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Foreword 11
Preface 13
1. Chapter: Introduction 15
Literature 17
2 Chapter: Revision of the Standardised Approach for Credit Risk (SA-CR) 19
2.1 Introduction 19
2.2 General aspects 23
2.3 Determination of the exposure value 25
2.4 Exposures to institutions 26
2.5 Exposures to corporates 29
2.6 Specialised lending exposures 30
2.7 Subordinated debt and equity exposures 32
2.8 Retail exposures 33
2.9 Exposures secured by mortgages on immovable property 34
2.9.1 General requirements 35
2.9.2 Calculation of the exposure-to-value (ETV) 36
2.9.3 Exposures secured by mortgages on residential immovable property 37
2.9.4 Risk positions secured by mortgages on commercial immovable property 40
2.9.5 Receivables related to land acquisition, development and construction (ADC) 41
2.9.6 Changes compared to the current CRR regulations 42
2.10 Defaulted receivables 43
2.11 Other assets 43
2.12 Additional risk weights for risk positions with currency mismatches 43
2.13 Use of external ratings 44
2.13.1 General aspects 44
2.14 Credit risk mitigation techniques 46
2.14.1 The financial collateral simple method 46
2.14.2 The financial collateral comprehensive method 47
2.14.3 Eligibility of repurchase agreements and similar transactions 48
2.14.4 Consideration of guarantees and credit derivatives 49
2.15 Summary 50
Literature 51
3 Chapter: The future of the IRB Approach 53
3.1 Introduction to the fundamentals of the IRB approach in accordance with CRR 53
3.1.1 Introduction to the IRB risk weight formula 54
3.1.2 The adoption of the IRB approach 60
3.1.3 Calculation of RWA and EL 60
3.1.4 Minimum requirements for the entry and ongoing use of the IRBA 66
3.1.5 Approval process: home/host coordination 73
3.1.6 Decision on the application 73
3.2 The implementation of the Basel Committee's initiative to improve the IRB approach in the EU 74
3.2.1 Introduction 74
3.2.2 Scope of the internal models 76
3.2.3 Partial use of the IRB approach 80
3.2.4 Risk parameter floors as an instrument RWA variability reduction 82
3.2.5 Parameter estimation procedure 84
3.2.6 Credit risk mitigation 87
3.2.7 Changes in the modelling specifications 88
3.2.8 Expected impact on banks 90
3.2.9 Conclusions 93
Literature 94
4 Chapter: Supervisory treatment of market risks 95
4.1 Introduction 95
4.2 General and overarching adjustments 96
4.3 Revised trading book boundary 97
4.4 Adjustments to the requirements for reclassifications (Article 104a CRR 3) 99
4.5 Adjustments to the requirements for internal risk transfers (Article 106 CRR 3) 100
4.6 Revised treatment of investments in funds in the trading book 101
4.7 Adjustments to the Alternative Standardised Approach for market risk 103
4.7.1 Adaptation to the qualitative requirements of the A-SA 104
4.7.2 Technical adjustments to the Alternative Standardised Approach for market risk (A-SA) 104
4.8 Simplified standardized approach for market risk (S-SA) 107
4.9 Alternative Internal Model Approach for market risk (A-IMA) 107
4.9.1 Permission and own funds requirements 108
4.9.2 General requirements 108
4.9.3 Internal model for default risks 109
4.10 Conclusion 110
Literature 110
Contents 7
5 Chapter: The CVA risk capital charge framework 113
5.1 Introduction 113
5.2 Hierarchy of approaches 114
5.3 CVA exemptions and securities financing transactions 116
5.4 Standardised approach for CVA 117
5.4.1 Regulatory CVA model 117
5.4.2 Calculation of own funds requirements 118
5.5 Basic approach for CVA 122
5.5.1 Determination of the regulatory capital requirements on the basis of the basic CVA 122
5.5.2 Determination of the reduced version of the BA-CVA in detail 122
5.5.3 Determination of the full version of the BA-CVA in detail 124
5.6 Conclusion and expected impact 126
Literature 126
6 Chapter: Operational risks 129
6.1 Background 129
6.2 Methods for Determining OpRisk According to Basel II 130
6.2.1 Basic indicator approach and standardised approach 131
6.2.2 Advanced measurement approaches 132
6.2.3 Criticism of existing approaches 133
6.3 Overview: From Basel II to CRR 3 133
6.4 Standardised approach to operational risk (BCBS 424) 135
6.4.1 Functioning of the revised standardised approach 135
6.4.2 Calculation of annual OpRisk-related losses 140
6.4.3 Management of operational risks 142
