On the Verge of Basel IV: What’s New in the Package for Banks?

Jun 30, 2020

Basel Norms and Their Key Facts

Basel norms in banking are an internationally agreed set of measures developed by the Basel Committee on Banking Supervision (BCBS) in response to the numerous challenges faced by the financial and capital markets. As the Bank for International Settlements (BIS) explained, the measures aim at setting minimum standards and requirements that apply to internationally active banks and financial institutions.

The BCBS regulations and requirements have no legal force. The Basel Accords are recommendations expected to be implemented by member countries. The first Basel Capital Accord was supported by G10 Governors and central banks. Today, there are 28 jurisdictions and 45 institutions, consisting of central banks and authorities responsible for banking supervision in their home countries.

Members and representatives responsible for supervision in the banking sector
Country/jurisdictionInstitutional representative
ArgentinaCentral Bank of Argentina
AustraliaReserve Bank of Australia
Australian Prudential Regulation Authority
BelgiumNational Bank of Belgium
BrazilCentral Bank of Brazil
CanadaBank of Canada
Office of the Superintendent of Financial Institutions
ChinaPeople’s Bank of China
China Banking Regulatory Commission
European UnionEuropean Central Bank
European Central Bank Single Supervisory Mechanism
FranceBank of France
Prudential Supervision and Resolution Authority
GermanyDeutsche Bundesbank
Federal Financial Supervisory Authority (BaFin)
Hong Kong SARHong Kong Monetary Authority
IndiaReserve Bank of India (RBI)
IndonesiaBank Indonesia
Indonesia Financial Services Authority
ItalyBank of Italy
JapanBank of Japan
Financial Services Agency
KoreaBank of Korea
Financial Supervisory Service
LuxembourgSurveillance Commission for the Financial Sector
MexicoBank of Mexico
Comisión Nacional Bancaria y de Valores
NetherlandsNetherlands Bank
RussiaCentral Bank of the Russian Federation
Saudi ArabiaSaudi Arabian Monetary Agency
SingaporeMonetary Authority of Singapore
South AfricaSouth African Reserve Bank
SpainBank of Spain
SwedenSveriges Riksbank
Finansinspektionen
SwitzerlandSwiss National Bank
Swiss Financial Market Supervisory Authority (FINMA)
TurkeyCentral Bank of the Republic of Turkey
Banking Regulation and Supervision Agency
United KingdomBank of England
Prudential Regulation Authority
USABoard of Governors of the Federal Reserve System
Federal Reserve Bank of New York
Office of the Comptroller of the Currency
Federal Deposit Insurance Corporation
Observers
CountryInstitutional representative
ChileCentral Bank of Chile
Banking and Financial Institutions Supervisory Agency
MalaysiaCentral Bank of Malaysia
United Arab EmiratesCentral Bank of the United Arab Emirates
Supervisory groups, international agencies and other bodies
Bank for International Settlements
Basel Consultative Group
European Banking Authority
European Commission
International Monetary Fund
Secretariat
Bank for International Settlements

Basel Committee membership, institutions, and representatives responsible for supervision in the banking sector

All the members, groups, agencies, and bodies responsible for supervision have played a vital part in formulating the BCBS’s core principles. These form a basis for the supervisory system and standards that are further explained and embodied in the Basel norms in banking.

The BCBS has already published three Basel Accords.

The Basel Accords and Their Principles

Evolution of Basel norms in banking: Basel I, Basel II, Basel III

The Basel Accords have continued to develop. Thus, from 2012 through 2017, the Committee addressed the issues of banks’ exposure to central counterparties, margin requirements, measurement of counterparty credit risk exposures, and calculation of capital requirements for securitizations by introducing Fundamental Review of the Trading Book (FRTB) capital requirements and enhancement of the framework for disclosure requirements. In 2017, new standards were put in place for the calculation of capital requirements for credit risk, credit valuation adjustment risk, and operation risk. One of the objectives of these new standards was to reduce the excessive variability of risk-weighted assets (RWA), which we will discuss further below.

The Basel III norms addressed a number of shortcomings and provided a foundation for more resilient banking. But the ongoing reform of Basel III and its implementation aims to reveal further systemic vulnerabilities.

Basel reform

Basel III Norms and More

The reasons for the global financial crisis are quite complex. Before the crisis in 2008, there was a period of excess liquidity, which became partially invisible for many banks and supervisors. Subsequently, the banks discovered they had insufficient liquidity reserves to meet their obligations, while the quality of their capital was also inadequate. Basel III, being the biggest regulatory change to date, allowed the reform of the entire banking sector landscape.

Basel III retained the three pillars from Basel II, i.e.,

  • Pillar 1 establishes regulatory capital requirements for calculating credit, operational, and market risks
  • Pillar 2 sets out a process for reviewing the overall capital adequacy by banks and a process for supervisors to evaluate how banks assess their risks
  • Pillar 3 outlines disclosure requirements

However, in addition, Pillar 1 was reinforced with capital and liquidity requirements.

Basel III norms, with Pillar 1 minimum capital requirements strengthened by additional capital and liquidity requirements

Moreover, Basel III introduced two liquidity ratios: the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). These two ratios ensure a sufficient level of high-quality liquid assets and promote resilience over a longer time horizon, respectively.

We should also mention that changes to Pillar 1 introduced the Capital Adequacy Ratio (CAR), and in particular the definition of capital and minimum CAR requirements, under which the BCBS issued a consultative document on the FRTB, which outlines market risk requirements such as

  • Stricter definition of tools and instruments applied to the trading book
  • Longer periods for value-at-risk calculations
  • Use of correlations under the standardized approach

According to the OECD Journal, Basel II never came properly into effect due to the crisis. Under Basel III, the Basel Committee introduced changes to capital requirements, such as raising the quality, consistency, and transparency of the capital base, enhancing risk coverage, introducing the leverage ratio, and considering the role of procyclical factors, though it failed to address some major concerns, particularly about the changes to the risk-weighted asset framework.

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From Basel III to Basel IV: A Journey through Risk-Weighted Assets

Basel I offered quite simple risk weights focusing on credit risk and offering a market risk component. However, in 2012, according to the European Parliament briefing, the BCBS initiated a comprehensive review of the risk-weighted capital framework to finalize the Basel III norms and strengthen the resilience of the global banking system.

In 2017, the Basel Committee published finalized rules covering major issues associated with RWAs. These rules outline fundamental changes to calculating capital ratio and RWA by all banks, no matter their size or the complexity of their banking model. Such changes were deemed to be the “finalization” of the Basel III package of reforms. Nevertheless, many experts consider this the beginning of the new Basel IV Accord, due to the scale of the modifications.

We will not look into the changes in any depth here. However, it is worth saying that the impact of Basel IV may vary by location as well as by the type and business model of certain banks. It is time for banks to work out their own capital management strategies in order to be ready for Basel IV. The development of such strategies requires extensive knowledge and expertise.

At CompatibL, we deliver support to our customers in adjusting their strategies in line with the forthcoming requirements and understanding the evolving regulatory requirements. In addition, we offer risk management software that covers such regulatory frameworks as Basel III, FRTB, ISDA SIMM, IRRBB, and SA-CCR.

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The winds of change regarding Basel IV have already forced some larger banks to apply advanced modeling and optimization approaches and even review their legal entity set up. There are many areas to consider while maintaining the pace of capital efficiency: product offerings, policies on collateral and guarantees, repricing, management of costs, etc. What is more, the technical side may become the major challenge. How to calculate RWA accurately? How to ensure the data is complete and used appropriately? At CompatibL, we strongly recommend considering investing in technical tools and implementing efficient capital management approaches.

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