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01/30/2017

BASEL IV

Upcoming regulatory changes for financial institutions and their impact on the banking industry

Introduction

Although Basel 3 is planned to be fully implemented only in March 2019, recent new proposals on international banking regulation are already in discussion under the name of Basel 4. Bank representative associations fear that these new prudential adjustments will raise capital requirements by tremendous amounts, claiming that the introduction of such extra regulations can be as influencing as Basel 3 for some banks. The financial sector believes it will be a huge challenge for banks to develop profitable and sustainable business models under these new requirements. Furthermore, it could be questioned if the new Basel proposals, if they get through, will over focus on financial stability at the expense of economic growth, as new regulations would force banks to curtail lending, and therefore hit the wider economy. The Basel committee is trying hard to complete all unfinished business in the area by end-2016, while the banking industry is mounting pressure on the regulators.

Why is a new capital regulation ought to be a necessity?

Recent studies of the Basel Committee on Bank Supervision (BCBS) show that banks with the same overall risk rated portfolio could still have substantial differences in risk weighed capital ratios. This is possible due to Basel 2 regulations, under which banks could base their risk-weighted asset (RWA) calculations on either standard risk weights, as defined by national regulators, or internally developed risk models, known as internal ratings-based models (IRB’s). The RWA is of major importance in capital regulation policies as it functions as the denominator of the risk-weighted capital ratio. The RWA itself covers six types of risk: credit risk, market risk, operational risk, counterparty credit risk, securitization and interest rate in the banking book. Each of these risk types carries its own distinct regulatory capital requirements. So by using different complex in-house risk rating models, it is possible that banks with the same overall risk could have different capital requirements. This imposes a widespread concern for regulators stating that banks may (mis)use their internal models to improve their Tier 1 capital ratio.

What is expected from Basel 4?

First and foremost the Basel Committee wants to evaluate, standardize and simplify the complex nature of the internal risk measuring models approved under Basel 2 and 3. It wants to achieve this by bringing back revised standardized risk measurements for all major types of risk factors. The advanced IRB approach used these days, is based on dozens of carefully selected risk drivers to calculate the bank’s risk weighted assets. To tackle this issue, the Basel Committee wants to introduce a limited number of ‘core’ risk drivers, as for example CET1 ratio and Net Non-Performing Asset (NPA) ratio for credit risk exposures to other banks, so that it is able to judge the bank’s risk management performances. The output of these standardized models can then be used to set capital floors as a percentage of the relevant standardized approach. Up until today, no percentages have been confirmed. In any case, these floors will have a huge impact on the RWA’s, and thus on the required capital of those banks using IRB’s.

 

Impact on micro and macro level

The most pertinent question to ask is what the impact of these new changes will be for individual banks on the one hand, and for the overall economy and power relations between global players on the other hand. It is clear that all banks will be affected by the new capital requirements, both large international banks as those more locally focused. Even banks that complied with the standardized approach under Basel 2 will see increases in their capital requirements, as non-modelled approaches become more risk-sensitive in comparison to those under Basel 2. Although an exception can apply for banks holding low risk and well diversified portfolios, such as mortgage banks with very low loan-to-value mortgages. The reason for this is that their RWA will not sufficiently change under Basel 4. The effects on individual banks will also be influenced in which internationally agreed standards are implemented in different jurisdictions, as the Basel Committee has not the authority to enforce regulations.