6.4.4 Disclosure 143
6.5 Outlook 144
6.5.1 Capital requirements for OpRisk 144
6.5.2 Further consideration 144
6.6 Summary and conclusion 145
Literature 147
7 Chapter: The output floor 149
7.1 Introduction 149
7.2 Reasons for the introduction of the output floor 151
7.2.1 Outdated or no Basel I calculation systems 151
7.2.2 National deviations in the implementation of Basel I and the Basel I capital floor 152
7.2.3 The scope of application of the Basel I floor 152
7.2.4 Development of new standard approaches 152
7.3 The CRR 3 output floor 155
7.3.1 Scope of CRR 3 output floors 155
7.3.2 Calculation of the CRR 3 output floor 155
7.3.3 Transitional arrangements for the output floor pursuant to CRR 3 158
7.3.4 Selection of the right standardised approach 159
7.3.5 Deviations from Basel IV capital floor 159
7.4 Objectives and effects of the output floor 160
7.4.1 Impact of the output floor on standard approaches and their implementation 160
7.4.2 Optimization of the standardised approaches 161
7.4.3 Influence of the output floor on valuation models 164
7.4.4 Interaction between the floor and the scope of the IRB approach 167
7.5 Conclusion 168
Literature 169
8. Chapter: Disclosure 171
8.1 Introduction 171
8.2 Proportionality principle 172
8.3 Risk management objectives and policy 174
8.4 Scope of disclosure 174
8.5 Own funds 175
8.6 Capital requirements and risk-weighted exposure amounts 176
8.7 Counterparty credit risk 177
8.8 Countercyclical capital buffer 178
8.9 Indicators of global systemic importance 178
8.10 Credit risk 178
8.10.1 Credit risk mitigation 180
8.10.2 Credit risk in the standardised approach 180
8.11 Asset encumbrance 181
8.12 Market risk 181
8.13 CVA risk 181
8.14 Operational risk 182
8.15 Disclosure of key parameters ("key metrics") 183
8.16 Interest rate risk of the banking book (IRRBB) 183
8.17 Securitisations 184
8.18 Environmental, social and governance risks - ESG risks 184
8.19 Remuneration policy 187
8.20 Leverage ratio 188
8.21 Liquidity ratios 188
8.22 Conclusion and expected impact 189
Literature 189
9. Chapter: MREL and TLAC as part of the resolution regime 191
9.1 Introduction 191
9.2 Key requirements for resolution capability 193
9.2.1 Minimum requirements of the EBA 193
9.2.2 Minimum requirements of the SRB 193
9.3 TLAC 197
9.3.1 TLAC implementation 197
9.3.2 TLAC calibration 198
9.3.3 TLAC-eligible liabilities 198
9.3.4 Resolution units and internal TLAC 198
9.3.5 TLAC holdings 202
9.3.6 TLAC reporting requirements 202
9.3.7 TLAC disclosure 203
9.4 MREL 203
9.4.1 MREL implementation 203
9.4.2 MREL calibration 204
9.4.3 MREL-eligible liabilities 205
9.4.4 Resolution units and internal MREL 208
9.4.5 MREL holdings 210
9.4.6 MREL reporting requirements 210
9.4.7 MREL disclosure 213
9.5 Outlook and conclusion 214
Literature 216
10 Chapter: ESG: Regulatory overview for dealing with sustainability risks 219
10.1 Sustainability risks in the financial sector 219
10.2 Consideration of sustainability aspects in SREP 219
10.2.1 Regulatory background 219
10.2.2 Overview of the expectations of European banking supervision 222
10.2.3 Consideration of ESG in the Supervisory Review and Evaluation Process (SREP) 225
10.3 ESG ratings - methodology and comparison 226
10.3.1 Introduction to the subject of ESG ratings 226
10.3.2 Overview of the ESG rating market 229
10.3.3 Methodological approaches and problems 232
10.4 Adjustment of capital requirements to cover sustainability risks 238
10.4.1 A possible adjustment of the minimum capital requirements on the basis of ESG ratings 238
10.4.2 Privileging of infrastructure projects under Pillar I 240
10.4.3 "Green Supporting Factor" and "Brown Penalty Factor" as adjustment factors 241
10.4.4 Sustainability Factor (SF) and Sustainability Weight (SW) as alternatives to the binary approach 243
10.4.5 Outlook 245
Literature 247
11. Chapter: Cryptoassets 249
11.1 Definition and types of cryptoassets 249
11.2 Development of a prudential framework 250
11.3 Classification procedure for cryptoassets 251
11.4 Regulatory requirements in relation to Group 1 cryptoassets 253
11.4.1 Credit risk 253
11.4.2 Market price risk 256
11.4.3 Add-on factor for infrastructure risk 257
11.4.4 Credit valuation adjustment (CVA) 257
11.4.5 Determination of counterparty default risk 258
