There is no Basel IV solution, leverage on initiated Finance and Risk optimisations

1.    Introduction

Since the reform of the Basel III supplements[1] in 2017, it has been one of the most important topics among banks and financial institutions. In order to prevent a wide range of stakeholders from losing confidence in banks’ reported capital ratio, the post-crisis regulation contributes to restoring the credibility of the calculation by enhancing the comparability of bank’s capital ratios, limiting the use of internal model approaches and complementing a sound capital floor on risk-weighted assets (RWA) ratio.

In short, the revised Basel III, renamed Basel IV, requires the banks to be more standardized, especially for banks using Advance Internal ratings-based approach (A-IRB). To a large extent, banks using A-IRB approaches have more freedom to use their own models to estimate risk parameters, such as PD (probability of default), EAD (exposure at default) and LGD (loss given default). However, Basel IV will no longer allow low default portfolios, such as Mortgages, Trade Commodity Finance (TCF) to use internal models.

This is due to the reason that the Basel Committee on Banking Supervision (BCBS) regards it challenging for banks to obtain reliable parameter estimations for low default portfolios. Instead, BCBS introduced input floors to PD, LGD and the Credit Conversion Factors (CCF) that are used to determine EAD for off-balance sheet items and the output floor on capital requirements to force A-IRB banks to better understand the behaviour of their portfolios and allocate capital appropriately according to the standardized approach.

Second reason is to increase the comparability between the models of different banks. A-IRB models have become sometimes too advanced in relation to their purpose and data availability. For some banks this is a good reason to start normalizing models, reduce the number of models and to lower implementation costs.

The implementation date of Basel IV regulation is postponed with one year till January 2023 and will phase until 2028 due to the COVID –19 outbreak.

With the longer implementation period, banks are allocating their limited resources to other regulations with the priority, such as BCBS 239 (deadline in January 2016), IFRS 9 (implemented in January 1, 2018) and Definition of Default (DoD) (come into action on January 1, 2021). Although these regulations do not seem to have a direct impact on capital requirements under Pillar 1, they do have a non-negligible common impact with Basel IV regulatory framework. Banks should not underestimate the importance of considering the common impact when adapting to the new regulation, as the efforts and costs of implementing each regulation are considerable.

Impact of COVID 19

The outbreak of the COVID –19 pandemic and the subsequent global lockdown put the banking system, particularly its capital positions, under severe pressure. Repayments of loans are Loans need to or will be written-off. The market movements are also hurting safety buffers. But because of the regulatory capital buffers banks remain resilient so far. With the pressure on capital there comes a huge demand for ad hoc regulatory and management reporting. Besides COVID there was already impact from huge backlogs in DoD, BCBS 239 and Modelling.

In order to allow banks to concentrate their resources on mitigating the effects of COVID –19 and maintaining financial stability, the Basel Committee on Banking Supervision (BCBS) has announced that the implementation of Basel IV will be postponed for one year to 1 January 2023 [1].

The revised implementation guidelines following a deferral are summarized below:

Basel IV main features

So, what is the Basel IV implementation about? Let’s have a quick recap:

• Introduction of Standardised Models (SA)
• Some portfolios need to move to foundation
• Input Floors
• Output floors
• Focus on tail end risk
• Business Impact indicator for Operational risk

The introduction of the SA models and the comparison with the IRB calculations seems to have the biggest impact. New data needs to be sourced and calculations need to be merged with IRB calculations. Additional data is requested that was not asked before like external client ratings and original collateral value. And, a new client segmentation needs to be made for the SA models. Therefore, in terms of data logistics there is a challenge.

As many banks are updating their financial and risk landscape, they are taking the opportunity to develop the Basel IV features on the target platforms. But not all target platforms will be ready in time, so there will be a hybrid implementation that increases IT implementation efforts.

Similarly, the output floor, known as one of the biggest challenges under Basel IV, is also raising the heavy workload and costs in banks. Banks have to allocate resources to revise methodologies and finalize the Basel IV framework, especially for those banks with large low default portfolios. The setting of lower bounds is designed to reduce the variability in RWAs and thus increase the comparability in capital ratios among banks. Mandatory RWA is at least 72.5% of RWA using the standardized approach.

In the picture below you will find an overview of the Basel IV framework.

For banks business management and business planning the introduction of SA models and floors opens up the opportunity to rethink their business planning and control, focussing on cost control and client revenue. To do this, this requires additional effort in terms of business and IT implementation. But when done there will be more balance between business modelling compared to risk modelling.