Impact on individual banks

On micro level, banks will depend to a lesser extent on their internal ratings based models. The mismatch between their IRB’s and the standardized models could lead to changing customer selection criteria when for example the RWA of a potential customer calculated based on the banks IRB is lower than the one calculated by the standardized approach. This could lead to an increase in the overall risk of the bank’s portfolios. The same goes for the implementation of floors in IRB’s, pushing capital on some potential lending higher than the risks, affecting the credit activity of the bank. The implementation of standardized models will also put credit rating agencies on the sideline, as they will no longer be needed in calculating risk-weights. Instead, external ratings will be mostly used for customer selection and pricing. This could indicate that banks need to further develop internal capabilities regarding credit rating. Next to these issues, banks will also need to be much more transparent and detailed in their risk reporting under the new standardized framework. Additional financial statement information will be required regarding counterparties and there will be a significantly higher punitive risk-weight in case of missing information on those counterparties. Also, banks not subjected to the Basel 3 standards will be requested by their creditor banks to calculate and disclose some core ratios in accordance with Basel 3 requirements, so as not to be subject to the highest risk-weight. This will mean that obligator banks would have to apply to Basel 3, even if they are not internationally active or if the national supervisor has not adopted Basel 3. Last but certainly not least, the time and effort required to implement these new possible changes and to boost capital to reach regulatory requirements it cannot be underestimated as is the need for new IT programs and data collection.

Impact on the global economy

To analyze the impact of new Basel regulations on macro level, we may first notice that current IRB’s are mainly used by large banks to calculate their capital requirements. Proposed restrictions in the usage of internal models to assess risks would have a ‘material impact’ on lending to financial institutions, corporations and other borrowers. In the post-crisis period, when many economic sectors in both developed and emerging markets still highly rely on banks as the main source of funding, reducing the alignment of capital and risk could negatively and unnecessarily affect the availability and pricing of credit to the economy, and therefore could affect growth. Nonetheless, the impact of this matter could differ for various economies over the world as explained in the next paragraph. 

Impact on worldwide power relations

When we discuss the overall macro impact of Basel 4 regulations, we may also notice that some international parties are more opponent to recent proposals than others. Especially the EU, Japan and Canada fear that the new capital requirements will undermine their competitive position in the global market. In Europe for example, the banking sector is responsible for 80% of financing the economy whereas in the US, which has powerful pension funds and a fully-funded pension system, capital markets provide the same proportion of financing.

Also US banks, unlike those in Europe, do not keep real estate loans on their balance sheets. This because the US government gives banks the possibility to securitize their loans. Real estate financing would be strongly affected in European countries as Belgium, the Netherlands and France, where loans are granted based on the borrower’s ability to repay - i.e. income – rather than on loan-to-value (LTV) ratios, which is the customary approach in English-speaking countries. If the BCBS introduces floors on LTV ratios, this could mean significantly less mortgage granting in these EU member states. These fundamental differences in financial models, coupled with the partial application by US banks of Basel 2, show that the new Basel regulations will have virtually no effect on US banks. This in strong contrast with the European bank sector, as the EBF estimated an increase by more than 50 percent in European banks’ capital requirements, forcing them to raise an additional 850 billion in capital.

Conclusion

Recent BCBS studies have shown that banks with the same overall risk rated portfolio could still have substantial differences in risk weighed capital ratios. These insights gave the Basel Committee the incentive to work on new capital regulations, identified under Basel 4. There is no doubt that these new minimum capital requirements will have a huge impact on the banking sector. Bankers feel like they have fallen into a never changing world of regulatory requirements. With revised standardized approaches for most risk types, and a proposed framework of capital floors, the Basel Committee looks to fundamentally change the way in which banks measure risk. It seems that simplicity and comparability have taken over the risk sensitivity IRB’s banks use in their risk calculations. Especially the implementation of floors in IRB models will play a crucial role in the final magnitude of the new regulations. Fear for enormous increases of minimum capital requirements, and raising concerns about the different impact on specific regions in the word, heat up pressure on the new regulations from several banking associations. Europe, as well as other opponents of the Basel proposals, fear to pull at the shortest end of the straw with much more risk weighting implications compared to the rest of the banking world. For these countries, the reforms could tremendously push up the cost of capital, forcing banks to look for new sources of yield, which could ultimately lead to the emergence of new risks and affect growth commitments. With still a lot of uncertainty left on the matter, the banking sector anxiously waits for the results of important BCBS meetings that took place in September and October 2016.

Sia Partners is your consultant in need for analyzing the impact of the new Basel regulations on your bank, as well as advising you on the definition and implementation of a proper business strategy to deal with new regulatory requirements. 

 

Please find here the full version of the article.

Sia Partners

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