Basel 4 – Emerging from the Mist? | 1

Basel 4 – Emerging from the mist? | 1

Financial ServiceS

Basel 4 – Emerging from the mist?

September 2013

kpmg.com 2 | Basel 4 – Emerging from the mist?

Executive Summary

Basel 4 – Emerging from the mist

Even before Basel 3 is supporting higher minimum leverage of banks’ internal models (perhaps fully implemented, ‘Basel ratios and reduced reliance with greater complexity allowed only on models; in the assessment of Pillar 2 capital 4’ may be emerging from requirements). the mist. Developments • A corresponding flurry of papers from the Basel Committee that Second, requiring banks to meet a in recent months lay the look beyond Basel 3, including on higher minimum leverage ratio. A groundwork: the regulatory approach to banks’ minimum leverage ratio of substantially treatment of trading books, on above 3 percent would act more as a • Some countries are already the variability across banks of risk ‘front stop’ for Pillar 1 minimum capital beginning to impose requirements weights generated by banks’ internal requirements than the ‘back stop’ role it that go beyond Basel 3. The US and models, and on the balance between plays in Basel 3. Europe are requiring banks to meet risk sensitivity, simplicity and minimum capital ratios even after the Third, greater disclosure by banks. To comparability; and impact of severe stress; Switzerland, the extent that banks are allowed to the US and UK have set a minimum • For euro area banks, the prospective use complex models, this would require leverage ratio at above 3 percent; actions of the European Central banks to explain and justify why their others (Australia and UK) are insisting Bank (ECB) as supervisor, regulator risk weightings based on internal models that ‘Pillar 2’ capital add-ons are met and macro-prudential authority – the differed from the standardised approach through highest quality capital; and emergence of ‘Frankfurt 1’. risk weightings. And to the extent that finally, countries such as the US greater reliance was placed on a simple and UK are pushing for tougher These developments are leverage ratio, banks would be able to liquidity standards; likely to result in three explain how this differed from a more risk-sensitive approach. • Widespread concerns among changes that might form the regulators and market analysts basis of a future Basel 4. What implications might about banks’ internal modelling and First, restricting the advantages to this have for banks’ capital the accuracy of the resulting risk banks of using internal models to weighted assets; requirements? calculate their capital requirements. • Resulting calls for greater simplicity This could take the form of limits on We understand the pressures for change in regulatory requirements from the extent to which risk weights based here, but an over-zealous pursuit of some leading regulators (including on internal models could diverge from simplicity and over-reliance on from Andrew Haldane in the UK risk weights under the standardised standardised risk weightings – or on a and Thomas Hoenig in the US), approach; or of reducing the complexity non-risk sensitive leverage ratio – could

have unintended consequences. It initiatives running in parallel to Basel 3. systemic risk buffer) under the EU could encourage banks to hold riskier These include stress testing, capital implementation of Basel 3, which will assets and could increase significantly surcharges for systemically important require these banks to increase their the cost of funding a portfolio of low banks, Pillar 2 add-ons, macro-prudential common equity capital by nearly £40 risk-weighted assets, including mortgage policy tools, and the loss absorbency billion collectively, from £220 billion to lending and high quality liquid assets. provided in a resolution by the bailing-in £260 billion. Moreover, the conditions that banks are of liabilities. To meet the core elements of a required to meet before they can use Indeed, there is a strong sense here prospective Basel 4 these banks would internal models were always intended of regulators building up layers and have to increase their common equity to encourage banks to improve their layers of uncoordinated conservatism capital by a further £50 billion or risk management capabilities: this link to address multiple perceived causes of reduce their balance sheets by around could usefully be reinforced, rather the financial crisis, rather than starting 20 percent – taking the core elements than weakened. from scratch and building a more to be (i) a minimum common equity Meanwhile, as we have commented coherent approach. leverage ratio of 5 percent, and (ii) a 20 elsewhere(1), the relentless introduction percent increase in risk weighted assets We support greater disclosure by banks, of more and more regulation may arising from restrictions on banks’ internal who should have a strong self-interest in already have taken many economies, models. A tougher approach to either demonstrating why their internal models especially in Europe, beyond the ‘tipping element would increase further the generate an accurate picture of their point’ to a position where the costs additional capital required. underlying risks. of regulation exceed the benefits. The In addition to these quantitative impacts, permanent downward drag on economic What would it mean for capital? banks need to ensure that they fully growth from greater regulation may now Taking the major UK banks in aggregate as understand their capital and liquidity exceed the benefit of avoiding future an example, at end 2012, their collective needs. This needs to be based on clear periods of financial instability. common equity risk-weighted capital ratio statements of strategy and risk appetite was 8.5 percent on a fully implemented Regulators also need to pay more that drive both their internal assessment of Basel 3 basis and their leverage ratio based attention to developing more coherent capital and liquidity and how they manage on common equity capital was and proportionate linkages between their businesses. 3.6 percent.(2) the Basel 3 minimum capital and liquidity requirements and the additional These banks are expected to be required demands on capital and liquidity arising to meet a 10 percent minimum common from the multiple regulatory reform equity capital ratio (including a 3 percent

