Basel IV: Credit Risk Changes and Global Business Impact
- smintell
- Mar 9, 2024
- 8 min read
Updated: Nov 5, 2024
Basel IV brings a set of significant enhancement on banking regulatory framework to address remaining short-comings and to improve the resilience in banking system.
This standard, which reflects the continuous evolution of regulatory requirements in response to new challenges, represents a continued commitment to strengthening the stability and resilience of the global financial system. The relevance of BCBS424 in forming contemporary banking regulation becomes more and more clear as we dig into its specifics, highlighting its significance in the quest for a more secure and resilient financial system.
Journey from Basel I to Basel IV
As a continued effort, Basel Committee focused on to enhance clarity and uniformity in assessing risks among different jurisdictions and financial institutions after the Basel III. It proposed revisions to credit risk and operational risk approaches, leading to the introduction of the standardized measurement approach (SMA) for operational risk in 2016. Additionally, discussions started on aggregated internal-rating-based (IRB) model floors to deal with variation in risk-weighted assets (RWA) derived from internal models used by banks. Known as Basel III final reform, Basel 3.1, or Basel IV, the Basel Committee on Banking Supervision (BCBS) released BCBS424 in December 2017. The same will referred as Basel IV, from now on in this whitepaper. This primary objective of this revision is to reduce the inconsistency in banks' RWA computations, which became evident during the global financial crisis.
The BCBS has come a long way since its establishment back in 1974 and continuously focusing to strengthening banking supervision systems worldwide. Among its initiatives, Basel Accords in 1988, focuses on credit risk and the Basel II came up with 3 regulatory pillars. Basel III was introduced after the 2008 financial crisis with a revised capital framework and then the Basel IV, represents a significant step towards refining regulations for a safer financial system.
Historical key publication dates
Expected Date of Implementation
BCBS: Initial effective date as per BCBS424 was 1Jan 2023 but due to covid-19 crisis, later BCBS extend it for an year and revised date was 1st Jan2023 followed by a 5-year phase-in period for output flooring.
UK: On 30th Nov2022, Prudential Regulation Authority (PRA) published its consultation paper (CP 16/22) on Basel IV and effective implementation date is postponed to 1Jan 2025 with a 5 years phase in period for output floor till 1st Jan2030.
EU: Financial institutions were granted an extension by the commission on 27th Oct2021, allowing them two more years beyond the initial deadline. Revised implementation date is now 1st Jan2025 with a 5 years phase in period for output floor till 1st Jan2030.
USA: Revised implementation date is 1st July2025 with a phase in period till 1st July2028.
5 years phase in period to implement the output floor
BCBS | EU & UK |
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National supervisors may allow banks to apply 25% capping on pre-floor RWA during transition period.
Key Changes
Standardized Approach
Exposure to sovereigns:
There is no change in treatment from Basel II framework (June 2006)
Exposure to PSEs:
There is no change in treatment from Basel II except the editorial change to remove the reference from Banks exposure RW and publish separate but same RW for PSEs.
Exposure to Banks:
RW for the exposures rated “A+ to A-“ is reduced from 50% to 30% and “BBB+ to BBB-“ is reduced from 100% to 50% respectively.
Earlier flat RW for unrated exposures are removed and a new set of RW is introduced based on grade using Standardised Credit Risk Assessment Approach (SCRA).
Grade-A exposure under SCRA can have 30% RW instead of 40% if counter party banks CET1 ratio is on or above 14% and Tier1 leverage ratio is on or above 5%.
Exposure to Covered Bonds:
Separate treatment is introduced for covered bonds.
Issue-specific rating is applicable for rated exposure whereas for the unrated exposure, issuer’s bank ECRA or SCRA RW is applicable.
Corporate Exposures:
Corporate exposures are newly classified broadly into two categories; general exposures and specialized lending.
For rated exposure, RW is applicable in more granular level now. 100% RW is applicable for unrated exposures which are allowed the use of external ratings.
For unrated exposure, where external rating is not allowed, previous flat RW is replaced by introducing three different segment and corresponding RW. Segment are Investment grade, Corporate SME, and Others.
Issue-specific rating to be applied if external rating is permitted. Wherever external rating is not applicable, separate RW is introduced by object finance, project finance or commodities finance.
Subordinated Debt and Equity:
250% RW will be applicable to capital instruments and subordinated debt.
For equity, 250% RW to be used as base RW. 100% RW to be applied to the equity holding exposures comes under certain legislative program and 400% RW for speculative unlisted exposures.
Instead of applying 400% and 250% RW in first year, these two are subject to 5 years linear phase. oInstead of applying 400% and 250% RW in first year, these two are subject to 5 years linear phase in program, where for speculative unlisted exposures, RW can start with 100% RW in first year and then reach to 400% RW in year 5 with a yearly 60% increment. Similarly, all other exposures can reach to 250% RW at fifth year starting from 100% RW with a 30% yearly increment.
Retail:
For retail, Transactors are separated out from Revolvers and lower RW with 45% is recommended for the same. For Revolvers, same 75% RW is applicable.
Real Estate:
For both residential real estate (RRE) and commercial real estate (CRE) exposures, a more risk sensitive RW is introduced by replacing constant RW. Newly proposed RW varies based Loan-To-Value (LTV).