So, all in all the deferral of the Basel IV implementation is welcomed. The postponement frees up operational capacity for other regulatory initiatives and provides banks with extra time to unlock the full Basel IV mitigation potential. However, banks should not underestimate the time needed to implement the Basel III reforms, but use this extra time efficiently.

2.    Basel IV & BCBS 239: the opportunity for Data and reporting optimisation

As we mentioned in our previous blog [2], banks are paying more attention on data management since the implementation of Basel III.  BCBS introduced more data complexity and additional data requirements for the banking sector to increase comparability between the banking books of different banks and to be able to benchmark risk-related transparency and comparability. The global financial crisis revealed the banks’ lacking ability to provide senior management with a true picture of the risks the organization faces. Therefore, BCBS 239 was introduced in response to the need for banks to strengthen their risk aggregation capabilities and the effectiveness of their risk reporting. In this section, we will talk about the common influence between Basel IV and BCBS 239.

To meet the “Principles for effective risk data aggregation and risk reporting”, BCBS calls the banks to highly automate and standardize their risk reporting and the underlying provision of data, which requires a rework of governance, data modelling, correction and maintenance processes, evaluations and evaluation dimensions to integrate different risk types. Risk IT and risk department are asked to collaboratively resolve the risk type alignment in risk management and provide data provision with adequate quality. It is therefore costly and challenging for banks to revolute their data quality management in order to be comply with BCBS 239. Remarkably, although the deadline for BCBS 239 has already passed, data quality remains the biggest concern among banks affecting each individual business unit. This is also recognized by the supervisor in many TRIM on-sites over the past two years. There needs to be real improvement in data management, data governance and data quality management. With an increase of the restrictions, minimal capital requirements and standardized risk methods, Basel IV requires more extensive data for Basel monitoring exercises and quantitative reporting. Also, the implementation of Basel IV requires extensive qualified data. High quality granular data will allow banks to make proper forecasts of accurate measurements and will then help banks to undo some mark-ups they get for uncertainty and provide the evidence on being compliant with the capital floors.

As better data quality improves RWA accuracy and thus reduce capital required, banks should take the advantage of using their clean data to test the regulator’s assumptions about defaults and loss. If less capital is stuck in the floor, more is available for new investments. In addition, accurate and granular data from banks will help the regulator and the bank to produce insights in what capital is to be reserved as a buffer. Meanwhile, banks should also seize the opportunity to further improve their data management such as data storage and migration when redeveloping their models under Basel IV. Managing the critical data elements in a way that they are managed once and used multiple times benefits risk management and profitability.

3.    Basel IV & new DoD:  New approach for credit risk management

From January 1^st, 2021, the European Banking Authority’s (EBA) new Definition of Default (DoD) will come into action. The new guidelines aim to harmonize credit processes in three perspectives: ensure a consistent and harmonized approach across countries, increase comparability of estimates and requirements, and reduce burden of different requirements for cross-border groups. To do so, EBA pointed out the need for banks to revising their current models and improving risk integration.

In this section, the common influence between new DoD and Basel IV is analysed to provide insight into the benefits of starting the implementation of Basel IV together with the urgent DoD guidelines.

3.1 Model change

As the new DoD requests banks to revise their models, the implementation of new DoD requires significant effort and resources of some institutions, in particular those using the A-IRB approaches as they tend to predict lower default losses. Those banks will need to adjust their definition to comply with the new definition of default and apply it retrospectively. IRB banks also need to recalculate and introduce additional margin of conservatism (MoC) when necessary to compensate for inconsistencies between different DoD definitions from the past. In comparison, the banks currently applying SA are expected to be affected less as they do not rely on historical data.

In Europe, larger banks tend to use A-IRB approaches for their portfolios and most of them have a substantial amount of PD and LGD models. Therefore, taking into account the floors for PD and LGD levels of Basel IV when adjusting historical data and redeveloping the models can certainly help banks to save resources and costs. We see that many banks take the opportunity to redo their data logistics for historical and production data and have clear communication between data owner and data user. This will increase data quality and save costs

3.2 Impact on capital requirements from New DoD definition

According to Article 178(1) CRR [3], there are two triggers that EBA considers an obligor as ‘default’:

1. Credit obligation is 90 days past due (DPD), which was 180 days before
2. Materiality threshold has been breached (e.g. The total amount of the credit obligation past due).

