EBA Report on Basel IV

The impact of Basel IV in the EU and the impact on pricing and capital optimization

October 17th, 2019 5th Annual Capital Relief Trades Seminar Agenda

1. Introduction - CRR II and Basel IV 2. The most important contents of CRR II at a glance 3. Basel IV - Contents and impacts 4. EBA Report on Basel IV implementation in the EU 5. Pricing and capital allocation

CRR II and Basel IV October 2019 PwC 2 The new requirements will come into force in stages from 2019

2019 2020 2021 2022 2023 2024

16.04.19 07.06.19 27.06.19 + 1 year June 28, 2021 + 4 years Publication in the EBA RTS on Own funds Adoption in the Entry into force Date of first EU Official Software EU Parliament of the CRR II application CRR II Journal Deduction Market

Securitisations

Definitions

Editorial

Mandates RTS / ITS

Equity Deduction (Exceptions), Compliance Tool, MDBs

MREL / TLAC

Immo LGD estimation Own funds requirement DA RTS CRR + CRD V II reporting A-SA / A-IMA

SA-CCR, Investment funds, NSFR, LR, large LR: G-SII buffer exposures, IRRBB, step- as of 2022 in-risk, disclosure, CCP EM

Floor: Output Floor, SA, IRBA, Transitional IV CVA, OpRisk regulations until Basel 2027

DA: Delegated act Transitional period publication until entry into force Date of application regulations Transition period until date of application CRR II and Basel IV October 2019 Date of application essential CRR II regulations PwC 3 Expected date of application essential Basel IV regulations The central requirements of CRR II at a glance

Counterparty (SA-CCR) NPL Backstop Own funds + consolidation MREL & TLAC

• Introduction of a new standardised • Implementation of the NPL Backstop • Profit transfer agreement • Introduction of TLAC in the EU approach to counterparty credit risk through separate CRR Amendment • New deduction positions • Extensive harmonisation with MREL (SA-CCR) • Additional capital deduction for the • holding companies regulations • Consideration of collateral agreements portion of non-performing exposures and netting not covered by risk provisions capital requirements complexity capital requirements complexity • Significant increase in risk sensitivity, • Increase over time, depending on OpRisk Net Stable Funding Ratio (NSFR) data requirements and complexity available collateral • Simplified procedures for institutions • Complex calculation methodology and • Consideration of depreciation on • Transformation into a binding minimum with small derivatives portfolios extensive data requirements leased assets analogous to interest ratio expense for loans • Simple alternative for small capital requirements complexity capital requirements complexity capital requirements complexity capital requirements complexity

Market risk (FRTB) Counterparty risk Leverage ratio Large exposure

• No new rules for the boundary between • Expansion of the SME factor and • Introduction of mandatory minimum • Limits based on banking book and trading book introduction of infrastructure supporting ratio (3%) and G-SII buffer • Changes in credit risk mitigation • New standardised approach for highly factor • New derogations complex market • Nomination of further MDBs and capital requirements complexity capital requirements complexity • New internal models approach for international organisations market risks with new approval • Monitoring RW for receivables secured Reporting Disclosure procedure by real estate • Reporting requirements starting from • New approaches to the treatment of • Scope / frequency of reporting • Amendment / extension of disclosure in 2020/21 for standardised approach shares in investment funds depending on size + complexity accordance with Basel requirements • EBA develops granular data model • proportionality

capital requirements complexity capital requirements complexity capital requirements complexity capital requirements complexity

CRR II and Basel IV October 2019 PwC 4 Introduction of the capital floor Impact of the capital floor on RWA and capital ratios

