Basel 4 – the effect on Swiss Banks 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 bank, 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 risk 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 credit risk 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 • Probability of default (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 loss given default (LGD) floor exposure contributions, standardised of 25% for corporates; 50% for qualifying RWAs and internal RWAs. • Minimal Credit Conversion Factor (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 capital requirement 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