11.5 Regulatory requirements in relation to Group 2a cryptoassets 258
11.5.1 Minimum capital requirements for credit and market risk 259
11.5.2 Credit valuation adjustment 260
11.5.3 Determination of counterparty default risk 260
11.6 Regulatory requirements in relation to Group 2b cryptoassets 261
11.6.1 Minimum capital requirements for credit and market risk 261
11.6.2 Credit valuation adjustment 261
11.6.3 Determination of counterparty default risk 261
11.7 Final BCBS standard 262
11.8 Conclusion 263
Literature 263
12. Chapter: Further requirements of CRD 6 265
12.1 Introduction 265
12.2 Supervisory powers 265
12.2.1 Requirements for the independence of competent authorities 265
12.2.2 Extension of supervisory powers in the case of acquisitions, disposals, mergers and divisions 266
12.2.3 Professional qualification and personal reliability (Fit & Proper) 267
12.3 Branches from third countries 269
12.3.1 Approval 270
12.3.2 Minimum regulatory requirements 270
12.3.3 Reporting requirements 272
12.3.4 Supervision 272
12.3.5 Conclusion 273
Literature 273
Friedemann Loch and Frank Marinkovic
For a typical bank, credit risk represents by far the most relevant type of risk.1 The concept for quantifying this type risk was the first one to be developed by the Basel Committee under the Basel I accord in 1988. Given that early stage in the development of regulatory rules for the quantification of risk, these rules did not have a proper level of risk sensitivity and were thus unable to distinguish adequately between low and high levels of credit risk. This lack of specificity was criticised by both the supervisory authorities and the banks and led to the first significant revision of the quantification rules from 1999 onwards, later referred to as "Basel II".
Under Basel II, a new concept was introduced that gave banks the option to choose between a so-called "Standardised Approach" (credit risk standardised approach, hereinafter also referred to as "SA-CR" or "SA"), in which almost all parameters and rules for quantification were prescribed by the supervisory authorities, and an approach based on internal ratings ("IRB approach", see Chapter 3), in which it was possible for banks for the first time to determine one or more credit risk parameters on the basis of internal procedures and to calculate the risk weighting based on these parameters.2
The SA-CR developed under Basel II already featured a much more granular breakdown of the risk weighting for different borrowers than under Basel I, as well as a significantly improved consideration of risk mitigation instruments.
With respect to the IRB approach, however, there were still simplifications, clearly intended by the supervisor, both in the determination of the risk weight of the individual borrower and in the form and scope of eligible risk mitigation instruments.
Since Basel II, and virtually unchanged by Basel IV, banks have the option of either using the less risk-sensitive SA-CR or the IRB approach (which requires prior supervisory approval), which generally leads to lower risk weightings. Banks may individually choose to apply the IRB approach. However, once the IRB approach is used, it has to be applied to all material positions (see section 3.2.3).
Basel II was implemented by means of several European directives, which were incorporated into German law as part of an amendment to the German Banking Act (KWG) and the introduction of the Solvency Regulation in December 2006.
In response to the financial market crisis, the implementation of the Basel III regulations changed the structure of the regulatory requirements at European level and replaced the previous national requirements under the Solvency Regulation with a European regulation ("CRR"), which in turn has been amended several times and currently has the status "CRR 2". The CRR and CRR 2 did not materially change the content of the SA-CR requirements. Thus, the current rules of the SA-CR correspond de facto to the requirements of Basel II from 1999.
CRR 3 leaves the basic structure of SA-CR and IRBA unchanged, but the SA-CR and IRBA rules are subject to fundamental changes and updates.
Figure 2.1 shows the main elements for quantifying credit risk.
Figure 2.1: Procedure for quantifying credit risk
Source: Own representation.