Calculation of the capital floor Impact on capital ratios

Example 1: Increase in MR and CR Own funds 8% 150 ≥ + Capital conservation buffer ; + Anti-cyclical capital buffer 100 100 , + G-SII buffer 72.5 (21% increase) 𝐑𝐑𝐑𝐑𝐑𝐑𝐈𝐈𝐈𝐈 + O-SII buffer 𝑴𝑴𝑴𝑴𝑴𝑴 60 𝟕𝟕𝟕𝟕 𝟓𝟓ퟓ𝟓𝟓𝐑𝐑𝐑𝐑𝐑𝐑𝐒𝐒𝐒𝐒 + Systemic risk buffer 50 + Pillar 2 Requirement (P2R) ! 0 RWA (IRBA, before Floor) RWA (SA) RWA (after Floor) Further challenges OpR MR CR Example 2: No internal model for MR, only use IRBA • Introduction under transitional arrangements (5 years, 25% increase p.a.) 150 • The amount of the additional RWA due to the application of the capital floors must be disclosed. 100 100 • RWAIM and RWASA should be reported and disclosed at the level of the 72.5 (21% increase) 60 exposure classes 50 • The floor must be maintained at all levels (solo, subgroup, group). • No adjustment to floor calculation to take account of the different treatment of 0 credit risk adjustments in the CRSA and IRBA (analogous to Basel RWA (IRBA, before Floor) RWA (SA) RWA (after Floor) specification) OpR MR Real Estate Retail Corp. Summe CR CRR II and Basel IV * PU: partial use October 2019 PwC 5 The Credit Risk Standard Approach (CRSA) Exposure classes Banks and Corporates

Banks Corporates • Derivation of the risk weight from external rating - due diligence necessary • Derivation of the risk weight from external rating - due diligence necessary

AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- external AAA A+ to BBB+ to BB+ to Below Unrated rating to AA- A- BBB- BB- BB- 20% 30% 50% 100% 150% Base RW 20% 50% 75% 100% 150% 100% 20% 20% 20% 50% 150% • Risk weight 85% for exposures to SMEs, but abandonment of the SME factor in the EU • In the case of unrated banks, abandonment of the country of domicile principle and • New specialised lending sub-category with its own risk weights allocation to risk grades: Category RW Grade A Grade B Grade C Object financing 100% 30%/40% 75% 150% Commodity financing 100% 20% 50% 150% Project financing (pre-operational phase) 130% Project financing (operational phase) 80%/100% Implementation challenges • Abandonment of the infrastructure supporting factor in the EU • Scope of the required Due Dilligence – Analysis „require institutions to design a rigorous internal process for challenging the credit assessments provided by ECAIs“ Implementation challenges • Data origin - group vs. solo level • Scope of the required due diligence • Basis for allocation to risk levels • Definition of specialised lending operations in the database • Significant increase in capital requirements for unrated banks

capital requirements complexity capital requirements complexity

CRR II and Basel IV October 2019 PwC 6 The Credit Risk Standard Approach (CRSA) Exposures secured by real estate

Residential real estate Commercial real estate General requirements

If the operational requirements are met If the operational requirements are met • Valuation using an independently determined, • RW = 20% for up to 55% of the real estate value • RW = Min (60%; counterparty's RW) for up to 55% of sufficiently conservative value, not taking into account the potential for future increases in value. • RW of the counterparty for the remaining part the real estate value • Abandonment of the use of market values and mortgage • No implementation of the LTV approach / Whole loan • RW of the counterparty to the remaining portion lending values in favour of uniform specifications approach • No implementation of the LTV approach / Whole loan • Maintaining the CRR requirements for monitoring and If the operational requirements are not met approach adjusting the assessment • Risk weight of an unsecured exposure to the borrower If the operational requirements are not met General treatment General • Risk weight of an unsecured exposure to the borrower

• Assess whether assignment to IPRE is based on the LTV ≤50% 50% < LTV ≤60% 60% < LTV ≤80% LTV ≤ 60% 60% < LTV ≤ 80% LTV > 80% ability to service the loan from sources other than the property income. Other sources may also include other 30% 35% 45% 70% 90% 110% properties

IPRE • Hard test 80% < LTV ≤90% 90% < LTV ≤100% LTV > 100% 60% 75% 105%

• RW = 150% • RW = 150% • RW = 100%, if the project risk has been reduced, e.g.

