for the intensive debate that took until end of 2017 before a compromise was reached.

On the other hand, national rule-makers – and especially the European Union – have begun their work to transpose those rules already finalised by the Basel Committee before December 2017 into applicable law and regulations. At the time of the editorial deadline, this process is still ongoing and we have to rely on current drafts instead of finalised law. However, it is clear already that, for example, the EU will implement the Basel Committee's proposals – adding some elements of proportionality where adequate – that may inform other jurisdictions choice as well, when it comes to devising rules for smaller, less complex institutions.

Both changes are reflected in the following pages. We hope, this will make this book worthwhile even for readers of the first edition.

Our thanks to the individual authors for their contributions and to Professor Dr Schulte-Mattler for the Foreword.

Martin Neisen and Stefan Röth – Frankfurt, 30 March 2018

1Revision of the Standardised Approach for Credit Risk

Luis Filipe Barbosa Nikolaos Kalogiannis Friedemann Loch and Sebastian L. Sohn

1.1 Introduction

As the original Basel I rules for credit risk – being the most relevant risk type for banks – were lacking an appropriate degree of risk sensitivity, they were considered to no longer adequately meet supervisory requirements. Therefore, aiming at greater economic differentiation of the credit risk, with a better recognition of exposures characteristics and a more appropriate reflection of risk-mitigation techniques, the Basel Committee developed two different approaches for the quantification of credit risk which represented the core elements of Basel II. The so-called “Standardised Approach” (standardised approach for credit risk, hereinafter also referred to as “SA”) available to all banks and also – subject to supervisory approval – an “Internal Ratings-based Approach” (hereinafter referred to as “IRB Approach”), in which for the first time banks were permitted to use internal methods to determine risk parameters (e.g. probability of default) that could be used to quantify the capital requirements of credit risk for regulatory purposes. Figure 1.1 illustrates both approaches available to quantify the capital requirements for credit risk.

Figure 1.1: Approaches for credit risk quantification

Under the SA, external ratings are used as a basis for the determination of risk weights and the quantification of capital requirements for certain exposure classes. The mapping of external ratings to risk weights, as well as the extent of eligible credit risk mitigation instruments and calculation of the risk mitigation effect, are entirely specified by the regulator. In contrast, the IRB Approach offers various options for internal estimation of risk parameters (see also Chapter 2 on the IRB Approach).

The quantification of risk-weighted assets (RWAs) and capital requirements under the SA is based on a set of components displayed in Figure 1.2.

Figure 1.2: Elements to determine risk-weighted assets under the standardised approach

It should also be highlighted that, under the standardised approach, exposures have to be risk-weighted net of specific provisions (including partial write-offs).

Once the Basel II rules on the standardised approach were finalised and implemented in the various national legislations it soon became apparent that the intended improvements in risk sensitivity within the standardised approach of Basel II were primarily achieved for claims on central governments – and depending on the national implementation also for banks. In many jurisdictions external ratings were only available to a small number of predominantly large corporates. The vast majority of corporates did not have any external ratings and had to be classified as “unrated” which resulted in the same risk weight as under Basel I.

Over time – and especially within the financial market crisis starting in 2007 – the insufficient risk sensitivity of the standardised approach and the use of external ratings for supervisory purposes were increasingly criticised.

Within the Basel III framework the Basel Committee changed the structure and definition of regulatory capital and introduced new regulation on liquidity and leverage, but did not modify any elements of the standardised approach for credit risk.

As a response to the ongoing criticism on the standardised approach, the Basel Committee published an initial consultative paper on a revised standardised approach in December 2014, followed by a second consultative paper in December 2015. The approaches consulted in these papers were aimed at achieving a higher risk sensitivity without further increasing the complexity of the standardised approach. Another intention was to increase the comparability of capital requirements between banks by reducing differences in capital requirements between the standardised approaches and the IRB Approaches. In addition it is intended to limit national discretions in the application of the standardised approach. Moreover, the Basel Committee plans to reduce differences regarding the definition of exposure classes under the standardised approach and the IRB Approach. An additional aspect of the revision of the standardised approach is to decrease the mechanical dependence on external ratings. While the first consultative paper contained extremely wide-ranging modifications in this respect by removing the use of external ratings completely, the second consultative paper still allows the use of external ratings, the same holding true in the new Basel regulation. The use of external ratings is, however, complemented by additional requirements requesting the institution to conduct an independent credit risk assessment (“due diligence”).

