Basel IV: A delicate act of balancing simplicity, comparability and risk sensitivity

For a regulator's perspective on Basel IV, Johan Trocmé, Director at Nordea Thematics, turned to Anders Kvist and Maria Blomberg at the Swedish Financial Supervisory Authority (FSA). They describe the aim of simplifying and clarifying the regulations as well as restoring faith in banks' reported risk-weighted capital ratios by improving global comparability.

While the Basel Committee is keen to prevent any significant increase in overall capital requirements, it may be unavoidable that outlier banks see changes to their levels, they say. It is, however, too early to predict any changes to the corporate lending arena.

JT: Basel III is a very comprehensive framework for bank regulation, and its finalisation is now turning into a quite ambitious Basel IV. How would you describe what has driven the need for such a major review?

Although comprehensive, we would not call the current regulatory changes a major review. In fact, it is more a case of completing the intentions behind Basel III, which was an important part of the Basel Committee´s response to the Global Financial Crisis in 2007-08.

Basel III aims to address a number of the shortcomings in the banking system and to provide for more resilient banks. It is the Committee’s answer to the question of how the capital requirements for large, internationally active banks could be made more robust and comparable.

The first part of the Basel III standard was agreed upon in 2010, and it was implemented in the EU in 2014. What you call Basel IV is really the finalisation of Basel III. The standard was finalised in 2017, but due to the coronavirus pandemic, the Basel Committee has postponed the implementation of finalisation of Basel III to 2023. Some parts of the standards are to be phased in over several years, and those transitional arrangements have also been postponed.

It is easy to forget that the agreed Basel standard needs to be transposed into legislation before it takes legal effect. We are still waiting for the EU Commission´s proposal for how the standard should be implemented into EU regulation. There is normally a negotiation process comprising the European Parliament and the EU member states after that. It is also quite usual that proposals include additional suggestions that are not included in the standard. That said, we are still facing uncertainty on what the actual regulation will look like in the end. It will probably take quite a long time before we see the full effect of the requirements of the new regulation.

JT: How would you, in simple terms, describe the key changes in Basel IV compared to Basel III?

The first part of Basel III focused, among other things, on increasing the quality of the capital that banks must hold in order to better be able to absorb losses. Other focus areas were the level of capital and buffers, the introduction of the leverage ratio, as well as liquidity requirements.

The main objective of the finalisation of Basel III now at hand is to improve comparability and reduce the risk of unjustified differences in capital requirements between banks and across jurisdictions by focusing on the calculation of the risk-weighted assets. In addition, a need to simplify and clarify the regulations has been identified. To give some example of what this means in practice, the approaches for determining the risk-weighted assets for credit risk, operational risk and market risk are being revised. Some limitations are introduced in banks´ use of internal models when determining the risk-weighted assets, for example, the standard does not permit the modelling of all credit risk parameters for corporate customers belonging to a group with a total consolidated revenue greater than EUR 500m, since there is not sufficient credit-loss data. The biggest change is, however, the introduction of a so-called output floor that limits how low the banks’ risk-weighted assets may be.

JT: Apart from protecting the stability of the financial system, do the banking regulators have other ambitions that affect the nature of the Basel IV framework, such as levels of indebtedness in the corporate or household sectors, desired mix between bank and capital markets funding for corporates, etc.?

The short answer is no. The things you mention can certainly affect financial stability, but the focus of the Basel standard is very much on the risks incurred by the individual banks. The development of the standard is based on the three principles of simplicity, comparability and risk sensitivity. To a large extent, the discussions in the Basel Committee have revolved around how to balance those principles against each other in different areas. Unfortunately, a solution that is simple is not always risk sensitive, and a solution that is comparable may not always be simple.

JT: Why do the new regulations limit the scope for banks to use internal risk models? Has there been evidence that such models have not worked? Is there a risk that a push towards using standardised models may reduce the room for total borrowing from banks, and may penalise models, systems and players that could work better through their greater precision?

At the peak of the Global Financial Crisis, a wide range of stakeholders and market participants lost faith in banks’ reported risk-weighted capital ratios. The Basel Committee also made its own analysis that highlighted a worrying degree of variability in banks’ calculations of risk-weighted assets, which simply was not a result of different levels of risk in the portfolios. The introduction of the internal risk model in the Basel II accord back in 2004 resulted in positive effects such as improved quality of risk models and surrounding risk management frameworks. However, the complexity also grew and made it harder to compare different banks´ risk-weighted capital ratios. This diminished conviction in the numbers. In a crisis, clarity is key, and it is imperative that all relevant stakeholders can trust the numbers reported by banks.

When realising this, the regulators asked themselves how the capital requirements for large, internationally active banks could be made more robust and comparable. The Basel Committee's answer was to limit the outcome of the internal models. Banks may, in other words, still use the models when calculating capital requirements but not to the full extent. In practice, the output floor means that the outcome of the banks’ total risk-weighted assets when using internal models cannot be lower than 72.5 per cent of what it would have been if the bank had used standardised methods instead.

Compared to this top-down perspective applied by the Basel Committee, the supervisory authorities within the EU have in parallel been trying to answer the question from a bottom-up perspective. This work is ongoing, and it is done in the form of guidelines and technical standards, with the purpose of improving how risks are modelled. The changes required in the models are of such a magnitude that banks are currently applying for new approvals for their models. There are, in other words, several ongoing changes when it comes to how risk weights are to be calculated.