ADC through advance sale / pre-letting contracts - to be interpreted further by EBA RTS

capital requirements complexity capital requirements complexity

CRR II and Basel IV October 2019 PwC 7 The Credit Risk Standard Approach (CRSA) Other exposure classes

Equity and subordinated liabilities Retail Other items

• RW = 250% for equity • RW = 75% for sufficiently granular portfolios (to be • The standard risk weight for all other assets is • RW = 150% for subordinated debt and capital interpreted by EBA RTS) 100%. instruments and for liabilities meeting the definition • RW = 45% for "Transactor" exposures, e.g. from • A risk weight of 0% applies to holdings of cash of 'other TLAC liabilities’ credit card receivables, if these have always been and gold bars held at the (or at another bank, • RW = 400% for speculative unlisted equity repaid in due time within the past 12 months. provided that they are kept in a safe place to avoid investments • RW = 100% for exposures to an individual or insolvency). • No adoption of the Basel exemption for equity persons who do not meet all criteria, unless they • 20% risk weight for cash receivables in the entered into within the framework of national are secured by real estate. process of being collected support programmes • Approximation of the definition of the residual • Debt/equity swaps from the restructuring of value of leased assets in the CRSA and IRBA as receivables are generally allocated to the the carrying amount at the end of the lease term, exposure class and receive a risk weight of 250% after deduction of minimum lease payments and or 400% respectively. purchase options (current distinction between • Equity and subordinated liabilities currently exposure value and residual value). classified as positions with a particularly high risk receive a risk weight of 250% or 400% respectively.

capital requirements complexity capital requirements complexity capital requirements complexity

CRR II and Basel IV October 2019 PwC 8 The Credit Risk Standard Approach (CRSA) Further changes

Off-balance sheet items Credit risk mitigation Currency mismatches

• Revision of the structure and allocation criteria of • Changes in the applicable haircuts in the • Adjustment of the risk weight for exposures to off-balance sheet items to risk categories comprehensive method natural persons in the exposure class Retail or according to Annex I of the CRR under an RTS • New formula and new haircuts for the netting of secured by residential real estate • Adjustment of the credit conversion factors to be securities financing transactions (SFTs) • Increase of the risk weight by application of an applied: • Changes to the list of eligible guarantors multiplier of 1.5 up to an upper limit of 150%. • Exclusion of basket credit derivatives as credit risk • If there are currency mismatches between the 120% mitigation technique in the CRSA currency in which the loan is denominated and the 100% • Adoption of the proposals for credit risk mitigation currency in which the borrower derives his income 80% from the EBA Report of March 2018 • Exceptions are positions hedged against currency risks; if banks cannot identify these, the multiplier 60%  Balance sheet netting for currency mismatches is used. 40%  Eligibility of gold 20%  Classification into credit ratings based on 0% non-nominated ECAIs  …

capital requirements complexity capital requirements complexity capital requirements complexity

CRR II and Basel IV October 2019 PwC 9 The Internal Ratings Based Approach (IRBA) Overview of the Basel Committee's new requirements

Focus Essential contents Scope of Internal Models • Elimination of the IRB approach for equity exposure • Complexity • Elimination of the advanced IRB approach for banks/other financial institutions Capital reduction of the 1 (including insurance) and corporates with a consolidated turnover exceeding EUR 500 requirements regulatory framework million. and improvement of • Maintaining IRB approaches for specialised lending complexity comparability • Elimination of the IRB scaling factor of 1.06

• Reduction of Floors for model parameters Introduction of floors on PDs and LGDs Capital excessive variability 2 • Corporates: PD 0.05%, LGD unsecured 25% and LGD secured 0%, 10% or 15% requirements • Retail: PD 0.05% or 0.10%, LGD unsecured 30% or 50% and LGD secured 0%, 5%, of the capital complexity requirements for 10% or 15% credit risk Parameter estimation More information on estimation practices Capital 3 • Stability of ratings (through-the-cycle) requirements • PD estimate based on historical one-year average default rates complexity

Implementation of a capital floor Output floors for capital Capital 4 requirements • 72.5% Standardised Approach (SA) risk-weighted assets (RWA) requirements • Transitional arrangements: 50% in 2022 -> 72.5% in 2027 complexity

CRR II and Basel IV October 2019 PwC 10 EBA Report on Basel IV Results of the quantitative impact study (QIS)

The full implementation of Basel IV has high quantitative impacts!

Impact on weighted average minimum capital requirements (RWA) Impact on aggregated capital Shortfall

Using the most conservative assumptions*.

