Introduction to Basel IV

What was the objective of Basel III revisions?

Revisions to the Basel III standard, which the market commonly refers to as ‘Basel IV’, were agreed upon in December 2017. The overall objective of the revisions to Basel III standards is to “restore credibility in the calculation of risk-weighted assets (or RWAs) and improve the comparability of banks’ capital ratios”.

In the final package, the BCBS made the following revisions:

• Amendments to the applicable risk-weights under the Standardised Approach for credit risk, credit value adjustment (or CVA), and operational risk
• A number of granular constraints on internal models, which includes the move of exposures to Banks and Large Corporates from Advanced Internal Ratings-Based Approach or AIRB, to Foundation Internal Ratings-Based Approach or FIRB, and a series of ‘input floors’ at Probability of Default and Loss-Given Default level
• The removed use of the Advanced Measurement Approach (AMA) for operational risk and CVA risk
• An output floor, which is calibrated at 72.5% of the Standardised approaches
• Amendments to the Leverage Ratio calculation, with confirmation of the new surcharge for global systemically important banks (or GSIBs)

What changes were made to credit risk?

Changes to credit risk were made more standardised and impacted the following entities:

• Banks and other financials
• Large corporates
• Middle market corporates
• Small to medium sized businesses
• Mortgages

Fundamental and standardised reviews of trading books were set in place to determine credit valuation and the adjustment of risk.

What changes were made to operational risk?

Operational risk capital will be calculated based on banks’ income (which represents the Business Indicator) and their historical operational losses (which represents the Loss Component). Within the Business Indicator component, the consultation document proposed 3 buckets.

What changes were made to the leverage ratio?

In relation to the Leverage Ratio, GSIBs will be subject to an additional Leverage Ratio buffer requirement. This buffer is to be met with Tier 1 Capital, and is set at 50% of a GSIB’s risk weighted higher-loss absorbency requirement – for example, for a Level 1 GSIB (subject to a 1.0% surcharge on their risk-weighted capital ratio), the Leverage Ratio surcharge will be an additional 0.5%, to make a total requirement of 3.5%. As with the capital risk-based framework, capital distribution constraints will apply for a GSIB if the leverage ratio buffer requirement is breached.

Where to next?

The individual new requirements are to be implemented by January 2022. To commensurate the standards, the BCBS also published analysis showing very moderate aggregate impacts globally, while confirming the very uneven nature of these impacts. Where some banks would appear to receive a benefit, those with adverse impacts vary from negligible to highly material, depending on each bank’s starting-point and portfolio mix.

While BCBS have said this is the finalisation of Basel III revisions, national supervisors are in a process of developing revised policies. National supervisors will be working on policy drafting and consultation and more granular assessment as to what the impacts, with the eventual implementation by 2022. Revisions to the RWA framework will be a key area of priority for supervisors, which will keep them and industry busy over the next 2 to 3 years.