In contrast to the current requirements, the revised standardised approach needs also to be implemented by all IRB banks in the future, as the capital requirements under the standardised approach will serve as a floor for the capital requirements under the IRB Approach (see Chapter 9). Presently, IRB banks have the option of determining the capital floor based on the Basel I provisions (“Basel I Floor”).

Securitisation exposures are addressed in the securitisation standard (Chapter 4). Credit equivalent amounts of OTC derivatives, exchange traded derivatives and long-settlement transactions that expose a bank to counterparty credit risk are to be calculated under the counterparty credit risk standards (Chapter 3). Equity investments in funds and exposures to central counterparties must be treated according to their own specific frameworks (Chapter 5).

Hereinafter the revisions based on the final Basel regulation are summarised and compared to the proposed changes of the first and second consultative papers as well as to the current requirements of the CRR.

1.2 General aspects

The Basel Committee's revision of the standardised approach for credit risk comprises all exposure classes, except for claims on sovereigns, central banks and public sector entities (PSEs) – in the latter case, only minor editorial changes have been made to remove reference to current options for banks. They are not included as the Basel Committee is considering these exposures as part of a broader and holistic review of sovereign-related risks.

While the first consultative paper replaced the use of external ratings by other risk drivers, the second consultative paper as well as the final Basel regulation still allows for the use of external ratings. However, in some countries (the USA for instance), the use of external ratings for regulatory purposes is not admitted. For these jurisdictions, and also for all exposures to unrated counterparties, a newly developed Standardised Credit Risk Assessment Approach (SCRA) will be available.

In order to avoid mechanistic reliance on external ratings, the due diligence requirements already included in the first consultative paper were further specified. Even in cases where ratings are used, due diligence is needed to assess the risk of exposures for risk management purposes and whether the risk weight applied is appropriate and prudent. This is to ensure that banks have an adequate understanding, both at origination and on a regular basis (at least, annually), of the risk profile and characteristics of their counterparties. Should the due diligence analysis reveal a higher risk compared to the risk weight based on external ratings, the higher risk weight has to be applied. However, if the due diligence analysis should reveal a very low risk compared to the external rating, it cannot result in a more favourable risk weight then determined by external ratings.

The exact extent and content of due diligence requirements is yet to be specified; the consultative paper only refers to the presently existing Pillar II-requirements of Basel II. Under Pillar II, banks are required to have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties. In this context, the importance of internal ratings as a tool to monitor credit risk on a borrower level is explicitly emphasised.

Banks need to ensure that they have an adequate understanding of the risk profile of the borrower at origination and thereafter on a regular basis (at least annually). They must take reasonable and adequate steps to assess the operating and financial performance levels and trends through internal credit analysis and/or other analytics outsourced to a third party, as appropriate for each counterparty. Banks need to be able to access information about their counterparties on a regular basis so that they can complete the due diligence analyses.

It is also necessary that banks can demonstrate to the supervisory authority that their internal policies, processes, systems and controls ensure an appropriate assignment of risk weights to counterparties.

Currently, it is expected that the majority of SA institutions in many countries will be largely compliant with the due diligence requirements due to their existing practice of applying rating procedures for bank-internal processes, even in their capacity as SA institution. It remains to be seen, however, how these requirements will be implemented at the European level.

1.2.1 Exposures to sovereigns

Exposures to sovereigns represent a very important asset class to many banks. In particular, during the financial market crisis, it became evident that the risk weighting of 0% for certain jurisdictions could not, ultimately, be fully justified. However the Basel Committee did not succeed in finding a compromise solution for a modification of the risk weighting for sovereign exposures. Consequently the treatment of sovereign exposures has been carved out from the Basel IV paper for both the standardised approach and the IRB Approach.

