Basel IV Impact on Capital Requirements and Risk Management

Basel IV is set to introduce significant changes to the way banks calculate their capital requirements, with the goal of making the system more risk-sensitive and robust.

Under Basel IV, banks will be required to hold more capital against their trading book, which includes investments in stocks, bonds, and other securities. This is expected to increase the overall capital requirements for banks.

The changes will also introduce a new approach to measuring credit risk, known as the "advanced measurement approach" (AMA), which will require banks to use more sophisticated models to estimate their credit risk.

Regulatory Requirements are in place to ensure banks have enough capital to absorb losses in times of financial distress. The Basel Accords are the main set of international rules governing banks' capital requirements.

Banks are required to hold a minimum capital ratio of 10.5% of their risk-weighted assets under the Basel framework. Risk-weighted assets refer to a bank's assets, including its interest-bearing loans to customers, adjusted for certain risks, such as the probability of a default by the borrower.

The Basel III reforms introduced a countercyclical capital buffer, which is built up in good times and released when systemic risks materialize. The buffer varies by country and can be anywhere between 0 and 2.5%, depending on what the national regulator has decided.

Here's a summary of the key regulatory requirements:

The capital requirement is a crucial aspect of banking regulations. The Basel Accords are the main set of international rules governing banks' capital requirements, designed to shore up banks' resiliency so they can absorb losses in times of financial distress.

To give you a better idea, the Basel framework requires a minimum capital ratio of 10.5% of a bank's risk-weighted assets. This ratio is a key component of the Basel III reforms, which were introduced in response to the global financial crisis in 2009.

The risk-weighted assets refer to a bank's assets, including its interest-bearing loans to customers, adjusted for certain risks, such as the probability of a default by the borrower and the loss that would result. The higher the risk in lending, the higher the bank's risk-weighted assets, and the more equity capital reserves a bank needs to hold.

The countercyclical capital buffer, which is built up in good times and released when systemic risks materialise, can add to the capital requirement. This buffer varies by country and can be anywhere between 0 and 2.5%, depending on what the national regulator has decided.

Here's a breakdown of the key components of the capital requirement under the Basel framework:

The capital requirement is a critical aspect of banking regulations, and understanding its components can help you navigate the complex world of banking.

Regulatory bodies are taking a close look at the way LIBOR is used in financial transactions. The transition to a new risk-free rate has been a challenge for many financial institutions.

We've been working with major market participants on LIBOR reform for the past 2 years, and we're well positioned to assist you throughout this journey.

Regulators are expecting financial institutions to submit information and participate in surveys related to LIBOR reform. This is a key part of the transition process.

A recent HKMA circular provided an update on LIBOR reform, highlighting the importance of timely information submission and survey participation.

The LIBOR transition is having a significant impact on corporate treasury functions. Financial institutions need to adapt to the new rate and adjust their operations accordingly.

Here are some key implications of the LIBOR transition:

Risk Management is crucial for banks and financial services firms to navigate the complexities of Basel IV. The new standardised approach for operational risk brings variability in capital impact across banks and jurisdictions.

KPMG can assist in reviewing and enhancing operational risk frameworks to meet current regulatory requirements. Their operational specialists can refine loss-data collection standards and processes to meet the requirements for usage in the internal loss multiplier.

Banks need to consider the risks associated with fluctuating interest rates, which can be managed with the right expertise and insights. The recalibration of shocks for Interest Rate Risk in the Banking Book (IRRBB) and finalised adjustments are essential for effective risk management.

The capital ratio is a key metric in risk management, and it's essential to understand what it means for banks. It's a bank's available capital expressed as a percentage of its risk-weighted assets.

The minimum ratio is 10.5% under the Basel framework, which is a set of international rules governing banks' capital requirements. This ratio helps regulators assess a bank's ability to absorb losses in times of financial distress.

Banks need to maintain a healthy capital ratio to ensure they have enough capital to cover potential losses. A higher capital ratio indicates a bank is more resilient and better equipped to handle financial shocks.