(1) Moving on: the scope for better regulation, KPMG International, May 2013. (2) Source: Prudential Regulation Authority completes capital shortfall exercise with major UK banks and building societies, Prudential Regulation Authority, June 2013.

The path to Basel 4

Basel 4 Implications for banks Already emerging?

Simplicity Capital requirements • Front stop leverage ratio • Less reliance on internal Liquidity requirements models Disclosure requirements National standards • Quality of Pillar 2 capital National divergences • Minimum requirements post stress testing Risk sensitivity • Liquidity Regulatory requirements Regulatory

Disclosure Use of internal models • Enhanced requirements to in decision making aid comparability

Basel 3 Parallel tracks ‘Strengthened global capital Large exposures Structure and liquidity regulations’ Balkanisation OTC derivatives Capital reform SIFI surcharge Banking union • Quality of capital base • Quantity of capital Bail-in liabilities Risk governance • Leverage Macro-prudential • Counterparty credit risk

Liquidity standards • Short term • Long term

Time Source: KPMG International, September 2013

Beyond Basel 3 to Basel 4

Differences are already emerging across countries in the design, interpretation and timing of the implementation of Basel 3. This is generating important inconsistencies across countries, and some unravelling of Basel 3 is already under way. However, we focus here on the significant steps being taken by some countries – and by the Basel Committee – to move beyond Basel 3. We view these steps as a move towards a Basel 4 characterised by: • A higher minimum leverage ratio playing a more prominent role in Pillar 1 minimum capital requirements;

• Tighter limits on the advantages to banks of using internal models to calculate their capital requirements;

• A tougher approach to stress testing, Pillar 2 capital add-ons and liquidity requirements; and

• More disclosure by banks.

Leverage ratio consultative document on the leverage • Simple rules (using leverage ratios Some countries are moving ahead of ratio(6) it stated that the ‘parallel run’ and market capitalisations) would the 3 percent minimum leverage ratio period (from 2013 to 2017) will ‘test’ the have predicted better which banks currently in the Basel 3 standards, in 3 percent minimum leverage ratio, and ran into difficulty during the financial terms of the level of the minimum ratio, will be used to track the impact of using crisis. Simple leverage ratios are the definition of capital and timing. different capital measures (both total better predictors of bank failure than regulatory capital and CET1 capital). The risk-weighted alternatives; and In the US, the Federal Reserve Board consultative document also provided is proposing a minimum leverage ratio • The 3 percent minimum leverage more detail on how exposures will be of 5 percent for systemically important ratio established in the Basel 3 measured, and on the disclosures that banks and 6 percent for retail banks standards may be too low. Some banks will be required to make from 2015. owned by a systemically important regulators, academics and other bank, to be applied from 2018(3) (it is not More generally, a number of commentators have argued for a yet clear whether these requirements regulators(7) and other commentators much higher minimum leverage would also apply to large foreign banks have argued for placing more emphasis ratio, often in the region of 6-8 operating in the US); in Switzerland, the on a higher minimum leverage ratio, on percent.(8) And two US senators, largest banks will be required to meet the basis that: Sherrod Brown and David Vitter, have a minimum leverage ratio against total proposed a 15 percent leverage ratio • In a world characterised not only by capital of around 4.3 percent by 2019(4); for the largest US banks.(9) risk, but also by uncertainty (where and in the UK the Prudential Regulation it is not possible to attribute precise A higher minimum leverage ratio would Authority (PRA) is currently assessing probabilities to outcomes), it may immediately increase its importance the capital adequacy of large banks be better for policymakers to follow within the set of regulatory capital against a 3 percent leverage ratio based a simple rule rather than trying to ratios, because it would become the on Core Tier 1 (CET1) capital (rather match the complexities of the world. binding constraint for a larger number than the Basel 3 use of the wider total Indeed, trying to fight complexity of banks. It would therefore increasingly tier 1 definition) and calculated after the by ever more complex rules can be become a ‘front stop’ rather than a imposition of a severe stress scenario(5). disastrous if the complex rules are ‘back stop’ requirement. By contrast, the Basel Committee has based on estimated relationships that taken a less radical approach. In a recent break down;