Separate from the work on Basel IV the Basel Committee has established a high-level Task Force on sovereign exposure to review the current treatment of sovereign exposures and develop recommendations on potential policy options. This review was completed in December 2017 and the Basel Committee has published the results of this review in a separate discussion paper.1

While this paper contains ideas on the possible treatment of sovereign risk the Basel Committee has pointed out that presently it has not reached a consensus to make any changes to the treatment of sovereign exposures, and has therefore decided not to consult on the ideas presented in this discussion paper.

Therefore, the treatment of sovereign risk remains unchanged from the current / the Basel II treatment which is described below:

The applicable risk weight to a sovereign exposure can either be derived by using the external rating of an external credit assessment institution (ECAI) or by using the risk score of an external credit agency (ECA). A very good external rating or ECA risk score results in a risk weight of 0%, unrated exposures receive a risk weight of 100%. The following tables in Figure 1.3 illustrate the applicable risk weighting based on the ECAI or the ECA score.

Figure 1.3: Risk weights for sovereign and central bank exposures

1.2.2 Exposures to public sector entities

The treatment of exposures to public sector entities remains largely the same. However, as the Basel II treatment of public sector entities had made references to the available options for the risk weighting for banks – which do not exist any more under Basel IV – some editorial changes were necessary.

The Basel Committee also allows for two options to derive the risk weight for public sector entities: either based on the external rating of the sovereign where the PSE is domiciled, or based on the individual external rating of the PSE directly.

Unlike the treatment for corporates or banks both options are based on the use of external ratings. There is no explicit reference to a different treatment in jurisdictions that do not allow the use of external ratings.

As with the current Basel II regulations, the risk weights are derived by using the tables as shown in Figure 1.4.

Figure 1.4: Risk weights for public sector entities

1.2.3 Exposures to multilateral development banks

The treatment of multilateral development banks has not changed significantly with respect to the current treatment. However, as the current treatment is partially similar to the risk weighting for banks, some changes had to be applied.

Unchanged from current treatment, the Basel Committee defines a multilateral development bank as an institution created by a group of countries, and which provides financing and professional advice for economic and social development projects. If certain quality criteria are being met, a risk weight of 0% can be applied. These qualitative requirements have not changed in substance and can be summarised as follows:

very high-quality long-term issuer ratings;

shareholder structure comprising a significant proportion of sovereigns with high quality external ratings;

strong shareholder support;

adequate level of capital and liquidity; and

strict statutory lending requirements and conservative financial policies.

In jurisdictions that allow the use of external ratings, it is possible to derive the risk weight for all other multilateral development banks using the table shown in Figure 1.5.

Figure 1.5: Risk weights for multilateral development banks (MDB)

1.2.4 Exposures to banks

Overall requirements

In this context, a bank exposure can be defined as a claim (including loans and senior debt instruments, unless considered as subordinated debt) on any financial institution that is licensed to take deposits from the public and is subject to appropriate prudential standards and level of supervision. Subordinated bank debt and equities are addressed in section 1.2.7.

Two approaches are available for calculating capital requirements of bank exposures: (i) the External Credit Risk Assessment Approach (ECRA); and (ii) the Standardised Credit Risk Assessment Approach (SCRA). These should be used hierarchically, according to the existence of the possibility, in the jurisdiction in which the bank is incorporated, of using external ratings for regulatory purposes. Additionally, SCRA should also be used for exposures regarding unrated banks, even when these are incorporated in jurisdictions that allow the use of external ratings.

Short-term claims between banks with an original maturity of less than three months, as well as on- or off-balance sheet exposures to banks that arrive from the movement of goods across national borders with an original maturity of six months or less, receive a reduced risk weight under most grades of both approaches, in an effort to avoid affecting negatively the liquidity of interbank markets.

In what concerns institutional protection schemes that allow for a 0% risk weight to exposures within these schemes, a preferential regime may be applied, with lower risk weights, subject to national supervisory option or discretion. This must not be applied to exposures giving rise to CET1, AT1 or T2 items.

