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