The Basel-related Capital Accord is the most comprehensive capital reform in banking history, demanding new models, granular data and – for some – an entire rethink of business models.
Whatever the reforms’ applicable name in your jurisdiction (referred to as Basel IV for the purposes of this article – see panel), they are not a minor tweak but a major rework of how capital outcomes are produced, evidenced and defended across credit risk, market risk, credit valuation adjustment (CVA) and operational risk. They require a substantial transformation programme, with the workload sitting in many areas including data, mapping, controls and explanation packs. CROs, CFOs and senior management should take note, if they have not already done so.
Credit risk capital
Basel IV introduces a new standardised approach for credit risk capital (SA-CR), with substantial changes across exposure classes, risk weights, collateral and guarantees and off-balance sheet treatment.
Expect more granular risk weight tables, mortgage risk weights that are more sensitive to loan-to-value bands, and tighter methodologies for bank and unrated exposures, including more explicit due diligence where external ratings are used. Specialised lending is also treated more explicitly under SA-CR.
It introduces unprecedented data requirements and demands all-encompassing preparatory work
Market risk capital
Market risk moves onto the fundamental review of the trading book (FRTB), designed to harmonise trading book capital and reduce arbitrage between trading and banking books. The new Advanced (or Alternative) Standardised Approach is built from a default risk charge, a sensitivities-based method for the market risk capital charge and a residual risk add-on. It relies heavily on pricing and valuation inputs, so data quality and governance are now even more important.
The FRTB also tightens the trading book boundary as classification and re-designation decisions become governance issues.
Operational risk
Operational risk shifts to a single formula-based framework, the Revised Standardised Approach or Standardised Measurement Approach. No other approaches are permitted.
Capital is calculated as the product of the business indicator component (BIC), a progressive measure of business income, and the internal loss multiplier, which reflects historical internal losses relative to the BIC. Accordingly, you need clean loss data, lineage and auditability.
Credit valuation adjustment
Basel IV enhances the credit valuation adjustment (CVA) framework by increasing risk-sensitivity and removing the old internally modelled CVA approach. Allowable methodologies include a Standardised CVA Approach and a Basic CVA Approach. The practical impact is tighter hedging recognition and a clearer explanation of what drove the CVA charge.
Advanced models
Basel IV restricts the use (and benefits) of advanced internal capital models, removing advanced credit risk internal ratings-based (IRB) for large corporates (turnover above €500m) and financial institutions, eliminating IRB for equity exposures, and shifting some portfolios toward foundation IRB or standardised methods.
The revised capital output floor then limits how far modelled risk-weighted assets (RWAs) can fall below standardised calculated RWAs. A bank must hold RWAs as the higher of its approved approaches, or 72.5% of RWAs calculated using standardised approaches. A phased implementation methodology (ie transitional period) will allow organisations more time to adapt while maintaining alignment with international jurisdictions.
Banks may need to adjust capital management strategies and rethink business models
More information
See further ACCA resources for members in financial services
Get ready
Prior to the launch of the new standards, many jurisdictions are operating data-collection exercises to support the implementation of these new requirements. For example, in the UK, the Prudential Regulatory Authority is running a data-collection exercise, collecting Pillar 1 data to calibrate for future Pillar 2 requirements. In the EU, the European Central Bank is organising a similar exercise for market risk for FRTB calibrations. Other jurisdictions are considering similar activities. In all cases, banks should use these exercises as a rehearsal for governance and explainability.
Some may find that they need to adjust elements of their business model because Basel IV can drive capital increases in specific products, portfolios or structures. This could profoundly impact operating models, which will then need to be revised, assessed and approved by the banks and their owners.
For example, Basel IV can reshape pricing, product mix and balance sheet strategy, from lower risk lending shifts to trading activity reassessments under FRTB. Therefore, banks may need to adjust their capital management strategies and rethink their business models to maintain profitability in the face of stricter regulatory requirements.
Basel IV, together with FRTB, represents significant regulatory capital reform. It introduces unprecedented data requirements and demands all-encompassing preparatory work across every applicable area of the financial institution.
Framed properly, Basel IV is a very large, structured change management programme. New capital calculation models will need to be built for credit risk, market risk/FRTB, operational risks, CVA and possibly some Pillar 2 risks. These new models will need to be designed, constructed and validated. Some of these models are very complex and will require significant resources. And, in many cases, additional new data will be required based on new types and additional required granularity.
Nomenclature
Basel IV is not a single regulatory framework but a collection of changing international banking standards. It is implemented through local regulation (eg Basel 3.1 in the UK, CRR III in the EU and B3E in the US). Each jurisdiction has its own implementation dates. Some of the names being used are as follows:
- In the UK, the final Basel III reforms are called Basel 3.1
- In the EU, they are known as Capital Requirements Regulations III (CRR III) and Capital Requirements Directive VI (CRD VI)
- In the US, they are known as Basel III Endgame (B3E)
- Some jurisdictions refer to them as Basel IV (which we also uses for the purposes of this article)
- The Bank for International Settlements’ (BIS) Basel Committee on Banking Supervision (BCBS) identify them as the final reforms of Basel III
- Other international jurisdictions using various other naming conventions
