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