THERE IS NO BASEL IV SOLUTION, LEVERAGE ON INITIATED FINANCE AND OPTIMISATIONS 2 1

Introduction

Since the reform of the Basel III supplements in 2017, it has been one of the most important topics among and financial institutions. In order to prevent a wide range of stakeholders from losing confidence in banks’ reported capital ratio, the post-crisis regulation contributes to restoring the credibility of the calculation by enhancing the comparability of ’s capital ratios, limiting the use of internal model approaches and complementing a sound capital floor on risk-weighted assets (RWA) ratio.

In short, the revised Basel III, renamed Basel IV, requires the banks to be more standardized, especially for banks using Advance Internal ratings-based approach (A-IRB). To a large extent, banks using A-IRB approaches have more freedom to use their own models to estimate risk parameters, such as PD (), EAD () and LGD (). However, Basel IV will no longer allow low default portfolios, such as Mortgages, Trade Commodity Finance (TCF) to use only internal models.

This is due to the reason that the Basel Committee on Banking Supervision (BCBS) regards it challenging for banks to obtain reliable parameter estimations for low default portfolios. Instead, BCBS introduced input floors to PD, LGD and the Credit Conversion Factors (CCF) that are used to determine EAD for off-balance sheet items and the output floor on capital requirements to force A-IRB banks to better understand the behaviour of their portfolios and allocate capital appropriately according to the standardized approach.

Second reason is to increase the comparability between the models of different banks. A-IRB models have become sometimes too advanced in relation to their purpose and data availability. For some banks this is a good reason to start normalizing models, reduce the number of models and to lower implementation costs.

The implementation date of Basel IV regulation is postponed with one year till January 2023 and will phase-in until 2028 due to the COVID –19 outbreak.

3 Impact of COVID 19

The outbreak of the COVID –19 pandemic and the subsequent global lockdown put the banking system, particularly its capital positions, under severe pressure. Repayments of loans are Loans need to or will be written-off. The market movements are also hurting safety buffers. But because of the regulatory capital buffers banks remain resilient so far. With the pressure on capital there comes a huge demand for ad hoc regulatory and management reporting. Besides COVID there was already impact from huge backlogs in DoD, BCBS 239 and Modelling.

In order to allow banks to concentrate their resources on mitigating the effects of COVID –19 and maintaining financial stability, the Basel Committee on Banking Supervision (BCBS) has announced that the implementation of Basel IV will be postponed for one year to 1 January 2023 [1].

The revised implementation guidelines following a deferral are summarized below:

An overview of the Basel IV1) framework. Because of COVID 19, go Live date has shifted to January 1 2023

COVID19 Today Deferral New regulations and adjustments 2017 2018 2019 2020 2021 2022 2023 to existing regulations

BCBS 239 / ANACREDIT NPL and Backstop Basel IV: TLAC/MREL - Total Loss Absorbing Capacity Basel IV – Banking Book - Securitisation framework NSFR - Net Stable Funding Ratio (incl disclosures) Basel IV: Capital Requirements - Leverage Ratio Basel IV: Trading Book - Fundamental review of the trading book (FRTB) Basel IV – Banking Book - Credit RWA Basel IV: Banking Book - – Standardized Approach (SA) Basel IV: Banking Book – OpRisk – Standardised Measurement Approach Basel IV: Banking Book - Credit Risk – Internal Ratings Based Approach Basel IV: Banking Book - Interest Rate Risk of the Banking Book (IRRBB) Basel IV: Banking Book SA for Measuring Counterparty Credit Risk Basel IV: Capital Requirements- Capital Floors Basel IV: Trading Book - Minimum Capital Requirements for CVA Risk

Final Requirements Extended eective date (Proposed) Eective date

Other BCBS standards, guidelines, consultation papers or working papers

• BCBS 279, 424 – SA Counterparty Risk • BCBC 374, 424 – Securitisation

• BCBS 283 – Large Exposures • BCBS 387 –TLAC

• BCBS 309, 356 – Pillar 3 Disclosure • BCBS 349, 398 – Step-in Risk

• BCBS 367 – Problem assets • BCBS 425 – The treatment of sovereign exposures

• BCBS 368 – IRRBB 1) Initial application depends, among others, on system relevance of the bankand the respective BCBS

1For more details: https://www.bis.org/press/p171207.htm

4 The introduction of the SA models and the comparison with the IRB calculations seems to have the biggest impact. New data needs to be sourced and calculations need to be merged with IRB calculations. Additional data is requested that was not Basel IV main features asked before like external client ratings and original collateral value. And, a new client segmentation needs to be made for So, what is the Basel IV implementation about? Let’s the SA models. Therefore, in terms of data logistics there is have a quick recap: a challenge.

