Basel 4 – the effect on Swiss How to act adequately March 2020 Brochure / report title goes here | Section title goes here

02 Basel 4 – the effect on Swiss Banks |How to act adequately

Summary

The aim of this paper is to (LTV) metric is needed for both This article examines the impact understand the drivers of the RWA standardized and AIRB banks. of the Basel 4 post-crisis reforms impacts across the different Furthermore, proper documentation (published in December 2017) portfolios of a typical Swiss , on this portfolio is necessary for for a typical Swiss retail bank. and hence shed light on which components of the bank will be appropriate allocation of capital. In particular, this article will most affected. This paper further Other portfolios that require focus on the updated credit gives guidance on first steps to take further attention are: exposures to framework, as well as the impact to start understanding the impact corporates (especially SME), project of the newly introduced output of the reforms on required data, financing (as part of specialised lending) and retail exposures to floor for banks using internal changes in processes, changes SME. For certain portfolios, the risk models. Our assessment indicates in modelling and the required governance, and how Swiss banks weights used in the standardised that Swiss banks with internal could commence implementation of approach depend on external rates, models are expected to have an these reforms. which require a due diligence process increase in capital requirements from the bank. Due to the capital as a consequence of the output As previously mentioned, the focus floor, AIRB banks will also have to get a deeper understanding of the floor. While in some countries, of this paper will be the changes in banking book equirements behaviour of their portfolios under high LTVs will lead to a significant and are from both a standardised the standardised approach. increase under the standardised and (advanced) internal ratings Analysing and understanding approach, in Switzerland we based (AIRB) perspective. The how the reforms will affect the analysis shows that overall impact of estimate far milder impacts as various portfolios of the bank and the reforms is particularly driven by a consequence of lower LTVs. how these drive the significant the new standardised approach for These observations are consistent increase in required capital is of the real estate portfolio, combined with the QIS impact studies paramount importance to Swiss with the introduction of a capital banks to ensure required capital is performed by BCBS 1. Even though floor for risk weighted assets (RWA) allocated appropriately to the various the overall credit risk framework at AIRB banks. In-depth analysis of components of the bank. Banks under Basel 4 is generally in line the composition of the real estate are therefore challenged to start portfolio and its responsiveness with Basel 3, it includes a number collecting new data as described in to the regulatory Loan-to-Value of enhancements for specific the requirements of the reforms. portfolios that will impact certain business and products. Fully understanding the changes and their impacts is hence crucial to adequately (re)define the capital plan, identifying mitigation levers and consequently the business strategy. Without this understanding, inappropriate allocation of capital requirements will occur. Inappropriate allocation will result in obscuring bad lending, lower availability of growth in low loss portfolios, mis- pricing of products and, therefore, increased cost to customers.

Further details: https://www.bis.org/bcbs/qis/

03 Basel 4 – the effect on Swiss Banks |How to act adequately

An introduction to the reforms

The Basel 4 reforms were finalised by the standardised approaches, increasing their have on the various portfolios of the bank Basel Committee on Banking Supervision sensitivity and granularity. The standardised will drive appropriate allocation of required (BCBS) in December 2017 and aim to further approaches are made more suitable to capital to the various components of the strengthen the regulation, supervision and complex banks that previously were only bank. practices of banks worldwide, with the reliant on IRB models, but will have to The following picture summarises the most purpose of enhancing financial stability. comply with the output floor requirement. important changes from Basel 4 for a bank: This is a fundamental overhaul of the Understanding the impact these changes

Restriction of full IRB Introduction of capital Revision to credit risk and introduction of risk output floor standardised approach parameter floors

