Basel IV and proportionality initiatives Upcoming changes to the Canadian capital and liquidity framework Introduction Enhancements to risk-based capital requirements and minimum Q1-2020. Attention is now focused on the implementation of liquidity and funding standards for Deposit-Taking Institutions final Basel III reforms, informally referred to as ‘Basel IV’, which (DTIs) are two foundational aspects of post-financial crisis introduces extensive revisions to the calculation of Risk-Weighted reforms introduced by Basel III. In Canada, initial Basel III reforms Assets (RWA) for Pillar 1 risks. OSFI’s proposed policy direction dedicated to raising the quality and quantity of capital have and implementation timelines for Basel IV are included in OSFI’s already been implemented. The domestic implementation of July 2018 discussion paper, Implementation of the final Basel III Basel III liquidity and funding standards will be complete when reforms in Canada. DTIs begin reporting the Net Stable Funding Ratio (NSFR) in Figure 1: Summary of basel capital, leverage and liquidity requirements Focus of CET1 Basel III: ratio Raising the Capital LCR, NSFR Leverage ratio quality and quantity of capital Focus of RWA Basel IV: Revising how risks are calculated Risk positions SA for Securitisation Operational SA for IRB for Market risk CVA risk Output measuring risk credit risk credit risk (FRTB) floor counterparty credit risk Source: Workshop Basel IV, KPMG International, 2018. While the Basel framework was originally designed to apply to which obligates DTIs to achieve compliance with updated large, internationally-active banks, domestic regulators including standards in short order. OSFI have applied Basel standards to a wider set of banks In this paper, we provide a consolidated overview of the for pragmatic reasons. However, the complexity introduced scope and timelines for the upcoming revisions to capital and by Basel III/ IV has led regulators to now consider how the liquidity requirements for DTIs and outline the extent to which framework can be better tailored to smaller, less complex proportionality considerations affect the scope of changes banks. OSFI’s July 2019 discussion paper titled Advancing affecting Small and Medium Sized Institutions (SMSBs). Foreign Proportionality: Tailoring Capital and Liquidity Requirements for Bank Branches (FBBs) are subject to different standards and Small and Medium-Sized Deposit Taking Institutions presents expectations with respect to capital and liquidity, and a brief outline its proposals to tailor requirements for non-D-SIB banks. of the current state and future changes is also provided. Finally, OSFI’s timelines for implementing the changes related to we conclude with a summary of KPMG’s perspective on key Pillar 1 capital and liquidity requirements conclude in Q1-2022, considerations and challenges for DTIs leading up to Q1-2022. © 2019 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. 2 Basel IV and proportionality initiatives Overview of the current Canadian capital and liquidity framework 1. Current capital and liquidity requirements for SMSBs and D-SIBs Capital requirements, leverage requirements and the output floor The following table summarizes the minimum target levels for risk-based capital ratios for DTIs: Table 1: SMSB and D-SIB Risk-based Capital Ratios Common Equity Tier 1 (CET1) Tier 1 Total Minimum Ratios 4.5% 6.0% 8.0% Capital Conservation Buffer (CCB) 2.5% 2.5% 2.5% Countercyclical Buffer (CCyB) Not activated Not activated Not activated Minimum Target for SMSBs (including buffers) 7.0% 8.5% 10.5% D-SIB Buffer 1.0% 1.0% 1.0% Domestic Stability Buffer (DSB) 2.0% 2.0% 2.0% Minimum Target for D-SIBs (including buffers) 10.0% 11.5% 13.5% Sources: Capital Adequacy Requirements Guideline, OSFI, 2019 Industry Notice on Domestic Stability Buffer, OSFI, June 2019 DTIs are also expected to maintain a leverage ratio (LR) of at DTIs that have received OSFI’s approval to use advanced least 3%. Disclosure requirements for capital and the leverage approaches to determine credit or operational risk capital ratio can be found in OSFI’s Capital Disclosure Requirements requirements are required to calculate a capital floor which limits and D-12 Leverage Ratio Disclosure Requirements. the extent that RWAs can be lowered relative to standardized approaches. Prior to Q2-2018, Canadian DTIs using internal In addition to the above changes that raise the quality and models to calculate a Basel I capital floor as per OSFI’s now quantity