Basel IV: Get ready to clear the next hurdles

As part of the ongoing Basel reforms, the Bank for International Settlements (BIS) is busy rewriting the rules that govern how much capital banks must maintain in order to mitigate their exposures to different types of risk. There is a long list of changes on the horizon. However, at present, many practitioners are focusing on two specific measures: the Standardised Approach for Measuring Counterparty Credit Risk Exposures (SA-CCR) and the Fundamental Review of the Trading Book (FRTB).

SA-CCR

SA-CCR uses much of the same terminology as the existing credit risk calculations. However, despite the superficial similarities, the new calculations are completely different from what has gone before. They are significantly more complex and include different calculations for individual asset classes and rules regarding the treatment of particular product sets. As a result, rather than tweaking what they already have banks will need to implement a totally new set of calculations.

The SA-CCR calculations bring with them new data requirements. While there is an overlap with the data used in the incumbent credit risk calculations, banks will also need to source many new attributes. For example, they will need information about margin agreements with counterparties, including threshold amounts and minimum transfer amounts, and the ability to link this information to their trade and collateral data.

Banks are likely to have most of the required data somewhere within their infrastructure. However, due to the complicated system structures that exist at most large banking groups, sourcing the data will be one of the most challenging aspects of implementing SA-CCR. In many cases it will involve changing not only the systems that feed directly into the regulatory capital calculation engine, but also other upstream systems. To expedite the data sourcing process, many banks are likely to work with a third party who has already identified which additional data attributes are required.

The FRTB

While SA-CCR addresses counterparty credit risk for derivatives, the FRTB is targeted at market risk. There has been much discussion in the industry about the internal model-based approach to the FRTB. However, it is important that banks do not underestimate the challenges of implementing the FRTB standardised method, particularly as it will impact all institutions – including those that adopt the internal approach.

Those that go down the FRTB standardised route will find they need many data points that have not previously been required. For example, banks will need to calculate deltas and vegas (volatility) for prescribed risk factors and then feed these into the standardised FRTB calculations. These data attributes have historically only been required for options, but will now also be needed for other product types.

As with SA-CCR, banks are likely to have most of the required FRTB data within their systems. However, due to the complex nature of their system structures, they face a significant challenge to ensure all of the data feeds into the FRTB calculations.

The FRTB standardised approach also introduces new stress scenarios, which have not previously been part of the standardised market risk process. Banks will now need to run both downward and upward shock stress scenarios in order to calculate their curvature risk charges. They need to consider now how they are going to smoothly and efficiently integrate these additional steps into their regulatory calculation processes.

While addressing the above challenges, it is important that banks do not lose sight of the wider context in which SA-CCR and the FRTB are being introduced. As mentioned, SA-CCR and the FRTB are just two elements of a much larger package of changes to the Basel capital adequacy rules. As well as credit risk and market risk, changes are being made to the way banks calculate the capital needed to cover their exposures to credit risk, central counterparties (CCPs), operational risk and credit risk due to securitisations. The changes are so fundamental and so numerous that, although they are part of Basel lll, some people are now referring to them as ‘Basel IV’.

There is a significant overlap between the data that will be needed to run all of these new Basel calculations and many of the calculations are interdependent. For example, the same product data will be required for all of the calculations, and the outputs from SA-CCR will need to be fed into the large exposure and credit valuation adjustment (CVA) calculations. It is therefore essential that banks plan strategically for the entire suite of new Basel capital rules rather than focusing on SA-CCR and the FRTB in isolation.

Banks that do not consider all the new Basel capital rules collectively may end up using a separate regulatory calculation tool to manage each of the calculations. Given the overlapping and interconnected nature of the requirements, it is clear this would be extremely inefficient and unnecessarily complex.

The strategic approach

The most efficient way for banks to tackle SA-CCR, the FRTB and other Basel capital rules is by using a single platform to run all of the different calculations. By taking this approach, they will avoid the need to load the same data onto many different systems; they will ensure consistency between the data used to run the different calculations; and it will be easier for them to feed the outputs of individual calculations into other related calculations.

Banks also need to think about how they will manage the staggered implementation timetable for the ‘Basel IV’ capital rules, which will be phased in over a number of years. Many banks struggle to keep up with a quick succession of regulatory changes, due the inflexibility of their technology. These banks often find they need a complete software update to accommodate each regulatory change. Installing and testing such an update is a long and complicated process, which eats into the time that banks have to prepare and increases the risk of missing a deadline.

To ensure they can keep pace with the implementation of the new Basel capital rules, banks should use a calculation platform that separates the regulatory functionality from the core platform functionality. This will mean that when the final version of one of the new calculations is published, a bank will be able to add it to the platform quickly without having to update the entire infrastructure, impacting other functionality and users in the process.

Impact analysis

The changes that are being made to the Basel rules will inevitably alter banks’ capital requirements. The priority for many banks now is to understand how their capital requirements will change. Historically, some banks have relied on spreadsheets to do this impact analysis work. This is a very cumbersome approach. It means that when the requirements come into force, in order to automate the calculations, banks need to spend months reconfiguring their capital calculation engines based on the changes they have worked out on paper.

They can avoid this situation by doing their impact analysis work within their regulatory calculation tool, running the new Basel calculations in parallel with their incumbent calculations. This approach makes it easier for banks to run the calculations over an extended period in order to get a more complete understanding of the impact. It also gives them more confidence in the accuracy of the results because they are based on production data. Furthermore, when the final requirements come into force banks will already have the calculations set up within their regulatory compliance infrastructure.

The new Basel capital calculations present many challenges for banks. However, by thinking strategically about the entire suite of reforms now and by using flexible calculation technology, they can adapt smoothly and efficiently to the new regulatory regime.

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