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The Basel Committee for Banking Supervision (BCBS) proposed finalization of Basel III encompasses so many changes that the industry started referring to it as Basel III Endgame. Basel III Endgame changes the calculation of risk-weighted assets (RWA) which will have a significant impact on business models and forces banks to rethink their capital allocation strategies.
BCBS published its final documents on the reform of Basel III in December 2017, which are now commonly referred to as “Basel III Endgame.” In the interim, implementation of Basel III Endgame has been deferred to January 2023, and the US Federal Reserve has yet to publish their final ruling. However, understanding the potential impacts of Basel III Endgame now is key, and will give firms a head start in implementation efforts once the final ruling is published.
Introduces due diligence requirements for certain types of counterparties
Adds more granular counterparty types (e.g. specialized lending), with distinct risk-weighting rules
Increases requirements for meeting certain treatments (e.g. real estate secured)
Segregates real estate exposure risk weights based on Loan-To-Value (LTV)
Credit card impact will be driven by customer behavior
Real estate exposure may receive relief
Corporate impact will be driven by counterparty type
New exposure classes require system changes
Impact will vary based upon business model
The CCF for unused consumer credit balances will increase from 0% to 10%.
Credit limit increases and customer spend behavior (e.g., “transactor” vs “revolving”) will directly impact capital requirements.
The ability to forecast expectations on both of these aspects should be a part of capital planning.
Introduction of risk weights scaled based on LTV band for commercial and residential real estate mortgages will likely provide a significant RWA benefit for banks’ real estate portfolios with lower LTVs.
A reduced risk weight is proposed for Investment Grade (IG) corporate exposures with public securities (100% to 65%) and for small and medium sized (SME) (100% to 75% or 85%) enterprises.
New exposures classes to the US SA for Credit Risk introduced, including retail, specialized lending and commercial real estate. New exposure classes require banks to update their exposure classification systems, processes and data.
Meaningful insights require more granular impact analysis to identify business impacts, refine capabilities, and identify opportunities and challenges.
Common issues achieving Credit Risk-SA requirements |
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Approach to addressing these issues |
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Common issues achieving Credit Risk-SA requirements |
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Approach to addressing these issues |
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Common issues achieving Credit Risk-SA requirements |
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Approach to addressing these issues |
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BCBS proposes to discontinue Advanced IRB (A-IRB) for equities, large corporates and banks. US regulators never implemented F-IRB under Basel II, so there is significant uncertainty regarding implementation.
Increase of PD and LGD floors and introduction of Supervisory-set LGD’s, may result in higher RWA under the Advanced Approach. Changes in PDs, LGDs resulting in higher RWA may result in the Advanced Approach becoming the RWA floor under the Collins Amendment, shifting capital planning and allocation practices.
Basel III Endgame narrows the applicability of the Advanced IRB approach for equities, large corporates and banks. Using the F-IRB approach or SA generally leads to higher RWA.
Common issues achieving IRB requirements |
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Approach to addressing these issues |
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Common issues achieving IRB requirements |
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Approach to addressing these issues |
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Common issues achieving IRB requirements |
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Approach to addressing these issues |
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SA-CCR’s EAD calculation is based on over 100 data elements that include trade, collateral, hedging set and counterparty information.
Robust data management practices for sourcing this granular data can improve the precision of the calculation and reduce exposure.
Netting of offsetting exposures will shift the focus of portfolio optimization from reducing gross notional exposures to reducing net exposure.
Netting of offsetting exposures may change the relative costs of some products, e.g., reducing the exposure from interest rate swaps but increasing the exposure from foreign exchange products.
Netting of offsetting transactions makes it no longer possible to see the capital charge associated with each trade.
Development of an allocation methodology and the ability to run “what-if” analysis can help to understand the capital charge of a trade before it is booked.
Common issues achieving SA-CCR requirements |
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Approach to addressing these issues |
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Common issues achieving SA-CCR requirements |
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Approach to addressing these issues |
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Common issues achieving SA-CCR requirements |
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Approach to addressing these issues |
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Electing IMA can be costly and costs depends on trading desk.
For larger/growing flow businesses with liquid underlying products, investing in infrastructure to get IMA approval is recommended.
For smaller desks and/or less liquid and complex desks, IMA approval is too costly.
FRTB is significantly more complex in calculations, governance and data needs, especially for IMA trading and CVA-SA.
Depending on current state and scope of infrastructure, it may be more optimal to overhaul operating model of current risk/modeling/PnL infrastructure and process for long term sustainability.
Getting and maintaining IMA approval requires careful selection of risk factors that has appropriate depth to explain PnL in PLA/backtesting and also has sufficient market observable price discovery per FRTB prescription (RFET).
Governance around market data will require upgrades to related processes and potential streamlining of front-to-back market data.
CVA-SA allows for more capital efficiency if the bank can demonstrate proper governance around CVA trading desk set up and models/calculations on par with industry standard.
If bank has material CVA hedging program, investing in upgrading infrastructure and governance to utilize CVA-SA is desirable.
FRTB requires reclassification of banking and trading book based on highly prescriptive product based designations, which can lead to significant added governance.
This change may require reoptimization of strategy and hedges, as needed.
Common issues achieving FRTB/CVA requirements |
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Approach to addressing these issues |
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Common issues achieving FRTB/CVA requirements |
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Approach to addressing these issues |
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Common issues achieving FRTB/CVA requirements |
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Approach to addressing these issues |
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Common issues achieving FRTB/CVA requirements |
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Approach to addressing these issues |
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There is considerable uncertainty around implementation of the operational risk framework into the US rules.
Operational risk RWA under the SA may be greater than the current AMA due to Internal Loss multiplier; The impact of operational risk losses on capital may be amplified due to capital requirements driven by the SCB through CCAR operational risk losses.
Banks should have robust processes for appropriately capturing operational risk loss data, including loss dates, accounting dates and recovery (legal and insurance) data.
High-quality operational loss data must extend back ten years.
Technology systems should be comprehensive and linked to the General Ledger to facilitate the capture of operational loss data, including the required operational loss data elements.
Banks need to have independent assurance that operational loss tracking systems, processes, and controls provide for high-quality data.
Common issues achieving operational risk requirements |
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Approach to addressing these issues |
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Common issues achieving operational risk requirements |
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Approach to addressing these issues |
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Common issues achieving operational risk requirements |
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Approach to addressing these issues |
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Levers |
Description |
Likelihood of incorporation |
Real Estate Exposures |
Maintain BCBS proposed risk weights for loan-to-value bands |
Medium |
Corporate Exposures |
Align the definition of investment grade with current industry practices and internal processes for evaluating and measuring risk |
High |
Retail Exposures |
Maintain BCBS proposed risk weights for retail and credit card balances |
Medium |
Capital Floors |
Align Collins Amendment with proposed capital floors to effectively keep capital neutral |
Low |
CVA |
Address potential double count of market risk losses between Standardized Approach (SA) and CCAR by further reducing the multiplier in the SA |
Medium |
Unused Commitments |
Decrease the proposed Credit Conversion Factor (CCF) of 10% or maintain the current 0% CCF for unused unconditionally cancelable commitments |
Low |
Operational Risk |
Address potential double count of operational risk RWA in the SA and stress losses in CCAR through the SCB |
Medium |
Steve Pearson
Managing Director, Risk & Regulatory - Financial Services
Cyber, Risk & Regulatory
PwC US
Email