• Introduction of Standardised Models (SA) As many banks are updating their financial and risk landscape, they are taking the opportunity to develop the Basel IV features • Some portfolios need to move to foundation on the target platforms. But not all target platforms will be ready in time, so there will be a hybrid implementation that • Input Floors increases IT implementation efforts.

• Output floors Similarly, the output floor, known as one of the biggest challenges under Basel IV, is also raising the heavy workload • Focus on tail end risk and costs in banks. Banks have to allocate resources to revise methodologies and finalize the Basel IV framework, especially • Business Impact indicator for for those banks with large low default portfolios. The setting of lower bounds is designed to reduce the variability in RWAs and thus increase the comparability in capital ratios among banks. Mandatory RWA is at least 72.5% of RWA using the standardized approach.

In the picture below you will find an overview of the Basel IV framework.

Basel IV added minimum requirements (in- and output floors, SA models) to increase comparability of the internal models!

Development Key Topics

� Basel IV is building on the eoled three pillar Basel frameork by limiting olatility and variance in Oct First consultations for banks’ capital calculations ith the aim of making outcomes more comparable across banks globally 2014 ne standard approaches � Reforms concentrate on the calculation of RWAs the denominator internal models should not fall belo 725 of the calculation using the Basel IV standardied models This loer limit is knon as an Dec Release of the "output floor“ hich is measured against the aggregated sum of In addition, hen computing 2017 RAs based on internal models, input parameters must not fall belo certain minimum leels, so rules Pillar 1 called “input floors”. an Go Live and First � Meet higher maimum leverage ratios 2023 round of auditing the ne Basel I rules � It strengthens microprudential regulation and superision, and adds a macroprudential oerlay that 1 year postponed due to COVID-19 includes capital buffers 2028 an nd of the transition � Supplemental Pillar 2 requirements address firm-wide governance and to increase phase for the output floor isibility

Pillar 2 � More detailed disclosure of reserves and other financial statistics. Challenges � Revised Pillar 3 disclosure requirements (Consolidated and enhanced frameork � Need to generate and retain � Reised disclosure reuirements for credit risk, operational risk, leerage ratio, credit aluation capital to support risk eighted adjustment (CVA) and overview templates on risk management, risk-weighted assets (RWA) and key assets and reduce risk eighted exposure prudential metrics Pillar 3 � High impact on usiness model, systems and data Basel IV is the final update of the existing capital resilience framework focusing on comparability

5 For banks business management and business planning the introduction of SA models and floors opens up the opportunity to rethink their business planning and control, focussing on cost control and client revenue. To do this, this requires additional effort in terms of business and IT implementation. But when done there will be more balance between business modelling compared to risk modelling.

So, all in all the deferral of the Basel IV implementation is welcomed. The postponement frees up operational capacity for other regulatory initiatives and provides banks with extra time to unlock the full Basel IV mitigation potential. However, banks should not underestimate the time needed to implement the Basel III reforms, but use this extra time efficiently.

6 2

Basel IV & BCBS 239: the opportunity for Data and reporting optimisation

As we mentioned in our previous blog [2], banks are paying more attention on data management since the implementation of Basel III. BCBS introduced more data complexity and additional data requirements for the banking sector to increase comparability between the banking books of different banks and to be able to benchmark risk-related transparency and comparability. The global financial crisis revealed the banks’ lacking ability to provide senior management with a true picture of the risks the organization faces. Therefore, BCBS 239 was introduced in response to the need for banks to strengthen their risk aggregation capabilities and the effectiveness of their risk reporting. In this section, we will talk about the common influence between Basel IV and BCBS 239.

To meet the “Principles for effective risk data aggregation and risk reporting”, BCBS calls the banks to highly automate and standardize their risk reporting and the underlying provision of data, which requires a rework of governance, data modelling, correction and maintenance processes, evaluations and evaluation dimensions to integrate different risk types. Risk IT and risk department are asked to collaboratively resolve the risk type alignment in risk management and provide data provision with adequate quality. It is therefore costly and challenging for banks to revolute their data quality management in order to be comply with BCBS 239. Remarkably, although the deadline for BCBS 239 has already passed, data quality remains the biggest concern among banks affecting each individual business unit. This is also recognized by the supervisor in many TRIM on-sites over the past two years. There needs to be real improvement in data management, data governance and data quality management. With an increase of the restrictions, minimal capital requirements and standardized risk methods, Basel IV requires more extensive data for Basel monitoring exercises and quantitative reporting. Also, the implementation of Basel IV requires extensive qualified data. High quality granular data will allow banks to make proper forecasts of accurate measurements and will then help banks to undo some mark-ups they get for uncertainty and provide the evidence on being compliant with the capital floors.

