Building for the Future with Basel IV
25. 10. 2020
The regulatory environment for the financial and banking industry is continually evolving. The financial crisis of 2007-08 had uncovered glaring deficiencies in financial regulation and the Basel Reforms were introduced, among other global and national measures, to prevent a repeat of the crisis.
The third installment of these reforms, Basel III, were designed to address weaknesses in banks’ resiliency through quantity and quality of bank capital and liquidity. The final set of Basel III Reforms, informally known as Basel IV, were published in December 2017, and are set to be implemented in the quarter 1 of 2023. This set of reforms seeks to enhance credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability and transparency of banks’ capital ratios.
For banks, this means revisions to the standardized approach and internal ratings-based approach to credit risk, the operational risk framework, the leverage ratio framework, and the credit valuation adjustment requirements. In addition, the Basel IV reforms will also replace the existing capital floor with more risk-sensitive output floor.
In light of the glaring gaps highlighted by the financial crisis, the Basel IV reforms are aimed at reducing variability of risk-weighted assets (RWAs) reported by banks. Basel IV proposes three key pillars as part of the revised regulatory framework to build transparency into RWA calculations. These pillars include:
Pillar 1 covers the following key elements - Capital, Risk Coverage, Leverage and Liquidity:
Level and Quality of Capital: The Basel IV reforms propose raising the minimum common equity to 4.5% of RWAs, after deductions. A capital conservation buffer with common equity of 2.5% of RWAs is also proposed, which will bring the total common equity standard to 7%.
Revisions to Standardized Approaches for Credit Risk, Operational Risk, Market Risk and Credit Valuation Adjustment: Banks and other financial institutions will be required to enhance the risk sensitivity of the Standardized Approach by increasing the granularity of risk weights (including real estate exposures) and reducing reliance on credit ratings by performing their own due diligence on exposures that are externally rated. They will also have to constrain the use of the Internal Risk Based Approach for Credit Risk by reducing the number of asset classes for which banks can use this approach and imposing supervisory constraints on certain parameters. Next, the output floor calculation will have to be based on the Basel IV standards, rather than the earlier Basel I framework. The floor level will also have to be raised from 50% to 72.5% of RWAs using the standardized approaches.
A single risk-sensitive standardized approach will replace the advanced measurement approach and existing standardized approaches for operational risk. The new calculation of Operational Risk capital requirements will be based on measures of the bank’s income and historical losses.
For Market Risk, the reforms incorporate the exposure components of credit valuation adjustment (CVA) risk along with corresponding hedges into the CVA capital charge. Moreover, they seek that the advanced approach be removed and instead banks align with the standardized approach along with the Revised Market Risk Framework under the Fundamental Review of the Trading Book (FRTB).
Containing Leverage build-up: Basel IV proposes a non-risk-based leverage ratio, which will include off-balance sheet exposures to help contain system-wide buildup of leverage and provide back up for risk-based capital requirements.
Liquidity Risk: Basel IV introduces the concept of a Leverage Ratio buffer for global systemically important banks. The reforms have also refined the exposure definitions in the Leverage Ratio, including changes to the treatment of derivatives and off-balance sheet exposures.
Pillar 2 focuses on firm-wise risk management and supervision:
These reforms include the risk of off-balance sheet exposures, compensation practices, valuation practices, corporate governance, and stress testing. A uniform approach for measurement of the extent of Interest Rate Risk in the Banking Book (IRRBB) has been introduced the in the reforms. This could provide better comparability in comparison to the Standardized Pillar 1 approach.
Step-in Risk is a concept where a bank may provide financial support to an entity beyond or in absence of any contractual obligations, should the entity experience any financial distress. The focus on the reforms is on identification on unconsolidated entities to which a bank may nevertheless provide financial support to protect itself from any adverse reputational risks. Significant step-in risk may exist when one of the step-in indicators, which range from capital ties, sponsorship, provision of financial facilities, decision making and operational ties, exists.
Pillar 3 focuses on market discipline and market-relevant disclosures:
Basel IV introduces a dashboard for banks’ key prudential metrics and revises disclosure requirements for market-relevant information to improve market discipline.
Perhaps the most significant change, however, is the inclusion of proportionality. For the first time, federally regulated small and medium size deposit-taking institutions (SMSBs) are included in the framework. Unlike large financial institutions that have been steadily strengthening their risk sensitivity through Basel I to Basel III and are prepared for change, small and medium banks are still struggling to plan compliance.
The scope of the SMSBs’ Basel IV implementation efforts will depend on their categorization within the SMSB segmentation scheme, which will determine the exact nature of their Pillar 1 capital and liquidity requirements. Phase 1 will typically require SMSBs to comply with Capital Adequacy, Leverage and Liquidity Adequacy requirements by Q1 2023.
IT architectures will need to be more powerful to support parallel calculation of standardized and internal approaches. Infrastructure and technology enhancements will be needed to handle the increased volume and granularity of data required under the more complex standardized approaches. Reporting software will need to be integrated into finance and risk architecture.
The increased complexity of the new approaches will involve extensive data requirements. For instance, detailed data on real estate collateral in lending business will be needed for the new credit risk standardized approach and granular market and historical data will be required for the internal market risk models. Overall, data requirements will be higher not only in terms of availability, but also evaluability, quality, and flexibility.
Adherence to the Basel IV reforms will also involve a massive expansion of reporting requirements to supervisory authorities with more frequent reporting needs. For instance, 109 new non-dimensional datapoints and 126 new validation rules have been added to Basel IV. Even internally, it will be imperative that the effects of Basel IV be visible in real-time as a basis for execution of trading decisions in the front-office.
Meeting OSFI’s mandates to produce high-quality financial, liquidity and risk reports, as frequently as daily by region, legal entity, and line-of-business with consolidated views over multiple time dimensions will require significant automation and enhancements to data management, technology, and infrastructures.
Adastra can support financial institutions in the end-to-end implementation of Basel IV reforms by means of a Basel IV implementation gap assessment, interpretation of OSFI requirements, complete solution architecture and design, including prebuilt calculation and reporting engines. Our solutions also include prebuilt data quality and governance workflows to ensure error-free reporting and analytics.
For SMSBs that are unfamiliar with the Basel reforms, Adastra’s experts will guide you through the regulatory requirements and develop a Basel-attributed Banking Data Model, a data warehouse and Basel reporting data marts to help your organization become compliant well within the timelines.
Based on the learnings from earlier installments of Basel Reforms, it is likely that Basel IV will change over time. Maintenance will become an important parameter to keep in mind while building to Basel IV. With Adastra, you can build flexibility into your model, so that your organization can quickly pivot to new regulatory requirements without having to re-do the data models.
Interested in learning more about how we can help your organization become BASEL IV compliant? Book a free consultation with our experts.
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