Basel IV

Foreword 13
Preface 15

1. Chapter: Revision of the Standardised Approach for Credit Risk 17
1.1 Introduction 17
1.2 General aspects 19
1.2.1 Exposures to sovereigns 21
1.2.2 Exposures to public sector entities 22
1.2.3 Exposures to multilateral development banks 22
1.2.4 Exposures to banks 23
1.2.5 Exposures to corporates 28
1.2.6 Specialised lending 30
1.2.7 Subordinated debt instruments, equity and other capital instruments 32
1.2.8 Retail exposures 33
1.2.9 Exposures secured by real estate/Real estate exposure class 34
1.2.10 Additional risk weights for positions with currency mismatch 51
1.2.11 Off-balance sheet items 52
1.2.12 Defaulted exposures 53
1.2.13 Other assets 54
1.3 Use of external ratings 54
1.3.1 Recognition process for external ratings by national supervisors 54
1.3.2 Mapping of external ratings and use of multiple ratings 56
1.4 Credit risk mitigation techniques 58
1.5 Conclusions 62
Recommended Literature 64

2. Chapter: The Future of the IRB Approach 65
2.1 Introduction of the fundamentals of the IRB Approach (Basel II) 67
2.1.1 A non-quantitative introduction to the IRB risk weight formula 67
2.1.2 The adoption of the IRB Approach 73
2.1.3 Calculation of RWA and EL 74
2.1.4 Minimum conditions for entry and ongoing use 81
2.1.5 Approval and post-approval process: Home/host coordination 88
2.1.6 Decision for application 89
2.2 Basel Committee’s initiatives to improve the IRB Approach 90
2.2.1 Introduction 90
2.2.2 Scope of application of internal models 90
2.2.3 Partial use of the IRB Approach 94
2.2.4 Risk parameter floors as an instrument of RWA variability reduction 97
2.2.5 Parameter estimation practices 99
2.2.6 Expected impact on banks 102
2.2.7 Conclusion 106
2.3 EBA regulatory reform and the revised supervisory assessment methodology 107
2.4 Definition of Default 109
2.4.1 Past-due criterion in the definition of default 111
2.4.2 Indications of unlikeliness to pay 113
2.4.3 Application of the definition of default in external data 117
2.4.4 Consistency of the application of default definition 118
2.4.5 Application of default definition for retail exposures 118
2.4.6 Criteria for the return to the non-defaulted status 119
2.4.7 Materiality thresholds 120
2.4.8 Implementation of changes 121
2.4.9 Impact of new default definition on RWA 122
2.5 Risk estimates 122
Recommended Literature 138

3. Chapter: The New Standardised Approach for measuring Counterparty Credit Risk (SA-CCR) 139
3.1 Counterparty credit risk 139
3.1.1 Definition of counterparty credit risk 139
3.1.2 Measuring counterparty credit risk in the EU 139
3.1.3 Background and motives for introducing the SA-CCR approach 141
3.2 Side note: Calculating EAD with the current exposure method 141
3.3 Measurement of counterparty credit risk according to SA-CCR 145
3.3.1 Exposure at Default 145
3.3.2 Current replacement cost 145
3.3.3 Potential future exposure 147
3.3.4 Calculation example: EAD determination under SA-CCR 158
3.4 Use of simplified approaches 159
3.4.1 Simplified SA-CCR 160
3.4.2 Revised original exposure method 161
3.5 Expected impact on the banking industry 161
Recommended Literature 162

4. Chapter: The new securitisation framework 163
4.1 Introduction 163
4.2 The securitisation framework under Basel II 164
4.2.1 Scope and definitions 164
4.2.2 Exclusion of securitised exposure from the calculation of risk-weighted exposure amount 165
4.2.3 Treatment of securitisation exposures 167
4.3 Revisions to the securitisation framework under Basel IV 168
4.3.1 Criticism of the existing rules 168
4.3.2 New approaches and a revised hierarchy for the determination of risk-weighted exposure amounts171
4.3.3 Risk weights for securitisation positions when complying with STC criteria 184
4.4 General Conclusions 189
Recommended Literature 190

