by Dimitrios Ntalianis
When Basel IV began implementation on January 1, 2023, it led to uncertainty among financial institutions as to what the true impact of these new regulations would be. The rules introduce major changes in risk management and require all banks to use standardized approaches. Banks will need to strategically design a capital portfolio management framework that helps them adapt to the new regulations.
What is Basel IV?
In the wake of the global financial crisis of 2008, the Basel Committee on Banking Supervision (BCBS) introduced a set of reforms in the form of Basel III to improve banks’ resilience to financial stress and strengthen their transparency and disclosure. As Basel III approached its final implementation, BCBS continued to tweak it into what has unofficially been referred to as Basel IV. Basel IV is a comprehensive set of measures that will make significant changes to the way banks calculate risk-weighted assets (RWAs). BCBS’s stated goal with these changes is to “restore credibility in the calculation of RWAs and improve the comparability of banks’ capital ratios.”
Basel IV is designed to accomplish this by constraining the use of internal models via the application of an output floor, making sure banks’ capital doesn’t fall below 72.5% of the amount required by the standardized approach – or in some cases removing the option to use internal models all together. Basel IV is also designed to improve the risk sensitivity and robustness of standardized approaches.
Full adoption of Basel IV is not expected to happen until 2025, and the stages of implementation vary by country:
- Australia: January 1, 2023
- Canada: Fiscal Q2 2023
- China: January 1, 2024
- European Union: January 1, 2025
- Hong Kong: January 1, 2024
- Japan: March 31, 2024
- Singapore: July 1, 2024
- United Kingdom: January 1, 2025
What Does Basel IV Mean for Financial Institutions?
Basel IV will bring a stricter set of rules than the previous international banking accords. Among the proposed changes are:
- Restricting the use of the internal model approaches used by some banks to calculate their capital requirements. Banks generally will have to follow the accords’ standardized approach unless they obtain the supervisor’s approval to use an alternative. Basel IV removes the Advanced-IRB (A-IRB) approach option for exposures to large corporate and financial institutions, and removes all IRB approach options for equity.
- Improving the earlier accords’ standardized approaches for credit risk, credit valuation adjustment risk (the pricing of derivative instruments, for which a standardized or basic approach is now required), and operational risk. Standardized approaches will be more risk-sensitive with more tiers, categories and requirements.
- Implementing a leverage ratio buffer to further limit the leverage of global systemically important banks. These are the banks that are considered to be so large and important that their failure could endanger the world financial system. The ratio will require them to keep additional capital in reserve.
- Substituting the Basel II output floor with a more risk-sensitive one, reducing the low levels of internally modeled RWAs and allowing for a better comparability between standardized and IRB banks. This refers to the difference between the amount of capital a bank would be required to keep in reserve based on its internal model as opposed to the standardized model.
Among the implications of the Basel changes is that they will lead to wider corporate credit spreads. The new risk-weight framework will make it more expensive for banks to hold non-rated or non-investment-grade corporate debt. As such, banks will have to allocate more capital against higher risk-weighted corporate debt. They will have to reevaluate their exposure since corporates that don’t carry RWA today will be considered riskier because of the wider credit spreads. Banks are concerned about how this could affect the availability of loans for non-rated or non-investment-grade companies. In order to thrive, banks will have to master a very difficult balancing act.
Originate-to-distribute and Secondary Distribution
Basel IV’s impact on financial institutions will vary depending on their portfolio, location, current internal risk methodologies and more. One constant is that banks’ management has set progressively higher KPIs for their trade finance teams each year. In order to grow their business under Basel IV, financial institutions will need to streamline their distribution business models. Distribution will enable them to support their balance sheet and facilitate efficient asset origination. What started as a risk mitigation tool, distribution has become an extremely useful tool for optimizing capital and liquidity.
- Through originate-to-distribute (OTD) models, financial institutions can derecognize the assets from their balance sheets, reducing the amount of regulatory capital they need to hold to cover the risks. This will enable them to obtain medium- and/or long-term funding partners without jeopardizing the relationship with their borrowers.
- With secondary distribution, financial institutions will “house” for a period the assets on their balance sheet and distribute later at a chosen time. This is equally important for a flexible and efficient business model.
Ideally, financial institutions will want to have both options on the table to maximize their ROI and support their trade teams in achieving their targets. Banks will need to maintain a compliant balance sheet with as many high tier 1 and tier 2 capital ratios as possible as they look to minimize the impact of the new framework.
Streamlining the Process with Powerful Software
The Basel regulatory framework has become progressively more complex throughout the years and many changes it’s seen. Even as they face challenges to their processes, financial institutions can safeguard themselves against too much disruption by being adaptable and more importantly, drawing from the right resources. By working with a cloud-based trade finance solution, financial institutions will see greater efficiencies and be able to outsource a significant part of their compliance burden. This will ultimately give them a competitive advantage in better serving customers. LiquidX offers a comprehensive solution for origination and distribution of trade finance assets, streamlining bank processes from purchase order to monetization. Our network provides a single legal and technology infrastructure enabling corporates and financial institutions to transact more efficiently. LiquidX empowers banks to do more business, reduce costs and mitigate risk with true digitization. Click here to request a demo of our product and see how it can help you.