How to calculate risk-weighted assets is important for banks, but that is just half the story when it comes to how capital requirements are set. The risk-weighted assets are multiplied by the capital requirement expressed in percentage terms in order to determine how much capital a bank must hold. Supervisors have some discretion in deciding this percentage. Finansinspektionen has previously communicated that the capital requirement should not mechanically grow, for example due to the output floor, but at the same time, it is key for financial stability that banks continue to have substantial usable capital buffers. How the capital requirement is set and applied is a very important factor in calculating how much capital a bank needs to have, something that the European Banking Authority (EBA) has also highlighted.

JT: Are differences in outcome in different geographical regions something the Basel Committee for Banking Supervision considers when finalising a new framework? If so, how does it weigh into what is ultimately decided to be the optimal global standard?

The Basel standards are global standards, which means that the same standards are used for large, internationally active banks across the entire world. Global standards are very important since they increase the lowest level applied anywhere and build trust in the whole banking sector. This is needed since financial problems of one large bank that is active in several markets can affect also other banking systems around the world. It is therefore important to strengthen the overall level of the requirements. At the same time, it is hardly possible to find a simple, comparable and risk-sensitive solution that is perfect in every way for all countries and all types of banks. Every banking market has its own specifics, so developing global standards is always going to be a game of give and take.

There are of course differences in the conditions of banks in different countries. Areas such as legal framework, type of products, collateral and how the market functions, all differ between jurisdictions. Some areas – such as market risk – are more in focus for the US, while mortgage lending and covered bonds are more central for some EU countries. Banks' credit exposures to corporate clients is one area that has been key for almost every country and that has been very challenging to handle. A lot of balancing between simplicity, comparability and risk sensitivity has been required in each and every issue in the Basel revision.

Comprehensive and rigorous assessments have been made on how the Basel revisions will impact banks. In addition to a consultation process, several quantitative impact studies with data gatherings from banks around the world have been conducted. Since Sweden is a member of the Basel Committee both via Finansinspektionen and the Riksbank, Swedish banks participated in this exercise. The EBA has also conducted quantitative impact studies on the EU banks.

The Basel Committee has been keen to ensure that the overall capital requirements should not be significantly increased as a result of the revisions, but it may be unavoidable that outlier banks will see changes in their levels.

JT: How would you expect European and Nordic banks to respond to the implementation of Basel IV? Could they abandon development of internal risk models completely? Will they need to raise more capital? Will they shrink their lending books or change their credit product mix? Other potential changes?

At the risk of disappointing you, we believe it is simply too early to conclude how banks will respond. The Basel standard has not yet been implemented into EU regulation and it is still too early to say exactly how the standard will be implemented. In addition, any impact will probably differ between banks depending on their business models, portfolios and their methods for calculating capital requirements.

It is also important to remember that the standard is like a foundation, but that the EU rules also contain EU-specific aspects, such as discounts on the requirements for small-and medium-sized corporates, and it remains to be seen how this will affect the outcome. Last but not least, the effects on the required capital will also be dependent on how supervisors decide to apply the capital requirements.

Judging by history, it is reasonable to assume that banks will adapt to the changes in one way or another. This can be a positive thing, but it might also create new risks. Since the banking system does not work in isolation from its corporate and private clients, the capital requirements can affect what kind of exposures remain within the banks. This is something that we as regulators will need to monitor.

When it comes to the issue of internal risk models, we believe that they will continue to play an important role. The internal models will still offer a capital benefit for banks in most cases. If a bank uses only the standardised methods, its risk-weighted assets will be 100 percent of the outcome of the standardised approaches, while with internal models and the output floor constraint, it will be 72.5 percent.

JT: Do you think Basel IV will bring changes to the funding landscape for Nordic large corporates? Could there be any challenges they need to prepare for before it is implemented?

In recent history, bank capital requirements have changed on several occasions. When the first part of Basel III was implemented almost a dozen years ago, Sweden introduced systemic risk buffers of five percent, as well additional buffers and a risk-weight floor for mortgages. As a result, the capital requirement increased significantly. Major changes in the funding landscape for bank clients were predicted by some experts, but not that much happened.

At the end of the day, banks are typically most comfortable offering the products the client base close to them demand. Vice versa, the clients need the banks even though many corporates now have access to the capital markets. As regulations change and some products require more capital, there may be some attempts at price changes; some traditional bank products may lose some of their attraction and profitability, but other bank products will be introduced.

It is possible that the finalisation of Basel III will lead to a similar adjustment process, but it is really too early to make any sensible predictions. Usually, new legislation does not take effect overnight. From where we are now, there will be a period of negotiation, and after that, some period before the regulation takes effect. In this run-up period, the market participants normally develop a keener understanding of how much they really need to change their behaviour. Usually, it is less than originally thought or feared. Also, other transformations driven by new technologies and changed client behaviour occur in parallel with the regulatory changes. So there is an intricate interplay of forces and it is always hard to define what change, if any, is driven specifically by new regulations.

It is possible that the finalisation of Basel III will lead to a similar adjustment process, but it is really too early to make any sensible predictions. Usually, new legislation does not take effect overnight. From where we are now, there will be a period of negotiation, and after that, some period before the regulation takes effect. In this run-up period, the market participants normally develop a keener understanding of how much they really need to change their behaviour. Usually, it is less than originally thought or feared. Also, other transformations driven by new technologies and changed client behaviour occur in parallel with the regulatory changes. So there is an intricate interplay of forces and it is always hard to define what change, if any, is driven specifically by new regulations.