Basel IV is here: What you need to know

Why do banks need to be regulated?

Banks operate in an industry where strict regulation and governance is essential to ensure a well-functioning and safe economy for all stakeholders, while upholding trust in the banking sector. Banks provide key financial services to households and companies as financial intermediaries, which enables efficient movement of resources within the economy. What’s more, banks are a vital part of the payments system and crucial for GDP.

Regulation is needed to ensure banks operate with sufficient standards and have enough capital in place as a cushion to absorb potential losses in times of financial distress while continuing to provide key financial services to the economy. 

How are banks regulated?

Banks are regulated at the national and regional levels, and since 1973, bank regulations have been coordinated globally by the Basel Committee for the Bank of International Settlements (BIS) to ensure adequate and consistent regulation across countries. The BIS is jointly owned by 63 central banks from countries that account for around 95% of global GDP.

The first Basel framework was introduced in 1988, followed by Basel II in 2004, which expanded the standardised rules, including making it possible for banks to use their own internal risk models to calculate their capital requirements.

In response to the global financial crisis in 2009, the Committee introduced Basel III in 2013, which added several reforms to mitigate risk in the global banking system:

• Capital ratio requirement - Basel III increased banks’ capital requirements compared to Basel II. Capital ratio is the ratio of a bank’s capital to its risk-weighted assets. Risk-weighted assets refer to a bank’s assets, including its interest-bearing loans to customers, adjusted for certain risks, such as the probability of a default by the borrower and the loss that would result. The higher the risk in lending, the higher the bank’s risk-weighted assets, and the more equity capital reserves a bank needs to hold. The minimum capital a bank needs to hold under the Basel framework is 8.0% of its risk-weighted assets and 3.0% of its total exposure measure. Furthermore, other additional capital requirements may be applied, such as the capital buffers.
   
• Combined buffer requirement - Basel III introduced capital buffer requirements in addition to the minimum capital requirements to address additional macroprudential risks not sufficiently covered by the minimum requirements. In addition to the fixed 2.5% capital conservation buffer, other buffers that could be applied include the global and other systemically important institutions buffer, the countercyclical capital buffer and the systemic risk buffer. These buffers can be activated for different reasons to varying degrees to ensure that banks have sufficient capital to absorb losses in times of stress.
   
• Leverage ratio requirement - In addition, Basel III added a leverage ratio requirement as a backstop to the risk-based capital measures. This requires banks’ Tier 1 capital to be at least 3% of the bank’s total exposure, referring to its equity, debt plus off-balance sheet liabilities such as derivatives exposures. The leverage ratio applies in addition to the minimum capital percentage a bank needs to comply with at all times.

What’s new in Basel IV?

In 2017, the Basel Committee agreed on changes to the global capital requirements as part of finalising Basel III. The changes are so comprehensive that they are increasingly seen as an entirely new framework, commonly referred to as “Basel IV,” which was implemented in the EU from 1 January 2025.

An analysis by the Basel Committee highlighted a worrying degree of variability in banks’ calculation of their risk-weighted assets. The latest reforms aim to restore credibility in those calculations by constraining banks’ use of internal risk models.

Advanced internal risk models give banks the most freedom to estimate their credit risk, often yielding a much lower risk than the regulator’s standard model. Under Basel IV, banks can no longer use these typically more sophisticated and complicated internal risk models for large corporates with a turnover of at least 500 million EUR. Also there are additional restrictions imposed on internally modelled risk parameters for credit risk, further limiting the risk sensitivity of internal models.

In addition, as a major change, Basel IV introduces a so-called output floor, that ties the output of the bank’s internal risk calculation to the standardised risk approach, as detailed in the regulation. Once fully phased in, this prevents the bank’s own internal measurement of its risk exposure from yielding less than 72.5% of the standardised approach. The output floor is gradually phased in from 50% starting in 2025 until 72.5% in 2030, allowing for internal ratings-based (IRB) banks to prepare for the floor’s limiting impacts on the bank’s risk sensitivity. In addition, there are transitional arrangements in place until the end of 2032, which are designed to temporarily reduce the impact of the output floor. 

This means that once the output floor is fully phased in, the maximum benefit of using internal models is limited to 27.5% of the risk-weighted assets. This will have the biggest impact on banks which are invested in utilising internal models but are no longer able to fully employ their risk sensitivity.

The new reforms also modify the leverage ratio, changing the definition of a bank’s total exposure. In addition, they make changes to the credit valuation adjustment (CVA) and operational risk frameworks. The implementation of the changes in market risk rules, Fundamental Review of the Trading Book (FRTB), stemming from Basel IV is still under discussion in the EU due to current uncertainty of implementation in the US and the UK. A delayed timeline and possible temporary relief measures in the EU in the market risk area are implemented to ensure a level global playing field.
 

How will Basel IV affect banks?

The purpose of Basel IV is to level the playing field and harmonise how banks calculate risks, not to increase the level of capital in banks on a global level. However, the reforms will likely have a disparate impact in different regions, due to regional differences in banks’ use of internal models for calculating risk.

Globally, the impact on banks’ required capital will be limited. The impact will be larger in Europe and the Nordics, where banks tend to be heavier users of internal risk models. As per the latest impact study on Basel IV for European banks with data as of 31 December 2023, the minimum Tier 1 capital requirement is assessed to increase by 8.6% for large international banks, 12.2% for global systemically important institutions and 3.6% for the rest of the banks not included under the other two classifications. 

For the European banking system as a whole, that means having to find an additional EUR 0.9bn of Tier 1 capital. Total capital shortfall has been estimated at EUR 5.1bn. The impact has decreased since the earlier impact assessments.

How does Basel IV affect banks’ lending to corporates?

The return on capital in the banking sector has dropped by around one-third since the global financial crisis of 2008-2009. The big question is whether banks will take the latest hit from the increased cost of capital related to Basel IV or pass that along to customers.

Large corporates, with revenues over 500 million EUR, that don’t have a credit rating and rely on bank loans for funding today are likely to be the hardest hit.

What can corporates do?

Large corporates should review all of the potential funding options available to them, including potential new funding sources, so they are not caught off guard by the changes. Companies will benefit from having different funding options to find what suits them best.

Having a credit rating is likely to become more important, given that unrated large corporates will be grouped at a higher risk level regardless of their actual credit risk history.

A Basel glossary