(3) Regulatory Capital Rules: Regulatory Capital, Enhanced Supplementary Leverage Ratio Standards for Certain Bank Holding Companies and their Subsidiary Insured Depository Institutions, Federal Reserve Board, July 2013. (4) Financial Stability Report 2013, Swiss National Bank, June 2013. (5) Prudential Regulation Authority completes capital shortfall exercise with major UK banks and building societies, Prudential Regulation Authority, June 2013. (6) Revised Basel III leverage ratio framework and disclosure requirements, Basel Committee on Banking Supervision, June 2013. (7) The dog and the Frisbee, Andrew Haldane, Bank of England, August 2012; Back to basics: a better alternative to Basel capital rules, speech by Thomas Hoenig, Federal Deposit Insurance Corporation, September 2012. (8) The bankers’ new clothes: what’s wrong with banking and what to do about it, Anat Admati and Martin Hellwig, Princeton University Press, 2013. (9) Terminating Bailouts for Taxpayer Fairness Act, US Senate, April 2013.

However, an over-reliance on the leverage • Enhancing disclosure – by Internal modelling ratio could have perverse consequences. encouraging banks to implement The Basel Committee and other regulatory It could encourage banks to hold riskier the Enhanced Disclosure Task authorities have been focusing increasingly assets; increase significantly the cost of Force (EDTF) recommendations; on the risk weightings generated by funding a portfolio of low risk-weighted requiring banks to disclose the banks using their own internal models. assets, including mortgage lending and results of applying their models to The complexity and opacity of the risk sovereign debt; and remove an incentive hypothetical portfolios or disclosing weightings generated by internal models (regulatory permission for a bank to use both modelled and standardised leaves banks vulnerable to moves by internal models to calculate risk weights) calculations; and requiring banks regulators to restrict the extent to which that can be used to drive improved risk to publish (on a consistent basis) internal modelling can drive down management by banks. additional metrics that might be risk weightings. useful to investors – capital ratios Simplicity The first move in this direction was using market values of equity, risk The Basel Committee has recently the Basel Committee’s proposals for a measures based on equity volatility, published a discussion paper on balancing fundamental review of the trading book.(11) revenue-based leverage ratios, risk sensitivity, simplicity and comparability.(10) This responded to a number of failures in historical profit volatility, and the ratio The paper explains how and why we the trading book regime highlighted by the of non-performing assets to total have reached the current high level of financial crisis, including inadequate capital assets; and complexity and non-comparability, primarily held against market risk and excessive through the pursuit of risk-sensitive capital • More fundamental longer-term latitude in determining which assets requirements; the advantages of greater reforms – using a tangible equity could be placed in the trading book. The simplicity and comparability; and the leverage ratio (as the UK and proposals included: potential disadvantages of overly simplistic some other countries are already • Changing the basis of definition capital requirements. doing); abandoning the use of for trading book assets to limit the internal models; imposing capital The paper sets out some ideas to improve assets that a bank could include in its requirements against income simplicity and comparability, including: trading book; volatility; or reducing risk and • Recognising simplicity as an additional complexity by limiting the use of • Changing the underlying model objective against which new Basel complex and innovative financial methodology from ‘value at risk’ to Committee proposals should be judged; instruments and restricting ‘expected shortfall’ – a fundamental change that would add modelling • Mitigating the consequences non-traditional banking business. complexity, and increase capital of complexity – adding floors to Reflecting these themes, the paper requirements for many assets; constrain the results of modelled also discusses a re-balancing of the capital requirements; introducing a three pillars to place more emphasis • A more detailed assessment of more refined ‘use test’; and limiting on Pillar 2 and Pillar 3, not least as a illiquidity risk – with additional capital national discretions in the area of way of simplifying Pillar 1 minimum add-ons for instruments at greater internal models; requirements by shifting some of the risk of illiquidity under stress; and • Strengthening the leverage ratio complexity – including risk-sensitive • Narrowing the differences by replicating elements of the weightings and internal modelling between internal models and the risk-based capital requirements approaches – into Pillar 2; and as a way standardised approach. – adding ‘buffers’ to the leverage of enabling shareholders, bondholders More recently, the Basel Committee and ratio and imposing tougher leverage and market analysts to exercise a more the European Banking Authority (EBA) requirements on systemically informed view based on the disclosure have released the preliminary findings important banks; by banks of a wider range of information. of their analyses of differences in risk weightings across banks.(12)