• The output floor restricts the bank- • The introduction of the capital floor • AIRB is withdrawn for exposures to level internal RWAs to 72.5% of the means that the SA RWA calculation will banks; financial institutions; large standardised RWAs. have to be implemented by all banks, corporates; and equities even those applying IRB. • For banks that actively manage their • For high-volatility commercial real estate, capital in coordination with business, the • Risk weights of exposures secured slotting is used. Specialised lending can capital floor will substantially impact the by real estate based on loan-to-value be subject to either slotting or either of allocation of capital costs, pricing and diversification. the IRB-approaches capital planning. • Separate risk weights for investment • Double default approach is withdrawn • The introduction of the capital floor property as well as the leverage ratio constraint • (PD) floor increases means that banks will have to manage • External ratings still allowed in most to 5bps from 3bps their capital across multiple fronts: jurisdictions and subject to appropriate due diligence • Unsecured (LGD) floor exposure contributions, standardised of 25% for corporates; 50% for qualifying RWAs and internal RWAs. • Minimal (CCF) of residential real estate exposure (QRRE) • The floor introduces an increased 10% for all exposures exposures complexity in the capital planning • Secured LGD floors imposed, varying by exercise. Impacts of the floor need to be collateral type understood not only in the current state but also under business scenarios and market stress.

BaselBasel 3III

Real estate Focus of impact study: core components of Swiss retail banking: Residential RW of 35% This article will focus on the core components of the balance sheet of a Swiss retail bank, real estate Commercial namely the real estate and corporate lending portfolios. In particular, mortgages comprise RW of 100% approximately 40% of the overall lending, and will hence be a key element when assessing real estate the impact of the regulatory changes.

Impact of changes to SA for real estate portfolios Basel 4IV Under the Basel 3 SA, claims secured by residential or commercial real estate are assigned Self-occupied risk weights of 35% and 100% respectively. As mentioned above, the introduction of the Residential ouput floor entails that every bank is impacted by the SA risk weights. In Basel 4, the real estate “Whole loan” approach or “Loan standardised approach is revised by introducing an increased level of granularity. Commercial splitting” approach real estate Indeed, the Basel 4 SA treats claims secured by real estate differently depending on whether the real estate is residential or commercial, and whether or not the exposure is dependent on the cash flow generated by the property. For each of the four property Income-producing groups, the bank is to apply the so-called “whole loan” approach, where risk weights are Residential assigned to different LTV buckets. If permitted by the local supervisor, an alternative real estate “Whole loan” approach “loan splitting” approach can be applied for exposures secured by real estate that are not Commercial real estate materially dependent on cash flow generation.

04 Basel 4 – the effect on Swiss Banks |How to act adequately

Effect of the capital floor

As discussed previously, one of the key conditions. The impact of the capital floor aim to manage their capital efficiency by changes under Basel 4 is the introduction is expected to be felt the hardest by the incentivising RWA reducing trades. Since of the capital floor, which sets a limit for larger banks, which are using primarily the overall depends how much banks can benefit from internal internal models to calculate their on both internal as well as standardised models. The rationale behind this floor capital charges. RWAs, the allocation of capital costs ought is to (i) weaken incentives for developing to take into account both metrics. Whereas “optimistic” RWA-reducing internal models In addition to the technical implementation, some portfolios contribute heavily to the and (ii) improve the comparability of capital the capital floor introduces new internal risk measurements, they might outcomes across banks. The final capital challenges in the allocation of RWA to lead to relatively lower contributions to the floor is set to 72.5%, and will be introduced the various business lines within a bank. standardised RWAs, and vice versa incrementally from 2023 to 2028, with the Capital performance, including return (see Figure 1 below). transitional period giving institutions time on regulatory capital, is a key metric for to adjust their capital base to the new investors. Hence, financial institutions will

Figure 1: Comparison of risk weights calculated with the standardised approach vs IRB approach

A desirable allocation approach ought to have the following characteristics:

• Lead to a management of both standardised and internal capital ratios, as investors are likely to consider both metrics;

• Holistically take into account not only group consolidated capital, but also subsidiary stand-alone;

• Reflect the “cross-subsidisation” of capital requirements between internal model RWAs and floor contributions;

• Be intuitive and simple, such as to be easily embedded within business decision making as well as capital planning;

• Not be (excessively) sensitive to portfolio changes. That is, the capital cost allocation to one business / division, should not be (significantly) affected by portfolio or RWA changes in other business units.