As better data quality improves RWA accuracy and thus reduce capital required, banks should take the advantage of using their clean data to test the regulator’s assumptions about defaults and loss. If less capital is stuck in the floor, more is available for new investments. In addition, accurate and granular data from banks will help the regulator and the bank to produce insights in what capital is to be reserved as a buffer. Meanwhile, banks should also seize the opportunity to further improve their data management such as data storage and migration when redeveloping their models under Basel IV. Managing the critical data elements in a way that they are managed once and used multiple times benefits risk management and profitability.

7 8 3

Basel IV & new DoD: New approach for credit risk management

From January 1st, 2021, the European Banking Authority’s (EBA) new Definition of Default (DoD) will come into action. The new guidelines aim to harmonize credit processes in three perspectives: ensure a consistent and harmonized approach across countries, increase comparability of estimates and requirements, and reduce burden of different requirements for cross-border groups. To do so, EBA pointed out the need for banks to revising their current models and improving risk integration.

In this section, the common influence between new DoD and Basel IV is analysed to provide insight into the benefits of starting the implementation of Basel IV together with the urgent DoD guidelines.

3.1 Model change

As the new DoD requests banks to revise their models, the implementation of new DoD requires significant effort and resources of some institutions, in particular those using the A-IRB approaches as they tend to predict lower default losses. Those banks will need to adjust their definition to comply with the new definition of default and apply it retrospectively. IRB banks also need to recalculate and introduce additional margin of conservatism (MoC) when necessary to compensate for inconsistencies between different DoD definitions from the past. In comparison, the banks currently applying SA are expected to be affected less as they do not rely on historical data.

In Europe, larger banks tend to use A-IRB approaches for their portfolios and most of them have a substantial amount of PD and LGD models. Therefore, taking into account the floors for PD and LGD levels of Basel IV when adjusting historical data and redeveloping the models can certainly help banks to save resources and costs. We see that many banks take the opportunity to redo their data logistics for historical and production data and have clear communication between data owner and data user. This will increase data quality and save costs

3.2 Impact on capital requirements from New DoD definition

According to Article 178(1) CRR [3], there are two triggers that EBA considers an obligor as ‘default’:

1. Credit obligation is 90 days past due (DPD), which was 180 days before

2. Materiality threshold has been breached (e.g. The total amount of the credit obligation past due).

Although EBA estimated in the paper that the new definition is unlikely to increase capital requirements considerably, most of the institutions still need to adequate their available capitals to meet the new definition. By adapting 180 DPD to 90 DPD, firms that are currently following 180 DPD will accelerate the trigger of default and end up with a higher PD estimate and lower LGD estimate. When the parameters change, the expected credit losses will increase correspondingly and thus lead to a higher risk provisions and higher capital required. In Basel IV, a 72.5% output floor is supplemented and will also lead to a higher RWA, especially for those A-IRB banks. In terms of implementation banks are already used to use input floors but output floors. Therefore, they should be less stressed on adapting to the capital floors, as the introduction of the new definition has already contributed to the adjustment of the required level of capital. Similarly, the standardized introduction of a materiality threshold for the credit obligation will also increase the number of defaults and thus affect capital requirements, which will also help to simplify the implementation of the Basel III reforms. This impact will be comparably significant on IRB banks as the threshold change more significantly.

9 10 4

So, what is the current implementation status of Basel IV?

The implementation of the Basel IV framework is of course a remarkable challenge for European banks, as most larger banks use A-IRB approaches for most of their portfolios in Europe. These A-IRB banks note that the redevelopment of internal models is more expensive than a possible increase in capital requirements, which is one of the main constraints for starting the implementation of the revised Regulation.

BIS (Bank for International Settlements) is publishing progress report on adoption of the Basel regulatory. In the latest report, BIS described the adoption status of Basel III standards for each BCBS member jurisdiction as of end-September 2019 [4]. Results show that the main reforms under Basel IV, namely ‘Revised standardized approach for credit risk’, ‘Revised IRB approach for credit risk’ and ‘Revised CVA framework’, are all in the ‘draft regulation not published’ phase. This classification represent that there is no draft law (waiting for CRR3) , regulation or other official document that has been made public to detail the planned content of the domestic regulatory rules, and it is applied not only for European Union but also for all other jurisdictions.