(10) The regulatory framework: balancing risk sensitivity, simplicity and comparability, Basel Committee on Banking Supervision, July 2013. (11) Fundamental review of the trading book, Basel Committee on Banking Supervision, May 2012. (12) Regulatory consistency assessment programme – analysis of risk weighted assets for market risk, Basel Committee on Banking Supervision, January 2013; Regulatory consistency assessment programme – analysis of risk weighted assets for credit risk in the banking book, Basel Committee on Banking Supervision, July 2013; Interim results update of the EBA review of the consistency of risk weighted assets, European banking Authority, August 2013.

The Basel Committee reports on the book credit risk, these factors generated • The extent to which banks are risk weightings of banks’ banking differences across banks of up to 20 engaged in ‘risk weighted assets book and trading book assets showed percent either side of the average, with optimisation’ as a means of reducing wide divergences in risk weights. It the main differences being in probability their capital requirements, even if is difficult to determine how much of of default estimates (especially for a large part of this reflects no more this variation reflects different levels of corporate exposures) and in loss given than cleaning up data and the planned actual risk, although for banking book default estimates (especially for retail rolling out of risk modelling to a assets the Basel Committee found exposures). Although the report plays broader set of exposures; that underlying differences in the risk down regional differences, it is • The extent to which a prolonged composition of banks’ assets explains up nevertheless striking that the three period of low interest rates is to three-quarters of the variation in risk banks applying the most aggressive enabling borrowers to avoid default, weightings across banks. (lowest) risk weightings under the and thereby generating misleadingly hypothetical portfolio are all from Europe. The remaining variation is driven by low probability of default estimates; two main factors – diversity in models For market risk positions, the highest • Low risk weights on exposures to across banks and diversity in supervisory and lowest risk weighted exposures other financial institutions that take no guidelines and practices. One way to reported by banks differed by a multiple account of the systemic risks inherent isolate these factors is to test how of almost three. in such interconnectedness; and banks would calculate risk weights for In addition to the data findings in the Basel a common hypothetical portfolio. The Committee reports, regulators are known Basel Committee found that for banking to be concerned by:

• The difficulty of establishing This would be consistent with the or setting more explicit constraints transparency – and therefore the recommendations in the Enhanced such as floors (or even fixed values) limited scope for relying on market Disclosure Task Force report; for certain parameters. discipline – in this area. • Additional policy guidance to These options seem likely to characterise The Basel Committee highlighted three constrain differences in bank and a ‘Basel 3.5’ amendment in due course. potential policy options in response to supervisory practices; and They would limit the extent to which a its data findings: bank could benefit from using its own • Limiting the flexibility of the internal calculations of risk weightings. • Enhanced Pillar 3 public disclosures advanced approaches, for example And they would increase the pressure by banks and regulatory data by setting ‘benchmarks’ (which on banks to explain and to justify – to collection to improve understanding supervisors could use as a reference regulators and other stakeholders – of how banks calculate risk weighted point for assessing firms’ internal the gap between standardised risk exposures using internal models. model estimates) for risk parameters, weightings and the weightings generated by internal models.