05 Basel 4 – the effect on Swiss Banks |How to act adequately

The Leverage Ratio constraints further capital costs into business planning and manage their capital performance across complicate the capital cost allocation pricing. Even though today the regulatory all three fronts simultaneously; leverage Indeed, the capital cost allocation should capital requirement is determined by one ratio, standardised RWAs and internal not only take into account a trade’s RWA of the three constraints (internal RWAs, RWAs. In Switzerland, the leverage ratio (standardised and internal), but also floor or leverage ratio), this “limiting” has already been in effect for two G-SIBs consider its exposure. constraint is likely to change in the future, since the height of the financial crisis. For as portfolios are managed to increase these institutions, the management of Many financial institutions actively manage capital efficiency. As a consequence, capital across different metrics will be a their capital efficiency and incorporate capital efficient institutions ought to recognisable theme.

06 Basel 4 – the effect on Swiss Banks |How to act adequately An example: A typical Swiss Retail Bank

The impact of Balance sheet statement (asset side) typical Swiss bank the reforms on Millions of CHF, end of period various portfolios is 2018 Note calculated for both Cash and balances at central banks 11'300 a standardised bank Loans and receivables: 50'000 as well as for an IRB Central banks and central governments 2'000 1 bank using the asset Institutions 4'000 2 side of the balance Corporates 15'500 of which specialized lending 1'000 3, 7 sheet of a typical of which SME 6'800 4 Swiss retail bank. of which other lending 7'700

A typical retail bank in Switzerland Retail 8'500 has a substantial real estate of which qualifying revolving 2'800 6 portfolio and a big large corporates portfolio, combined with smaller of which other retail 5'700 8 portfolios in other asset classes. Real estate 20'000 The constructed balance sheet of which self-occupied residential real estate 6'800 5 on the right side is based on information from SNB as well as of which income-producing residential real estate 10'200 5 annual reports of multiple Swiss of which commercial real estate 3'000 5 banks, and is hence considered representative of a Swiss retail Financial assets at fair value held for trading 10'900 9 bank. Derivative financial instruments 13'200 10

Financial assets at fair value not held for trading 8'600

Other assets (e.g., goodwill, intangible assets, deferred tax assets, 6'000 11 property, etc.)

Total assets 100'000

Table 1: Balance sheet of the fictional bank

1.Blended portfolio of AAA to A- rated central banks and central governments (95% AAA to AA-, 5% A+ to A-) exposures 2.Long term exposures in a blend portfolio of AAA to A- rated institutions (50% AAA to AA-, 50% A+ to A-) 3.Assuming object and commodity finance exposures and operational phase for Project finance exposures 4.Assuming no regulatory retail SME and therefore risk of counterparty is equal unrated SME exposures with a risk weight of 85% 5.For these exposures it is assumed that the whole loan approach corresponding to each real estate type is applied 6.This includes overdrafts, credit card receivables, etc. All exposures qualify as ‘regulatory’ retail and exposures are 50% ‘transactors’ and 50% ‘non-transactors’ 7.Exposures are assumed unrated 8. Including Lombard lending 9. Treated under framework 10. Treated under Market Risk and Counterparty Credit Risk framework 11. Deducted or risk-weighted - no major impacts expected due to introduction of Basel 4

07 Basel 4 – the effect on Swiss Banks |How to act adequately

Impact on a standardised Bank

Volume wise the key drivers Table 2 shows that the reforms will decrease to be collected on the property value at of the Swiss bank's balance required capital for a typical Swiss standardised origination, the various LTV buckets, the type of sheet are the corporates and bank by approximately 9% . This decrease is exposure (income driven or rental/sale driven) residential mortgages portfolios. driven by the real estate portfolio. In addition, and the LTV movements over time of these Under Basel 4, the standardised further attention should be paid to corporate exposures. The reforms also require proper approach methodology for real SMEs and QRRE. documentation on the exposure to allow for estate exposures has been reduced risk weights. For the other portfolios In Switzerland, mortgages have origination LTVs of interest, similar in depth analysis will be overhauled by introducing that are commonly capped at 80%, but are a "risk-sensitive" LTV-based necessary. Exposures to corporates are often of higher quality with lower LTVs. This diversified using external ratings. Using these approach. The decrease in could result in Swiss retail banks with strong risk-weighted assets is primarily external ratings will require a due diligence underwriting standards and low LTVs to process by the bank. driven by the newly introduced benefit from the new regulations of treatment LTV diversification for exposures of residential mortgages and commercial real Appropriately analysing the drivers of secured by real estate. Assigning estate under Basel 4. Analysis of the effect the decrease in required capital for these the exposures to appropriate of the reforms on the real estate portfolios portfolios, will bring forward opportunities to risk weights requires some new will be important, to determine the impact. further decrease the risk-weighted assets and procedures for banks A proper understanding of the sensitivity of will encourage appropriate and can only be performed the portfolios over time to the regulatory LTV allocation of capital requirements. if appropriate data on these metric will strengthen management’s decisions exposures is collected. on these exposures. To enable banks to perform this in-depth analysis, data need

