Basel IV

Martin Neisen is a partner at PwC in Frankfurt and head of the global Basel IV initiative of PwC. With extensive experience and technical expertise in the German and European banking industry, Mr Neisen has more than 15 years of project and audit experience with banks and financial services providers. In particular, he advises institutions on issues relating to the entire spectrum of banking supervision and risk management. Stefan Röth is a Senior Manager in the Regulatory Management division of PwC in Frankfurt; he advises banks and financial services providers on all aspects of banking supervision. 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.

• Foreword 13Preface 151. Chapter: Revision of the Standardised Approach for Credit Risk 171.1 Introduction 171.2 General aspects 191.2.1 Exposures to sovereigns 211.2.2 Exposures to public sector entities 221.2.3 Exposures to multilateral development banks 221.2.4 Exposures to banks 231.2.5 Exposures to corporates 281.2.6 Specialised lending 301.2.7 Subordinated debt instruments, equity and other capital instruments 321.2.8 Retail exposures 331.2.9 Exposures secured by real estate/Real estate exposure class 341.2.10 Additional risk weights for positions with currency mismatch 511.2.11 Off-balance sheet items 521.2.12 Defaulted exposures 531.2.13 Other assets 541.3 Use of external ratings 541.3.1 Recognition process for external ratings by national supervisors 541.3.2 Mapping of external ratings and use of multiple ratings 561.4 Credit risk mitigation techniques 581.5 Conclusions 62Recommended Literature 642. Chapter: The Future of the IRB Approach 652.1 Introduction of the fundamentals of the IRB Approach (Basel II) 672.1.1 A non-quantitative introduction to the IRB risk weight formula 672.1.2 The adoption of the IRB Approach 732.1.3 Calculation of RWA and EL 742.1.4 Minimum conditions for entry and ongoing use 812.1.5 Approval and post-approval process: Home/host coordination 882.1.6 Decision for application 892.2 Basel Committee’s initiatives to improve the IRB Approach 902.2.1 Introduction 902.2.2 Scope of application of internal models 902.2.3 Partial use of the IRB Approach 942.2.4 Risk parameter floors as an instrument of RWA variability reduction 972.2.5 Parameter estimation practices 992.2.6 Expected impact on banks 1022.2.7 Conclusion 1062.3 EBA regulatory reform and the revised supervisory assessment methodology 1072.4 Definition of Default 1092.4.1 Past-due criterion in the definition of default 1112.4.2 Indications of unlikeliness to pay 1132.4.3 Application of the definition of default in external data 1172.4.4 Consistency of the application of default definition 1182.4.5 Application of default definition for retail exposures 1182.4.6 Criteria for the return to the non-defaulted status 1192.4.7 Materiality thresholds 1202.4.8 Implementation of changes 1212.4.9 Impact of new default definition on RWA 1222.5 Risk estimates 122Recommended Literature 1383. Chapter: The New Standardised Approach for measuring Counterparty Credit Risk (SA-CCR) 1393.1 Counterparty credit risk 1393.1.1 Definition of counterparty credit risk 1393.1.2 Measuring counterparty credit risk in the EU 1393.1.3 Background and motives for introducing the SA-CCR approach 1413.2 Side note: Calculating EAD with the current exposure method 1413.3 Measurement of counterparty credit risk according to SA-CCR 1453.3.1 Exposure at Default 1453.3.2 Current replacement cost 1453.3.3 Potential future exposure 1473.3.4 Calculation example: EAD determination under SA-CCR 1583.4 Use of simplified approaches 1593.4.1 Simplified SA-CCR 1603.4.2 Revised original exposure method 1613.5 Expected impact on the banking industry 161Recommended Literature 1624. Chapter: The new securitisation framework 1634.1 Introduction 1634.2 The securitisation framework under Basel II 1644.2.1 Scope and definitions 1644.2.2 Exclusion of securitised exposure from the calculation