Stress Testing implemented EU Capital Requirements Many authorities – including the US, the Regulation (CRR) and Capital Possible implications for banks EBA, Ireland and the UK – are using the Requirements Directive (CRD) rules. These moves towards Basel 4 have results of regular stress test exercises to three major implications. Pillar 2 capital add-ons require banks to be in a position to meet In principle, the tougher Basel 3 First, banks are likely to face minimum capital ratios even after severe requirements on the quality and quantity significantly higher capital stress events. This requires banks to hold of minimum Pillar 1 capital requirements requirements, arising from a significant capital buffers to enable them should mean that banks are subject combination of a higher minimum to meet the minimum requirements not to smaller Pillar 2 capital add-ons – leverage ratio, restrictions on just on a backward-looking basis (using since there are fewer risks that are the extent to which exposure standard calculations of capital ratios), not adequately captured by the Pillar calculations can be based on but also after applying stress scenarios. 1 minimum requirements. However, it internal models, and a generally These authorities are also beginning to use remains far from clear to what extent tougher regulatory approach to the Basel 3 minimum capital ratios as the regulators will follow this route. imposing stress test and Pillar 2 basis for such exercises, thus turning Basel buffers above minimum capital There are some indications that the 3 into a minimum post-shock requirement, requirements. This will require capital conservation and counter-cyclical with the additional required capital acting banks either to hold more capital or capital buffers will be regarded by some as the primary shock absorber. This to reduce their on- and off-balance regulators as a partial substitute for creates ‘buffers on buffers’ and negates sheet activities. This in turn will Pillar 2 capital. But at the same time the intention in Basel 3 that the capital raise the cost and reduce the Australia(14) and the UK(15) are moving conservation buffer and any counter availability of bank finance for to requiring Pillar 2 capital to be held cyclical capital buffer would be the cushion individuals, corporates and other primarily or solely through CET1 capital, to absorb a shock. bank customers. rather than through a combination of National authorities can also use stress tier 1 and tier 2 capital. Second, banks will likely testing to introduce considerable need to improve their capital Liquidity national discretion into how much management, not least in terms Although the Basel Committee capital their banks are required to hold, of understanding fully the capital signed off on a revised approach to irrespective of attempts to introduce required to support their various the Liquidity Coverage Ratio (LCR) in greater international consistency in the businesses and linking this clearly January 2013, in the EU the EBA is still setting of minimum capital standards of to their strategy, risk appetite and working on the definition of high quality internal models. business models. liquid assets and on the appropriate In addition, the EBA has recently issued run-off assumptions for different types Third, a less risk-sensitive a recommendation(13) that national of deposit. Meanwhile, the UK is clearly approach to both capital ratios regulators should ensure that major unwilling to replace its current tough and internal modelling is likely European banks should maintain a capital regime with the LCR, and the Financial to force banks to re-evaluate the floor expressed as a monetary amount Policy Committee has asked the PRA balance between lower and higher (not as a ratio to assets) that continues to consider whether additional liquidity risk businesses. Once liquidity to meet the requirements set in the requirements are needed on systemic needs have been met, there will December 2011 EBA Recommendation grounds to supplement the LCR. be a strong incentive for banks (following the EBA’s earlier stress tests). to reduce their holding of less In the US, Federal Reserve Governor risky assets, including sovereign However, it is not clear how this will Tarullo has proposed that banks that are debt, other highly rated securities, prevent further deleveraging by European substantially dependent on wholesale prime mortgage lending, high banks. National regulators will be allowed funding should hold additional capital(16), quality corporate lending and fully to waive this requirement, where banks which might become the basis for a secured exposures. This may lead hold sufficient capital to meet minimum revision to (or even the replacement of) to a significant shift in some banks’ CET1 capital requirements, under fully the Basel Committee proposals for a business models, and in the price Net Stable Funding Ratio. and availability of these types of bank intermediation.

(13) Recommendation on the preservation of core tier 1 capital, European Banking Authority, July 2013 (14) Implementing Basel III capital reforms in Australia, Australian Prudential Regulation Authority, September 2011. (15) Strengthening capital standards: implementing CRDIV, Prudential Regulation Authority, August 2013. (16) Federal Reserve Board approves final rule to help ensure banks maintain strong capital positions, Opening statement by Governor Tarullo, July 2013. © 2013 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved. 10 | Basel 4 – Emerging from the mist?

In addition to the Basel 3 standards, banks face Parallel tracks many other regulatory reform initiatives relating to capital and liquidity.

