Basel IV Credit Risk

The Basel Committee on Banking Supervision (BCBS) consists of representatives from Central Banks and regulatory authorities. The Basel Accord was provided by BCBS in a bid to ensure that the banking system has enough operation Risk Management practices in place. Basel 4 was finalized by BCBS in December 2017 and is due to be implemented by January 2022.

Brief History of Credit Risks from Basel 1 to 4

Basel I had constant risk weights for various asset classes. With the introduction of Basel II norms in early 2000, banks were keen to move to Internal Risk Based (IRB) approach to reduce the capital held as capital provisioning. Basel III introduced loan-to-value (LTV) based risk weight calculation for standardized approach. There were also some changes to credit exposures on unrated loans and exposures against large corporates and banks. The IRB approach allowed the banks to maintain minimum capital in comparison to the standardized one, allowing revenue maximization. BCBS and EBA (European Banking Authority) conducted a research on how the capital requirements were calculated in standardized and IRB approaches. The studies found IRB model resulting in large variability of risk weighted assets. It was identified that the probability of default (PD) and the loss given default (LGD) parameters calculated from the internal models were far from reliable. The monitoring practices in validation of the models were not quite robust. Poor data quality also drastically decreased the accuracy of IRB models. With the 2008 recession which pushed most banks to bankruptcy, the regulators had to go back to the drawing board. Some of the key changes that came our way are related to data management (BCBS239), capital calculation (stress testing), liquidity management, calculating future losses, review on trading book risk, operation risk management, and conduct risk etc.

Basel 4 Credit Risk Capital Floor Framework

BCBS has introduced a new capital floor framework that will replace the current transitional floor based on Basel 1 standards. BCBS identified financial institutions in certain jurisdictions and implemented Basel 2 and 3 without implementing Basel 1. The new framework will allow financial institutions to have one logical and simplified capital requirement.

Read how do Basel 4 changes affect Banks in our new blog. #baselIV #creditrisk @hclfs

The objectives of capital floor include:

• Ensuring the level of capital management across the banking system does not fall below a certain level
• Mitigating model risk and measurement error stemming from internally modelled approaches
• Addressing incentive-compatibility issues
• Enhancing the comparability of capital management outcomes across the banking system

Key Changes on the New Capital Floor Framework

1. Risk weighted assets (RWA) calculated by internal models will be floored by a percentage of RWA calculated using standardized approaches
2. The floor will be eventually 72.5% based on the new standardized approach
3. The new floor will be introduced in 2022 and capital floors will be implemented in phases until 2027

BCBS eventually decided 72.5% as a compromise as US regulators wanted higher flooring and EBA regulators wanted a lower flooring.

How do Basel 4 changes affect Banks?

Banks may need to start increasing their liquidity management reserve to offset off-balance sheet activities. For banks operating on standardized approach, there may be an improvement in RWA if their books have a lower LTV. With simplification of calculations for standardized approach, there will be significant benefits for banks operating on this approach.

There is significant impact to banks operating on IRB approach. With the introduction of capital floors and the removal of scaling factor, there would be a reduction in CET1 (Common Equity Tier 1) ratios, which will then have direct impact on pillar 1 capital requirements.

How can we mitigate the impact?

Banks will have to think through their business and operation risk management strategies and arrive at a resolution to minimize Basel 4 impact. Banks with diversified portfolio will have to undertake lower mitigating actions than the ones with an intensive portfolio.

To assist banks with the mitigation efforts, we have devised certain steps which can be undertaken. These might help in optimal capital management.

Improve Data Management Quality

Analyze the quality of the data needed to calculate RWA and see if data management enhancements can be done to improve the calculations. This may include ensuring all loans are included for RWA calculation or by obtaining additional data sets from the customers to improve RWA. These may not require significant operational or system changes but can create considerable impact on the end goals for the bank

Restructure Products

A slight restructure of the product offering to make it more capital efficient for the bank. This may mean convincing the customer to take up the new offering with a positive impact.

Revisit Non-Performing Customers

Sometimes taking a decision to exit a non-performing customer or renegotiating terms with the customer will assist in improving capital requirements.

Realignment of Business Strategy

Revisiting the business strategy to diversify the portfolio will significantly improve RWA which in turn will improve capital requirements for the bank.

How HCLTech can help?

HCLTech’s dedicated Credit Risk Centre of Excellence (CoE) has extensive experience in designing, building, and delivering tools, solutions, and risk scoring models. Our end-to-end solution development and delivery can assist customers in being able to comply with Basel and other country specific risk management practices/regulations.

We have extensive capabilities with the solution and implementation of Basel 1, 2 and 3 across various organizations across the globe. Based on the learnings from previous implementations we have created a sequence of steps that need to be carried out by customers to arrive at an optimal solution for implementation of Basel 4 accord.