But we cannot wait for CRR3 to be ready and so the preparations for Basel IV are in progress. In general, can something be said about the current implementation status? Yes and no. No because every bank is different and has its own planning. Yes, because there is one deadline, the framework is not completely new and the challenges for existing European (IRB) banks are mostly the same. We see that banks finished their IFRS9 implementation and are busy implementing BCBS239 and TRIM on site recommendations. In most cases banks took the opportunity to completely redevelop their model landscape for simplification and cost efficiency purposes. These initiatives are multi-year implementations which are ongoing as Basel IV needs to be implemented. The development of the Basel IV Standardized Model is already new. Besides there are floors that needs to be implemented. For these the floors themselves are not so much the challenge as well as the effect they have. So, we see a choice for broad insight in SA vs IRB results and Floored vs Unfloored results. These insights are triggering discussion about making a choice between IRB and SA models in capital planning and pricing. Therefore, we see the granularity in data improving which makes banks more flexible in their reporting and planning decision making.

It is clear Basel IV is triggering desired discussion about more transparency in the model function and comparability between peers.

11 Status 2020 Current 2023 Go Live 2028 Full Implementation

• Policy & Requirements • Just updated with new • CRR3 will be available and • Eyeing the comparability DoD and NPE requirements. some adjustments needs to of banks in terms of Capital Evaluation for Basel IV be done. 2023 is only the reserves and IRB models a ongoing awaiting finalization first step in implementing further rationalization of the of CRR3. the complete framework to model landscape continues. Requirements already set 2028. We expect business pricing with use of Basel Frame- differentiation requirements work. Impact studies and to increase. PoC’s finalizing. Awaiting EBA reporting templates.

• Architecture & IT systems • The integration of the • When Basel is live the inte- • We expect in the end state finance and risk data and re- grated FR functions in many situation that banks are bale porting function is ongoing banks are live. Adjustments to “play with the capital for years. Now it is entering to the FR implementation requirements”. They will the end game of showing and decommissioning of evaluate the numbers based results and benefits. For the redundant applications will on their information from model function the new FR be the main challenge. IFR, ALM, Stress testing and data architecture should Capital planning. start to pay off in terms of costs and transparency.

• Data Management • We see the single sources • At Go Live there will be • In the end state we hope to of truth in FR emerging. FR mostly hybrid solutions with see a mature data manage- Data dictionaries are matur- target platforms present ment function. However, in ing, and Data quality is man- combined with supplying data challenges are emerg- aged. We see a turnaround data marts. Data logistics will ing on a daily basis. from data use to data owner be more mature and fresher in managing DQ and solving than currently. DQ issues.

• Capital Calculation & Capi- • The new SA approach • For implementation data • A daily reporting system re- tal Reporting needs to be designed and still a monthly reporting mains the target and should implemented. chain will be in place, but be the ambition of any bank. The input and output floors it will be much shorter and need to be designed and fresher with mostly daily implemented. data refreshments. As the We see a mostly monthly data will be richer including batch reporting chain. For three Basel IV requirements Basel IV there needs to like external client ratings be a good online Capital and more data from the con- calculation process in place. tract at inception. Remedia- Detailed Basel IV reporting tion efforts continue as they requirements are not known are paying off. yet but it would be wise to aim for the lowest possible granularity level to facilitate transition calculations and avoid allocations.

• Business Impact • Currently capital require- • At go Live Capital add-ons • Target for business is more ments are seen as a neces- from Basel IV are more an focusing on business than on sary addition to the price option for pricing where the regulatory cost compo- banks will have the choice nent. It should be possible to between Standardized and offer products for competi- internal models. Improving tive pricing. The playing field capturing of client data will will more equal than every continue to pay off with increased transparency in capital calculations.

12 So, what we see is that banks are implementing Basel IV and at the same time taking the opportunity for improvements. BCBS 239 and new CRR regulations allow them to make fundamental improvement choices, and to re-allocate their resources and save costs in developing models (adjusting historical data) and application architecture. There is still a long way to go to the desired state, but we see FR integration initiatives paying off.

5

How can we help?

Aspect Short Term Support Intermediate Support ( Project support) (Solution offer)

Policy & Requirements BIV Advanced Requirements Analysis Policy Adherence Automation

Architecture & IT systems IT readiness Scan Target Finance and Risk Architecture transformation

Data Management Data Analysis Data Management Flywheel

Capital calculation & Capital Reporting Model Readiness Analysis Model portfolio OptimisationCapital SA implementation (chain) Calculation Optimisation Floor implementation Model Optimisation

Business Impact Pricing Analysis Pricing Paradigm shift design RAROC analysis Basel IV Business Maturity Assessment

Please work with us to determine your needs in getting Basel IV compliant.

