Basel IV, a mere finalization of the Basel III Agreement ?

After the financial crisis of 2008, the Basel committee, on Banking Supervision established a new regulation – Basel III aimed at strengthening prudential standards. Now this regulation is questioned by a new regulation in the making: Basel IV. So, is Basel IV just the finalization of Basel III or a real evolution of Risk Management.

The Basel III regulation was based on three key pillars:

  • Improvement of the minimal requirements for equity
  • Oversight by supervisory authorities
  • Market transparency / discipline

The improvement of the minimal requirements for equity resulted in:

  • The increase of the minimum ratio of bank’s solvency =  equity / (credit risk + market risk + operational risk)
  • The improvement of the liquidity for the required equity
  • The establishment of a minimum leverage ratio, which is acting as a solvency lower limit

However, the Basel III Agreement kept the way of estimating credit, market and operational risk.

This estimation is mostly made by internal approaches resulting from a variability of the Risk Weighted Asset when calculated by banks.

Thus, in order to reduce this variability, the Basel committee met again to negotiate a finalization for Basel III, highlighting the calculation rules of the RWA. The major goals of this reform of credit risk are:

  • Improving the comparability for calculation approaches of RWA
  • Reducing their complexity
  • Limiting the local regulators’ overlay discrepancies

This is put into practice through :

  • A modification of the standardized approach by increasing the use of economic indicators (as the loan to value) instead of external ratings.
  • A limitation of the use of internal approaches by:
    • Their exclusion for the estimation of losses in case of defects on some perimeters (the “very large corporate” for example)
    • The implementation of an output floor at 72.5%. It’s acting as an estimated lower limit for the RWA on internal approach. In practice if risk estimation using the standardized approach leads to a RWA of 100, the calculation of the RWA using an internal approach cannot be below 72.5. This lower limit will be reached through a transition period from January of 2022 to 2027.

The European Banking Authority made a Quantitative Impact Study on this reform with the main banks that it supervises. This study reveals that for more than the third of the main supervised banks, the output floor leads an increase of the requirements for equity and that all the suggested reforms would lower the bank’s average solvency ratio CET1 from 12.3% to 11.6%.

All in all, from the banks’ point of view this reform appears more as a capital overload than a harmonization of the risk estimation approaches.