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Basel IV Quantitative Impact Study on Cyprus Banks September 2020 1 Basel IV | Quantitative Impact Study on Cyprus Banks

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Basel IV Quantitative Impact Study on Cyprus Banks September 2020 1 Basel IV | Quantitative Impact Study on Cyprus Banks Basel IV | Quantitative Impact Study on Cyprus Banks Basel IV Quantitative Impact Study on Cyprus Banks September 2020 1 Basel IV | Quantitative Impact Study on Cyprus Banks The aim of this paper is to provide an (especially SME) and retail customers, Summary overview of the changes in Credit Risk as well as project financing (as part of quantification under Basel IV, focusing on specialised lending). Banking-book credit risk requirements both Our most recent publication from a Standardised and Internal Ratings Analysing and understanding how the examines the impact of Basel IV Based (IRB) approach. reforms will affect the various portfolios of on Cyprus Banks. a bank and how these drive the decrease Our paper also provides guidance on the in required capital, is of paramount In particular, this article steps required to begin understanding importance to Cyprus Banks to ensure focuses on the updated Credit the impact of the reforms on required required capital is allocated appropriately Risk assessment framework. data, changes in processes, modelling and to each of the components of a bank. governance. Banks are therefore challenged to start Our analysis indicates that collecting new data as required by the Cyprus Banks are expected to For our analysis, we have performed reforms. a Quantitative Impact Study (QIS) to have a reduction in capital understand the impact across the different Separate to the Standardised approach requirements as a consequence portfolios of a typical Cyprus Bank, (SA) reforms, our paper considers the Basel of the revised risk-weights shedding a light on which components of IV changes under the IRB approach. assigned to specialised lending the Bank will be most affected. and the introduction of a The quantitative aspect of this paper This is an area which merits further risk-sensitive Loan-to-Value reflects the impact of the reforms on consideration by Cyprus Banks. Adopting (LtV) based approach for real Standardised approach Banks, being the the IRB approach could allow Cyprus Banks estate exposures. approach currently adopted by the entire to embrace a more accurate consideration Cyprus banking sector. of their own risk profile through the use of Even though the overall credit internal risk management practices and risk framework under Basel IV Our analysis indicates that ,overall, the processes, leading to the optimisation of is generally in line with Basel III, impact of the reforms in the local Banking their capital requirements and thereby sector is predominantly driven by the new increasing their overall lending capacity. it includes a number of standardised approach for the real estate enhancements for specific portfolio. Basel IV introduces a capital floor between credit portfolios that will the Standardised and the IRB approaches. impact certain business and For certain portfolios, the risk weights used Despite the capital floor, Cyprus Banks may products. in the Standardised approach depend still be incentivised to adopt Foundation on LtV ratios, which require a thorough IRB in order to benefit from the potentially Fully understanding the review from Banks’ perspective. It is lower risk weights, thereby reducing their changes and their impact is, therefore imperative for banks that wish overall capital requirements. therefore, crucial to adequately to take advantage of these revised risk re-defining Banks’ capital plan, weights to enhance their current LtV review and consequently their procedures. “The impact of the business strategy. In-depth analysis of the composition reforms on the local of a Bank’s real estate portfolio and its Without this understanding, responsiveness to the regulatory LtV Banking sector is inappropriate allocation of metric is needed if it is to benefit from predominantly driven capital requirements may these changes. Furthermore, proper occur, resulting in a skew in documentation and monitoring of LtV by the new lending, potential mispricing of is necessary for benefiting from these products and increased cost to reforms. standardised customers. Other portfolios that require further approach for the real attention are exposures to corporate estate portfolio." 