Although EBA estimated in the paper that the new definition is unlikely to increase capital requirements considerably, most of the institutions still need to adequate their available capitals to meet the new definition. By adapting 180 DPD to 90 DPD, firms that are currently following 180 DPD will accelerate the trigger of default and end up with a higher PD estimate and lower LGD estimate. When the parameters change, the expected credit losses will increase correspondingly and thus lead to a higher risk provisions and higher capital required. In Basel IV, a 72.5% output floor is supplemented and will also lead to a higher RWA, especially for those A-IRB banks. In terms of implementation banks are already used to use input floors but output floors. Therefore, they should be less stressed on adapting to the capital floors, as the introduction of the new definition has already contributed to the adjustment of the required level of capital. Similarly, the standardized introduction of a materiality threshold for the credit obligation will also increase the number of defaults and thus affect capital requirements, which will also help to simplify the implementation of the Basel III reforms. This impact will be comparably significant on IRB banks as the threshold change more significantly.

4.    So, what is the current implementation status of Basel IV?

The implementation of the Basel IV framework is of course a remarkable challenge for European banks, as most larger banks use A-IRB approaches for most of their portfolios in Europe. These A-IRB banks note that the redevelopment of internal models is more expensive than a possible increase in capital requirements, which is one of the main constraints for starting the implementation of the revised Regulation.

BIS (Bank for International Settlements) is publishing progress report on adoption of the Basel regulatory. In the latest report, BIS described the adoption status of Basel III standards for each BCBS member jurisdiction as of end-September 2019 [4]. Results show that the main reforms under Basel IV, namely ‘Revised standardized approach for credit risk’, ‘Revised IRB approach for credit risk’ and ‘Revised CVA framework’, are all in the ‘draft regulation not published’ phase. This classification represent that there is no draft law (waiting for CRR3) , regulation or other official document that has been made public to detail the planned content of the domestic regulatory rules, and it is applied not only for European Union but also for all other jurisdictions.

But we cannot wait for CRR3 to be ready and so the preparations for Basel IV are in progress. In general, can something be said about the current implementation status? Yes and no. No because every bank is different and has its own planning. Yes, because there is one deadline, the framework is not completely new and the challenges for existing European (IRB) banks are mostly the same.  We see that banks finished their IFRS9 implementation and are busy implementing BCBS239 and TRIM on site recommendations. In most cases banks took the opportunity to completely redevelop their model landscape for simplification and cost efficiency purposes. These initiatives are multi-year implementations which are ongoing as Basel IV needs to be implemented.  The development of the Basel IV Standardized Model is already new. Besides there are floors that needs to be implemented. For these the floors themselves are not so much the challenge as well as the effect they have. So, we see a choice for broad insight in SA vs IRB results and Floored vs Unfloored results. These insights are triggering discussion about making a choice between IRB and SA models in capital planning and pricing. Therefore, we see the granularity in data improving which makes banks more flexible in their reporting and planning decision making.

It is clear Basel IV is triggering desired discussion about more transparency in the model function and comparability between peers.

So, what we see is that banks are implementing Basel IV and at the same time taking the opportunity for improvements. BCBS 239 and new CRR regulations allow them to make fundamental improvement choices, and to re-allocate their resources and save costs in developing models (adjusting historical data) and application architecture. There is still a long way to go to the desired state, but we see FR integration initiatives paying off.

5.    How can we help?

We can offer you support in various ways, from project support to concrete solutions you will be able to use in your organisation.

Please work with us to determine your needs in getting Basel IV compliant.

6.    Conclusion

There is no doubt that Basel IV has a significant implementation effect on banks’ processes and systems. There is already effect from BCBS 239 implementation and the new DoD. And now there is this pandemic impact from COVID –19 hurting capital buffers.

So far the lesson is, there is no Basel IV solution, banks need to leverage on your FR and Model Integration efforts.  Since most banks are still in the starting phase, they can analyse common effects and make use of the achievements under other two regulations to save costs and stimulate the implementation of Basel IV. There is model optimisation initiatives, finance and risk IT integratrion initiatives, data logistics optimizations and reporting initiatives. The challenge is to leverage on these initiatives and orchestrate them to have the best and most realistic Basel IV implementation possible. This requires transformation plannining and a lot of stakeholder alignement.

Besides banks may now have enough incentives to move towards the standardized approach and focus more on business case modelling again and taking the standardized capital numbers for efficiency reasons. In that sense the deferral of the Basel IV implementation deadlines may be an unexpected gift.

There is another thing which than comes into mind and that is the opportunity of testing  solutions that facilitates simplifications of your portfolio’s. Why not try it on some? New technologies are opening ways that are closed in legacy situations but with Basel IV there is the time to test new technologies.

[1] For more details: https://www.bis.org/press/p171207.htm

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Co-authors

Elena Paniagua Avila

Managing Consultant

Capgemini Invent

Siyun Han

Consultant Data, Finance, Risk & Regulatory

Capgemini Invent