1. External Credit Risk Assessment Approach (ECRA)

The ECRA shall be applied, provided that an external rating for the counterparty/exposure is available and that their use is allowed in the respective jurisdiction. Under this approach, each claim is assigned a so-called “base risk weight” based on the external rating. The resulting risk weights range from 20% to 150%. The referred ratings must not incorporate assumptions of implicit government support – in line with the objective of breaking the link between banks and their sovereigns – unless the rating refers to a public bank owned by its government. Banks based in jurisdictions that allow the use of external ratings for regulatory purposes can only apply SCRA for their unrated bank exposures.

For short-term exposures, or for those arising from the movement of goods across national borders with an original maturity of six months or less, reduced risk weights in 3 of the 5 buckets are in place.

As a second step, banks have to perform due diligence analysis to ensure that the external rating appropriately and conservatively reflects the credit risk of the exposure. As stated, if the due diligence reveals a higher risk than implied by the external rating, the risk weight shall be increased by at least one grade. If the outcome of the due diligence analysis is more favourable, the risk weight remains unchanged.

Figure 1.6 illustrates the risk weights to be used for banks based on applicable external ratings under the ECRA.

Figure 1.6: Risk weights for banks based on applicable external ratings (ECRA)

The consultative paper does not entail any changes in relation to the use of issuer and issues assessments. With the exception of the due diligence element, the proposed rules as well as the mapping of external ratings into risk weights is comparable with the current standardised approach. However, differences arise if no external rating exists for the counterparty or the exposure. Under current CRR regulation these claims receive a risk weight derived from the external rating of the borrowing bank's country of incorporation, leading to a risk weight of 20% for banks in Germany. The revised SA however will require the use of the Standard Credit Risk Assessment Approach (SCRA).

2. Standardised Credit Risk Assessment Approach (SCRA)

The SCRA is applied if no external rating is available or if the use of such external rating is not allowed in the respective jurisdiction. Under this approach the exposures are categorised into three grades (A, B, C). For each grade, the Basel Committee has specified criteria for the allocation. Main elements of these criteria are the extent to which the counterparty fulfils its financial obligations and the degree to which it complies with regulatory requirements.

If a borrower exceeds the minimum regulatory requirements (e.g. leverage, capital ratios) and meets his financial commitments accordingly, he can be classified within Grade A, leading to a risk weight of 40%. Additionally, this risk weight can be reduced to 30% if the debtor bank meets or exceeds a CET1 ratio of 14% and a Tier 1 leverage ratio of 5% and meets criteria imposed to Grade A exposures.

If one or more buffer requirements are not met, and the borrower is subject to substantial credit risk, a risk weight of 75% under Grade B has to be used. More concretely, Grade B refers to exposures to banks, where the counterparty bank is subject to substantial credit risk, such as repayment capacities that are dependent on stable or favourable economic or business conditions.

Not meeting the requirements applicable to Grade B by not meeting the regulatory requirements, leads to a risk weight of 150% under Grade C. This grade refers to higher credit risk exposures to banks, where the counterparty bank has material default risks and limited margins of safety. In this context, for these counterparties, adverse business, financial, or economic conditions are very likely to lead (or have led) to an inability to meet their financial commitments. This Grade is also to be applied if the external auditor has expressed an adverse audit opinion.

Exposures with an original maturity of three months or less, as well as exposures arising from the movement of goods across national borders with an original maturity of six months or less, receive reduced risk weight of 20%, 50% or 150%. Defaulted exposures receive a risk weight of 150%.

Also, under the SCRA, the bank has to perform the same due diligence assessment as under the ECRA and classify the exposure as Grade A, B or C, based on the result of the due diligence. If the due diligence reveals a higher level of risk, the bank has to assign the position to a more conservative grade than that which is applicable by simply using the minimum criteria. As under the ECRA, a due diligence can never result in a risk weight lower than that determined by the minimum criteria for each grade.

The Basel Committee specifies that the requirements referring to regulatory ratios include buffers, but are limited to publicly disclosed information, thus bank-specific supervisory-imposed requirements, such as Pillar 2 instruments (P2R or P2G) are not included. Moreover, when such information is nonexistent, or not publicly disclosed, such exposures must be classified as Grade B or lower.

