COVID-19 Should Not Jeopardize the Implementation of Basel IV

Courtesy of Mete Feridun

While it is important to consider which regulatory measures may alleviate the impact of the COVID-19 pandemic, it is equally important not to allow the pandemic to derail the planned implementation of future regulations.

The complex final phase of the Basel III reforms—referred to as “Basel IV” by the industry—are especially important because they target risk weighted assets (RWAs), aiming to reduce excessive variability and inconsistency in how banks’ internal risk models calculate RWAs. This is expected to restore confidence in banks’ regulatory capital ratios and, consequently, the global banking sector.

The Need for Basel IV

Basel IV was announced at the end of 2017, with a planned implementation date of January 2022 onwards. However, in response to the pandemic the Basel Committee decided to postpone this start date until January 1, 2023, while deferring the transitional arrangements for the capital output floor to January 1, 2028.

Depending on how the pandemic progresses and how much damage it causes to the global economy, it is likely that these start dates could be pushed back even further. This may put the implementation of the post-crisis global banking reforms at risk.

While the initial phase of Basel III has already been implemented, Basel IV—which is equally important—has not. In fact, the implementation of Basel IV hasn’t even started, with the exception of a few jurisdictions.

Amidst the fluctuations in global forex and equity markets, the need for global reforms to address excessive variability in RWAs and risk-based capital ratios is as urgent as ever. Although Basel III has raised the quality and quantity of capital and introduced liquidity and leverage ratios, Basel IV is still needed to address issues regarding the calculation of regulatory capital requirements.

It took the Basel Committee more than 10 years to finalize the post-crisis reforms. If these reforms are pushed back further, inconsistencies across banks’ RWAs, challenges with respect to their internal risk models, and remaining issues regarding the Basel Committee’s prescribed standardised approaches will continue to plague the banking sector in the years to come.

The Basel IV reforms are aimed at enhancing the robustness and risk sensitivity of the standardised approaches for credit risk and operational risk. These reforms are expected to facilitate the comparability of banks’ capital ratios. Further, these reforms constrain the use of internally modelled approaches to credit, market, and operational risks, and overhaul standards with respect to credit valuation adjustment. Taken together, the Basel IV reforms should increase stakeholder confidence in banks’ assessment of their risks.

Basel IV also complements the risk-weighted capital ratio with a finalized non-risk based leverage ratio, as well as a 72.5% capital floor, which is expected to limit the extent to which banks can use their own internal risk models to drive down capital requirements.

Therefore, it is clear that the completion of Basel IV is at least as important as Basel III, if not more urgent. However, as with all other standards agreed to by the Basel Committee, components of Basel IV are not directly applicable in member jurisdictions. Instead, domestic regulatory authorities must transpose the standards into national law.

Different Jurisdictions, Different Speeds of Implementation

Alas, legislative progress towards the implementation of Basel IV across different jurisdictions is moving slower than anticipated, with the exception of the European Union.

In the European Union, the implementation of Basel IV is ongoing through the revised Capital Requirements Regulation (CRR 2) and Directive (CRD 5). This is partially driven by the European Banking Authority’s two subsequent reports recommending full implementation of the final Basel III framework in response to the European Commission`s call for technical advice in 2018. The remaining elements are expected to be announced under the forthcoming CRR3 and CRD6.

Non-EU Basel Committee members have also expressed a firm commitment to full, timely, and consistent implementation of Basel IV; so they are likely to undertake preparations to transpose the related standards into their respective national laws in compliance with the Basel Committee’s implementation timeline.

However, in the absence of regular updates and public information from the respective national regulators in these countries, progress remains uncertain in the wake of the Basel Committee’s decision to defer the implementation of Basel IV.

In particular, it remains unknown whether the rules will be implemented in non-Basel Committee member jurisdictions at all, and if they are, whether this will take place in line with the Basel Committee’s implementation target.

Conclusion

Given the expected disastrous economic impact of the pandemic across the globe, markets are likely to remain in turbulence for years to come. Accordingly, there will be even more need for comparability and consistency in risk measurements across different approaches, jurisdictions, and banks. Neither the Basel Committee nor national regulators should allow COVID-19 to jeopardize the implementation of Basel IV. To ensure a globally consistent and simultaneous completion of the reforms, all stakeholders should act in a coordinated and non-complacent manner.

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