of risk-weighted exposure amount 1654.2.3 Treatment of securitisation exposures 1674.3 Revisions to the securitisation framework under Basel IV 1684.3.1 Criticism of the existing rules 1684.3.2 New approaches and a revised hierarchy for the determination of risk-weighted exposure amounts 1714.3.3 Risk weights for securitisation positions when complying with STC criteria 1844.4 General Conclusions 189Recommended Literature 1905. Chapter: Capital Requirements for Bank’s Equity Investments in Funds 1935.1 Overview 1935.2 Trading book vs banking book boundary 1945.3 Own funds requirements for funds in the banking book 1955.3.1 Scoping and hierarchy of approaches 1955.3.2 Funds under the standardised approach 1965.3.3 Funds under the internal ratings-based approach (IRB) 1995.3.4 Leverage adjustment under the LTA and the MBA 2005.3.5 Treatment of funds that invest in other funds (target funds, fund of funds) 2015.4 Summary and conclusion 202Recommended Literature 2036. Chapter: Fundamental Review of the Trading Book: A New Age for Market Risks . 2076.1 Introduction 2076.2 Revised trading book boundary 2086.2.1 Revised boundary of the trading and banking books 2096.2.2 Reallocation of positions between books 2126.2.3 Internal risk transfer 2136.2.4 Example for national implementation: Boundary requirements and thresholds in the EU 2146.3 The revised standardised approach for market risks 2156.3.1 Linear and non-linear price risks 2176.3.2 Default risk charge 2296.3.3 Residual risk add-on 2306.3.4 Simplified alternative to the standardised approach 2316.3.5 Example for national implementation: The implementation of the SBA in the EU 2336.4 Internal Models Approach for market risk (IMA-TB) 2356.4.1 Regulatory background and goals 2356.4.2 Procedural and organisational challenges 2366.4.3 Methodological amendment 2376.4.4 Impact on capital requirements 2486.5 Business implications and impact in the financial markets 2516.5.1 Market microstructure 2526.5.2 The competitive landscape 2536.5.3 Possible solutions and workarounds 2546.6 Optimisation considerations 2566.6.1 Selective IMA – general aspects 2576.6.2 Example I: Diversification benefit realisation 2586.6.3 Example II: Optimisation of risk factors 2586.7 Conclusions 259Recommended Literature 2627. Chapter: CVA Risk Capital Charge Framework 2657.1 Credit Valuation Adjustment 2657.1.1 Definition of the term “Credit Valuation Adjustment” 2657.1.2 Background of the regulatory CVA 2667.1.3 Revision of the CVA framework 2677.1.4 Hierarchy of approaches 2697.2 FRTB-CVA framework 2707.2.1 Regulatory requirements for the application of the FRTB-CVA framework 2707.2.2 Exposure value for the FRTB-CVA 2727.2.3 Standardised approach for CVA (SA-CVA) 2737.3 Basic CVA framework 2777.3.1 Side note: Calculation of the CVA Risk Capital Charge under the current standardised method according to Basel III 2777.3.2 Regulatory requirements for the application of the basic CVA framework 2807.3.3 Exposure value for the basic CVA 2807.3.4 Determination of regulatory capital requirements based on the basic CVA framework 2817.4 Additional aspects and expected effects 285Recommended literature 2868. Chapter: Operational Risk 2898.1 Introduction 2898.2 Current methods pursuant to Basel II 2908.2.1 Basic Indicator Approach and Standardised Approach 2908.2.2 Advanced Measurement Approaches 2928.2.3 Criticism of the existing approaches 2938.3 Overview: From Basel II to Basel IV 2938.4 Standardised Approach for operational risk (BCBS 424) 2948.4.1 Methodology of the SA 2948.4.2 Minimum standards for the use of loss data 3018.5 Future impact 3028.5.1 Capital requirements for OpRisk 3028.5.2 Practical considerations 3028.5.3 Disclosure 3038.6 Conclusion 303Recommended Literature 3059. Chapter: Capital Floors 3079.1 Introduction 3079.2 Reasons for the new capital floor 3099.3 Basel IV Capital Floor 3129.3.1 Capital Floors in Basel I and II 3139.3.2 Calculation of the floor 