Furthermore, under SCRA, to capture transfer, convertibility or currency risk, a risk-weight floor is applicable, based on sovereign risk of the country where the relevant counterparty is incorporated. This floor is applicable when the exposure is not expressed in the local currency of the debtor bank and must not be applied to short-term (i.e. with a maturity of less than 1 year), self-liquidating, trade-related contingent items that arise from the movement of goods.

Figure 1.7 Risk weights for banks based on the internal standardised risk assessment (SCRA)

Figure 1.7: shows the SCRA risk weights for banks.

Comparison of the new framework to the specifications of the first and second consultative papers and the current provisions

Exposures of banks with an external rating receive a risk weight ranging between 20% and 150. On the other hand, banks without external ratings may receive risk weighted between 30% (conditional on several criteria including the robustness of capital and leverage ratios) and 150%.

As the treatment for banks without external rating (thus under SCRA) will regularly result in a change in risk weights from the previous 20% to Grade A, the Basel Committee has lowered the base risk weight from 50% to 40% between the second consultation and its final form. Additionally, the risk weight of Grade B has been reduced from 100% to 75%. Alongside this, the base risk weight for Grade A may further be reduced to 30% if the debtor bank meets or exceeds a CET1 ratio of 14% and a Tier 1 leverage ratio of 5% and meets criteria imposed on Grade A exposures.

The first consultative paper aimed to remove completely the use of external ratings and proposed a derivation of risk weights based on the CET 1 ratio and the asset quality based on the Net Non-Performing-Asset-Ratio (Net-NPA-Ratio) of banks. In some circumstances, the risk weight was set at 300%. It became evident that this approach would represent a significant increase in the resulting risk weights without necessarily leading to increased risk sensitivity. Within the second consultative paper this approach was removed and the use of external ratings re-introduced. Quantitative impact studies showed that the capital requirements under the first consultative paper would have been significantly higher than under current CRR requirements and also under the second consultative paper.

The current applicable standardised approach according to the CRR is based on external rating of the counterparty/issuance, the risk weight of the country of residence and the maturity of the exposure and represents a combination of the currently available two options under Basel II.

Furthermore, although the second consultative document included a reference to a sovereign risk-weight floor in order to reflect the macroeconomic profile of exposures, the final document does not incorporate such provision or better saying it only considers a floor when exposures are not expressed in the local currency of the debtor bank – i.e. it aims to capture transfer and convertibility risk, based on the country where the relevant counterparty is incorporated, resulting in lower risk weights for such exposures.

Short-term exposures against banks with an original maturity of less than three months are subject to a more favourable risk weight, under most grades of both approaches. If no rating is assigned, a general risk weight of 20% is applied. In practice, a risk weight of 20% is often applied as external ratings are frequently not available for short-term exposures. In the final version of the reform, in addition to short-term exposures, exposures to banks that arise from the movement of goods across national borders with an original maturity of six months or less may also be subject to the mentioned favourable regime.

With respect to the treatment of institutional protection schemes that allow for a 0% risk weight to exposures within these schemes and the preferential treatment of covered bonds, existing rules under CRR can now also be applied under the final document. In the case of institutional protection schemes, this preferential regime is subject to national supervisory option or discretion, and cannot be applied to exposures giving rise to CET1, AT1 or T2 items.

In situations where no external ratings are available, significant differences are evident. In countries where only a very small number of banks are externally rated, the resulting risk weight under SCRA will be at least 30% while these exposures currently receive a risk weight of 20%. This represents a significant increase in terms of risk weights.

Finally, the final version of the document introduces further detail on the requirements for the classification of bank exposures under the SCRA. In particular, the Basel Committee specifies that the requirements that regard supervisory-imposed ratios do include buffers but are limited to publicly disclosed information, thus not including bank-specific requirements, such as Pillar 2 instruments (P2R or P2G).

1.2.5 Exposures to corporates

Overall requirements

Comparable to exposures to banks two approaches are available for exposures to corporates.

