The last decade of banking has been dominated by implementation of the reforms passed in the wake of the global financial crisis. With many major initiatives (Dodd Frank, MiFID II, EMIR, etc.) reaching their final phases, this period of rapid regulatory changes is slowly winding down. Basel III – the package of bank capital, risk and liquidity guidelines issued by the Basel Committee on Banking Supervision (BCBS) in 2010 – was likewise largely implemented by 2017. However, several essential components of the Basel III reforms were never completely finalized because the BCBS and industry participants agreed that further modifications were required. As a result, the BCBS announced a number of modified and additional requirements, which were dubbed “Basel IV” by many industry participants. Basel IV marks the final phase of Basel III implementations. These changes are intended to “restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios”[1] by remedying issues the BCBS identified following the initial implementation of Basel III guidelines.
The major components of Basel IV are:
The addition of a leverage ratio surcharge for Globally Systemically Important Banks (G-SIBs), equal to 50% of the bank’s existing risk-based capital buffer
A required floor for RWA calculations generated by banks’ internal models of no less than 72.5% of the level generated by the standardized approaches (to be phased in over five years)
A standardized approach for modelling operational risk
A Standardized Approach for Calculating Credit Risk (SA-CCR) – including a standardized approach for Credit Valuation Adjustment (CVA), limits on the use of internal models for some credit portfolios and revisions to the standard model for credit risk.
Changes to market risk calculations – generally referred to as Fundamental Review of The Book (FRTB).
The implementation timing for the different Basel IV components for US banks varies significantly. SA-CCR went live for smaller US banks in April of 2020, though US regulators allowed compliance on a “best-efforts basis” given the complications of the COVID pandemic. “Advanced Approach Banking Organizations” (i.e. the largest US banks) have until 2022 to comply. While the BCBS calls for the remaining Basel IV changes to go live in 2023, with the RWA floor phased in through 2028 – following a one-year delay to both due to the COVID-19 pandemic – national regulators have yet to set their own dates or finalize rules for many remaining requirements. It seems likely that Basel IV go-live will instead be an ongoing process, rather than a single “big bang.”
As depicted in Table 1 below, the changes required as part of Basel IV impact the way RWA calculations are performed and place limits on the benefits banks can gain from deploying proprietary models. While not directly impacting the capital ratios, higher RWAs will inevitably translate into additional capital ratios for some firms. In addition, G-SIBs will be subject to a leverage ratio surcharge that discourages large banks form excessive debt build-up.
Table 1
A Very Real Impact
The upshot of Basel IV is an expected capital shortfall among European and Asian banks, though estimates of the size of the impact differ widely. In contrast, US banks are expected to see relatively minimal changes to capital requirements – the Collins Amendment of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires US banks to report RWAs as the higher of standardized or internal models, effectively setting a floor of 100%. In addition, current modelling of operational risks by US banks closely resembles the standardized Basel approach, which is not the case for many European and Asian banks. The main impact for US banks will be felt in the changes to market risk capital standards (e.g. FRTB), a subject MCG covered in a prior publication.
The changes to RWA calculations will require many banks to re-examine their capital strategies and take a careful view of RWA-intense businesses and products. Banks should undertake a head-to-toe review of how they are currently allocating their capital across their operations and identify the future gaps that will emerge under the revised regulatory capital regime. Difficult decisions may need to be made regarding capital-intensive activities. Banks may need to change their activity levels or alter their pricing strategies in certain market segments to remain competitive.
Managing Complex and Competing Requirements
Beyond the headline capital numbers and strategic concerns, banks’ technology organizations will have their hands full managing another major regulatory initiative. This is at a time when banks are already juggling widespread changes from the ongoing LIBOR transition, implementation of IFRS 9/Current Expected Credit Loss, and the final phases of UMR. This will require a strong change management culture that allows them to effectively govern many competing initiatives.
Some of the changes will make generating risk metrics much more complex than the initial Basel III standardized approaches. For example, SA-CCR will require new models to be developed and validated, while the RWA floor will require functionality to run both internal and standardized models in parallel, then select the outcome that meets the 72.5% requirement. This may entail significant additional hardware requirements, in addition to software development. All these changes which will also need rigorous testing, both within and across systems, to make sure new functionality and models work correctly and play nice with the changes required by other programs.
Basel IV is further intended to ensure banks are in compliance at all times, not just for specific reporting dates or periods. This further complicates the changes needed and makes it vital for banks to create an integrated system of reporting that can be run from one single point at any time. Linkages across systems, records and functions must be as automated and seamless as possible while also providing a comprehensible audit trail.
Elsewhere, new approaches for modelling operational risk will require entirely new models, processes and reporting. Proper governance will be vital to validate and control these new procedures, which will also entail even further testing. Testing Automation can play a major role in helping firms better manage resources and meet the increasing testing burden efficiently. Overall, Basel IV will represent a test of banks’ ability to handle changes across several dimensions at once, just as they thought the sun was finally setting on the post-crisis regulatory phase.
About Monticello
Monticello consultants have extensive experience in the implementation of large-scale regulatory initiatives. Our firm understands the importance of diligent analysis, program management, and collaboration across teams within major financial institutions and across the industry. Our current work on LIBOR Transition, Uncleared Margin Rules (UMR), Qualified Financial Contract (QFC) Record Keeping and US Stay regulations demonstrates the important regulatory expertise our consultants bring to our clients. Our teams possess deep knowledge of capital markets instruments, legal agreements and operational processes, as well as the related data and information systems impacts that will be in focus for the migration to RFRs. Monticello teams are dynamic, flexible, and highly motivated to assist you in meeting all of your regulatory requirements.
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