Basel 3 is but one element of the cooperation and coordination; and • The introduction by member multiplicity of regulatory reforms will be given powers – alongside the states or the Commission of more under way – the ‘more and more of relevant national authorities – to use stringent large exposure limits, sector- everything’ approach to regulation(17). macro-prudential tools across the banking specific risk weightings, liquidity and The parallel tracks discussed here can union area. This range of ECB roles and disclosure requirements on all, or a be seen primarily as supplementing responsibilities may lead in due course to subset of, firms. Basel 3, although in some cases they an identifiable ‘Frankfurt 1’ approach to Large exposures may also provide a means for regulators bank supervision and regulation. The Basel Committee has consulted on to bypass and marginalise Basel 3. Capital surcharges for SIFIs the measurement and limits on banks’ Either way, they add significantly to the Prospective capital surcharges of between large exposures.(20) The main proposed regulatory burden. 0.5 and 2.5 percent have been announced changes are to: Banks need to consider the combined for 28 global systemically important banks • Tighten the reporting (by moving to a 5 impact of all these initiatives, in addition (G-SIBs), and attention is now turning to percent of CET1 threshold) and ‘hard’ to the impact of Basel 3 and of moves the designation of – and imposition of limits on large exposures (leaving the towards Basel 4, on their strategies and tougher capital, supervision and resolution upper limit at 25 percent of capital, but business models. (18) requirements on – banks of national again narrowing the definition of capital systemic importance (D-SIBs) (19). Policymakers also need to take proper to CET1 capital); account of the collective impact of all Macro-prudential oversight • Define more precisely how exposures these initiatives on both banks and the Macro-prudential regimes are still evolving. should be measured, so the wider economy. Adding layers and layers They are taking shape around the Basel 3 requirements can be applied more of conservatism may reduce the risk of counter-cyclical capital buffer, other consistently across countries; and future financial crises, but this comes macro-prudential tools, and stress and at a high cost in terms of a permanent scenario testing to assess resilience • Impose tougher limits on the reduction on annual growth rates. against systemic risks. large exposures of systemically important banks. Banking Union In Europe, the CRR/CRD package provides for: Balkanisation Although many of the details remain Localisation is not a new phenomenon, to be finalised, banking union within a • The counter-cyclical capital buffer; but its extent is increasing, even as the sub-set of EU countries is likely to have • An additional systemic risk buffer (SRB) G20 is promoting greater international a major impact on the supervision and that member states can apply to all, or a cooperation and coordination. Examples regulation of banks in Europe. One key subset, of firms to cover medium-term range from the US rules to require foreign rationale for moving bank supervision to structural or systemic risks. The UK is banking organisations with a significant the ECB was that it would take a more expected to apply a SRB of 3 percent, US presence to create an intermediate consistent and challenging approach bringing the minimum CET1 capital ratio holding company and to hold stronger to supervision, as is already emerging up to 10 percent. It is not yet clear how capital and liquidity positions locally in through its intended asset quality review far the SRB will substitute for capital the US; to the moves by many Asian of the major banks for which it is to surcharges on global and domestic supervisors to require or encourage become the primary supervisor. systemically important banks – the EU foreign banks to operate in their countries The ECB will also be a key player in legislation allows for both the SRB and through subsidiaries rather than branches, developing and operating the resolution the capital surcharge to be applied to at least for retail business. regime within the banking union; a key a bank where the SRB relates only to Host country authorities are increasingly member of the EBA in developing binding exposures located in the member state requiring foreign banks to operate technical standards and encouraging that sets the buffer, not to exposures within the host country as subsidiaries outside the member state; and

(17) Moving on: the scope for better regulation, KPMG International, May 2013. (18) Evolving Banking Regulation, KPMG International, Feb 2013. (19) A framework for dealing with domestic systemically important banks, Basel Committee on Banking Supervision, October 2012. (20) Supervisory framework for measuring and controlling large exposures, Basel Committee on Banking Supervision, March 2013.