Here are the key components of the capital ratio, according to the Basel framework:

By maintaining a strong capital ratio, banks can reduce their risk exposure and improve their overall financial stability. This is critical for preventing bank failures and maintaining public confidence in the financial system.

Risk management is a crucial aspect of banking, and it's essential to understand the various risks that banks face. Banks need to consider the risks associated with fluctuating interest rates, which can impact their capital requirements.

Banks are required to hold a minimum amount of capital, known as the capital ratio, which is 10.5% under the Basel framework. This ratio is calculated based on a bank's risk-weighted assets, which take into account the probability of a default by the borrower and the potential loss.

Credit risk is a significant concern for banks, and the internal ratings-based (IRB) approach can have a significant impact on capital requirements. Banks using the IRB approach will be affected by the constraints on the use of internal models to measure credit risk, which can force banks to apply higher risk weights to certain exposures.

Banks also need to consider interest rate risk management, which involves recalibrating shocks for interest rate risk in the banking book. The finalised adjustments to interest rate risk in the banking book will require banks to reassess their risk management strategies.

To mitigate these risks, banks can use external ratings to reduce risk weights under the revised standardized approach for high-rated corporates and banks. The table below shows the risk weights for different external ratings:

Banks should ensure that they maintain accurate external ratings information for their business entities to avoid misclassification and understating or overstating risk weights.

Credit Valuation Adjustment is a key aspect of risk management, particularly for banks operating in Hong Kong. Banks have three options for CVA capital calculations, but only one if their total OTC trade notional is less than HKD 1 trillion.

The standardized approach (SA-CVA) is a new framework that requires significant implementation efforts, including data management and modeling of sensitivities. This approach will have a substantial capital impact on banks.

KPMG can assist banks in implementing SA-CVA with their hands-on experience and well-tested tools. Their CVA experts can provide a comprehensive roadmap for implementation.

Banks must choose between the basic approach (BA-CVA) and SA-CVA. Our CVA experts can help analyze the pros and cons of each approach, making it easier to make an informed decision.

In Basel IV, an 85% risk-weight has been introduced for unrated Corporates that classify as Small & Medium Enterprises (SMEs), as opposed to 100%.

This benefit of the SME identification for a corporate can be nullified if the data for classifying SMEs as such is not available.

Banks would therefore be prudent to identify the correct sources of client revenue to get the benefit of the RWA reduction from SMEs (85% instead of 100%).

SMEs are defined as corporate exposures where the reported annual sales for the consolidated group of which the corporate counterparty is a part is less than or equal to €50 million for the most recent financial year.

Data improvements can be obtained in the bank portfolios by adding/updating the SME indicator.

Most banks do not have sufficient/accurate information when it comes to client annual consolidated revenues, and this could be a problem for identifying the €50 million threshold.

The Revolver/Transactor Indicator is a crucial tool for banks to assess risk in lending. It categorizes obligors into two groups: transactors and revolvers.

Transactors are obligors who have repaid their credit card or charge card balances in full at each scheduled repayment date for the previous 12 months. This indicates a lower risk profile.

Obligors with overdraft facilities are also considered transactors if there have been no drawdowns over the previous 12 months. This suggests a more stable financial situation.

Revolvers, on the other hand, are obligors who only pay the minimum due payment for revolving products. This increases the risk of high interest income and potential risks due to their spending activity.

The risk-weight assigned to transactors is 45%, while revolvers are assigned a higher risk-weight of 75%. This highlights the importance of accurately categorizing obligors to manage risk effectively.

Banks will need to rely on historical data to populate this field, making data aggregation a unique challenge.

Implementing initial margin rules can be a complex task, but it's essential for mitigating risks in OTC derivative trading.

The initial margin rules have a significant impact on the entire trading lifecycle, from deal initiation to risk mitigation standards.

KPMG has assisted numerous banks in implementing these rules, defining best-in-class processes and providing dedicated local teams with global talent sharing regional and market practices.

A suite of tools and services can help you build an implementation framework for initial margin rules, including validation and back-testing of the SIMM model.

