Basel IV is the latest set of global regulatory standards for banks that was introduced by the Basel Committee on Banking Supervision. It builds upon the previous Basel III framework and aims to improve the resilience of the banking sector, enhance risk sensitivity, and address issues that were not adequately covered by the previous framework.
Some of the key features of Basel IV include:
- The introduction of a new standardized approach for measuring credit risk, which aims to make risk-weighting more transparent and consistent across banks.
- The implementation of a new output floor, which will limit the extent to which banks can use internal models to calculate their risk-weighted assets.
- The introduction of new capital requirements for operational risk, which will be based on a bank’s actual loss experience rather than a hypothetical calculation.
- The incorporation of new standards for the measurement and management of interest rate risk in the banking book.
The Basel Committee on Banking Supervision (BCBS) is the primary global standard-setter for the prudential regulation of banks, based in Basel, Switzerland. Committee members include central banks and other banking regulators from around the world. Their main target is to improve supervisory understanding and the quality of banking supervision worldwide. The Basel Committee on Banking Supervision (BCBS) sets the Basel Framework, and they have issued a round of regulations in recent years.
Basel I, followed by II, III, and IV, reforms the Basel Accords. In the beginning, capital adequacy was the main focus of the Committee. Its purpose was to strengthen the international banking system’s stability and remove a source of competitive inequality arising from differences in national capital requirements. Basel I was introduced in 1988, requiring banks to hold capital of at least 8% of their risk-weighted assets. In 1999 Basel Committee issued a proposal for a new capital adequacy framework to replace the first one, and finally, after intensive preparation, Basel II was introduced in 2004.
The banking sector entered the financial crisis in 2007 with too much leverage and inadequate liquidity buffers. Additionally, poor governance and risk management were seen in the mispricing of credit and liquidity risks and excess credit growth. Responding to these risk factors, in 2009, the Basel Committee issued a package of documents to strengthen the Basel II capital framework. In 2010 the Group of Governors and Heads of Supervision (GHOS) announced higher global minimum capital standards for commercial banks. This followed an agreement reached in July regarding the overall design of the capital and liquidity reform package, now referred to as Basel III. The Committee issued the proposed standards in mid-December 2010 (and have been subsequently revised). The enhanced Basel framework revises and strengthens the three pillars, and most reforms are being phased in between 2013 and 2019. Basel III was at the beginning scheduled to begin implementation by 2015. Still, the deadline has been pushed back several times, and its current deadline is Jan. 1, 2023, although some provisions are already in effect in some countries.
Even though Basel III wasn’t fully implemented yet, the BCBS continued to adjust it. In 2017, the Basel Committee agreed on fundamental changes for Basel III. The changes became so vast that they were seen as a completely new framework, informally called Basel IV. It is also referred to as Basel 3.1. Basel IV is the final reform of Basel III, and the purpose of Basel IV was to strengthen the banking sector against future crises. Basel Committee’s analysis highlighted that banks’ calculation of their risk-weighted assets varied enormously. Basel IV aims to restore credibility in those calculations by constraining banks’ use of internal risk models. Advanced internal risk models give banks the most freedom to estimate their credit risk, often yielding a much lower risk weighted assets (RWA) than the regulator’s standard model. Under Basel IV, banks couldn’t longer use these typically more sophisticated and complicated internal rating-based (IRB) models for large corporates with a turnover of at least 500 million EUR. Instead, Basel IV introduced a so-called output floor, which prevents a bank’s own internal measurement of its RWA exposure from yielding less than 72.5% of the standardized approach.
Basel IV is split into two pieces. The first package includes:
• Fundamental Review of the Trading Book (FRTB)
• Counterparty Credit Risk
• Net Stable Funding Ratio (NSFR)
• Leverage ratio
• Large exposure
• Market risk
• Intermediate EU parent undertaking
The second package covers:
- Credit risk – Standardized Approach to Credit Risk (SA CR)
- Credit risk – Internal models
- Credit risk – mitigation techniques
- Market risk
- Operational risk
- Output floors
- Credit Valuation Adjustment (CVA) risk
Basel IV timeline
Basel IV was intended to begin implementation on Jan. 1, 2022, and it was supposed to be fully implemented by January 2025. The first package (described above) was originally supposed to go into effect in January 2023. Then the second package was supposed to follow and go into effect in January 2025. Now the situation with Basel IV is a bit uncertain. Due to the global pandemic, the start date has now been pushed back to Jan. 1, 2023. Based on recent history, it is still possible that the deadline will be extended and that some provisions may be further modified before they go into effect.
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