of capital, the implementation of updated Basel IV expired A-3 Guideline. Effective Q2-2018, Canadian DTIs using standards related to the calculation of RWAs has also begun. internal models, or Internal Models Approved Institutions Revisions to the securitization framework, the capitalization of (IMAIs), switched over to revised capital floor based on Basel II central counterparty exposures (for inclusion in the calculation standardized approaches which will stay in place until Q4-2021 of both risk-based capital and leverage requirements), and the using a scaling factor of 72.5%. standardized approach for counterparty credit risk (SA-CCR) were implemented in Q1-2019. Outstanding revisions to RWA calculations will be implemented by Q1-2022. Figure 2: Interim domestic Basel II output floor Modelled requirement Floor requirement Modelled RWA 75% x Floor RWA Less 12.5 x deductions for allowances included in capital Plus 12.5 x allowance for shortfall deductions Modelled RWA = Total RWA using OSFI-approved advanced approaches plus partial-use portfolios treated under non-modelled approaches Floor RWA = Credit RWA, Market RWA, Other Credit RWA and CVA RWA using standardized approaches (with some advanced inputs for CVA and market ris dependin on a Is approval status). Source: Capital Adequacy Requirements Guideline, Chapter 1.9.1., OSFI 2019 © 2019 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Basel IV and proportionality initiatives 3 Liquidity requirements As stated in the Liquidity Adequacy Requirements (LAR), OSFI’s with OSFI’s D-11 Guideline. DTIs are also required to report to assessment of an institution’s liquidity adequacy is informed by OSFI the Net Cumulative Cash Flow (NCCF) metric for multiple its minimum liquidity and funding standards, additional liquidity time horizons up to one year as well as a suite of liquidity and metrics and supervisory standards. All DTIs are currently required intraday liquidity monitoring tools. Although NCCF and other to maintain a Liquidity Coverage Ratio (LCR) of no lower than monitoring tools do not have defined minimum thresholds, OSFI 100% and D-SIBs must provide public disclosures in accordance reserves the right to set regulatory requirements as needed. Figure 3: Factors in the supervisory assessment of liquidity adequacy Minimum liquidity and Additional liquidity metrics Supervisory assessments funding standards NCCF Monitoring tools BCBS 144 OSFI B-6 Principles for sound liquidity risk LCR NSFR Liquidity principles Effective Q1-2020 management and Intraday monitoring tools supervision Source: Liquidity Adequacy Requirements Guideline, OSFI, 2019 2. Current capital and liquidity requirements for foreign bank branches (FBBs) FBBs are subject to different capital and liquidity requirements Figure 4: FBBD maintenance requirements for full-service than D-SIBs and SMSBs. Instead of risk-based capital branches requirements, FBBs hold a foreign bank branch deposit (FBBD) requirement that is met by unencumbered assets deposited Supervisory concerns with an approved financial institution in Canada. For a lending (if required by OSFI) branch, the FBBD is $100,000, whereas for a full-service branch there is an initial FBBD requirement of $5 million with additional Fluctuation in liabilities maintenance requirements to account for fluctuations in liabilities and supervisory concerns. With respect to liquidity, OSFI’s draft B-6 guideline indicates that Base requirement FBBs may require quantitative reporting pertaining to the liquidity of the branch in Canada and its degree of ongoing reliance on its head office. Source: Draft Guideline A-10, OSFI, 2019 © 2019 KPMG LLP, a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. 4 Basel IV and proportionality initiatives Overview of the upcoming changes to the Canadian capital and liquidity framework In this section, we begin by reviewing the upcoming changes to in Canada. Next, we explore OSFI’s proposals for how the the Canadian capital and liquidity framework for D-SIBs, which tailoring of base D-SIB requirements helps to better fit the unique are directly transcribed from Basel, with modifications to take characteristics of SMSBs. This section concludes with a brief into account the unique aspects of domestic implementation synopsis of changes to FBB branch capital requirements. 1. Domestic systemically important banks (D-SIBs) Capital requirements, output floor and leverage (SA), and modifications to the Internal Ratings Based (IRB) – requirements the removal of the IRB eligibility