KPMG's services also cover system implementation, use of data, and enhancing your OTC trading target operating model for compliance with local and international initial margin rules.

Here are some of the key services KPMG offers to support your initial margin journey:

Companies will need to have maximum flexibility to choose between different funding options to find what suits them best. This is especially important for large corporates, as they will be grouped at a higher risk level regardless of their actual credit risk history.

The implementation dates for Basel IV have changed, with transition rules set to take effect from 2025. This gives companies a bit of breathing room to prepare.

Banks must ensure their systems can handle substantial data volumes and complex processing to meet deadlines and avoid reputational risk. Institutions of all sizes can benefit from working with third-party partners that specialize in cross-jurisdictional reporting.

Regnology's cloud-based reporting platform is built to handle Basel IV's increased requirements around granularity and speed, with a flexible architecture and unified data ingestion model that enables easy integration, calculation and reporting.

If you'd like to learn more about how Regnology can help your institution efficiently address Basel IV data and reporting requirements, visit their designated solution page or get in touch with them directly.

KPMG can help banks prepare for Basel IV by advising on data collection and operational requirements for the CR-SA, and assessing the implications of the interplay between the restrictions on the use of the IRB approach, the output floor and the revised Standardised Approach.

Banks will need to adapt to the new rules under Basel IV, which will take effect under transition rules from 2025. This means they'll have to start preparing for the changes soon.

The Basel Committee has agreed on changes to the global capital requirements, which will constrain banks' use of internal risk models for large corporates with a turnover of at least 500 million EUR. This will limit the benefits of these models, which often yield a lower risk than the regulator's standard model.

Banks will need to modify their leverage ratio definition and make changes to the credit valuation adjustment (CVA) and operational risk frameworks. This will require significant updates to their systems and processes.

The new output floor will prevent a bank's internal measurement of its risk exposure from yielding less than 72.5% of the standardized approach. This means banks can't reduce their risk-weighted assets by more than 27.5% using internal models.

Large corporates with revenues over 500 million EUR that don't have a credit rating and rely on bank loans for funding today will be hardest hit by the increased borrowing costs. This could lead to higher borrowing costs for these companies.

Banks must ensure their systems can handle substantial data volumes and complex processing to meet deadlines and avoid reputational risk. This is crucial for identifying issues, optimizing methodologies, and taking proactive steps toward efficiency.

Optimizing technology and data management infrastructure will look different for every bank, but the increased granularity of the required calculations will present significant challenges. Undertaking modernization efforts early in the implementation process is essential.

Banks of all sizes can greatly benefit from working with third-party partners that specialize in cross-jurisdictional reporting. Regnology's cloud-based reporting platform is built to handle Basel IV's increased requirements around granularity and speed.

The implementation dates for Basel IV have changed since the original publication, with transition rules set to take effect from 2025. Banks must ensure they are prepared for this change and have the necessary systems in place to comply.

To prepare for implementation, banks should focus on optimizing their technology and data management infrastructure. This will help them identify issues, optimize methodologies, and take proactive steps toward efficiency.

Some key considerations for banks when preparing for implementation include:

By taking these steps, banks can ensure a smooth transition to Basel IV and avoid reputational risk.

Banks must now source the value of the property at origination to compute LTV ratios, as per the Basel IV regulation.

This can be a challenge, especially for banking portfolios other than Mortgages, where banks will need to have proper sourcing mechanisms in place.

Banks currently develop their LGD models using the latest collateral values, but now they'll need to fetch transaction-level collateral for both IFRS 9 and Basel IV calculation processes.

The right collateral data can make a significant difference in ensuring correct credit risk mitigation and reducing risk-weighted assets (RWA) to an optimal value.

Banks must use the collateral value at origination, unless national supervisors decide to revise the property value downward, as stated in BCBS D424: Page 20, paragraph 62.

Transaction-level collateral is already important for Standardized and FIRB approaches, to get updated LGDs based on secured-unsecured splits.

One possible synergy is using the same collateral data for both IFRS 9 and Basel IV calculation processes, which could be ideal for an efficient implementation.