What will the ‘Basel IV’ package mean for banks?
07 March 2018
The finalisation of the Basel III rules, widely referred to as the ‘Basel IV’ package, marks the end of a period of regulatory change, according to the Basel Committee. On issuing the finalised rules in December 2017, the Committee stated that firms can now focus on implementation.
Whether we have truly seen the end of new rules remains to be seen, but nonetheless firms now need to get on with implementing the changes – a task not without its difficulties.
The changes are wide ranging and will affect UK-based banks, building societies and PRA-designated investment firms. They relate to capital requirements and affect credit risk, operational risk and credit valuation adjustment (CVA) calculations. The reforms also update the leverage ratio, add a leverage ratio buffer for globally systemic banks, and define a new minimum capital output floor. Firms have until 2022 to implement the changes and until 2027 to phase in the capital floors. It’s also worth noting that the Basel Committee has aligned the implementation timeline for the new market risk framework to 2022.
While this may be four years away, the changes are significant and firms should begin planning now.
The new rules restrict the use of internal models to calculate capital requirements. Internal models can only be used on a limited basis for CVA and not at all for operational risk. Firms will also be limited to using the foundation internal ratings based approach to calculate certain credit risk capital requirements. And the benefit from using internal models is further constrained by the new output floors. The Committee’s desire to reduce variability in calculating capital and promote a level playing field is driving these changes. Smaller firms will welcome the changes after seemingly being penalised under current rules with higher capital requirements due to their inability to implement internal models.
However, the standardised approaches for credit risk, operational risk and CVA will become more granular and risk sensitive, which means more complexity and the need for better data for all firms, big or small.
Overall, the reforms affect many aspects of firms’ businesses - ranging from data and infrastructure to pricing and overall strategy. One of the first issues for firms to consider is cost, not only of holding additional capital but also the operational and resourcing costs of implementing these changes. Secondly, firms must take stock of which approaches they currently use for each of their portfolios, whether they can continue using those approaches or not, and whether the investment in adopting internal models still makes economic sense. An additional headache for international groups is the room left in the package for national discretion, which could mean increasing divergence in requirements between jurisdictions.
The Basel Committee expects these changes will also result in some redistribution of capital in the financial system. Overall, the European Banking Authority (EBA) estimates that EU banks' minimum Tier 1 capital requirement will increase by 12.9% at the full implementation date, with larger, internationally active banks most impacted given their more extensive use of internal models.
A broader point for firms to consider is what other regulatory developments are in the pipeline, and whether they can align different change programs to achieve cost savings where possible. With its myriad implications, it’s crucial that firms prioritise preparations for Basel IV.
For a more detailed analysis of the Basel IV package, please read our Being Better Informed feature article.