Provided that the use of external ratings is allowed in the respective jurisdiction, these ratings can be used to derive base risk weights ranging from 20% to 150%. The mapping process between external ratings and risk weights has a slight extension with respect to Basel II. While under Basel II regulation the risk weight buckets range between 20%, 50%, 100% and 150%, Basel IV introduces an additional risk weight of 75% for exposures rated between BBB+ and BBB–. The corresponding risk weight under Basel II for these ratings is 100%.

Similarly to the treatment of exposures to banks, performance of due diligence analysis is necessary both at origination and on a periodic basis (at least annually). This analysis aims at ensuring that external ratings appropriately reflect the creditworthiness of the bank's counterparties. Since the operational impact of case-by-case periodic due diligence is expected to be significant, especially for smaller banks, the Basel Committee applies the proportionality principle. Therefore, the sophistication level of the assessment should be appropriate to the size and complexity of each bank's activities. In assessing the operating and financial performance of their counterparties, banks should perform adequate internal credit analysis and/or outsource this assessment to third parties.

Depending on the outcome of this analysis, an increase of risk weights may be required. It is noted that due diligence must not result in a lower risk weight – compared to external ratings approach – in any circumstances. Therefore, solely in case the due diligence analysis results in a higher rating, then a risk weight of at least one bucket higher must be assigned.

Since due diligence will form an integral part of risk weight assignment, a framework for governing due diligence, including internal policies, processes, systems and controls, is imperative.

Unrated exposures are subject to a risk weight of 100%, unless they refer to exposures to corporate small and medium sized entities (SMEs).

In jurisdictions that do not allow the use of external ratings, the following concept applies: A risk weight of 65% is assigned to all corporates that have – among other criteria – an adequate capacity to meet their financial commitments in a timely manner irrespective of the economic cycle and business conditions and can therefore be classified as “investment grade”. All other corporate exposures receive a risk weight of 100% unless they refer to exposures to corporate SMEs.

The risk weights to be assigned to corporates are presented in detail in Figure 1.8.

Figure 1.8: Risk weights for corporates based on external ratings

Regardless of the permission to use external ratings, unrated corporate SMEs, with (group) sales of up to EUR 50 million for the most recent financial year, are assigned a risk weight of 85%, which represents a more favourable treatment than under the previous Basel II framework.

This preferential risk weight can be applied to all corporate exposures that fall under the IRB definition of SMEs given that they do not meet the criteria allowing them to be classified as “retail SMEs”. Claims to SMEs of up to EUR 1 million can be categorised as “retail SMEs” according to supervisory requirements and are allocated a risk weight of 75%. In contrast to the SME-scaling factor in Art. 501 of the CRR there is no total volume connected to the preferential treatment of SMEs. Figure 1.9 illustrates the determination of preferential risk weights for SMEs.

Figure 1.9: Determination of preferential risk weights for SMEs

Comparison of the new framework to the specifications of the first and second consultative papers and the current provisions

Under current CRR rules, exposures to corporates with an available external rating receive a risk weight between 20% and 150%. Unrated exposures are assigned a risk weight of 100%. If the risk weight of the country of incorporation has a higher risk weight than the corporation itself, the risk weight of the country has to be used.

The process of deriving risk weights from externally rated clients/exposures does not differ from the current CRR rules, only the additional due diligence requirements represent a new element that may lead to increased risk weights.

The new Basel regulation introduces a more favourable treatment of unrated corporate SMEs in terms of capital requirements regardless of the volume of the exposure, which is presented as an additional factor in the CRR. The introduction of a separate risk weight of 85% for SMEs represents a significant modification of the currently existing Basel rules. On a European level, however, Art. 501 CRR already contains a special factor to reduce the risk weight of exposures to SMEs (“SME factor”). A simple multiplier 0.7619 is used (for SA and IRB exposures) to requirements for SME. However, this factor is limited to a total exposure of EUR 1.5 million, whereas the SME treatment in the new Basel framework does not have an exposure limit. The draft document of the amendment of the CRR (so called “CRR II”) however is proposing to modify the application of the factor as follows: Exposures up to EUR 1.5 million will receive the currently applicable factor of 0.7619 and any exceeding amount will receive a factor of 0.85. This procedure will combine “the best of the two worlds”.

1.2.6 Specialised lending