13 6

Conclusion

There is no doubt that Basel IV has a significant implementation effect on banks’ processes and systems. There is already effect from BCBS 239 implementation and the new DoD. And now there is this pandemic impact from COVID –19 hurting capital buffers.

So far the lesson is, there is no Basel IV solution, banks need to leverage on your FR and Model Integration efforts. Specifically add Basel IV requirements like SA models and floors to the optimized implementations. Now there is the opportunity to build on revised or new FR platforms. In addition, try to use them as much as possible. Look for those benefits and savings! Since most banks are still in the starting phase, they can analyse common effects and make use of the achievements under other two regulations to save costs and stimulate the implementation of Basel IV. There is model optimisation initiatives, finance and risk IT integration initiatives, data logistics optimizations and reporting initiatives. The challenge is to leverage on these initiatives and orchestrate them to have the best and most realistic Basel IV implementation possible. This requires transformation planning and a lot of stakeholder alignment.

Besides banks may now have enough incentives to move towards the standardized approach and focus more on business case modelling again and taking the standardized capital numbers for efficiency reasons. In that sense the deferral of the Basel IV implementation deadlines may be an unexpected gift.

There is another thing which than comes into mind and that is the opportunity of testing solutions that facilitates simplifications of your portfolio’s. Why not try it on some? New technologies are opening ways that are closed in legacy situations but with Basel IV there is the time to test new technologies.

Sincerely Yours

The Capgemini Invent risk and regulatory innovation team

Casper Stam Fons Pommée Head of Data, Finance, Risk Lead, Risk and Regulatory and Regulatory Intelligence [email protected] [email protected] tel. +31 6 2220 4304 tel. +31 6 1503 0985

Elena Paniagua Avila Siyun Han Managing Consultant Data, Finance, Consultant Data, Finance, Risk Risk and Regulatory and Regulatory [email protected] [email protected] tel. +31 6 1524 5949 tel. +31 6 2130 8815

14 References

1. Basel Committee on Banking Supervision (2020), Governors and Heads of Supervision announce deferral of Basel III implementation to increase operational capacity of banks and supervisors to respond to Covid-19. Retrieved from: https://www.bis.org/press/p200327.htm

2. Rick Vermeer (2018), Banking – It’s no longer about money. Retrieved from: https://www.capgemini.com/2018/11/ banking-its-no-longer-about-money/

3. EBA (2016), Final Report, Guidelines on the application of the definition of default under Article 178 of Regulation (EU) No 575/2013. Retrieved from: https://eba.europa.eu/sites/default/documents/files/ documents/10180/1597002/fe1db887-c6dc-4777-89c1-4f243584cafd/ Final%20draft%20RTS%20on%20the%20materiality%20 threshold%20for%20credit%20obligations%20(EBA-RTS-2016-06).pdf

Basel Committee on Banking Supervision (2019), Seventeenth progress report on adoption of the Basel regulatory framework. Retrieved from: https://www.bis.org/bcbs/publ/d478.pdf

15 About Capgemini Invent

As the digital innovation, consulting and transformation brand of the Capgemini Group, Capgemini Invent helps CxOs envision and build what’s next for their organizations. Located in more than 30 offices and 25 creative studios around the world, its 7,000+ strong team combines strategy, technology, data science and creative design with deep industry expertise and insights, to develop new digital solutions and business models of the future. Capgemini Invent is an integral part of Capgemini, a global leader in consulting, digital transformation, technology and engineering services. The Group is at the forefront of innovation to address the entire breadth of clients’ opportunities in the evolving world of cloud, digital and platforms. Building on its strong 50-year+ heritage and deep industry-specific expertise, Capgemini enables organizations to realize their business ambitions through an array of services from strategy to operations. Capgemini is driven by the conviction that the business value of technology comes from and through people. Today, it is a multicultural company of 270,000 team members in almost 50 countries. With Altran, the Group reported 2019 combined revenues of €17billion.

Visit us at www.capgemini.nl/invent

Capgemini Invent P.O. Box 2575, 3500 GN Utrecht Tel. + 31 30 689 00 00 www.capgemini.nl/invent 06-031.20

The information contained in this document is proprietary. ©2020 Capgemini Invent. All rights reserved.

16