Under the current SA-CR - which has remained virtually unchanged since Basel II - external ratings play a key role in determining the risk weights and hence the regulatory capital requirement. Both the classification of exposures into individual asset classes and the process for deriving risk weights on the basis of external ratings are prescribed in full for banks by the supervisory authorities, with no scope for discretion. The scope of collateral and guarantees eligible for risk mitigation purposes is also clearly defined. Only in the case of the recognition of financial collateral are banks permitted - albeit only to a very limited extent - to use their own estimated haircuts.
In contrast to the SA-CR, it is possible under the IRBA to determine the borrower's creditworthiness using internal ratings. In addition, there are also so-called "advanced IRB approaches" in which the effect of the recognition of risk mitigation instruments (i.e. the loss given in the event of default) and the credit conversion factors can also be individually quantified by the banks (see Chapter 3 on the IRB approach).
After the adoption and European/national implementation of Basel II, it became apparent that the objectives of greater economic differentiation of credit risks pursued with the development of the SA-CR were essentially only achieved for claims on central governments and central banks. For other asset classes, in particular for claims on corporates, it became apparent that, due to the often-low number of available external ratings, a differentiation of different credit ratings - and thus risk weights - was not possible, or only possible to a very limited extent. All claims on corporates without an external rating are to be classified as "unrated" within the currently valid SA-CR and are assigned a risk weight of 100 percent, which corresponds materially to the requirements of Basel I (or Principle I /"Grundsatz I" in Germany).
In the course of the financial market crisis that began shortly after the implementation of Basel II, not only the limited extent of risk differentiation but also the appropriateness of the use of external ratings for regulatory purposes was increasingly questioned and criticised.
After the Basel Committee had made a series of adjustments to the regulatory framework known as "Basel 2.5" as an immediate reaction to the financial market crisis, which did not, however, relate to the SA-CR, the Committee devoted itself to a fundamental revision of practically all aspects of the determination of capital ratios under the heading "Basel III".
The adoption of Basel III essentially took place in two parts. The first part involved - among other changes - a radical and fundamental revision of the rules for the definition of regulatory capital and the form and level of regulatory capital ratios. In addition the concept of capital buffer has been introduced. Regarding the rules of the SA-CR, there were practically no changes at Basel level at this time.
Since the Basel III regulations were essentially implemented for the first time at European level by means of a central regulation ("Capital Requirements Regulation/CRR") instead of a directive to be implemented on a decentralised basis, the associated standardisation of previously existing national differences also resulted in individual changes in detail for the SA-CR in Germany.
The second part of Basel III involved a fundamental revision of virtually all methods for the quantification of risk weighted assets.
Activities regarding the revision of the SA-CR started at Basel level in December 2014 with the publication of a first consultation paper for the revision of the SA-CR.3 The objective of the revision was to increase risk differentiation and to move away (to the maximum extent possible) from the use of external ratings without increasing the complexity for the calculation of RWA. Another objective of the Committee was to increase international comparability by reducing existing national options in the implementation of the SA-CR and to improve comparability between the SA-CR and the IRBA by better aligning the asset classes in both approaches.
The first consultation paper envisaged a fundamental change in the structure of the SA-CR and included a complete move away from the use of external ratings. Since the new proposals for the quantification of credit risk contained in this consultative paper showed clear conceptual weaknesses and the resulting capital charges were also significantly higher than the previous level, the Basel Committee published a second consultative paper4 in December 2015, in which the use of external ratings was again permitted and the procedures for determining the capital charge were again more closely oriented to the previous regulations.
In the further course of the negotiations at Basel level, adjustments and refinements were made to numerous individual aspects of the SA-CR and published in December 2017 as part of a paper known as the "Finalisation of Basel III".5
The Basel requirements relating to the SA-CR will be incorporated into European law via a further revision of the CRR ("CRR 3"). The first draft of this amendment regulation was published on 27 October 2021. As of the first quarter of 2023 discussions will take place. It is expected that the rules will be finalised and published by the end of 2023. The date of the application of the new rules is scheduled for 1 January 2025. In principle, the Basel requirements are to be implemented as precisely as possible, but the current draft of CRR 3 already shows numerous deviations and specifications in detail for the individual requirements.
A fundamental difference between the current SA-CR and the revised SA-CR under CRR 3 arises from the fact that the SA-CR in CRR 3 must be implemented in full by all banks - including all IRB banks - as the SA-CR represents the starting point for the calculation of the "capital floor" (see Chapter 7) for all IRB...
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