3179.3.3 Transitional Cap Rules 3189.3.4 Choice of which standardised approach 3209.3.5 Global implementation 3209.4 Interactions and interdependencies to other Basel IV rules 3219.4.1 Overview of the goals and quantitative impact of the capital floor and other Basel IV changes 3239.4.2 Impact of the capital floor on the standardised approaches and their implementation 3249.4.3 Optimisation of the standardised approaches 3259.4.4 Impact of the capital floor on pricing models 3279.4.5 Relationship between the capital floor and the scope of application of the IRB Approach 3319.5 Conclusions 332Recommended Literature 33310. Chapter: New Basel Framework for Large Exposures 33510.1 Background 33510.2 Scope 33610.3 Large exposure limits 33610.4 Eligible capital 33810.5 Counterparties and connected counterparties 33910.6 Definition of exposure 34110.7 Assessment base 34210.7.1 On and off-balance sheet items in the banking book 34210.7.2 Counterparty risk 34210.7.3 Trading book items 34310.8 Recognition of credit risk mitigation 34310.9 Exemptions 34510.10 Look-through of funds and securitisations 34710.11 Regulatory reporting 35010.12 Implementation of the updated framework in the CRR II 35010.13 Summary 351Recommended Literature 35411. Chapter: Disclosure 35711.1 Introduction 35711.2 Disclosure guidelines 35811.3 Risk management, key prudential metrics and risk-weighted assets (RWA) 36211.4 Linkages between financial statements and regulatory exposures 36511.5 Composition of capital and TLAC 36811.6 Macroprudential supervisory measures 37111.7 Leverage Ratio 37211.8 Disclosures related to liquidity 37311.9 Credit risk 37811.9.1 General information on credit risk 38011.9.2 Credit risk mitigation 38311.9.3 Credit risk under the standardised approach 38411.9.4 Credit risk under the IRB Approach 38511.10 Counterparty credit risk 38611.11 Securitisation 39011.12 Market risk 39111.13 Interest rate risk in the banking book 39911.14 Remuneration 40011.15 Benchmarking 40211.16 Operational risk 40311.17 Credit valuation adjustments 40611.18 Asset encumbrance 40711.19 European implementation 40811.19.1 European implementation of phase I 40811.19.2 European implementation of phase II 41011.20 Conclusions and expected effects 410Recommended Literature 41212. Chapter: Interest Rate Risk in the Banking Book (IRRBB) 41512.1 Introduction 41512.2 Principles for treatment within the framework of Pillar 2 41612.2.1 Definitions 41612.2.2 The twelve Principles for the management of IRRBB 41612.2.3 Interest rate shock scenario design 41912.2.4 The EBA guidelines on the management of interest rate risk arising from non-trading book activities 42012.2.5 Similarities and differences between the BCBS Principles and the EBA Guidelines 42112.3 The Standardised Framework 42312.3.1 Introduction 42312.3.2 Assigning positions to time buckets 42412.3.3 Estimating the impact on EVE 42612.3.4 Calculation of minimum capital requirements 42712.4 Conclusion and outlook 427Recommended literature 42813. Chapter: TLAC and MREL – The Extension of the Regulatory Capital Definition and the Scope of Supervision 42913.1 Background 42913.2 TLAC 43113.2.1 TLAC implementation 43113.2.2 TLAC calibration 43113.2.3 TLAC eligible instruments 43113.2.4 Resolution entities and internal TLAC 43213.2.5 TLAC holdings 43313.2.6 TLAC-Reporting 43513.2.7 TLAC disclosure 43613.3 MREL 43713.3.1 MREL implementation at EU level 43713.3.2 MREL calibration 43913.3.3 Resolution entities and internal MREL 44513.3.4 MREL holdings 44613.3.5 MREL reporting 44613.3.6 MREL disclosure 44813.4 Outlook and summary 448Recommended Literature 45014. Chapter: Strategic Implications 45314.1 Introduction 45314.2 The capital squeeze 45314.2.1 RWA impact 45314.2.2 Impact on capital 45514.3 How to cope with Basel IV – Strategic implications 45814.3.1 Capital management 45914.3.2 Portfolio composition 46014.3.3 Product structure 46214.3.4 Operations 46214.4 Conclusion 463