Putting Basel IV into perspective – What is in store for Banks
With advent of Basel III, which was focused on improving the quality and quantity of regulatory capital and liquidity position of banks, there was a need felt to bring in an element of transparency and consistency in measurement of risk weighted assets (RWAs) across approaches and jurisdictions. To address this aspect, the Basel committee brought in improvements/modifications to the Basel III framework, which were drafted in December 2017, and have come to be commonly called - Basel IV.
Overview of Key Changes
Some of the key changes that Basel IV envisages to bring in relate to:
Standardized Approach for Credit Risk
Enhancing the robustness and risk sensitivity of the Credit Risk standardized approach through redefining risk weightages across various asset classes and reducing mechanistic reliance on credit ratings.
Internal Ratings Based (IRB) Approach for Credit Risk
Constraining the use of IRB approaches for credit risk through:
Disallowing the option to use the advanced IRB (A-IRB) approach for certain asset classes that cannot be modelled in a robust and prudent manner (such as exposures to large and mid-sized companies, banks and other financial institutions)
Disallowing the option to use IRB approach for equities
Adopting minimum floors (known as input floors) for certain metrics that are used as inputs in the calculation of RWAs, such as probabilities of default (PD), loss-given-default (LGD) and exposure at default (EAD)
With a more robust IRB framework in place, the Basel Committee will be removing the current 1.06 scaling factor that is applied to RWAs determined under the IRB approach.
Credit Valuation Adjustment (CVA) Risk Framework
Removing the use of the internal model approach for calculation of CVA risk and requiring the use of standardized approach, to which certain amendments have been made to improve risk sensitivity and consistency. Further, in a bid to simplify the process, banks with an aggregate notional amount of non-centrally cleared derivatives up to €100 billion will be allowed to calculate their CVA capital charge as a simple multiplier of its counterparty credit risk charge.
Operational Risk Framework
Disallowing the use of the internal model approach and the existing three standardized approaches for calculating operational risk capital requirements. These approaches will be replaced by a single risk sensitive approach which is based on two components (i) bank’s income and (ii) bank’s historical losses. This will be reflected through the Business Indicator Component and the Internal Loss Multiplier.
Output Floor for Risk Weighted Assets
Introducing an output floor of 72.5% i.e. the risk weighted assets of a bank using any of the approved approaches should be at least 72.5% of that calculated by the standardized approach.
Leverage Ratio for Global Systemically Important Banks (G-SIBs)
Introducing a leverage ratio buffer for G-SIBs to the tune of 50% of a G-SIB’s risk weighted higher loss absorbency requirement.
Market Risk Framework
The revised market risk framework was finalized by the Basel Committee in January 2016 and mainly encompasses the following three areas:
Revising the boundary for banking book and trading book to reduce incentives for a bank to arbitrage movements of instruments between the two books
Revising the Internal Model Approach to make it more coherent and comprehensive in its risk capture (through replacing VaR with Expected Shortfall metric). The revision also requires a more granular model approval process and constrains the capital reducing effects of hedging and portfolio diversification
Revising the Standardized Approach to make it more risk sensitive. The revised approach will explicitly take into account Default Risk Charges and Residual Risk Add-on charges
Implications for Banks
For the changes highlighted above, except for the one on output floor, the Basel Committee has set 1 January 2022 as the implementation date.
For the regulation on output floor, the Basel Committee has set a transitional arrangement to phase it in over a five-year period starting from 1 January 2022.