Basel 3 Basel 4

Risk weighted Risk weighted Risk weight Risk weight Effect (+/-) assets assets

Sovereigns and their 1% 20 1% 20 0% central banks

Banks and securities 25% 1'000 25% 1'000 0% traders

Corporates

Corporates - 100% 1'000 100% 1'000 specialized lending

Corporates - SME 100% 6'800 85% 5'800 -10%

Corporates - other 75% 5'800 70% 5'400 lending

Retail

Retail - qualifying 75% 2'100 60% 1'700 revolving -5% Retail - other retail 100% 5'700 100% 5'700

Real estate

Self-occupied 35% 2'400 30% 2'000 residential real estate

Income-producing 35% 3'600 35% 3'600 -12% residential real estate

Commercial real 100% 3'000 75% 2'300 estate

Total 31'420 28'520 -9%

Table 2: Basel 3 versus Basel 4 risk weights and risk weighted assets for the fictional bank Given a balance sheet total of 100 billion and an average capital ratio of 18% 08 Basel 4 – the effect on Swiss Banks |How to act adequately

Impact on an AIRB bank

Table 3 shows that the reforms will increase required capital are necessary to make sound The increase in riskweighted required capital for a typical Swiss AIRB bank management decisions on investments in AIRB assets is primarily driven by approximately 30%, and is driven by the modeling and mitigating measures. Furthermore, by the newly-introduced introduction of the capital output floor. AIRB banks should consider how the output floor output floor. The output is affecting the required capital allocation to the It is important to note, however, that in this various components of the bank. floor requires AIRB banks article, the output floor is applied directly to the to comprehend the drivers credit risk RWAs, and hence does not take into In addition to the output floor, Basel 4 restricts of required capital using account any potential offsets from other risk banks from applying the AIRB approach to the standardised approach. types (e.g., market risk or ). The certain portfolios such as institutions and large "cross-subsidisation" of RWAs across the different corporates. For these portfolios it is still possible Furthermore, AIRB banks risk types, means that overall impact of the to use the Foundation IRB approach (FIRB). need to consider how to output floor is likely to be less severe. Assessing When utilising this method, only the probability allocate the required capital the impact on the credit portfolio, however, still of default (PD) is calculated by the bank itself; due to the application of provides valuable insights regarding the future the parameters for other components in the risk the floor to the various capital management under the floor regime. weight calculation are based on the supervisory estimates. Banks need to investigate components of the bank. In the banking book credit portfolio, the whether investing in this approach versus introduction of the output floor will primarily the standardised approach provides for affect the capital contributions of corporate better allocation of required capital. Note that exposures, commercial real estate, and observations for AIRB models made in this article, specialised lending portfolios. In-depth largely hold for FIRB models as well. analysis of these portfolios and the drivers of

Basel 3 Basel 4

Risk weighted assets Risk weight Output floor Effect (+/-) (pre floor)

Sovereigns and their central 2% 40 14 banks

Banks and securities traders 30% 1'200 700

Corporates

Corporates - specialized lending 50% 500 700 +45%

Corporates - SME 40% 2'700 4'200 +54%

Corporates - other lending 50% 3'900 3'900

Retail

Retail - qualifying revolving 35% 1'000 1'200 +20%

Retail - other retail 35% 2'000 4'100 +105%

Real estate

Self-occupied residential real 20% 1'400 1'500 +7% estate

Income-producing residential 25% 2'600 2'600 real estate

Commercial real estate 30% 900 1'700 +89%

Total 16'240 20'610 +27%

Table 3: The effect of the output floor on the portfolio of the fictional bank Given a balance sheet total of 100 billion and an average capital ratio of 18% 09 Basel IV – the effect on Swiss Banks |How to act adequately

10 BaselBasel IV 4 – the effect on Swiss Banks |How to act adequately

What can Swiss banks do?