€ 135.1 € 0.9 € 0.1 24,4% 11,3% 5,5% bn bn bn

All Medium size Small All Medium size Small banks banks banks banks banks banks

*Assumptions: • Banks' balance sheets were assumed to be static • Given the uncertainty about the impact, the underlying data are likely to reflect conservative reporting by banks • The analysis assumes that current EU-specific decisions and exemptions will be discontinued and that the impact will fully reflect existing global standards. • This assessment includes the impact of Pillar 2 and the macro-prudential requirements assumed to be static in the analysis compared to the previously presented Basel impact analyses. • Due to the late finalization of the FRTB, the effects were determined based on the calibration of the market risk regulations of 2016. The inclusion of the recently adopted FRTB reform would reduce the impact.

CRR II and Basel IV October 2019 PwC 11 The impact of Basel IV on RWA is heavily dependent on the portfolio and business model

0% Floor = Floor = 50% 72,5% Total Strong influence of the capital floor on IRB RWA banks, effects of the new CRSA -10% 10% 30% 50%

Revised credit High impact on real estate, specialised risk SA lending and capital instruments -10% 10% 30%

F-IRBA partly benefits from Basel IV, no F-IRBA (New) partial use as an opportunity for CRSA pre Floor -10%-5% 5% banks

Impacts in particular from the LGD A-IRBA (New) determination of collateralised exposures, pre Floor No partial use as an opportunity for CRSA -5% 20% 40% banks

Increase especially in the case of complex FRTB (SA) products, calculation of credit risk (junk 10% 30% 100% bonds)

CRR II and Basel IV October 2019 PwC 12 The Internal Ratings Based Approach (IRBA) Impact of the new Partial Use

Exemplary impact of IRBA implementation (EUR million)

Decomposition of the portfolio Under the standardised approach, With the introduction of the IRBA for 72.5% floor 1 Basel IV leads to an increase in RWA retail exposures and exposures secured 4.527 of 21-28%. by real estate, total RWA could fall 7% 2.264 For some portfolios, the exact increase from current levels and remain above 8.356

IRBA 2 the output floor. 6.539 can only be estimated when

- 6.093 3.829 additional information is collected RWA optimization could further

SA (e.g. income-producing real estate). 4 improve the results, e.g. it helps to The new partial use allows the IRB reduce the RWA for the standard approach to be implemented only for approach. 3 certain portfolios.

RWA increase for portfolios Sovereigns 2.000 Sovereigns 2.200 Sovereigns 2.200 Sovereigns 2.200 transferred to the SA 3.000 4.300 BanksBanks 4.300 BanksBanks 4.300 2.000 3.000 SpecialisedSpecialised lending lending 3.000 SpecialisedSpecialised lending lending 3.000 Output floor - 46 038

SA Corporates 10.000 10.000 - Corporates 14.500 CorporatesCorporates 14.500 15.000 15.000 63.500 RetailRetail 22.000 RetailRetail 22.000 45.500

IRBA IRBA 10.000 10.000 43.000 RetailReal estate Mortgages finance. 16.500 RetailReal estate Mortgages finance. 16.500 1.000 1.000 Equity exposureEquity 1.000 Equity exposureEquity 1.000

RWA RWARWA (CSA) (SA) RWA RWARWA (CSA)(SA) RWA RWA RWA RWA(before) (original) RWA(afterwards) (after) CSA(SA) RWA CRR II and Basel IV October 2019 PwC 13 The floor compensation effect - a sample calculation EUROPA BANK’s initial situation

EUROPA BANK RWA overview (€ million)

Risk position EAD RWA (SA) RWA (IRBA/IM) RWA based on capital 6.227,75 Sovereigns 500 50 50 floor Banks 500 150 100 Retail other 1.500 1.125 525 RWA increase through Retail mortgages 3.000 750 300 912,75 capital floor Retail revolving 500 250 175 Equity 200 540 540 Corporates SMEs 2.000 1.500 800 Corporates 2.000 2.000 900 Taking into account the capital floor, the cost of Large corporates 500 250 175 capital can only be calculated as a "marginal Specialised lending 500 475 750 contribution to total RWA".

