Basel IV Evolution

Basel IV refers to a set of reforms to the Basel III framework, introduced by the Basel Committee on Banking Supervision (BCBS) after the 2007-2009 financial crisis. These reforms, finalized in 2017, are intended to strengthen global capital standards and reduce risks in the banking sector. Although officially considered an extension of Basel III, the changes were so significant that they are often referred to as Basel IV.

Overview of the evolution of Basel IV:

1. Context and Genesis

• Post-2008 Financial Crisis: The global financial crisis exposed significant weaknesses in the regulatory framework that governed the banking sector. Basel III was introduced in response, focusing on capital adequacy, liquidity, and leverage standards to improve the resilience of banks.
• Shortcomings of Basel III: As Basel III was being implemented, concerns arose that the framework did not go far enough in addressing issues like excessive risk-taking, variability in risk-weighted assets (RWAs), and capital adequacy across different jurisdictions.

2. Key Elements of Basel IV

• Revisions to the Standardized Approach for Credit Risk: The standardized approach under Basel IV is more risk-sensitive, addressing issues related to overreliance on internal models by banks. The reform introduces more granular risk-weighting for different categories of credit risk, such as residential real estate, corporates, and equity exposures.
• Changes to Internal Ratings-Based (IRB) Approaches: Basel IV restricts the use of the advanced internal ratings-based (A-IRB) approach for certain exposures like large corporates and financial institutions. This is designed to reduce inconsistencies in risk-weighted asset calculations and reduce model variability between banks.
• Capital Output Floor: One of the central aspects of Basel IV is the introduction of a capital output floor, which sets a lower bound on the capital requirements that banks must hold under the internal models approach. The floor is calibrated at 72.5% of the standardized approach, effectively capping the benefits banks can derive from their internal models.
• Operational Risk: Basel IV introduces a new standardized approach to operational risk, replacing the previous advanced measurement approaches (AMA) and standardized approaches (SA). The new methodology is based on business indicators and historical losses, aiming for a more standardized assessment of operational risk.
• Leverage Ratio Framework: The leverage ratio remains an essential backstop to risk-based capital requirements under Basel IV. It is set at 3% of Tier 1 capital for large banks, with higher rates applied to globally systemically important banks (G-SIBs).

3. Timeline of Implementation

• 2017 Finalization: The Basel Committee finalized the Basel IV reforms in December 2017.
• Original Implementation Timeline (2022): The reforms were initially scheduled to be implemented starting in January 2022, with a transitional period until 2027.
• Delayed Implementation Due to COVID-19: In response to the economic fallout from the COVID-19 pandemic, the BCBS announced a delay in the implementation timeline, pushing it to January 1, 2023, with full phase-in by 2028.

4. Key Objectives

• Reduce Variability in RWA Calculations: One of the primary goals of Basel IV is to reduce the variability in RWAs between banks using different internal models. The reforms aim to make capital requirements more consistent and comparable across banks.
• Enhance Risk Sensitivity: Basel IV enhances risk sensitivity, particularly in the standardized approaches for credit, market, and operational risks, ensuring a more accurate reflection of the risks banks face.
• Strengthen Capital Adequacy: By raising capital requirements and introducing new buffers like the capital output floor, Basel IV seeks to ensure that banks hold sufficient capital to absorb losses, particularly during times of financial stress.

5. Impact on Banks and the Financial System

• Increased Capital Requirements: Basel IV is expected to increase capital requirements for many banks, especially those heavily reliant on internal models to calculate their RWAs. This may lead to a recalibration of balance sheets and adjustments to business models.
• Higher Operational Costs: Complying with Basel IV will involve significant operational and compliance costs for banks, especially those with complex internal models. These costs include investments in data management, risk modeling, and reporting systems.
• Potential for Lower Profitability: Higher capital requirements and operational costs could lead to lower profitability for some banks, particularly in regions or sectors where risk-weighted assets increase significantly under the revised framework.

6. Global Implications

• Consistency Across Jurisdictions: One of the long-standing challenges of the Basel framework has been the uneven adoption of Basel III and its predecessors across different jurisdictions. Basel IV continues to push for global consistency in the application of banking regulations, although implementation may vary depending on local regulatory environments.
• Pressure on Smaller and Regional Banks: While Basel IV is primarily aimed at globally systemic institutions, smaller and regional banks may also face significant challenges, especially in terms of complying with new operational risk and capital requirements.

Conclusion

Basel IV represents a significant overhaul of the Basel III framework, aimed at further strengthening the global banking system in response to the lessons learned from the 2007-2009 financial crisis. While the reforms will lead to more robust capital standards, the increased complexity and compliance burden will challenge banks to adjust their strategies and operations accordingly.