Focus on Actively manage Loan-to-Value (LTV) Balance sheet and portfolio implementation challenges for the real estate portfolio management under the floor regime

Understanding the impact of the reforms The real estate portfolio is a key element In order to efficiently manage capital on the various components of the bank is of a Swiss bank’s balance sheet. Defining under the new reforms, it is advisable for key to ensuring appropriate allocation of appropriate property valuation policies at financial institutions to assess their capital required capital; however, implementation inception of a mortgage loan will improve performance on three fronts; internal of the new requirements will be challenging. LTV-dependent calculations. Furthermore, RWAs, standardised RWAs and leverage New definitions of metrics like LTV have to banks should evaluate LTV movements ratio. To achieve this, banks ought to be interpreted and data on these metrics over the lifetime of the loan of their annuity develop a capital cost allocation approach needs to be mapped and collected. Other and linear residential mortgage portfolio that reflects the cross-subsidisation of metrics, like the use of external credit risk to balance the growth rate of the portfolio. capital requirements between internal ratings, require a due diligence process For the illustrative Swiss balance sheet model RWAs, floor contributions and with appropriate governance. Portfolios presented in this article, the overall impact exposures, all while being intuitive and might have to be redefined to meet newly of the floor on the real-estate portfolio was simple. introduced subcategories of exposures, limited. The impact, however, significantly and changes in flat rates like the conversion depends on the composition of the factor need to be adjusted. Implementation mortgage portfolio and the corresponding of the floor for AIRB banks also requires IRB models. It is hence important that understanding at the appropriate banks evaluate how the new regulations level of management of the drivers of will affect the capital charges stemming required capital due to the standardised from their real estate portfolio. approach. It is important for banks to start collecting data and perform analysis as soon as possible to allow for appropriate understanding of the effects of the reforms.

Reconsider investment in models Consider impact on pricing

Given that Basel 4 does not allow banks to Since the reforms will increase required use AIRB models for exposures to capital for banks, this comes at a cost. institutions and large corporates and Banks should adjust their pricing model to taking into account the output floor, allow for the increase in cost to be included. banks should evaluate investments in internal models, consider the option to use FIRB approach or a full standardised approach and consider alignment with models used for other purposes like IFRS 9 and stress testing.

11 Deloitte Risk Advisory CH Deloitte Centre of Excellence for Financial Risk Modelling Regulatory Reporting Deloitte Risk Advisory B.V. General-Guisan-Quai 38 8022 Zürich Switzerland Gustav Mahlerlaan 2970 1081 LA Amsterdam The Netherlands Philipp Flockermann T: +41 58 279 6026 Ronald Koppen E: [email protected] T: +31 6 12345126 E: [email protected] George Garston T: +41 58 279 7199 Eelco Schnezler E: [email protected] T: +31 6 12345158 E: [email protected] Hallgerður Helga Þorsteinsdóttir T: +41 58 866 5611 Noortje Corbey E: [email protected] T: +31 6 11 620 775 E: [email protected]

Dirk Boersma T: +31 6 8333 0462 E: [email protected]

Michiel Mulder T: +31 6 3085 9067 E: [email protected]

Stijn Roersch T: +31 6 8201 9475 E: [email protected]

Important notice

This publication has been written in general terms and we recommend that you obtain professional advice before acting or refraining from action on any of the contents of this publication. Deloitte AG accepts no liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication.

Deloitte AG is an affiliate of Deloitte NWE LLP, a member firm of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”). DTTL and each of its member firms are legally separate and independent entities. DTTL and Deloitte NWE LLP do not provide services to clients. Please see www.deloitte.com/ch/about to learn more about our global network of member firms.

Deloitte AG is an audit firm recognised and supervised by the Federal Audit Oversight Authority (FAOA) and the Swiss Financial Market Supervisory Authority (FINMA).

© 2020 Deloitte AG. All rights reserved.