Consolidated Basel-4 framework (part-2)

Also seen in https://www.innovaest.org/blog

Previous post was about:

• Border between Banking and Trading books, 
• Alignment (mostly data) problems and solutions of Credit risk measures used in these books
• Structural changes in Trading book capital measurement
• Alignment between EL (Banking book) and CVA (Trading book)

1. Changes in Banking book:
1. Change in Credit Risk measurement is driven by IFRS9 requirements about classification of portfolio items, measurements (Fair Valuation vs Amortization vs FVOCI (Fair Value Other Comprehensive Income))
2. Changes from TTC (Through The Cycle) to PIT (Point In Time), which is closer to the Risk Neutral measure used in Trading book). It helps to reduce delay in recognition of asset impairments
3. (Current) Expected (Credit) Loss (CECL) model with smoother and faster reaction to the state of counterpart. Compare to IAS39, where loss is expected and accounted in pre-default and default state. 
4. With regard to what has been discussed in the previous part, the questions are: 
1. Can we compare CECL and CVA directly? 
2. Hence can we compare PD(PTI) and PD(Risk Neutral)?
3. Also, can we compare LGDs? Trading book credit related items are mostly governed by ISDA, while Banking book is governed by local legislation and loan agreements with lender (be it mortgage or plain customer loan)
5. Remark: Changes in BigData industry led to openness of SME financial data, better predictability of economical data and also increased research about predictions of economic activities coming from satellite surveillance (by the way, this is interesting for separate discussion)
2. Balance sheet structural effects, related to ALM:
1. IRRBB - Net Income Interest (NII) risk
1. Main driver of confusion and problem here is the existence of different methods of accounting interest:
1. accrual as in contract method vs 
2. aligned with IR instruments, like swaps. 
2. This difference in methods is the main reason for the gap.
3. Consistent simulation of IR-scenarios across entire book can be a source for more optimal resource allocation.
2. Liquidity
1. HQLA requirement creates demand for government bonds, which are required to be supported with deposits. Liquidity Coverage Ratio (LCR) implicitly demands equalisation of HQLA with run-out Cash Flows within 1-month, where deposits are the most vulnerable in this regard. Net Stable Funding Ratio (NSFR) is closely related to this ratio
3. Structural FX risk 
1. This one comes from the necessity to protect capital adequacy ratio at the aggregated level (denominated in base currency) from changes of capital in branches (denominated in other currencies) due to movements in foreign exchange rates (see "Minimum capital requirements for market risk", jan2016, item 4, page 5). 
3. In summary, overall balance sheet optimization must be done within the following regulatory constraints:
1. Capital adequacy ratio
2. Leverage ratio
3. LCR and NSFR

Consolidated Basel-4 framework (Part-1)

Also seen in https://www.innovaest.org/blog

BIS has published their Consolidated B4 framework for Banks.

Summary of themes:

1. Introduce stronger border between Banking and Trading books.
2. Better alignment between Credit Risk measures withing Trading and Banking books:
1. Trading Credit Risk was measured over risk neutral measures (i.e. implied from traded instruments, such as CDS, Bonds etc.), while
2. Banking Credit Risk was simpler, but had more complicated structure. It was a blend of
1. Ratings coming from major rating agencies
2. Statistics from the sample of default events
3. Fundamental information coming from business (market size, accounts etc) of the counterpart
3. Main difficulty of implementation of such alignment lies in the search of equivalent measure between Risk Neutral and Fundamental/Structured Credit risks present in the Trading and Banking books. 
3. Trading book (Market and Trading Credit risks):
1. It fixes capital arbitrage problem as a main concern from regulators. In the past, it was possible to shuffle instruments between those books in order to optimize (reduce) capital requirement. FRTB (Market risk) sets two restrictions:
1. on product definitions, where they can be "hold till maturity" (banking book) or "available for trade" (trading book). 
2. it is not possible to change capital model for those items which changed the book
2. Capital for Trading book must be calculated with Standardized  Approach. It is done for the better and more homogeneous capital benchmark between banks.
3. Traded Credit risk formerly accounted in IRC (Incremental Risk Charge) now moves into DRC (Default Risk Charge).
1. IRC included both, credit spread (tradeable diffusion-type series) and default events (jump)
2. DRC moves capital from default event into banking book.
4. Cross-border (banking/trading) hedges are disallowed.
5. Replacement of VaR with Expected Shortfall seems to be not much of the problem.
6. NMRF (Non-Modellable Risk Factors) are very close to those mentioned as RNIV (Risk Not In VaR) by PRA (UK).
7. New regulation requires approval at desk level. 
8. Overall, the structure has changed:
1. Basel-2: Regulatory Market risk RWA was a blend of IMA and Standardized approaches. Regulators encouraged banks to develop Economic Capital to allow regulators to benchmark both numbers. 
2. Basel-3: Market risk RWA is calculated ultimately by SA, while IMA becomes the "new Economic Capital" and will be used for regulatory benchmarking.
4. Cost of Credit - Expected Loss and CVA (Credit Valuation Adjustment)
1. Within Basel-2 Expected Loss (EL) was provisioned within annual budget. Any Unexpected Loss was covered from Capital buffer. Trading Credit Risk (also Credit Counterparty Risk) accounted EL similarly.
2. After and during the crisis of 2007-2009, CVA became important as a measure aligned with other instruments in Trading Book. Resolution of problems related to hedging rules. 

Continued here