COVID-19 and implementation of regulatory requirements

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Innovative risk management, automated regulatory compliance audits, and communication with the regulator on a regular basis are key success factors

Background

In just a few months, the COVID-19 pandemic has dramatically changed the global economic situation. Even the largest and most successful corporations have announced production stops and short-time work and continue to grapple with the fear of liquidity bottlenecks. Credit institutions have been hit hard as well due to increased credit risks and the need to allocate more capital to meet these increased capital requirements. In fact, we estimate that processing costs incurred by banks for loans with a significant deterioration in credit quality have tripled. This overall situation has called into question the implementation of Basel IV by January 2022 with its stricter capital requirements. However, while the corona pandemic is an important factor in the discussion to possibly delay Basel IV, in our opinion it is not the only cause for this.

Postponed implementation of regulatory requirements

From a historical perspective, it is important to realize that there have been delays in the implementation of regulatory capital requirements, including those from the Basel Committee. For instance, the introduction of the Basel II framework, initially planned for 2007, was implemented on time in Europe but postponed by two years in the US with subsequent further delays. This was due to the extreme financial situation caused by the mortgage crisis. There were also delays in Europe: the ECB’s TRIM audits could not be completed in 2019 as planned, so that the remaining work had to be completed in the current year.

With respect to Basel IV, preliminary results of European studies by the ECB and the EBA indicate that European banks are not prepared for the introduction of the Basel IV regulations. This is the case both on the bank capital side – where a shortfall of EUR 135 billion equity currently exists – and at the technical level – where the implemented internal processes and existing know-how hardly allow it to be completed in a short period of time – TRIM, EBA. Moreover, highly indebted “zombie companies”, which appear abundantly on European books and are heavily dependent on the economic situation, exacerbate the problem. This situation has led banks to stay in constant communication with regulators. Ultimately, it was decided to postpone the implementation of the regulatory framework. Some requirements of Basel IV, such as RWA output floors, will not be implemented until January 2028:

Table 1: Postponed implementation of Basel IV, Source: BIS, March 2020

Europe-wide EBA stress tests will come in 2021. The agreed postponements would give European banks more time to implement the new strict capital rules and relieve the financial sector of some organizational and administrative tasks. The aim here is to continue to provide the economy with sufficient liquidity. However, this goal cannot be achieved by the postponed deadlines alone; now it is the banks’ turn.

Our recommendations for banks

Through several years of implementation experience, we were able to identify the following success factors for the implementation of regulatory requirements:

  1. Innovative risk management: The use of alternative publicly available data sources, such as social media, news agencies, and industry blogs can provide up-to-date information on the companies affected by the crisis (especially zombie companies). These help to better assess credit default risks so that banks can timely implement risk mitigation measures.
  2. Automated regulatory compliance audits:When implementing Basel IV requirements, the strategic decision on the partial use of CRSA/ IRBA should first be worked out on the basis of a comprehensive cost-benefit analysis. Based on this, internal risk models can be adapted or developed, and early warning systems can be improved. Changing framework conditions can influence the decision over time, whereby process automation enables rapid adaptation.
  3. Communication with the regulator on an ongoing basis. The evidence from the implementation of regulatory requirements shows that the regulator’s primary objective is financial stability, as opposed to implementing the regulatory requirements at any price. Therefore, banks should inform the regulator immediately of new capital hurdles to ensure an adequate response.

At Capgemini Invent, we have many years of expertise in regulatory project planning and implementation, in the development and implementation of risk models and in communication with the regulator. If you have any questions, we will be happy to advise you.

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