rather than branches, and to meet local through a combination of capital and namely the current exposure method and standards – on capital, liquidity, stress- long-term bail-in debt instruments. Under standardised method), and the capital and testing, bail-in liabilities, intra-group the BRRD national authorities will have the other support required by CCPs, including exposures and intra-group shared discretion to set minimum requirements for their recovery and orderly resolution. services. This reflects three main drivers: for loss absorbency for each bank based Disclosure on its size, risk, resolvability, systemic • Financial stability concerns – host The G20 and the FSB welcomed impact and business model. A more country authorities are focusing more and endorsed the October 2012 harmonised approach could be introduced on preventing the failure of the local recommendations of the EDTF (a by the Commission in 2016, based on operations of foreign banks where private sector group comprising banks, recommendations from the EBA. they are of systemic importance for investors and audit firms) to enhance the local system, and on maintaining Structural separation the risk disclosures of banks(24). These critical local economic functions in the Some countries – including the US, recommendations included enhanced event of failure; UK, France and Germany – are already disclosure by banks of how risk weighted introducing various requirements for assets are calculated; the impact of • Home country resolution planning and structural separation between differing the use of internal models on a bank’s structural separation – home country types of retail and investment banking regulatory capital requirements; how recovery and resolution planning, and activities. The EU Commission has banks’ internal ratings grades map across moves to introduce greater structural issued a ‘road map’ on the possible to external credit ratings; and how internal separation, may reduce the confidence implementation of the Liikanen report models are back-tested and validated. of host country authorities that the local recommendations, most likely through the operations of foreign banks will receive Risk governance ring-fencing of a set (still to be specified) of support from their home country International standard-setters are placing investment banking activities rather than authorities; and increased emphasis on the importance of through the UK-style ring-fencing of the good risk governance, including: • Home country deposit protection retail bank. arrangements to protect overseas • Sound risk governance practices, OTC derivatives depositors – home country deposit covering the Board, Chief Risk Officer Most of the rules are now in place in the guarantee arrangements may be and risk management function(25); major markets for the standardisation, inadequate to protect depositors in exchange trading, central clearing and • Risk appetite framework, covering the overseas branches. reporting of derivative transactions. risk appetite statement, risk limits, and Resolution Attention is now focused on efforts to clear roles and responsibilities for risk The main focus on resolution in recent achieve greater convergence of approach management(26); and months has been on the bail-in tool, across the US and the EU. • The aggregation and reporting of risk including the latest version of EU Bank Meanwhile, the Basel Committee, the data, covering the generation of risk Recovery and Resolution Directive International Organisation of Securities data, its reporting to the Board and (BRRD), FSB guidance on resolution(21), Commissions and the Committee on senior management, and governance including the multiple and single point Payment and Settlement Systems are arrangements.(27) of entry approaches, and proposals for developing capital adequacy standards the single resolution mechanism in the for exposures to central clearing banking union in Europe. counterparties (CCPs)(22), counterparty The BRRD and similar proposals in the US credit risk(23) (where the Basel Committee and Switzerland require banks to meet is consulting on consolidating the two minimum overall levels of loss absorbency existing non-modelled approaches,

(21) Guidance papers on recovery and resolution planning, Financial Stability Board, July 2013. (22) Capital treatment of bank exposures to central counterparties, Basel Committee on Banking Supervision, June 2013. (23) The non-internal model method for capitalising counterparty credit risk exposures, Basel Committee on Banking Supervision, June 2013. (24) Enhancing the Risk Disclosures of Banks: Report of the Enhanced Disclosure Task Force, Financial Stability Board, October 2012. (25) Thematic review on risk governance, Financial Stability Board, February 2013. (26) Principles for an effective risk appetite framework, Financial Stability Board, July 2013. (27) Principles for effective risk data aggregation and reporting, Basel Committee on Banking Supervision, January 2013. © 2013 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved. Contact us

Jeremy Anderson CBE Hugh Kelly Chairman, Partner, Financial Services Global Financial Services Regulatory Centre of Excellence, T: +44 (0)20 7311 5800 Americas region E: [email protected] KPMG in the US T: +1 202 533 5200 Bill Michael E: [email protected] EMA Head of Financial Services KPMG in the UK Steven Hall T: +44 (0)20 7311 5292 Partner, Financial Services E: [email protected] KPMG in the UK T: +44 (0)20 7311 5883 Giles Williams E: [email protected] Partner, Financial Services Regulatory Centre of Excellence, Clive Briault EMA region Senior Adviser, Financial Services KPMG in the UK Regulatory Centre of Excellence, T: +44 (0)20 7311 5354 EMA region E: [email protected] T: +44 (0)20 7694 8399 E: [email protected] Simon Topping Principal, Financial Services Regulatory Centre of Excellence, ASPAC region KPMG in China T: +85 2 2826 7283 E: [email protected]

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