Total credit risk 11.200 7.090 4.315 This is because the granting of credit does not Total market risk 1000 1000 500 lead to a proportional increase in the RWA compared with the loan amount (EAD). Total OpRisk 500 500 500 Total 12.700 8.590 5.315

It is recommended to define more granular subportfolios in order to approximate the floor compensation effect even more precisely.

CRR II and Basel IV October 2019 PwC 14 EXAMPLE Calculation of the cost of capital for additional exposures must in future be carried out via “marginal contribution to total RWA” Example 1:

New Sovereign exposure The new exposure does not increase 0,50 EAD 5,00 EUROPA BANK's total RWA by The correct calculation of the cost of RW Standardised approach 10% capital for lending is carried out by calculating the effects on the total but rather by the capital floor and RWA isolated 0,50 RWA. ! the resulting 0,36 Total RWA (incl. new exposure) 6.228,11 floor compensation effect, the RWA only increase by RWA increase 0,36

The level of the floor compensation effect is determined by: 1. Loan amount Since the influencing factors on the floor Average RW (PD/LGD/EAD/KSA-RW) of the exposure class compensation effect are subject to 2. concerned fluctuations over time, these factors must be simulated on the basis of the 3. Share of partial-use exposure classes business/capital plan.

Average RW (PD/LGD/EAD/KSA-RW) of all other exposure 4. classes

CRR II and Basel IV October 2019 PwC 15 EXAMPLE The actual cost of capital can be approximated by RWA sensitivities

The RWA sensitivities express the sensitivity of the total RWA compared to the exposure increase. Alternatively, the RWA sensitivities can also be described as "marginal risk weights" based on a given portfolio.

Based on the initial portfolio, the floor sensitivities for each exposure class are as follows Example 1: Lending in the asset class sovereigns RWA RWA Floor Exposure class sensitivity Sensitivity EAD 5.00

Sovereigns 0,07% -0,03% Total exposure 505.00 Banks 0,22% 0,02% RWA increase 0.36 505.00 x 0.07% Retail other 0,54% 0,19% Total RWA after lending 6,228.11 6,227.75 + 0.36

retail mortgages 0,18% 0,08% Example 2: Retail revolving 0,36% 0,01% New equity exposure Equity 1,96% -0,74% EAD 2.00 Corporates SMEs 0,54% 0,14% Total exposure 202.00 Corporates 0,73% 0,28% RWA increase 3.95 202.00 x 1.96% Large corporates 0,36% 0,01% RWA total after new exposure 6,231.70 6,227.75 + 3.95 Specialised lending 0,69% -0,81% If the RWA sensitivities are known, it is easy to optimize the RWA/ capital costs.

CRR II and Basel IV October 2019 PwC 16 EXAMPLE Capital allocation to individual portfolios taking into account the capital floor

Capital allocation today is based on capital requirements / capital demands of individual portfolios / business units

Example EUROPA BANK The Retail unit comprises the following asset Retail other 525 classes retail mortgages 300 Therefore, a completely new form of The future capital floor leads Retail revolving 175 capital allocation must be implemented, to compensation effects sum 1,000 which can reflect the positive effects between the portfolios and as well as the negative effects of the The Corporate unit comprises the following Corporate SMEs 800 risk types. asset classes Corporate 900 capital floor. Large corporates 175 Specialised lending 750 Sum 2,625 Positive effects are allocated to a floor RWA fund, negative effects to a floor add on. These can be allocated according to the polluter. The Treasury unit comprises the following Sovereigns 50 asset classes Banks 100 Equity 540 Sum 690 Trading unit corresponds to the market risks in the trading book 500 OpRisk is applied based on an algorithm 500 The sum of the RWA of the business units corresponds to the Total RWA RWA Floor Funds RWA Floor add on RWA by floor 5,315 Total RWA 5,315 -262.25 1,175 6,227.75

CRR II and Basel IV October 2019 PwC 17 EXAMPLE Thank you for your attention.

Martin Neisen Partner Global Basel IV Leader

Mobile:+49 151 5380 0865 Phone: +49 69 9585 3328 [email protected]

DE: digital.pwc-tools.de/basel-iv pwc.de www EN: pwc.com/baseliv youtube.com/PwCBaselIVChannel DE: blogs.pwc.de/regulatory

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