02 Basel IV | Quantitative Impact Study on Cyprus Banks Overview of the reforms The Basel IV reforms were finalised by the Basel Committee on Banking Supervision (BCBS) in December 2017 and aim to further strengthen the regulation, supervision and practices of banks worldwide, with the purpose of enhancing financial stability, restoring credibility in the calculation of RWAs and improve the comparability of bank’s capital ratios. An understanding of the impact these changes have on the various portfolios of the bank will drive appropriate allocation of required capital to the various Banks' business lines. The following summarises the most important changes: Revision to Credit Risk Restriction of full IRB and Introduction of capital output floor Standardised Approach introduction of risk parameter floors for F-IRB Approach • The output floor restricts the bank- • Risk weights of exposures secured • AIRB is withdrawn for exposures to level internal RWAs to 72.5% of the by real estate based on loan-to-value banks; financial institutions; large standardised RWAs diversification corporates; and equities • For banks that actively manage their • Separate risk weights for investment • For high-volatility commercial real capital in coordination with business, property estate, slotting is used. Specialised the capital floor will substantially impact lending can be subject to either slotting • Diversification based on external the allocation of capital costs, pricing or either of the IRB-approaches ratings, to determine risk weight and capital planning • Double default approach is withdrawn • Minimum Credit Conversion Factor • The introduction of the capital floor (CCF) of 10% for all exposures • Probability of default (PD) floor as well as the leverage ratio constraint • New risk weights for rated/unrated increases to 5bps from 3bps means that banks will have to manage exposures • Unsecured loss given default (LGD) their capital across multiple fronts: • Exposures to covered bonds floor of 25% for corporates; 50% exposure contributions, standardised introduced as an asset class for qualifying residential real estate RWAs and internal RWAs exposure (QRRE) exposures • Improved granularity for exposures • Impacts of the floor need to be to project finance, object and • Secured LGD floors imposed, varying understood not only in the current state commodity finance by collateral type but also under business scenarios and market stress 03 Basel IV | Quantitative Impact Study on Cyprus Banks Impact on the Cyprus Banking sector Focus on Standardised approach Cyprus Banks follow exclusively the Standardised approach in their calculation of Credit Risk capital requirements. As such, the main focus of this note is on the changes proposed under Basel IV in relation to the Standardised approach for the quantification of Credit Risk, with emphasis on the changes expected to affect Cyprus Banks. Under CRD IV SA, claims in relation to specialised lending (project finance) and claims secured by residential or commercial real estate are assigned risk weights of 100%-150%, 35% and 100% respectively. In Basel IV, the SA is revised by introducing an Quantitative Impact Study: a typical In particular, specialised lending exposures increased level of granularity in these areas. Cyprus Bank and exposures secured on real estate (both corporate and retail) comprise Indeed, under Basel IV SA, claims arising To evidence the impact of the upcoming approximately 20% and 30% respectively of from specialised lending are treated changes under Basel IV on the Cyprus the overall lending, and will hence be a key differently depending on whether they arise Banks, Deloitte performed a Quantitative element when assessing the impact of the from objects and commodities (100% RW), Impact Study (QIS) the results of which are regulatory changes. or from project financing (ranging from 80- set out on page 6. 130% RW). The detailed list of our assumptions used in The impact of the reforms on various constructing the balance sheet of a typical Furthermore, claims secured by real portfolios is calculated for a Standardised Cyprus Bank and in assigning the applicable estate are treated differently depending Bank based on the asset side of the balance risk weights is presented in Appendix 2 of on whether the real estate is residential sheet of a typical Cyprus Bank 1. this publication. or commercial, and whether or not the exposure is dependent on the cash flow A typical bank in Cyprus has substantial The constructed balance sheet on the generated by the property. portfolios of project finance exposures next page is based on information from (corporates of which: specialised lending), published annual reports and Pillar III For each property type, banks are to apply retail exposures secured on real estate disclosures of multiple Cyprus Banks, as well the so-called “whole loan” approach, where property and exposures which are in as data from the EBA EU-wide transparency risk weights are assigned to different LtV recovery, under restructuring or in default, reports. buckets. combined with smaller portfolios in other asset classes. The revisions to the Standardised approach for credit risk are outlined in Appendix 1. 1 The fictional bank balance sheet is based upon data collected from various publicly available resources, namely Annual Reports, Pillar III Disclosures
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