5. Chapter: Capital Requirements for Bank’s Equity Investments in Funds 193
5.1 Overview 193
5.2 Trading book vs banking book boundary 194
5.3 Own funds requirements for funds in the banking book 195
5.3.1 Scoping and hierarchy of approaches 195
5.3.2 Funds under the standardised approach 196
5.3.3 Funds under the internal ratings-based approach (IRB) 199
5.3.4 Leverage adjustment under the LTA and the MBA 200
5.3.5 Treatment of funds that invest in other funds (target funds, fund of funds) 201
5.4 Summary and conclusion 202
Recommended Literature 203

6. Chapter: Fundamental Review of the Trading Book: A New Age for Market Risks . 207
6.1 Introduction 207
6.2 Revised trading book boundary 208
6.2.1 Revised boundary of the trading and banking books 209
6.2.2 Reallocation of positions between books 212
6.2.3 Internal risk transfer 213
6.2.4 Example for national implementation: Boundary requirements and thresholds in the EU 214
6.3 The revised standardised approach for market risks 215
6.3.1 Linear and non-linear price risks 217
6.3.2 Default risk charge 229
6.3.3 Residual risk add-on 230
6.3.4 Simplified alternative to the standardised approach 231
6.3.5 Example for national implementation: The implementation of the SBA in the EU 233
6.4 Internal Models Approach for market risk (IMA-TB) 235
6.4.1 Regulatory background and goals 235
6.4.2 Procedural and organisational challenges 236
6.4.3 Methodological amendment 237
6.4.4 Impact on capital requirements 248
6.5 Business implications and impact in the financial markets 251
6.5.1 Market microstructure 252
6.5.2 The competitive landscape 253
6.5.3 Possible solutions and workarounds 254
6.6 Optimisation considerations 256
6.6.1 Selective IMA – general aspects 257
6.6.2 Example I: Diversification benefit realisation 258
6.6.3 Example II: Optimisation of risk factors 258
6.7 Conclusions 259
Recommended Literature 262

7. Chapter: CVA Risk Capital Charge Framework 265
7.1 Credit Valuation Adjustment 265
7.1.1 Definition of the term “Credit Valuation Adjustment” 265
7.1.2 Background of the regulatory CVA 266
7.1.3 Revision of the CVA framework 267
7.1.4 Hierarchy of approaches 269
7.2 FRTB-CVA framework 270
7.2.1 Regulatory requirements for the application of the FRTB-CVA framework 270
7.2.2 Exposure value for the FRTB-CVA 272
7.2.3 Standardised approach for CVA (SA-CVA) 273
7.3 Basic CVA framework 277
7.3.1 Side note: Calculation of the CVA Risk Capital Charge under the current standardised methodaccording to Basel III 277
7.3.2 Regulatory requirements for the application of the basic CVA framework 280
7.3.3 Exposure value for the basic CVA 280
7.3.4 Determination of regulatory capital requirements based on the basic CVA framework 281
7.4 Additional aspects and expected effects 285
Recommended literature 286

8. Chapter: Operational Risk 289
8.1 Introduction 289
8.2 Current methods pursuant to Basel II 290
8.2.1 Basic Indicator Approach and Standardised Approach 290
8.2.2 Advanced Measurement Approaches 292
8.2.3 Criticism of the existing approaches 293
8.3 Overview: From Basel II to Basel IV 293
8.4 Standardised Approach for operational risk (BCBS 424) 294
8.4.1 Methodology of the SA 294
8.4.2 Minimum standards for the use of loss data 301
8.5 Future impact 302
8.5.1 Capital requirements for OpRisk 302
8.5.2 Practical considerations 302
8.5.3 Disclosure 303
8.6 Conclusion 303
Recommended Literature 305

9. Chapter: Capital Floors 307
9.1 Introduction 307
9.2 Reasons for the new capital floor 309
9.3 Basel IV Capital Floor 312
9.3.1 Capital Floors in Basel I and II 313
9.3.2 Calculation of the floor 317
9.3.3 Transitional Cap Rules 318
9.3.4 Choice of which standardised approach 320
9.3.5 Global implementation 320
9.4 Interactions and interdependencies to other Basel IV rules 321
9.4.1 Overview of the goals and quantitative impact of the capital floor and other Basel IV changes 323
9.4.2 Impact of the capital floor on the standardised approaches and their implementation 324
9.4.3 Optimisation of the standardised approaches 325
9.4.4 Impact of the capital floor on pricing models 327
9.4.5 Relationship between the capital floor and the scope of application of the IRB Approach 331
9.5 Conclusions 332
Recommended Literature 333