There are two different approaches are introduced which are “whole loan approach” and “Loan splitting approach”. While for General RRE and CRE, both the approaches are applicable but only “Whole loan approach” is applicable for income producing residential real estate (IPRRE) and commercial real estate (IPCRE).
Off balance sheet exposure:
40% Credit Conversion Factor (CCF) is applicable to the commitment unless satisfying criteria for lower CCF .
A 10% CCF applies to unconditionally cancellable commitments (UCC) or those automatically cancelled due to credit deterioration.
Internal Rating Based Approach:
AIRB approach is no more applicable for the following exposures:
Exposures to general corporate with total consolidated annual revenues > €500M. Revenue threshold must be based on the average amounts calculated over the prior 3 years or on the latest amounts updated every 3 years by the bank.
Banks exposures, other securities firms and financial institutions (including insurance companies and other financial institutions in the corporate asset class).
Off balance sheet exposure:
PD floor for IRB model is increased from 0.03% to 0.05% except for Revolvers where 0.10%.
Floors for LGD and EAD are newly introduced.
LGD Haircuts
LGD for senior claims on other corporates without recognized collateral is now 40%, down from 45%. LGD has been reduced and haircuts increased for collateralized transactions, except for eligible financial collateral (EFC).
For eligible financial collateral, haircut to be adjusted for various holding periods and non-daily re-margining or revaluation.
Open for National Supervisors
Property Valuation: Basel IV has introduced a new framework for property valuation in place of the previously given market value and mortgage lending value principles in Basel II. Central idea is to make the property valuation in a conservative manner. Although, it encourages to calculate property valuation based on the origination value, but it permits downward changes if exceptional circumstances result in a long-term decline in value. On the other hand, if the value has dropped, it can be increased up to the initial amount. Also, any improvements made to the property can be considered to offset the origination value. Basel IV places a strong emphasis on matching property assessments to market value whenever feasible. However, no precise standard is mentioned for adjusting valuation or figuring out market worth; instead, National Supervisors are responsible to develop reasonable standards for valuation.
IPRRE identification criteria: A set of new criteria is introduced to identify materially dependent IPRRE loans and aim is to manage this riskier segment separately from general residential real estate (RRE). However, the standard does not explicitly specify the exact criteria to identify the material dependence. Like, IPRRE should be treated as an IPRRE only if the individual mortgaged a required minimum number of properties but the exact numbers are not mentioned. Basel IV recommends that National Supervisors provide guidance on defining the criteria.
UCC: National supervisors are responsible for assessing different factors within their jurisdiction that might limit banks' ability to cancel commitments effectively. They should consider applying a higher Credit Conversion Factor (CCF) to specific commitments where appropriate.
RWA capping during transitional phase: National supervisors may allow banks to apply 25% capping on pre-floor RWA during the transition period.
Proposed Changes by EU and UK Supervisors
European Union (EU) and United Kingdom (UK) supervisors have come up with their own proposals-based on Basel IV and below table demonstrates are the key changes for UK (CP16/22) and for EU (CRR III and CRD VI). The PRA released a near-final Part 1 policy statement on December 12, 2023, providing feedback on CP 16/22 for Basel IV standards implementation, excluding Credit Risk and the Output Floor. Part 2, covering these remaining areas, is expected to publish in Q2 2024.
BASEL IV Impact on Capital Requirements
The European Banking Authority's first mandatory Basel IV Monitoring Report (published on 30 Sept2022) shows that the full implementation by 2028 will increase EU banks' Tier 1 capital requirements by 15.0% and additional EUR 1.2 billion Tier1 capital to be compliant. The impact includes the economic impact due the 2019 pandemic.
Data from 86 banks show that, Basel IV's impact has somewhat increased since December 2020, which is mostly attributable to the impact by market risk. Nevertheless, the impact continues the declining trend started in 2018 as compared to pre-COVID-19 levels in December 2019.
Excluding the EU-specific modifications, the capital monitoring exercise shows that by 2028, the minimum Tier 1 capital requirement for European banks will increase by 15.0%. Excluding leverage ratio contributions, the reform's impact is 18.2%, primarily driven by the output floor (6.3%) and credit risk (4.4%). For large and internationally active banks (Group 1), the Tier 1 capital requirement would increase by 16.0%. Global systemically important institutions (G-SIIs, a subset of Group 1) and Group 2 banks would face increases of 24.7% and 9.6%, respectively.
Mitigating the High Capital Impact: Strategies for Banks
Where we comes in
Basel IV is a notable regulatory achievement in the banking sector that focuses to enhance the stability and resilience of the worldwide financial system. Though, the standard brings many advantages and improves the capital requirements, risk management practices, and regulatory monitoring, but it also presents challenges to the financial institutions in implementing the same.
We are aware of the difficulties and consequences associated with implementing BCBS424. We are well equipped to work with banks to navigate the Basel IV criteria and ensure successful compliance with our experience in risk management and banking regulations. We support in building comprehensive strategic planning, regulatory analysis, development, implementation, and monitoring; that are customized to meet the specific requirements of each financial institution.
Smintell is dedicated to helping banks maximize value and compete in the market while attaining regulatory compliance.
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