10. Chapter: New Basel Framework for Large Exposures 335
10.1 Background 335
10.2 Scope 336
10.3 Large exposure limits 336
10.4 Eligible capital 338
10.5 Counterparties and connected counterparties 339
10.6 Definition of exposure 341
10.7 Assessment base 342
10.7.1 On and off-balance sheet items in the banking book 342
10.7.2 Counterparty risk 342
10.7.3 Trading book items 343
10.8 Recognition of credit risk mitigation 343
10.9 Exemptions 345
10.10 Look-through of funds and securitisations 347
10.11 Regulatory reporting 350
10.12 Implementation of the updated framework in the CRR II 350
10.13 Summary 351
Recommended Literature 354

11. Chapter: Disclosure 357
11.1 Introduction 357
11.2 Disclosure guidelines 358
11.3 Risk management, key prudential metrics and risk-weighted assets (RWA) 362
11.4 Linkages between financial statements and regulatory exposures 365
11.5 Composition of capital and TLAC 368
11.6 Macroprudential supervisory measures 371
11.7 Leverage Ratio 372
11.8 Disclosures related to liquidity 373
11.9 Credit risk 378
11.9.1 General information on credit risk 380
11.9.2 Credit risk mitigation 383
11.9.3 Credit risk under the standardised approach 384
11.9.4 Credit risk under the IRB Approach 385
11.10 Counterparty credit risk 386
11.11 Securitisation 390
11.12 Market risk 391
11.13 Interest rate risk in the banking book 399
11.14 Remuneration 400
11.15 Benchmarking 402
11.16 Operational risk 403
11.17 Credit valuation adjustments 406
11.18 Asset encumbrance 407
11.19 European implementation 408
11.19.1 European implementation of phase I 408
11.19.2 European implementation of phase II 410
11.20 Conclusions and expected effects 410
Recommended Literature 412

12. Chapter: Interest Rate Risk in the Banking Book (IRRBB) 415
12.1 Introduction 415
12.2 Principles for treatment within the framework of Pillar 2 416
12.2.1 Definitions 416
12.2.2 The twelve Principles for the management of IRRBB 416
12.2.3 Interest rate shock scenario design 419
12.2.4 The EBA guidelines on the management of interest rate risk arising from non-trading bookactivities 420
12.2.5 Similarities and differences between the BCBS Principles and the EBA Guidelines 421
12.3 The Standardised Framework 423
12.3.1 Introduction 423
12.3.2 Assigning positions to time buckets 424
12.3.3 Estimating the impact on EVE 426
12.3.4 Calculation of minimum capital requirements 427
12.4 Conclusion and outlook 427
Recommended literature 428

13. Chapter: TLAC and MREL – The Extension of the Regulatory Capital Definition and the Scope ofSupervision 429
13.1 Background 429
13.2 TLAC 431
13.2.1 TLAC implementation 431
13.2.2 TLAC calibration 431
13.2.3 TLAC eligible instruments 431
13.2.4 Resolution entities and internal TLAC 432
13.2.5 TLAC holdings 433
13.2.6 TLAC-Reporting 435
13.2.7 TLAC disclosure 436
13.3 MREL 437
13.3.1 MREL implementation at EU level 437
13.3.2 MREL calibration 439
13.3.3 Resolution entities and internal MREL 445
13.3.4 MREL holdings 446
13.3.5 MREL reporting 446
13.3.6 MREL disclosure 448
13.4 Outlook and summary 448
Recommended Literature 450

14. Chapter: Strategic Implications 453
14.1 Introduction 453
14.2 The capital squeeze 453
14.2.1 RWA impact 453
14.2.2 Impact on capital 455
14.3 How to cope with Basel IV – Strategic implications 458
14.3.1 Capital management 459
14.3.2 Portfolio composition 460
14.3.3 Product structure 462
14.3.4 Operations 462
14.4 Conclusion 463